First of all, if you were one of the many people who responded on the message boards with comments and questions, I'd like to thank you for doing so. For those of you who haven't yet taken part in the ongoing discussions on the boards, I'd like to invite you to click on one of the links at the end of this report.
Okay, let's move on to the topic that resulted in the most messages, which was my sample Unified Fool Portfolio. Please keep in mind that this is only meant to illustrate the possibilities, and you should not consider it as gospel. I've reprinted it here below:
Tax-advantaged portfolio:
- 25% S&P 500 Index fund or Spiders (AMEX: SPY)
- 25% Nasdaq 100 Index Trust (AMEX: QQQ)
- 25% Beating the S&P (a variation of the Foolish Four)
- 25% Rule Maker
Taxable portfolio:
- 60% Rule Maker
- 20% Rule Breaker
- 20% Foolish 8 or Value Investing
Most of the questions I saw on the message boards concerned my allocation of strategies into the tax-advantaged and taxable portions of my sample portfolio, so let's start there.
In general, you'll notice that I allocated the lower risk strategies to my tax-advantaged portfolio, and the higher risk, higher turnover strategies to the taxable portfolio. This has a lot to do with my own personality. Tax-advantaged investments, in my mind, equate to retirement money. It could also represent an educational IRA for some of you. Whatever it is, it's something you don't want to have to compromise on. I'm fairly risk-averse in this portion of my portfolio, despite the fact that I am looking at 30+ years to retirement. I mean, this is the retirement home, the trips to Europe, and the Viagra.
Sorry, but I'm really interested in limiting the worst case with my retirement money. I still want to beat the market, if possible, and I always want to reduce my transaction costs, which is why I allocated my sample portfolio this way. I want the diversification that the S&P 500 index provides. The Nasdaq 100 provides additional diversification, but more importantly, offers a tremendous group of high-growth companies. I should point out that both of these index products, as well as their mutual fund variations, are also perfectly suitable for taxable portfolios.
Again, this is just an exercise to stimulate thinking, so please feel free to do what makes the most sense to you. If you want to be more aggressive than I was in my sample portfolio, that's fine. I should note that having a retirement portfolio allocated 100% to stocks is riskier than many financial advisors would recommend, and it is only because of my longtime horizon that I am comfortable with this allocation. Generally, however, I believe that even shorter-term retirement portfolios should be as heavily weighted in stocks as one's comfort level will allow. (For more ideas on the percentage of your portfolio that should be in stocks, see these recent Bore Port articles: Stay Fully Invested? Part 1 and Part 2.)
For the mechanical component of my sample tax-advantaged portfolio, I chose one of the high-dividend yielding approaches that have proven to be very good strategies in bear markets (check out these numbers versus the market averages in 1973-74). The Beating the S&P variation of the Foolish Four offers the little extra kick of dividends and also has managed to beat the S&P over an extended period of time. If I was a little more aggressive with this money, I could choose one of the mechanical growth strategies, like the PEG or Spark. Mechanical strategies are much better suited to tax-advantaged portfolios. Using them in your taxable portfolio will cost you both in capital gains taxes and dividends.
Let's talk about adding money to the tax-advantaged portfolio. Because we are only talking about a possible $2,000 per year in new money to most tax-advantaged portfolios, I just mentally break this down into four additions of $500 each. I would allocate the first $500 to a mechanical strategy. Historical backtesting has shown that this is generally best done in either December or January. The other three could either be added to the Spiders, the QQQs or to purchase either additional shares in an existing Rule Maker or to add a new Rule Maker stock. Making investments of less than $500 doesn't make sense if you are using a discount broker, but if you're using an S&P index fund, you can be just as cost-efficient getting your money into the market in smaller increments.
Now, let's turn to the taxable portion of the portfolio. Assuming I've already allocated my savings for the year to my retirement portfolio, the rest is money with which I feel free to take a bit more risk. I still rely on a core of Rule Makers for low-maintenance growth. As has been repeated in this column many times, Rule Makers are excellent for taxable portfolios because it is a long-term, low-turnover strategy. As far as Rule Breakers are concerned, these are also generally long-term investments, but these will typically require a sale more often than a Rule Maker. Because a certain percentage of Rule Breaker investments will blow up on you, there is often an opportunity to actually generate a tax credit when the losers are sold.
The Fools over in the Rule Breaker Portfolio will usually sell off some losers and small portions of runaway winners when they want to raise funds to buy a new Breaker. This allows the RB Fools to offset some of their capital gains from the winners with the capital losses from the losers. Since the BreakerPort only makes two or three purchases a year, this strategy allows them to maintain a fairly tax-efficient portfolio. Of course, there's nothing stopping you from including Rule Breakers in your retirement portfolio if you want to. In fact, if you turn over stocks a lot, you might be better off allocating your Rule Breakers to the tax-advantaged portfolio. As I mentioned earlier, it has a lot to do with your personal risk appetite.
The small-cap growth stocks that I purchase, which I often select from the Foolish 8 list, are pure candy for me. That means I make sure to eat my veggies first. I consume a healthy diet of Rule Makers with the majority of my portfolio. I also find that I can get some great results by combining the Foolish 8 stocks with Rule Maker criteria, as described in my Mini-Maker articles (Part 1 and Part 2). I also inevitably find that about one out of four of these small company stocks explodes in my face, and despite the fact that I am long-term oriented, I need to be willing to pull the sell trigger if the company just isn't making satisfactory progress.
I choose to keep the Foolish 8 and other small company growth stocks in my taxable portfolio because I can usually offset any capital gains with my inevitable annual blowup, and because none of these are companies that I can forget about for six months at a time. Again, there isn't anything keeping you from having these higher-turnover, higher-risk strategies in your retirement portfolio, and you should of course review your own portfolio to see if it makes sense for you to do so. The same can be said for the Value Investing component which I included in my sample taxable portfolio.
To sum up, let's go through the strategies one by one and rank them according to tax efficiency:
Turnover/ Dividends/ Tax
Strategy Cap Gains Income Efficiency
Index Products Very Low Moderate Very High
Mechanical Investing High Varies* Low
Rule Maker Low Moderate High
Rule Breaker Moderate Low Mid
Foolish 8 Moderate/High Low Low/Mid
Value Investing Varies Varies Varies
Let me add a little commentary to the above table. For mechanical dividend yield strategies such as the Foolish Four, the dividends would be relatively high. For growth strategies, the dividends would be relatively low. Value investing is generally too broad and individual to characterize, but if I were using the Fool's own Boring Portfolio as an example, I would rank tax efficiency as mid, with turnover as low and dividends as low. If you're daytrading, your annual turnover is too high for those of us without degrees in mathematics to even ponder, and you are likely receiving thank you cards from the government every year.Because I'm running out of space (again), and because Matt Richey has threatened to rough me up (again) if I exceed my limit, let me finish with a last thought: You can give yourself an extra edge by dollar cost averaging into the market. Especially with the index strategies, just investing the same amount at regular intervals over a long period of time will practically guarantee superior results, because you'll be buying more shares when the price is lower, and fewer shares when the price is higher.
Finally, for some excellent levelheaded thinking on how to beat the market, be sure to check out this week's Bore Report by Whitney Tilson.
Until next time, y'all stay Foolish!
Zeke