As you decide how to invest your money, you face a multitude of questions. What kind of investment do I like? What can get me the greatest return? How much should I invest? Am I conservative or a little adventurous with my money? The list goes on and on.
While we cannot address all of those questions in one article as I do in my book, let’s look at some factors you need to think about as you determine where to put your money. No matter what you do with your investments, there are three main factors that will affect your return no matter where you invest your money:
1. Asset Allocation
Asset allocation is following the old saying of not putting all of your eggs in one basket. You want to balance risk versus reward by having an investment portfolio with a certain percentage of your money going to each investment type that you choose. Your risk tolerance, goals, and investment time frame come into play as you decide on your investments.
The general types of investments to choose from are stocks, bonds, real estate, cash, commodities, and cash-value life insurance. Each of these has pros and cons that will weigh on you depending on what your attitude toward investing is. For instance, investments can have high risk or low risk. You have to figure out where your comfort level is on that score. You also have to weigh the liquidity of your investment. This is how quickly you can convert your investment into cash without losing your principal. That can be an important factor depending if you are investing for the short-term or long-term.
To help balance out your investments, it is a good idea to select a variety of vehicles in which to place your money. Ray Dalio, the founder of the world’s biggest hedge fund firm, Bridgewater Associates is the 25th richest man in America. He has been investing since he was 12 years old and is famous for his “All Weather Portfolio” investment philosophy. This concept balances out the different pros and cons of each type of investment. This “All Weather Portfolio” has produced a 10% return with an average loss of just under 2%. He breaks down the portfolio and suggests you put 30% in stocks, 15% in intermediate-term bonds (7 to 10 years in maturity), and 40% in long-term bonds (20 to 25 in maturity). The stability of the bonds counters the volatility of the stocks. He rounds out the portfolio with 7.5% in gold and 7.5% in commodities. The reason is that you want your portfolio to have a hedge against inflation, and rapid inflation can hurt both stocks and bonds.
While I agree wholeheartedly with Mr. Dalio’s philosophy and asset allocation, my only enhancement will be to use a general account based cash value life insurance as an alternative to long-term bond allocation. It creates tax-efficiency and adds the advantage of death benefits into the equation.
Understanding taxation of your investments is crucial to maximizing returns. There are three tax beneﬁts to any investment: 1) tax-deductible contributions, 2) tax-deferred growth, and 3) tax-free withdrawal of growth.
Most investments such as CDs, brokerage accounts, and savings accounts only have one of these three tax beneﬁts, and that is tax-free withdrawal of growth. If you happen to have a good size of investment portfolio, then the majority of your money will be in this category, where only one tax benefit out of the three exists.
Traditional qualiﬁed plans such as IRA, 401K, 403b, SEP, simple plan, proﬁt sharing and deﬁned beneﬁt pension plans enjoy tax-deductible contributions and tax-deferred growth, but the 100 percent withdrawal will be taxed at the marginal income tax rate after the age of 59.5. If taken before the age of 59.5, there will be an additional 10 percent excise penalty on the entire withdrawal.
The Roth IRA, the Roth 401K, and a cash value life insurance policy such as indexed universal life and whole life (as governed by the IRS Sec 7702) enjoy the tax-deferred growth of the account value, and you can withdraw the entire account tax-free. In the case of Roth plans, the withdrawal should be after the investor turns 59.5 or ﬁve years after starting the plan, whichever is later. For the cash value of a life insurance policy, no such restrictions exist and withdrawals can be made any time.
Two speciﬁc investment vehicles—real estate and municipal bonds—are taxed a little diﬀerently. Real estate primarily allows tax-deferred growth and is tax-free up to a certain dollar limit if it is the primary residence. Municipal bonds’ earnings partially act like Roth plans and the cash value of a life insurance policy. Earnings on municipal bonds are income tax free (only federal income tax unless the investor lives in the same state and/or city of the municipal bond), but the growth in the principal (if any) will be subject to capital gains if it is held more than a year, and ordinary income tax if held less than a year. Tax efficiency is a measure of how much of an investment’s return remains after you pay taxes on it. Tax-efficiency is within reach of most investors if you plan properly and choose the right vehicle. To keep a great percentage of your investment earnings and not raise your tax bracket, choose investments that minimize the tax burden.
There are fees in any investment. In just about every type of investment mentioned here, there are both clearly defined charges and those that are hidden. Sometimes you pay them upfront and in other instances, they come off the earnings as an asset management fees. There could be annual or quarterly fees. You will end up paying anywhere from 1% (100 bps) to 1.5% (150 bps) in total fess including disclosed and undisclosed. There where indexed funds comes in the play. Indexed funds will cost less than 1/10 of 1% or 10 bps helping you keeping most of your return to yourself. If you think money buys better return then that is not true. Over the past 15 years, a whopping 88.97% of domestic mutual funds have underperformed their respective investment benchmarks, in the large-cap value arena, where a “mere” 79.33% have lagged their benchmark. Meanwhile, 98.17% of small-cap growth funds, 97.44% of small-cap core funds, and 96.73% of all small-cap funds trailed their respective investment benchmarks.
Once you know the real return of these various asset classes, you will understand the importance of minimizing fees on your investment as there is not much room. The fees are affecting substantially to your investment return.
The following chart is the comparison of the main six asset classes by the average long-term return, risk category, liquidity, and tax efficient yield. Expenses are not listed since that variable fluctuates greatly between companies. Once you understand the real return potential from following table, the role of expenses become very important. We believe in no-load index funds for your stocks, bonds and commodities allocation.