Before we get into the topic for this issue, I offer a reminder. If the contents of your inbox resemble mine, it is filled with appeals from charitable organizations seeking year-end contributions. My article “A Guide to Smarter Giving” appeared in MD-Update issue #105. This could be a good time to go back and re-read it.
Now for our current topic: Investments. If you have read this column for very long, you know our work as financial planners begins with goal setting, and that we believe goals should be SMARTER (Specific, Measurable, Actionable, a bit Risky, Time Bound, Exciting to you, and Relevant to other goals and your station in life). However, many people find it difficult to set investment goals that meet these criteria.
When clients have difficulty setting investment goals, I lead them through a guide adapted from the work of Georgetown University’s William G. Droms. He addressed the question of allocation and security selection systemically, i.e., by examining the economic benefits of various investment vehicles and the tradeoffs associated by prioritizing certain benefits over others.
We will examine each one, but first let’s take a little quiz to aid in our conversation. Assume that the economic benefits of an investment portfolio can fit into one or more of the following categories: Liquidity, Tax Benefits, Cash Flow, Moderate Growth, Substantial Growth, and Safety of Principal. You must choose among these benefits and give relative weight to each one by ascribing a value from 0 to 6 and have them all total to 12. See the table below. For example, if Substantial Growth is absolutely the most important objective for your investments, you would score it a 5 or 6. You then have 6 or 7 more points to spread among the remaining 5 categories. They can all go to one of the remaining categories or can be spread among the 5 as you see fit. Zero is a valid entry.
There are two aspects of liquidity to consider. Everyone should have some liquidity (readily available cash) to meet emergencies and to take advantage of opportunities as they arise. If the emergency fund will be part of the investment portfolio, more points need to be ascribed to liquidity. Another way to think about liquidity is the ability to sell an asset and turn it into cash. A building is much less liquid than shares of a widely-traded stock. If there will be a need for cash in the near term, the score you give liquidity might be higher than the others.
Obviously, the higher your tax bracket, the more important tax benefits become. There are at least four tax considerations in your investment portfolio: 1) the immediate taxation of dividends and interest is a cost, 2) short term and long term capital gains tax when an asset is sold is also a cost, 3) tax deferral from saving within a qualified retirement account produces a benefit, and 4) the elimination of capital gains when an asset’s tax basis is stepped-up at the date of death is a benefit that often gets overlooked. Some studies show that tax-efficient investing can add an extra point or two to annual return. Security selection and asset placement (retirement account vs. taxable account) can make a significant difference over the long run.
Cash flow from investments (current dividends, interest, and other distributions) becomes an important consideration for many investors, especially retirees who are counting on their portfolio for income. Usually, but not always, there is a tradeoff between current cash flow and growth. This trade-off can be accommodated by focusing on total return of the portfolio as opposed to its annual dividend yield.
We have included two categories of growth because, while moderate growth may be important to some, more substantial growth may be needed by others to reach their other financial objectives. Choosing one over the other may be driven by the need for return as well as risk tolerance and capacity, either of which could constrain growth. A higher score on substantial growth coupled with more risk tolerance may result in a portfolio that contains leveraged assets or option strategies.
Safety of principal is a category that has a lot of appeal but is difficult to achieve in the short run. It competes with the need for long term growth or certain tax benefits. Safety of principal usually goes along with a liquidity need, but in the current low interest rate environment it certainly works against any form of growth.
The actual scores in this quiz are not nearly as important as the thought process and the advisor–client conversation that comes from working out the answers. Completing the quiz leads to setting meaningful objectives, potentially more optimal asset allocation, and ultimately more satisfaction with the portfolio.
Scott Neal is the president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Contact him via email firstname.lastname@example.org or 1-800-344-9098.