Resources

Create a portfolio at Morningstar


Calculate risk grade of a portfolio at Riskgrades

Calculate risk of your portfolio, Optimize your portfolio at
FinPortfolio

Rebalance your  portfolio to meet retirement goals with specified risk 
FinancialEngines

Portfolio Strategies

Portfolio monitoring:

We created this portfolio in the previous section. Now we need to monitor it. After we purchase shares for the four funds mentioned we can enter the number of shares purchased into a mutual fund portfolio created at Morningstar.  Morningstar will then automatically update this portfolio every trading day.

We can then X-Ray the portfolio for fund overlap at Morningstar

FinPortfolio and Risk Grades have several tools for portfolios including portfolio optimization.
 
Buy and Hold/Market Timing:

Some investors buy into a mutual fund and hold it until the money is needed. This defers capital gains (not distributions). A market timer on the other hand, attempts to buy low and sell high, a difficult task that involves not missing the best month and avoiding the worst month. Market timing also generates capital gains that have tax consequences. One such strategy is outlined in fundadvice.com. See how rebalancing may be a better form of market timing in the next section.
 
Portfolio Rebalancing:

This is done once or twice a year to maintain the asset allocation.

One example could be an investor who desires 60% in stock funds and 40% in bonds. But stocks have done well changing the stock allocation to 70%. The investor then sells the stock fund and buys the bond fund so that the 6/40 allocation is maintained. 

Besides instances when one asset class swells or shrinks, rebalancing can be useful when the investor would like to change the asset allocation, for example,

  Lower stock allocation due to a major life event such as retirement
  Move allocation gradually from aggressive to moderate as you age.

Rebalancing may also be done when a new asset class is added.

Since Rebalancing involves selling the asset class that has outperformed and buying the asset class that has under-performed, it is viewed by many as a prudent and disciplined form of market timing. See article on Trigger-point rebalancing. 

Dollar Cost Averaging or "Automatic investing":

A fixed amount is invested at regular intervals (e.g. $100 every month) irrespective of market conditions. More shares are purchased when the market is low; fewer shares are purchased when the market is high. Dollar cost averaging avoids timing the market and also saves you from riding the emotional roller coaster of daily stock market performance. Here is how it works:  

  * shares purchased = monthly investment divided by share price
 
Average cost per share = $600/153.57 = $3.91
Total amount invested = $600
Total account value @ June = 153.57 * 5.00 = $767.85
Gain=$767.85-$600=$167.85  

In this example, our investment has a gain, however, this is not assured by dollar cost averaging especially in declining markets and can be worse than lump sum investing in rising markets.

But the best feature of Dollar cost averaging is it enforces discipline to investing and is very simple to implement since most mutual funds have an automatic investment plan where they will deduct an amount you are comfortable with periodically.

Sell a fund:

1. Rapid Growth in assets
2. Increase in Expense ratio
3. Performance lags index/peers
4. Veteran manager leaves the fund
5. Change in fund's investment strategy (style drift)
6. Create a loss (described in "Tax Loss")
7. Need the money

See list of 3-alarm funds (funds to sell) at fundalarm
 
Compounding:

Money grows in time by the magic of compounding. 

See how $1000 grows in 5, 10 and 15 years at annualized returns (APR) of 5%, 9% and 20%:

Compounding has a more pronounced effect with 1) higher returns or 2) longer time periods. The highest growth 9sahded in green) is achieved by both a higher return and a longer time period. Start investing early, reinvest distributions and choose investments wisely to take advantage of compounding.

Some interesting facts about compounding:

Let us say a fund delivers returns of 20% in the first year, second and third years but a negative 20% return in the fourth year. The annualized return for this fund over a 4-year period is only 8.43%!

Also the rule of 72: Number of years to double your investment is 72 divided by your rate of return on your investment. e.g. at 12% rate of return, money doubles in 72/12 or  6 years.

Buy funds before they close

Some good performing funds (especially small-cap funds) close to new investors when they reach a certain asset level (soft close: fund accepts new money from only existing investors but not new investors, hard close: fund does not accept any new money). Sometimes closed funds reopen. Remember, closed and closed-end funds are not the same.

Buy new funds

Newly launched funds especially from large fund companies tend to usually do well since they can use IPO's, smaller stocks and hot ideas more effectively.

Tax strategies:

Please consult your tax advisor for details on Tax issues.

a. Tax Exemption:
Municipal bond funds are tax-exempt at the federal level and are beneficial for incomes in the higher federal tax bracket.

b. Tax Deferral:
IRA's, 401(k)’s and 403(b)’s are examples of tax-deferred accounts, where the investment is shielded from taxes until you cash out. The effective rate of return is higher and results in a remarkable difference in the account value after a few years because of the effects of compounding.

c. Tax Deduction:
Under certain conditions, annual IRA contributions may be partially or fully deductible.  Annual 401(k) distributions are generally fully deductible subject to a maximum limit - this is called the Pretax 401k . There is also the deductible Catch-up 401(k) for older workers. In addition you may be able to contribute to the 401K) on an Aftertax basis. 

d. Calculate your tax bracket:

Calculate your tax bracket based on your projected income. If you are in a lower tax bracket than you originally thought, you may have to rethink how much to contribute to a 401(k).

e. Harvest Tax Losses:

Sell a fund/ETF that lost you money, take the loss on your return and buy a similar fund/ETF. This way you maintain your objectives and also benefit from lowering your taxes.  Pay attention to Long-Term and Short-Term losses.
(See www.irs.gov for details on the Wash rule. Make sure that reinvested dividends do not void the tax selling loss.)


f. Negative Potential Capital Gains Exposure:

Also some funds have accumulated large capital losses that can offset future gains and can be a potential tax shelter. For instance, a fund with a -50% Potential Capital Gains Exposure can go up by 50% before it pays out any capital gains distributions. Look at Morningstar's  Fund Tax analysis for this information. e.g. Tax Analysis of Fidelity Contrafund. 

g. ROTH conversion:

Convert a fund in your traditional IRA that lost you money to a Roth IRA. Pay lower taxes now, withdrawals are tax–free. There are income limitations in order to qualify.

Fund Tax Basis:
There are several ways to calculate the tax basis of a fund,  the most popular method is the Average Basis. Tax Basis is information that is needed to figure out loss/gain when you sell your fund. Check the Vanguard site for more details. Remember, reinvested dividends/capital gains distributions are a part of cost basis.

h. 401(k) match:

If your employer matches your contribution in the 401(k) plan, take full advantage of it.

i. Choosing funds for IRA/401(k) based on distribution:

Select funds that have large distributions in the retirement accounts and funds that have small distributions in your regular accounts (except when investing for income).

j. Buying after the distribution:

Many funds distribute capital gains around the end of the year. If you are buying such a fund, the best time to buy it is after the distribution date.

k. College Savings:

Tax advantages play an important role in choice between a) 529 College Savings Plan
 b) Coverdell Education Savings Account and c) UGMA/UMTA accounts  d) IRA accounts
Check out the details here.