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How Taxes, Fees and Inflation Can Affect Your Portfolio Growth

Regardless of where you might be in your investing career-whether you’ve been at it for a while or if you’re just getting started-it’s safe to say we all share a common goal: we hope to maximize the size of our portfolios over time.

As we’ve seen in recent weeks, market movements can be volatile.

But while you can’t control the market’s ups and downs, there are elements that you can control. And that means having a solid approach to playing both offense and defense as an investor.

What does that mean? When it comes to offense, you want to be sure you’re saving as much as you can, as soon as you can, so you see the benefits of compounding returns over time. You will also want to diversify your investments in various asset classes.

But you also need to play defense in investing-and that means being aware of the things that can eat away at your returns (or even your principal) over time, leaving you with less than you should have. Here are some examples:

Taxes. Many investors may not like thinking about the effect federal and state taxes have on their returns, but you should be aware of how much you’re paying and look for ways to reduce the size of the tax bite.

As this tax primer from Fidelity emphasizes, you have three key tax strategies when investing:

  • Defer paying taxes with tax-advantaged accounts, such as 401(k)s, 403(b)s and IRAs. These accounts can serve a double tax benefit, providing for deferral of current taxable income as well investment income within the account.
  • Manage your tax burden with strategic asset location, invest in tax efficient mutual funds, and take advantage of the charitable and capital loss deductions.
  • Reduce taxes on investment income with tax favored municipal bonds, or by contributing to a Roth IRA or 529 college savings account.
    Fees. Another threat to your portfolio’s growth comes in the form of fees. Depending on a variety of factors-the type of financial professional model you use, the frequency of your trading, the types of securities you hold in your portfolio-fees will have different impacts on different investors.

    In general, most investors want to strike a balance that gives them the best advice and service they can get for the most reasonable fee level. You want fees to take as small a bite of your returns as possible.

    But that measure is relative, depending on your circumstances and needs.
    If you’re considering working with a financial professional, recognize that different advisors have differing pay arrangements. Some may work on a flat fee basis, while others may charge commissions. Neither model is necessarily better than the other, so it’s a good idea to consult with a professional to determine what works best for you and your portfolio.

    Inflation. Even in times of relatively low inflation like today, savers and investors should be aware of how inflation can affect your returns so you’re not bleeding purchasing power over time.

    Keeping a close eye on inflation is particularly important for retirees or those nearing retirement age. Many seniors live on fixed incomes, drawing primarily on Social Security and their own savings and investments for a retirement income. While Social Security provides regular cost-of-living adjustments, based upon increases in the Consumer Price Index for Urban Wage Earners and Clerical Workers, so that beneficiaries maintain their purchasing power to help keep pace with rising prices, the reality is that those living on a fixed income are vulnerable to the loss of purchasing power that inflation brings.

    That goes for cash, too. Many savers like to hold some portion of their portfolio in cash, in order to address unforeseen emergencies like a car repair or a job loss, or to take advantage of unexpected opportunities.

    But too large of a proportion of your savings kept in cash can leave you subject to losses from inflation. That’s because cash holdings like savings accounts, CDs and money market accounts typically command relatively low rates of interest-which means inflation can take a bigger bite.

    How to confront these threats to portfolio growth

    The reality is that taxes, fees and inflation probably won’t represent a catastrophic threat to your portfolio’s success. But in combination, they can slowly reduce your returns over time, which is why you should be aware of strategies to mitigate these costs.

    All that said, keep in mind that playing offense by saving more is probably the best thing most of us can do for our portfolio’s health over the long-term-particularly when studies show again and again that Americans save too little for retirement.

    You want to put away as much as you can comfortably afford (and then some!), so that compounding can do its work for you over time. This is particularly true for younger investors-if you’re at or near the beginning of your career, that approach will likely help you reach your investment goals more quickly.

    As you mature in your investing career and build a larger portfolio, you may find that defensive strategies play a larger role in your approach. So keep an eye on those silent killers like taxes, fees and inflation-and talk to a financial professional to ensure you’re pursuing the optimal offensive and defensive strategies to keep your portfolio growing.