Growing and protecting wealth requires a written financial strategy.

Put it in writing

Written financial plans minimize “equity freak-out,” which occurs when markets turn hyperbolic. Stocks either plummet and tug at you to sell. Or they soar and tempt you to buy into the irrational exuberance. Either way, emotions sometimes trigger choices that damage your wealth.

Knowing what to do is not enough. Even the most seasoned investors make better financial decisions by developing written Investment Policy Guidelines before trouble strikes and emotions take over. To get started on yours, answer our question: What do you want your wealth to accomplish? The more specific you are, the better.

Your goals are where advisory work begins. Most professionals (not just us) consider variables including expected returns, correlations among asset classes, and time horizons. They ask how you feel about risk and, generally, define financial strategies with target asset allocations.

Documents vary among providers, of course. Ours address non-investment details like communication and reporting. But no matter what, clarity is key because you can’t have confidence in what you don’t understand. The best Investment Policy Guidelines translate sophisticated financial strategies into simple actions. They withstand market turbulence, generate buy-in from family members, and promote investment discipline.

Cut out the F.A.T.

Fees, Annual expenses, and Taxes bite into your wealth. But you can minimize their impact. Which is why “Control What You Can” is a core tenet of our investment philosophy — and any successful financial strategy. Below, we mention several third-party resources that can help you root out the F.A.T. in your portfolio. (Or you can hire us to manage your investments and make decisions on your behalf.)

Let’s start by focusing on management fees. If you pay 1% per annum on gross annualized returns of 7% (which is an arbitrary number that we’re using for illustrative purposes), the cost reduces the size of your portfolio by about 25% over a 30-year period, give or take. Now layer on the annual of the funds in your portfolio, say .75% per annum. The combined drag is -1.75% on your gross returns, which reduces the size of your portfolio by about 39%.

These numbers are hypothetical — our calculations at Second Opinion. But you can use FeeX to calculate the actual operating expenses inside your portfolio free of charge. We do not receive compensation for describing it. Nor do we warrant its services. We simply believe FeeX increases financial transparency and is, therefore, worthy of consideration.

Income taxes bite into your wealth too. Morningstar publishes its estimates of after-tax returns for most mutual funds and exchange-traded funds, which enables you to look before you invest. Tax-loss selling is another way to manage income taxes. The simple version: Sell losing funds; use the losses to offset up to $3,000 of ordinary income taxes; and wait 30+ days to repurchase the funds so you don’t trigger the Wash Sale Rule. It voids your ability to apply capital losses against your income or capital gains elsewhere.

Problem. You are out of the market for 30 days. But there is a solution. You can sell the losers in your portfolio, use the proceeds to purchase funds which are similar but not “substantially identical” to them, and remain fully invested. Make sure to speak with your accountant or tax lawyer before implementing this strategy though. There are several subtleties to the Wash Sale Rule, and the penalties for mistakes are costly.

The final way to cut out the F.A.T. is to reduce estate taxes. During 2018, the maximum federal rate is 40%. The federal taxes become a consideration when estates exceed $11.2 million for individuals and $22.4 million for married couples. Many of the 50 states levy estate taxes on much lower minimums. Which makes it critical to get advice from a trust-and-estate lawyer with local expertise.

Get the facts

Is it possible to beat the market? Sure. But few active managers outperform their benchmarks over extended periods of time. Consider the following statistics from S&P Global and Morningstar:

S&P Global

The following statistics come from SPIVA, which is an acronym for S&P Indices Versus Active.

• For the 15-year period ending Dec. 31, 2016, 92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks.
• 88.3% of large-cap managers, 89.95% of midcap managers, and 96.57% of small-cap managers underperformed their benchmarks for the five years ending Dec. 31, 2016.
• And for the one-year period ending on the same day, 66% of large-cap managers, 89.37% of mid-cap managers, and 85.54% of small-cap managers underperformed the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600, respectively.

Morningstar

Funds that beat the market do not stay on top according to Morningstar. According to a report it published in January 2016 (which you can obtain here):

“Of the U.S. equity funds that fell in the top quartile over the trailing three years through March 2015, only 33.5% remained in that top quartile over the subsequent three years. That figure fell to 24.8% in the five-year windows. S&P’s results indicated that performance was more likely to persist on the fixed-income side, particularly over the three-year windows. But even here, the results suggested that many previous top performers fell in the rankings.”

The same research report described the futility of investors or their advisers to pick funds that beat the market consistently, writing “in most cases, the odds of picking a future long-term winner from the best-performing quintile in each category aren’t materially different than selecting from the bottom quintile.”

Active versus passive investing is an ongoing and especially fierce debate. We offer the preceding information to help you evaluate wealth management advice and ask better questions when choosing a financial strategy.