Portfolio Management Complexity

Depending on your appetite for complexity, you can spend anywhere from almost zero to many hours per year managing your retirement portfolio. We think that it is important to decide how much time you think you will be able to spend on your portfolio. We believe that you can increase your returns by spending some time wisely managing your portfolio. Remember to be realistic. You could achieve worse results if you setup your portfolio in a certain manner but fail to manage it appropriately.

Below, we describe 7 Levels of Complexity for Portfolio Management (listed in order of increasing complexity). The levels build on one another. You should take a look and determine where you feel most comfortable. Levels 1 through 3 are focused on making sure that you have a basic portfolio consisting of diversified index funds and ETFs. Levels 4 through 6 involve techniques that will reduce the tax drag on your portfolio. Finally, Level 7 introduces a formula-based strategy for making periodic purchases in your account.

7 Levels of Complexity

Level 1 – Hire an advisor

• If you’re not interested in spending any time with your portfolio, you can always hire a professional to manage it for you. You’ll most likely give up some of your return in fees but this is definitely a reasonable approach for many people. Two things to watch out for: First, as usual, beware of high management fees. Second, make sure they are following the strategy that you want (rather than actively investing your money). You will want them to invest most of your money in low-cost index funds and ETFs.

• Time requirement: Minimal – finding the right professional may take some time.

Level 2 – Target Retirement funds

• Recently, funds like Vanguard have established target retirement funds. These funds contain a diversified portfolio of index funds and will shift the asset allocation over time from heavily based in equities to consisting of more fixed income. You don’t need to handle any account management when you own shares of these funds. The fund will take care of the rebalancing and the gradual asset allocation shift as you move closer to retirement. Some of these funds are very low cost and offer a diversified portfolio all in one fund. See our page on Target Retirement Funds.

• Time requirement: Minimal – We’d suggest just picking the appropriate Vanguard fund and setting up automatic purchases from your bank account or paycheck.

Level 3 – Design your own portfolio

• If you want more control over the specific asset classes that you are investing in, then you can create your own portfolio. We’d suggest focusing on low-cost index funds and ETFs. If you have both taxable and tax-free retirement accounts, then you can simply create the same portfolio in each account. Here is a sample portfolio: Implementation.

• You’ll need to take care of the rebalancing (probably once per year) and the gradual change in your asset allocation as you grow older.

• Time requirement: Small – you’ll need to do some initial research to find appropriate funds. After that, you’ll just need to set up some automatic deposits and check in annually to perform your rebalancing and any shift in your asset allocation.

Level 4 – Leverage your tax-free accounts

• If you have access to tax-free retirement accounts (like your 401k or IRA), you use those accounts to hold your least tax efficient asset classes. You need to think of your taxable and tax-free accounts as forming one big portfolio. Use the space in the tax-free accounts to keep your least tax efficient assets (Treasuries, REITs, Value funds, Emerging market funds). Thus, you will shield your portfolio from the maximum amount of taxes possible. Take a look at our page on this topic: Tax Sheltered Accounts.

• Time requirement: Medium – This will require slightly more annual accounting and a little more setup time.

Level 5 – Research tax managed funds

• In some asset classes, you might be able to squeeze out some extra return by using a tax-managed fund instead of an index fund or ETF. There are a couple of advantages that the tax-managed fund can possess. First, it may invest in companies which have lower amounts of dividends than the average for the asset class. This will reduce the tax hit from dividends that you will incur on an annual basis. Second, it might have a lower expense ratio than a competing ETF.

• Time requirement: Medium – This will require a bit more research at the outset and it is something that you probably want to track over time to ensure that the tax-managed fund remains the best choice.

Level 6 – Advanced tax management

• Handling Distributions – In your taxable accounts, you may incur capital gains taxes when you sell shares in a fund to rebalance your portfolio. One approach to reducing the likelihood of this happening is to not have your distributions automatically re-invested. Instead, you can have the distributions deposited into a money market account then use them to buy the asset classes which have dropped below their desired allocation percentages. You’ll give up some return on these distributions since they will be sitting in money markets so it is wise to consider when you should attempt this strategy.

• Tax Swapping – Another means of postponing capital gains charges is to use capital losses to offset some of your gains. If you have an index fund which could be sold to realize a capital loss, then you can sell it and immediately buy shares in a very similar index fund to maintain your position in that asset class. The new fund should be offered by a different company and be based on a different index. There are plenty of indices that are similar so this should not present a huge problem. This technique allows you to realize the loss without needing to reduce your position in that asset class.

• Time requirement: High – This will require you to keep your eyes on your positions on a more frequent basis. Additionally, you’ll need to make more decisions annually.

Level 7 – Use value averaging

• Instead of simply depositing a fixed amount of money into your overall account on a monthly basis, there is a more advanced method of making contributions that can boost your returns. The concept of Value Averaging relies on fixing target values for your assets and then making purchases or sales to ensure that these targets are attained. The concept relies on formulae which you will need to calculate and modify over time. Based on these formulae, you will determine how much of an asset to buy or sell. Thus, you have a better chance of buying low and selling high with this approach. It has been well tested on historical data and appears to be superior to dollar cost averaging. Please read our full description: Value Averaging.

• Time requirement: High – Implementing Value Averaging will require some dedicated time. You’ll need to set up some spreadsheets and monitor them on a monthly or quarterly basis.

Your returns should benefit from each move down the levels of complexity. Exploiting some of the techniques in levels 4 through 6 is very helpful for lowering your tax drag. However, as you can see, each step down the complexity ladder will require more work on your end.