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This has been the year of unpredictability.
The pandemic, including self-quarantining for months, is top of mind for people around the globe. The many other surprises this year include the fastest bear market in history, civil unrest, quite a unique U.S. presidential election, the speedy creation of a coronavirus vaccine and the market hitting all-time highs despite the scary headlines.
Nobody could have predicted how this year would unfold.
With so much uncertainty, the one strategy that will be particularly relevant for investors in 2021 is “investor alpha.” Basically, factor-driven alpha investment strategies are designed to manage risks within a portfolio while also delivering market-bearing returns.
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Many people are familiar with manager alpha, or the additional return a successful portfolio manager can provide above the index. However, with choppy markets and a continuous stream of bad news, it would be wise for investors to focus on the alpha that they can personally generate by being mindful of the below four concepts.
1. Tax efficiency: A tax-efficient portfolio allows investors to keep more of their money. It can be accomplished by utilizing proper “asset location,” a process of having investments located in different types of accounts based on their tax efficiency.
For example, tax-inefficient investments, such as real estate investment trusts and funds with a high portfolio turnover or that generate a high level of income, may be better suited in tax-deferred retirement accounts. Conversely, tax-efficient investment strategies like exchange-traded funds that passively track an index and generate a modest level of income may be better suited in a taxable account.
Another way for investors to minimize their tax liability is to max out their contributions to tax-advantaged accounts. This includes 401(k) plans, individual retirement accounts, Roth IRAs or a triple tax-free health savings account. If one has college-bound children, it may also include a 529 college savings account, which provides federal tax-free growth and tax-free withdrawals for qualified expenses, as well as the possibility of a tax credit or deduction for contributions to one’s in-state plan. Paying close attention to taxes, in addition to investments, may meaningfully increase one’s wealth over time.
2. Savings rate: Over the past decade, the S&P 500 index has experienced an attractive 13% annualized return, several points above the historical long-term 10% average. While all investors are rooting for continued strong performance, it’s prudent to plan for the possibility of lower future growth.
The market moves in cycles and can experience years of relative underperformance. For instance, the S&P 500 averaged -3% annually during the decade ending in February 2009.
One step investors can take in planning for a low-return environment is to increase their savings rate. It’s far more exciting to pick a winning stock or watch the market hit all-time highs. However, simply putting away more money is a more reliable way to meet your financial goals.
3. Automation: One of the hardest things about investing is controlling one’s emotions. When the market plummets, many investors want to sell everything and move to cash. On the other hand, as the market skyrockets many feel the urge to chase high-flying stocks and take an imprudent level of risk.
Instituting a level of automation into one’s investment process is a good way to keep emotions in check and your investment strategy on track. Investors can effortlessly execute this strategy through their employer’s 401(k) plan, where money is automatically deducted from each paycheck and invested in the market. Investors can also sign up for “automatic escalation” of contributions to ensure that they are effortlessly contributing more money every year. The same automations can be set up in a brokerage account by working with your financial advisor.
Another automation is the process of rebalancing, which is readjusting the weightings of a portfolio as an investment goes up or down over time. When a portfolio is rebalanced, the investor is buying or selling assets in order to maintain their original asset allocation. They are also selling high and buying low, which is a way to lock in gains and reinvest the proceeds into investments that have underperformed. Rebalancing can be set up to occur at predetermined times throughout the year or once an investment hits a certain percentage threshold relative to the rest of the portfolio.
4. Portfolio fees: Two of the major recent breakthroughs in the world of investing have been the democratization of investment solutions and the substantial reduction in fees across the industry. Today, U.S.-based investors can get exposure to almost any market in the world for a minimal fee. This exposure can be attained in many ways, including easily accessible exchange traded funds or low-cost mutual funds.
A worthwhile exercise for all investors is to comb through their existing holdings to determine if they can swap out expensive legacy positions for new low-cost investments. While fees are definitely not the only consideration, or even the most important factor, when it comes to accumulating wealth, paying substantially more than industry averages may lower your returns over the course of your investing lifetime.
As we approach year-end, folks can only guess what 2021 has in store for society and the markets. If we learned anything from the past year, it’s that none of us owns that crystal ball that can help us predict the future. However, investors can take solace in the fact that focusing on those items they can control may be sufficient to achieve their financial objectives.
