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Archive for the ‘Risk Management’ Category

Exchange Traded Funds (ETFs) have been growing in popularity with investors and their advisers.  They offer low costs and opportunities to more precisely create an asset allocation or take advantage of trading and hedging ideas.

Currency Exchange Traded Funds have grown popular over the course of 2011 to investors who are attempting to gain exposure to foreign currency while avoiding the cost and complexity of the foreign exchange (Forex) market. Investing in foreign stocks and bonds can be a good investment when looking for a financial diversification and also offer the potential of producing substantial returns.

Up until recently, an investor’s only choice to hedge foreign exposure has been through the Forex markets. These markets can be complex for most investors and require substantial capital at risk.  Investing in Forex is promoted by some as a speculative way to make profits.  But an investment in foreign currency comes with the risk of losing money through exchange rates.

ETF’s that focus on currencies are a less complex way to hedge an overseas investment. They give the average investor the opportunity to invest away from the US dollar. ETF’s are also used as ideal instruments for investors to diminish the loss of money due to exchange rates.

Why Invest in Currency Exchange Traded Funds?

Investing in an ETF is much less complex than investing in the Forex market. Although the Forex is the most liquid market (trillions are traded each day), it can be difficult for the average investor to get a seat at the table considering the capital that may be needed and the trading costs incurred. ETF’s offer a simpler way to invest in foreign markets.

If an investor feels as though there is potential economic growth overseas or in an emerging market, ETF’s are a perfect vehicle for international exposure.  Buying individual stocks overseas may be difficult for US investors and may be costly as well.  Mutual funds are a great way to gain access but they have higher costs compared to ETFs.

Why invest in currencies?  Consider this:  Living in the US means that your source of income and most of your investments are denominated in US dollars.  If your portfolio is loaded with domestic investments (and most investors tend to be woefully under-allocated in foreign equity positions), adding a currency ETF to your portfolio can help balance your investments and add diversity to your portfolio away from the US dollar.

Let’s say you are investing overseas through mutual funds in your 401(k) or brokerage account.  Most of these portfolio managers tend to not hedge their exposure to currency changes.  This can turn a positive fund return into a loss when converting back to the US dollar.

Now an investor may want to hedge by holding a position in a foreign currency.  But investing in foreign markets can be risky because of the constant fluctuation of currency and exchange rates. The currency market never closes and is open twenty-four hours of everyday. For the average investor, constantly keeping up with the currencies to figure out the best times to sell and buy may not be worthwhile and result in a loss in money (as well as sleep).   ETF’s offer a more efficient opportunity to manage these risks of foreign investments.

Why bother?  Well, just look at the news headlines.  There continues to be debt crises in foreign and US markets.  This tends to lead to potentially higher interest rates as investors demand a higher return for attracting their money to a particular country.  Higher interest rates in turn will negatively impact the value of the currency and lead to a “weaker” currency. (The upside, on the other hand, is that a weak dollar, for example, will make our exports more competitively priced and help those business dealing overseas).

Investors may be interested in “safe haven” currencies during poor financial times. Countries with strong political stability, low inflation, and stable monetary and fiscal policies tend to be magnets for money in tough times. While that doesn’t necessarily describe the US right now, we are still considered the best option out there as a “safe haven.”

Hedging Examples

According to this article appearing on Investopedia, “a weakening currency can drag down positive returns or exacerbate negative returns in an investment portfolio. For example, Canadian investors who were invested in the S&P 500 from January 2000 to May 2009 had returns of -44.1% in Canadian dollar terms (compared with returns for -26% for the S&P 500 in U.S. dollar terms), because they were holding assets in a depreciating currency (the U.S. dollar, in this case).”

Disadvantages of ETF’s

No investment comes without risks and ETFs and currency ETFs in particular are no different. As is the case with many ETFs, there is always the issue of liquidity of the ETF.  (An ETF without a deep market or volume can produce exaggerated and volatile price changes). And in the case of currency ETFs there is the added issue of dealing with foreign taxes.

The Bottom Line

Whether or not a currency ETF makes sense for your particular situation is something that only you with the help of a qualified professional can determine.

But you should at least be aware of the tools available that may help you protect your portfolio. At the very least, it makes sense to hedge overseas investments especially during volatile times.

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When you’re on an airplane and hit turbulence or rough weather, the flight crew tells you to stay seated and buckled.  Unfortunately, when the markets hit bad weather, there is rarely such a warning.

You might want to call it “Black Thursday.”

Yesterday, the markets around the world went into a tailspin reacting almost violently to the ongoing drumbeat of dour economic news.

On the radar, we’ve seen the storm clouds moving in for a while now:

  • lower than expected GDP in the US last quarter,
  • downward revisions of the GDP to a negligible 0.4% for the first quarter,
  • lower business and consumer confidence surveys,
  • sharply lower than expected new jobs created,
  • higher unemployment,
  • foreign debt crises weighing down our Eurozone trading partners.

There was a temporary distraction over the last couple of weeks as we in the US focused on the debt ceiling debate to the exclusion of all else.  Self-congratulatory press remarks by politicians aside, nothing done in Washington really changed the fact that we are still flying into a stiff head wind and storm clouds that threaten recovery prospects.

Eventually, though, the accumulation of downbeat news over the past few weeks seems to have finally come to a head yesterday.  No one thing seems to have caused it.  It just seems that finally someone said “the Emperor has no clothes” and everyone finally noticed the obvious: global economies are weak and burdened by debt and political crises.

All of this has been creating doubt in the minds of investors about the ability to find and implement policies or actions by governments or private sector companies.  And doubt leads to uncertainty.  And if there’s one thing we know for certain, it is that markets abhor uncertainty.

While many commentators may have thought that the “resolution” of the debt ceiling debate in Washington would have calmed the markets, it seems that upon further review of the details the markets are not so sure.  And in an “abundance of caution” market analysts who once were so OK with exotic bond and mortgage investments are now reacting overly negatively to any and all news and evidence of weakness by governments or companies.

What’s An Investor to Do?

Don’t panic.  It may be cliché but it’s still true.  If you hadn’t already put in place a hedging strategy, then what is past is past and move forward.

So the Dow has erased on its gains for 2011 and has turned the time machine back to December 2008.

If you sell now — especially without a plan in place — you’re setting yourself up for failure.

Here’s a simple plan to consider:

  1. Hold On:  You can’t lose anything if you sell.
  2. Hedge: As I’ve said before in this blog and in the ViewPoint Newsletter, you need to put in place a hedge.  There are lots of tools available to investors (and advisers) to help:  Exchange Traded Funds (ETFs) on the S&P 500, for instance, can be hedged with options or you can use “trailing stop-loss” instructions to limit the market downside; another option – inverse ETFs that move opposite the underlying index. These aren’t buy-hold types of ETFs but can be used to provide short-term (daily) hedges.
  3. Rebalance:  If you’re not already diversified among different asset classes, then now’s the time to look at that. You may be able to pick up on some great bargains right now that will position you better for the long-term.  Yes, every risky asset got hit in the downdraft but that’s still no reason to be bulked up on one company stock or mutual fund type.
  4. Keep Your Powder Dry and in Reserve:  Cash is king – an oft-repeated phrase still holds true now.  Take a page from my retirement planning advice and make sure you have cash to cover your fixed overhead for a good long time.  With cash in place, you won’t be forced to sell out at fire sale prices now or during other rough times. This is part of what I refer to as “Buy and Hold Out.”
  5. Seek Professional Help:  Research reported in the Financial Planning Association’s Journal of Financial Planning shows that those with financial advisers and a plan are more satisfied and overall have more wealth.  Avoiding emotional mistakes improves an investor’s bottom line.

As a side note:  The old stockbroker’s manual still says “Sell in May and Go Away.”  Probably for good reason.  Historically, the summer months are filled with languid or down markets and volatile ups and downs.

 

While it’s tempting to give in to the emotional “flight” survival response that you’re feeling right now, don’t give in.  Stand and fight instead.  But fight smart. Have a plan and consider a professional navigator.

If you are seeking a second opinion or need some help in implementing a personal money rescue plan, please consider the help of a qualified professional.

 

Let’s Make A Plan Together:  978-388-0020

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Do you want to clear a room or stop a conversation fast?  Talk about life insurance.  Mention life insurance to someone and the reaction is something like hearing nails across a chalk board. Folks will either run for fear that you’re going to try to sell them something or their eyes will glaze over.

Most folks don’t want to talk about it.  The topic is boring.  And it’s kind of weird to talk about death.

Heck, when I speak with folks about planning, the inevitable phrase I hear in the conversation is “If I die …” as if they have found some secret to living forever.

So assuming that you’re not featured in the Vampire Diaries, there is a very high likelihood (about 100% give or take 0%) that you may die someday. So it only makes sense to consider life insurance as part of your overall planning.

Life Insurance Through Work Is Only A First Step

Most folks will get some insurance through their employer.  It’s cheap. It’s fast. There’s no medical exam.  It’s simple.

And as I’ve said time and again, there’s always a simple solution to every problem.  (In this case, employer-sponsored group life insurance). And as I’ve also said before, simple solutions are probably wrong.

Now don’t think that I’m saying that the group policy that you get and pay for through your paycheck is wrong.  It’s a good start.  But there’s more to proper life insurance planning than simply figuring a multiple of your salary.

How Much Life Insurance Is Needed?

The reason for any insurance is to cover the costs of risks that we are either not willing or don’t have the resources to cover ourselves.  That’s true whether you’re insuring a car, a home, your life or your paycheck.  So first you need to know what it is that you’re covering.

In the case of life insurance, it’s usually a good idea to figure out how much money your family needs to maintain their current standard of living if you and your income are no longer part of the picture.  Then add in any large expenses to cover.  Typically, this would include an amount to pay off any mortgages and loans and even college funding or other similar expected obligations. Net out the amount of other insurance and investments available and this will give you an idea of the amount of insurance coverage to get.

The amount of insurance that one needs throughout life changes with circumstances.  This is why it’s critical to include an insurance needs analysis as part of your regular financial planning progress reports.  This is why I use a particular tool from ESPlanner that helps project the amounts of coverage needed over time.

Insurance as An Asset Class to Reduce Risks

Now I’ve said that insurance is an asset class.  Why?  Well consider this.  When you invest, you’re likely to spread your money into different types of asset classes:  stocks and bonds of large, small, US and foreign companies.  This is the basis of diversification: don’t put all your eggs in one basket. You do this to help reduce risk.  In this case, you’re trying to reduce the risk of having your investment wiped out by spreading your bets to other sectors of the economy and even parts of the world.

Like asset diversification, insurance is also a risk tool.  In this case insurance is there to replace things that you may not have the cash or investments to cover on your own.  Or maybe you feel you’d be better off investing the cash and earn a return on your money that will hopefully increase the resources you need for your lifestyle whether now or in retirement.

Think of it this way.  You could hit home run after home run picking stocks but what happens if you or your family are hit with an unexpected loss?  You’d have to dip into your savings and investments.  You’d need to sell those winning stocks.  You’d probably incur huge capital gains and have to pay taxes on it.

Life insurance is there to cover living expenses, replace in some small way the loss of income if you or your loved one dies and it does this for the most part tax free to the beneficiary.

And you can carry over the idea of diversification to insurance.  Just like mixing up the kinds of stocks or bonds you own, you can carry insurance from two or more insurers.  You do this by having your employer-sponsored group plan plus something you pay for on your own separate from your employer.  You can further diversify by mixing up the kinds or terms of coverage dividing some between term and permanent type policies.

Kinds of Life Insurance: Term vs Permanent

Insurance comes in two basic varieties: term and permanent.  Term insurance has a fixed premium for a fixed time period.  It’s great for covering specific risks for a defined time period (i.e. a mortgage, college costs).  Permanent life insurance has many flavors but in essence the key is that some of your premium that you pay is used to build up cash value.

Now for those who are unhappy with the stock market, you may want to consider some of the benefits offered by permanent life insurance.

  • The value is guaranteed. You’ll always know how much you have. And the insurer is required to credit a minimum amount to your value each year.
  • You receive dividends and their tax-free. Policyholders will receive dividends that increase the value of their account.
  • You can access the cash value at any time. Unlike going to a bank for a loan, the insurer will give you access to your account’s cash value with very little delay. You pay no penalty when receiving the cash as long as you repay yourself.  And if you set up the account properly, you can build up enough cash value to tap into for anything from buying a car to buying a home to funding retirement without paying a penalty or taxes.  (This is described by some as the Infinite Banking Concept where you become your own banker).

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It’s natural for investors who are still skittish after a decade-long roller coaster ride with the stock market and plummeting real estate values to be risk averse and seek out investment alternatives for protecting their nest eggs for retirement, college funding or simply their emergency cash.

And where there is demand, there will be supply.  So naturally, financial firms will design products geared toward satisfying this demand.

One such product that’s getting more attention recently are Market Linked Certificates of Deposit (CDs).

These are in essence a savings product designed to provide a minimum guaranteed interest rate plus the opportunity to increase the return by linking to the return of a specific market index or in some cases an index for inflation.

Such products are part of the larger class of “structured products” produced by investment banks that can come in many flavors and various strategies:  reverse-convertibles, principal-protected notes, Exchange Traded Notes.  They essentially are debt bundled with a derivative and marketed as a way to bet on stocks and interest rates as a way to manage certain risks. All offer in one package strategies using some sort of derivative and may offer a combination of principal protection, risk reduction and/or enhanced returns.

Recent surveys of more than 17 brokerage firms and more than 38 million investors show that most of these products are used by those with under $500,000 in investable assets.  For those with assets between $250,000 and $500,000, about 1.5% of their assets are placed in such products which is slightly higher than the 1.33% of assets for those with under $250,000 to invest.  (Investment News, 11/15/2010, page 52).

More than $70 billion of such products are held by investors with more than $42 billion bought in 2010 according to Bloomberg data.  And given continued uncertainty about the markets, the demand looks like it will not be abating any time soon especially as financial marketing organizations use investor fears as a selling point. Brokers and banks often receive higher fees and commissions for selling such products.

Keith Styrcula of the Structured Products Association said in a recent interview “these kinds of investments have become so attractive because people can no longer trust stock market indexes to go up.” He added that “there’s a lot of fear in the market right now, and a lot of investors don’t just want one-way exposure anymore.”  (Investment News, 11/15/2010, page 51).

But even though these products are marketed as a way to reduce risk they are not risk free.  There is no free lunch and this is no exception. Such products are subject to liquidity risk, market risk, credit risk and opportunity costs.

Market-Linked CDs are a form of principal-protected note offered by an investment bank.  These are not your Grandmother’s bank CDs.  First, such notes are offered as debt of the sponsoring institution so there is always the potential of credit risk.  Think of Lehman Brothers which was a large producer of such notes.  If the issuing firm fails, as Lehman did, the investment is at risk. While there is FDIC-protection on the principal, that may be small comfort when dealing with the time frame to get access to your money through a FDIC claim process.

They may involve a complex strategy which may be buried in the details of the offering’s prospectus.  For market-linked CDs, for instance, the issuer offers the downside protection by managing a portfolio of Treasury bonds (like zero coupon bonds to meet the projected maturity date of the CD).  The upside potential that is offered comes from investing in the bond yield through various strategies.

In such a low interest rate environment, these notes work only if provided sufficient time for the issuer to implement its strategies.  This is one reason that such CDs typically have long lock up periods that can be five years or more.

An issuer may guarantee a minimum interest amount but this is typically not FDIC-insured.  And this is really an obligation of the issuer so that’s where the credit risk comes into play. And you should note that the minimum guarantee usually only applies when the investment is held to maturity.  An investor will lose this guarantee by redeeming before the contract maturity date. And because of the nature of these products, there really is no secondary market around to allow someone else to buy you out early.

The upside potential is calculated based on the performance of the index chosen.  The CD investor does not own the index or the stocks in the index.  The issuer uses its money to invest and potentially reap the dividends issued as well as the appreciation.

What the issuer offers to the CD investor is a certain percentage of the upside gain of the index (called a participation rate) but limited by a ceiling (called a cap).  This calculation of the gain can be convoluted for an investor to understand. While it’s pretty simple to understand a typical CD (put $1000 in at an annual interest rate of 3% means you have $1,030 at end of the period), the same is not true for market linked CDs.

Your gain may be based on an average (so now the question is how are they calculating that average: monthly,  semi-annually, annually, term of the CD) or a Point-to-Point calculation. (Example: If the market index is 1000 when the account opened, went up to 2000 after one year but drops to 1050 by the maturity date, then the point-to-point is from 1000 to 1050 or 5% in this case).

In many ways these are similar to other structured products like market linked annuities (sometimes referred to as index annuities or equity-indexed annuities).

I addressed many of the same issues about calculating returns and possible risks in a post on the subject a while back.

Bottom Line:

Whether or not such products make sense for your personal portfolio really requires a good, long chat with a qualified financial professional. Like any other investment, the potential risks and opportunity costs need to be weighed against your personal goals, time frame, liquidity needs and the potential offered by other alternative options.

So if you are considering such products, just be aware of all the risks and look beyond the marketing brochure at the local bank.

Resources:

SEC Investor Education on Market-Linked CDs

MoneyLinkPro Blog Post on Market Index Annuities

Wikipedia Definition

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Recent academic research by Gordon Pye on the impact of emergency withdrawals on retirement planning may put into question the rule of thumb used by many advisers to determine a safe, sustainable withdrawal rate.

For many investors and their financial advisers, the accepted rule of thumb has been to withdraw no more than 4% of an investment portfolio in any given year to provide a sustainable income stream when in retirement.

Is this rule of thumb reasonable given the potential impact of personal emergencies?  And how can a withdrawal strategy be created to account for them and the impact of external forces like a market correction or longer bear market?

Cloudy Crystal Ball

Analytical tools and software have come a long way but even contemporary tools can’t account for everything.

I spoke with an estate attorney the other day.  We were talking about the many challenges for helping clients plan properly for contingencies in the face of so many internal and external variables.

What he said is worth keeping in mind when thinking about any sort of financial planning:  If you tell me when you’re going to die, I can prepare a perfect estate plan for you?

The same sentiment can be adapted for retirement income planning.  Sure, if you tell me how long you’ll live in retirement, how much it will cost each year and when you’re going to die, I can tell you how much you’ll need.

In reality, this is unlikely.  More often than not, the crystal ball is cloudy. So you have two choices here: Wing it or Plan.

Winging it is pretty simple. Nothing complicated.  Simply keep shuffling along. Sometimes you’ll scramble. Other times you’ll be “fat and happy” for lack of a better phrase.

Planning, on the other hand, is a lot like work.  It requires assumptions and conversations.  It may even require bringing in others to help create the framework.

While nobody wants another job to do given an already busy day, there is an upside to investing the time here: Peace of mind.

What the Doctor Says:

Here’s a summary of what Dr. Pye wrote recently in his article.

  • In retirement, you may never have an emergency or you may have one or more.
  • The timing and extent of these emergencies is unknown.
  • While a retiree may be able to reduce the damage caused by a bear market maybe through market growth, other emergencies may require withdrawals that siphon money away from the investment pot that can never again be used to help repair the hole left by that withdrawal.
  • The timing of these emergency withdrawals may cause a retiree to abandon a market strategy at an inopportune time.

The biggest unknown?  Health care is the biggest likely emergency on your retirement budget.  These can be related to your own health or even an adult son or daughter.  Other emergencies may be caused by catastrophic weather (mudslide, wind or flood damage to your home), the extended loss of a job by a son or daughter or a divorce compelling you to help out.

In other research by Dr. John Harris supports the notion that what matters most to all investors – and retirees in particular – is the sequence of returns not simply the average rate of return on a portfolio.

Intuitively, we understand this.  A bird in the hand is worth two in the bush.  Cash now is better than cash later (which may be a deterrent against planning now for a future need).  If you were to just retire and the market takes a nosedive as you are withdrawing funds, you would be in tough shape because you have a smaller base that is invested that has to do double (or triple) duty.  The amount of appreciation needed to make up for the hole left by the withdrawals combined with market losses would be near impossible or require an investor to take imprudent risks to try to regain lost ground.

So what’s an investor to do?

  1. Save more – easier said than done but this is really key or otherwise choose a different lifestyle budget.
  2. Reduce initial withdrawal rates from 4% to 3%.
  3. Follow an “endowment spending” policy instead of a simple rule of thumb.
  4. Invest for income from multiple sources (dividend-paying stocks as well as bonds).
  5. Stay invested in the stock market but change up the players.  Not even a championship ball club has the same line up from game to game.  As markets change, you need to add more tactical plays into the mix of asset types
  6. Separate your investments into different buckets:  short-term lifestyle budget, medium-term and longer-term.  Each of these can have different risk characteristics.
  7. Keep a safety net of near-cash to cover lifestyle needs for 1 to 2 years.
  8. Monitor the buckets so that one doesn’t get too low or start to overflow.  This will require moving funds from one to the other to maintain consistency with the targets.
  9. Don’t let your insurances lapse.  Insurance is there to fill in the gap so you don’t have to shell money out-of-pocket.  Here you want to regularly recheck your homeowner coverage for inflation protection riders, cost of replacement and liability.  Check your coverage and deductible limits for wind, sump pump and other damage.

 

 

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The holiday season is almost upon us.  Before we all get caught up in the spirit of the season (or mayhem, depending on your perspective), consider taking time to get your fiscal house in order with these tips.

The Year of the RMD

Last year, required minimum distributions (RMDs) were not required as Congress granted a reprieve to not force clients to take distributions from severely depressed retirement accounts.

That free pass is not available this year.  So if you or someone you know is over age 70 1/2, you have to take a distribution from your IRAs.  This also applies to those who are beneficiaries of inherited IRA accounts as well.

Distributions don’t have to be taken from each IRA account but a calculation must be made based on the value of all accounts at the end of last year.  Then a withdrawal can be made from one or more accounts as long as it at least equals the minimum amount.

Think Ahead for Higher Taxes

In all likelihood, taxes will be higher next year.  As things stand, the Bush-era tax cuts are set to expire and marginal income tax rates and estate taxes will increase.

So look to booking capital gains this year if possible since tax rates on both long-term and short-term gains are certainly lower this year.

Reduce Concentration

There’s obviously enough going on to distract any investor but what I’m talking about here is concentrated stock positions.  Many clients may take advantage of company-sponsored stock purchase plans or have inherited positions concentrated in just a few stock positions.

Regardless of one’s age, this is risky.  This is especially risky to concentrate your income and your investments with your employer.  Remember Enron?  How about WorldCom?  Or maybe Alcatel-Lucent?

So given the lower capital gains tax rates that exist definitely now (versus a proposed but illusory extension later), it makes sense to reduce the highly concentrated positions in one or more stocks.

I know a widow who inherited the stock positions that her husband bought.  These included AT&T and Apple.  While AT&T was once a great “widow and orphans” stock paying out a reliable dividend because of the cash flow generated from its near monopoly status in telephone services, it broke up into so many Baby Bells.  The dividends from these have not matched the parent company and the risks of these holdings have increased as the telecom sector  has become more volatile.

And while Apple has been a soaring success for her (bought very low), it represents over one-third of her investment holdings.

Like most people I come across, she has emotional ties to these holdings.  And while she and others like her would not think of going into a casino to put all their chips on one or two numbers at the roulette wheel, they don’t find it inconsistent to have a lot of their eggs in just one or two investment baskets.

Since she relies on these investments to supplement her income, she needs to think about how to protect herself.  Although people may recognize this need, it doesn’t make it any easier to get people to do what is in their best interests when their emotions get in the way.

‘Tis the Season for Giving

Right now the highest marginal income tax bracket is 35% which is set to rise to 39.6%.  And capital gains tax rates are set to rise as well.  And come January 1, the capital deduction on gifts will be reduced from 35% to 28%.  All of this makes giving substantial gifts to charities a little more costly for your wallet.  So if you’re planning to make a large charitable donation, it pays to speed it up into this year.

To Roth or Not to Roth – Year of the Conversion?

This year provides high-earners an opportunity to convert all or part of their tax-deferred accounts to Roth IRAs which offers an opportunity to pay no income tax on withdrawals in the future.

The decision to take advantage of this opportunity needs to be weighed against the availability and source of cash to pay taxes now on previously deferred gains in the tax-deferred IRAs or 401ks. It also must consider the assumptions about future income tax rates and even whether or not future Roth IRA withdrawal rules might be changed by Congress.

Create an Investment Road Map

To really help gain clear direction on your investing, you really should consider sitting down with an adviser who will help you draft your personal investment road map (an Investment Policy Statement) that outlines how investment purchase and sale decisions will be made, what criteria will be used to evaluate proposed investments and how you will gauge and track results toward your personal benchmark.

This exercise helps establish a clear process that minimizes the impact of potentially destructive emotional reactions that can lead you astray.

Rebalance and Diversify

Just as you might plan on changing the batteries in your smoke detectors when you reset the clocks in the spring and fall, you should rebalance your investments periodically as well.

Now is as good a time as any to reassess your risk tolerance.  Research has shown that an investor’s risk tolerance is dynamic and influenced by general feelings about yourself, your situation and the world around you.  With the world’s stock markets showing many positive gains, this may lead some to become more willing to take risks.  This may not be a good thing in the long run so really question your assumptions about investing.

Armed with your investment road map and a risk profile, you will be in a better position to determine the mix of investments for diversification.  Don’t be afraid of adding to the mix investment asset classes that may not be familiar.  The idea of diversification is assembling investment assets that complement each other while potentially reducing risk.  And just as the economy has changed and the types of industries that are dominant rise and fall, it’s fair to say that what is “in” now may be “out” later making it important to reconsider your mix.

For this reason, this is why looking abroad to developed and emerging markets still makes sense.  Many of these economies are not bogged down by the after-effects of the great financial meltdown. And the rise of their consumerist middle classes means the potential to take advantage of demographics favoring growth sectors like natural resources, telecom, agriculture and technology.

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Whatever your retirement dreams, they can still be made a reality.  It just depends on how you plan and manage your resources. On any journey it helps to have an idea where you’re going, how you plan to travel and what you want to do when you get there.

If this sounds like a vacation, well, it should. Most people invest more time planning a vacation than something like retirement.  And if you think of retirement as the Next Act in your life and approach it properly, you won’t be so easily bored or run out of money to continue the journey or get lost and make poor money decisions along the way.

It’s How You Manage It That Counts

How much you need really depends on the lifestyle you expect to have.  And it’s not necessarily true that your expenses drop in retirement. Assuming you have an idea of what your annual expenses might be in today’s dollars, you now have a target to shoot for in your planning and investing.

Add up the income from the sources you expect in retirement.  This can include Social Security benefits (the system is solvent for at least 25 years), any pensions (if you’re lucky to have such an employer-sponsored plan) and any income from jobs or that new career.

Endowment Spending: Pretend You’re Like Harvard or Yale

Consider adopting the same approach that keeps large organizations and endowments running.  They plan on being around a long time so they target a spending rate that allows the organization to sustain itself.

1. Figure Out Your Gap:  Take your budget, subtract the expected income sources and use the result as your target for your withdrawals. Keep this number at no more than 4%-5% of your total investment portfolio.

2. Use a Blended Approach: Each year look at increasing or decreasing your withdrawals based on 90% of the prior year rate and 10% on the investment portfolio’s performance.  If it goes up, you get a raise.  If investment values go down, you have to tighten your belt.  This works well in times of inflation to help you maintain your lifestyle.

3. Stay Invested:  You may feel tempted to bail from the stock market.  But despite the roller coaster we’ve had, it is still prudent to have a portion allocated to equities.  Considering that people are living longer, you may want to use this rule of thumb for your allocation to stocks: 128 minus your age.

If you think that the stock market is scary because it is prone to periods of wild swings, consider the risk that inflation will have on your buying power.  Bonds and CDs alone historically do not keep pace with inflation and only investments in equities have demonstrated this capability.

But invest smart. While asset allocation makes sense, you don’t have to be wedded to “buy-and-hold” and accept being bounced around like a yo-yo.  Your core allocation can be supplemented with more tactical or defensive investments.  And you can change up the mix of equities to dampen the roller coaster effects.  Consider including equities from large companies that pay dividends.  And add asset classes that are not tied to the ups and downs of the major market indexes.  These alternatives will change over time but the defensive ring around your core should be reevaluated from time to time to add things like commodities (oil, agriculture products), commodity producers (mining companies), distribution companies (pipelines), convertible bonds and managed futures.

4. Invest for Income: Don’t rely simply on bonds which have their own set of risks compared to stocks. (Think credit default risk or the impact of higher interest rates on your bond’s fixed income coupon).

Mix up your bond holdings to take advantage of the different characteristics that different types of bonds have. To protect against the negative impact of higher interest rates, consider corporate floating rate notes or a mutual fund that includes them.  By adding Hi-Yield bonds to the mix you’ll also provide some protection against eventual higher interest rates. While called junk bonds for a reason, they may not be as risky as one might think at first glance. Add Treasury Inflation Protected Securities (TIPS) that are backed by the full faith and credit of the US government.  Add in the bonds from emerging countries.  While there is currency risk, many of these countries do not have the same structural deficit or economic issues that the US and developed countries have.  Many learned their lessons from the debt crises of the late 1990s and did not invest in the exotic bonds created by financial engineers on Wall Street.

Include dividend-paying stocks or stock mutual funds in your mix.  Large foreign firms are great sources of dividends. Unlike the US, there are more companies in Europe that tend to pay out dividends. And they pay out monthly instead of quarterly like here in the US.  Balance this out with hybrid investments like convertible bonds that pay interest and offer upside appreciation.

5. Build a Safety Net: To sleep well at night use a bucket approach dipping into the investment bucket to refill the reserve that should have 2 years of expenses in near cash investments: savings, laddered CDs and fixed annuities.

Yes, I did say annuities.  This safety net is supported by three legs so you’re not putting all your eggs into annuities much less all into an annuity of a certain term. For many this may be a dirty word.  But the best way to sleep well at night is to know that your “must have” expenses are covered.  You can get relatively low cost fixed annuities without all the bells, whistles and complexity of other types of annuities.  (While tempting, I would tend to pass on “bonus” annuities because of the long schedule of surrender charges). You can stagger their terms (1-year, 2-year, 3-year and 5-year) just like CDs.  To minimize exposure to any one insurer, you should also consider spreading them around to more than one well-rated insurance carrier.

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