In our last post we briefly discussed seven principles of long-term investing. Beginning with this post, we will take a deeper look at each. Before we do, however, let’s remind ourselves of the seven principles:
- Total Return on Investment
- Don’t Chase the Crowd
- Remain Flexible and Diversified
- Buy Value
- Manage Risk
- Learn from Mistakes
- Monitor your investments
Total Return on Investment
The word “total” is not to be taken lightly. In fact, it is the operative word in this principle, because there is more to the ROI (return on investment) than the daily gains and losses your investments experience. It’s human nature to focus on the daily activity, but there are other factors lurking that can eat away at your portfolio. You rarely, if ever see them, but the damage they can do is not insignificant.
The three most insidious are taxes, inflation and fees.
If you are not accounting for these three, then you are not accounting for the total ROI of your portfolio and, in doing so, are missing a major piece of the picture that could lead to considerable financial pain when you retire.
On the surface, fees may seem less onerous than taxes and inflation, and you can certainly look at them in that way, but they do add up. Even at 1% you are paying $1,000 for every $100,000 invested. That may not seem like much, but that fee comes right off the top regardless of how well your portfolio has performed.
Fees structures vary depending on a few factors. If you have a professional managing your investments, you can count on paying a flat 1%-2% fee on the balance of your accounts.
You can avoid that percentage by managing your own accounts, but beware that there you will likely be paying fee for every transaction you make.
The bottom line with fees is to do your homework, ask the questions and make your decision based on what you are most comfortable doing.
When it comes to paying taxes, we all want to keep as much of what we earn as possible. When it comes to investing, there are a few ways taxes can reduce the value of your portfolio each year with taxes on capital gains, dividends and income (from taking distributions).
Whatever your investment strategy, you need consider the tax burden with the goal, of course, of keeping as much of what you earn as possible. Don’t take this to mean that taxes should drive your investment strategy. On the contrary, like all other variables, it is something to keep in mind. There are two things to consider here, tax efficiency and tax-deferred investments.
By incorporating a tax efficiency plan into your investments, you will reduce the burden of capital gains, dividends and income taxes. If you use a tax deferral plan, your investments will grow tax free, paying taxes only on the money you withdraw.
As always, study your options and create a plan that balances your goals with your risk tolerance.
Of the three portfolio eaters, inflation is the worst. While fees and taxes also reduce the overall value of your investments, at least you can see them on your statements and tax forms. Inflation is different. It’s constantly at work, but you can’t see it. There is no box for it on your monthly or annual statements. So how do you account for something that can’t be seen. Let’s start by doing a little math.
We’ll start with a portfolio of $100,000 and an annual inflation rate of 4 percent. In ten years, that same $100,000 will have the purchasing power of $67,500. If you want $100,000 in today’s money to be worth $100,000 in 10 years, the real value of the account will have to grow by 48% to $148,000. Oh, and we aren’t including fees and taxes in this total, so it will need to be much higher.
Part of your strategy must include investment vehicles that will appreciate enough in value to overcome the rate of inflation, which has averaged 3.2% over the last century. Equities such as common stock have proven to be good performers over time. They do open you up to more of a tax risk, but putting too much in fixed-income securities, leaves you exposed to inflation because they don’t grow at the rate of equities.
Total return on investment is where your focus should be when calculating the value of your investments. Accounting for fees, taxes and inflation will give you a better picture of the health of your portfolio and better visibility into your future standard of living.
As always, do your research and think about your decisions in terms of where you are in terms of timeline to retirement and your comfort level in terms of risk.