Ferri: 5 Ways To Improve Your Portfolio

Although it's not rocket science, the basics of investing can be hard to stick to.

Experienced investors know what makes a portfolio work. The keys to success are contained in a few timeless concepts that, if followed religiously, will lead to the best outcome. These five “reminders” will help you focus on the big picture and avoid the noise.

These ideas are not new. You’ve seen and heard them before. I gathered these five tips from my All About Asset Allocation book and previous writings. I also found this white paper helpful: Vanguard Principles for Investment Success.

1. Asset Allocation: A portfolio’s asset allocation—the percentage invested in different asset classes such as stocks and bonds according to the investor’s financial situation, risk tolerance, and time horizon—is the most important factor in determining the expected long-term performance and return variability of a broadly diversified portfolio.

A sensible investment plan begins with an individual’s long-term financial goals. These include a savings and spending strategy, an assessment of risk tolerance and risk needs, time horizon, and an emergency fund. This information is used to determine a required rate of return, which in turn leads to a prudent long-term asset allocation between risky assets (stocks), less risky assets (bonds) and no risk assets (cash). See All About Asset Allocation for more details.

2. Rebalance: After selecting an asset allocation for a portfolio and implementing it, it’s vitally important to maintain that allocation through time. Different investments generate different returns over time and a portfolio will drift from its target allocation. This creates different risk-and-return characteristics that aren’t appropriate for your needs. The goal of a rebalancing strategy is to maintain targeted risk rather than maximize return. Rebalancing puts a portfolio back on track.

3. Control cost: “Costs matter!” John Bogle, the founder and former Chairman of Vanguard, has probably said this a million times. Every dollar paid for management fees, trading costs, and taxes is a dollar less of potential return. The cost of an advisor also matters. The more one pays for advice and investment management, the less one earns in one's portfolio.

Mutual fund costs can be a large component of overall expenses. Low-cost index funds and exchange-traded funds that track market indexes are an excellent way to keep fund expenses down.

4. Manage taxes: Taxes can be the highest expense in a portfolio and should be managed. Tax management falls into three categories: asset location, tax-loss harvesting, and withdrawal strategy in retirement.

Asset location is the practice of allocating different investments across different types of accounts based on tax efficiency. Basically, the idea is to put the most tax-efficient investments in taxable accounts and the least tax-efficient investments in non-taxable or tax-deferred accounts. Although this strategy is widely heralded in the media and by investment advisors, I find it has pros and cons. I lay out the case for both sides in Does Asset Location Make Sense?

Tax-loss harvesting is a way to make an investment portfolio work harder by generating potential tax savings. An investor takes advantage of investments that have declined in value by selling at a loss, which could generate a tax deduction and lower the investor’s taxes. An alternative fund can be purchased to replace the asset class in the portfolio. The tax-loss can be used to offset future gains, and up to $3,000 per year can be used to offset ordinary income. Consult your tax advisor for details.

Withdrawal order is a tax-management strategy for retirees. Most people fund many types of savings accounts over their lifetimes. These may include, but are not limited to, a tax-deferred IRA, 401(k), tax-free Roth IRA, taxable personal savings account, etc. Each of these accounts has different tax consequences for withdrawal of assets. A smartly planned withdrawal strategy can save a retiree a lot of money in taxes.

5. Discipline: Most investors are aware of the first four time-tested principles I’ve listed, but the hardest part of investing is sticking to them in the best and worst of times. Abandoning an investment strategy can be costly, and research has shown that some of the most significant harm is done to a portfolio when investors attempt market-timing or chase the performance of a hot sector.

The most important element of a well-managed investment strategy is discipline. Investing can become emotional during bear markets and bull markets. Successful investors maintain a long-term perspective and a disciplined approach through all market environments. A second John Bogle quote that he’s repeated a million times is, “Stay the course!”

Setting an asset allocation to your needs, rebalancing to control risk, minimizing cost, managing taxes, and maintaining discipline are the five keys to long-term investment success. They’re the core of prudent investment strategy. All else is secondary.

This blog, which first appeared on Rick Ferri’s blog, is part of a regular series of articles on ETF.com featuring some of the most influential voices in the world of index and passive investment. Ferri is the founder of Portfolio Solutions, a Michigan-based registered investment advisor with about $1.2 billion in assets under management.