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How To Intelligently Invest for Stable & Consistent Returns

Part 2

Equitable Divergence is a series of papers written by our Chief Investment Officer. Every quarter a new paper in the series will be released. All papers in the Equitable Divergence Series are free.

Welcome to Part 2 of our Equitable Divergence Series. We hope you enjoyed Part 1!

In Part 1 we discussed ways to invest for stable and consistent growth through diversification, rebalancing, and asset allocation. This week will be along the same lines, but will be very interesting for those looking to plan for their future. The investment strategies discussed below can easily be put into action today.

Without further adieu please enjoy Part 2 of the Equitable Divergence Series.

Fees & Taxes – The Silent Killers

Fees are on everyone’s minds, and it’s easy to understand why. The fact of the matter is, there’s no better time to be an investor. With the advent of Exchange Traded Funds (ETF) and extremely low trade costs almost anyone can have an investment account with less than $100. But, there are still some potholes we all need to watch out for.

For instance, Mutual Funds have taken it to the chin recently as assets have poured out of these investment vehicles for lower cost options. Most investors think that a mutual fund’s expense ratio (ER) is their true cost of ownership. That would be incorrect. There are actually three more layers of fees beyond the ER. These consist of advisory fees and administrative expenses, while the third layer of fees is commissions on transactions. These fees are not included in the ER, but they are still required to be reported.  

Many active mutual funds tend to turn over their investments frequently. Excessive trading reduces profitability. While it’s probably not the best idea to own actively managed mutual funds in general (there are exceptions of course) it’s even worse to own them in taxable accounts for a couple different reasons. First, because of their high turnover. Second, because actively managed mutual funds have higher distributions of capital gains which are taxed at your capital gains rate at both the federal and state level. In contrast, an index fund or ETF allows your capital gains to grow largely undisturbed until you sell the ETF.  There’s one more factor to consider as well. Most actively managed mutual funds are purchased because of their superior performance, but this outperformance never persists. Once these managers start missing the mark investors tend to turn over their mutual funds once every several years. This produces more unnecessary capital gains and taxes. Understand what you are buying before you buy it!

Below, Exhibit A shows why fees matter. Consider you have a $100,000 investment account and over the course of 30 years you generate 6% annually. Let’s also assume that you have two choices. You can invest in a mutual fund that charges 1.5% or an ETF that charges 0.35%. The difference between returns is staggering. The ETF after expenses returns $520,098, while the Mutual Fund returns $374,532 after expenses. There are aren’t many active managers with the skill to make up that gap in returns.

Value Averaging

Many people use dollar cost averaging (DCA) versus value averaging (VA). There are significant differences in each of these methods, although both are beneficial. If you use DCA you are investing a sum certain amount of money every month no matter what. For example, you may decide to contribute $100 per month to your IRA, so at the end of the year you contributed $1200. In value averaging (VA), instead of blindly adding $100 per month, one draws a value-averaging path, consisting of a target amount, which increases by $100 each month. In other words, you may aim to have $100 in the account in January, $200 in February, and so forth, out to $1,200 by December of the first year, and $2,400 by December of the second year. Sounds similar to DCA, right? But here’s the difference: in the case of VA we are not simply investing $100 per month; this will happen only if the fund does not change value. If the fund value declines, then more than $100 will be required; if the

fund goes up, then less will be required. It’s even possible that if the fund value goes up a great deal, no money at all will have to be added in some months.

There are many strengths to VA as an investment strategy. For instance, the investor is investing at both market lows and market highs. In other words, one buys many more shares at the low point than at the high point, which produces significantly higher returns. It also provides the investor with the experience of investing regularly during times of market pessimism and fear, which is an extremely useful tool in an investor’s toolbox. The major benefit of VA versus DCA is that VA requires investing larger amounts of money at market bottoms than at market tops, increasing returns even further. It’s an incredibly easy strategy that will produce higher consistent gains in the long term.

The Power of 4 and 72

Most individuals decide to retire at some point in their lives, although people are living longer and working longer. There are TONS of articles on retirement and how to best prepare for retirement. Many of these articles have practical and actionable advice. Many do not. If you stick with the math we lay out below it can save you a ton of time and headache in figuring out how much you need for retirement. This is not meant to be the holy grail of retirement, but if you understand these concepts, reaching your retirement goals will be a confident journey.

Take this example: a reasonable estimate for the real return of a mixed stock and bond portfolio is somewhere in the neighborhood of 4%. That means that you should be able to spend 4% of your portfolio each year while maintaining value indefinitely.  If you can live on 4% before tax savings, and you can shelter almost all of your retirement money in a Roth IRA (which do not require “required minimum distributions” after 70 ½ years of age) then you are guaranteed success for up to 30 years!

So, let’s do a case study on what we laid out in the previous paragraph. Let’s say that in retirement you need $80,000 in annual income outside of your social security benefits. As we mentioned above, a reasonable estimate of a mixed stock and bond portfolio is somewhere in the neighborhood of 4%. This means that you should be able to spend 4% of your portfolio each year while maintaining its real value indefinitely. If you can maintain the real value of your portfolio, so too can you maintain the real value of your withdrawals. So, let’s plug in some numbers to this calculation:

Required Savings  =  income requirement/real investment return

In our case = $80,000/0.04.

As such, a conservative estimate is that you will need $2,000,000 in assets to retire comfortably. Now, that wasn’t so hard was it?

Let’s take a quick jaunt back to fees and do some math on the importance of knowing how expensive your investments are. If your retirement account or 401(k) plan uses the typical assortment of mutual

fund choices bearing a 1-2% total expense, then you may need up to twice as much ($80,000/.02 = $4,000,000) in retirement savings than if you had used low costs ETF options. This calculation emphasizes the extreme importance of attention to expense. In our situation, 2% of additional cost translates into a doubling of your retirement savings account. That’s an eye opener!

Additionally, the Rule of 72 is a helpful tool as well. This tool allows you to estimate the length of time an amount of money takes to double. To calculate simply divide an investment’s assumed growth rate into 72. For example, if a stock has an assumed growth rate of 6%, your money will double in 12 years (72/6 = 12).

About The Author:

Jason C. Hilliard, J.D. is the President and Chief Investment Officer at Forecast Capital Management. Jason has been involved in the financial markets for two decades, which started at the Chicago Board of Trade in the 30-year bond pit. He was coached by some of the most successful bond traders at the time. In 2011, Jason decided to fuse his educational background as an attorney with his practical experience as a professional futures trader and investor in order to provide clients a better service and investment strategy than was currently provided in the market. Jason has been quoted in major publications and books including Bloomberg, Infusionsoft, and Wall Street Kitchen by Victor Chiu.