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What is Sequence Risk?

A common assumption when planning for retirement is that your portfolio will grow at an average rate each year. This helps simplify projections when determining if your nest egg is sufficient enough to last through your retirement.

However, in the real world, future investment returns are rather unpredictable from year to year. This means a string of poor investment returns is not uncommon and can potentially cause your returns to be lower than expected. This is known as sequence risk.

The Potential Impact Sequence Risk Can Have on Your Retirement

If a series of negative returns occurs during the period leading up to or immediately after your retirement, there could be a major impact on your retirement nest egg. This is because sequence risk amplifies investment volatility since you are selling shares at a depressed value to fund your retirement expenses.

As a result, there could potentially be a permanent impairment in the amount of retirement income you could generate from your portfolio if there was a dramatic market decline early in your retirement.   

How to Potentially Mitigate Sequence Risk

Unfortunately, there is little you can do to control the economy or stock market conditions surrounding your retirement. However, you are able to take steps to attempt to insulate your portfolio from the volatility of the market.

This means you could carve out portions of your nest egg and place it in investments that attempt to mitigate risk to fund your upcoming years of retirement spending. This way you do not have to sell other investments that may have decreased in value but instead are using funds that were already set aside for that purpose.

In addition, it could make sense to reduce your discretionary spending during a period of poor returns. This could include, postponing a trip, delaying major purchases, or cutting your portfolio withdraws by a certain percentage.

During this time, you could also look to tap other sources of liquidity to allow your investment portfolio to recover.

Conclusion

With a retirement that could last 30+ years, it is important to consider the impact that a sequence of negative investment returns early on can have on the longevity of your nest egg. Awareness of this risk allows you to develop a strategy to attempt to mitigate this risk during the years surrounding your retirement.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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Understanding Longevity Risk

One of the key assumptions in a financial plan is how long you expect retirement to last.  However, the longer you expect to live, the greater the possibility you could run out of money in retirement.

This is what’s known as longevity risk. With longevity risk, the concern is not about dying early, but rather living longer than anticipated. For married couples, this means looking at the likelihood that one of the two of you will live much longer than expected.

Estimating Your Longevity with Software

A useful tool when estimating your, and your spouse’s, longevity is the Actuaries Longevity Illustrator (ALI) which was developed by the American Academy of Actuaries and the Society of Actuaries.¹  

Their projections are based on mortality tables used by the Social Security Administration in the annual Trustees’ Report and separate rates are used for males and females. They also assume the trend of improving longevity will continue when making their projections.

To account for individual differences, they make additional adjustments based on four other factors (age, gender, smoking, and health.) They have found that these factors account for significant individual variations in longevity.  

Their models suggest a retirement period lasting 30 years (to age 95) would be appropriate for the average, non-smoking, 65-year-old male/female couple retiring today.

Longevity’s Potential Impact on Your Retirement Plans

Once you have a grasp on what your potential retirement horizon may be, you might begin to view some financial decisions differently. Some of these decisions include:

When you decide to retire

Knowing that your retirement may last 30+ years could cause you to rethink when you retire. This could be due to not having enough saved to cover your future expenses. Or it could be that want to gradually reduce how much you work over several years before finally retiring.

When you claim Social Security

Social Security is a source of retirement income that can help protect you from longevity risk. This is because your benefits are adjusted annually for inflation, and continue for your lifetime.

Additionally, if you’re married, your spouse could receive survivor benefit payments once you pass. With this in mind, it’s important to consider when you claim your Social Security benefits.

It may make sense to not receive your benefits as soon as possible since you will receive a larger benefit by delaying. If you can wait until age 70, you will receive what is considered the maximum benefit.

How you invest in retirement

With a retirement that could last decades, it’s important to invest your retirement assets with a goal of maintaining your standard of living throughout retirement.

This means you must have a mix of assets that allows you to fund your current needs while providing you the potential for long-term growth to meet your future spending needs.

Conclusion

Although longevity risk can pose a serious threat to your retirement plans, its impact can be mitigated with prudent planning and using reasonable assumptions for how long you and your spouse may live.

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Endnotes

1. See American Academy of Actuaries and Society of Actuaries, Actuaries Longevity Illustrator, http://www.longevityillustrator.org/ (accessed September 21, 2021).

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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What Causes Company-Specific Risk

Oftentimes, those who have accumulated significant wealth did so through the concentrated holdings of stock/option compensation from an employer, business ownership, a successful long-term investment, or inheritance.

This can mean their ability to fund their retirement can be contingent on the continued prosperity of a specific asset. Although this concentrated investment strategy allowed you to generate your current nest egg, it may not make sense from a risk/reward perspective to continue to hold these assets.

This is because holding a large percentage of your retirement portfolio in a single asset increases something known as “unsystematic” risk. Unsystematic or company-specific risk is an additional kind of risk you take on when investing in an undiversified asset.

To illustrate this point J.P. Morgan Asset Management published a report on how often a concentrated position would have underperformed the Russell 3000 Index from 1980 to 2020. They found about 2/3rds of the time, a concentrated holding in a single company would have underperformed a diversified holding in the Russell 3000 Index.

A potentially more alarming finding was approximately 40% of all Russell 3000 Index components lost at least 70% of their value and never recovered.

However, the potential permanent loss of value that comes from holding a single asset can be mitigated through diversification. Proper diversification can limit the risk you take to “just” the inherent risk that comes with investing in the market. 

Potential Barriers to Reducing Company-Specific Risk

In theory, diversifying a concentrated holding should be a relatively straightforward process. You would simply sell a portion, or all, of the asset and invest the proceeds based on your long-term investment strategy.

In the real world, the diversification process can be more complex due to the following factors:

Taxes

Many times, holdings in a single asset have large unrealized gains, as a result of years of compound growth. Selling this asset would create a large tax bill that many would find undesirable. As a result, many continue to defer the sale indefinitely due to their unwillingness to pay taxes.

Although, if the position happens to be in a tax-deferred or tax-free account, there will not be tax consequences on the sale of the position. The tax liability would not be a factor in this case.

The Endowment Effect

There is something known as the “endowment effect” where you value something more, simply because you own it. It could be the stock of a company you’ve worked at or your share of a business you started. Or this holding could have been inherited from a spouse, parent, or grandparent, and as a result, carries a strong emotional attachment. 

This attachment can tilt your investment decisions. You may continue to hold the asset even if it doesn’t fit in your investment strategy. 

Future Regret (FOMO)

Often you don’t want to sell an asset because you are afraid you will miss the opportunity of future gains. This is especially true with an investment you have seen have significant appreciation in value. You can become overconfident that this past success will continue into the future and will regret ever selling.

A Question to Ask Yourself When Thinking About Company-Specific Risk

With these barriers potentially clouding your judgment, we have found this question helpful when thinking about selling an asset.

“If you didn’t own this asset, but instead had the equivalent amount in cash, how much would you buy of it today?”

Let your answer dictate how you should proceed. If you would feel comfortable buying less than you currently own, or none at all, it may be time to create a diversification strategy.

Create a Diversification Strategy

Having a diversification strategy can allow you to incorporate the sale of this asset with the rest of your retirement plan. Depending on the size of the position, it may make sense to sell portions of the asset over a number of years. Doing this can allow you to spread your tax liability over time while still diversifying away from the position.

Also, the annual sales could be coordinated with your retirement cash flow plan. This could allow you to take advantage of other retirement income-boosting strategies such as delaying your Social Security benefit.

A final option for those who are charitably minded is to donate some, or all, of the assets to charity. By donating the financial asset held for more than 12 months, you can avoid paying capital gains taxes. In addition, your gift may be deductible for income tax purposes.  

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The company-specific risk that comes with concentrated holdings can be mitigated through diversification. However, the process of selling can have many nuances. Having a diversification strategy in place could be useful when making investment decisions that have tax and emotional implications.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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Breaking Down Important Retirement Milestones

As you approach retirement there are certain age-based milestones you should be aware of. Some of these milestones create potential planning opportunities to boost savings, maximize retirement income, or improve tax efficiency.

Others mark deadlines that could result in stiff penalties if overlooked. Below, I have listed each key retirement milestone by age along with a description.

Age 50

Once you reach age 50, you can begin taking advantage of something called catch-up contributions. This provision allows you to increase your annual contributions to qualified retirement accounts during what could be the high-earning part of your career.

For instance, in 2021, participants in 401(k), 403(b), and governmental 457(b) plans can contribute as much as $19,500 per year. However, those who are age 50 and older can contribute an additional $6,500.

Additionally, there are catch-up contributions for eligible traditional and Roth IRA account holders age 50 and older. You can save an additional $1,000 above the base $6,000 federal contribution limit in 2021.

Age 55

At age 55 you are able to withdrawal employer-sponsored retirement plan savings without incurring the 10% early withdrawal penalty if you leave your job or retire. Important: This only applies to assets in your current 401(k) or 403(b) and money in a former 401(k) or 403(b), or individual retirement account, is not covered. Also, if you were to roll over those assets after leaving your job, you would lose your eligibility for early penalty-free withdrawals. 

In addition, this is the age where you can make catch-up contributions to your HSA account. For those eligible, the annual catch-up contribution is $1,000 above the 2021 limits of $3,600 for self-coverage and $7,200 for family coverage. However, any employer contributions that are excludable from your income reduce your contribution limit.

Age 59.5

After age 59.5 withdrawals from qualified retirement accounts are not subject to the 10 percent early withdrawal penalty. This includes employer plans such as 401(k)s, 403(b)s, and 457s, Traditional IRAs, Roth IRAs*, Simple/SEP IRAs, and annuities. For Roth IRA distributions, they must meet the five-year holding requirement in addition to taking place after age 59.5.

Age 62

62 is the earliest age you can claim Social Security benefits. *  Depending on the year you were born, your monthly benefit will be permanently reduced by 25 to 30 percent of your full retirement age (FRA) amount.

Also, something called the retirement earnings test could reduce the social security benefits you receive prior to FRA if your employment income is above certain thresholds. *Important: Surviving spouses can claim survivor benefits as early as age 60.

Age 65

For those eligible, the initial enrollment period for Medicare starts three months before the month you turn 65 and ends three months after the month you turn 65. Failure to enroll during this window could result in gaps in coverage or potential late enrollment penalties.

Age 66-67

Depending on your year of birth, your Full Retirement (FRA) Age for Social Security is anywhere between 66 and 67. FRA is when you are entitled to receive 100 percent of your primary insurance amount (PIA.)

Age 70

This is the last age you can receive delayed retirement credits (DRCs) for your Social Security benefit. There is no advantage to waiting to file for benefits beyond age 70.

Depending on your year of birth, this could result in you receiving up to 124 to 132 percent of your full retirement age benefit.

Age 70.5

Traditional IRA owners may begin making qualified charitable distributions (QCD’s) at age 70.5. A QCD, allows you to donate directly to an eligible qualified 501(c)(3) charity. This distribution is then excluded from your taxable income. The annual QCD limit is $100,000 per individual.

Age 72

The year you reach age 72 you must begin taking required minimum distributions (RMDs) from your employer-sponsored retirement plans and traditional IRAs. Your annual RMD is based on your age, the value of your accounts on December 31 of the previous year, and your life expectancy factor.

If you do not take your required minimum distribution by the applicable deadline, the amount not withdrawn is subject to a 50 percent tax penalty. Important: original Roth IRA owners are not subject to required minimum distributions.

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These retirement milestones mark the rules of retirement as they currently stand. If the past is any indication of the future, these rules are subject to change.

If/when they do, current retirement planning strategies could become less effective. As a result, being able to process new information and adapt your plans accordingly will be an important skill to have in retirement.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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How to Choose a Retirement Investment Strategy

As you enter retirement, you may be in a position where you are investing outside of your employer-sponsored retirement plan for the first time. This can often leave people feeling confused and overwhelmed.

Something that may be helpful is, to begin with understanding how to approach your retirement investment strategy. Financial author and academic Charles  D. Ellis wrote in The Investor’s Anthology: Original Ideas from the Industry’s Greatest Minds, there are three ways to succeed as an investor.

The first is intellectually difficult, the second is physically difficult and the third is emotionally difficult.

The Intellectually Difficult Approach to Investing

The intellectually difficult way is reserved for those with superior brainpower, and a deep understanding of the markets they are investing in. Think of people like Warren Buffet, Ray Dalio, or George Simons.

The Physically Difficult Approach to Investing

The physically difficult approach requires you to outwork your competition. This is the approach many people on Wall Street take. They are known for working extremely long hours trying to get an advantage over one another.

The Emotionally Difficult Approach to Investing

The emotionally difficult approach requires you to withstand the uncomfortable emotions you experience when investing. This discomfort can include the pain of missing out on an investment or the dread brought on by a bear market. Everyone’s tolerance for emotional difficulty is different and can change over time.

Managing an Emotionally Difficult Retirement Investment Strategy

Assuming you are not of superior intellect, nor do you want to spend your retirement working long hours on investing decisions, you are left with the emotionally difficult route.

In order to increase your likelihood of success, you need to improve your ability to withstand emotionally difficult times in the market. This can be done by creating a long-term investment strategy that is tied to your personal goals.

For example, a primary goal for those in retirement is to fund their expenses not covered by other retirement income. Depending on the amount of income you need, your portfolio will require a certain rate of return.

Typically, the greater rate of return you need to generate, the more risk, you must take. If you are not comfortable with a given level of potential risk you may need to adjust your goals downward.

After creating your long-term investment strategy, you must then execute it. When implementing your strategy, you will need to follow an investing process where you monitor, review, and adjust your portfolio based on your changing needs.

The Role a Financial Advisor Can Play

If you struggle with this, you can seek the support of a fiduciary financial advisor. An advisor can help you develop, optimize and implement an investment strategy suited to your needs in retirement.

They can also show you have this strategy integrates with an overarching retirement plan. Lastly, they can provide an additional layer of support when making investment decisions during uncertain market conditions when emotions are high. 

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A successful retirement investment strategy does not require great genius nor tremendous effort, but it does require you to stick with that strategy in good times and bad.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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Shifting Your Investing Focus

During your accumulation years, your investing focus was primarily on long-term growth. The main goal for your portfolio is to earn an acceptable average annual return, while the emphasis was put on how much you saved each year.

But in retirement, the demands on your portfolio are likely to be very different. You are now withdrawing money from, not contributing money to, your investment portfolio. This requires a retirement income plan that balances your need for ongoing income with maximizing the likelihood of your savings lasting as long as you and your spouse may live.

What complicates things are the many factors that should be considered when creating your retirement income plan.

Factors to Consider When Creating Your Retirement Income Plan

• The Size of Your Retirement Nest Egg
• The Need for Income in Retirement
• Your Life Expectancy
• Your Spouse’s Life Expectancy
• The Anticipated Return From Your Investments
• The Anticipated Rate of Inflation
• The Effect of Taxes

As you can see, there are many assumptions to be made about future events when creating your retirement income plan. The longer we project into the future the less certain we can be about any outcome. We do not know how long we will live, nor know exactly what our future expenses will be. Also, the performance of the market is anything but consistent or predictable.

Determining Your Required Rate of Return

Now that you have determined how much retirement income you need to generate each year, you must invest in a way that allows you to continue to fill this income gap. Depending on your annual spending level, your investment portfolio will require a certain rate of return to maintain this standard of living over time.

Once you know what rate of return your personal savings need to generate, you can determine the appropriate mix of assets for your investment portfolio to attempt to earn the necessary rate of return. This may mean you pursue growth with a portion of your assets and the degree of risk that accompanies it. 

​How Should You Allocate Your Portfolio?

One way to determine how you should allocate your portfolio is using the Bucket Approach. In this method, you segment your portfolio based on your income needs over time. You would allocate your assets into one of three buckets; Now, Later, and Much Later.

The Now Bucket

Assets in the Now bucket should be in very safe assets such as cash or cash alternatives. Assets in this bucket should be liquid since they will be funding your living expenses within the next 12-24 months.

The Later Bucket

Assets in this bucket will be used to fund your upcoming expenses within the next 5 years. These assets could be placed into high-quality government bonds to potentially generate income greater than cash while minimizing the risk you take.

The Much Later Bucket 

Assets in this bucket are meant to fund expenses that are 5+ years in the future. This portion of your portfolio will likely be invested in the stock market. Stocks have historically provided returns greater than cash however you are taking on additional risks by investing in them.

Because of these risks, the Bucket approach attempts to ensure there is sufficient cash and fixed income reserves on hand in advance of any turbulent market conditions. This might enable you to avoid selling investments during a down market.

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Developing and adhering to a sound investment strategy is essential in retirement. This strategy will likely look different than the one you used during your accumulation years. You must find a balance between today’s spending needs and those of the future if you plan on maintaining your standard of living throughout retirement.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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The Power of Compounding

When you are saving for retirement you hope that your investments will grow over time. The sooner you begin saving the more time you will be able to take advantage of the power of compound interest.

This is because you are potentially able to achieve growth on your growth. Not just growth on your initial investment. This may seem hard to conceptualize, but there is an easy way to see how it works.

It is called the rule of 72 and it shows you how long it will take for an investment to double. To perform the calculation you divide the number 72 by the rate at which the investment will increase in value.

The resulting number is how many years it will take for a hypothetical investment to double. The graphic below shows some hypothetical examples to illustrate how the rate of return affects the time of doubling.

The Power of Negative Compounding

The power of compound interest can provide a large tailwind for someone who has many years of saving ahead of them. Unfortunately, for people who are in retirement and are utilizing their personal savings to fund their living expenses, they can potentially have compound interest working against them.

This is because of the impact inflation has on your purchasing power over time. The average annual rate of inflation since 1914 has been approximately 3%, according to the U.S. Department of Labor. This means at 3% annual inflation, something that costs $100 today would cost $200 in 24 years. This potential of negative compounding could have serious implications for a retirement that could last for 30+ years.

Addressing Inflation In Retirement

We can go back to the equation I’ve discussed in prior posts to see what can be done to combat inflation.

Income – Expenses = The Gap

Inflation’s Impact on Your Expenses

We know your expenses will increase in retirement, but everyone is impacted by inflation differently. This is because all goods and services do not increase uniformly.

Different sectors have different inflation rates. Also what you spend money on can shift over time and certain expenses can become a larger percentage of your spending in retirement. Healthcare costs, for example, are expected to increase faster than the average inflation rate.

It is also something that could become a larger proportion of your spending in retirement as you age. With this in mind, it could be prudent to separately account for your healthcare expenses in your retirement spending plan.

Inflation’s Impact on Your Retirement Income

The income you receive in retirement can play an important role in funding your living expenses. This role could be diminished based on the source of the income stream. Not all pensions or annuities are adjusted for inflation. This means they can lose their purchasing power over time.

Social Security, on the other hand, has an annual cost of living adjustment, COLA. This means it increases with inflation. This inflation adjustment is regardless of the size of your monthly Social Security benefit.

If you were able to delay claiming your Social Security, the increased monthly benefit you receive will be adjusted for inflation. This larger monthly benefit could mean a greater portion of your retirement income is less sensitive to a loss of purchasing power. 

Inflation’s Impact on Your Retirement Income Gap

If your retirement income does not cover all your expenses you will need to fill this income gap with your personal savings. This income gap may become larger over time if your retirement income does not increase with inflation.

This widening income may require you to rely more on your personal savings later in retirement. With this being the case, it is important to invest in a way that allows you to maintain your purchasing power.

You may have investments that aren’t decreasing in value in nominal terms but are losing their purchasing power when accounting for inflation. With this in mind, you could look at your portfolio’s real rate of return, meaning adjusted for inflation.

If your current allocation is not keeping pace with inflation you may consider investing a portion of your portfolio in things that can potentially generate returns above inflation.

These investments would be earmarked for the long term. They are meant to fund your future expenses and could experience short-term market volatility.

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Inflation is yet another risk you may face in retirement, though its effects may not be felt for many years. With smart planning and prudent investing, there are ways to attempt to mitigate its effects on your purchasing power.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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I have spoken before on how to rehab your portfolio and return to investing after suffering an investment ‘injury’. In this post, I will discuss the idea of preventative maintenance and how to incorporate these concepts into your investing.

What is Preventative Maintenance?

There is a concept in the training space known as preventative maintenance. This is where you take action before you get injured to reduce the risk of injury altogether. This can include, but is not limited to:

• Getting enough sleep
• Proper Nutrition
• Proper Hydration
• Allowing adequate time in between training sessions to recover
• Adapting your training to your current abilities
• Performing exercises to strengthen potential weak or problem areas
• Stretching
• Soft-tissue mobilization work
• Seeking professional guidance, therapy, or coaching

I wanted to include things that may seem obvious, but are often neglected. Meaning someone may want to pay for expensive treatments or recovery devices, but doesn’t get enough sleep and eat very poorly. Doing the basic things well is a simple concept but difficult to execute consistently.

Doing these things will not guarantee you won’t get injured, since there are factors you cannot control. Preventative maintenance, instead shifts the focus on things you can do that are directly in your control to reduce your risk of injury. 

What is Preventative Maintenance for Your Retirement Portfolio?

When investing for retirement there is a benefit to regularly monitoring your portfolio and making periodic adjustments. This is because over time the composition of your portfolio is likely to change due to the uneven nature of the financial markets. A well-diversified portfolio will have assets that behave differently and growth will not be uniform.

Making many minor periodic adjustments to keep you in line with your long-term investment strategy can reduce the risk of having to make a major investment choice with short-term emotions clouding your decision-making.

Three Preventative Maintenance Strategies for Your Retirement Portfolio

1. Revisit Your Purpose for Investing

We feel it is important to have a reason behind your investment strategy. Understanding your purpose can be helpful when there is a lot of uncertainty in the markets.

However, it is possible your priorities could change and you should ask yourself:

• Is my current strategy still appropriate given any change in circumstances?
• Am I still investing in a way that is serving my goals?
• Am I taking too much risk?

2.Review the Asset Allocation of Your Portfolio

Once you revisit your purpose for investing you can look at how your portfolio is allocated. You can view this on an account-by-account basis, but there is also a benefit to looking at the overall allocation of your total portfolio since you likely have stocks, bonds, and cash in a number of places.

I have provided a worksheet you can use to calculate your overall portfolio across all of your accounts.

Once you know your overall asset allocation you can ask yourself:

• Is my current allocation different than when I created my investing strategy? If so:
  • What do I need to sell and what do I need to buy to get back to this allocation. This concept is known as ‘Rebalancing’ your portfolio.
• Are you currently taking any money from your portfolio or do you plan on taking any money out of your portfolio within the next 5 years? If so:
  • How much?
  • From which account will these funds becoming from?
  • Do you already have assets earmarked for these expenses?
  • Will there be any tax consequences from these distributions?

3.Investment Due Diligence

The third thing I will discuss is a review of what you are investing in. The specifics of what you are investing in are often overemphasized by the financial media. In reality, your individual investments could be very boring. Meaning your investments could be in low-cost broad-based funds that are well diversified across the financial markets. 

With that being said it is a good idea to review the fees you are paying for your investments and compare what you are investing in with other similar investments to see if their relative performance is adequate.

If you hold active funds or individual investments, this process should be more thorough and more frequent in nature. I will not detail what this due diligence process would consist of since it is outside of the scope of this article.

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Feel free to email us at info@westernreservecm.com with any questions you have.

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