2022 has been a tough time for investors as tough equity and debt markets weighed on account balances. As we enter a new year, there is hope and optimism for better returns, tempered by some significant risks for investors to navigate.
On the upside, inflation in the US appears to have peaked; however, inflation remains historically high, with no guarantee that the pace of rate hikes will completely prevent future price flare-ups. Meanwhile, geopolitical events continue to fuel uncertainty, with no imminent solution to Russia’s ongoing invasion of Ukraine in Ukraine, and the uncertain impact of the reopening of China’s economy amid easing of Covid restrictions. The Federal Reserve is still raising rates, albeit at a slowing pace, and investors have generally been wise to avoid “fighting with the Fed.” Rates are unlikely to drop next year.
All this creates a challenging environment for investors who are already reeling from last year. Unfortunately, we have no control over the markets, but we can take some steps to ensure that this year does not turn into a disaster for our portfolios. We can work to build wealth and ensure that our financial goals are met, even in uncooperative markets.
When the environment for returns is not as favorable as we would hope, the importance of basic investment practices increases. There will be no single factor or portfolio trick that will lead to investment success in 2023. But paying attention to the (sometimes boring) details of good portfolio management and personal financial hygiene can give us a better chance of success than trying to time the bottom of the market or chasing returns from a popular company or industry.
Re-evaluate your risk tolerance
A good activity to start the year is to evaluate our own risk tolerance and how that tolerance to market volatility may have changed after a bad year. It can be a useful thought experiment to imagine a different year like the last and think about the impact it would have on our finances, both fiscally and psychologically.
We also don’t want to overreact, so it’s just as important to understand the impact of shedding too much risk in our portfolio, especially when the market may be making only moderate gains. So think about what a year would look like if the market moved forward, but your portfolio – invested too cautiously – lagged substantially, maybe even fell in terms of inflation.
Finding an acceptable distribution of stocks, debt, and cash can help you stay invested for the long haul. And we want to stay invested. Even the sharpest investors cannot reliably predict when the market will turn, but missing positive market days can be detrimental, especially when we are in a lower yield environment. Stay invested, but do so in a way that suits your risk tolerance.
Keep an eye on costs
The effect of the fees and charges you pay for your asset management is magnified when the markets are down or treading water. Fortunately, there are more choices and tools available today to keep trading costs down than even a decade ago. A lower yield environment is a great opportunity to assess our investment costs and examine whether we are taking advantage of the best deals for managing our assets.
Mutual fund management fees – The amount of your investment in a mutual fund that is spent on the costs of managing the underlying portfolio is expressed as the expense ratio. The expense ratio can vary significantly depending on the fund manager and the type of mutual fund or ETF.
The rising popularity of passively managed index funds and ETFs over the past decade has contributed to a price war between some of the largest asset managers, resulting in extremely low expense ratios for some index funds and ETFs.
That does not mean that we should blindly invest in the cheapest funds. The near-zero expense ratios may have downsides to fund management practices, and there may be valid reasons to invest in more expensive strategies. But when we evaluate mutual funds and ETFs, we need to compare the expense ratio to similarly managed funds to make sure we keep costs reasonable. Price compression that has led to lower expense ratios is a positive development for investors, but there are still overpriced funds that may not be worth the pressure on returns compared to a cost-efficient index fund.
Trading Fees or Commissions – The price you pay when you sell a stock, option or other types of securities is often an unavoidable cost of investing. But fees can be a drag on returns, especially for frequent traders who rely on their brokers for advice or to execute trades. Like the expense ratios of mutual funds and ETFs, trading fees have come under competitive pressure over the past decade, reducing or even eliminating trading fees. If you haven’t compared your broker’s fee schedule to other options lately, now is a good time to do so. Like mutual funds, you want to weigh the value of the services you receive from your brokerage when considering trading costs.
Taxes – No one likes to pay more tax than they need to, and tax missteps can be even more painful if returns are hard to come by. Be sure to invest as much as possible in tax-deferred retirement accounts such as IRAs and 401ks. When investing in a taxable account, keep in mind that you sell shares within a year of purchase, as gains are taxed at your normal income rate; instead of the generally lower long-term capital gains tax. It’s also a good idea to talk to a tax advisor before making any major portfolio transactions, such as switching brokers, to understand potential tax consequences before you incur them.
Other fees and expenses – A host of other expenses can wreak havoc on your wallet if you’re not diligent. Be aware of short-term redemption costs in mutual funds. Avoid paying a “tax” or sales commission on a mutual fund – there are usually cheaper alternatives for the same investment.
Paying for investment advice can be a wise decision, but you may also want to consider free sources of advice, including low-cost robo-advisor investing. Some robo-advisor products can even help control tax costs through tax loss harvesting options.
Invest in healthy companies
Companies with healthy balance sheets that can generate cash under difficult conditions tend to be safe gamblers and often withstand a recession.
For our fixed income (bond) allocation, you need to ensure that default risk is low, especially when economic conditions deteriorate. Investors can evaluate this risk by examining a company’s interest coverage. If a company has to spend a large portion of its free cash flow to cover interest payments, it is more likely to default. A company with significant debt that needs to be paid in the short term should also be evaluated more carefully. Prioritize companies with enough cash to meet their obligations.
On the equity side, looking for companies with a history of solid dividend growth can help individuals invest in companies with strong capital management and receive a real return on their investment even when markets fall. Again, it’s important to evaluate whether a company can afford to pay and grow its dividends and whether the company is not responding to pressure to keep dividends high, jeopardizing solvency.
These investment strategies can be found in many actively managed mutual funds. Look for fixed income mutual funds that evaluate and prioritize credit quality and invest in equity funds that prioritize dividend growth. As mentioned earlier, compare mutual fund expense ratios to ensure fees are competitive.
Exposure to the future
By following these principles and remaining patient and diversified, investors can continue to focus on what matters: long-term growth. Hopefully investors will be prudently allocated and see the market turn around sometime in 2023, but we have a range of possibilities to consider. That way we can avoid reacting to the momentary noise, and there seems to be a lot of noise next year.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.