My E-Book is Complete!

I have finally completed my e-book, which can be viewed by clicking on the link on the right of this page.

Each chapter of the e-book describes a misunderstood financial topic. Please view the table of contents and determine which subjects you would like more information on. Then simply refer to that particular page of the e-book.

Introduction	4
Exactly What is a Bond?	5
What are the Different Types of Bonds?	6
Preferred Stock - Stock or Bond?	7
Common Stock - Value, Growth, Large, Small?	8
Should I Utilize Money Market Accounts?	9
What Should I Look for in a Mutual Fund?	10
How are ETFs Different Than Mutual Funds?	11
What are Target-Date (Lifecyle) Funds?	12
How is Ordinary Income Different than Capital Gains?	13
What do I Need to Know About my 401k?	14
How do 403(b) and 457 Plans Compare to 401(k)s?	15
What is an IRA?	16
What is the Difference Between a Traditional IRA and a Roth IRA?	17
How is a SEP Different From a IRA or 401(k)?	18
Are 529 Plans the Best Way to Save for College?	19
What do Stock Indices Measure?	20
What is the Value of Diversification?	21
Why is it Important to Understand Your Tolerance for Risk?	22
What do I Need to Know About Variable Annuities?	23
What are Equity-Indexed Annuities?	24
What are REITs?	25
How do Options Work?	26
What are Hedge Funds?	27
What are the Differences Between Load and No-Load Investments?	28
What are the Differences Between a Broker/Dealer and Registered Investment Advisors?	29
Fee-only or Fee-based?	30
Questions?	31

Thanks for everyone's participation, and please let me know if you think of other financial topics that should be added. Additionally, please share this e-book with anyone you believe may benefit from its content. Thanks!

Chart of the Day

For some perspective on the current stock market rally and how it compares to the 1929-1932 bear market (which also included bank failures, bankruptcies, severe stock market declines, etc.), this chart illustrates the duration (calendar days) and magnitude (percent gain) of all significant Dow rallies that occurred during the 1929-1932 bear market (solid blue dots). For example, the bear market rally that began in November 1929 lasted 155 calendar days and resulted in a gain of 48%. As today's chart illustrates, the duration of the current Dow rally (hollow blue dot labeled "you are here") is longer than any that occurred during the 1929-1932 bear market. As for magnitude, only the November 1929 bear market rally resulted in a better performance than what has occurred during the current rally to date.

Implications of the Deficit

The Office of Management and Budget revised its May deficit projections to forecast a record $1.6 trillion deficit for the fiscal year ending September 30. Worse, the White House forecast $9 trillion in additional debt over the next decade. Amazingly, borrowing alone will account for 40% of federal revenues in 2010!

Over the short term, a majority of the deficit surge stems from temporary outlays. Of the $700 billion increase in spending that is forecast for 2009, $424 billion comes from the Troubled Asset Relief Program (TARP) and the rescue of Fannie Mae and Freddie Mac. An additional $115 billion comes from President Obama's stimulus plan. Unfortunately, beyond 2010, deficits will remain high largely because of spending on Medicare, Medicaid, and Social Security. These costs aren't tied to recession; they simply rise as baby boomers age.

A higher federal deficit would cause several hurdles as the U.S. tries to dig itself out of the recession. First, the Federal Reserve recently communicated that the U.S. must show progress on deficit reduction by next year to avoid the possibility of a rise in interest rates, which might be needed otherwise to entice global investors to keep buying U.S. government bonds. Higher interest rates slow economic growth, and would raise the U.S. government's borrowing costs.

Large federal deficits could also weaken the U.S. dollar against foreign currencies. That could fuel inflation as the cost of imports rises in dollar terms. Of course, high inflation would reduce purchasing power, putting a squeeze on American consumers.

Finally, how is the federal government going to reduce this deficit? Simply, there are two potential solutions: reduce spending, or raise revenues. We've already identified several financial obligations that are not likely to be eliminated anytime soon, so let's examine the possibility of raising revenues. What is the easiest source of new revenues? Tax dollars. In fact, budget experts are increasingly reiterating their belief that tax increases may need to hit families that the president vowed to protect --family earning below $250,000. Consequently, it is a very real possibility that tax rates will be increased across the board.

Now would be an ideal time to visit a financial advisor to prepare your portfolio for uncertain tax implications. Roth accounts and alternative investments are a couple of investment options that can provide "tax diversification" to your portfolio. However, to protect yourself from salesmen posing as "financial advisors," be sure to speak to an independent, fee-only financial planner to ensure your best interests are the priority.

FiLife.com: Market Pullbacks Lead to "Madness"

Recently, I was honored to have an article I wrote published by FiLife.com, a website published in partnership with the Wall Street Journal. The article discusses the willingness of the financial planning industry to play on the fears of the investing public, and why it is important to find an independent financial advisor with a fiduciary responsibility to do what is in the client's best interest. I was surprised to receive an email from FiLife.com yesterday that highlighted my article in their weekly newsletter. Additionally, I have received a significant amount of support and backing from other independent, fee-only financial planners. Check out the article here.

The Positive Impact of the Credit Crunch

The stagnant economy has led to high unemployment, a reduction in pay raises, and the elimination of 401k matches by many employers. Of course, retirement portfolios have also been hit hard, leading many to wonder how they can afford to retire. No doubt, times have been tough.

However, if your looking for a positive effect to come out of the recent recession, look at how individuals handle their personal credit. In May of 2009, there was a total of $928 billion of revolving debt outstanding. That number is down from $960 billion in 2008. Additionally, households received a total of 3.8 billion new credit card offers in 2008, down from 5.2 billion in 2007. Currently, 27% of U.S. households do not own a credit card, while 55% of households pay their card balances in full every month. Compared to historical trends, these numbers are encouraging.

If you'd like to know how you compare to the average U.S. consumer, consider these statistics:

• The average person owns a total of 4 credit cards.
• 1 in 10 people carries more than 10 credit cards.
• 1 in 7 consumers uses 80% or more of his or her available credit limit.
• The average credit card holder has a total credit limit of $19,000.
• Of consumers carrying a balance, the median credit card debt equals $3,000.

Of course, helping people develop a strategy for organizing and eliminating debt is a primary function of a financial advisor. However, make sure the advisor is financially motivated to help you get out of debt rather than into more debt so you have money to invest with him. It's best to speak to an independent, fee-only financial planner with a fiduciary responsibility to do what is in your best interest.

Chart of the Day

Today's chart illustrates how the recent plunge in earnings has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1936 into the late 1980s, the PE ratio tended to peak in the low 20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the recent plunge in earnings and recent stock market rally, the PE ratio spiked and just peaked at 144 – a record high. Currently, with 97% of US corporations having reported for Q2 2009, the PE ratio now stands at a lofty 129.

"Financial Advisors" and Marketing

Flipping through the local paper, I noticed a standard advertisement from a “financial planning” firm. We’re seeing more and more of these advertisements that are designed and written to appear as an actual article of the publication.

The ad titled “How to Get up to a 10% Return on Your Money Without the Risk!” tells us the story of Denny Dolan, who drives a car dealer courtesy van twice a week because he got bored after a year of fishing, golfing, and skiing. Denny says “I haven’t lost $0.01. In fact over the past five years I have made almost 6% (per year).

The rest of the article/ad continues to talk about achieved returns and a horror story about Denny’s neighbor, who used a traditional financial planner and had their nest egg cut in half. Suddenly, the ad ends. Notice anything missing? The large 4” x 11” ad failed to tell us how the advertiser produced such impressive returns without the risk.

Almost certainly, the advertiser was selling equity-indexed annuities. First, as anyone who has read my blog before knows, I am of the opinion that these people need to stop referring to themselves as “financial advisors” and call themselves what they really are: salesmen. After all, are these people ever paid for providing advice? No. They are only paid when they sell a product. Second, I’m not particularly a fan of equity-indexed annuities because they pay salesmen such a hefty commission and they put a debilitating cap on annual earnings. However, that’s not the point. The real question is why these “financial planners” are so secretive about the products they recommend.

To make my point, I called the 800 number at the end of the ad and had them send me their free report. Not surprisingly, the report was nearly as secretive as the newspaper ad. The 15 page report didn’t bring up the product they were recommending (equity-indexed annuities) until page 11. More alarming, the report never discussed what an equity index annuity actually is! It only reproduced quotes that had been posted on a general discussion forum online about how great these products are, but not WHY they were attractive. None of the people quoted were even credentialed. (It’s a sad fact that the annuity industry hires people to do nothing but surf the web all day and write quotes that look like they are from a satisfied annuity customer explaining how happy they are with their purchase.)

My point is that a lack of disclosure and transparency in an ad should be a red flag when it comes to financial products and advisors consumers should consider. If the product being recommended isn’t of high enough quality to mention in the ad, is it worth purchasing?

Beware of advertisements that don’t clearly identify the investment product or strategy being pushed, and educate yourself about the difference between a financial advisor who is paid to provide objective advice and “financial advisors” who are nothing more than salesmen. A good place to start is by speaking with a fee-only financial planner who accepts a fiduciary obligation to always do what is in the best interest of their client.

Chart of the Day

Today, the Labor Department reported that the unemployment rate actually decreased from 9.5% to 9.4% during July. This is the first decrease in the unemployment rate since April 2008. For some perspective on the current state of the labor market, today's chart illustrates the unemployment rate since 1948. Despite this month's encouraging decline, there was only one general period in the post-World War II era during which the unemployment rate was higher than the current rate of 9.4% (i.e. June 1982 - June 1983). It is worth noting, however, that a one-month decline in the unemployment rate (even a small decline) after a significant spike (i.e. the unemployment rate spikes by 1.5 percentage points or more) has tended to occur slightly after a recession had ended.

28 Days of Blogging

For six weeks, I’ve attempted to define and highlight common financial terms that are not always understood. I now intend to construct an e-book consisting of the covered subjects. Look for it soon…

If I missed a subject that you have questions about, or know other financial terms that might be beneficial to review, please drop me a note. I appreciate all of your participation and feedback.

What is the Difference Between Fee Only and Fee Based Financial Advisors?

Fee only financial planners never accept commissions or compensation from the products they recommend. They are compensated only by their clients and their compensation is the same regardless of the products they recommend. This compensation structure enables fee only planners to truly represent their clients rather than an insurance or brokerage firm signing their paycheck. Consequently, they can focus on doing what is in the absolute best interest of their client without worrying about maximizing their own compensation. Finally, most fee only financial planners have a fiduciary responsibility to always do what is in their client's best interest. Working with a fiduciary is critical.

Fee based financial planners have the ability to collect fees from their clients, but they also have the ability to collect commissions from the products they sell. Thus, fee based planners may charge the client a fee for managing assets, but may also collect commissions from a mutual fund that charges the client ridiculously high fees. Additionally, fee based advisors have the ability to collect commissions from selling insurance and annuity policies which may not be the best fit for the client. Finally, many fee based advisors are only held to a suitability standard, meaning they agree to act in a way which does not harm the client.

Almost anyone can call themselves a financial planner. Over 800,000 Americans currently refer to themselves as “financial advisors.” This includes stockbrokers, insurance agents, and annuity salespeople. However, how much advising do people in these professions provide? Sure, they are capable of advising clients to purchase their products, but they are never compensated solely for providing sound advice; they are only paid when they make a sale. Consequently, these individuals should be forced to refer to themselves as salespeople, not advisors.

Why are people not more aware of the distinction between fiduciary and suitability, and why is there so much confusion revolving around commission vs. fee based vs. fee only? It's on purpose. Fee based is a term heavily touted by the brokerage, insurance, and annuity industries. They do everything they can to narrow the perceived gap between themselves and fee only advisors. After all, why would a consumer work with an advisor who is financially motivated to represent the best interests of their firm rather than that of the client? Unfortunately, their "blur-the-line" campaign has worked. The vast majority of investors are not even aware that there is a difference between fee only and fee based financial planners. In fact, most consumers are not even familiar with the term fee only, because of those 800,000 individuals calling themselves “financial advisors,” only .25% (about 2,000) of financial advisors are members of the National Association of Personal Financial Advisors (NAPFA) and never accept product commissions.

What Are the Differences Between a Broker/Dealer and a Registered Investment Advisor?

Survey results indicate 76% of Americans do not know the difference between a broker/dealer and a Registered Investment Advisor. People in the financial business currently have the freedom to call themselves whatever they like: “financial advisor,” “financial planner,” or “financial consultant” are all popular. Unfortunately, none of these terms express exactly what the individual is paid to do.

A “broker/dealer representative” is a salesman of stocks, bonds and mutual funds. Many times they are also involved with the sale of insurance and annuity products (all for commissions). “Insurance agents” represent the interests of one or more insurance companies and only get paid when they sell a policy.

Neither the broker/dealer representative nor the insurance salesman gets paid to provide advice—hence, they are not truly “advisors.” These individuals only get paid when they sell a product-- they are salesmen. As you might expect, salesmen only come around when they have a product to sell. Salesmen do not make a living servicing the products they have already sold.

Fee-only Registered Investment Advisors do not sell products. They work for their clients and are only compensated by their clients in exchange for professional advice. Thus, a fee-only planner’s compensation encourages objective advice and behavior that is always in the client’s best interest. These individuals are true “financial advisors.” Fee-only Registered Investment Advisors do not collect commissions, so they must continually ensure their clients satisfaction in order to make a profit. These advisors must constantly provide superior service to maintain their client’s business.

Most broker/dealer and insurance representatives are held to a “suitability standard,” meaning they must do what is suitable for their clients. By contrast, fee-only Registered Investment Advisors are held to a “fiduciary standard,” meaning they must do what is in the client’s best interest. To illustrate the difference, suppose the S&P 500 index is a suitable investment for a client, but there are two funds the advisor can choose from. One fund has an expense ratio of .75% and pays a .6% commission to the salesperson. The other fund has a .15% expense ratio, and pays no commission to the advisor. Both funds are “suitable” for the client, so a broker/dealer is allowed to recommend the more expensive fund. However, a fiduciary is obligated to recommend the fund with the lower expense ratio that does not pay a commission. Big difference!

The Battle Between Fee Only and Fee Based Financial Advisors

Recently, I was honored to have an article I wrote published by FiLife.com, a website published in partnership with the Wall Street Journal. I was shocked to receive an email from FiLife.com yesterday that highlighted my article in their monthly newsletter. The article has drawn out a heated discussion among other financial advisors. Check out the article here.

What Are the Differences Between Load and No-Load Investments?

Load investments are frequently sold by stockbrokers, insurance agents, and annuity salesmen. These investments subtract a sales charge from the dollars invested in order to compensate the individual who sold the product. The vast majority of mutual funds, insurance policies, and annuity contracts are loaded investments.

Load mutual funds are sold as A, B, or C shares. All load products pay the individual who sold the product their commission upfront. However, each share class charges the investor differently. A-shares subtract an upfront sales charge, usually 5 percent, from the investment. B-shares impose a deferred sales charge (as much as 5 percent) if the investor sells the investment within a defined period of time, usually within six years. Additionally, B-shares traditionally charge high annual fees to enable the fund to quickly recoup the cost of the commission paid to the salesperson. B-shares turn into A-shares once the period when the deferred sales charge passes. Finally, C-shares do not charge an upfront or deferred sales charge. Rather, C-shares charge the investor high annual fees during the life of the investment.

No-load mutual funds do not charge the investor sales charges at any time, and usually come with a much lower annual expense ratio than loaded C-share funds. Investors usually purchase these funds without the help of a broker, or through the services of a fee-based or fee-only financial planner. Almost universally, no-load funds are more cost effective than loaded funds. In fact, the average annual expense ratio of no-load funds is approximately 1.07 percent compared to an annual expense ratio of 2.05 percent for loaded C-share funds.

Cost savings are equally relevant when comparing load and no-load annuities and insurance products. The average loaded variable annuity has an annual expense ratio of 2.39 percent, while no-load annuities have an average expense ratio of .72 percent. Additionally, the average first-year premium of a loaded $1 million universal life insurance policy on a 55 year-old male is approximately $10,032. By comparison, the first-year premium on the same policy without a load is $3,595.

What Are Hedge Funds?

Traditionally, a hedge is an investment that minimizes the risk associated with another investment. The hedge is designed to increase in value when the value of the original investment declines.

In 2007, Jordan’s Furniture, a Boston-area retailer, held a sale in which customers who bought certain items of furniture were promised they would get their money back if the Boston Red Sox won the World Series that year. Jordan’s then purchased an insurance policy from an insurer willing to pay out the money needed if the Sox actually won. If the Sox had not won, Jordan’s would have paid out the insurance premium, but gained lots of sales. When the Red Sox won the Series, the insurance company paid the bills, and Jordan’s presumably generated excess sales from the promotion. Jordan’s use of insurance to address the possibility of facing a large obligation if the Sox won is a great example of a traditional hedge.

Recently, the phrase “hedge fund” has taken a new meaning. There is clearly confusion about the term, but here are some general characteristics of current-day “hedge funds:”

• Hedge funds can invest in almost anything – stocks, bonds, options, mortgage-backed securities, commodities, currencies, insurance policies – there is practically no limit.

• Many, but not all, hedge funds attempt to increase their returns by investing borrowed money (using leverage).

• Hedge fund managers generally receive much higher levels of compensation than mutual fund managers. Mutual fund managers are prohibited from charging a fee that’s based on investment performance; hedge funds can charge an investment-performance fee. This provides a heavy incentive for successful investment managers to start hedge funds instead of mutual funds.

• Only “accredited” investors are permitted to invest in hedge funds. Individual investors must have a net worth of at least $1 million or income of at least $200,000 per year.

• Hedge fund Investors are often not permitted to withdraw invested funds at will. There are periods when withdrawals cannot be made at all or there may be a fee for withdrawals.

• Hedge funds are often organized in tax havens like the Grand Cayman Islands in order to provide tax benefits for the fund (though investors still have to pay tax on their returns).

• Because hedge funds must invest large amounts without other investors discerning the strategy they are using, the funds typically operate under a good deal of secrecy.

Hedge funds are obviously rather complicated investment vehicles. This is another reason investing in hedge funds is limited to people who have substantial assets. Speak to a fee only financial planner to learn more about these risky investments.

I would like to thank and give credit to Thomas Fisher, CFP® of Fisher Financial Strategies, an independent fee-only planning firm in Cambridge, MA, for his research and writings on hedge funds. Thomas runs The FFS Blog, a personal finance web log, and has been quoted in various publications, including The New York Times, The Washington Post, Financial Planning magazine, and Bloomberg.com.