The answer to the following question seems obvious until you stop to think about it: why is it important to maintain control of your investments? After all, unless you’re buying and selling individual securities for yourself, you’re ceding control to someone – a money manager, a no-load mutual fund manager, a financial advisor selling mutual funds. The purpose of investing is to use assets to satisfy current or future expenses. That’s it, plain and simple. And given that, the importance of maintaining control becomes clear. Investing well is an entirely subjective exercise – your current or future needs are not the same as anyone else’s needs.

Maintaining control of your investment portfolio will go a long way to ensuring that your own unique needs are met. Peloton portfolios are each uniquely managed to the specific needs of each client. We use individual securities in part because they allow us to be far more precise when managing money for an individual. Using “off-the-rack” tools like mutual funds to meet your particular objectives is tougher and, like buying a new suit, requires some tailoring. Let’s explore the metaphor a little more closely as we look at three important areas of control: taxes, portfolio allocation, and cash flow.

The tax implications of investment actions are many and complex. Dividends, interest, and capital gains income are each taxed differently, and of course tax brackets vary significantly from person to person. Mutual funds arose originally to satisfy two specific needs for individuals with limited resources: to achieve 1) professional investment management, while 2) sharing the cost for that service with others. The result of sharing costs with other people means that a single portfolio has to represent many divergent tax needs. No one portfolio can do this well. The best way to mitigate this aspect is to minimize taxable behaviors of the mutual fund managers. An easy way to do this is by reviewing the “turnover” rate of the portfolio. Portfolio turnover is expressed as the percent of the total portfolio that is sold and reinvested in a given year. We recommend that fund shareholders seek managers with a history of 30% or lower annual turnover. We also recommend that investors carefully study where best to locate funds: placing a tax-free bond fund or a variable annuity in an IRA makes no sense yet we see those sorts of things commonly.

One of the cardinal sins of investing is to avoid the sometimes powerful temptation to time the market – the practice of being either “all in or all out” of long-term investments, particularly stocks. We’ve written frequently about how this scheme never works like it’s theoretically supposed to. It’s tragic to see people still in cash after the stock market moves significantly higher. It is far wiser to decide how much money you need to keep in cash reserves and leave the rest invested strategically. Unfortunately, mutual fund managers sometimes also try to time the market. We recently reviewed a bond fund with a 30% cash allocation! It’s important to regularly review the fund’s annual and semi-annual reports to determine whether the fund manager is staying fully invested.

Bond investors need to know that, all else being equal, bond prices will go down when interest rates rise. As the Federal Reserve begins to raise interest rates, this will have a detrimental impact on bond prices broadly, and will cause some investors to despair, selling into the price weakness. When someone owns an individual bond, this practice has no bearing on their investment outcome because they can choose to hold the bond until maturity. But consider the person invested in a bond fund whose fund manager is faced with the need to liquidate a large segment of the portfolio to satisfy other investors’ withdrawals. Unfortunately, this risk is inherent in all bond mutual funds. For this reason, we recommend that individuals stick with short-intermediate bond funds to lessen the risk of loss due to someone else’s panic attack.

The final installment of this series, Mutual Fund Investing: Cost, examines several ways in which the many expenses of investing in mutual funds work against savers’ long term goals. Next week’s article reviews ways to manage costs to your benefit, not your advisor’s.


Next: Mutual Fund Investing: Cost

Mutual Fund Investing: Introduction

Mutual Fund Investing: Complexity