Model Tax-Efficient Portfolios for Short- and Intermediate-Term Investors
The key isn't to take no risk at all, but to let the probabilities tell you how much.
Note: This article is part of Morningstar's Tax Relief Week special report. A version of this article appeared on Aug. 12, 2016.
Many investors--especially heavy savers--end up building up taxable assets for retirement, especially when they've maxed out their contributions to tax-advantaged retirement accounts like IRAs and 401(k)s. And holding assets with an array of different tax treatments--traditional tax-deferred, Roth, and taxable--can come in handy when it comes to the distribution phase of retirement.
From a practical standpoint, however, many investors hold assets in taxable accounts because they're planning to use the money for nonretirement goals: down payments for homes, special family vacations, and new cars. Tying up the money in a retirement account wouldn't make sense because they could incur penalties for tapping those assets prior to retirement.
Positioning investments for short-term goals tends to get less attention than how to invest for retirement, but it merits attention because it's a delicate balance. Investors may confuse their risk capacity with risk tolerance, for example, venturing out on the risk spectrum and courting the risk of incurring losses just before they need to tap their portfolios. Or they might assume that just because stocks have delivered returns that have bested other asset classes' in the past five years, they'll do it again during the next five.
At the opposite, conservative extreme, investors might assume that the best way to meet short- and intermediate-term goals is to stick exclusively with guaranteed products such as CDs or money market accounts. That's not unreasonable given how small the current differential is between cash and products that do not promise stability of principal; for very near-term expenditures, cash is best. But if the investor's time horizon is longer than a couple of years, the bite of inflation means that guaranteed products will be a losing proposition.
Running the Numbers
In the end, it's valuable to determine any portfolio's asset allocation by matching your anticipated spending horizon to those assets that are apt to have a positive return between now and when you'll need the money.
For example, the S&P 500 posted a positive return in more than 90% of rolling 10-year periods in the past 25 years, meaning that investors who have at least a 10-year horizon can reasonably steer a sizable share of their portfolio to stocks. But stocks have been much less of a sure thing for shorter time horizons. Over rolling one- and three-year periods over the past 25 years, the S&P has posted a loss roughly 20% of the time, and some of those short-term losses were punishing, especially in one-year windows. The unlucky soul who invested in the S&P 500 in early 2008 and needed to get his money out a year later would have had to settle for a 43% loss, for example.
Meanwhile, bonds have a much higher probability of holding their ground over shorter time periods. During the same 25-year period, which was admittedly strong for bonds, the Barclays U.S. Aggregate Bond Index had a positive return in every rolling three-year time period and in more than 90% of rolling 12-month periods. And the worst 12-month loss for bonds was much milder than what stocks incurred at their nadir: just 3.7% (between late 1993 and late 1994). Of course, past is not prologue. In a sustained period of rising interest rates, bond losses could be higher and more frequent than they have been in the recent past. Indeed, in the wake of the election, the Barclays Aggregate incurred a steep, 2.5% loss in November alone.
What's a well-meaning short- or intermediate-term investor to do?
The answer is that if you're saving for a goal that's close at hand, you need to take some risk but not too much. And if you're saving in a non-tax-advantaged account, it's also worthwhile to pay attention to tax efficiency. If your portfolio is apt to deliver muted absolute returns over your holding period, it's valuable to limit every cost you can--from transaction costs to fund expense ratios to tax-cost ratios.
The following portfolios are geared toward taxable investors who expect to need their money over the short-term (within five years) or intermediate term (within five-10 years). Investors with very short time horizons of just a few years should stick with cash.
A Short-Term Portfolio for Taxable Accounts
Spending Horizon: 5 Years or Less
This portfolio is geared toward taxable investors with time horizons of roughly five years. Thus, it's anchored in cash (certificates of deposit, money market accounts, and so forth) and a short-term bond fund. It also features an intermediate-term fund to help boost its yield, albeit with a bit more volatility.
Morningstar analysts have long been impressed by Fidelity's careful and deliberate approach to the muni markets, and the funds that dominate this portfolio showcase what the firm does well. Both the Limited Term and Intermediate funds are lead-managed by Fidelity veteran Mark Sommer, who eschews risky credits and leveraged structures. That means his charges typically hold up well in muni market shakeups such as 2008 and 2013. That attention to downside protection makes these funds a good fit for short-term investors.
An Intermediate-Term Portfolio for Taxable Accounts
Spending Horizon: 5-10 Years
Geared toward a taxable investor with a spending time horizon between five and 10 years, this portfolio includes cash and the same municipal-bond funds that appear in the portfolio above, albeit in slightly different allocations. It also includes a slice of tax-efficient equity exposure. I've used a broad market traditional index fund, but investors could reasonably use a large-cap exchange-traded fund or a tax-managed equity fund such as Vanguard Tax-Managed Capital Appreciation (VTCLX).
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.