With the Standard & Poor's 500 Stock Index up 4.89 percent and the Lehman Aggregate Bond Index up 2.41 percent last year, you could be thinking of adjusting your portfolio to improve its performance by taking bigger risks--perhaps more than would be appropriate for you. Given the potential losses inherent in such a plan, the following resolutions may be helpful as you review your investment strategies this year:
- Allocate your assets among bonds, stocks, money-market instruments and funds in proportions that reflect the amount of risk necessary to achieve your goals. In many cases, that may mean your portfolio shouldn't be more conservative "just because" you're older or because that's what a rule of thumb tells you. It should really be about allocating for your particular goals, tax situation, risk tolerance and unique circumstances, and not just because you're at a certain age or point in your life.
- Be wary of recommendations of all-purpose model portfolio asset allocations. While they may indicate how various investment strategists feel about the near-term relative attractiveness of stocks and bonds, they're not taking your particular investment goals and risk tolerance into account. On the other hand, if you don't have the time or inclination to do the necessary initial portfolio construction, disciplined re-balancing and continuous re-alignment over time, you may want to consider "lifestyle" or "life cycle" funds, which perform these functions for you.
- Have realistic expectations about the performance of your portfolio. On average, the years of exceptional returns for stocks are just a memory now. Annual returns below the long-term average of about 10 percent per annum seem more likely in the foreseeable future. With that in mind, understand that the average returns for balanced portfolios are likely to be in the single-digit range.
- Resolve to maximize your net returns by minimizing commissions when buying or selling individual securities and purchasing mutual funds with reasonable expense ratios. When investing in taxable accounts, be mindful of the tax consequences of owning mutual funds that make large taxable distributions of capital gains. Consider placing funds with low turnover ratios that distribute long-term capital gains in taxable accounts and funds that have large amounts of short-term gains distributions in retirement accounts, such as IRAs, 401(k)s, or other tax-deferred accounts.
- When investing for income, resist the temptation to chase high yields. Higher yields are generally associated with higher risk. Plus, with some investments, what appears to be a yield may actually be a return of capital.
- Don't forget about tax-exempt bonds and bond funds. Tax-exempt state or local government bonds or bond funds, whose yields are usually lower than those of taxable issues of comparable credit quality and maturity, may pay more than the after-tax return you'd receive when investing in comparable taxable securities. So do the math and make sure you compare apples with apples--meaning, compare your prospective after-tax income from taxable securities with the return from tax-exempts.
- Accept that there's no shortcut to mutual fund selection. Whether you do it or an adviser does it for you, funds need to be researched to determine if they're suitable for your portfolio. One of the best and most robust sources of research is the prospectus. Data indicating superior past performance--which funds must report in accordance with the Securities and Exchange Commission (SEC)--don't assure you of superior future performance. Neither do ratings, such as the star rating calculated by Morningstar. They may provide the additional dimension of past performance, but, as Morningstar points out, the stars don't have predictive value. Such data constitute the beginning, not the end, of the selection process and provide a first-round screen as to which funds you might want to study further.
- Don't be too impressed by high absolute returns. It's important to compare performance data for a mutual fund with performance data for the relevant benchmark index for the same time period. You can find the appropriate index in the fund's prospectus. For domestic stock funds, the index will generally either be the S&P, Russell or another broad market index. For domestic bond funds, you'll generally see a Lehman Brothers bond index. You should also consider comparing fund returns with the returns of its peer group, as computed by Lipper or Morningstar. By focusing on relative returns, you should get a sense as to whether the fund has performed as well as could be expected.
Finally, always remember that stocks and bonds--and the funds that own them--are long-term investments, requiring patience and the ability to ride out market cycles.
Debra Neiman, CFP, is and principal of Neiman & Associates Financial Services, a financial planning firm and registered investment advisor in Watertown, Massachusetts. She's also the co-author of the recently released book, Money Without Matrimony: The Unmarried Couple's Guide to Financial Security.