Social Security Jitters? Better Prepare Now If you are worried about the future of Social Security, [more] For Savers, It Was Hardly a Lost Decade By RON LIEBER Published: January 1, 2010 It was the age [more] New Rules Ease Roth Conversions, but Benefits Vary Don’t be surprised if your broker calls in the next [more] ...more news»
Sign up below to receive our email notifications!

Three Steps to Financial Confidence

By: Thomas M. Lewry, CFP®, President

ASSET ALLOCATION

PORTFOLIO OPTIMIZATION

AND OTHER IMPORTANT

INVESTMENT TERMS



THE OLDER I GET, the more it seems that there are certain fundamental truths, if learned properly, will make our lives happier, less fretful, more fulfilled. When we are young and trying to survive, raising young families, feeling new responsibilities, trying to figure out multiple challenges . . . . just trying to find personal direction can be demanding.

So the irony is that when we are young and struggling with modest assets and incomes, we have all these issues to contemplate. When we get older, we are still struggling, perhaps at a different level, but having already erred in so many departments, the number of obvious alternatives shrinks and we come back to those BASIC, TRIED AND TRUE PRINCIPLES!

I think that this is the case in investing. There are certain SIMPLE, BASIC INVESTMENT PRINCIPLES that, if you understand them and force yourself to respond to that knowledge, you will save yourself from that nagging feeling of ignorance, futility, and most importantly, HELPLESSNESS.

Much of the literature written to “educate” the masses on these basic principles, although well intended, is unfortunately more than the average person wants to bear in terms of time or commitment. We also must recognize that there is a meaningful part of the population, that finds something appealing about being victimized by the markets, enjoys talking about it, enjoys being part of the uninformed crowd. If you are one of those people, don’t bother to read this article.

For those of you who would like to feel a little more like the ship captain drawing upon basic skills to navigate uncertain seas (without the necessity of a post-graduate degree in finance or economics), I would invite you to review the following BASIC INVESTMENT PRINCIPLES. They are not guaranteed to remove the uncertainties of the marketplace, but will allow you to understand the task better and to respond with more appropriate visions for your PERSONAL LONG-TERM FINANCIAL WELL-BEING.





THREE BASIC PRINCIPLES

LESSON #1

BUILD YOUR FINANCIAL PYRAMID

FROM THE GROUND UP



Many years ago, in Boston, we used to give seminars on the importance of assembling a personal financial plan as one would build a pyramid, from the ground up. The concept is as valid today as it was then.

THE THEORY IS that one should assess their financial profile by first establishing a financial base, not moving off that base until it has been understood and resolved. At the base of the planning pyramid are the three basic financial concerns that everyone has in life. They are:

1) WHAT HAPPENS IF I GET DISABLED AND HAVE TO FINANCIALLY SURVIVE A DISABILITY?
2) WHAT HAPPENS IF I LIVE INTO RETIREMENT AND HAVE TO FACE THE FINANCIAL REQUIREMENTS OF RETIREMENT?
3) WHAT HAPPENS TO MY FAMILY IF I DIE WHILE THEY ARE DEPENDENT ON ME?

When you think about it, these are the three major pitfalls we all have to worry about, with the exception of that monster called EDUCATION OF MY CHILDREN, and earning a living, which is our fundamental responsibility. Once these areas are considered and addressed, we can literally blow the excess at the racetrack . . . because we have taken care of the only three things in life that can really hurt us financially. That assurance, then, creates enormous INDEPENDENCE!

Of course, this is easier said than done. For most of the people we counsel financially, just getting these basic areas to a point of resolution is a major challenge. Indeed, many middle and lower income clients barely, if ever, get there. Let’s spend a moment examining why this is true.

Planning around one’s DISABILITY is difficult, particularly if benefits are not available through an employer. Disability income protection is expensive to provide individually, and may only provide subsistence levels of income for long-term benefits.

RETIREMENT PLANNING today is commonly focused around one’s employer. Indeed, the only portfolio decisions many people will make in their lifetime are concerned with their 401k or IRA accounts. Some people supplement these activities with long-term investment in real estate or other tangibles. But the bulk of portfolio decision-making most individuals will make in today’s society, workers and professionals alike, will be those decisions made with respect to their retirement accounts. (Thus the importance of Lesson #2 and Lesson #3, which have to do with investment decision-making and portfolio management.)

ESTATE PLANNING, an inevitable necessity for all of us, is in a state of disaster for an alarming part of the population. This I fail to understand, because I know people care about their families and care enough about their financial stability to plan accordingly. Since we get so many questions about this area (and it is relatively simple to understand and fund) I will spend a few paragraphs on this important topic as part of that “base” of planning. ESTATE PLANNING is an important topic for one’s OVERALL ASSET ALLOCATION.

If you don’t have a will, the State in which you declare permanent residence will decide for you how your assets will be distributed. This might not be a distribution you would like if you made the plans yourself. To have an attorney draft a will does not cost more than a couple of hundred dollars. For many people, the creation of a will is a great place to start.

When there are more assets, or there have been previous marriages, or there are insurance proceeds to manage, a trust may be appropriate. Again, this planning is an inexpensive price to pay for family security. An attorney will charge you anywhere from a few hundred dollars to a few thousand dollars to draft a trust or trusts, but even in the most complex situations, I have rarely seen the legal bill exceed $2,000 to $5,000. And the savings to an estate, in avoiding senseless financial waste, in providing family guidance and security, can overwhelm the expense.

The greatest will and trust documents in the world, however, cannot create an estate. And it is here that many well-intended estate plans completely miss the mark. There simply isn’t enough money to do the jobs that need to be done. I resent all the articles that suggest that you must have 3 times, 4 times, 6 times your income in life insurance. How can these formulas apply to everyone when everyone has completely different needs? Some people, to be frank, care more about their spouse’s absolute level of survival than others. Some people want their kids to be able to afford private school educations, others assume they will go to state institutions or make it on their own. These decisions create completely different financial parameters.

The point here is that it doesn’t take a Rhodes scholar to figure out how much money is going to be needed in an estate, as long as we understand a simple principal:

If income for a dependent family is going to survive for long-term needs, principle cannot be dissipated.

Period. You don’t need a 75 page financial plan, you don’t need a trust officer, and you don’t need anybody in order to have some basic understanding of your liquidity needs. You can figure out what it will take in five minutes, on a yellow pad of paper.

First sit down and make some notes about needs (the NEEDS side of the equation). For example; let’s look at a hypothetical situation:

“Let’s see, I am making $90,000 a year, I have three children, all in need of a college education, and I think my wife could not survive in her current lifestyle with less than $70,000 per year. I want her to be in a position to send all three kids to my alma mater, a private university currently costing about $30,000 per year. If I provided those funds today, I would assume that the investment growth will keep up with the cost of education at those institutions, and if it does not, perhaps they will have to take out some loans (what the heck, I can’t do everything!).”

I now have roughly all I need to figure out what I need to provide to her in her time of “need”.

She will need educational funds to be isolated for approximately $360,000 (3 kids times 4 years times $30,000 per year). Pretty much a no-brainer, unless I also want to hedge against the rising cost of education.

I need a dependable, long-term source of income for my surviving spouse, so that the poor dear is not forced to remarry some slug that couldn’t care less about my children’s financial needs. I am going to make this a little easier on myself, and subtract the $15,000 she will get from Social Security as a result of being my widow with dependent children. So, $70,000 less $15,000 is $55,000 that needs to be provided from “Other” assets.

Now I divide that $55,000 by a current interest rate, say the current 4% (since I know that this principal has to be set aside and never touched, in order to be available to generate income year after year), to get $1,375,000 that has to come from SOMEWHERE, if I am going to accomplish my minimum stated goals. If I add the educational funds that must also be available to accomplish that need, I get a total liquidity need of ($1,375,000 plus $360,000), or $1,735,000.

Why $1,735,000? Because we need (1) to set aside $360,000 for education, and (2) because it takes the balance, or $1,375,000, sitting in an account at 4% interest, to generate $55,000 in income to support the family.

Now I have to go looking for what sources of liquidity might be available to contribute to that need. Let’s assume that I know there will be $270,000 coming from my retirement plan, $50,000 from my group life insurance, $100,000 from personal life insurance, $20,000 from my IRA, and $65,000 that might reasonably be expected, after mortgages, from some real estate I own but which wouldn’t be required by my spouse. Deducting those sources of liquidity from my total liquidity need of $1,735,000, I conclude that I need to find a way to provide an additional $1,230,000 to my spouse, probably via a trust, funded by additional life insurance, to take care of her after I am gone.

SIMPLE. NO FUDGING. NO WAY AROUND IT. THE NUMBERS DON’T LIE. WITHOUT THE MONEY, IT JUST ISN’T GOING TO HAPPEN!

The failure of most people here is that they look at liquidity of, say $300,000, and having never seen that much money in ONE place at any ONE point in their lifetime, they assume that this is a reasonable amount.

The key is not the amount of the asset. The key QUESTION IS: WHAT IS THE JOB THAT MONEY HAS TO DO, AND FOR WHAT DURATION DOES THAT JOB HAVE TO BE DONE.

I contend that if caring people knew how inexpensive it is to resolve these issues, they would rush to get their planning done. As it is, almost 90% of people have no will or trust, and probably an equal percentage is grossly underinsured. This is unfortunate, and creates stress and uncertainty where it is totally unnecessary.

The charts provided will provide some graphic insight into the concepts of pyramid building and estate planning.



LESSON #2

UNDERSTANDING THE BASICS

OF RISK



In further consideration of my “base planning”, I must now consider my RISK PROFILE and ASSET ALLOCATION.

This is almost too simple, because the lessons proliferate throughout every kind of literature, from the time we are children to our adulthood. (“Nothing ventured, nothing gained” and “No risk, no reward”) And yet some of the best-educated executives and professionals fail to comprehend a basic understanding of RISK.

I am trying to create an informative brochure, without creating a textbook that no one will read. So trust me when I state that if you were to create a graph, and on that graph you were to plot out every type of investment available to man, you would find that return is a function of risk (see graph). You don’t get one without the other.

The moment you move away from short-term U.S. Government securities and reach for higher return, you take on additional risk. The reason you have the POTENTIAL for higher return, and the reason the market is willing to offer you the hope for that higher return, is because you are willing to accept that higher risk.

Higher risk can take many different forms, including higher volatility (as in certain kinds of stocks), low liquidity (as in real estate or private company investments), or credit risk (ability to pay back), but IF THERE IS THE POTENTIAL FOR HIGHER RETURN, REST ASSURED THERE IS THE POTENTIAL FOR HIGHER RISK.

Not too many years ago, in our state, there was a local municipality that had a lot of cash that was earning very low rates of return. A young broker from a national brokerage firm presented the concept of investing in long-term U.S. Treasury bonds, the “safest investment in the world”. The yield offered was substantially higher than the money market rates currently being held, and this Board of Directors, composed of professionals and executives, transferred the entire account into long-term Treasury investments.

Within six months, interest rates on long-term Treasury investments rose by over 2%, causing the value of the long term Treasury investments, the “safest investment in the world”, to plummet in value by 18%. In just six months! Obviously, neither the salesman, nor this “sophisticated” Board of Directors had bothered to mention or explore, the profound interest-rate risk that is inherent in long-term Treasury investments. All someone had to do was ask the question: “If we are getting a rate of return significantly above that of short term money markets, WHAT IS THE RISK WE ARE GETTING PAID TO TAKE?!”

SIMPLE RULE:

HIGHER RETURN= HIGHER RISK= HIGHER VOLATILITY= NO FREE LUNCH

Another important point about this discussion is that once you decide to “reach” for additional yield, understanding that such “reach” implies greater risk, it is no longer fair to compare your achieved return with that of secure, short-term investments (unless you are either an egotist or a masochist). It was your decision, made for perfectly legitimate reasons, to reach for a higher return, so now compare yourself to reasonable standards for THAT environment.

ANOTHER EXAMPLE: I sit on a City Retirement Board, wherein we hire 15 different, specialized managers to manage a portfolio valued at approximately $100 million. Each one of those managers has a specific charge (for example, large capitalization investments, small capitalization investments, bond investments). When we hire these managers, they know exactly the market index they are going to be compared to in evaluating their management expertise. If they outperform that index, even by only 1%, we think they are doing a great job (and we don’t fire them, normally, unless they under- perform for three consecutive years).

The point is, it would be ridiculous to ask these managers to take higher risk for higher return, over time, and then to compare them to a risk-less investment. Therefore, there are times when they have negative absolute performance, and yet we consider them to be doing an excellent job (for example, their comparative index is down 10%, and they are only down 8%)! We asked them to take that risk, and we have to evaluate them accordingly.

WE HAVE TO UNDERSTAND THAT THE MOMENT WE REACH FOR ADDITIONAL YIELD, WE TAKE ON ADDITIONAL RISK. THIS IS CALLED OUR RISK/ REWARD PROFILE.

IT IS UP TO THE INVESTOR TO DETERMINE HIS/ HER RISK PROFILE, AND, ONCE DETERMINED, TO COMPARE RESULTS TO REASONABLE STANDARDS.



LESSON #3

ASSET ALLOCATION,

PORTFOLIO OPTIMIZATION,

AND OTHER CONFUSING,

YET CRITICALLY IMPORTANT,

INVESTMENT TERMS.



Whether we are working on the “base” of our financial Pyramid, or have somehow managed, through our diligent efforts (or blind luck) to move beyond the base of the Pyramid, we are likely at some point in our lives to have to make decisions reference investing liquid assets (stocks, bonds, money markets). Most likely, today, would be decisions reference employer-sponsored 401k retirement plans, so prevalent at this time.

Many employees don’t have a clue how to make such decisions, and, unfortunately, guidance from employers and plan sponsors is minimal, or non-existent. Employers, and employees, would do well to attempt a basic understanding of the concepts of asset allocation.

ASSET ALLOCATION, simply defined, is the percentage breakdown between stocks, bonds, and money market instruments in a given investment account. It doesn’t matter whether the breakdown is in individual stocks and bonds, or mutual funds, the definition is the same.

The theory of all asset allocation strategies is to mitigate volatility (risk) by owning different asset classes (stocks and bonds), which generally do not move in unison, and thus tend to offset each other’s price action.

Asset allocation has become a real buzzword on Wall Street in recent years, which can be confusing, because there are many varieties. All of them break down into two main types: STRATEGIC ASSET ALLOCATION AND DYNAMIC ASSET ALLOCATION.

The reason the strategy works is that bonds and stocks don’t move the same direction all of the time. One-third of the time stocks and bonds rally or fall in value together. One-third of the time stocks and bonds move in opposite directions. And one-third of the time stocks and bonds move at random to one another. So, it is easy to see that at least two-thirds of the time stocks and bonds tend to cancel out, or reduce, each other’s volatility.

You see, if an investor had an infinite time horizon (a term we will also discuss), they would always invest 100% of their funds in stocks, since that asset class has, over extended periods of history, outperformed any other form of liquid asset investment. The problem is that very few investors, institutional or individual, have the psychological tolerance for the volatility (risk) that portfolio would provide. So, managers attempt to reduce volatility by combining stocks with other asset classes that will mitigate volatility and enhance predictability of return.


STRATEGIC ASSET ALLOCATION

By far, the most common type of professionally managed asset allocation falls under the category of STRATEGIC Asset Allocation. The simplest example of this strategy is bank trust departments, which tend to maintain their diversified accounts in a strategic asset allocation that almost always approximates 60% stocks and 40% bonds. Although this strategy doesn’t work in ALL markets (no strategy does), it does work in MOST markets, which is why they stick with it.

A slightly more complicated example is the City Retirement Plan I mentioned previously. That $100 million portfolio may be broken down, overall, similarly to a bank trust account, but it goes even further, specifying in its strategy percentage breakdowns between very specific components (large cap growth, large cap value, mid cap growth, mid cap value, etc., etc.). The specified percentages never change, except that a consultant is hired to bring the percentages back into line with plan specifications on a quarterly basis.

Even small 401k accounts can employ strategic asset allocation, if the plan sponsor/employer seeks to make it available. Under such arrangements, a participant’s risk profile is defined through a Questionnaire/ Evaluation, and then a third party firm periodically readjusts the holdings to a strategic asset allocation suitable for the participant’s risk profile. This is a great option for a small participant seeking continuous investment monitoring.

DYNAMIC ASSET ALLOCATION

Dynamic Asset Allocation is practiced by some of the more sophisticated institutions or individuals, as very few managers are capable of the asset class evaluation this practice demands. Again, the account, or pie, is allocated into different components, to reduce volatility, but in this case the manager attempts to periodically adjust the asset class percentage allocation based upon valuation work and the probability of various asset classes outperforming each other over the client’s investment time horizon.

The theory here is that appropriate reallocation, in periods of unusual market over-valuation or under-valuation, can reduce volatility and enhance return. This approach is not market timing, but rather one of adjusting the allocation to reflect the current relative expected returns of stocks, bonds and other asset classes.

Again, this particular discipline is practiced by very few managers. In a recent search for an institutional client, we were able to isolate only a handful of managers practicing “dynamic asset allocation”, catering mostly to institutional clients.

TIME HORIZON FOR RISK

When you pick up a book on investments, or listen to an investment presentation, professionals love to throw around terms like “tolerance for risk”, or “risk profile”. While these are critically important concepts, it must be hard for individuals to understand the importance of this issue.

Again, if an investor had an infinite “time horizon for risk”, they would always be 100% invested in stocks. This is true because over any extended time frame in our history, stocks have outperformed the alternatives of bonds and money market instruments. But I know of almost no investors who could tolerate the volatility (risk) that a 100% stock portfolio would suggest.

When an investment professional asks a client about their time horizon, or risk profile, they are asking a reasonable question, but who knows how to answer it? The easiest way to explain how to answer that question is by example:

Several years ago we had a client in the West, a mining company. When we took on its accounts, we knew that the minerals in the mine they operated would be totally exhausted in seven years. They asked us to manage three accounts for them. Their corporate cash was to be managed on a ONE-year time horizon, being extremely conservative (they never knew when they would need the money). An executive benefit program could be managed somewhat more aggressively, with a THREE-year time horizon. The employee pension plan was to be managed with the awareness that the mine was to be closed in seven years, and the funds would be paid out to the participants….thus, each year it would be progressively managed more conservatively, using a 7 year time horizon, then a 6, then a 5, etc., until the funds were finally paid out.

This was an astute client, which had properly assessed the appropriate risk tolerance, or time horizon, for specific pockets of assets. Since no one can predict market direction in the short term, accounts that may need funds over short time horizons must be very conservatively managed (fewer stocks, more bonds and money markets). Accounts that have time to allow normal market dynamics to play out can be more aggressive (more stocks, fewer bonds and money markets).

SO, TIME HORIZON DICTATES ASSET ALLOCATION, IN ANY MARKET ENVIRONMENT.

When you assess your RISK PROFILE or TOLERANCE FOR RISK, you are telling an investment advisor what time period the advisor should be comparing the probability of stocks, bonds, and money markets outperforming each other. This, in turn, will allow the advisor, or you, to determine the appropriate portfolio mix. This is true whether or not you are attempting to employ either STRATEGIC ASSET ALLOCATION or DYNAMIC ASSET ALLOCATION. This is true whether your situation is modest (which makes it all-the-more important), or you are a billionaire!

In conclusion, I would suggest that most of the frustration, and most of the miscalculations leading to financial suffering, are the result of a lack of attention to the simple financial principles outlined above. Commit to these three simple principles (Einstein said the human mind deals well with “threes”) and you will save yourself and your family an enormous amount of emotional consternation and financial grief. They are, simply stated:

1. Know where you are on the Financial Pyramid. Take care of your most fundamental needs first, then consider more esoteric investment alternatives.
2. Take the time to understand the basics of Risk (Volatility) and what it can do to your emotions and financial stability.
3. Let your understanding of your personal (or institutional) risk profile dictate an overall asset allocation that you can live with through both positive and negative market environments.

If you can conquer these three simple concepts, you will know more, and live more confidently, than most investors, and many of the professionals in the field.

Wishing you good fortune and great happiness.




Thomas M. Lewry, CFP®
President
Curbstone Financial Management Corporation