Wealth "Myth-Management": Debunking Popular Misconceptions about How to Invest Your Wealth
By Vistage expert resource speaker Peter Mallouk
Investing is a complex, sophisticated activity. If it were simple, we would all be rich.
At the same time, investing requires a personalized approach that doesn’t lend itself well to cookie-cutter solutions. Time and again I see investors get into serious trouble by trying to apply very broad rules of thumb to their individual investing situations.
What that in mind, here are some popular investing "rules of thumb" that can lead investors astray:
- Rule of thumb: To determine the appropriate asset allocation, subtract your age from 100. For example, if you’re 60, 60 percent of your portfolio should be in bonds and 40 percent in stocks.
- Reality: Your asset allocation depends on the four building blocks of every investment portfolio: what you have, what you need out of it, when you need it, and the risk you’re willing to take. The starting point is to work with a good wealth manager or financial planner, someone who specializes in analyzing what you really need to get from here to retirement and can help you put together the "big picture" portfolio that will most likely get you there. Then you select the investment managers to carry it out.
- Rule of thumb: Everyone should have enough life insurance to cover at least five times their annual salary.
- Reality: The proper amount of life insurance depends on your survivor needs or estate planning needs. If you die, how much do you need to pay off the house, eliminate other debts, put the kids through college and have a lump sum for your spouse to live on? To the extent your liquid available assets are not enough to meet this need, make up the difference with inexpensive term insurance. For those with estate tax issues that cannot be eliminated with basic estate planning, permanent insurance held inside of an Irrevocable Trust can provide the liquidity your estate needs. This requires a sophisticated overlap of advanced estate planning and insurance planning, so make sure you are dealing with experts.
- Rule of thumb: Everyone should have at least three to six months’ pay as an emergency reserve.
- Reality: Many business owners don’t need a large personal reserve. Instead, put your emergency reserve into your house, where you will get an immediate five to seven percent guaranteed rate of return by paying down your mortgage. In an emergency, you can always take out a home equity loan. In the meantime, your money is working harder for you.
- Rule of thumb: You will need 70 percent of your current income in retirement.
- Reality: You may need more, you may need less; it all depends on your lifestyle. For example, some people find they need more because they travel a lot, have higher healthcare costs, and spend more in retirement, while others cut back and can live on a smaller income.
- Rule of thumb: All investment assets in your portfolio should be allocated in the same manner, such as 70 percent stocks and 30 percent bonds.
- Reality: Divvy up your portfolio so that the right investments are in the right accounts. For example, you want to place some bond funds inside of IRAs and retirement plans, where you won’t need to pay taxes on the income. Place index funds in a taxable account since they don’t generate much capital gains or dividends anyway. You can increase your portfolio’s real rate of return simply by having the right investments in the right places.
- Rule of thumb: Mutual funds are the most cost-effective way to diversify.
- Reality: Mutual funds do provide diversification and active management, but most are not tax-efficient. With mutual funds, you may pay taxes even if the market goes down. Plus, they have high ongoing fees and carry a lot of hidden charges.
- Rule of thumb: Investing in small amounts on a regular basis (dollar-cost averaging) is the safest way to invest because it smoothes out the ups and downs of the market.
- Reality: Dollar-cost averaging does reduce risk, but most investors dollar-cost average the wrong way. Putting money into the market with every paycheck is not the best strategy. If you have a retirement plan, fund it all at the beginning of the year, as long as you can still retain any company match. That way, your money has more time to compound and you end up with more money down the road. If you invest $15,000 at the beginning of each year for 25 years and it grows at 10 percent, you will end up with $69,000 more than by investing the same amount over the same period but with each paycheck.
The only real rule of thumb is that for high net worth individuals there are no rules of thumb in investing and estate planning. Every situation is different.
Managing Your Wealth
How do you invest wisely?
Start by creating your own personalized wealth management plan, which consists of four basic steps:
- Identify where you are now (your current financial condition).
- Determine where you want to go (establish your financial goals).
- Figure out how much you will need to get there.
- Invest your assets to generate maximum return with minimum risk.
When creating your plan, set specific, measurable goals. "I want to retire with enough money to live comfortably" isn’t specific enough. "I want to retire at age 65 with an after-tax income of $150K a year" is a goal. Or, "I need to have $40K a year per child to put all four kids through five years of college." These kinds of goals give you targets to shoot for. Once you have completed the plan, you can begin to build a successful investment portfolio.
The most important part of investing is asset allocation, which involves the process of determining how much to invest in each of the five different asset classes -- stocks, bonds, commodities, cash and real estate. Diversification determines how you distribute your assets within each asset class. Asset allocation is critical because it determines 91 percent of the volatility of your portfolio. An average investor with the right allocation and average holdings (mutual funds, etc.) has a much better chance of reaching his or her goals than a sophisticated investor with the wrong allocation but great holdings.
Once you have your investment portfolio in place, reset it and rebalance it once a year. This demands discipline because it forces you to add money to the worst performing sector, not the best. In the long run, however, it forces you to buy low and sell high.
Put investments that create a lot of taxes, like high-yield bonds and small-cap mutual funds, into your retirement accounts so you can defer the taxes until a later date. Put tax-efficient holdings, like municipal bonds and exchange-rated funds, into your individual accounts.
Once a year, update your net worth, financial projections, financial plan and risk tolerance and adjust your wealth management plan accordingly.
Above all, stay away from the aforementioned investing rules of thumb and remember that investing is for the long term -- determine a plan and stick with it!
Vistage expert resource speaker Peter Mallouk provides investment planning, estate planning and wealth management services for high net-worth individuals and families.