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Wealth Extractions: Wealth accumulation strategies

March 3, 2011
Another in the "Wealth Extraction" series from J. Haden Werhan, CPA/PFS
By J. Haden Werhan, CPA/PFS
In our last Wealth Extractions, “Investing a lot with a little,” I offered some ideas for your early investing efforts. By putting a little down in your nest while you’re young, you’ll be much better positioned to add some serious feathers later on while your overall portfolio moves into the triple-digit figures. Let’s explore several investment strategies for getting your fledgling wealth to soar.
Diversification: Portfolio pain management
No pain, no gain? In your practice, there are times this holds true and times it does not. Your goal is to prevent pain from resulting from injury or decay. But to avoid that sort of damage, you must inflict a little controlled discomfort — unpleasant yet necessary scraping and drilling. In investing, a key goal is to prevent injury or decay in your long-term wealth. To avoid real damage to your wealth, you must accept some periodic discomfort in the form of market risk. Briefly, after adjusting for inflation, the stock market has provided average returns to the tune of about 6% per year since 1926, when the earliest credible data became available. (Without getting too technical, this means annualized returns of 9%, since inflation has averaged 3% over the same period.) That’s the expected gain. But to capture these returns, you must be willing to stay the course, even when there is risk during periods that deviate widely from that long-term average. And unfortunately, unlike your patients’ experience, the markets are far less specific on how much and how long drilling must be endured. That’s the pain. And it can really hurt. Your most powerful instrument for managing the ache of market risk is to diversify your holdings across the widest appropriate range of asset classes and remain diversified through thick and thin. That’s very important, so I’m going to call it out to make sure it sticks: Diversify your holdings across the market and remain diversified throughoutDiversification through this kind of asset allocation is as old as the adage about not putting all your eggs in one basket. Beyond that, there is a considerable body of evidence, from Nobel Prize-winning economists who have built on more than a half century of academic inquiry, to support that you can apply buy-and-hold diversified asset allocation to build wealth with less risk. Equal or more gain with a little less pain — who wouldn’t want that? Advanced asset allocation On the highest level, diversification means 1) stocks versus bonds, 2) safer versus riskier stocks, and 3) worldwide. When you’re young and your assets are limited, if you can diversify across these three key areas and stay put, you’ve accomplished quite a bit. As your assets accumulate, you still want to maintain a steadfast, diversified portfolio, but you can refine the allocations among your stock funds to more accurately reflect your unique financial goals. You accomplish this by building in more or less of specific types of stock risk/expected return. Let me explain. If you’re comfortable with higher doses of equity (stock) risk, you can overweight or "tilt" your allocation toward riskier equity asset classes with a history of average returns above the market. Research by professors Eugene Fama and Kenneth French found that small company “small-cap” stocks have had higher average returns than large company “large-cap” stocks, and the “value” stocks of less credit worthy companies have had higher average returns than the “growth” stocks of more stable companies. By holding larger portions of small-cap and value stocks in your portfolio, you can increase your potential to earn higher returns for additional risk. (Or you can lower risk and expected returns by decreasing your exposure to them.)Enhanced global diversificationWith limited assets you may need to purchase a single, no-load, index or index-like fund to achieve global diversification while best managing investment costs. As your wealth grows, you can augment the core of your holdings with the above-mentioned component funds, as well as across funds that focus more specifically on U.S., international (developed countries), and emerging markets, which will expose you even more accurately to the benefits of global diversification. Tax efficient investingWith increased wealth, you gain more opportunity to locate your assets across taxable versus tax-sheltered accounts, placing your least tax efficient holdings where they can best accumulate, such as in your 401(k) profit-sharing plan or Roth 401(k). Portfolio rebalancing Last but not least, most investors have heard the term “buy and hold,” but that really should be, “buy, hold, and periodically rebalance.” As the markets ebb and flow, your portfolio can get out of whack (to use a technical term). For example, say you planned to hold half of your assets in fixed income and half in stock. If the stock markets soar while fixed income holds steady, you may find you have a significantly higher percentage of stocks than you intended. To rebalance to your intended allocations, you may sell the assets that have outperformed and/or purchase those that have underperformed. Rebalancing can be achieved by shifting assets between holdings, or more cost-effectively, by purchasing more of your underweighted holdings whenever you’re injecting new money into your portfolio.When your portfolio is small, you may need to limit rebalancing to the broad levels of stock versus fixed income. As you further diversify your wealth into more specific asset classes, you can rebalance among them as well. In some ways, it will feel weird to buy what’s been doing lousy and sell what’s been doing great. But when you think of it as what it really is — buying low and selling high — it makes enormous sense, plus it ensures that you remain true to your personal goals for your wealth. However, it’s important to note that rebalancing does incur transaction costs and, within your taxable accounts, it can have significant tax ramifications. So especially once you’re investing among specific asset classes, an advisor who is well-versed in the intricacies of rebalancing can help you maximize the benefits and minimize the costs. Ready to fly?We’ve offered a flock of ideas here, each worthy of its own article in future Wealth Extractions. Stick around and you’re likely to see them arriving soon.
Editor's Note: To read more from the "Wealth Extractions" series, please click here.
J. Haden Werhan, CPA/PFS, is a partner at Capital Performance Advisors and Thomas, Wirig, Doll & Co., CPAs. He regularly lectures and provides seminars to the dental community that he has been serving his entire career. By supporting dentists in their tax and accounting strategies, practice transitions and, ultimately, their lifelong wealth planning, Mr. Werhan and his partners assist dentists in achieving financial freedom. More information about his firms’ services can be found at Mr.Werhan can be reached at [email protected].