Yellowstone Financial, Inc.

The Three T’s of Superior Portfolio Returns

Most investors aspire to superior portfolio performance. It’s what drives us to seek alpha, the additional return of a particular investment over its asset class.

But alpha isn’t necessary to surpass your fellow investors. By keeping in mind the 3 T’s — Timing, Transactions, and Taxes — above average returns could be yours.

Let’s first clarify what we mean by superior returns. The latest report by Dalbar on investor behavior states that the 20-year average return for equity mutual fund investors is 3.2 percent for the period ending in 2009. This barely beat inflation, which was 2.8 percent in that period. So the average equity investor essentially earned nothing over the past 20 years.

While some may interpret this as proof that the stock market is rigged against the individual investor, the S&P 500 had an average annual return of 8.2 percent during the same period. Even if you consider the mutual fund fees to invest in an index, this return crushes that of the average investor.

So there are methods to beat your peers, and the three T’s can give your portfolio an additional boost.

Timing. Left to our instincts, humans are horrible creatures when it comes to market timing. We are the most decisive when driven by emotion.

We tend to panic in a market crisis and go on euphoric buying sprees when the market is breaking through new highs. What may have served our species well a million years ago when pursuing wildebeests on the savanna undermines our financial security today.

Mutual funds have had their biggest investor outflows in the waning stages of a bear market — such as late 2002 and 2008 — right when stocks were cheap.

The trick here is to avoid market timing. Most investors would be best served by ignoring hunches and market timing signals. Instead devise an investment strategy with target asset allocations. Then rebalance to that allocation every year or two.

Transactions. Too many transactions in your portfolio as a whole and inside of individual investments can drain portfolio returns. When you purchase or sell a mutual fund, bond, or stock there is a transaction cost in most cases.

For mutual funds, there may be upfront or back-end loads, short-term redemption charges, or transaction costs if you use an independent custodian like Schwab.

Stocks have explicit transaction costs plus the spread between the purchase price and the sale price that is pocketed by intermediaries. Bonds, especially municipals and thinly traded corporates, usually have a bigger spread between “the bid” and “the ask.” Annuities and variable life insurance policies can have formidable surrender fees.

Even if you work to minimize portfolio transactions, a mutual fund that you hold may be turning over its basket of stocks once or twice a year. Mutual funds pay millions in brokerage fees and bid-ask spread costs that are not disclosed in standard fee calculations. The higher the expenses of your mutual fund, the bigger the drag on returns.

Taxes. Carefully managing the asset location of your investments in taxable, tax-free (Roth), and tax-deferred (IRA, 401(k)) accounts is key to prudent portfolio management. Investments that generate ordinary income, such as bonds and REITs, should first be used in tax-deferred accounts.

In particular, inflation-protected bonds and STRIPS generate “phantom income” and holding them in taxable accounts should be avoided. Taxable accounts are designed for tax-managed international and domestic equity funds, but watch out for short-term capital gains upon their sale.

Tax-free accounts are ideal locations for investments that have a high growth potential, such as small-cap and emerging market equity funds.

By keeping timing, transactions, and taxes in mind, it shouldn’t be hard for you to achieve portfolio returns that outpace those of the average investor.

Dave Gardner, for the Daily Camera.