Four Rules for Asset Allocation
May 25, 2010 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
As a special guest blog post, the Motley Fool staff has provided the following article on asset allocation. It’s an excellent summary of some of the most important concepts of investing and asset allocation, and is definitely worth the read. Enjoy!
By The Motley Fool
When it comes to asset allocation, the biggest decisions come down to how much you should have in cash, how much in bonds, and how much in stocks. These four rules for asset allocation will help you slice up your portfolio into these important pieces.
Rule 1: If you need the money in the next year, it should be in cash.
You don’t want the down payment for your vacation home to evaporate in a stock market — or bond market — crash. Keep it in a money market or savings account. And, of course, make sure it’s FDIC-insured.
Rule 2: If you need the money in the next one to five (or even seven) years, choose safe, income-producing investments such as Treasuries, certificates of deposit (CDs), or bonds.
Whether it’s your kid’s college money or the retirement income you’ll need in the not-so-distant future, stay away from stocks.
As with all investments, risk and reward go hand-in-hand when it comes to “safe” assets. So, in order of “safest” to “still safe but technically riskier,” we have Treasury notes and bills, CDs, and corporate bonds. That’s also the order of lowest- to highest-yielding. CDs are still very safe (as long as they’re FDIC insured), can usually be bought commission-free, and you should be able to find some that pay a percentage point above Treasuries. Shop around for the best rates; your local bank may not be the best-yielding option.
As for corporate bonds, the general rule is to choose bond mutual funds if you have less than $25,000 to $50,000 to invest. That’s because buying individual bonds can be tricky. With a stock, you can pull up a quote on your computer and — presto! — you have a good idea of the going price. However, most bonds don’t trade on a centralized exchange. And instead of charging a commission, most brokerages (discount and full-service) embed a “markup” in the price of the bond. This makes it difficult to know what fees you paid.
It is gradually becoming easier (and more cost-effective) to buy individual bonds, so it can be done if you’re willing to put in the effort. The advantage of individual bonds over bond funds is you know exactly how much you’ll get back when the bond matures. However, since bond funds don’t technically “mature,” you don’t know what your investment will be worth when you need the money. In fact, they can lose quite a bit of money, which can be inconvenient if it happens right before you need it.
If you’re going to choose a bond fund, stick with short- to intermediate-term bonds (i.e., bonds that mature in two to five years). And be vigilant about costs — you can find plenty of good funds with expense ratios below 0.50%.
Rule 3: Any money you don’t need for more than five to seven years is a candidate for the stock market.
We Fools are fans of the stock market, and we know our history. According to Ibbotson, large-cap stocks, on average, have returned 10.4% annually from 1926 to 2007, compared to 5.5% for long-term government bonds and 3.7% for short-term Treasury bills.
However, investors in stocks have to keep that “long run” part in mind, since in the short run, no one knows what stocks will do. Make no mistake: Even if you’re in or near retirement, a portion of your money should be invested for the long term. That’s because, according to the Center for Disease Control, a 55-year-old can expect to live another 26 years. A 65-year-old has another two decades. The average 75-year-old lives into her late 80s. A 110-year-old, however, should sell everything and get to Vegas while he still can.
So unless you’re a 95-year-old skydiver who smokes, expect your retirement to last two to three decades. To make sure your portfolio lasts that long, you should …
Rule 4: Always own stocks.
Over the long term, equities are the best vehicles to ensure your portfolio withstands inflation and your retirement spending.
According to Jeremy Siegel’s Stocks for the Long Run, for every rolling five-year investing period from 1802 to 2006 (i.e., 1802-1807, 1803-1808, etc.), stocks outperformed bonds 69% of the time. Stocks beat bonds in 80% of the rolling 10-year periods, and almost 100% of the rolling 30-year periods. For holding periods of 17 years or more, stocks have always beaten inflation, a claim bonds can’t make.
But don’t forget that four-letter word
The bottom line is that when you need your money will partially dictate where you put it. What else determines your asset allocation? Risk.
Most people base their investment strategies on the returns they want, but they have it backward. Instead, focus on managing risk and accept the returns that go along with your tolerance for it. It’d be great if we could get plump returns with no risk at all. But to achieve returns beyond a minimal level, we have to invest in things that involve the possibility that we’ll lose money.
Of course, this isn’t just hypothetical theory for modern investors. The 2000s have brought us two wrenching bear markets, a mere six years apart. (Maybe there was something to all that Y2K hullabaloo after all!). Have you been able to hold on — or did you panic and sell? That’s the true test of an investor’s risk tolerance: the ability to cling to those shares as they become worth less and less, while clinging to the hope (based on history, but nothing more) that they will one day be worth more and more.
So ask yourself: What would you do if your portfolio dropped 10%, 20%, or 40% from its current level? Would it change your lifestyle? If you’re retired, can you rely on other resources such as Social Security or pensions, or would you have to go back to work (and how would you feel about that)? How you answer those questions will lead you to your risk tolerance. The lower your stomach for portfolio ups and downs, the more your portfolio should be in bonds.
As an extra aid in determining your mix of stocks and bonds, consider the following table, from William Bernstein’s The Intelligent Asset Allocator:
|
I can tolerate losing ___% of my portfolio in the course of earning higher returns |
Recommended % of portfolio invested in stocks |
|
35% |
80% |
|
30% |
70% |
|
25% |
60% |
|
20% |
50% |
|
15% |
40% |
|
10% |
30% |
|
5% |
20% |
|
0% |
10% |
So, according to Bernstein, if you can’t stand seeing your portfolio drop 20% in value, then no more than 50% of your money should be in stocks. Sounds like a very good guideline to us.
Copyright © 1995-2010 The Motley Fool. All rights reserved. Used with permission. www.fool.com
Should you pay off the mortgage?
May 18, 2010 by Jean Keener, CFP, CRPC, CFDS · 1 Comment
One of the best financially freeing moments in life is the day you compare your savings and mortgage principal balances and realize that you could pay off your mortgage if you wanted to. If you’re at that point, congratulations! If you’re not there yet, keep saving; it can come sooner than you think.
Of course, immediately following the discovery of being able to pay off the mortgage comes a question: should I? Here’s how you decide:
First, consider what you would do with the money if you didn’t pay off the mortgage.
Would it sit in savings, be invested for long-term retirement goals, or something else? Based on your plans if you didn’t pay off the mortgage, you can estimate a rate of return you expect to receive. From this rate of return, you’ll need to subtract taxes paid on the earnings (15% if capital gains, your income tax rate if regular interest).
Second, figure out what your mortgage is costing you.
Look at your interest rate, calculate the annual interest expense, and subtract any income tax savings you’re receiving. Be sure to avoid over-estimating the benefits of tax savings. For example, if your mortgage interest is $5,000 and you have another $8,000 of itemized deductions, your total itemized deductions are $13,000. If you’re married filing jointly, the standard deduction is $11,400 this year. So the mortgage interest is only increasing your deductions by $1,600. If you’re in the 28% tax bracket, this equates to a $448 tax savings.
Third, compare your answer in step 1 with your answer in step 2.
If it’s costing you more to keep your mortgage than you would earn with the money invested or in the bank, then you should generally pay off the mortgage. If you can get a greater return on your investments than what your mortgage is costing you, then you should generally keep the money invested and wait to pay off the mortgage.
Of course there are exceptions and other considerations including:
If you would be taking the pay-off money out of a pre-tax IRA or deferred compensation in a lump sum, take a really close look at the tax consequences of that lump sum withdrawal! They can often totally cancel out any savings on the mortgage interest.
If you would be using “retirement” savings funds to pay off the mortgage, you really need to look at your retirement projections and ensure that they still work with the funds withdrawn. If your projections rely on you beginning to save what you’re currently paying on the mortgage, know yourself. Will you stick with this savings program? If not, probably best to just keep your retirement funds intact and continue paying the mortgage.
If paying off the mortgage would take your emergency funds dangerously low or short-change funds for other important goals, it’s likely not a good idea.
Making your decision
While it seems like a fairly straight-forward question, when you think about the whole picture, you realize there are lots of what-ifs and options to consider. The important thing is to take time to do your homework, complete the analysis, and seek professional assistance if needed.
Even if the process reveals you’re better off with the mortgage, you might still want to go ahead and pay it off because of the peace-of-mind benefit that comes from not having any debt. If that’s the case, by going through the process thoughtfully and thoroughly, you will know what you’re giving up financially for that peace of mind so you can make an informed decision about whether it’s worth it to you.
And if the process does show that you would be better off getting rid of that mortgage, you can move forward with confidence.
Of course, everyone’s situation is different. While the process described above addresses many considerations, you may have some issues not addressed here or that are unique to you. Make sure you fully consider your own situation before making any decision.
Quoted by Jean Chatzky
May 12, 2010 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
Jean Chatzky’s column in the New York Daily News on “How to get by when jobless pay runs dry” quoted me on several considerations and strategies to cope with this difficult situation. I’m a fan of Jean Chatzky, so having the opportunity to be interviewed by her staff and being quoted in her column was pretty exciting for me. In the article, she provides excellent suggestions on how you can prioritze your expenses and resources in this challenging time to do the least amount of damage to your financial situation long-term. You can read the full article here.
May 2010 Newsletter
May 10, 2010 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
The May 2010 newsletter is now available. It includes investing information with perspective on last week’s market plunge and an update on the new reduced fees for trading Vanguard ETFs. For taxes, there’s information on the new 3.8% medicare tax for high income individuals. For cash flow, we cover using a Roth IRA as a back-up emergency fund. For insurance, it includes information on incorporating TX state guarantee association coverage limits and exclusions into your financial planning. Click here to read the newsletter.
When an Insurance Company Fails
May 10, 2010 by Jean Keener, CFP, CRPC, CFDS · 1 Comment
Last week I attended the Financial Planning Association annual symposium in Dallas, and one of the speakers was Bart Boles, executive director for Texas’ insurance guaranty association. He shared the association’s processes when an insurance company fails, and how we as the consumer would likely be affected. Some of the exclusions and limits are important information to consider in your individual planning process. With this information, you can make smart insurance purchase decisions and avoid any surprises if the worst happens.
If your insurance company fails, here are the limits to what the association would cover.
Funds required for this coverage don’t come from tax payer dollars. They come from assessments of other insurance companies.
Health Insurance (all per individual per insolvent company)
- $500,000 for hospital, medical & surgical and major medical
- $300,000 disability and LTC insurance
- $200,000 all other health insurance
Life Insurance (all per insured life per insolvent company)
- $100,000 of cash surrender value
- $300,000 of death benefits
- $5 million per owner of multiple non-group policies
Annuities (all per insolvent company)
- $100,000 of the present value of annuity benefits per insured life (individual and allocated group annuities)
- $100,000 per payee for structured settlement immediate annuities
- $5 million per owner of unallocated group annuity
Aggregate Limit
- $300,000 of aggregate benefits for an individual per insolvent company (with the exception of the individual limits listed above exceeding this amount)
Exclusions
Some of the exclusions include:
- Insurance policies with insurance companies not licensed to do business in Texas
- Benefits of an insurance policy that are not guaranteed by the insurance company (such as the non-guaranteed portion of a variable life insurance or annuity contract)
- Benefits for which the policyholder bears the risk (such as certain variable or indexed annuities). Specifically, equity-indexed annuities are not covered.
- Interest rate yields that exceed an average rate set by the terms of the Texas Guaranty Association law. This can come into play with some annuities offering high guaranteed rates.
- Items not part of the specific written terms of the policy, such as claims based on marketing materials, side letters, riders not part of the approved policy form, misrepresentation, etc. For example, if the agent wrote a note on your application guaranteeing a benefit that’s not expressly in the contract, that’s not covered.
- PBGC protected annuities
- Property and casualty insurance policies (such as auto, homeowner’s, workers compensation, etc.). This is covered by a separate guaranty organization. Their website is: http://www.tpciga.org/
There are other exclusions as well. For more information on this, visit the FAQ section of the Texas Guaranty Assocation’s website.
In addition to the limits, being aware of the exclusions is also an important part of the insurance purchase process. If your policy is fully excluded, an extreme amount of due diligence needs to be done on the company prior to purchase. If a particular guarantee is a critical part of your purchase decision, you need to read the actual contract and make sure it’s clearly communicated in the contract and not just in the marketing materials. You should also verify that the guarantee falls within the limits of what’s covered. If it’s above the limits, consider the worst-case scenario and ask yourself if you could live with that outcome and if your purchase decision still makes sense given that possibility.