AAII Investor Update: Investment Strategies for Fiscal Uncertainty

Thursday, November 24, 2011
Charles Rotblut, CFA
AAII Journal Editor

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Guide to the Top Mutual Funds
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I tried to withhold my frustration at the Congressional super committee as I wrote my editor’s note for our 2011 tax guide, which went to the printer on Tuesday. The committee’s failure was a sad example of ideology and politics colliding with a math problem whose solution will impact the lives of many U.S. citizens.

Ultimately, our elected leaders will have to find common ground on a long-term solution. Though I’m not one to bet on what politicians will or won’t do, there are potential changes that individuals can prepare to deal with. These include changes to entitlement programs, higher taxes and cuts to government spending.

Changes in Social Security and Medicare would, obviously, have a wide impact. For current retirees, this could mean smaller cost of living (COLA) increases and higher out-of-pocket costs. Depending on the size of your portfolio, you may need to adopt a more conservative allocation with a bigger focus on income-producing assets. Those who have yet to reach retirement age may need to readjust their savings targets to assume that a larger nest egg is required.

Higher taxes may come in the form of fewer deductions and credits, higher rates, or some combination of the two. The Bush-era tax cuts will expire on December 31, 2012, unless Congress acts otherwise. You can prepare for any possible changes by focusing now on making your portfolio as tax-efficient as is reasonable given your investment strategies and financial goals. Specifically, if you have taxable and tax-deferred accounts (e.g., an IRA), use them to your advantage. Tax-efficient investments such as municipal bonds and index funds should go into your taxable accounts. Mutual funds with high turnover and other less tax-efficient assets should go into your tax-deferred accounts, where the taxable events do not have to be reported to the IRS.

Investing in companies dependent on government spending requires a judgment call. There is a real risk that spending could be cut in the future, but uncertainty also creates opportunity. Not every company will be impacted the same way. Plus, there are many lobbyists who will fight to preserve every possible dollar of government spending. The decision comes down to both an analysis of individual companies and your personal tolerance for risk.

Finally, I would be remiss if I didn’t bring up interest rates. Current Treasury yields are at historical lows and even without the massive government debt, rates will eventually rise. We don’t know when or by how much. You can protect your portfolio by diversifying your bond holdings, just as you do with stocks. Corporate, municipal, and international bonds can all play a role.

The upshot is that if Congress does reach a pragmatic agreement (yes, I realize that is a big “if”), you will still have taken measures that will help your financial situation over the long term.

Do you have an investment-related tax tip? If so, tell us on the AAII.com Discussion Boards.

Checking a Fund’s Tax Efficiency

Tax cost ratios for thousands of funds are available in our mutual fund guide and exchange-traded fund (ETF) guide. The tax cost ratio shows how much a fund’s annualized return is reduced by taxes paid on distributions, assuming the maximum marginal tax rate. The higher the number, the less tax-efficient a fund is. As stated above, less-tax-efficient funds are better suited for tax-deferred accounts than taxable accounts.

The Week Ahead

Just four S&P 500 member companies will report earnings next week: Tiffany (TIF) on Tuesday, H&R Block (HRB) and Kroger (KR) on Thursday, and Big Lots (BIG) on Friday.

The week’s first economic report will be October new home sales, which will be published on Monday. Tuesday will feature the November Conference Board consumer confidence survey. October pending home sales, the November ADP employment survey, the first revision to third-quarter productivity and the periodic Federal Reserve Beige Book will be published on Wednesday. Thursday will feature the November ISM manufacturing index and October construction spending. November jobs data, including the unemployment rate and change in nonfarm payrolls, will be published on Friday.

Minneapolis Federal Reserve Bank President Narayana Kocherlakota will speak publicly on Tuesday. Philadelphia Federal Reserve Bank President Charles Plosser will speak publicly on Friday.

AAII Sentiment Survey

I wrote this week’s Investor Update newsletter yesterday (Wednesday), one day prior to the Thursday release of our weekly Sentiment Survey results. You can see the latest numbers on AAII.com.

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

Happy Thanksgiving,

Charles Rotblut, CFA
AAII Journal Editor