It's Not Rocket Science

I read an article written by my associate, Bob Rall -- another fee-only financial planner -- and I thought it was worth passing along:

Living on Florida’s Space Coast, I am surrounded by the rocket scientists, engineers and technicians who make up our country’s space program. They are very smart people. In fact, they do their jobs so well that those of us not directly involved in the space industry often take the success of a particular mission for granted.

As a layperson, it’s hard to fathom the knowledge and skill sets that are necessary to carry out a successful mission. First you have the complexities and dangers of the launch itself. Then you have the many teams that are involved in deploying satellites, building a space station, or carrying out a variety of scientific experiments and exploration of our solar system. Pretty heady stuff.

I started thinking about this recently, when I began to read the latest book by William J. Bernstein, The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between. Having previously written two books suggesting that anyone, given the right tools, can successfully manage their own investments, he now admits to being wrong. In fact, he says that he has come to the sad conclusion that only a tiny minority of people will succeed in managing their money “even tolerably well.”

As an investment manager, you can imagine that I was pleased with his new conclusions. I make my living by helping my clients execute a successful investment plan. Granted, investment management is not rocket science or brain surgery, but it’s not something that should be left to amateurs either…especially amateurs trying to manage their own portfolios.

In the foreword of his book, Mr. Bernstein says that successful investing requires a skill set that very few people possess. He concludes that successful investors need four abilities.

First, they must have an interest in the process of investing. If a person does not have an interest, or I would say a passion, for investing, they will not do well. Just like carpentry, playing a musical instrument or parenting, if managing investments is not enjoyable, your results will suffer. And most people don’t enjoy finance.

Second, successful investors must have a good bit of what he calls “math horsepower.” Mastering the laws of investment theory goes way beyond basic arithmetic or knowing how to work a spreadsheet. A successful investor must understand the laws of probability and have a working knowledge of statistics. Unfortunately, with the exception of our aforementioned rocket scientists, just dealing with fractions is a challenge for a large part of our population.

Next, Mr. Bernstein suggests that investors need a firm grasp of financial history. The Dutch tulip bubble of 1637, the great stock market crash in 1929, and the more recent dot com and real estate busts all provide valuable lessons for the learned investor. But even many investment pros have trouble with this ability.

Finally, he says that even if an investor has all three of these abilities, they aren’t enough unless they have the last ability…the emotional discipline to execute their strategy…no matter what. It’s easy to stick with your strategy when things are going well. But when the financial world goes into turmoil, as it often does, it takes real discipline to stick with your plan. The events of the last 18 months in our markets drive this point home very well.

Mr. Bernstein estimates that only 10% of the population passes muster on each of the four skills, which means that only 1 in 10,000 (10% to the 4^th power) has the skill set to successfully manage a portfolio. But even a more optimistic estimate suggests that only a small percentage of people are qualified to manage their own money.

But that is exactly what is happening. Not that long ago, individuals didn’t have to worry about managing a portfolio. In many cases, they didn’t have enough money to invest, and in others, they had a company pension plan, which was professionally managed for them. The old pension plans are mostly gone and now most of us have a 401(k), 403(b), or a similar plan which puts us in the position of portfolio manager.

Unless you are trained to do so, you wouldn’t try to fly your own jet, or perform surgery on yourself or a loved one. So, why would you manage your own portfolio? Many people say it’s because it’s too expensive to hire a professional. That always brings up one of my favorite expressions…”If you think it’s expensive to hire a professional, wait until you hire an amateur."

A Change of Scenery

Sorry that I haven't had time to contribute to my blog as of late. Net Worth Advisory Group has been busy preparing to move to a new office location. As of April, our address will be:

Net Worth Advisory Group
9980 South, 300 West Suite 110
Sandy, Utah 84070

As always, we offer complimentary consultations to learn how we can add value to your financial planning efforts. Please stop by and check out our new location.

401(k)s with Inferior Investments

Recently, I developed several financial plans for clients who work for employers with weak 401(k) plans. These plans have few investment options, don't offer proper diversification tools, and utilize mutual funds with poor track records. What did I advise these clients to do? It depends on the individual's personality.

First, let's briefly review the benefits of participating in a 401(k) plan. A 401(k) plan offers employees the ability to invest in their retirement on a tax-deferred basis. Employees can invest up to $16,500 ($22,000 if they are over the age of 50) without having to pay taxes on that income until the money is withdrawn during retirement. Additionally, many 401(k) plans offer an employee match. For instance, an employee might get a 50% match on all contributions up to 8% of their salary. In this case, if the employee contributed 8% of their salary, they would automatically receive a return of 50% on their investment. Not bad!

So should an individual invest in a 401(k) even if the investment options are sub-par? First, the individual should assess their commitment to investing and whether they are disciplined enough to stick to an investment strategy. An unspoken benefit of 401(k) plans is that contributions are made from an employee's compensation automatically, so the investment is sure to take place. Some individuals intend to make contributions to an IRA or a Roth IRA, but never get around to writing a check. If the investor isn't committed to saving for retirement, or lacks the discipline to continually contribute to an IRA, the 401(k) is still likely the best option.

Investors who are devoted to saving and continually place making retirement contributions ahead of spending may want to utilize a different strategy. First, if the individual's employer matches contributions to the 401(k) plan, the investor would be wise to take full advantage of that match. However, the investor should only invest the amount necessary to obtain the full employer match, and then invest additional retirement funds in an IRA or Roth IRA. Of course, IRAs have access to a virtually unlimited number of mutual funds, of which an investor could develop a diversified portfolio consisting of high performing investments.

Thus, devoted individuals should first contribute as much as necessary into a 401(k) to obtain the full employer match. After taking advantage of the match, the investor should make maximum contributions ($5,000 or $6,000 for those over 50) to an IRA or a Roth IRA, where they have a wider range of quality investment options. If the investor wishes to save more than is allowed in the IRA, they could then return to investing in the 401(k) and take advantage of it's tax-deferred benefit.

This article was written by Lon Jefferies of Net Worth Advisory Group. To learn more about Net Worth Advisory Group, visit www.networthadvice.com or visit Lon's blog at www.utahfinancialadvisor.blogspot.com.

Opting Out of Social Security

Certain professions are offered the ability to opt out of Social Security. Normally, a tax rate of 12.4% is applied to the first $106,800 of earned income -- half paid by the employer and half paid by the employee. When an individual opts out, the 6.2% of their salary that their employer contributes to the Social Security Administration is deposited into a tax-deferred account specifically for the individual involved. The employee can either invest the 6.2% of his salary that he would normally need to pay in Social Security taxes to the same tax-deferred account, or even spend it.

A case I recently looked at involved a 36-year old male. By projecting his estimated Social Security benefit utilizing a tool provided by the Social Security Administration (www.ssa.gov) we determined that if the man stopped participating in the program, his benefit would be reduced by $310 per month upon reaching age 62. After accounting for inflation, the difference was $8,022 per year. This difference was assumed to grow by inflation of 3% per year.

If this individual contributed the 6.2% of his salary that would normally go towards paying the Social Security tax along with his employer's 6.2% contribution, was he able to make up the difference of his smaller Social Security payment? Keep in mind that the S&P 500 (a broad measure of the stock market) has achieved an annualized return of approximately 10% since 1929. If the individual achieved a return of 8% while he was employed and only 6% during retirement, he would have been able to make up for the smaller Social Security payment and still have $177,129 left in his investment account upon reaching age 90.

Of course, investing on your own rather than relying on a steady payment from the U.S. Government involves more risk. However, this analysis doesn't consider the strong possibility that Social Security benefits may be reduced by the time this individual begins taking withdrawals. The takeaway from this example is that if you have the ability to opt out of Social Security, it is worth examining.

Chart of the Day -- PE Ratios

Today's chart illustrates how the recent rise 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 early 1990s, 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), surged even higher during the dot-com bust (early 2000s), and spiked to nosebleed levels during the financial crisis (late 2000s). Currently, with 99% of US corporations having reported for Q4 2009, the PE ratio stands at 22.

The Mutual Fund Funnel

The primary task your financial advisor should perform is to provide you with a comprehensive financial plan. The plan should include an investment management section which outlines your strategy for managing your investment portfolio. First and foremost, this section should identify an appropriate asset allocation mix between stocks, bonds, and cash. This mix should coincide with the investors' risk tolerance. Next, the plan should determine a diversification strategy that outlines how much of the portfolio will be invested in certain asset classes, such as large cap stocks, international bonds, and money markets. Some of the more common asset categories include:

• large cap growth and value stocks
• mid-cap growth and value stocks
• small cap growth and value stocks
• international growth and value stocks
• emerging market stocks
• government bonds - short, intermediate, and long term
• corporate bonds - short, intermediate, and long term
• international bonds - short, intermediate, and long term

However, after we determine how much of our portfolio is going to be invested in each of these asset categories, we still need to identify high quality investments. This is where the mutual fund funnel can be of use. There are currently over 26,000 mutual funds. How do we know which ones to trust?

Start by only considering funds that invest in the asset category you are looking for. In our example, we'll assume we are looking for a large cap value fund. Of the 26,000 funds available, only 1,076 invest solely in large cap value stocks.

Of course, we want a mutual fund that is going to achieve superior investment performance. As we all know by now, past performance is not an indicator of future success. However, if you were looking for a coach for your basketball team, would you want a new coach with an unproven track record, or would you jump at the chance to hire Phil Jackson? We can further narrow our search by looking for a fund that has achieved above average performance over 3, 5, and 10-year investment horizons. This reduces the number of funds under consideration to only 143.

What are the other qualities we typically look for in a mutual fund? Ideally, we'd like to have a no-load (no-commission) fund, and we'd like the fund's annual management fees (or expense ratio) to be below average. After applying these filters, we are now down to just 45 funds.

The next filter is one that investors often forget about: manager tenure. Of course, we'd prefer a manager with two decades of experience to one who is straight out of training. Additionally, if a manager has only been with a fund for three years, he isn't the person solely responsible for the funds 5 and 10-year performance. Let's further narrow our search to funds who have had the same manager for at least 10 years, and we are now down to just 11 funds.

Lastly, trading costs can decimate a funds return. In fact, according to a recent Wall Street Journal article, the average mutual fund incurs trading cost of 1.44% in addition to its expense ratio (unfortunately, this expense is not required to be reported). Let's wrap up our search by focusing on funds with a below average turnover. We are now down to 9 funds.

Using this funnel, we have now narrowed our search from over 26,000 funds to just 9, and I would suggest that any of these nine funds are likely to be productive members of a portfolio.

This article was written by Lon Jefferies of Net Worth Advisory Group. Learn more about Net Worth Advisory Group at www.networthadvice.com, or visit Lon's blog at www.utahfinancialadvisor.blogspot.com.

The Benefits of Financial Planning -- Investment Management

One of the major components of a financial plan is a complete, objective analysis of your investment portfolio. Note, a portfolio analysis is only one element of a comprehensive financial plan. If your financial advisor presents you with a review of your investments but not a retirement, insurance, estate, and tax analysis, you do not have a truly comprehensive financial plan.

A financial plan should be objective in nature. If the investment section of the plan revolves around pitching certain products, you may be working with a commission-based financial advisor. From my experience, the best comprehensive financial plans are developed by fee-only financial planners who are not motivated to sell products.

The investment section of a financial plan should begin with general, basic financial principles, such as determining an appropriate asset allocation between stocks, bonds, and cash. Identifying the appropriate allocation is mainly a function of three things: the return you need in order to achieve your retirement goals, when you will need the funds invested, and your risk tolerance. Of course, there is a trade-off between risk and return, and every investor needs to know where they lay on this continuum so they can stick to their investment strategy during the bad times without the temptation to sell at market lows. Before determining the appropriate asset allocation, focusing on more specific investment issues such as which stocks to invest in is likely a useless and dangerous task.

After identifying an asset allocation, the investor can now narrow their focus. The next step is to develop a diversification strategy. For instance, suppose the investor decided on a 60% stock / 40% bond portfolio. How much of the stock portion of the portfolio is going to be invested in large cap, mid cap, and small cap stocks? How much will be invested in growth vs. value stocks? How much will be invested in U.S. vs international vs. emerging market stocks? Further, what portion of the bond portfolio will be invested in corporate bonds, government bonds, and international bonds? How much will be invested in short vs. intermediate vs. long term bonds? What about TIPS (Treasury Inflation Protected Securities)? The diversification strategy needs to be specific, and the investor needs to determine a consistent schedule to rebalance the portfolio.

An example of how diversification can help: during the late 1990's, growth stocks performed extraordinarily well while value stocks illustrated muted performance. Consequently, many investors placed large bet on growth stocks at the turn of the century. Additionally, many investors forgot or decided to not rebalance their portfolios in an attempt to capitalize on growth's amazing run. Guess what stocks were hit hardest during the bursting of the tech bubble? Meanwhile, value stocks not only held their value, but experience significant gains. In fact, an investor who had a balanced portfolio likely lost very little money during the early 2000's, and may have even seen their account balances rise.

Only after committing to an asset allocation and a diversification strategy is an investor ready to again narrow their focus and evaluate certain stocks, bonds, mutual funds, or ETFs. What qualities should people look for in these investment options? Stay tuned. That is the focus of my next post!

The Hidden Costs of Mutual Funds

The Wall Street Journal had a great article detailing how expensive it truly is to own a mutual fund. Of course, the average investor knows that when investing in a mutual fund, they will need to pay an expense ratio to compensate the portfolio manager and cover operating expenses. Currently, the average expense ratio of a U.S. stock fund is 1.31%.

However, that's not the true bottom line. There are costs not reflected in the expense ratio related to the buying and selling of securities, and those expenses can make a fund two or three times as costly as advertised.

Unfortunately, the average investor has no idea what these additional costs amount to due to a lack of information. These trading costs aren't even disclosed in a fund's prospectus.

A study conducted last year of thousands of U.S. stock funds concluded the average trading costs amounted to 1.44% of asset. Again, that average trading expense of 1.44% is in addition to the average expense ratio of 1.31%, bringing the average cost of investing in a mutual fund to 2.75%. This means the fund would need to achieve a return of 2.75% just to break even. The study even concluded that it wasn't uncommon for a mutual fund's trading expense to exceed 3%, which when added to the average expense ratio brings the cost of these funds to over 4%!

The "Best Stocks, Best Funds" Advantage

At Net Worth Advisory Group, we commonly utilize a strategy we call "Best Stocks, Best Funds." With this strategy, we essentially build custom mutual funds for our clients. We utilize a service called FolioFN (www.foliofn.com) which enables us to conduct unlimited trading for just .25% of the invested assets. With the ability to conduct unlimited trading, we are able to offer our investment services to clients for an all-inclusive fee that rarely exceeds 1.5%, and can be as low as 1% (depending on the amount of assets invested).

Think about this. A 1.5% all-inclusive fee buys you a professionally managed portfolio, custom built for your needs. The same fee gets you a full-time financial planner who is in your corner, who meets with you at least twice a year and is available at all times to answer any questions you have and assist with any issues that come up. That same fee gets you a comprehensive financial plan consisting of retirement planning, an insurance analysis, education funding information, estate planning, and more, and that plan is updated twice a year. What is better spent: the 1.5% that buys you all this, or the 2.75% fee charged by a mutual fund who doesn't know your name or the first thing about your financial situation, can never shake your hand, and certainly won't be available to answer your questions or ensure you are on pace to meet your retirement goals.

Clearly, Net Worth Advisory Group provides superior service when compared to a mutual fund. When you conclude that working with Net Worth can cut your financial planning expense nearly in half, why not give us a shot? Call to schedule a complimentary consultation.

This article was written by Lon Jefferies of Net Worth Advisory Group. Learn more about Net Worth Advisory Group at www.networthadvice.com or visit Lon's blog at www.utahfinancialadvisor.blogspot.com.