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FIGURE 1.1 A FRAMEWORK FOR TAXABLE INVESTING.

      Parenthetically, as we've already explored, some investments may appear to generate decent returns, but after being subjected to inefficient structures, high fees, and tax rates of 50% or more, in fact they aren't so great. As a general rule, the shorter the hold period of an investment and the more of its total return that comes in the form of taxable income, the higher the risk-adjusted, pretax returns need to be in order to justify their inclusion in taxable portfolios. In the chapters ahead, we will explore further how to invest in that upper-right-hand quadrant with consistency and success.

      Most predictably, the best investments for taxable investors are ones that generate decent to strong capital gains for long periods of time. Nevertheless, even with success there are consequences. As unrealized gains grow, a rigidity creeps into taxable portfolios: the more successful an investment becomes, the more expensive it is to sell and the harder it is to replace. With greater rigidity, each decision about whether or not to sell becomes more important and more deserving of studied, professional analysis.

      Estate planning can also have a big influence on where an investment falls in the two-by-two matrix shown in Figure 1.1. Anyone can establish tax-deferred or tax-exempt retirement plans. Assets that would otherwise be in the bottom half of the matrix move to the top half if they are in one of these vehicles. Tax-inefficient assets within retirement plans add diversification in the traditional sense. They also give you the means to manage future changes in tax rates. As wealth grows there is also the opportunity to share it with others: children, grandchildren, philanthropies. Good estate planning can be incredibly valuable, both for tax planning and for perpetuating family business.

In some ways, all these moving parts add complexity to taxable investing. But an investment strategy, designed and executed with forethought and care, will minimize the adverse impact, and maximize the upside with high probability of success. Taxable investors and their advisors have tools at their disposal, some of them low cost and quite straightforward, to increase net-of-tax-and-fee returns. Understanding how to create better odds of success, where to look for higher magnitude, how to measure risk symmetries and how to retain a higher proportion of profits creates additional benefit. That understanding also will encourage advisors and their taxable clients to ignore vast areas of the investment ecosystem. Most hedge funds, most credit-driven funds, most real estate funds, and most actively managed equity funds are structurally unattractive for taxable investors, even if they make sense for tax-exempt ones. A reduced universe of investment options makes investing easier for us by tightening our focus exclusively onto those opportunities that have the best odds of adding value net of taxes and fees.

KEY CHAPTER TAKEAWAYS

      Notes