The Flip Side of Location, Location, Location

By Emily Sanders, CPA

In real estate investing, the golden rule is "location, location, location."  In financial planning, the paradigm is "diversification, diversification, diversification."  The main reason for this truism is to manage financial risk.  In other words, diversification enables the prudent investor to maximize returns while minimizing risk on an after-tax basis.

During the pre-retirement years, an individual's or family's overall net worth should be roughly balanced in thirds:  one third in real estate (residential or commercial), one third in financial assets such as stocks, bonds and mutual funds, and one third in business assets.  The latter could be in the form of company stock or a small business owned by an entrepreneur.  Insurance is complementary to protect personal investments, as well as net worth and earning power.

Post retirement, which normally occurs between the ages of 55-65 in the U.S., model one's assets to be allocated roughly half between real estate and financial assets.  By retirement, it is more likely that real estate property will be mortgage-free, thus making it's net value even higher.  A business may have been sold or passed to younger generations.  It is recommended that no more than 15 percent of a given portfolio be in any single investment, for purposes of diversification.

Within financial assets, there are a number of ways to look at diversification to reach your goal.  It is important to diversify across market sectors as well as investment classes.  For example, when considering stocks or equities, be sure to have representation among financial stocks, energy, healthcare, technology, consumer goods and services.  The more conservative, income-oriented investors can look toward utilities and real estate investment trusts for a higher dividend yield.

Within asset classes, it is equally important to have a mix or large capitalization stocks (those with more than $30 billion), mid-caps (more than $10 billion in market cap) and small-caps (less than $3 billion in market cap), as well as a healthy smattering of international stocks.  The latter have outperformed US stocks for the last two years by a wide margin, returning double digits.  Most investors should keep at least 5 percent in cash or money market funds to have liquidity available to buy on market dips.

It is very helpful to include assets in one's portfolio that perform counter-cyclically to traditional investments.  For example, gold tends to go up when financial investments go down, so having about 5 percent of a portfolio in gold stocks makes sense when gold prices moderate off their recent highs.  A Brazilian stock will tend not to move in tandem with a U.S. stock, whereas British stocks more closely mirror the U.S. market.  Even within an asset class such as real estate, one can diversify between commercial, apartments, retail, timberland, etc.

Tax efficiency is key.  There are two basic types of tax when considering investment vehicles:  income tax and capital gains tax.  Income tax is triggered when the investment pays dividends (typically large or mid-sized stocks) or interest (from money market, CD's, fixed income instruments, etc.).  Depending upon one's tax bracket, or whether the investment is held in a tax-deferred account such as an IRA, you might want to consider tax-exempt bonds issued by your state of residence, sometimes called "munis".

Capital gains taxes are incurred when assets are sold, and are broken into long-term (one year or more holding period) and short-term (one year or less).  Capital gains taxes are at the lowest level they've been in more than 40 years, with only a 15 percent long-term federal capital gains tax rate.  For low-wage earners such as children, or retirees on a fixed income, the long-term gains rate can be as low as 5 to 10 percent.  Some parents wisely choose to gift highly appreciated stock into their children's names to lower the family’s overall tax bill.