Staying on Track: The Five Technical Principles of Financial Success

When it comes to your financial future, there are things you cannot control such as the stock market, the economy, or major world events. To increase your odds of financial success, I believe it is more important to focus on the things you can control. My Five-by-Five formula for reaching your financial goals includes five behavioral and five technical principles you can control. Today we’ll look at the five technical principles.

Have the Proper Asset Allocation
Asset allocation pertains to how your portfolio is divided among asset classes, i.e. equities (stocks) and interest earning (cash and bonds). I believe having an appropriate asset allocation can help people control their emotions during the ups and downs of the markets. For example, assume someone has 80% of their portfolio invested in equities but is unable to sleep at night, constantly worries about their investments, and then sells when the market goes down 20%.

This person has likely exceeded their risk tolerance. By selling every time the market goes down 20%, this person is sabotaging their financial plan. Having plenty of cash available to see you through downturns in the markets and for emergencies is also key to long-term success.

Be Properly Diversified Within Asset Classes
Within each of the asset classes, it is important to diversify among different types of investments. For example, I believe the equity portion of the portfolio should be divided among US-based small capitalization, mid capitalization, and large capitalization stocks, as well as international stocks from developed countries and international stocks from emerging market countries. I believe the interest-earning portion of the portfolio should be divided among cash (and cash equivalents), treasury bonds, and corporate bonds.

At any one time, nobody knows which investments are going to do well or struggle economically. Instead of guessing which type will do well, I believe it is better to diversify across many different types of investments. This spreads the risk around. At different times, different investments in the diversified portfolio will be doing better or worse than other investments.

Rebalance Periodically
Over time, a portfolio will drift from its original asset allocation. When this happens,  adjustments need to be made to get it back in alignment. For example, assume an investor starts out with an asset allocation of 60% equities and 40% interest-earning assets. Also, assume that the equity markets do well over time and this investor’s asset allocation drifts to 80% equities and 20% interest-earning because stock prices increased in value while bonds went down in value.

To get back to the original asset  allocation, some equities could be sold and the proceeds added to the interest-earning part of the portfolio. Why is it important to rebalance? Asset allocation drift changes the risk and as a result, the portfolio may no longer align with the investor’s risk tolerance or risk capacity.

Be Tax Aware and Tax Efficient
When I meet with prospective clients the first time, I ask them to bring their last three years’ tax returns to the meeting. I do this for several reasons. Not only do I learn more about them both personally and financially, but sometimes I find an opportunity to help them correct  an error in their tax return that will save them money.

Often, when I meet a new prospect I learn that they experienced an unexpected tax surprise in a recent year and paid a large tax bill to the IRS. This happens when  someone is not aware of their tax situation until it is time to file a return. I believe it is important to proactively manage the tax bill and avoid unexpected surprises.

I tell my clients that almost every financial decision they make has an impact on their taxes. When drawing money out of an IRA, selling investments in a brokerage account, buying or selling a house or other asset, it is important to know the effect on taxes. Proper planning can help identify opportunities to legally reduce or eliminate taxes.

Keep Expenses Low
In general, I believe in investing in low-cost passive index mutual funds and ETFs. Historical data shows that over long periods of time, actively managed funds do not consistently outperform the benchmarks they are trying to beat. Index mutual funds and ETFs generally cost less than actively managed funds.

As an example of the cost savings that can be achieved, if $500,000 were invested in a portfolio of actively managed mutual funds with an average expense ratio of 1%, the annual expenses on the portfolio would be $5,000. If $500,000 were invested in index mutual funds with an average annual expenses would only be $500. Over time, these savings add up.

Source: Steven Clark, CPA, EA Coconut Creek, FL