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6-Steps to an Excellent, Passive, Low Cost, Investment Portfolio Thumbnail

6-Steps to an Excellent, Passive, Low Cost, Investment Portfolio

Passive Investing

Why do retail investors waste their money trying to beat the market by investing in high cost managed mutual funds or broker provided portfolio managed funds? The average cost of a managed equity mutual fund is 1.49% and wrap account arrangements from brokerage managed funds is in the range 1.5% to 3% of assets under management (AUM). Vanguard provides a variety of indexed mutual funds and ETF’s for .06% to .30% of asset value.  Does the difference in the cost (expense ratio) matter??

I recently attracted a 62 year old client who had a brokerage account worth $1M being managed by a large brokerage firm under a wrap account arrangement. The brokerage was charging this person 1.5% or $15,000 a year to manage the money. My client was frustrated because the domestic equities were not returning as much as the S&P 500 index  and the bonds were underperforming the applicable bond market index ((Barclays Bond Index) while taking the same amount of market risk. We moved his account to a discount brokerage and changed his investments to low cost, tax efficient index funds with an asset allocation more suited to the client’s personal risk tolerance and life situation. The client now has better peace of mind, better index tracking and is paying less than ½ the investment management fee that he was paying at “big brokerage”. Saving $7,500 a year over 25 years at a return rate of 6% is $411,484 of extra money for retirement.  Yes, it does matter, significantly!

Aust Financial Advisory (AFA) believes in the efficient market theory of investing. This means that the developed world stock markets efficiently process information and immediately reflect the prices of new information immediately in each individual stock. The implication is that the market prices of companies are immediately priced into the stock price so it is futile to stock pick or to try to beat the market. As matter of fact, Nobel winning academic research and studies has shown that over 10 to 20 years, 67% of managed mutual funds do not perform as well as their performance market index benchmarks. These same studies have shown that the cost of investing is the major determinate of fund performance. The conclusion to this vast amount of research is that low cost, diversified market index investing has the highest probability of achieving individual financial goal targets.

An intelligently constructed individual portfolio should consider the following criteria:

  1. Time- Time is the most important factor in determining the make-up of the assets in the construction of a portfolio. When will the money in the portfolio be needed for a financial goal?
  2. Occupation- Are you employed by a business that is highly cyclical such as real estate or one that is more resilient against market cycles like the heath care business.
  3. Risk Tolerance- “Are you a Stock or a Bond” What is your personal tolerance for risk. When markets are rising, people tend to not concern themselves with risk, it is when markets contract, like in 2001 & 2008, when we are confronted with our aversion to risk. Stocks are approximately 4 times more volatile or risky than Bonds.
  4. Expected Returns- What are the returns that you require to meet you financial goals in the future. The 6 month U.S. Treasury Bill rate, which is currently yielding .14% annually, is the baseline for a risk free asset. If we need a higher expected return we must invest in riskier assets to get to our financial goal number. Over the last 75 years, Bonds have yielded 5.6% and stocks, a volatile/risky asset class, has returned on average about 9%. Your expected return and the other factors will help determine our asset mix. Never take risk you do not need to take.
  5. Asset Class Preference- Based on all of the other criteria, we determine the asset class preference for the portfolio. It is prudent to only take risk for which we need to take and will be compensated for taking. If a client already has all of the money they need to fund a comfortable retirement over their expected life span, it would be imprudent to have a portfolio that is equity/stock heavy (riskier). This is taking risk that the client doesn’t need to take.
  6. Tax Status- AFA uses Electronic Traded Funds (ETF) and low cost mutual funds to construct portfolios for our clients. We look for funds that have low portfolio turnover and operate tax efficiently. Additionally we optimize asset location to optimize the tax treatment of your different account types. Tax deferred accounts such as IRA and 401K account should hold assets that generate ordinary income distributions and taxable accounts should hold more tax efficient equity funds that generate foreign and domestic qualified dividend income.

To construct a proper investment portfolio it is imperative for us to know our clients well. AFA portfolios are low cost, risk appropriate, tax efficient and appropriately diversified based on your individual criteria. We recommend you have us construct your portfolio and monitor and rebalance it over time. As a holder of the Accredited Investment Fiduciary® (AIF®) we us the FI360 methodology suggested for prudent investment fiduciaries for constructing and monitoring our client portfolios.