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1. Better Diversification
Typically, the average investor who buys stocks tends to have a poorly diversified
portfolio. There is often a concentration in sectors or types of stocks with very similar
risk characteristics. Using an ETF to buy a core position provides instant diversification
and reduces overall portfolio risk. (For more insight, read The Importance Of
Diversification.)
But you could diversify even further because there are many risks that affect both rail
and air because each is involved in transportation. An event that reduces any form of
travel hurts both types of companies - statisticians would say that rail and air stocks
have a strong correlation. Therefore, to achieve superior diversification, you would want
to diversify across not only different types of companies but also different types of
industries. The more uncorrelated your stocks are, the better.
It's also important that you diversify among different asset classes. Because different
assets - such as bonds and stocks - will not react in the same way to adverse events, a
combination of asset classes will reduce your portfolio's sensitivity to market swings.
Generally, the bond and equity markets move in opposite directions, so, if your portfolio
is diversified across both areas, unpleasant movements in one will be offset by positive
results in another.
There are additional types of diversification and many synthetic investment products
have been created to accommodate investors' risk tolerance levels; however, these
products can be very complicated and are not meant to be created by beginner or small
investors. For those who have less investment experience and do not have the financial
backing to enter into hedging activities, bonds are the most popular way to diversify
against the stock market.
Unfortunately, even the best analysis of a company and its financial statements cannot
guarantee that it won't be a losing investment. Diversification won't prevent a loss, but it
can reduce the impact of fraud and bad information on your portfolio.
How Many Stocks You Should Have
Obviously owning five stocks is better than owning one, but there comes a point when
adding more stocks to your portfolio ceases to make a difference. There is a debate over
how many stocks are needed to reduce risk while maintaining a high return. The most
conventional view argues that an investor can achieve optimal diversification with only 15
to 20 stocks spread across various industries. (To learn more about what constitutes
a properly diversified stock portfolio, see Over-Diversification Yields Diminishing
Returns. To learn about how to determine what kind of asset mix is appropriate for your
risk tolerance, see Achieving Optimal Asset Allocation.)
Summary
Diversification can help an investor manage risk and reduce the volatility of an asset's
price movements. Remember though, that no matter how diversified your portfolio is, risk
can never be eliminated completely. You can reduce risk associated with individual
stocks, but general market risks affect nearly every stock, so it is important to diversify
also among different asset classes. The key is to find a medium between risk and return;
this ensures that you achieve your financial goals while still getting a good night's rest.
Read: 2. Improved Performance
2. Improved Performance
It is widely accepted that a large portion (more than 50%, by most accounts) of
professional money managers underperform the stock market. The average individual
investor typically fares worse. An investor who sells some stocks and replaces them with
a broad-based ETF core holding may be able to improve the portfolio's overall
performance. (For related reading, check out Pump Up Your Portfolio With ETFs.)
ETFs also offer exposure to U.S. nominal and inflation-protected fixed income. Unlike
equities, fixed-income asset classes generally offer mid single-digit levels of volatility,
making them ideal tools to reduce total portfolio risk. However, investors must be careful
to neither use too little or too much fixed income given their investment horizons. You
can even purchase ETFs that track commodities such as gold or silver or funds that gain
when the overall market falls.
Investment Horizon
An individual's investment horizon generally depends on the number of years until that
person's retirement. So, recent college graduates have about a 40-year time horizon
(long-term), middle-aged people about a 20-year time horizon (mid-term), and those
nearing or at retirement have a time horizon of zero-10 years (short-term). Considering
that equity investments can easily underperform bonds over periods as long as 10 years
and that bear markets can last many years, investors must have a healthy fear of market
volatility and budget their risk appropriately. (Read more about time horizons in Seven
Common Investor Mistakes and The Seasons Of An Investor's Life.)
Let's look at an example:
3. Easier Rebalancing
A change in an investor's asset mix is easier to implement when an ETF is used as the
core position. If an investor wants to increase his or her equity exposure, the purchase of
additional shares of an ETF makes it easy. (To read more on portfolio rebalancing, see
Rebalance Your Portfolio To Stay On Track.)
At the end of the year, Bob finds that the equity portion of his portfolio has dramatically
outperformed the bond and Treasury portions. This has caused a change in his allocation
of assets, increasing the percentage that he has in the equity fund while decreasing the
amount invested in the Treasury and bond funds.
More specifically, the above chart shows that Bob's $40,000 investment in the equity
fund has grown to $55,000, an increase of 37%! Conversely, the bond fund suffered,
realizing a loss of 5%, but the Treasury fund realized a modest increase of 4%. The
overall return on Bob's portfolio was 12.9%, but now there is more weight on equities
than on bonds. Bob might be willing to leave the asset mix as is for the time being, but
leaving it too long could result in an overweighting in the equity fund, which is more risky
than the bond and Treasury fund. (Learn more about the relative risk of various
investments in Determining Risk And The Risk Pyramid.)
The Consequences Imbalance
A popular belief among many investors is that if an investment has performed well over
the last year, it should perform well over the next year. Unfortunately, past performance
is not always an indication of future performance - this is a fact many mutual funds
disclose. Many investors, however, remain heavily invested in last year's "winning" fund
and may drop their portfolio weighting in last year's "losing" fixed-income fund.
Remember, equities are more volatile than fixed-income securities, so last year's large
gains may translate into losses over the next year.
Let's continue with Bob's portfolio and compare the values of his rebalanced portfolio
with the portfolio left unchanged.
At the end of the second year, the equity fund performs poorly, losing 7%. At the same
time the bond fund performs well, appreciating 15%, and Treasuries remain relatively
stable with a 2% increase. If Bob had rebalanced his portfolio the previous year, his total
portfolio value would be $118,500, an increase of 5%. If Bob had left his portfolio alone
with the skewed weightings, his total portfolio value would be $116,858, an increase of
only 3.5%. In this case, rebalancing is the optimal strategy.
However, if the stock market rallies again throughout the second year, the equity fund
would appreciate more and the ignored portfolio may realize a greater appreciation in
value than the bond fund. Just as with many hedging strategies, upside potential may be
limited, but, by rebalancing, you are nevertheless adhering to your risk-return tolerance
level. Risk-loving investors are able to tolerate the gains and losses associated with a
heavy weighting in an equity fund, and risk-averse investors, who choose the safety
offered in Treasury and fixed-income funds, are willing to accept limited upside potential
in exchange for greater investment security. (Determine your risk tolerance in
Personalizing Risk Tolerance.)
How to Rebalance Your Portfolio
The optimal frequency of portfolio rebalancing depends on your transaction costs,
personal preferences and tax considerations, including what type of account you are
selling from and whether your capital gains or losses will be taxed at a short-term versus
long-term rate. Usually about once a year is sufficient; however, if some assets in your
portfolio haven't experienced a large appreciation within the year, longer time periods
may also be appropriate. Additionally, changes in an investor's lifestyle may warrant a
change to his or her asset-allocation strategy. Whatever your preference, the following
guideline provides the basic steps for rebalancing your portfolio:
2. Compare - On a chosen future date, review the current value of your portfolio
and of each asset class. Calculate the weightings of each fund in your portfolio by
dividing the current value of each asset class by the total current portfolio value.
Compare this figure to the original weightings. Are there any significant changes?
If not, and if you have no need to liquidate your portfolio in the short term, it may
be better to remain passive.
3. Adjust - If you find that changes in your asset class weightings have distorted the
portfolio's exposure to risk, take the current total value of your portfolio and
multiply it by each of the (percentage) weightings originally assigned to each
asset class. The figures you calculate will be the amounts that should be invested
in each asset class in order to maintain your original asset allocation. You may
want to sell securities from asset classes whose weights are too high, and
purchase additional securities in asset classes whose weights have declined.
However, when selling assets to rebalance your portfolio, take a moment to
consider the tax implications of readjusting your portfolio. In some cases, it might
be more beneficial to simply not contribute any new funds to the asset class that
is overweighted while continuing to contribute to other asset classes that are
underweighted. Your portfolio will rebalance over time without you incurring
capital gains taxes.
Conclusion
Rebalancing your portfolio will help you maintain your original asset-allocation strategy
and allow you to implement any changes you make to your investing style. Essentially,
rebalancing will help you stick to your investing plan regardless of what the market does.
Read: 4. Easier Monitoring
4. Easier Monitoring
The more stocks there are in a portfolio, the harder it is to monitor and manage; after all,
there are more investment decisions that have to be made and more factors to be
considered. With an ETF or index fund representing a core position, the number of
stocks can be decreased, resulting in a portfolio that is less complex and easier to
understand.
5. Lower Taxes
Investors should consider the impact of taxes on their returns. A portfolio containing all
stocks tends to generate more trading activity as the market and investment outlook
changes. With more trading activity, more capital gains are realized, creating a higher tax
liability for the investor. ETFs are very tax efficient and, with a larger proportion of the
portfolio in a single core ETF, fewer capital gains will be triggered. (Be sure to read A
Long-Term Mindset Meets Dreaded Capital-Gains Tax for more information.)
A Long-Term Mindset Meets Dreaded Capital-Gains
Tax
by Investopedia Staff, (Investopedia.com) (Contact Author | Biography)
It's easy to get caught up in choosing investments and forget about the tax consequences
of your strategies. After all, picking the right stock or mutual fund is difficult enough
without worrying about after-tax returns. However, if you truly want the best
performance, you have to consider the tax you pay on investments. Here we look into the
capital-gains tax, and how you can adjust your investment strategies to minimize the tax
you pay.
The Basics
A capital gain is simply the difference between the purchase and selling price of an asset.
In other words, selling price - purchase price = capital gain. (If the price of the asset you
purchased has decreased, the result would be a capital loss.) And, just as tax collectors
want a cut of your income (income tax), they want a cut when you see a gain in any of
your investments. This cut is the capital-gains tax.
For tax purposes, it is important to understand the difference between realized and
unrealized gains. A gain is not realized until the security that has appreciated is sold. For
example, say you buy some stock in a company and your investment grows steadily at
15% for one year, and at the end of this year you decide to sell your shares.
Although your investment has increased since the day you bought the shares, you will not
realize any gains until you have sold them. (For more on this subject, see What are
unrealized gains and losses?)
As a general rule, you don't pay any tax until you've realized a gain - after all, you need
to receive the cash (sell out at least part of your investment) in order to pay any tax.
Holding Periods
For the purposes of determining tax rates on an investment, an investment can be held
for one of three time periods: the short term (one year or less), the long term (more than
one year and less than five years) or the super long term (more than five years).
The tax system in the U.S. is set up to benefit the long-term investor. Short-term
investments are almost always taxed at a higher rate than long-term investments, and
long-term investments are charged at a higher tax rate than super-long-term
investments. Note that the taxation rules for super-long-term investments are effective
only for securities purchased after January 1, 2001. So, if you purchased an investment
on January 1, 2001, you'd have to hold onto it until at least January 1, 2006, for it to be
taxed at the lowest rate.
Example
Say you bought 100 shares of XYZ stock at $20 per share and sold them at $50 per share,
and say you fall into the tax bracket according to which the government taxes your long-
term gains at 15%. The table below summarizes how your gains from XYZ stock are
affected.
Uncle Sam is sinking his teeth into $450 of your profits! But had you held the stock for
less than one year (made a short-term capital gain), your profit would have been taxed at
your ordinary income tax rate which, depending on the state you live in, can be nearly
40%. Note again that you pay the capital-gains tax only when you have sold your
investment or realized the gain.
Compounding
Most people think that the $450 lost to tax is the last of their worries, but that
misconception is where the real problem with capital gains begins - unless you are a true
buy-and-hold investor. Because of compounding - the phenomenon of reinvested
earnings generating more earnings - that $450 could potentially be worth more if you
keep it invested. If you buy and sell stocks every few months, you are undermining the
potential worth of your earnings: instead of letting them compound, you are giving them
away to taxes.
Again, this all comes down to the difference between an unrealized and realized gain. To
demonstrate this, let's compare the tax consequences on the returns of a long-term
investors and a short-term investor. This long-term investor realizes that year over year
he can average a 10% annual return by investing in mutual funds and a couple of blue chip
stocks. Or short-term investor isn't that patient; he needs some excitement. He is not a
day trader, but he likes to make one trade per year, and he's confident he can average a
gain of 12% annually. Here is their overall after-tax performance after 30 years.
Because our short-term trader continually gave a good chunk of his money to tax, our
long-term investor, who allowed all of his money to continue making money, made nearly
$20,000 more - even though he was earning a lower rate of return. Had both of them
been earning the same rate of return, the results would be even more staggering. In
fact, with a 10% rate or return, the short-term investor would have earned only $80,000
after tax.
• Long-term investing - If you manage to find great companies and hold them for
the long term, you will pay the lowest rate of capital-gains tax. Of course, this is
easier said than done. Many factors can change over a number of years, and there
are many valid reasons why you might want to sell earlier than you anticipated.
• Retirement plans - There are numerous types of retirement plans available, such
as 401(k)s, 403(b)s, Roth IRAs and Traditional IRAs. (For further reading, see A
Tour Through Retirement Plans.) Details vary with each plan, but in general the
prime benefit is that investments can grow without being subject to capital-gains
tax. In other words, within a retirement plan, you can buy and sell without losing a
cut to Uncle Sam. Additionally, most plans do not require participants to pay tax
on the funds until they are withdrawn from the plan. So, not only will your money
grow in a tax-free environment, but when you take it out of the plan at retirement
you'll likely be in a lower tax bracket.
• Use capital losses to offset gains - This strategy is not as advisable as the others
we just mentioned because your investments have to decrease in value to be able
to do this. But if you do experience a loss, you can take advantage of it by
decreasing the tax on your gains on other investments. Say you are equally
invested in two stocks: one company's stock rises by 10%, and the other company
falls by 5%. You can subtract the 5% loss from the 10% gain and thereby reduce
the amount on which you pay capital gains. Obviously, in an ideal situation, all
your investments would be appreciating, but losses do happen, so it's important to
know you can use them to minimize what you inevitably owe in tax. There is,
however, a cap on the amount of capital loss you are able to use against your
capital gain. (For further reading, see Selling Losing Securities For A Tax
Advantage.)
Summary
Capital gains are obviously a good thing, but the tax you have to pay on them is not. The
two main ways to reduce the tax you pay are to hold stocks for longer than one year and
to allow investments to compound tax free in retirement-savings accounts. The moral of
the story is this: by adopting a buy-and-hold mindset and taking advantage of the
benefits of retirement plans, you are able to protect your money from Uncle Sam and
enjoy the magic of compounding at the same time!
Non-Discretionary Account
In a non-discretionary account, the investor is responsible for creating an asset
allocation model, selecting ETFs to match the model, monitoring the portfolios and
rebalancing as necessary (this can also be done with the help of an advisor).
7. Decreased Volatility
For the typical investor with an ETF representing a core holding, the overall portfolio will
likely be less volatile than one made up entirely of stocks. This is because an ETF is, in
itself, diversified, making it less likely to suffer the price swings that are possible for a
stock. (Learn to adjust your portfolio when the market fluctuates to increase your
potential return in Volatility's Impact On Market Returns.)
% % If
Chance Chance If Up Down
Volatility Up Down Avg Avg Expected
Quartile Range Month Month Gain Loss Gain/(Loss)
-
st
1 0-1.0% 70% 30% 2.7% 1.8% 1.3%
1.0- -
nd
2 1.4% 61% 39% 3.1% 2.2% 1.0%
1.4- -
rd
3 1.8% 59% 41% 3.1% 3.1% 0.6%
1.8- -
4th 2.6% 44% 56% 5.0% 4.6% -0.4%
% % If
Chance Chance If Up Down
Volatility Up Down Avg Avg Expected
Quartile Range Month Month Gain Loss Gain/(Loss)
-
st
1 0-1.0% 91% 9% 14.3% 1.5% 12.9%
1.0- -
nd
2 1.4% 82% 18% 19.1% 9.0% 14.0%
1.4- -
rd
3 1.8% 82% 18% 15.6% 11.6% 10.6%
1.8- -
th
4 2.6% 42% 58% 13.4% 16.6% -4.1%
As a general trend, when the VIX rises the S&P 500 drops. When the VIX is at a high, the
S&P 500 is at a low, which may be a good time to buy. However, if the VIX is high, there
is a concern that the market is going to continue to go down. This fear makes it difficult
to buy during high stock market volatility. But, investors who used the high on the VIX to
time their buys entered the market at or near the low. (To find out how the VIX measures
volatility, read Getting a VIX on Market Direction.)
Volatility works well to help identify market bottoms based on high volatility. For long-
term investors, it also does a pretty good job of helping investors identify that the stock
market is at or near a top, when volatility is very low. Keep in mind that this indicator is
not intended to time the exact top, but rather that the volatility of the market does not
stay substantially below the mean for long period of time. As the volatility increases, then
the market's performance will tend to decrease.
Bottom Line
The higher level of volatility that comes with bear markets has a direct impact on
portfolios. It also adds to the level of concern and worry on the part of investors as they
watch the value of their portfolios move more violently and decrease in value. This
causes irrational responses which can increase investors' losses. As an investor's
portfolio of stocks declines it will likely cause him or her to "rebalance" the weighting
between stocks and bonds by buying more stocks as the price falls. Investors can use
volatility to help them buy lower than they might have otherwise.
8. Better Focus
In any well-designed and diversified portfolio, an investor will have to invest in sectors or
stocks that he or she does not like, but is required to own for diversification purposes.
Using an ETF for a core position provides the necessary diversification, allowing the
investor to focus on stocks in his or her preferred sectors. (For more on sectors, read
Sector Rotation: The Essentials.)
Most of the time, financial markets attempt to predict the state of the economy, anywhere
from three to six months into the future. That means the market cycle is usually well
ahead of the economic cycle.This is crucial to remember because as the economy is in
the pits of a recession, the market begins to look ahead to a recovery.
Economic Cycle in Four Stages
Here is a list, in the same order as above, of four basic stages of the economic cycle, and
some associated telltale signs - again, keep in mind that these usually trail the market
cycle by a few months.
• Full Recession - Not a good time for businesses or the unemployed. GDP has
been retracting, quarter-over-quarter, interest rates are falling, consumer
expectations have bottomed and the yield curve is normal. Sectors that have
historically profited most in this stage include:
o Cyclicals and transports (near the beginning).
o Technology.
o Industrials (near the end).
• Early Recovery -Finally, things are starting to pick up. Consumer expectations
are rising, industrial production is growing, interest rates have bottomed and the
yield curve is beginning to get steeper. Historically successful sectors at this
stage include:
o Industrials (near the beginning).
o Basic materials industry.
o Energy (near the end).
• Late Recovery -In this stage, interest rates can be rising rapidly, with a flattening
yield curve.Consumer expectations are beginning to decline, and industrial
production is flat. Here are the historically profitable sectors in this stage:
o Energy (near the beginning).
o Staples.
o Services (near the end).
• Early Recession -This is where things start to go bad for the overall economy.
Consumer expectations are at their worst; industrial production is falling; interest
rates are at their highest; and the yield curve is flat or even inverted.Historically,
the following sectors have found favor during these rough times:
o Services (near the beginning).
o Utilities.
o Cyclicals and transports (near the end).
Summary
With this general outline in mind, traders can try to anticipate which companies will be
successful in the coming stages of an economic cycle. Equally important can be the signs
the market is exhibiting on future economic conditions. Watching for these telltale signs
can give great insight into which stage traders believe the economy is in. For those
looking to dig deeper into sector rotation, below are three great resources:
9. Increased Sophistication
Investment strategies such as enhanced index strategies, risk budgeting, portfolio
insurance, style tilts, hedging strategies and tax loss harvesting become easier to
implement with a core/satellite approach.