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Sweat the Small Stuff by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research May 16, 2003
“Don’t sweat the small stuff” might be good advice when it comes to life in general, but when it comes to the business of investing, little things can add up quickly to make a big difference at the end of the day. The difference between what you make and what you keep could be significant as fees, expenses, trading costs, and taxes can conspire together to eat away at hard-earned gains. For example:
Fees and expenses. The Schwab Center for Investment Research (SCIR) found that the average mutual fund expense ratio is around 1.5 percent per year. But that’s not the whole story. Less-noticed internal expenses such as trading commissions, spreads and the potential market impact of buying and selling large blocks of shares can add as much as another 3 percent—or even more, depending on the level of portfolio activity. Of course, such expenses can apply to individual stock investors as well.
Income taxes. SCIR found that higher-tax-bracket investors using actively managed mutual funds in taxable accounts lost an average of 2.36 percentage points annually due to taxes from 1981 to 2001. Again, this kind of return lost to taxes can apply equally to individual stock investors who employ an active management style.
Put it all together and you could be looking at nearly 7 percent of return, or more, lost to taxes and expenses every year. That’s quite a built-in hurdle for those hoping to “beat the market.” While it may have seemed doable a few years ago, perhaps the time has come for a reality check—expenses and taxes really do matter in all kinds of markets, especially if a reasonable expectation for the near-term market is in the neighborhood of high single-digit returns. Let’s face it: It’s time to sweat the small stuff.
What can investors do to take back some control and maximize the amount they might get to actually keep? If you’re looking to gain an edge, consider the following:
First and foremost, focus on an appropriate asset allocation and broad diversification. Yes, it’s boring. Who said prudent investing was supposed to be exciting? The best way to take as much control as possible over the inevitable ups and downs is through asset allocation and broad diversification. You won’t end up with everything in the best possible place ahead of time this way, but neither will you end up with everything in the worst possible place at the worst possible time. Give it some serious thought and effort, and you could end up with a solid plan upon which to anchor your goals and objectives—one that could allow you to exercise the discipline so necessary for successful long-term investing.
Keep costs as low as possible. Consider no-load, low-cost mutual funds or a collection of quality individual stocks and bonds you can hold for the long haul. If you already own a high-cost variable annuity, consider a tax-free section 1035 exchange to a no-load, lower-cost provider (be sure to compare benefits and watch out for surrender charges). When considering active money managers, look for those with proven track records. Of course, index funds can do a terrific job of keeping expenses low, and are tax efficient to boot.
Be tax smart. Consider holding tax-efficient equity investments in taxable accounts, and less tax-efficient equity investments and taxable bonds in tax-advantaged accounts—within the context of your overall asset allocation, of course. You might also consider offsetting realized gains in taxable accounts, when you have them, with some proactive capital-loss harvesting. Finally, be aware of your marginal income tax bracket when considering the potential after-tax benefits of taxable vs. tax-free municipal bonds and/or money market funds held in taxable accounts.
Taking control over portfolio allocation, expenses and income taxes might not have seemed so compelling in the past, but such things always matter in all kinds of markets. This is especially so in times of lower returns when the percentage impact on what we actually keep at the end of the day can be felt to an even greater degree. We may not know what the future holds for us, but we do know that now is always the best time to take as much control as possible. So, get your investment house in order today, positioned as prudently and efficiently as possible for whatever kind of market lies ahead.
Schwab Center for Investment Research is a division of Charles Schwab & Co., Inc.
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