MONEY Master the Game: 7 Simple Steps to Financial Freedom (56 page)

Just like dollar-cost averaging, you’ve got to take your emotions out of the picture. Portfolio rebalancing makes you do the opposite of what you want to do. In investing, that’s usually the right thing to do.

Let’s take a real-world example: say it’s the summer of 2013, and the S&P 500 index is lurching back to record-breaking levels, while bonds are still coughing up meager returns. Do you want to sell your stocks and buy bonds? No way! But the rules of rebalancing say that’s exactly what you have to do to keep your original ratio—even though a voice inside you is shouting, “Hey, stupid! Why are you putting money into those dogs?!”

The rules of rebalancing don’t guarantee you’re going to win every time. But rebalancing means you’re going to win more often. It increases your probabilities of success.
And probabilities through time are what dominate the success or failure of your investment life.

Sophisticated investors also rebalance
within
markets and asset classes, and that can be even more painful.

Say you owned a lot of Apple stock back in July 2012. It would have seemed insane to sell those shares, which had been surging—up 44% in the previous two quarters—and were worth more than $614 per share. But if Apple stock is dominating your portfolio (remember, it has grown 44%, and it’s put you out of balance, likely significantly), the rules of rebalancing say that you have to sell some Apple to get your ratio right. Ouch. But you would have thanked yourself the same time next year. Why? Apple stocks took a roller coaster ride, plummeting from a high of $705 per share in September 2012, to a low of $385 the following April, and ending at $414 in July 2013—a 41% loss that you avoided because you rebalanced.

How often should you rebalance? Most investors rebalance once or twice a year. Mary Callahan Erdoes of J.P. Morgan told me she believes rebalancing is such a powerful tool that she does it “constantly.” What does that mean? “That’s as often as your portfolio gets out of whack with the plan that you originally put in place, or the adjusted plan based on what’s happened in
the world. And that shouldn’t be set.
It should be a constant evaluation, but not an obsessive evaluation.”

Burt Malkiel, on the other hand, likes to ride the momentum of bull markets.
He advises rebalancing only once a year. “I don’t want to just be trigger-happy and sell something because it’s going up,” he said. “I like to give my good asset class at least a year in the run.”

However often you do it, rebalancing can not only protect you from too much risk—it can dramatically increase your returns. Just like dollar-cost averaging, the discipline once again makes you invest in underperforming assets when their prices are low, so that you own lots of them when their prices go up. Your profits get passed along to the other players on your team, like the ball in an LA Lakers motion offense, or relay runners passing the baton on the way to victory at the finish line.

The number of times you rebalance does have an impact on your taxes, however. If your investments are not in a tax-deferred environment, and you rebalance an asset you have owned less than a year, you’ll typically pay ordinary income taxes instead of the lower long-term investment tax rate!

If rebalancing seems a little intimidating, the good news is this work can be done for you automatically by Stronghold or any other fiduciary advisor you choose. He or she will guide you on being tax-efficient while still tapping into the power of rebalancing.

So now you’ve learned two time-tested ways to reduce your risk and increase your returns just through asset allocation. But there’s still one final trick that can take the sting out of your losses—and your taxes!

IT’S HARVEST TIME

So what happens when it’s portfolio-rebalancing time, and you have to sell some stocks that aren’t in your 401(k) or other tax-advantaged account? Uncle Sam will have his hand out for part of your profits. Are the capital gains taxes making you crazy? Listen,
there’s a perfectly legal way for you to lower those taxes while keeping your portfolio balanced: tax-loss harvesting.
The benefit you get by tax-loss harvesting is that
you reduce your taxes, and that increases your net return!
In essence, you use some of your inevitable losses to maximize your net gains.

Burt Malkiel believes that tax-loss harvesting can increase your annual
rate of return by as much as 1% per year, so it’s certainly worth investigating.

Billionaires and big institutions increase their returns this way, although few ordinary investors take advantage of these powerful techniques. Few know of them, and even those who do may think rebalancing and tax harvesting sound too complicated to try on their own. Not to worry! You can get access to your own fiduciary advisor or access to software that will make it as easy as ordering a pizza online, or at least updating your Facebook security settings.

Now, bear in mind, my goal is to make investing simple for everyone, and this section is probably the one that tested your brain the most! So first, congratulations on sticking with me. This stuff feels very technical, and most people avoid it like the plague. If you feel a bit overwhelmed by asset allocation and the idea of dollar-cost averaging, rebalancing, and tax-loss harvesting, I want you to know all of this can be automated for you. But it’s still helpful to understand what these strategies are and the principle reasons why they’re effective.

Just remember four things from this section of the book:

1. 
Asset allocation is everything!
So you want to diversify between your Security Bucket and your Risk/Growth Bucket. You want to diversify across asset classes, markets, and time.

2. 
You don’t want to hesitate to get in the market trying to have perfect timing; instead, use dollar-cost averaging and know that volatility can be your friend,
providing opportunities to buy investments cheaply when the market is down. This technique will increase your portfolio’s value when the markets come back up.

3. 
Have a Dream Bucket that gives you emotional juice and excitement so you can experience the benefits of your investing prowess in the short term
and midterm instead of just someday far in the future.

4. 
Use rebalancing and tax harvesting to maximize your returns and minimize losses.

When I first brought up that I was going to teach asset allocation and
these additional refining strategies in this book, many of my friends in the financial world said, “You’re crazy! It’s just too complex. The average person won’t understand it, and few will even take the time to read it.” My answer was simple: “I’m here for the few who do versus the many who talk.” It takes hunger to push yourself to master something new. But in the case of mastering investment principles, it truly is worth the effort. Even if you have to read something a couple of times to get it down, the rewards can be immense—it could mean saving years of your life without having to work. More importantly, mastering these will give you a greater sense of empowerment and peace of mind today.

Mastering this section is a lot like trying to learn to drive a stick-shift car for the first time. What?! I’m supposed to figure out how to use the accelerator, the brake, the clutch, the stick, the rearview mirror, the steering wheel,
and
watch the road too? Are you kidding me?! But after awhile, you’re driving the car without thinking about it.

Well, we’ve already come a long way together on the 7 Simple Steps to Financial Freedom.
Let’s check in where we are now:

1. 
You’ve made the most important financial decision of your life by deciding to save a percentage of your income—your Freedom Fund—and invest it automatically for compounded interest.
Have you acted on this yet by setting up an auto-deduct account? If not, do it today!

2. 
You’ve learned the rules of investing and how to avoid Wall Street’s nine biggest marketing/investment myths.
You’re becoming the chess player, not the chess piece.

3. 
You’ve taken the third step on your path to financial freedom by making the game winnable.
There are three stages within this step: Number one, you’ve calculated your top three financial goals, which for many people are financial security, vitality, and independence. Number two, you have a plan with real numbers. And number three, you’ve looked for and are implementing ways to speed it up so you can enjoy your rewards even sooner.

4. 
In this section, you’ve made the most important
investment
decision of your life by allocating your assets into a portfolio with a specific percentage into different buckets (Security, Risk/Growth, Dream). You’ve diversified, and you have a plan that will fuel your financial dreams.

You’re already light-years ahead of other Americans (or investors anywhere in the world) when it comes to understanding your finances and managing your money. And if you’re anything like the men and women who have been gracious enough to read this book in manuscript form, you might already be so excited by what you’ve learned that you’re jumping up and down and grabbing your friends by the collars to show them some of the ways you’ve learned that they can add hundreds of thousands of dollars, or even millions, to their lifetime investment earnings.
So you might be surprised to learn: you ain’t seen nothin’ yet! I promise you, the best is still to come. And everything from here on out is much easier than this section!

Now that you’re thinking and acting like an insider, I’ll show you how to truly invest like one.
Let’s find out how you can be successful in any financial environment and how you can tap into the power of the upside without the downside, creating a lifetime income stream.

DOLLAR-COST AVERAGING VERSUS LUMP-SUM INVESTING

But is it the best approach if you have a lump sum to invest?

What do you do if you have a sudden windfall, like that $10,000 bonus we talked about earlier in this section? Or what if you got a $50,000 insurance payout? Do you use dollar-cost averaging to invest it over a set time schedule of months or even years, or do you invest in a lump sum?

Here’s where the controversy comes in. Some investment advisors have turned against dollar-cost averaging because, as even Burt Malkiel admits, it’s not the most productive strategy for investing in the stock market when it keeps going straight up—like it’s been doing in the years following the recent Great Recession.

You would have made more money by investing “everything” at the beginning of the bull market than if you had doled out your money over five years. That’s obvious, right? And there have been recent studies, including one by Vanguard in 2012, showing that in rolling ten-year periods over
the past 80 years in the US, UK, and Australian stock markets, lump-sum investing has outperformed dollar-cost averaging more than two-thirds of the time.

Why is this true? Because you’re putting more of your money to work sooner and over a longer period of time, and limiting your trading fees. Onetime lump-sum investing gives you the opportunity for greater potential growth but also greater overall loss when markets drop. Research shows that lump-sum investing over the long term, when diversified successfully,
is more profitable. But by how much? In the end, the average increased returns were no more than 2.3% more. And remember the statistics that Burt Malkiel shared with us for the 2000-to-2010 lost decade period—in that case, if you had invested $1 in the S&P 500 on December 31, 1999, ten years later it was worth only 90 cents. But if you did dollar-cost averaging, you made money during that same period. What would you do? Would you plunk down the whole ten grand as soon as you got it? Or would you keep it in a more secure place and invest $1,000 a month over ten months? Or $50,000 over two years? If the market keeps going up and up, you might lose out on some gains. But behavioral economics tells us you won’t have as much regret as you would if the market crashed two days after you’d invested it all!

So it’s totally up to you. Once again, I’m not here to give you my opinion, just the best insights available from the best experts. For most people, lump-sum investing is not an issue because they don’t have a significant sum to invest! If that’s your situation, you’ll still maximize your returns by investing in a diversified portfolio with dollar-cost averaging.

12
. If you look on most of today’s stock charts, you may see that Citigroup was selling for $10.50 on March 9, 2009, and $50.50 on August 27, 2009. This is not accurate. These charts have been reformatted to reflect the fact that on May 6, 2011, Citigroup did a reverse stock split. Every ten shares of stock that was selling for $4.48 on May 5 were combined into one share of stock worth $44.80 a share, which ended the day at $45.20, for a small gain per share. Thus 29 billion shares of Citigroup were converted into just 2.9 billion shares in order to raise the price per share. Or as the
Wall Street Journal
stated on May 10, 2011, “Citigroup became a $40 stock the first time since 2007, as its share price appeared to rise more than 850% from Friday’s close. One catch: Investors didn’t earn a dime.”

SECTION 5

UPSIDE WITHOUT THE DOWNSIDE: CREATE A LIFETIME INCOME PLAN

CHAPTER 5.1

INVINCIBLE, UNSINKABLE, UNCONQUERABLE: THE ALL SEASONS STRATEGY

Invincibility lies in the defense.

—SUN TZU,
The Art of War

There are events in our lives that forever shape our view of the world. Mile markers on our journey that, whether we knew it or not, have given us the lens through which we now see the world. And what we choose to allow those events to mean to us will ripple through our behavior and decision making for the rest of our lives.