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Achieving Wealth In The 21st Century by Arn Bernstein

Arn Bernstein discusses the principles behind sound investing in the current economic times.

Has the process of meeting your financial goals changed at all in the past seven years? Well, yes… and no.

It’s something we all dream of; choosing the right investments and making enough to take care of us the rest of our lives. But is it really possible in today’s economic climate? The majority of experts seem to feel it is, provided it’s done properly.

There are a couple of schools of thought on investing. Some investment groups, such as Oxford Club’s Investment U, stress developing a strategy for the long-term. Instead of wondering where the market or economy are going to go, ask yourself how to get the highest return via the least risk, how to guarantee your portfolio will continue to increase in value, and how to protect your profits as well as the principal.

The Four Pillars

Investment U calls the strategy the Four Pillars of Wealth. The basic premise is that to invest successfully, there will always be a degree of uncertainty. Makings predictions on the market can be right, or wrong, and nobody gets it right all the time. The critical solution to guesswork is what it terms asset allocation. It differs from basic diversification in that it involves distributing investments not only in various market sectors or securities, but also in different asset classes. One example is high-grade bonds, which have actually increased when the market in general has fallen. Others include real estate investment trusts (REITs), high-yield investments, inflation-adjusted treasuries and precious metals. Since different asset levels move in different directions, you can increase returns while keeping the overall volatility of your portfolio to a minimum. To learn about the basics, it’s recommended reading a book such as The Intelligent Asset Allocator, by William Bernstein.

The second pillar is knowing when to sell. Some investment services, such as Investment U, have a built-in point to do this that guarantees the protection of profits and principal. Here’s how it describes it: “We start all of our trading positions with a recommendation that you place a sell stop 25% below your execution price. As the stock rises, we raise the trailing stop. In other words, if you buy a stock at $20, your stop loss is at $15. When the stock hits $32, your stop loss (still trailing at 25%) will be at $24. As long as the stock keeps trending up, we’re happy to hang on. If the stock pulls back 25% from it’s closing high, we sell, no questions asked.”

Another element of this is that while common sense dictates that one should cut losses early on should things begin to slip, few investors actually pull the trigger. The trailing stop strategy eliminates any uncertainty. Allowing portfolios to continue to grow without taking profits is risky at best. By not selling, an investor is opening themselves up to the chance of the profits not only decreasing or even disappearing, by actually turning into losses.  Not having a sell discipline in place is investing by the seat of one’s pants, so to speak.  A trailing stop is necessary, but so is the resolve to stick to it.

How Much Is Enough?

The third pillar is how much to invest in a specific stock. Obviously, this is affected by one’s net worth, basic investment experience and risk tolerance.

Investment U recommends 3% of one’s equity portfolio – less if you wish to be conservative, a bit more if you feel aggressive. But never more than you can really afford to gamble with. In short, it doesn’t pay to be so confident in a particular stock or market that you put too much into it. While it’s true some people have made fortunes this way, that’s almost always the exception rather than the rule. To maximize profit potential, spread the risk around.

In addition, never make taxes a key priority in assembling and maintaining an investment portfolio. Don’t refuse to diversify because you steadfastly believe you can’t afford the tax hit. When you consider the alternative should a stock nosedive (Enron or United Airlines, for example), the tax suddenly becomes eminently preferable.

The final pillar ties into the above point; you can avoid higher taxes by slimming initial investment expenses. According to a study done by the Vanguard Group of mutual funds, average investors relinquish 2.4% of their annual returns to taxes, more if they trade often. One example: In Oxford’s case, it chose not to buy, the Pimco Total Return Fund, the largest and best-performing bond fund in the country. Rather, it recommended the Manager’s Fremont Bond Fund, a no-load fund, which didn’t involve the typically high fees associated with Pimco. Similarly, Oxford went with the Templeton Emerging Markets Fund, which is closed-end, instead of the Templeton Developing Markets Fund, which has a 5.75% front-end load, while the Emerging Markets fund has none, and sells at an 11% discount to its net asset value. Both funds are run by the same manager, and invest exclusively in emerging markets.

Put more simply; try to avoid all investments with a front-/back-end load, surrender penalties or 12b-1 fees. Get recommendations for deep-discount brokers and keep all portfolio expenses to a minimum.

Another way to help keep the IRS at bay is to manage your portfolio in a manner that leaves nothing for it to take. This can be accomplished by sticking to higher-quality investments, which have fewer turnovers, and hence less capital gains taxes. The less you trade your core portfolio, the less tax liabilities you incur. Further, stick with investments for at least a year. Whatever you sell in less than 12 months is a short-term capital gain, taxed at the same level, as earned income. Long-term gains are taxed at a maximum rate of 20%. And any short-term trading done in your IRA is tax-exempt.

If you stop out in under a year, offset the capital gains with capital losses. The IRS permits offsetting all realized capital gains by selling any stocks that have been lemons. You can take up to $3,000 in losses against earned income.

Other tips include avoiding actively managed funds in non-retirement accounts. Managed funds usually have high turnover and Federal law requires them to distribute at least 98% of realized capital gains each year. Put high-yield investments such as bonds, utilities and real estate investment trusts in your IRA, pension, 401K or other tax-deferred account. There’s no provision in the tax code to offset your dividends and interest. If you’re in the upper tax brackets, choose tax-free instead of taxable bonds. An example: A cost-efficient, taxed-managed $100,000 portfolio can be worth $419,000 more in 20 years, and those figures don’t factor in any positive investment performance.

Other Viewpoints

Investment U’s strategy is one angle. Others suggest a more conservative approach in today’s economy where a financial safety net is critical. “Long-term investments like 401Ks and savings accounts are the best way to go,” says Delores Sims, president/CEO of Legacy Bank. Unless you have an investment broker who really understands the stock market, you can lose a lot. Sticking with companies such as utilities, something safe.”

Her suggestion is to seek out an investment club, or, if none exists, start one. This way, you and your peers can study investment to learn as much as possible about the market. Investment seminars can help as well.

As far as how much to invest, Sims notes, “You should have enough in your savings account to cover three to six months of your lifestyle should anything happen. You should do nothing to change your life dramatically, but add up your fixed and variable expenses. But at the same time, you really have to sacrifice to invest, because you’re building a future for yourself and your family at the bottom line. You need to perhaps let some material things go, but you still need cash in the bank as a safeguard. It’s very difficult passing money from one generation to the next. If you don’t save, you simply cannot do it.”

In the same vein, Matthew Yale, vice president of public affairs of Ariel Mutual Funds, also says one needs to take a steady as opposed to a complicated course. “Since 1929, there’s no investment stronger than the US Stock Market in general,” he says. “But real wealth is created over the long term. Investing takes discipline and patience.”

His answer? Mutual funds. “They’re the best way to diversify, and you can do so on a minimum monthly investment,” he notes, “If you ask a professional money manager, they’ll say the same. To simply play the market with various stocks is very high-risk.”

He also doesn’t believe in making a large stake. “How much you invest isn’t as important as doing it consistently,” he explains. “Each month, you should put part of your paycheck toward investing, and you’ll build up a portfolio. One of the best benefits of mutual funds is that you don’t have to worry about the best time to buy or sell. The mutual funds manager will simply do it, after advising you why. You can simply invest at will into anything.”

Does he see any downside to mutual funds? “In all honesty, no. Even for experienced investors, they still represent the best diversification available.”

In the final analysis, building equity via investment all comes down to knowing what you’re doing. But one has to do their homework diligently first. It sounds simplistic, but with the proper knowledge and advice, it can become fairly uncomplicated.

Arn Bernstein is a freelance writer based in Philadelphia.

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