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What does it take to be a good long term investor? When it comes to the public markets, it is nearly impossible to be able to time the market consistently. The same goes for being able to consistently outperform the market by choosing individual stocks to beat their respective indices. That is why it essential to focus on what you can control. The three biggest drivers of investment success in the long term are: Limiting Costs, Diversification, and Investing with an After Tax Bias. LIMITING COSTS When investing in securities, there can be different costs that are associated with ETF’s and mutual funds that most often times go unnoticed. It is very important to limit the costs investors don’t always see. Expense ratio- This is the percent charged by a fund for administrative and other operating expenses. Turnover ratio- how frequently the fund trades You don’t see these costs, but (all else being equal) this is coming out of your take home return. To put this into perspective, you could use the analogy of a 100 yard dash. A fund with a high expense ratio would be like starting 10 yards behind the starting line. In this instance, the runner is now forced to make up all that extra ground in performance just to finish even. The same goes with investments that carry high costs- they need to make up the difference in return by outperforming lower cost funds. Funds with high turnover ratios are like running that same 100 yard dash with a parachute on. These funds ‘create drag’ because of all the frequent trading that takes place and incurs extra costs. This drag within certain funds can significantly impact performance, just as it would with a runner competing and trying to keep up in a race while running with a parachute on. THE VALUE OF DIVERSIFICATION It’s a saying we’ve all heard since our early childhood- “Don’t put all your eggs in one basket.” This is the same when it comes to investing and what diversification is in its simplest form. The same way a GM wouldn’t construct a baseball lineup with all 9 hitters that are of the same skill set, a portfolio should not be constructed in a way that all investments are alike. There is a certain role for a leadoff hitter, vs the role of 2nd, 3rd and 4th hitter in the lineup. They usually have different strengths and weaknesses, and they usually hit different types of pitchers differently. The same goes for the different securities within your investment portfolio. Each investment in your portfolio should have a different role. Diversification can dramatically reduce your risks without reducing your expected returns. Take a look at the above graph showing a sample portfolio and the risk/ return of each security. Each security has a specific role within the overall portfolio construction. It is good to invest in uncorrelated assets to reduce your risk-to-return ratio because the different securities don’t always move in the same direction. By diversifying among different asset classes, countries and investment styles you are able to reduce your risk by more than you reduce your expected return. INVESTING WITH AN AFTER-TAX BIAS IN MIND Its also very important take everyone’s tax situation into account when it comes to investing because its about one's AFTER TAX Return. This is the amount that actually goes into your pocket. Taxes account for a 2% annual drag. As I mentioned before, this drag is like putting a parachute on your investment returns. While this might be a good training technique for sprinters, no one wants this drag taking away from their take home returns. Every time you sell and realize a short term capital gain, it is adding extra income taxed as ordinary income. This means for tax payers in the highest tax bracket, they’re paying 37% on these gains. That means theyre losing almost half of what their gains are. Whenever possible, AVOID selling any Short Term Capital Gains. This gain gets taxed as ordinary income versus preferential tax treatment that long term gains get taxed at. Tax Loss Harvesting Tax loss harvesting is the use of investment losses to offset short-term capital gains, long-term capital gains, and even ordinary income taxes. By using capital losses, investors can lower their current tax bills and defer capital gains, helping you keep more of what you earn. So, if you had $20,000 in capital gains and were in the 15% capital gains tax bracket, you would owe the IRS $3,000. However, if you could sell enough other assets to properly generate $20,000 in losses, this would negate your $3,000 tax bill. A successful tax loss harvesting strategy should generate a tax loss in the short run without generating an actual monetary loss in the long run. The strategy involves buying an “alternate security” that behaves similarly, but not identically to the original security. We do this to generate a tax loss without changing your exposure to the underlying asset class. These are a few things to keep in mind when investing for the long term. Remember, it's not just about what you make, but also what you keep.
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Regan Flaherty
CFP®, CPWA®, AAMS®
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