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Charitable Giving – A Smarter Way

2007-01-25T10:26:00.000-08:00

Most taxpayers understand the tax benefits of charitable giving. Subject to limits of as high as 50% of income, charitable contributions are fully deductible as itemized deductions. However, many taxpayers don’t realize there’s even more tax savings to be wrung from charitable contributions. Where possible, contributions should be made of appreciated property – stocks, mutual funds, real estate, etc. – rather than cash. Why? Contributions of appreciated property have a double tax benefit. First, you enjoy the same full tax deduction as cash contributions. The donation is equal to the fair market value (rather than the cost) of the appreciated property. Second, the donated property escapes the income tax that would be imposed if the property were sold. Two tax benefits with the same charitable contribution.

An Example

Here’s an example of how this works. Mr. and Mrs. Smith wish to donate $10,000 to their favorite charity. They review their brokerage account and find they own XYZ Mutual Fund which they purchased three years ago for $6,000. Rather than contributing cash of $10,000 they arrange a transfer of the mutual fund to the charity. This contribution saves them $3,500 of income taxes (assuming a combined federal and state marginal tax rate of 35%). This strategy also avoids $1,000 of capital gains tax (assuming a combined federal and state marginal tax rate of 25% on capital gains) on the $4,000 of appreciation. So, an investment costing $6,000 has generated tax savings of $4,500.

Two More Tweaks to Consider

The above example can have even more tax planning impact. Assuming XYZ Mutual Fund was an investment the Smiths wanted to keep, they can use $10,000 of cash to replace the shares of XYZ they contributed to Ascend. Now, they have the same XYZ holdings as before but the $4,000 capital gain potential has disappeared. Taxpayer wins. Charity wins. Internal Revenue Service loses. Perfect.

A further refinement of this strategy can occur in the last months of the year. That’s when most mutual funds distribute taxable dividends. To avoid the taxable dividend the Smiths make their contribution to Ascend right before XYZ’s distribution date (usually announced in October-December). Once the dividend has been distributed the Smiths replace the XYZ shares (as described above) they contributed to Ascend. This really amounts to a triple tax benefit – deductible charitable contribution, capital gains tax avoided, and taxable dividend avoided.

Your Own Private Foundation – Without All of the Costs

No doubt you’ve heard about the large private foundations of the wealthy. Legal and tax preparation costs and regulation mean private foundations usually make sense only for funding of $500,000 or more. For everyone else there’s a simple, elegant solution – a donor-advised fund. These are large public charities that allow considerable flexibility as to the management of your donated funds and the charitable purposes for which the funds are used. And, of course, you get a charitable contribution deduction.

Continuing the example from above, the Smiths’ annual charitable contributions total $50,000. Again, rather than contribute cash to their various favorite charities they want to contribute $50,000 of appreciated mutual funds and stock. Since they contribute to ten different charities it’s a bit unwieldy to make the securities transfers to each of the ten organizations. And, some of the charities aren’t set up to accommodate this kind of donation. So, the Smiths contact a donor-advised fund and set up the Smith Family Charitable Fund. The $50,000 of appreciated securities is transferred to the donor-advised fund and the Smiths receive a $50,000 charitable contribution deduction. The donor-advised fund immediately sells the securities and invests the proceeds in an investment pool selected by the Smiths. The Smiths then direct the donor-advised fund to make charitable grants to the ten favorite charities. These grants may be made in any year and do not affect the $50,000 charitable contribution deduction the Smiths have already received. The donor-advised fund makes the grants in cash and directly to the charities in the Smiths’ names.

There are many donor-advised funds. Here’s information on the three largest funds:

Acting in Your Best Interests

2006-11-05T21:04:00.000-08:00

Most logical and reasonable people take actions that are in their best interests. They avoid unnecessary risks like using a blow dryer in the bathtub and smoking while filling the lawnmower with gas. And, those same people typically seek out and engage other persons where their best interests are optimized.

How can one be sure that a financial advisor has a client’s best interests in mind? To be sure, there’s no ironclad method of ensuring against the bad acts of others. But, engaging an advisor who will act as a fiduciary – seeking and securing your best interests – can be your best bet.

The National Association of Personal Financial Advisors (NAPFA) and a number of other financial planning and investment advisor organizations are promoting the idea of a fiduciary code or oath that an advisor would pledge in connection with providing financial services. Here’s the oath developed by NAPFA.

Will you sign the Fiduciary Oath below?

• Yes
• No

FIDUCIARY OATH The advisor shall exercise his/her best efforts to act in good faith and in the best interests of the client. The advisor shall provide written disclosure to the client prior to the engagement of the advisor, and thereafter throughout the term of the engagement, of any conflicts of interest which will or reasonably may compromise the impartiality or independence of the advisor. The advisor, or any party in which the advisor has a financial interest, does not receive any compensation or other remuneration that is contingent on any client's purchase or sale of a financial product. The advisor does not receive a fee or other compensation from another party based on the referral of a client or the client's business.
What the Fiduciary Oath means to you - the client:

I shall always act in good faith and with candor.
I shall be proactive in my disclosure of any conflicts of interest that may impact you.
I shall not accept any referral fees or compensation that is contingent upon the purchase or sale of a financial product.

________________________________ Signature

This oath seems reasonable to most folks. Who wouldn’t want an advisor willing to exercise best efforts to act in good faith and in the best interests of the client? Who wouldn’t want an advisor without undisclosed conflicts of interest? To know if your current or prospective advisor shares this belief is as easy asking for his or her signature. Handing this oath over to an advisor can be a very telling moment. Don’t be surprised to see a sudden paleness, cold sweats, and stammering. It can be like holding a cross up to Dracula. The true advisor who is willing to act as your fiduciary will readily sign the oath. The non-advisor will attempt to discredit the fiduciary concept or cite employer policy against signing such an agreement. In other words, the non-advisor can’t assure you that his or her actions will ever be in your best interests. What should you do? Since you’re one of those logical and reasonable people I first spoke of, I’ll let you figure that out.

Dow 12,000. What Happened to All of the Fear?

2006-10-19T17:03:00.000-07:00

So, we finally did it. The Dow attained that lofty, never-before-attained level of 12,000 (Dow Finishes Above 12000, WSJ, 10/19/06). Now we can all get back to our regularly scheduled programming.

I clearly recall a day back in mid-June of this year when one of my clients called to say that his wife was concerned about the state of world affairs and their portfolio's exposure to equities. I'm not sure why the wife couldn't call me to express her fears and felt a need to send her surrogate. This couple, in their early 60s, is invested about 60% in diversified equities. They have plenty of wealth (but not too much) and a long time to live. Anyway, the client (not the wife) proceeded to tell me her fears about the falling Dow (10,706), gas prices ($2.91/gal on 6/13/06, but higher in California where they live), oil prices ($68.56/barrel on 6/12/06), bad outcomes in Iraq, potential for a crash in real estate prices, and assorted other worries. Of course, we all felt cranky back then with the dearth of blockbuster summer movies and Al Gore's litany of inconvenient truths. Things just seemed bad and were likely to get worse.

My advice to the client? Do nothing. I realize that when we're feeling fear and emotion the natural reaction is to do something. OK, then go buy a 72-hour kit or a hybrid car. But, don't let it affect your sound, reasoned long-term plan for wealth accumulation and preservation. What I gave the client was a dose of discipline and told him he'd feel better in the morning.

Fast forward to today. Gas prices at $2.21/gal (still higher in California), oil at $59/barrel, Iraq is worse, Congress is in a heap, no good movies, and more inconvenient truths. And, the Dow at 12,000+. See, I knew he'd feel better in the morning.

Many times the best strategy is to do nothing. You're better off kicking the cat than kicking yourself later.

The Danger of Simplified Projection Techniques

2006-10-18T09:36:00.000-07:00

In my last post I reviewed The Number, a wonderful book that will help you understand the issues in arriving at your own number. It's been interesting to read the book's reviews on Amazon.com. So many of the readers/reviewers really miss the point of the book. The author of "The Number" never intended the book to be a "how-to" on projecting one's retirement needs. It's not about formulas and projections.

A recent reviewer proposed his own formula for projecting the wealth needed by a hypothetical couple. Here are the assumptions he used:

"Let's say you want to retire on $100,000 a year. Assuming that you and your spouse will pull $30,000 a year from Social Security, and $20,000 a year from old defined benefit pension plans; you have a gap of $50,000. As a short cut, you can use the Dividend Discount Model to value stock. Using a conservative after tax investment return of 7.5% and a long term inflation rate of 2.5%, by dividing $50,000 by (7.5% - 2.5%) you need $1,000,000 in your own retirement funds (401K, IRAs) to retire. In reality, you need a bit less because the Dividend Discount Model assumes you live forever."

The true result of this projection is so far off base and really highlights how people can underestimate the wealth they need. I ran a Monte Carlo projection using the reviewer's figures with the couple retiring at age 60. I used the same 2.5% inflation figure and I allowed the pension, social security, and living expenses to grow at this rate. I also assumed a 60% equities, 40% fixed income diversified allocation with an 8.1% average return and a standard deviation of 10.8%. I put 50% of the $1 million of additional retirement wealth in a taxable investment account and the other 50% in an IRA. The result is a 95% chance of exhausting the couple's wealth by age 95. If the retirement is delayed until age 65 there's still an 80% chance of running out of money by age 95. Forget his formula. It will end in financial disaster.

Why was the reviewer's projection so far off base? First, there was no mention of taxes. He assumed that the annual distributions of $30,000 of social security and $20,000 pension and the $1 million of savings would be free of tax. This just can't be. To live on $100,000 per year you need distributions totaling about $150,000 before tax. Second, the issue of volatility is completely ignored. Where do you get a 7.5% after-tax return with zero volatility? Not on this planet.

Seat-of-the pants, back-of-the-envelope projections? Forget 'em. You'll end up in the poorhouse. Or, in your children's spare bedroom.

What’s Your Number?

2006-10-11T13:21:00.000-07:00

In late January of this year I read a review of Lee Eisenberg’s book “The Number.” I was intrigued by the book title and the subject matter. Probably the question I’m most frequently asked is “how much money do I need?” It’s always a question that’s easily asked but most difficult to answer. It’s a question that’s regularly pondered by advisors and all sorts of other folks. It’s a puzzle dealt with in books, articles, seminars, and software programs. I’m convinced there’s no simple, single answer. Even if you discover your “number” you should expect it to me an ever-moving target.

I devoured “The Number” over one weekend. This is not "Financial Planning for Dummies." The author assumes you have a number or the hopes for a number. If you have no wealth, aspirations for wealth, or hope of wealth, this book won't magically create it. There are no magic recipes, formulas, or templates. Instead, Mr. Eisenberg takes you on a journey of discovery – uncovering the issues, elements, and questions integral to the search for your number. The author does this through a very entertaining writing style full of many interesting stories and examples. If you’re easily bored by all of the figures, statistics, and formulas in most finance books, you’re in luck. That’s not what this book is about.

The Number will help you rethink your number and the whole concept of retirement or ‘the new rest of your life.’ I highly recommend this wonderful book. See: http://www.thenumberbook.com/

Dow Tops All-Time High. Significant?

2006-10-03T15:49:00.000-07:00

So, today the Dow Jones Industrial Average hit an all-time ("Dow Tops All-Time High," WSJ 10/3/06) of 11727, bursting past the old mark of 11723 (1/14/2000). My reaction is "so what?" It's interesting how we humans put significance on insignificant numbers. The Dow high is just another number. It's information. But, what are investors supposed to do with that information? My answer, contrary to the many other advisors and pundits running about with this useless bit of trivia, is that investors should do absolutely nothing. That's right. Nothing.

You see, the world didn't change from yesterday to today as we all waited breathlessly for this incredible threshold to be passed. The truth yesterday, today, and forever is still the same. And, that truth is that investors should be diversified and not speculate in any narrow sector or index.

The Russell 2000 (index of small company stocks) also hit an all-time high this year. In May 2006 (somewhere around May 1st) this index topped 785. Where was the fanfare, balloons, cut the cake, write it up in the journals? Didn't happen. Why? Don't know, except too many investors (and, their enablers) seem enamored with large company stocks 24/7. It must the familiarity of these companies. We fly on their planes, drive their cars, buy their toasters, eat their burgers, and take their medicine. So, why not buy them? OK, but spread it out. There are more than 5,000 publicly traded companies in the U.S. and many more than that overseas.

Is the Dow too high? Over-priced? Don't know. Ask me again in 2015.

The Wrong Bet. This Isn't Investing.

2006-09-18T16:54:00.000-07:00

Investing: laying out money or capital in an enterprise with the expectation of profit.

Gambling: any behavior involving risking money or valuables (making a wager or placing a stake) on the outcome of a game, contest, or other event in which the outcome of that activity depends partially or totally upon chance or upon one's ability to do something.

It's interesting how we can get our vocabulary all confused. Consider the revelation by Robert "Bo" Collins of MotherRock LP (a hedge fund ) that it was closing down after making the wrong bet on the direction of natural gas prices. Investors were told they were unlikely to get any of their money back (See: "Hedge Fund Takes Huge Losses On Bad Natural Gas Bet," WSJ, 9/18/06).

So, my question is: did the investors in MotherRock believe that Bo was investing their money or betting with their money? I'd be curious to know more about the "investors." Certainly, they were more substantial than the average Joe Lunchbox who isn't at all confused between making a 401(k) investment and buying a lottery ticket. No, these were likely folks of above-average wealth. Which then begs the question: why did they feel the need to take the risk associated with giving their money to Bo to bet on natural gas prices?

My definition of investing assumes a person has a financial objective or goal in mind. He or she is then willing to take just enough risk to meet that financial objective -- and no more. The name of the game is to maximize returns while minimizing risk.

Investors who gamble are a lot like those who participate in extreme sports. It's about maximizing risk. The risk is the thrill. The more exteme the risk the more the thrill. In neither case should the participant be surprised when the word 'demise' is used in connection with their name.

My theory on risky behavior is confirmed by a new study from U.C. Berkeley's Haas School of Business entitled "Power, Optimism, and Risk-Taking." Quoted in an article ("Power Tied to Risky Behavior, Study Says," Contra Costa Times, 9/19/06), one of the study's authors said:

"There seems to be this link between rising to an incredibly powerful position and engaging in incredibly risky behavior."

"We looked to a psychological theory that when people possess power, a lot of power, sometimes unmitigated power, they become blinded to the kind of risk involved in certain behaviors."

"They become more focused on the potential upside. They become optimistic that the risk can pay off."

Watch for more news in the weeks as more bad betting comes to light.

The Missing Questions

2006-09-13T11:22:00.000-07:00

One of the professional publications I semi-regularly read is Financial Planning. A little news item in the August 2006 issue caught my attention. A company that regularly surveys and researches the investment industry asked advisers how they choose the mutual funds they use. I looked down the list of responses to compare how I would have answered such a survey. The factor cited by most respondents as extremely important (59%) or somewhat important (39%) was whether the fund had a consistent style of investing. Sure. I can buy that. I proceeded to look down the list of other factors. What struck me were the factors that were missing. Not mentioned was whether the fund had a sufficiently high front-end load. I’m sure a number of advisers (using the term in a liberal fashion) count that high on their list. More importantly, also missing was whether the fund had low expenses (low expense ratio and low portfolio turnover). Low costs to my clients are very high on my list of important factors. Yet, this factor was completely absent from the survey. It wasn’t even a write-in candidate.

Any smart investor faced with the choice of Fund A or Fund B that are the same in all respects other than annual costs will choose the fund with the lower cost. Why? Because they learned in first grade that a 1.0% annual cost means 1.0% less goes into your pocket. Compound that over a lot of years and you come up with a significant number. Costs do matter – whether advisers consider them important or not.

4,000 Financial Plans a Month!

2006-09-05T15:28:00.000-07:00

A recent Investment News article (“Vanguard Creating 4,000 Plan per Month,” 9/5/06) revealed that the Vanguard Group is churning out financial plans at a clip of about 4,000 per month. Just think of all of the paper. But, more importantly, how are they able to meet that with that many clients, help them consider and establish their long-term financial and non-financial goals, review their investment holdings and savings vehicles, assess their risk profile, and implement an appropriate diversified investment strategy? And, what about the periodic ongoing meetings to review and refine the whole financial plan and integrate risk planning (insurance), tax planning, and estate planning? The answer is that they can’t possibly provide meaningful planning advice of this magnitude.

You see, Vanguard and a lot of other advisors (and those who pretend to be advisors) see the planning process as mainly about numbers. And, often those numbers are the ones that move to their pockets from their clients’ pockets. But, even if we’re talking about a client’s financial numbers, real planning is more than just printing out a ream of charts, figures, and projections on a one-time basis. Real planning is a consultative approach that fleshes out what’s really important to a person – long-term goals, circumstances, hopes, and fears. Those issues become the basis for planning one’s financial future. Any resulting charts, figures, and projections are only a part of the roadmap to achieving what’s important. And, the roadmap is but a snapshot in time. Because goals, circumstances, hopes, and fears are ever-changing, so must one’s planning adapt to those changes. The roadmap needs to be regularly consulted, adjusted, and re-oriented. Planning is not a static, one-time event. It is a process.

Churn out 4,000 plans a month? I’ll settle for ten meaningful new planning encounters per month. And, many trees will be saved in the process.

Roth IRAs for Everyone

2006-09-02T16:00:00.000-07:00

For a number of years I’ve advised clients against nondeductible IRAs. As a quick review, nondeductible IRAs are for folks with incomes too high to be eligible for regular deductible IRAs or Roth IRAs. Nondeductible IRAs offer no upfront tax deduction, but the earnings and growth of the IRA are taxable when withdrawn. And, that’s why I haven’t liked them. Assuming you’re not doing a lot of trading in your IRA, most of the IRA’s growth will be in appreciation. Outside of an IRA that appreciation gets taxed at low capital gain rates. However, if distributed from an IRA the appreciation gets whacked with the higher ordinary income tax rates. I just haven’t believed the tax deferral of the IRA overcomes the higher tax rates upon withdrawal.

Congress has recently (Tax Increase Prevention and Reconciliation Act of 2005, passed in May 2006) changed my mind. Beginning in 2010 anyone, no matter the income level, can convert a regular IRA or nondeductible IRA to a Roth IRA. The hitch? You have to pay the tax either at the time of conversion or 50% in each of the years 2011 and 2012. So, why do I think this is a good idea? I figure just about everyone under age 60 (and some those over age 60 also) should have a Roth IRA. The problem is that most of my clients have been locked out of Roth IRAs due to the income limit. Now they can have a Roth IRA by funding a nondeductible IRA for 2006-2009 and then converting to a Roth in 2010. The tax shouldn’t be too oppressive since only the earnings and growth will be taxable. And, there’s the special two-year tax spread.

I’ve never had an IRA (for the above reasons). Count me in for 2006.

I Have Some of That!

2006-08-29T14:10:00.000-07:00

Not long ago an acquaintance was speaking to me about investing and the recent stock advice from his broker. The friend wanted to know what I thought of the broker's advice to buy several oil company stocks. I told him I had no idea whether that was a good move but that my clients and I have oil stocks in our portfolios. In fact we have most of the oil company stocks. "What about investing in Brazil?" he asked. "We have some that too," I told him. "In fact," I said, "we own a portion of about 14,000 companies. If you name a company or country, the odds are we own some it." Of course, he wanted to know how that was possible.

"You see," I said, "we don't fret about whether we should be buying Exxon or whether Brazil is a good place to invest. I don't have that knowledge. No one does. It's just speculation. Since we're investors and not speculators we invest in a broad cross-section of securities in a highly-diversified fashion. That investing is done not to get the highest returns but to get the appropriate returns with the least amount of risk given our long-term financial objectives. We're all free to stop watching CNBC and reading Money magazine. We feel assured that we'll get exactly the returns the markets will produce in the future. It's a sensible, no-gimmick approach. Sure, it doesn't pay big commissions to brokers and it won't be popular on TV, but meeting our financial goals is all that matters."

My friend went away scratching his head a little, at the same time wondering whether his own life wouldn't be simpler and his financial future more secure if he just embraced sound principles of investing and eschewed speculating.

Prepay the Mortgage or Put that Money in Tax-Deferred Savings?

2006-08-02T11:28:00.000-07:00

Many individuals are faced with the choice of increasing their mortgage payment beyond the required amount (prepaying the mortgage) or increasing their investments in tax-advantaged retirement accounts. The authors of a 2006 paper entitled, “Responsible Fools? The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings,” examined whether individuals were making choices that were financially optimal.

In general, the benefit of increasing the contribution to a tax-advantaged account is that the investment grows either on a tax-free basis (Roth accounts) or on a tax-deferred basis (IRAs, 401(k)s, profit-sharing plans, etc.). This allows for a tax arbitrage. The mortgage interest is tax deductible if one itemizes, while the earnings inside of the retirement savings account are either tax deferred or tax free. In the paper, the authors documented that, for some individuals, the tax benefit more than offsets the slightly higher rate on the mortgage (which in turn is higher than that which can be earned by investing in a mortgage-backed security of similar maturity — used by the authors because it matches the risk characteristics of a mortgage). They found that the advantage enhanced if, by increasing their investment into a 401(k) plan, individuals also received a matching contribution from their employer.

The paper concluded that 45% of individuals would benefit from the strategy of increasing contributions to a retirement savings account instead of prepaying their mortgage. Note that individuals most likely to benefit were those in higher tax brackets. According to the paper, the decision to increase retirement savings yielded incremental savings of between 11 cents per dollar (if the investment was made in Treasury instruments) and 17 cents per dollar (if the investment was made in a mortgage-backed security). Finally, they estimated the cumulative cost of inefficient decisions. They concluded, “In the aggregate, correcting this inefficient behavior could save U.S. households as much as 1.7 billion dollars per year.”

Since the above benefits are basically riskless (they are just a tax arbitrage), why did individuals forego the benefit? The authors hypothesized that, in general, a high aversion to debt (the desire to be debt free) drove an individual’s “investment” choice toward paying down the mortgage instead of increasing retirement savings.

The paper also pointed out that there are two circumstances that work in favor of prepaying the mortgage. First, those with mortgages with a loan-to-value (LTV) of more than 80 percent might consider paying down the mortgage to that level to eliminate the cost of private mortgage insurance (PMI). For those who do not itemize deductions in a lower tax bracket, the prudent choice would be to pay off the debt (particularly if it is likely one would be in a higher tax bracket when taking future withdrawals).

The second point concerns penalties that individuals would face if they were to withdraw funds early from a tax-advantaged account. Individuals who withdraw funds from such accounts before age 59 ½ would face a 10% penalty. Thus, individuals should consider whether there could be a liquidity risk — meaning a reason that might require them to withdraw funds from a tax-advantaged account before the end of the early withdrawal penalty period.

The authors acknowledged that, in a perfect world, individuals would not have to choose between prepaying their mortgage and contributing those funds to savings. When faced with a situation of “one or the other,” your individual financial profile determines the final call; but for some individuals it might be more prudent to contribute funds now earmarked for mortgage prepayment to a tax-deferred savings vehicle.

Why Brokers Load Up on Large Cap Stocks

2006-03-02T16:17:00.000-08:00

For many of my prospective new clients I perform a portfolio analysis before we start working together. It's a way to assess what the client has and whether the current portfolio is diversified and fits the client's long-term financial goals. So, I see a lot of the statements of the big brokers. It's amazing how often the portfolios are so concentrated on large cap stocks, mostly of the growth variety. I've puzzled and pondered over this and come to the following as the best explanation for such behavior:

Large cap growth companies are mostly household names – Microsoft, Merck, Walmart, Abbott Labs, Citicorp, etc. Clients feel comfortable investing in companies they recognize. There’s a feeling of (false?) safety when they open their statements and see all of those names and mentally consider the all-American products and services these companies represent. Contrast this with the mostly unrecognizable names if you buy small companies or international stocks with all of those foreign-sounding names.
Many large cap growth stocks are sexy, trendy, and have a youthful appeal. Google, Apple, and Verizon are a lot more exciting than some old, worn-out restaurant chain in the Midwest.
When large cap growth stocks falter or gain, investors see it in the newspaper, on TV, hear it on the radio. They then expect the same when they get their monthly statements and performance reports. The paper reports only confirm what they already know.
Investors assume that everyone else is in the same boat. When the Dow and the S&P are down, all investors are glum. So, investors just think “that’s the way things are” and are less likely to complain to the broker. In other words, there's no tracking error risk if one sticks with large caps.
A broker is less likely to be faulted for a poor large cap pick. There’s always a ton of research from his firm and other firms saying XYZ stock is a “buy.” If something goes wrong with the pick, there’s plenty of ammo to show that the even the experts were fooled.
Large cap stocks are a lot easier to pick and manage compared to small cap or international stocks. Just compare the expense ratios on large cap index funds (0.10%-0.30%) to small cap index funds (0.25%-0.80%). It’s a lot tougher for a broker to pick stocks outside of the S&P 500. Many brokers just opt for a small cap mutual fund (nearly always with a load and a high expense ratio). Or, the broker just sticks with the large caps and continues to charge the same commissions and fees without the heavy lifting of a truly diversified portfolio.
Finally, many brokers just won't believe the years of evidence that's there's a "size premium," i.e., that small company stocks have outperformed large company stocks, and that diversification is the best way to obtain better long-term returns with the least amount of risk. Since many brokers will only benchmark their returns against the S&P 500, investors rarely recognize their own underperformance.

Too many large cap stocks in your portfolio? Those are the reasons why.

Warning: Coming Soon to Brokerage Statements

2006-01-16T13:41:00.000-08:00

Some investors may be surprised to see the following disclaimers on their brokerage statements: "Your account is a brokerage account and not an advisory account" and "Our interests may not always be the same as yours."

You're saying 'what?' You see, in the regular world a doctor is a doctor, a dentist is a dentist, and a CPA is a CPA. But, in the investment world just about anyone can use the term "investment advisor." But, the SEC (the regulatory god of the investment world) is about to tighten up on the use of the term. Brokerage firms who do NOT register as investment advisors will be required to include the above disclaimers in the documents and statements they provide to clients. Such firms are expected to recommend investments that are suitable to your needs, but they are not required to act in your best interest. These firms can only give investment advice which is incidental to their job as "investment order-takers." How can you know the difference? Just ask for a copy of the advisor's Form ADV. If you get a blank look you'll know you're not speaking to an investment advisor.

The group that's not required to include these discalimers are brokerage and other firms who DO register as investment advisors. Registered Investment Advisor (RIA) firms must select suitable investments for you. Plus, they are required to ensure that your best interests are being met. These folks will gladly offer you a copy of their ADV and their firm's code of ethics.

The bottomline? It makes sense to be aware of the source of any investment advice you may choose to act upon and whether it is coming from someone who is obligated to act solely in
your best interests. Knowing the answers to these types of questions makes it quite a bit easier to make a decision when considering with whom to entrust your life's savings.

Addendumum (1/30/06) (See WSJ, January 28, 2006; Page B1):

"Generally, only two types of titles are scrutinized by regulators, and therefore offer consumers legal protections: broker-dealers and registered investment advisers. Broker-dealers (think: stockbroker) serve primarily as stock-market order-takers, facilitating trades on Wall Street and in the bond market. They report to the NASD, the brokerage industry's self-regulatory arm. Registered investment advisers (think: financial planners), which report to the SEC, primarily provide services such as building a financial plan or offering tax- and estate-planning advice.

"Broker-dealers and advisers are held to different standards when dealing with clients. Brokers must abide by so-called suitability rules requiring they "know the customer" and offer investments suitable to a client's needs.

"The concept of "suitability" can be murky, however, and brokers aren't obligated to act solely in your best interest. The NASD has been strengthening suitability rules in recent years. Still the organization last year fined the industry a record $125.4 million for transgressions including inappropriate sales of annuities and mutual funds.

"By contrast, registered investment advisers are subject to a so-called fiduciary duty, a legal standard mandating they act solely in your best interest. Advisers also are subject to disclosure rules requiring they provide to clients Form ADV listing potential conflicts of interest, compensation practices and disciplinary proceedings."

2006 Wealth-Building Resolutions

2005-12-22T08:24:00.000-08:00

Out with the old, in with the new. It's time to consider 2006 and what you're going to do differently. Here are my suggested resolutions for investors who want to be on the road to growing and preserving wealth.

Find a coach who is truly on your side. Would you do brain surgery on yourself? Have a professional wealth management advisor working for you to plan the road to wealth.
Start NOW. To accumulate the capital you need to fund your dreams, make regular diversified investment allocations that fit your long-term goals. Ignore the market noise, prognosticators and soothsayers and quit hoping the government, your rich aunt or the lottery will “bank roll” your retirement.
Invest for total returns. Invest for long-term yield, not short-term security. The great long-term investment risk isn’t losing your money. It’s outliving your money.
Let it be. The more often you change your portfolio, the lower your lifetime investment returns will be.
Update your will and ensure you have adequate insurance - Life, health and disability insurance is the highway of life’s financial seatbelts. Don't leave your family a legacy of poverty by “driving” without them.

There they are. Five very important things to consider and work on in 2006. Wealth building is a process that doesn’t have to take over your whole life, but one in which investor behavior is key. Don't be a slave to the market, but do be a slave to a disciplined plan of wealth building.

What to Do With Your Year-End Bonus

2005-12-06T11:30:00.000-08:00

Wondering what to do with your big year-end bonus? Here are my "Top Ten" ideas. If you've already spent (actually or virtually) your bonus, then save this for next year.

1. Fully fund your 401(k) or other employer tax-deferred retirement plan.
2. Fully fund a traditional or Roth IRA.
3. Fund a tax-favored educational plan for your child or grandchild.
4. Plunk the money into a no-load, low expense, index fund or other investment
appropriate for your long-term wealth building plans. Then, forget about it.
5. Start or add to your emergency savings fund – 3-6 months of living expenses
6. Pay down or eliminate high interest rate debt.
7. Increase your life insurance and/or disability insurance if you’re underinsured.
8. Fund a health savings account (HSA).
9. Give the money to your kids or charity – they deserve it.
10. Go on a vacation – you deserve it!

Roth 401(k) Plans -- The Next Big Thing

2005-10-31T10:20:00.000-08:00

Prediction time (something I rarely do). Roth 401(k) plans will take off in 2006. They may be a little slow getting out of the gate since a lot of folks are just learning about them and the IRS hasn't provided a ton of guidance. But, I predict Roth 401(k)s will become more popular than traditional 401(k)s. Why? Because they combine all of the great benefits of regular 401(k)s with the non-taxability of the Roth IRA. Below is a table which compares the provisions of the two types of 401(k) offerings.

When we've run the calculations, the Roth beats the traditional over the long haul due to the investment growth never being taxed. That's huge, and it overcomes forgoing the 401(k) deduction today. When might the traditional 401(k) deferral be better? Since there's tax on withdrawals within five years of contribution, if you're going to withdraw right away then the Roth 401(k) may not be best for you. Since our clients are a more wealthy lot, we expect the Roth deferrals will be the last money they ever spend -- if they ever spend need to spend it. That's why we're pushing Roth 401(k)s as great wealth accumulation vehicles.

For more information on Roth 401(k)s read the article by PensionOne Advisors ( http://www.pensionone.com) at: http://www.pensionone.com/insights/bi2005-08.pdf

Equity Indexed Annuities -- A Sucker's Bet

2005-10-27T10:34:00.000-07:00

The heat is on. More and more articles ("Popular Annuity Can Be Tricky," WSJ, 10/15/05; "EIAs: Behind the Hype," Financial Planning, October 2005; "Do Clients Understand Equity Indexed Annuities?," Morningstar Advisor, 10/27/05) are raising the warning flag about equity indexed annuities (EIAs). And, rightly so. EIAs are a great example of an investment product designed to be sold but not bought. The whole premise of EIAs plays on the fears of uneducated investors. The product pushers oversell the risks of equity investing to the point that the purchasers are willing to give up huge portions of upside return in order to be protected from the exaggerated downside risk.

Investment risk needs to be put in perspective. First of all, investors need to understand that risk and reward go together. It's fundamental. If you don't want to take risk, then don't expect a huge return. If you want a huge return, then don't expect to do it without risk. Sure, there are anecdotal exceptions, but those have more to do with luck than skill. Diversification is the way to minimize risk and optimize expected returns, but that's a subject for another day.

The second point is that time reduces the probability of a sustained loss. That's why we're big proponents of long-term investing. Let's check the record using the S&P 500. The worst one-year loss for the S&P 500 beginning in 1926 was -43.4% in 1931. The worst ten-year period? An annualized loss of only -0.90% (1929-1938). The worst 20 years? Surprise! Not a loss, but a +3.1% annualized return (1929-1948). Furthermore, most investors overestimate the history of loss years. See my August 31, 2005 blog, but also consider that in the 79 years 1926 - 2004 over 70% of the years the S&P 500 had gains (non-negative returns), and the average return of the good years (non-negative returns) was 22.7% versus the average -12.6% loss of the bad years (negative returns).

So, back to EIAs. Folks who buy EIAs are so fearful of a loss they're willing to live with an 8%-13% commission to a broker, surrender penalty periods of ten years or more, about one-third of the return of the actual index, tax penalties for withdrawals before age 59 1/2, no dividends, and no capital gains treatment for the appreciation. Some deal. Which is why EIAs are only sold to little old ladies and the unsuspecting. Which is why the SEC and the NASD are beginning to take notice.

Who’s Paying Your Advisor?

2005-10-19T15:19:00.000-07:00

A recent report from financial-planning.com (“NASD Fines Eight B-Ds for Accepting Fund Kickbacks,” Giselle Abramovich, 10/17/05) points out the problem of compensation in the investment industry. Here’s a portion of the news:

“The NASD has fined eight broker-dealers, including one fund distributor, $7.75 million for giving preferential sales treatment to mutual funds in exchange for lucrative trading commissions from directed-brokerage agreements. Four of the companies are subsidiaries of National Planning Holdings, which collectively paid $3,850,000. They include Invest Financial, which paid $1,520,000; National Planning Corp., which paid $1,308,000; SII Investments, which was fined $658,500; and Investment Centers of America, which was penalized $363,500. Other companies charged included Commonwealth Financial, which was fined $1,400,000; Mutual Service Corp., fined $1,300,000; Lincoln Financial Advisors, fined $950,000; and Lord Abbett Distributor, fined $255,000.

“Lord Abbett, the fund distributor, was accused of paying three brokerages more than $900,000 in trading commissions to be included in their lists of recommended funds and on their internal Web sites. Lord Abbett also gained enhanced access to the dealers' sales teams through participation in broker training events, according to the NASD. Two of the companies received the commissions directly for carrying out the trades. The third company, which did not have a trading desk, split the payment with a clearinghouse that completed the trades in its place, according to the NASD.

“The NASD has been busy on the directed-brokerage front in recent months, fining 15 brokerages--including six subsidiaries of AIG $34 million in June for these violations. Since it began its crackdown, some of its cases have been handled in conjunction with the Securities and Exchange Commission.”

Think of the hundreds (thousands?) of investors who thought their advisors were acting in the client’s best interest. Surprise. The advisor was acting in his (I’m sure no women advisors were involved) own best interest.

The honest and ethical investment advisor will never accept compensation from anyone other than the client. That means no revenue-sharing, no bribes, no kickbacks, no Caribbean vacations, no NFL tickets – just fully-disclosed compensation from the client.

The wise investor should ask the following questions of his or her advisor:

Other than the fee or commission you charge me, in what other ways are you compensated?
Do you or your firm accept compensation for promoting certain securities or placing them on a “select list?”
Where commissions are charged, explain the differences in commission or payment to you based on the security you recommend.
Are you provided any form of non-cash compensation for meeting certain sales levels, such as vacations, access to sporting events, computer equipment, etc.?

The NASD, SEC, and Elliot Spitzer will continue to hunt down the dishonest advisors and investment firms. I’m sure there will be far too many culprits who will escape the net. So, be smart and ask the right questions.

Hedge Funds -- We're Off to See the Wizard!

2005-09-28T13:12:00.000-07:00

A recent WSJ article ("Race to Rate Hedge Funds Begins in Heavy Fog," September 28, 2005; Page C1) set me off on my regular rage against hedge funds. The article's author, Scott Patterson, was just reporting the news, but the whole subject gets me going. So, here's my rant, set to quotes from the Wizard of Oz.

Auntie Em: Now you go feed those hogs before they worry themselves into anemia!
Some investors, fed on the frenzy of the tech bubble, just can't get enough of losing money chasing hot returns. To them, investing is more like gambling. And, the new game of chance is hedge funds.

Professor Marvel: Professor Marvel never guesses. He knows!
Ever met with a hedge fund manager or salesman (never seen a hedge fund saleswoman -- a credit to womanhood)? They spout all kinds of statistics and mysteries of investing that are sure to bring you great riches -- all fact, no speculation. But, there's a void of statistical evidence to support any superior performance of hedge fund investments. How could there be since they invest in the same markets as everyone else? Not even mentioning the high fees extracted by hedge funds. It's just hamburger served up a different way.

Dorothy: Weren't you frightened? Wizard of Oz: Frightened? Child, you're talking to a man who's laughed in the face of danger, chuckled at catastrophe, and sneered at danger.
Ever wonder where these wonderful hedge fund folks came from? Well, they're the same ones who were pumping tech stocks and managing failed mutual funds anf IPOs five years ago. Before that they were pushing real estate limited partnerships and oil drilling programs. Sure, these deals all made economic sense -- for the promoters. This fearless crowd has laughed in the face of bankruptcy, chuckled at subpoenas, at sneered at regulators. Lion-hearted courage.

Wizard of Oz: You, my friend, are a victim of disorganized thinking.
Wizard of Oz: Pay no attention to that man behind the curtain.
How hedge funds get away operating in a cloak of secrecy is beyond me. The door is beginning to open a little and the government is beginning to pay some attention. But I'm afraid the SEC may be a little outmatched by the hedge folks. I recently saw the annual letter from one hedge fund of a new client (about to be former hedge fund investor). There was so little information about the fund's actual holdings and investment strategy. The returns information was presented in a non-standard way and there was evidence of data mining. The horror was that this investor has nearly 90% of his wealth in this one hedge fund. And, the hedge fund manager is a doctor! And, I should be doing brain surgery.

Wizard of Oz: I can't come back! I don't know how it works! Good-bye folks!
Think disaster can't happen? Just reflect back on Long Term Capital Management which spiraled out of control in 1997 and threatened to extinguish investors' wealth and jeopardize the nation's financial institutions. LTCM wasn't being run by rookies. "The fund’s principal shareholders included two eminent experts in the "science" of risk, Myron Scholes and Robert Merton, who had been awarded the Nobel prize for economics in 1997 for their work on derivatives, and a dazzling array of professors of finance, young doctors of mathematics and physics and other "rocket scientists" capable of inventing extremely complex, daring and profitable financial schemes." (Le Monde Diplomatique, November 1998). But, when the dust settled, Good-bye folks! was all the investors heard.

Tin Woodsman: What have you learned, Dorothy? Dorothy: Well, I - I think that it - it wasn't enough to just want to see Uncle Henry and Auntie Em - and it's that - if I ever go looking for my heart's desire again, I won't look any further than my own back yard. Because if it isn't there, I never really lost it to begin with! Is that right?
Sooner or later investors will wake up to the fact that to find smart investing one needn't look any further than the basics -- risk management, disciplined savings, and diversified investing. There's no hocus pocus. There's no great investment Oz -- despite what the hedge fund managers would tell you.

The Problem With Average Life Expectancy

2005-09-05T22:24:00.000-07:00

Many advisers (and individuals without advisers) underestimate life expectancy in their wealth/retirement projections. How does this happen? The commonly used data is that of average life expectancies at various ages and by gender. There's an obvious flaw (maybe not so obvious if so many folks commit the error) in using this data. This is "average" data. In other words you have a 50% chance of living either more or less than the indicated age. If you end up living less than the average age, that shouldn't be a problem financially. Your heirs just get their money earlier and they get more of it. The real risk is that you live longer than expected. There's a 50% failure rate inherent in the data. If you plan to live to age 80 with $1 in your pocket, then living to age 90 can be a big problem.

So, what should be done? We recommend extending the life expectancy in planning. Below is a table showing the ages one should use assuming 20% longer lives.

As you can see from the table, rather than using age 80 for a 60 year-old, age 90 would be a more prudent approach and would be successful 80% of the time. Use age 95 if you wanted even less probability of outliving your wealth.

Worried About Long-Term Low Returns?

2005-08-31T21:29:00.000-07:00

Watching the events of the day, too many investors worry about the long-term impact of short-term events. Has the market experienced long periods of low or negative returns? Let's check the data.

Here are the S&P 500 returns for 1926-2004, shown in ten-year rolling periods (e.g. 1926-1935, 1927-1936, etc.). Of the 70 ten-year rolling periods, only one period (1929-1938) had annualized losses (-1% per year). Amazingly, fewer than 13% of the periods had annual returns of less than 6%. The large majority (73%) had annual returns of 8% or better.

What's to be learned? If we expect the future looks a lot like the past (wars, recessions, prosperity, technological change, social upheaval, etc.), then I expect a similar dispersion of future returns. But, hey, that's just my guess.

The other lesson is that investors with enough discipline to stick with the markets are rewarded in the end. The undisciplined investor is spooked by short-term events and doomsdayers. Long-term, diversified investing is the best strategy.