Being Tax Smart Just One Part Of A Broader Financial Strategy
(written by Hartford Investments)
As Canadians prepare to file their income tax returns ahead of the April 30 deadline, talk inevitably turns to the tax efficiency of their investment plans. And why not? We’ve all learned – sometimes the hard way – to be highly skilled at minimizing how much we pay to the tax man.
It stands to reason then, that the tax implications of your financial strategy will always take centre stage at this time of year. It also makes sense that you consult your personal tax advisor when examining just how tax effective your investment strategy is.
That said, being tax smart is only one element of a sound investment strategy.
There are many other investment fundamentals that we should pay attention to as we develop our personal investment plans. At this time of year – in fact, at any time of year – it’s worth looking at how many of these fundamental principles are incorporated into your investment plan.
Say “yes” to diversification – but keep it focused and watch your turnover
Let’s begin with the most basic investment principle: diversifying your holdings. Even novice investors understand the importance of diversification to managing risk. What many investors do not always recognize, however, is that diversification does not mean you have to own a little bit of everything.
As Gerald Loeb, author of The Battle for Investment Survival notes: “I think most accounts have entirely too much diversification of the wrong sort and not enough of the right” adding that “the intelligent and safe way to handle capital is to concentrate.”
That might sound a bit counterintuitive to investors. After all, while it makes sense that complete diversification will simply mirror the market and lead to mediocre returns (and even guarantee a loss in a down market), we’ve all been schooled that too little diversification means too much volatility and risk. Fortunately, there is a happy medium. We can even measure it.
Studies¹ have shown that as you move beyond the range of 20-30 holdings, the risk benefits you get from further diversification are marginal at best. That fact is you can achieve the risk management benefits of diversification with a handful as opposed to a bushel full of holdings.
For proof, look no further than Bill Kanko of Black Creek Investments, who sub-advises Hartford Global Leaders Fund for Hartford Investments. Mr. Kanko is an industry veteran who has several fund management awards to his credit. His approach is to construct a diversified portfolio of 20 to 25 holdings, using an investment process identifies companies that are market leaders, firms with distinct competitive advantages, and companies operating in industries where barriers to entry are high. By fully understanding each business with a focus on uncovering the long-term intrinsic value of the firm, and targeting an average holding period of three to five years, he builds a relatively low turnover portfolio (less than 20% in 2007) of companies to comprise the Fund.
This strategy offers a couple of valuable lessons to investors:
1. A bottom up collection of distinct business ideas (as opposed to a company selection process pre-determined by sector, region, asset class or market capitalization) inherently assures diversification of the portfolio. You can’t have two market leaders in the same sector, for example. The proof of this approach is in the holdings of Hartford Global Leaders Fund, which are a diverse, eclectic mix of instantly recognizable and sometimes obscure firms²: Unilever, American Express, e-Bay, Hamamatsu Photonics, Nitto Denko, Zimmer, Coca-Cola to name a few.
2. Because Mr. Kanko is given the latitude to have his investment ideas play themselves out, there’s less need to rotate companies in out of the portfolio to achieve short-term results. A lower turnover portfolio, to return to the theme at the beginning of this article, incurs far fewer tax implications. With fewer transactions and potentially lower taxable distributions, it’s typically more tax efficient to manage funds this way.
Keep your priorities clear – build a winning portfolio, then make it tax smart
Here’s another reason why it’s important to incorporate tax considerations into your broader financial strategy: The benefits of being a tax efficient investor will be far greater if you’ve got a winning portfolio. After all, while there are tax strategies to help you when your portfolio is in a losing position, the primary goal of tax smart investing is to protect your gains.
That’s why focusing on building a strong, long-term portfolio should be your first priority – unless, of course, you consider just getting started to be the first, and most important, step.
There are strategies to help with that, too. One of the best approaches is to use dollar cost averaging (DCA). DCA is the technique of buying a fixed dollar amount of an investment – such as a mutual fund – on a regular schedule, regardless of market price. That way, you buy more when stock prices fall, and less when they go back up again. The other benefit of DCA is that it makes it easy to get started on the road to building your investment portfolio. By investing smaller amounts, at regular intervals, you ensure you’re always able to invest.
Hartford Investments has come up with a program that extends the benefits of DCA even further. Hartford DCA Advantage Program actually pays you interest on money waiting to be invested, rather than have the money you’ve set aside for DCA just sitting there. That way, you’ll end up investing more than you originally planned, giving you an extra step up in building your portfolio.
The smartest approach is to use professionals
Finally, although integrating tax thinking into your investment plan is clearly a smart thing to do, it’s not always straightforward. Simply sticking to the fundamentals of investing takes discipline, focus and a lot of time. Throw in tax considerations and things can get complicated in a hurry.
It’s easier – and smarter – to engage professionals to help manage an integrated investment and tax plan. Have your Wellington West Investment Advisor speak to your tax consultant to make sure both understand your needs and plan.
¹ 2003 University of Michigan study (Sialm, Kaperczyk, Zheng,) 2003 Standard & Poor’s study, 2004 Morningstar study
² Portfolio holdings are subject to change.
Continuous or periodic investment plans neither assure a profit nor protect against loss in declining markets. Because Dollar Cost Averaging involves continuous investing regardless of fluctuating price levels, you should carefully consider your financial ability to continue investing through periods of fluctuating prices. Please see the prospectus for full Dollar Cost Averaging (DCA) Advantage Program details.
Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Please read the prospectus before investing which is available from your investment professional or Hartford Investments Canada Corp. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.