by Lars Kroijer
Stages of life
Your age will be a big factor in how you allocate your portfolio.
Early savers
It is generally the case that younger savers allocate a greater portion of their portfolio to riskier assets. They are in the early stages of saving and the cumulative benefits of even a small expected outperformance from a slightly riskier asset can add up to a large amount over the coming decades. Also, should markets be bad early on, savers have decades before they need the money and more time either for the investments to make up the shortfall, or for them to adapt their lifestyles or savings rate. My advice to you: take risk with your savings and put lots in the equity markets, be ready to lose a lot of it, but also keep enough in the bank so that you can afford a crisis. It’s a good time to learn about the markets and how you deal with the risks. You should also familiarise yourself with all the tax benefits that might arise from pensions or other savings (such as ISAs in the UK). Getting into the habit of saving up and maintaining the discipline to stick with it is something that will serve you very well, particularly as you begin to see the cumulative gains from being a saver.
Mid-life savers
Once you enter the 30s and 40s you pass into the ranks of the mid-life savers. You might be at your prime in terms of earnings power and starting to get a good sense of how things will turn out careerwise. For many mid-life savers, tax considerations will play a major role in the execution of their portfolio, and many will want to allocate a greater fraction to the minimal risk asset, perhaps in longer-term bonds, than they did a decade or so earlier. Whilst these savers have accumulated some savings, the potential added return from allocating to equities is still important in reaching their financial goals in retirement. And should the equity markets be bad in future there are still some working years to address the losses from those investments, either by saving up more and reducing current spending, expecting to work longer or reducing expected retirement spending. At this point in your life savings cycle you might start to get a sense of what your expenses in retirement will look like, and perhaps how many income-earning years you have left before retiring.
In terms of practically shifting your investments from equities into lower-risk assets as you age I would encourage you to do this as you either put money into your savings or take money out anyhow, as that reduces trading costs and potentially taxes.
Retirees
At the other end of the spectrum is someone already in retirement. Particularly those without a great amount of savings to see them through their remaining years typically have a far lower risk tolerance as there are fewer options to make up a shortfall if markets turn against them. At the risk of over-simplifying, if you don’t share the upside of having more savings (with limited years left to enjoy them), but would experience the painful downside, then don’t take risk and stay with minimal risk bonds. Of course estate planning and passing on assets to the next generation will play a major role here in terms of the exact structuring of your portfolio. Also think about what non-investment income you can expect in the form of company pensions, social security, etc. and compare that to your expected outgoings. The difference between the two will need to come from investment income, or liquidating part of your portfolio. While many rules of thumb don’t apply universally, if you stick to only spending 4% of your portfolio a year, you will probably be fine (you can increase that percentage as you grow older).
For those in retirement I would encourage you to get ready for the day when you can no longer handle your savings yourself, or even plan for eventually passing them on. Keep things simple; have only a couple of accounts and not too many investments, and make clear to whoever is going to take over the management of your assets how you want them managed and why.
For those retirees with savings in excess of what they need, the risk profile of the portfolio may be different. These retirees are no longer only investing for their own needs, but also for the longer-term needs of their descendants or whoever the assets will be going to. Since the time horizon for those descendants can be much longer term, the portfolio could well include some equities and a generally riskier profile than if it was just for the retirees.
It really does depend on your circumstances
Like most things in investing, allocations are highly subject to individual circumstances and risk tolerance. Figure 10.4 shows how an investor’s allocations may change over his or her life, ignoring the complication of risky government and corporate bonds in the rational portfolio.
Figure 10.4 Stages of life: moving from equities as you age
Risk surveys
As discussed above, getting a handle on your risk tolerances is not only critical in investment management, but also a very individual thing. In my view, far too often investors rely on their gut feelings in deciding on the risk levels in their portfolios, or are guilty of what some call ‘recency’ where we over-emphasise recent events in planning for the future.
Risk surveys are increasingly common in the financial industry and are sometimes mandatory for companies taking on new clients. You find them at most banks, insurance companies, asset management firms or your local regulator. As suggested, they are meant to give you an idea about your risk tolerances, often via stress tests, but in my view risk surveys often leave a lot to be desired.
Risk surveys that I have completed are too simplistic to give a really detailed view of your risk profile, often because they don’t ask enough questions about your specific situation. Sometimes I find that the surveys are a prelude to someone trying to sell me a specific ‘tailor-made’ product (read: expensive), instead of objectively trying to help me understand my risk tolerance. In addition, risk surveys often fail to properly incorporate all my other assets and liabilities, including seemingly odd ones like education, inheritance, future tuition for children, or other critical things like what stage of life I’m at regarding career or retirement. The surveys therefore often fail to get a full picture of my financial life and in my view suffer in quality as a result.
With the caveats listed above, I would still encourage you to undergo a few risk surveys and to be on the lookout for new and improved surveys. Particularly if you are someone who is not used to thinking about your risk profile in the financial markets it probably makes sense to try a few surveys either through your financial institution, your domestic regulator or one of the many you can find on the internet. Who knows, they may tell you something you hadn’t thought about, or perhaps you will have added comfort from confirming what your gut feeling tells you – see Figure 10.5.
The understanding and integrated tailoring of risk profiles will be a future growth area in financial services. While a risk survey is only as good as the information you put into it, if there was a seamless way to integrate all major aspects of our life to provide a fuller risk picture then those results could be very helpful to individual investors. One day I imagine that risk surveys will be informed by an incredibly detailed profile of you based on your portfolio, annuities, insurance, credit card bill, LinkedIn/Facebook profile, where you holiday, your tax filings, how you drive your car, online games, if you tend to book flights last minute, the state of your marriage, and how you play golf, etc. While all that sounds distastefully intrusive I wouldn’t be surprised if some IT companies already know most of it.
Figure 10.5 Utility curves: what kind of person are you?
A few rules of thumb
In researching this book I came across several publications on the topic of investment and savings which had rules of thumb that were pushed as gospel truths. While I think rules of thumb fail to incorporate individual circumstance and attitudes here are a few to consider:
Your age in bonds (60 year old = 60% in bonds).
Don’t withdraw more than 4% of your portfolio a year in retirement.
If you react badly to losing money in your portfolio, reduce the equity exposure by 10%. Keep doing that until you are OK with portfolio falls.
E
quity exposure = amount of years until retirement in percentage terms. So with 10 years to retirement your equity exposure should be 10%.
Equity exposure = 120 – your age.
Put aside 10% of income for retirement.
The value of your house should be less than three times your annual income. (It was staggering to see how often and by how much this rule was broken particularly pre-crash.)
Base your retirement needs on 100% of pre-retirement expenses plus 10%.
Have at least 7–10 times your annual income in life insurance.
Have at least 6–8 months of living expenses in cash in the bank.
Clearly these are exactly that, rules of thumb. Obviously these rules don’t apply to everyone, or indeed most people (and some are even slightly contradictory). Instead, in this chapter I’ve tried to give you a sense of how to think about your individual risk and some ways to understand the probabilities of encountering tough conditions when saving.
Adding government and corporate bonds
In earlier chapters, I suggested that there could be merit in adding risky government and corporate bonds to the portfolio, but we have not incorporated them in the examples above. This is not out of neglect, but to keep the discussion above simple and practical. If we attempt to add risky government and corporate bonds to the excel model outlined earlier we would significantly add to its complexity and you would need to have a view on complex things like asset correlations. Taking an average correlation between risky government bonds, corporate bonds and equities would be too much of a simplification. During times of great distress, correlations between asset classes tend to go up (just like they do between various equity markets), and as we run the multiple scenarios we would need different correlations for different states of the equity markets, resulting in something like this:5
Equity return Sub-AA government bond correlation Corporate bond correlation
15%+ 0.35 0.40
5% to 15% 0.28 0.32
−5% to 5% 0.22 0.28
−15% to −5% 0.34 0.38
Below −15% 0.55 0.67
What this adjustment incorporates is that the addition of risky government and corporate bonds adds less diversification when you need it the most, namely when equity markets are poor. Since the bonds I suggest adding here are sub-AA rated return generators, in a crisis they may not be seen as a ‘flight to safety’ and go up in value. Your minimal risk asset will probably be seen as a safe haven and increase in price.
At the risk of oversimplification, other government and corporate bonds will add less risk to the portfolio than equities, but will not be risk free. Depending on the exact mix of sub-AA government bonds you add, you could perhaps see the other government and corporate bonds as adding half the risk of equities, although realise that this more a guesstimate than a precise calculation.
Adding great complexity to the simple model misses the point that all this is far from an exact science. The point of the excel model is to show that even the best-laid plans are subject to market risk, and to point out how we can incorporate this element of chance in thinking about our portfolio allocations and planning. By making the model excessively complex we run the risk of giving a false sense of precision.
1 On Youtube you can find a brief and instructive video called ‘Geometric vs. Arithmetic Average Returns’.
2 There are a surprisingly large number of books and articles that seem to neglect this issue. A typical example will be an illustration that talks about $1,000 invested making an average of 5% a year so that after 30 years you will have made $4,320, ignoring the fact that high volatility in the yearly returns could significantly reduce the final value.
3 If you wanted minimal risk you should buy inflation-adjusted government bonds with maturities similar to when you will start needing the money. In this case, that would involve some of the longest-dated bonds available, which typically carry a higher yield than the 0.5% used in this example.
4 As you increase the risk of the minimal risk asset the importance of introducing correlation with your equity investment increases. This is a complication I have left out.
5 This is still a significant simplification. The correlations in the various return scenarios would be an average expected correlation. Since each crisis is unique there is no guarantee that the actual correlations would be like those in the table.
chapter 11
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Tax
Benjamin Franklin famously said that death and taxes are the two certainties in life. The residents of Monaco may disagree, but for most people tax planning is an integral part of investment management.
A book on investments ignoring tax would be incomplete. With state finances around the world in tatters, taxes are going to be a bigger, not smaller issue. New taxes will be introduced, either to close former loopholes or simply to raise revenues. And with the sentiment in the general population being one of anger towards banks and the wider financial community, taxes will probably go up for this sector and the products it offers. What this means in individual jurisdictions will vary a great deal, but as an investor it’s well worth understanding tax.
Let’s remind ourselves that the point of the rational portfolio is that we have a more optimised, liquid, cheap and risk-adjusted portfolio. Those are undoubtedly good things. But if we construct that portfolio in a tax-inefficient manner, all our good intentions can quickly disappear.
In general the taxes I will refer to are:
income tax, including taxes on dividends and coupons;
capital gains tax (CGT): this covers a broad range and depending on jurisdiction will be greatly affected by the holding period and type of asset;
transaction taxes, such as stamp duty in the UK;
other taxes such as inheritance tax, corporation tax, taxes on gifts, etc.
Owing to its simple construction with a strong bias towards minimum turnover and very long-term holding periods, the rational portfolio is very tax-efficient for most people. Below are some of the most obvious tax benefits most people would realise from holding a rational portfolio:
Low turnover = less capital gains and transaction tax A passive investment product will have fewer trades than an active fund. This will typically lead to lower capital gains (including short-term ones often taxed at higher rates), but also fewer payments of transaction taxes such as stamp duty. In addition to tax, there are other obvious advantages such as trading costs associated with the low turnover.
Fewer fund changes = defer tax on gains into the future Related to the low turnover of securities in the fund, investors in index trackers also change funds far less frequently than investors in active funds. They are not chasing the next ‘hot manager’. On top of the advantages of not constantly triggering ‘one-off’ or front-loaded charges in some active funds and avoiding higher fees, this has the tax advantage of deferring the tax on the gains.
Diversity of products = getting the right product to help reduce tax As the underlying securities in the rational portfolio consist of an extremely broad and easy-to-construct array of securities, product providers can easily create construct products that cater to specific investor needs. For example, some investors would prefer to have dividends reinvested in the fund rather than paid out. So instead of having an index tracker valued at $100 and receiving a $2 dividend, the index tracker would be valued at $102. For some investors there are large tax advantages with this kind of structuring. It is such dividend versus capital gains advantages that are among the features making some exchange traded funds (ETFs) tax efficient.
Jurisdiction = pick the right one for your investment product Should you be buying an ETF or index fund through a Dublin or Frankfurt listing of the same underlying exposure? Understand the tax implications of your choices as they can be very different for different investors. Since setting up an ETF in a new jurisdiction is not that costly, not that many investors need to demand it before a provider will meet the market demand. This issue of juris
diction is one that is perhaps of overriding importance for some investors and not a big deal to others.1
Tax wrappers = because of a simple portfolio, tax wrappers and planning should be cheap Since the underlying product of the rational portfolio is relatively straightforward, potential tax saving wrappers should be more transparent and cheaper. You are not paying for a complicated investment product, even if the specific tax structure is complex. If you find yourself investing in a film project to get a tax saving that may be fine, but it’s probably not an investment you would have made without the wrapper and there is therefore an implicit additional cost of the tax structure. The rational portfolio is so simple and transparent that at least the investing part of your tax wrapper should be simple. This simplicity should give you greater transparency regarding any other charges you face in implementing the tax savings.
My mother bought some insurance-related savings products to reduce tax in the late 1980s. These products invested money in a portfolio of stocks, and had the advantage of saving her about 40% in tax on the money invested. It all looked good at the time, but my mother recently realised that there is absolutely no way to move the tax structure/wrapper away from the large Nordic bank it is with currently. Not that the tax wrapper legally requires it, but because the contract with the bank says so, and they won’t let my mother move her business elsewhere. I think she has been overcharged at about 2.5% a year for over 20 years for a wrapper which consists of very normal equity investments. For decades the bank in question has essentially used the structure to tie in my mother as a very high fee-paying client. If instead she had received only the legal and tax advice and implemented the underlying investment as a separate matter there would have been massive savings relative to the expensive current structure. If my mother had used the rational portfolio as the baseline investment, instead of having the tax structure and investment product bought combined, it would be far more transparent what she is being charged for – in both advice and set-up fees – and she would realise that those costs are a small fraction of what she is being charged now.
