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Simplicity vs. Flexibility In Your Portfolio

By Scott Roark, MBA, PhD | December 18, 2020

There is much to be said for the practice of simplifying and de-cluttering in life.  It seems like I keep seeing consultants and tools that will help you clean out and organize your garage, your food pantry, or your closet.  It seems that the hoarding gene (apparently it resides in a region on Chromosome 14) is relatively widespread among us.

It turns out that this tendency to accumulate clutter can be fairly common in the financial arena as well.  If you change jobs, move around or respond to financial services marketing, chances are that you have more accounts than are really necessary for a smoothly functioning life.  While there may be some arguments to having more than a couple of accounts for a particular category, it may sometimes be easier to keep track of financial matters when you are not dealing with endless statements at the end of each month. This logic also transfers to the actual investments that make up your multiple accounts. The financial services industry has attempted to provide simplicity with an investment vehicle called a Target Date Fund.

Target Date Funds have been marketed is as a simplifying tool for retirement savings.  They can be appealing because, in one fund, you can get a well-diversified holding that can achieve a targeted asset allocation (or at least get very close to one). The theory behind Target Date Funds is rather than having a portfolio with a dozen or more varying asset classes, one simple fund may do it all. As a quick overview of Target Date funds, they have dates contained in their name that roughly correspond to a “targeted retirement date”, often occurring in 5-year increments. Funds with a target date in their name closest to the current year will theoretically have less volatility and more fixed income and cash-like holdings in them while funds with a target date in their name furthest from the current year will be invested in a more growth-oriented manner. For example, a fund sponsor may have funds that range from a 2020 fund that might have 35% in stocks and 65% in fixed income and cash-like holdings while a 2065 fund could be allocated to 90% stocks and just 10% in fixed income and cash-like holdings.

Obviously, a full discussion of Target Date funds is beyond the scope of this simple article.  I will get into more depth on these complex funds in the future, perhaps on one of our EDU podcasts! But in terms of adding simplicity to your portfolio, they may be an attractive tool, especially in the accumulation phase of retirement planning – that period of time when you’re just adding to your portfolio every month and you are not taking any distributions.

However, in retirement when you begin sending your savings and living off them, I would argue the simplicity that Target Date funds offer starts to lose its appeal.  In the distribution phase of retirement planning investment flexibility become more valuable than account holding simplicity.  Unfortunately, that is where a Target Date fund can lose some appeal.  For instance, consider the situation of March 2020 when the Corona Virus scare had the equity markets down 30%+ in a short period of time. However, in the same period, some fixed income and cash-like holdings (not all, but some) held steady or even gained in value.  If you were taking a $20,000 quarterly distribution from your retirement funds in March, it would have been nice to pull from the fixed income or cash-like holdings that were more stable in value and had not dropped rather than selling your stock holdings which had likely dropped in value. This is where the simplicity of a Target Date fund loses out to its inflexibility.  If all your assets are in a Target Date fund, you can’t choose to sell the winners and leave the losers alone. If the Target Date fund’s “losers” dropped enough that they took the entire fund’s value down, even though the fund holds some “winners”, you must still sell the entire fund as one. There is no picking and choosing allowed!  It is the proverbial “Throwing the baby out with the bathwater” conundrum.

When you are close to, or in retirement and you are actively spending from your portfolio, I think it is better to have the flexibility that comes from breaking your actual retirement portfolio into its constituent parts.  At Jim Saulnier & Associates we call this “positioning” and it allows you the flexibility to pick and choose what holdings you sell under what market conditions.

Target Date funds and others in their ilk, do offer simplicity and can be a useful option to busy professionals lacking the time and inclination to monitor and manage an investment portfolio during their accumulation years. But in retirement, when assets must be sold to fund your spending needs, I would suggest you opt away from simplicity and begin “positioning” your portfolio for spending by utilizing separate low-cost passive asset classes in your portfolio for the spending flexibility they afford. After all, babies should not be thrown out with the bathwater!


Additional Disclosure:

Diversification and asset allocation strategies do not assure profit or protect against loss. Past performance is no guarantee of future results. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including loss of principal.

Asset Allocation and Asset Positioning

By Scott Roark, MBA, PhD | November 23, 2020

Asset Allocation

One of the most important decisions investors make is the “asset allocation” decision.  This is the decision about the broad categories of investments that will be held in a portfolio.  In the broadest sense, these categories would be things like stocks and bonds.  But many times, investors also consider other categories of assets like cash, commodities and real estate and maybe even more esoteric categories like private equity, blockchain currencies (e.g. bitcoin) and vintage cars.  In this article, we’re going to stick with a mix of asset types (also called “asset classes”) that addresses the needs of the vast majority of investors – stocks, bonds and cash.  And in terms of how investors participate in these asset classes, I’m going to assume that broad based ETFs are used for stocks and bonds and a money market fund is the stand-in for cash.

There are a few important characteristics of asset classes that matter to investors, including average return, risk, liquidity and correlation. Each asset class will usually have slightly different expressions of these characteristics and several are listed below.

  • Average return reflects the expected total return of an asset is going forward. This return is made up of income and capital gains (price increases) that benefit the owner.  Over the past 100 years or so, stocks have had the highest average return, followed distantly by bonds with cash bringing up the rear.  According to the 2020 edition of the SBBI Yearbook, the average annual compound return for the various classes is:

Large-cap stocks                                 10.2%

Long-term corporate bonds                  6.1%

U.S. Treasury Bills (cash proxy)          3.3%

Inflation                                                2.9%

  • Risk reflects the uncertainty associated with returns and is frequently measured by the standard deviation of returns. The more ups and downs there are in the returns for an asset class, the higher the standard deviation will be.  From 1926-2019, stocks have been the riskiest asset class, followed by bonds and then by cash. Based on the 2020 SBBI Yearbook, the standard deviation of returns for the asset classes is:

Large-Cap stocks                                 19.8%

Long-term corporate bonds                  9.8%

U.S. Treasury Bills (cash proxy)          3.1%

Inflation                                                4.0%

  • Liquidity is really about the ease of converting an asset to cash without losing too much value in the conversion. The asset classes we are considering are very liquid.  Of more concern here is really the interaction between risk and liquidity.  It is easy to sell a stock ETF, but you don’t really want to do that when the market has tanked by 25%.  A better time to sell investments is when they have had a nice increase.
  • Correlation is the last important characteristic of asset classes that we will consider. Correlation touches on the diversification benefits of an investment – does having this asset reduce the overall risk of your portfolio?  This could also be thought of as a measure of how one asset zigs when another asset zags.

According to the 2020 SBBI Yearbook, the correlations between stocks, bonds and cash are all below 0.17 – which means they have generally contributed to diversification and reduced risk when held together in a portfolio.


Asset Positioning

The notion of asset positioning ties investing decisions related to asset allocation to spending decisions based on timing.  Many times, this is thought about as matching the timing of a known liability (spending need) to the characteristics of an asset.   Here are a few principles of matching that are commonly used in the accumulation phase of life (up to retirement):

Saving for retirement – there is a long horizon (anywhere from 20-40 years of future participation in the labor force), so a heavy dose of stocks is usually called for.  The need for a high average return to provide a sizable nest-egg and the fact that there is plenty of time to recover from a downturn means stock are an appropriate choice.

Saving for college education – this might be up to 18 years away if you start setting aside money at birth in a 529 account (use a stock-heavy allocation) all the way up to saving some money for next year when junior or juniorette starts college (use money market).

Saving for a house – if you are planning on buying a house in the next couple of years, the biggest need from an investment is stability.  If the money you’ve set aside for a down payment takes a 25% haircut from a market downturn, then perhaps the purchase decision has to be put off for quite some time.  Generally, for these needs that are imminent, setting aside money in low-risk money market accounts is best.

In retirement planning, asset positioning is also key.  At Jim Saulnier & Associates, we believe strongly in the need to position assets in such a way that spending decisions are aligned with investment decisions.  We work with our clients to move away from one catch-all portfolio to a portfolio that has been positioned with different mini-portfolios (also known as “sleeves” in our business) to meet different spending objectives.  For instance, we position clients such that they have a principal-protected sleeve for immediate spending needs (anywhere from 1-5 years of spending will be set aside in cash or cash-like holdings so that there is no risk of a market downturn causing a loss of spending power.  The drawback of this safe approach, especially in the past few months, has been the very low interest rates that can be earned on these kinds of investments.

For intermediate spending needs (from 5-10 years or more in the future), we may position clients where there is some modest level of risk, but also the opportunity to have the investments grow in value to keep up with and hopefully exceed inflation.

Because retirement can last anywhere from 10-30 years (or more), it is important to have some investments allocated to more aggressive holdings (i.e. stocks) that can continue to grow over time.

And because some needs don’t necessarily have a definite timetable attached – such as the need for long-term care – there may be sleeves set aside with a mix of immediate liquidity and longer-term growth potential.

Because of all these considerations, asset positioning is a dynamic process that requires on-going maintenance and attention.  We always want to manage investments in such a way that there is plenty of cash available for near-term spending while keeping an eye on longer term goals and needs of our clients.

Net Investment Income Tax (NIIT)

By Bob Palechek, CPA | October 2, 2020

Today’s blog is about Net Investment Income Tax, otherwise referred to as “NIIT”.   NIIT came into existence on January 1, 2013, and applies to individuals, estates, and trusts.  The focus for today is on individuals.

NIIT is a tax on certain types of investment income applied at 3.8% if the taxpayer has income above certain income thresholds.   The income thresholds for single filers is Modified Adjusted Gross Income (MAGI) above $200,000.   For married filing jointly files, the MAGI amount is $250,000.  These thresholds have been the same since 2013 and are not indexed for inflation.

The 3.8% is applied to the lower of net investment income or the amount of your MAGI that exceeds the applicable threshold amount.   For example, if a married couple has net investment income of $150,000 with a MAGI of $305,000, then the 3.8% tax will be applied to $55,000 (since $305,000-$250,000 is lower than $150,000).   In this scenario, the NIIT tax reported and owed will be $2,090.  The calculation and reporting of NIIT is found on IRS Form 8960.

Types of Investment Income included in NIIT:

-Interest and dividends (including qualified dividends)

-Capital gains and capital gain distributions

-Rent and royalty income

-Non-qualified annuities

-Income and gains from passive activities (where the owner is not involved)

-Gains from the sale or disposition of those passive activities

Types of Investment Income not included in NIIT:

-Tax-exempt interest

-Distributions from qualified plans (typical IRA’s ROTH’s, and 401(k)’s)

-Any portion of the gain on your home if excluded under Section 121.

So RMD’s from my IRA are not subject to NIIT?   Correct, but if the RMD amount raises your MAGI above the applicable threshold, it will trigger NIIT on your net investment income.  This is especially important when looking at Roth Conversions!  If this causes an additional 3.8% tax on your investment income, it should be factored into the current cost of the Roth Conversion.  Fortunately, the tax planning software we utilize factors all of this into the Roth Conversion Analysis plans we perform for our clients.

One last common item that I see preparers miss on tax returns:   If a business that you own and operate rents from real estate that you also own, a sale of that real estate that generates a capital gain is excluded from NIIT.  The IRS allows the gain to be considered as part of the business activity and not subject to the 3.8% additional tax, if applicable.

Active Investing vs. Passive Investing

By Scott Roark, MBA, PhD | September 18, 2020

In this blog post, I want to talk about the characteristics of passive and active investing and how those terms relate to activities frequently associated with investing.

For a working definition, I am going to consider passive investing as the set of activities and decisions that is consistent with an investor seeking to match the performance of their benchmark.  The benchmark would be consistent with the level of risk that is appropriate for the investor – consider for simplicity a 60% equity, 40% bond (60/40) portfolio.

For active investing, a good working definition is the set of activities and decisions that an investor takes to beat the performance of their benchmark.  Again, the benchmark would be consistent with the level of risk for the investor.

Let’s talk about that most important of decisions for an investor – their asset allocation.  This is really divorced from the whole active/passive discussion – at least when talking about the strategic asset allocation.  This is a decision that is made with an eye on the risk appetite, stage in life, types of assets, amount of assets, presence of guaranteed secure income, etc.  For some people this might be a 20/80 allocation and for others perhaps it is 80/20.

While the strategic asset allocation doesn’t really touch on active vs. passive, the tactical asset allocation does.  This is where certain investors/strategists/managers will adjust their target stock/bond mix based on market conditions and more importantly where they think the market will go in the near future.  This is trying to beat the market by tweaking things.  For instance, if there has been a big run up in equities, perhaps the active investor will decrease their allocation from the target 60/40 allocation to 50/50 because the fear is that the market will have a correction and by tweaking the asset allocation, the portfolio will do better than the 60/40 benchmark.

There is another important part to this asset allocation discussion.  In the absence of rebalancing a portfolio, an investor who does nothing after a run up in equities is really making an ACTIVE decision to be overweight equities because they will most likely have a higher proportion of equity than their target allocation.  It is a bit of a paradox, but by neglecting the account, the investor is effectively making a bet that they will do better than their 60/40 benchmark.  So periodic rebalancing is actually an important part of PASSIVE investing – keeping your portfolio allocated in a way that is consistent with your benchmark.

By far the most common characteristic of investing that people think about in the active vs. passive discussion is the actual investment they are picking.  A broad-based market index like the total stock market index or the S&P 500 index is a passive approach to the choice of what to buy.  Buying a mutual fund where the fund manager is trying to uncover undervalued stocks, on the other hand, is consistent with an active approach to investing.  Typically, there is a direct cost involved here.  Passive index funds or ETFs typically have VERY low expenses (less than 0.1%).  And while the expense ratios associated with active funds have come down dramatically over the years, many of these funds are still close to 1% (or more).  These higher fund expenses typically come at a cost to the investor:  Passive funds consistently beat actively managed funds over time.  A recent Morningstar report (https://www.morningstar.com/articles/999669/busting-the-myth-that-active-funds-do-better-in-bear-markets) showed that less than 10% of actively managed large cap funds beat their passive benchmark over the most recent 10 year period ending in June 2020.  For all funds (large, mid, small, international, etc.), only 24% of actively managed funds beat their passive counterparts over that time.   The biggest reason is those fees.

There is one other critical component to the active vs. passive discussion and that is the amount of trading and attempted market timing involved.  Active investors try to time the market and are usually much more frequent traders than passive investors.  This usually leads to underperformance AND to tax inefficiency.  Study after study shows that investors who trade frequently underperform those who hold onto investments.  I’ve seen multiple reports of one particularly interesting study from Fidelity when they looked at which types of clients had the best performance between 2003 and 2013.  They found that the customers with the best performance were the ones who were dead or who were inactive (i.e. they forgot they had an account).  In other words, they were messing around with their investments – trying to time the market, buy the hot stock or guess which sector was about to take off.

While this is not an exhaustive list of all the ways an investor could try to “beat the market” (sector rotation, stock selection, interest rate forecasting, exotic investments, cryptocurrency, etc.), this hits on a few common differences between active and passive.

At our firm, we choose to use a passive approach to investing for a few reasons.  First, it has been shown over time to do well in comparison to benchmarks.  Jim has talked repeatedly in podcasts and we’ve had a number of blog posts that touch on the importance of benchmarking and the passive approach holds up well when comparing to the gold standard of performance.

Second, passive investing is a tax-efficient way to invest.  By minimizing trading, capital gains and the associated taxes are kept low.

And importantly, passive investing is relatively easy to implement and monitor.  With periodic rebalancing it is pretty easy to “set it and forget it” and look up after 5 or 10 years and be surprised at how well an account has performed – how much an account has grown (if you are in the accumulation phase) or how well an account has held up (if you are in the harvesting phase).

Why Investor Returns Usually Fall Short of Benchmarks

By Scott Roark, MBA, PhD | July 17, 2020

In podcast episodes and in past blog posts (10/25/2019, 4/20/2019) we’ve talked about the importance of benchmarking – comparing the investment performance on a risk-adjusted basis to an objective measure.

At Jim Saulnier & Associates, we use five Morningstar benchmarks that are adjusted based on risk tolerance.  The benchmarks are for Conservative portfolios (20% equity, 80% fixed income), Conservative Growth portfolios (40% equity, 60% fixed income), Moderate portfolios (60% equity, 40% fixed income), Moderately Aggressive portfolios (80% equity, 20% fixed income) and Aggressive portfolios (95% equity, 5% fixed income).  The Morningstar benchmarks we use consist of around 15-18 individual holdings that are a mix of domestic equity, international equity, large cap, small cap, mid-cap, long-term bond, intermediate bond, short term bond, international bonds, REITs, TIPs, etc.

We have designed our five “Convenience” portfolios to mimic these Morningstar benchmarks.  Jim has repeatedly stated in podcast episodes and in meetings with clients that we do not expect to beat the benchmark, but instead we fully expect to trail the benchmark to at least a certain extent. The reason is that there are several factors that act as a “headwind” for the investor and can mean their performance will not match the performance of the benchmark.  Below is a discussion of the biggest factors.  While this list is not an exhaustive list of everything that can hinder performance, it will touch on the main reasons that an investor might not see the same returns as the benchmark returns they are tracking.


The most obvious reason that an investment generally lags a benchmark is the fees involved.  These would include, but not necessarily be limited to, fees on the mutual fund or ETF that is used, fees from an investment advisor, fees paid to a broker-dealer and brokerage wrap fees.  A quick example with worst case numbers will quickly show why performance might lag a benchmark by quite a bit.

Assume that you have a relationship with a financial advisor that charges an Assets Under Management (AUM) fee of 0.75% per year.  This advisor outsources investment management to a 3rd party who creates a portfolio that is consistent with the risk tolerance of the client.  This investment manager would also charge a fee – let’s assume 0.40% per year.  Finally, there are likely fees in the mutual funds or ETFs held in the investment account.  Let’s assume that the funds are actively managed funds and that the fund fees are close to the average for large-cap stock funds and are equal to 0.85% per year.  All together these fees add up to 2.0%.  This means that if the investments earned 6.0%, you netted only 4.0% after paying the fees.  Even if the investment choices were perfectly aligned with the benchmark, you as an investor would trail the benchmark by 2% per year because of these fees.


Even if fees were not part of the equation (there are funds and ETFs available now that are 0% fee index funds), there are still reasons your performance may trail a benchmark.  The timing of the investment additions or cash withdrawals will affect the performance.  If you are dollar cost averaging and making additions to your investments each month, then the part of returns that occur later in the year have a bigger impact then the part of returns that occur earlier in the year.  The reason is that you have more money in your account being affected by the return.  Say the return for January is -3% and the return for December is +3%.  If you have been adding money along the way, you will have more invested by the time December comes around and it will help your “dollar-weighted” performance.

On the other hand, if you are in retirement and making consistent withdrawals then the sooner bad returns happen, the worse it is for you.  This is the whole idea behind sequence of return risk (see 08/02/2019 blog post).

Regardless of whether you are adding money or withdrawing it, the simple fact that you have cash flows coming in or going out will cause the returns you experience in your account to be different from the benchmark which assumes that the only additions would be from reinvested dividends or interest.

Investment Composition

A third reason your returns might not match a benchmark is that the particular investments you have don’t exactly match what is in the benchmark.  This might easily happen if a large-cap fund manager for an actively traded fund has different sector weights than the S&P 500 index (which we’ll assume is the appropriate benchmark).  Perhaps she even holds the same 500 stocks as the S&P 500 index.  She just holds them in different proportions than the index.  If she is “overweight” the good performers, her fund will outperform the benchmark (assuming her fees don’t eat up all the difference!).  On the other hand, she might have decided to be overweight in the sectors that are lagging and her fund performance will be worse than the index.  The difference that is there is the result of differences in the individual holdings in the fund compared to its benchmark.

This might also happen if one is comparing the performance for a conservative allocation fund to a conservative benchmark (like the Morningstar Conservative model portfolio).  Perhaps the conservative allocation fund manager has decided to be 24% equity and 76% fixed income as compared to the 20% equity, 80% fixed income in the benchmark.  In this case, if equities outperform fixed income, this fund will do better than its benchmark.  It will have a different composition, it will entail more risk, but it will compare favorably to its benchmark.


Yet another reason that investment performance in your account might be different from its benchmark is due to rebalancing.  Typically, a benchmark will involve systematic rebalancing to determine performance.  For the Morningstar portfolio benchmarks that we use the rebalancing occurs on a monthly basis.  If a particular investor’s account isn’t rebalanced on the same schedule, this could again create differences in performance over the course of a year.


The final reason I’ll mention in this post relates to taxes.  This is more of a stealthy reason for performance difference because taxes are rarely if ever paid out directly from the investment account.  However, if there are dividend payments or interest income or capital gains distributions that occur in a taxable account, there will be an increase in the tax amount an investor pays because of these gains.  This is effectively reducing the performance of the account compared to its benchmark where the returns reported are not affected by taxation.

For all the reasons listed, and probably a few more that aren’t listed, it is unlikely that your investment performance will match the performance of the benchmark you have chosen.  But it is important that you understand how big the difference is and what is causing the differences.  Are you being killed by fees?  Is your investment selection very different from your benchmark?

The goal at the end of the day is that your performance over time is close to and perhaps slightly lower than the performance of the benchmark.  However, ideally you would see a very high correlation between your performance and the benchmark’s performance.  That will mean that you have invested in a way consistent with your goals.