Personal Finance

The primary focus of a Financial Plan is to help you build and manage your wealth more effectively.  Achieving that goal requires you to choose one of three core financial strategies:

1. Accumulation
2. Conservation
3. Distribution

If you select the Accumulation strategy, your #1 priority is to build your wealth.  Accumulation may be the most suitable strategy if you do not have much wealth to protect or you do not have sufficient wealth for your life expectancy.  While you never want to lose money, adopting an accumulation strategy means that growth trumps safety.  A higher return is often more important than lower risk.

If you select the Conservation strategy, your #1 priority is to preserve your wealth.  Conservation may be the most suitable strategy when you have significant wealth to lose.  You may be near retirement or you may possess sufficient wealth to match your life expectancy.  In either case, not losing wealth becomes more important than gaining more.  Why risk going backwards if you have already arrived at your destination?  While you always want your money to work hard, during the conservation stages, safety trumps return.  Lower risk is more important than a higher return.

If you select the Distribution strategy, your highest priorities are enjoying the use of your wealth and planning for its final disposition.  Establishing and updating a values-based estate plan becomes very important.

You can leverage the Cambridge Financial Life Cycle© to determine the most suitable strategy for your situation.

Off course you can!  Most people underestimate their ability to grow both their income and their wealth.  Most people do not create a written plan to increase their income and wealth.  Do you believe you can double your net worth in five years?

The four primary areas of increase where average people build their net worth are:

1. Savings
2. Portfolio return
3. Real estate (home) appreciation
4. Debt reduction/amortization

There are five major inputs or “levers” by which you can control the four sources of increase.  These include:

1. The growth rate of your income
2. Your savings rate
3. The rate of return on your investment portfolio
4. The rate of appreciation on your home
5. The rate at which you pay off debt

You have the most control over your income, your savings rate and your debt reduction rate.  You influence your portfolio rate of return with your asset allocation.  You have the least influence over the rate of your real estate appreciation.  However you influence the return on your investment or equity in real estate through leverage or the size of your mortgage debt and the rate at which you pay it off.

Start now!  For the next 30 days, when you get up in the morning and before going to bed at night, ask yourself the question: “How can we increase our income?”

It is extremely important that you believe your plan is achievable.  90% of achieving financial goals is mental, not financial.  “Whether you think you can or can’t, you’re right.”(Henry Ford).  Belief determines behavior.

For example, you can reject your Financial Plan because it does not fit your belief systems.  Or you can change the Financial Plan until it fits your belief systems.  Or you can work on changing your belief systems.  Helping people change their belief systems is the work of therapists, psychologists, ministers, educators and financial planners.  The purpose of all human communication is to change belief systems.

There are many ways to change your belief systems which are beyond the scope of the work of a Financial Advisor.  I believe the primary way to influence your belief system is through education.

Tip #1:  The best way to save for college is to put money in the most effective place to build wealth the fastest.  That often means maximizing our contributions to our 401(k) or IRA.  Money saved in a 401(k) or IRA can be used to pay for college and under current law does not reduce eligibility for financial aid.

Tip #2:  The best way to pay for college is to take the money from the most effective source with the least impact on your wealth.  That may mean using government subsidized loans and tax credits, paying out of current income or pulling equity out of your home.

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Asset Allocation is the process of dividing investments among different kinds of asset classes (such as stocks, bonds, cash, real estate, commodities, etc.) to try to meet specific financial goals.  Research shows (Brinson, Hood & Beebower, 1986) that over 90% of investment portfolio performance over time is explained by the asset allocation decision. Thus asset allocation is so important, way more than security selection.

Do not believe the myth that diversification can be achieved with 10-30 individual stocks.  Academic research indicates that it takes at least 60 randomly selected individual stocks to eliminate 88% of diversifiable (uncompensated) risk.  Build a $250,000 core portfolio with low cost index funds or at least 60 individual stocks from different industries and countries.

For this core portfolio, adopt a financial asset allocation target of equity mutual funds and interest earning vehicles.  The split between these groups is based on your risk profile.  As you build wealth with this proven strategy, you create the solid foundation which increases your risk capacity. Your asset allocation will also change to match your increased risk capacity as your overall financial position on the Financial Life Cycle improves.

Use Morningstar’s fund screener to find mutual funds under these categories.  We recommend passively managed or index funds with low expense ratios.

There are many strategies for changing your financial asset allocation to more closely proximate the model of middle income millionaires.  All the strategies accomplish the same goal, but differ in terms of:

• Transaction costs
• Tax consequences
• Complexity
• Time to implement
• Financial benefits ($$$) to you
• Your emotional resistance

These strategies include:

• Liquidating portfolio equity assets and reinvesting in interest earning assets
• Invest 100% of your new IRA contributions/salary deferrals into interest earning assets until you achieve the target.
• Purchasing  US Savings bonds with after-tax dollars
• Some combination of the above

The National Association of Personal Financial Advisors (NAPFA) wants you to become more knowledgeable about personal financial issues, like basic money management, investments, kids and money, and much more. That’s why they’re launching a series of FREE online seminars (webinars) over the next year. The Consumer Webinar Series is for everyone – no matter how in tune you are with personal financial issues.

Each session is led by a NAPFA-Registered Financial Advisor who commits to the highest of standards in the financial planning industry. Many of the instructors are authors, educators and leaders in the industry.

The Consumer Webinar Series is a year-long initiative beginning August 7 (2009) that will provide an opportunity for anyone in the country to learn about a wide range of financial issues.  Each month a new session will be conducted live online. Consumers can attend the live session after registering for free, or listen to an audio file after the program.

The series will include 12, one-hour sessions delivered via the internet.  The individual sessions will be conducted from 11:00am – 12:00 noon Colorado time and will include:

• August 7, 2009:  Money 101: Knowing the Basics
• September 4, 2009: Kids & Money
• October 2, 2009:  What is Financial Planning?
• November 6, 2009:  Protecting What You Have
• December 4, 2009:  Investments: The Basics
• January 8, 2010:  Investments: Advanced Concepts
• February 5, 2010:  Managing Your 401(k)
• March 5, 2010:  Leaving a Legacy
• April 2, 2010:  Women and Money
• May 6, 2010:  Financial Planning and Small Business Owners
• June 4, 2010: Your Retirement
• July 1, 2010:  Financial Windfalls

Learn more about the Consumer Webinar Series by visiting the webinar page on the NAPFA website.

Asset Allocation is the process of dividing investments among different kinds of asset classes (such as stocks, bonds, cash, real estate, commodities, etc.) to try to meet specific financial goals.  Brinson, Hood & Beebower research of 1986 proved that asset allocation is the single most important decision that an investor makes.  Over 90% of portfolio performance is explained by the asset allocation decision.

 Traditional asset allocation models do not work for real people because their portfolios are much different from institutional portfolios.  Over 80% of all American households have a net worth that is less than $250,000 which includes the value of their home. Some of the big differences between institutional portfolios and those of most individuals include single vs. multiple goals, single vs. multiple time horizons, simple vs. complex tax treatment, professional vs. amateur investment management.

These differences led the founder of the Cambridge system to create a Functional Asset Allocation (FAA) model for individuals.  FAA illustrates how individuals build wealth as measured by Net Worth.

1)      Functional Asset Allocation – all your assets, including your home and personal belongings.

2)      Traditional (institutional) Asset Allocation – only financial assets, including checking accounts, savings, emergency funds, etc.

Using Functional Asset Allocation, your assets should be distributed across three asset categories: Interest Earning, Equities, and Real Estate. Generally, you want to have 1/3 (range of 25-40%) of your net worth in each of the three major asset classes.  Each of the major asset classes serves practical functions in wealth accumulation and risk management.

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If I were a prospective client, here are the steps I would take to reduce the possibility of hiring a financial advisor or being defrauded by him if he is tempted to take money from my accounts.  Each step increases my Peace Of Mind, but also reduces the number of potential advisors.

Step I: Choose Fiduciary standard of care OVER Suitability standard of care.  Why?  It provides you with highest legal standard of care under federal law, converts personal trust into a legal right, places advisor under growing body of fiduciary law & principles governing money management, increases risk of criminal prosecution for advisor and severity of penalties, including prison. It also increases the probability of restitution for investor losses.

Step II: Choose a FEE-ONLY advisor with a preference to flat fee compensation OVER Commissions and fees from sale of products, fee-based combination.  Why?  It reduces conflicts of interest between investor and advisor.  It also creates greater alignment between investor and advisor interests.

Step III: Choose Passive management investment philosophy OVER Active management investment philosophy.  Why?  It removes expectation for advisor to “beat” the market by speculating with investor money in an economic “zero-sum game”. Frees advisor to focus on areas where he has much higher probability of delivering value, such as goal setting, tax planning, retirement planning, wealth building, risk management, values clarification, conflict resolution, estate planning, asset protection, etc.  An advisor who simply helps client harvest market returns with index funds or passively managed portfolios is MUCH less likely to lose money in speculative investment activities. 

Step IV: Run a background check OVER using gut feeling, “we like him”.  Why?  It removes advisors with criminal backgrounds, previous securities violations and history of compliance problems

Step V: Give a Limited Power Of Attorney (POA) for trading or View/Read only POA only OVER Custody of your account.  Why?  Advisor does not have power to execute trades.  You can execute trades recommended by the advisor.

One of the biggest reasons investors underperform the market is that they try to beat it. Since the early 1970s there have been two competing theories on how to get better investment returns. Active Management is the oldest and still most widely held. The goal of active management is to “beat the market”. The last time I checked about 93% ($6.5 trillion) of all mutual fund dollars were actively managed.

Passive Management is the relatively new theory which is gaining acceptance among a growing number of academics and institutional money managers. The goal of passive management is to “capture market returns” by simply investing in a statistical sampling of the whole market and eliminate all the costs of trying to beat the market. About 7% ($500 billion) of all mutual fund dollars were passively managed.

Active management begins with the assumption that stock and bond prices do not always reflect their “true” or “intrinsic” value. Active managers spend billions of dollars on research to find the “mispriced” securities. Using fundamental analysis, technical analysis and market timing, professional money managers actively trade (buy & sell) securities in search of higher investment returns.

Passive management begins with the assumption that free markets, while not perfect, are a very effective mechanism for setting prices for anything, including publicly traded companies and bonds. In other words, the the capital markets are just as efficient as the free markets for automobiles and toothpaste. Proponents of passive management like to say that the only people who don’t believe free markets work are the Cubans, North Koreans and believers in active money management.

The “market” is all investors together, functioning like a super computer processing all the information about a company and calculating the best estimate of the intrinsic value of a company at any particular moment. This estimate is called the “fair market price”. Investors who try to beat the market, believe they know something the supercomputer does not. I like to compare passive management with the game of golf. Instead of trying to beat the golf course by scoring birdies and eagles, investors who adopt passive management are satisfied with par. Instead of trying to beat the golf course, they are satisfied with beating 99% of all other golfers (active managers) who spend billions of dollars and make a lot of mistakes trying to overcome almost insurmountable odds.

Can information be bad for investors? Prof. Paul B. Andreassen from Harvard University, compared the investment performance of four groups of investors. Two groups managed a volatile growth stock like Google. The other two groups managed a stable value stock like Sears. In each pair of groups, one group was fed a steady stream of news reports about their stock, while the other group received no information. In both pairs, the group that received no news performed better than the group that was given a steady stream of information. In fact, the investors who received no news and traded the volatile growth stock performed twice as well as the investors who received regular updates on the company’s performance!

How can this be? How does easy access to financial news and the ability to track portfolio values harm investors? Researchers in behavioral finance observe that when investors receive new information there is a natural tendency to “do something” in reaction to that information. It turns out the human brain is programmed to act on new information.

In most cases, acting on new information is good. But when it comes to implementing a long term investment strategy, it’s usually disastrous. Information stimulates emotions which in turn increase the urge to act. So a steady stream of information about losses, moves investors to sell. Later, a steady stream of news about market gains, induces investors to buy. Without realizing it, most investors have abandoned their strategy, if they had one in the first place (See previously posted Mistake #1). Driven by natural urges to act on information, investors unintentionally implement a strategy of selling low and buying high.

Watching daily movements in your investment portfolio is like watching paint dry. Imagine a paint job with a one-hour drying time and checking it every minute by touch to see if it’s dry. Sixty fingerprints can ruin a great paint job.

Assume your portfolio has at least a ten (10) year time horizon. Checking the value every day is like touching the paint 3600 times an hour to see if it is dry. One of the worst things we can do after creating and implementing our investment strategy is to touch the paint. Treat all the daily headlines like static on the radio. Ignore them. Because information can be harmful to investors, we recommend the discipline of an annual investment review.

From 1988 thru December 2007, investors underperformed the stock and bond markets by -7% and -6% respectively.  It is an empirical fact that individual investors sabotage their own portfolios because they have no strategy.  If you think you are an exception, you should have what professionals call an Investment Policy Statement that describes your strategy by answering questions like the the following:

What is the target return for your investment portfolio?   4-6%?   7-9%?   10-12%?   

How much risk are you willing to take in order to get that return?   Are you willing to lose 40% of your portfolio one out of every five years in order to have a 65% chance of averaging 12% over 20 years?   How much risk is acceptable as defined by the “volatility” or “variablity” in your annual returns?

What is the time horizon for your portfolio?   When do estimated withdrawals from your portfolio exceed the contributions and earnings?  Ten years from now?  Twenty years?  Fifty years?

How many asset classes do you use?   Three?  Five?  Seven?  What is your target allocation for each asset class?  What are the band limits?  When do you rebalance?

Have you chosen an active or passive management philosophy for security selection?    

If you have chosen active management for the equity (stocks) asset class, what strategy have you selected?   Do you buy growing companies or beaten down value companies?  Do you use a buy and hold, momentum or market timing strategy?

Achieving investment goals requires a plan and a strategy.  One of the most frequent mistakes investors make is they have no written plan or strategy to address some of these most important questions.