ACTION Framework

How you divide up your investments is called your asset allocation. You could invest in only one or a combination of cash, bonds, stocks and alternatives. The point is that you can control how you deploy your assets. Asset allocation is the most important part of an investment plan. An allocation and how it is managed can have a significant impact on your retirement lifestyle. Here’s our plan for asset allocation:

• Know the purpose of the portfolio. Is the purpose for growth, principal preservation, income, etc.? For what time frame? Two different goals and time frames (funding college in 5 years and retirement in 20) may warrant two different portfolios. The purpose of the portfolio drives its construction.
• Determine an appropriate stock-to-bond ratio. The first step of construction is based on the purpose of the portfolio (what level of returns or income is needed) and personal factors (comfort level, experience, etc.). Risk tolerance is assessed from initial and ongoing conversations, not a one-time questionnaire. The stock-to-bond ratio that is developed serves as the foundation of the portfolio and helps determine its risk level.
• Know what adds value. A mix of an S&P 500 fund and a broad bond fund is a good start, but there are other investments that can add value to the portfolio. Research suggests that small-cap stocks, value stocks and companies with higher profitability tend to outperform the S&P 500 over time. Technology and thematic funds may also help deliver better performance. International stocks and REITs deliver equity returns, but add some diversification. Bonds and alternatives (commodities, etc.) deliver the best diversification to stocks. Bottom line: only add an investment to a portfolio if it increases expected return, or decreases volatility
• Construct a broadly diversified allocation for the overall portfolio. An investor may have multiple accounts, but a single overall allocation should be used to tie them together. This holistic view can reduce confusion, costs, and taxes of managing a separate portfolio for each account.
• Recognize constraints on the portfolio. Constraints such as limited 401(k)/403(b) investment options, taxable positions with low cost-basis, employer stock options, and investments with surrender charges need to be addressed with strategies on a case-by-case basis.
• Determine asset location to maximize tax efficiency. Place tax-inefficient investments in tax-deferred accounts and tax-efficient in taxable accounts. This goes beyond "put bonds in an IRA and stocks in a taxable account". There can be wide variations in tax-efficiency within stock and bond asset classes. Our Asset Class Tax-Efficiency Rankings allow for further fine tuning.
• Select appropriate investment options. Avoid individual securities. Mutual funds and ETFs are much more diversified. Select investments that represent their respective asset classes well. Preferred investments are passive (index funds), very low cost, and have a large number of holdings.
• Implement portfolio in the most cost- and tax-efficient manner. Keep transactions to a minimum (a good portfolio design should do that). Control the tax impact on sales of existing holdings that won't be included in the portfolio.
• Manage it. "Buy-and-hold" investing implies a "set it and forget it" mentality. Allocations can stray and opportunities can be missed with that approach. Instead, practice "buy, hold, and manage." Management requires rebalancing at both the stock-bond level and at the individual asset class level based on certain tolerances. It requires an eye on taxes (what taxable income and gains is the portfolio generating, and are there any opportunities to offset these with losses?). It includes managing ongoing contributions and purchases, or distributions and cash management. Management also includes monitoring performance, implementing certain strategies (withdrawal for retirement income, portfolio constraints, investing cash windfall, etc.) and staying abreast of new research and investment options.

Cost containment is an essential element of successful investing. The lower your costs, the more return you get to keep. Commissions, advisory fees, expense ratios, transaction fees, and bid-ask spreads can all add up to some serious money. Here's our plan:

• Avoid commissions. Commissions are expensive and lead to conflicts of interest. In today's market, there are plenty of no-load investment options.
• Advisory fees must be competitive and add value. There is a cost to electing investment management services. Value must be derived in some manner (potential increased returns, potential tax savings, convenience, time savings, less worry, etc.) or it is not worth the cost.
• Use funds with low expense ratios. Expense ratios cannot be avoided, so they should be minimized. There are plenty of great investment options with very low expense ratios.
• Minimize transaction fees. Use a "buy-and-hold" approach to avoid frequent trading. Go direct to a fund company. Use ETFs without transaction fees (available at some discount brokers).
• Avoid higher bid-ask spreads. Use well-known ETFs that have a higher trading volume to minimize the difference between the buy price and the sales price.

Tax-efficient investing is about finding the right balance between minimizing current taxes and future tax liabilities. Here's our plan:

• Use proper asset location. A portfolio designed using an overall allocation for multiple accounts allows for better tax-efficiency. Pre-retirement portfolios usually place high growth assets in Roth IRAs, tax-efficient growth assets in taxable accounts, and tax-inefficient assets in tax-deferred accounts. Retirement portfolios will vary due to the withdrawal needs, assets, and tax situation of each person.
• Don't just max out your 401(k) or 403(b). Having only tax-deferred accounts in retirement could present a tax nightmare. Forgoing an immediate tax deduction (Roth IRAs, taxable accounts) provides for better tax flexibility in the future.
• Use a buy-and-hold approach. Frequent trading in a taxable account could result in more taxes. The more taxes you generate, the lower your after-tax return. Only trade when necessary.
• Buy investments with low turnover. The investments you buy should also practice a buy-and-hold approach. Active trading within a fund usually leads to lower return and higher taxable distributions (if held in a taxable account).
• Sell smart. Make sure sales in a taxable account are long-term gains. When rebalancing, try to make trades in tax-deferred or tax-free accounts to avoid taxable gains.
• Review taxable accounts for losses throughout the year. Tax-loss harvesting is not just a December activity. Tax losses should be taken whenever they are available, even if no gains exist yet.

Consistent savings into your portfolio has many benefits. Regular inflows can help you reach your financial goals faster, and help your portfolio stay balanced, reduce its risk, and lower transaction costs. Here's our plan:

• Use the power of time and savings. With the "Rule of 72" you divide the expected rate of return into 72 to see how long it'll take for an investment to double (72/8% = 9 years). The "Rule of 72 + You" adds your savings to the equation and demonstrates how you can accelerate these results.
• Use ongoing contributions to maintain your portfolio's balance. Just like an old-fashioned lawn sprinkler needs to be moved around to prevent over-watering, ongoing savings work the same way. Periodically review what investments are being bought and if any changes need to take place. This can help save time and costs of rebalancing through buys and sells.
• Shift your asset allocation with ongoing contributions. Similar to above, but ongoing savings are used to slowly move a portfolio to a more conservative allocation (move from a 60-40 to a 55-45). Don't forget about dividend reinvestments. They are contributions too.
• Avoid dollar-cost averaging into ETFs and mutual funds if you're going to be hit with transaction charges. Most low-cost, no-load mutual funds and ETFs trade with a transaction fee at discount brokerages. Decrease transaction charges by saving up 4-6 months worth of contributions before you buy a fund.
• Larger windfalls should be handled according to your comfort level. Some people may prefer to just deposit the whole amount while others may want to utilize periodic purchases to ease into the market. Lump sums usually perform better, but dollar-cost averaging tends to avoid bad timing. Comfort is key.

Just like with inflows, outflows provide opportunities to rebalance and manage the portfolio. However, if you're taking distributions, you are likely retired, and the bigger concern is how to create adequate and sustainable income for the rest of your life. Here's our plan:

• Retirement income planning is unique for each person. Rules of thumb may work in other areas of financial planning and investing, but not with retirement income. Financial goals, assets, income needs, ages, and life expectancies all play out differently for people. The retirement plan drives the investment decisions.
• Have a withdrawal plan. Withdrawals should not be random, they should be part of an overall plan. The plan should 1) provide for a smooth and predictable income stream, 2) insulate the cash flow from market volatility, 3) shield the portfolio from untimely cash needs, 4) opportunistically replenish cash and rebalance the portfolio, and 5) provide for tax flexibility.
• Withdrawal rates are not static. Withdrawal rates have to respond to market conditions and the health of the retirement plan. If the plan is going well, more withdrawals may be OK. However, withdrawals may need to be lowered if it is not. Age also plays a factor in appropriate withdrawal rates.
• Don't overlook the option of annuitization. Some people are dead-set against annuities or not aware of what's available. For the most part, that's fine. Variable and fixed annuities usually don't make a lot of sense. However, annuitization (turning a portion of your assets into a lifetime stream of income – like a pension) should at least be considered, especially for very risk-averse investors.
• Distributions allow for portfolio rebalancing. As cash is withdrawn, sales are needed to replenish the cash. Review portfolio's asset allocation. Investments that are over-weighted could be perfect for trimming back. Not only do you free up cash, but you also rebalance the portfolio.
• Consider taxes. Sales in taxable accounts may create taxable gains. Review accounts for offsetting losses. Distributions from tax-deferred accounts are taxed as ordinary income. Taxes need to be considered and accounted for on all withdraws.

The last, and probably the most difficult step of a successful investment plan is to control your nerves. You can't control the direction of the market, but you can control how you react to it. Your behavior can dramatically affect your investment results. Here's our plan:

• Don't be fearful. Fear decreases returns. Too many people move out of stocks after they've gone down. Sitting in cash or an ultra-conservative portfolio "until things look better" practically guarantees missing out on the returns of a market turnaround (i.e. 2009-2010). Investing is a long-term endeavor. Take tax losses in down years to set up "free" capital gains in good years.
• Don't be greedy. Greed increases losses. Too many people throw caution to the wind after the market has gone up. Abandoning your diversified target allocation in favor of more stocks or a "hot" investment is a recipe for magnified losses. Enjoy your gains by taking some off the table (i.e. rebalancing).
• Don't be naive. There is no such thing as a no-risk, high-return investment. If it sounds too good to be true, it is. If you're unsure about an investment, seek a 2^nd or 3^rd opinion.
• Relax. You can't do much more. Take comfort in the fact that you are utilizing a similar, if not better, investment approach than most people and even professional advisors.
• Recognize your biases. Investing is more of a mental game than anything else. In fact, a relatively new field has emerged that is devoted to the mental challenges of investing — Behavioral Finance.