By David Ning | U.S.News & World Report LP – Thu, Jun 26, 2014 1:54 AM AEST
Aiming for perfection is a common desire of investors. Everyone wants to be able to pick the next hot stock or find a risk-free investment that also promises high returns. Many of us spend countless hours contemplating the details of our investments in hopes of tweaking them to be just a bit better. Retirement could be a possibility much sooner if we could just nail the exact mix of bonds and stocks we need at all times. But tinkering with your investments can cause a lot more problems than it solves. The next time you start thinking about changing your asset allocation, run though this checklist first:
Accept that you won’t find the perfect split. It’s not that the perfect split doesn’t exist. There’s absolutely a mix of stocks and bonds that will produce the highest return. The problem is that no one knows what it’s going to be until after the fact. Spending hours computing and analyzing past returns ultimately tells you nothing about what will happen in the future because no amount of back-testing will ever take into account when and how much you will contributein the future and how that’s going to affect your returns.
Always keep tax implications in the back of your mind. Paying taxes on gains reduces your investment returns, which is why you need to be certain any changes you make are going to be worth the significant cost of paying capital gains taxes. What may work in theory won’t be useful to you if there’s a high tax cost to implementing the strategy. For example, there are many valid arguments for adding real estate investment trusts to your portfolio. But REIT income is taxed at ordinary income tax rates instead of the lower capital gains rate. To avoid the higher tax rate it’s often prudent to put REITs in tax-advantaged accounts like IRAs, so that the extra tax cost doesn’t detract from the potential gains of the strategy.
Don’t let theoretical gains lure you into thinking a strategy is implementable for you. With the REIT example, there are tax complications. But the troubles don’t stop there. Many small time investors have to pay for the privilege of investing, and often at higher rates than people who have more money to invest. Let’s say an investment product you want to try charges a bit over half a percent. While that may be reasonable for the type of investment, that’s still significantly more than you would pay investing in a standard S&P 500 index fund. Some investment options even require you to work with an advisor, who will tack on additional fees.
Sleep on any asset allocation changes and only make infrequent moves. I love to tinker, but I have to remind myself that changes are never as good as they seem at first glance. Taxes play a big part, but the bigger danger is that I may be sucked into the latest fad. There are constant claims of great investments, but I know that the most effective choice is one that constantly delivers returns at a low cost year after year. If I can’t stay the course I’ll trigger unnecessary taxes and fees, and may make choices in the heat of the moment that turn out to be far worse than my portfolio would have performed if I just left it alone.
Increase allocation to an asset when it’s underperforming. Investments always appear more attractive after an outsized run up, but history has shown us again and again that all investments have periods of good and bad returns. If we only buy in after a strategy appears to be working and abandon it when the tide turns, then we will always be paying the hotly bid up prices and selling at the lows. When I hear about strategies that I think make sense for my situation, I’m not going to implement them when they are popular and highly priced. Instead, I’m writing them down for consideration later, at a time when they are trashed and available at bargain prices.