Thursday, December 16, 2010

Five Awful Investments to Avoid in 2011*

Bert Whitehead, M.B.A., J.D.

1.Timeshares. This preposterous “investment” is based on the doubtful proposition that a $117,000 condo is really worth $585,000 because 50 chumps can be convinced to rent it one week a year for the rest of their natural lives, and pay most of the rent (totaling $11,700) in advance and the rest annually disguised as maintenance fees. These are always sold by very friendly people, usually named Joe, who cannot begin a sentence without grasping your forearms and saying, “Let me be honest with you.” In addition to a very fuzzy explanation of the investment potential, you will find out how you could get AIDS from hotel sheets (presumably not a danger at Vacation Ownership Resorts because they don’t have maid service).
a.A hint: If after reading this, you still can’t help yourself and simply must buy a timeshare, buy it on a the secondary market (i.e., look in the classified ads and buy one from some dummy who spent his kid’s college money for it last year and now is trying to dump it at half price). This is still twice what it is worth.
b.A better hint: Put your $11,700 in a well-balanced investment portfolio. Each year use the accrued earnings to rent a timeshare anywhere in the world. Then go job hunting while you’re there and write it off!

2.Lottery Tickets. Lotteries were designed by scheming Republicans as a patriotic way to entice poor people into voluntarily returning their welfare checks to the state coffers. They sort of work like variations of the old 50/50 church raffle except the church doesn’t tax your 50 percent and then pay you over 20 years. Assuming a tax bracket of 33 percent, and an annual present value of money at 8 percent instead of a return of 50 cents for every dollar bet, you actually “win” slightly less than 17 cents. This is not attractive, even compared to roulette tables in Las Vegas where they pay 95 cents for each dollar bet. Plus you get free drinks.
a.Hint: If you could borrow $7.7 million at 8 percent over 20 years and buy every single number on the Michigan lottery, you would be a sure winner if the jackpot was $22 million or more. (If you don’t have to split the pot with some bloke on the dole.)

3.Life Insurance Investments. These quaint arrangements were popular and considered by some to be relatively competitive in the Fabulous ‘50s. Then your only alternatives were U.S. Savings Bonds (which your elders still called “war bonds”), paying 4 percent, and savings accounts which aggressively paid 4.5 percent. Pseudo-tycoons had Christmas Club accounts, a scam whereby you gave money to the bank every week and then they gave it back to you at the end of the year. No interest, but no service charge either. Now, bank savings accounts pay virtually no interest which is dwarfed by service charges if you don’t have very much money and just let it sit there. The service charge compensates the tellers who take your money out for a walk every month until it all evaporates. But we digress: back to life investments. They are variously called whole life, variable life, universal life, permanent life, etc. They sport many supposed advantages none of which are exclusive to this investment vehicle. Despite reams of projections and lengthy enthusiastic explanations, these investments are bereft of S.E.C. scrutiny, and the investor thus usually is at the mercy of inscrutable policy language as explained by a hyperkinetic salesperson with a snappy patter but no prospectus to evaluate risk or disclose the sales commission. Moreover, these are inevitably touted as “Long-term Investments”. Long Term Investments in financial lingo refers to generally inferior investments that are impossible to fully understand on which salespeople earn very large commissions.
a.Hint: Continue to ask your insurance person A) exactly how much commission is paid for selling this to you and B) exactly how much of your money you get back if you bail out after two years. If you can get a straight answer, you will be amazed that the amount of money you will lose under B is uncannily close to the amount disclosed under A. If still in doubt, we will demonstrate how much better you will be buying term insurance and investing the difference in the S&P 500 Index mutual fund. NOTE: This does not mean you should cancel or cash-in existing policies.

4.Any Investment Sold Over the Phone. Legitimate investments are never sold over the phone. Period. If their investment was as good as they say it is, and then they wouldn’t be spending their time talking to strangers like you on the telephone. Actually we encourage clients to never buy anything over the phone because of the increased exposure to fraud. And also because it only encourages even more unsolicited telephone intrusions.

5.Any Investment Someone Comes to your House to Sell You. If you think it through: anytime someone comes out to see you , at your convenience, in the comfort of your own home, and you are under no obligation, you are going to get a very high pressure sales pitch for something you probably never before considered buying, at an outrageous price. The sales commission on these arrangements is usually 25-50 percent of your investment. This makes shopping at home very expensive.

* This article was originally written 20 years ago. Interest rates have changed, but the scams remain the same…

Tuesday, October 5, 2010

Bert’s Blog, by Pamela Landy 2010 Year-end Tax Tips

I have turned this blog over to my esteemed colleague Pamela Landy as she is better versed on many of these pointers than I am. These next three months will be a terrific opportunity for tax-smart citizens!

2010: A Challenging Year for Tax Planning

At Cambridge Connection we pride ourselves on our proactive approach to tax planning. In our spring meetings, we normally estimate the current year’s taxes and suggest tax saving opportunities. In our fall meetings, we again review your situation and make sure that the appropriate tax reduction strategies are being implemented.

This year there is an unusual degree of uncertainty about the ground rules for the 2010 tax planning. After a decade of predictable tax rates, 2010 and 2011 will bring a multitude of changes which could impact you in unpredictable ways.

There is a good chance that income tax rates will increase next year for a majority of our clients as the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 expires. Over the past decade, tax rates have steadily declined under this law. Absent Congressional action, certain tax cuts, credits, and other tax provisions referred to as the “Bush Tax Cuts” will become history.

The following are just a few examples of the complexities that impact this year's tax planning decisions.

Should you accelerate income to 2010?

As tax rates decreased over the past 10 years, conventional wisdom was to defer income to the next year whenever possible. This may not be true this year. Ordinary income tax rates for 2011 may increase by 3% to 5% over the 2010 tax rates especially for clients who are currently in the 33% to 35% brackets.

A taxpayer who can control the timing of income may be able to pay lower taxes in 2010 than in 2011. In prior years, forcing a large amount of income into one year did not always make sense because the higher income would trigger a phase out of exemptions and itemized deductions. But in 2010 there are no phase outs regardless of the amount of adjusted gross income. In 2011, however, these phase outs come back and revert to amounts which were in effect in 2000. This can make moving income into 2010 make even more sense.

Will Alternative Minimum Tax Add To Your Tax Bill?

Many people do not realize that there are two separate tax computations used to determine the amount of income tax that individuals must pay. The first tax calculation is the one that is widely known. The second method of calculating tax is referred to as the “Alternative Minimum Tax” or AMT. The AMT is calculated using different rules than the regular Income Tax; these do not permit deductions for state and local income taxes, property taxes, miscellaneous itemized deductions subject to 2% of Adjusted Gross Income, as well as some other less common items. The tax is calculated using different rates and if the AMT Tax is higher than the regular tax, then you have to pay the higher amount.

As the AMT began to affect more taxpayers; on a year by year basis, Congress has approved a “patch” that increased the amount of the AMT exemption. To date, for 2010, no patch has been approved; and the exemption amounts will revert to 1986 levels. It is important to determine whether you may be affected by the AMT, because if you are, different tax planning strategies apply. We will be following year end legislative developments to determine whether another “patch” will be approved for 2010. This fall, we will be projecting your tax due with and without the AMT to demonstrate the amount of tax that you would have to pay under alternative tax planning scenarios.

Should You Defer Deductions to 2011?

Over the past decade, conventional wisdom has suggested that due to declining tax rates, it makes sense to accelerate deductions into the current year. Logically then, you would think that when rates are increasing you should defer deductions into the following year when the rates go up. While this may be true in many cases, it should be remembered that when the phaseouts return in 2011, some of these deductions may be lost. Certain deductions are also lost when you are subject to AMT.

What About Capital Gains?

Accelerating capital gains into 2010 makes sense for most taxpayers. The 15% long term capital gains rate is scheduled to increase to 20%, and the short term rate will increase with the ordinary income tax rates. The 0% capital gains tax rate for those in lower tax brackets is also disappearing. In addition, the favorable 15% tax rate for qualified dividend income is also being eliminated, so that the dividends will be taxed at your highest marginal tax bracket.

Is a Roth Conversion Strategy Right For You?

Over the next several months, be prepared to be bombarded with a media blitz about Roth Conversion opportunities. The Roth Conversion decision involves paying taxes up front to move assets from a retirement plan that contains pre-tax dollars to a Roth Conversion account that holds after-tax dollars. While the pre-tax dollars will be taxed when they are withdrawn; the after-tax dollars grow and are distributed tax-free.

This year, 2010, is the first year that taxpayers with incomes over $100,000 are permitted to take advantage of the Roth Conversion. It is difficult to come up with any standard recommendation as to whether or not you should convert, how much should be converted, and in what year income should be recognized. While the Roth Conversion strategy is not right for everyone, it is important to examine the opportunity in the context of you financial goals and resources.

The previous examples illustrate why there are no “one size fits all” recommendations. This year, your personalized tax projections, which consider the impact of both scheduled and potential tax law changes, will be particularly beneficial.

We look forward to assisting you in making smart tax planning decisions this fall.

Pamela Landy, MBA, JD, CFP®, CSA®
Senior Advisor
Cambridge Connection, Inc.
Franklin, Michigan Office

Wednesday, September 15, 2010

Affordable College: Don’t Pay Retail!

Bert Whitehead, M.B.A., J.D.

Is college now only for the wealthy? The College Board announced that tuition and fees increased over 14% for public universities and 6% for private colleges in
2009. The posted prices for higher education have more than doubled over the last decade, a rate averaging over 7% a year, which far outpaces the general rate of inflation for that time period. Have we reached the point that only the wealthy can afford to send their children to college?

The New York Times reports that families earning $100,000 a year would have to save about $1,000 a month for 18 years in a 529 plan to send 2 children to a public college such as the University of Michigan ($51,000/year/per child for four years). That’s more than the parents are likely to be saving for their own retirement! Looking at the numbers can be disheartening, but the information I have outlined below for you will show how college can be within the reach of average American families.

It is interesting to speculate why tuition has risen so much so quickly. Critics point out that the answer may lie in the perceived importance of a college degree and the corresponding public and social policy of expecting, or even insisting, that children to go to college. As a result, colleges have increased their non-tuition sources of revenue from federal and state governments and from alumni contributions so that those sources now account for over 70% of college funding. The big secret is that over half of non-tuition funding is used to subsidize tuition expenses for students with more moxie than money.

You may conclude that colleges simply spend more as their funding increases. Having tenured faculty, building more buildings, and offering more courses are all huge status symbols in higher education. These involve costs that never do down, only up. So our culture's emphasis on the importance of college leads to open-ended support for higher education, which in turn ratchets up college costs.

It is important to keep college costs in perspective. More than half of the four-year colleges in this country cost less than $9,000 per year. This includes tuition and fees, but not the other components of college costs: room and board, personal spending, books, and transportation. Is a college degree worth it? There is no question that college graduates earn much more than their cohorts (it is estimated $1million more over a lifetime) who are high school graduates and don't go to college. College graduates are also half as likely to become unemployed as those with only a high school degree.

But there is increasing doubt whether ‘Ivy League’ schools are worth the price. Do Ivy League graduates earn that much more than graduates of other schools to justify shelling out $200,000 for a B.A. degree? The value of better schools is not just their faculty and facilities, but the other students. High-end colleges provide much stiffer competition, and that continuing challenge is ingrained in the experience, deepening student scholastic relationships. This results in very strong ties to the highest achievers in society; networking that can shape opportunities in later life.

Many parents ignore college options for their children because they look at only the ‘sticker price.’ In fact, the only parents who pay the full sticker price are the more affluent. There are huge amounts of grants, scholarships, loans, and other subsidies available to most students. The more modest the means of the parents, the more aid is available. Many of the most highly regarded colleges (Harvard, Yale, Princeton, etc.) have programs to pay 100% of a gifted student’s costs if their parents don’t have the means. Many schools have acceptance policies that are "need blind," meaning that the student's acceptance is not based on whether he or she can afford to pay the full tuition. (It's a good idea to ask the admissions office of a prospective school whether or not their acceptance policies are "need blind.")

With this in mind, I recommend that my clients consider the “1/3, 1/3, 1/3 College Strategy.” I am using this strategy to fund my seven grandchildren's education, and my clients have used it successfully in one form or another for the past 20 years. I call it the “1/3, 1/3, 1/3” plan because the funding comes from three sources:
1. The student must come up with one-third of the total college costs. This may be from savings, working, scholarships, grants, gifts, — it is the student’s obligation to chip in this part.
2. Student loans, not cosigned by the parent, should make up another one-third of the costs and it’s up to the student to research the options and get a good deal.
3. Finally, the parents chip in one-third. And, if/when the student graduates, the parents commit to making the payments on the student loans. Upon the parents’ death, the students can use their inheritance to pay off the loans, if any still remain unpaid.

The advantage of the “1/3, 1/3, 1/3” plan is that the students have ‘skin in the game’. They can go to whichever school they choose, but they have to come up with their third of the correspondingly higher cost. And if they drop out without finishing college, they are on the hook to pay off their own student loans.

The bottom line of this strategy is that the student will find out very quickly that the ‘sticker price’ of college is much less when educational aid is subtracted. Most of the other things needed (textbooks, room and board, transportation, etc.) are either discretionary or are available inexpensively, if researched. For example, used text books, and now electronic books, cut the cost of books dramatically.

So even if you can’t pay the full freight for college at retail prices, if your student wants it enough to learn to find the grants, scholarships, loans, and other subsidies, any college is available. The plus is that finding out how not to have to pay retail will be a life-long financial lesson he or she will have mastered!


I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY

Friday, July 23, 2010

How Long Will My Money Last?

By Bert Whitehead, MBA, JD

Dear Bert: I have read in various publications that the safe withdrawal rate from an investment portfolio during retirement is around 4% if you want your money to last. Could you please comment?
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While I recognize that the 4% withdrawal rate has become the standard wisdom in financial planning, I respectfully disagree. Keep in mind that most financial planners are actually investment managers, and so minimizing the withdrawal rate keeps more assets under management for them, and correspondingly higher fees.

It seems to me that a withdrawal rate must take into account the after-tax return to the client. This is highly individualized, so I don't think you can know this unless you are intimately knowledgeable about the client's tax situation. It also focuses attention on the actual tax efficiency of the portfolio. Because Functional Asset Allocation is very tax efficient, I am able to keep almost all my clients with under $3 million in their investment portfolio in a 15% marginal tax bracket. This obviously impacts their appropriate withdrawal rate.

Most financial planners figure that a balanced portfolio in retirement with 60% interest earning and 40% equities will earn ~7% over a 15-20 year period. This is historically true, and is the number I use. But then they assume an 'inflation rate' of 3% and in one way or another come to the 4% withdrawal number.

I disagree that the inflation rate is the driver in retirement. While inflation may occur in general, the overall rate has little relevance to the actual rate an individual client experiences. The CPI (Consumer Price Index) is heavily weighted by education, housing, and medical costs -- none of which are significant to most retired people (especially with health insurance which most of my clients have, even absent 'universal coverage'). CPI may be meaningful to individuals who live at a subsistence level, but most people who have a financial advisor are affluent to some degree. Just ask yourself: "When gas went to $4.00 a gallon, did that affect my living standard?"

The driver for most clients is not cost-of-living, but their "standard-of-living." During accumulation stages a client's standard-of-living generally increases at a higher rate than inflation, usually in tandem with increases in their earned income. So using CPI through the accumulation period grossly underestimates the amount a client actually spends. Upon retirement many financial planners say that clients only need 80% of their pre-retirement spending. I find that, at the beginning of retirement, clients need 100% of their pre-retirement spending.

Retirement spending normally remains flat for the first 10-20 years of retirement, as the standard-of-living stabilizes. It is critical that planners monitor client spending during the first few years of retirement. If standard-of-living increases at the same rate as when they were working, they will certainly end up living beyond their means. However, there is a selection bias I've noted with financial planning clients. They tend to be savers rather than spenders. Most often I find that a client needs permission to spend because they are so accustomed to being frugal and are afraid that they will run out of money during retirement.

Interestingly, the actual expenses needed to support a client’s standard of living starts dropping around their late 70's and early 80's. They have 'been there, done that, have the T-shirt.' They don't need to buy new cars, or to keep up with fashion demands. If we exclude gifts to charities and children, the amount they need decreases year by year, regardless of what the CPI does or how their portfolio performs. Recent studies published in the Journal of Financial Planning have corroborated this phenomenon.

Two other points about estimating withdrawal rates…

Many financial planners use software that depicts an inflated future as a single estimated percentage increase of past expenses. As you well know, I consider financial planning to be a process, not an event. Clients are generally very capable at adjusting their behavior. If there is a lean year in the stock market, they put off an expense until times get better. The software projections don’t show how smart clients can be!

Another point is that investment managers define their value as “return on investment.” However, clients tend to view supporting their lifestyle in terms of liquidity, or simply “will I have the money?”

As you know, our approach (Functional Asset Allocation) uses 15 year bond ladders with US Treasuries to assure that a client's pension, social security, and cash flow from the bond ladder is sufficient to meet their living expenses, including income taxes. This approach requires that we manage a client’s living expenses, preferably for 5+ years before they retire so we can determine the amount needed from the bond ladder. Note that Treasuries are not included in a portfolio to generate yield, but rather to provide guaranteed cash flow. "Safety Trumps Yield" is our mantra for this portion of the portfolio. We stress liquidity, not performance.

The 15-year span enables the stock market to fully cycle, so that the bond ladder can be replenished during prosperous years. It gives clients assurance that they will not have to change their life style for 15 years, so they don't fret over stock market down cycles and resist capitulating during severe market drops. Even over the past 'lost decade' we were able to rebuild client's bond ladders during the up years of the market cycle, e.g. 2003-2004 and 2009.

Finally, we also factor in savings of 10% of a client's income each year, which is reinvested in their portfolio. Obviously if clients save 10% each year (which they are accustomed to during their working years), they will by definition continue living within their means. This eliminates the need to estimate their life expectancy and makes Monte Carlo theory, which calculates the probability of future investment returns, largely irrelevant because they will never run out of money.

In summary, 'withdrawal rates' that are based on combating inflation are much too simplistic to determine a client's real annual cash flow requirements. The driver for income in retirement is not a ‘withdrawal rate‘ that depends on the Consumer Price Index, but rather changes in expenses needed to support their personal standard-of-living.

Friday, July 2, 2010

The Gold Frenzy

By Bert Whitehead, M.B.A., J.D.

These blogs are intermittent because I only write them when a topic is raised by a client. Clients have recently been asking about Gold, and it’s been in the news since the value has increased to over $1,200/ounce. This is an actual response to a recent client inquiry (edited as appropriate).

Dear Bert,

Please give me your thoughts on reducing the ladder to a more frugal level, and buying gold with the difference. If a person were to buy, say $1mm in gold, would you think storing it in say 5 different safe deposit boxes would make sense?

Hi Joe,

Of course it is your money, so I can advise on whatever you decide to do. I also know that you realize that you tend to be impulsive, and have a knee-jerk reaction to market volatility. This is the reason, I assume, why you emailed me – and I am honored that you do respect my opinion. Now I’ll tell you why I think putting that much money in gold would be a stupid thing to do…

As an investment, gold never has much glitter. It isn’t really an investment, because it can’t be capitalized for growth like bonds or productive equity assets in your portfolio– any profit is based on speculation because gold doesn’t earn anything. Especially in recent years, it has been very volatile because you can now buy ETFs (exchange traded funds), which actually hold gold. As a result, speculators have been alternately dumping money in and pulling it out in sudden unpredictable moves, since they don’t have to take possession of the gold itself.

As an inflation hedge, gold has a terrible record. From 1980-2000, gold prices were essentially flat. Yet, inflation was up 3.7% per year, cutting the value of the dollar in half during that period. This is because we are now experiencing world-wide inflation. Gold can hedge the dollar, but only in relation to other currencies. As we continue growing into a worldwide economy, the dollar moves much more in synch with other currencies, and gold’s value during inflationary times doesn’t protect against worldwide inflation.

As a deflation hedge, selling Treasury bonds to buy gold would leave you extremely vulnerable to deflation, which is the primary global concern right now. If the US dollar were to drop so that it was virtually worthless, you might think that gold would become the substitute currency. The problem is that anarchy would likely erupt, and guns trump gold. So you should plan on having guns and ammo, because you wouldn’t be able to count on the government to protect you.

You could move to another country, and this is a reason why you might consider holding gold. You could take your gold and run if you or your family became vulnerable to adverse governmental action. Your accounts would be frozen, and the only wealth you could transfer with you to someplace else would be your gold. Many people who distrust the government expect that guns would be outlawed, so in a severe social/economic shift you could at least have transferable wealth (assuming there was a country left which wasn’t in anarchy). This situation would likely be endogenous, where one was accused of a crime, or the IRS decided to pick on you and come after all your assets.

There are practical obstacles: Many of my clients, and that includes me, feel more secure having some wealth that is not dependent on the benevolence of our government and their management of the economy. But there are limits = $1,000,000 in gold would weigh over 50 lbs.! That would be a problem to lug across the border!

The US dollar is the world’s reserve currency, which has a unique status and advantage. No other currency (euro, Yuan, franc, pound, etc.) carries enough respect to challenge the dollar…and none of them have enough depth to support world commerce. So where does the smart money run when the world economy gets dicey? The Arabs, Swiss, Chinese, etc. all buy Treasuries, which is why your bond ladder’s current value has been rising so quickly in recent weeks!

Basically, Joe, you already hold the best investment you can have in these fragile times. To hedge inflation, which I reckon we will be worrying about in 6-12 months, think about making sure you have some super 4.75% 30 year fixed mortgages!!

I hope this is helpful.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY., as well as the blog editing by Susan Stanley

Friday, May 14, 2010

Greece: When the Trough Gets Smaller.....

Greece: When the Trough Gets Smaller, the PIIGS Get Meaner!*
Bert Whitehead, M.B.A., J.D.

The credit meltdown in Greece amplified the panic caused by a trading error to cause tumult in the stock market. While placing a sell order, an anonymous trader mistakenly entered ‘1 billion’ instead of ‘1 million’ (oh those pesky decimals…) The overreaction caused by the error subsided for the most part within an hour, but the unfolding events in Greece kept world markets in turmoil.

Watching crowds in Athens and other Greek cities participating in violent protests, to the point of killing 3 bankers, brought the impact of possible economic collapse up-front and personal. While Greece’s debt is not significant relative to other larger common market (EU) countries, it appears that the rest of the “PIIGS” (Portugal, Ireland, Italy, Greece, and Spain) are also teetering on the edge. Each of these countries has accumulated debt equal to 66%-124% of their GDP (Gross Domestic Product produced by a country). Since the gross U.S. debt is now 93% of our GDP, Jason Zweig suggests the US should be added to the acronym: “PIG IS US.”

If the workers in other countries resort to violence as a reaction to the cuts in pay, benefits, and pensions, then their leaders may not be willing to institute much needed reforms, and other EU countries will not be willing to lend money to the PIIGS. International banks have already reacted by tightening credit offerings to customers including other banks.

Early on, Britain managed to sidestep the allure of the Euro keeping control of the British Sterling. But even so their politicians have ignored the dire economics of their situation. Britain must reduce an annual deficit that hovers at 13% of GDP, which is even worse than the U.S. Public spending in Britain is now over 50% of their GDP. There are so many Brits dependent on government spending for their livelihood, that during the election earlier this month not one of the three national candidates mentioned cutting pensions or government benefits. Instead they all relied on the empty promises of populist insanity to ‘reduce fraud, waste, and abuse.’

There is widespread concern that the U.S. is heading down the same path. According to Barrons, government employees in the U.S. are paid 50% more than employees working equivalent jobs in the private sector. This disparity is mostly attributable to factoring in lavish benefits such as holidays, vacation time, generous early retirement packages, and life-long health care. This is why nearly half of the states and cities in the US have huge underfunded pension plans. Already there is an expectation that the federal government will come to the rescue, and some localities have been using Stimulus grants to continue paying pensions.

Currently, 58% of Americans receive all or part of their livelihood from the government. During the period from September 30, 2008 to December 30, 2009 the U.S. accumulated debt has mushroomed from $5.8 trillion to $7.8 trillion. Since then it has increased another 8% so that it now totals over $8.4 trillion. This does not include unfunded liabilities for Social Security, Medicare, and the new national health plan. The popular concern is that the U.S., along with other countries, will buckle under the weight of their spoiled citizenry and inflate their currencies.

But we have reached the point where the real danger is that investors may refuse to loan more money to subsidize nations currently living beyond their means. This is the downside of an interwoven global economy. The fear is that the Greece virus can start a cascade of “the deadly Ds” = downturns, deficits, more debt, downgrades, and defaults. Many on Wall Street expect another financial shock, not unlike the 2008 collapse of credit markets. There is rising concern even about the liquidity of money market funds.

Despite the fears of impending inflation coupled with the dread of more deflation, I would caution against extreme reaction. It is easy to underestimate the momentum of prosperity and the resilience of free countries. Many investors are wondering: “Are stocks undervalued now?” So what is a prudent investor to do?

First, don’t sell off your bond ladder. As bad as the U.S. economy looks right now, it is healthy relative to Europe and most of Asia, and is much more diversified. The economic situation is so complex at this time, that it would be foolhardy to try to predict the outcome with any degree of certainty. That is why U.S. bonds are still considered the monetary safe haven by the rest of the world. Many brokers are stampeding their clients into investments such as commodities, inflation-adjusted bonds, and emerging markets, but these are likely already overpriced and are subject to the mania of market timing.

Gold is a possibility, if it is held as gold bullion. Unfortunately right now the market is dominated with speculators, so selling gold at any given ‘market price’ is chancy. Dollar cost averaging into the market now may seem brazen, but will likely be the winning strategy for the long term. Finally, don’t pay off your 30-year fixed rate mortgage any faster than you have to and pay attention to your liquidity and cash flow.

The one change we are recommending to our clients is to move their cash from commercial money market funds to money market funds that exclusively hold government bonds.

Keeping a balanced investment portfolio that includes government bonds, diversified stocks, and cash has shown to protect clients through all types of economic cycles. Greece may be the harbinger of the New World Economy, but eventually politicians throughout the free world will have to wake up and smell the coffee.

*To paraphrase Dan Sullivan

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY., as well as the blog editing by Susan Stanley

Thursday, April 29, 2010

What To Do When Your House Is Underwater

Bert Whitehead, M.B.A., J.D. © 2010
Almost one of every four homeowners are faced with the sad reality that they owe more money on their home than they could sell it for. In the real estate world, that’s called ‘being underwater.’ This blog is a realistic review of your options, and discusses the biggest mistake people make when they are in this tight spot.

1. If you can still afford to live in your home and enjoy living where you do, stay there. If you are still working (or retired with the same income as when you bought the house and qualified for the mortgage) and living within your means – don’t worry about how much your home is worth because you don’t have to sell it. Your home is an inflation hedge, especially if you have a long-term fixed rate mortgage. In most areas of the country home values will eventually rise again. Keep in mind that one of the primary purposes of owning a home is the joy of living there.

2. If, however, you need to move, then you have to review your options. It may be that you have become unemployed, or your job requires relocation, or you want to downsize to cut expenses. Many people have adjustable rate mortgages that have been reset to a higher interest rate, so they cannot afford to live in their home. The obvious answer is that you can sell the house for what you can get, then sell other assets (perhaps some investments) and bring a check to the closing to cover the amount of the mortgage not covered by your sales proceeds. As we will discuss later, this is often the best option.

Regardless of what you may have heard, the following options (#3-#8) are successful only for homeowners who stop making payments. Banks are not likely to negotiate with you if they are still getting paid…and why would they?

3. There are 12 states* in the U.S. which provide that homeowners have no personal recourse for a mortgage taken out to purchase a principal residence. That means you can just walk away from the loan. The bank will foreclose and sell the home at auction, but they will not be able to sue you for any deficiency should the net sales proceeds not equal what you owe. Your credit score will drop by about 200 points, but this is a viable option. From a moral perspective, keep in mind that you paid a premium (built into your closing costs) when you bought the home to have this option. So it is not unlike collecting on an insurance policy.

In the past forgiven debt was taxable as income but currently this does not apply to cancellation of the unpaid portion of a mortgage used to buy the house. If there is a second mortgage, any unpaid amount may be taxable income.

4. In the 38 other states, if you walk away from your home the bank will foreclose and sell the home at auction. If the house doesn’t sell for enough to pay off the mortgage, they can sue you for the deficiency. With a judgment they can then put liens on other assets (like bank accounts or other real estate) and garnish your wages. So not only are you on the hook for the deficiency (plus the bank’s collection costs and attorney fees), but your credit score will likely crash about 300-400 points and you could have to pay income taxes on the unpaid portion of the mortgage.

5. A better option than foreclosure is to deal with the bank and work out an arrangement called a “deed in lieu of foreclosure.” When banks stop receiving payments, they will be open to talking about this approach. In these situations the bank agrees to have you just sign over the deed so they don’t have the expenses of foreclosure. With the bank’s agreement, you can qualify for non-taxable debt forgiveness. It will cut your credit score by 300-400 points initially, but you end up free of the debt. Again, the bank is not likely to agree to this if you are working or have other assets they can levy

6. In recent years there has been an effort by the government to pressure banks to provide “Loan Modifications” to homeowners who are unable to make their payments and who meet strict criteria. For most people, this is not a viable option. Loan modifications may include lowering the interest rate or extending the term to reduce monthly payments. However banks are not willing to reduce the principle owed. This is a time consuming process, and thousands of applicants have overwhelmed banks. It takes an inordinate amount of time to check applicants and banks don’t make any money beyond the $1,500 offered from the federal government (more red tape) if a loan is modified. Of the 4 million homes in foreclosure last year only 2% were approved for modification and 2 of every 3 modifications were in default again within 6 months.

7. Most homes selling now are ‘short sales.’ This requires the owner to find a buyer at a reduced price. If a bank accepts the low offer, the owner signs the house over to the bank and the buyer/investor buys the home from the bank and the bank releases the owner. Thus, there is no deficiency and the forgiveness of debt does not trigger a taxable event. It will knock about 250 points off your credit score. There are now some real estate agents who specialize in these transactions, although most avoid getting involved because of the paperwork, the time commitment, and very small commissions.

8. The final solution for most people who need to move from their home is to continue cutting the price until it sells, even though it means taking a check to the closing to pay off the mortgage. There are very few buyers in the market now, mortgages are difficult to get, and appraisals are very conservative. So even if you get a willing buyer at a reasonable price, often the appraisal will not be high enough to get a mortgage. As prices drop, this process reinforces itself.


You can sell your house if it is priced right but the ‘right price’ has nothing to do with what you paid for it, what you invested in it, what it was worth 3 years ago, or how much you owe on it. The ‘right price” is what someone in this market will pay for it.

To arrive at the ‘right price,’ recognize that pricing is a process, not an event. Start by listing your house somewhat below other comparable houses in your neighborhood. Keep in mind that current listings are overpriced – otherwise someone would have already bought them. Then ruthlessly cut the price on your house every 6-8 weeks by 5-10%, and keep cutting until you get an offer. Cutting the price will put you on the top of the pile and keeps your house from becoming a ‘stale listing.’

This makes good financial sense when you realize the tremendous carrying costs of a vacant house. Ignoring carrying costs is the biggest mistake people make when they face this scenario. Carrying costs generally run about 10% per year of the home’s value and include the house payment, taxes, insurance, repairs and upkeep, as well as opportunity costs for the equity (if you still have equity.) So if your home is worth $400,000, the carrying costs are about $40,000/yr. If you are determined to get your price, you might easily wait 2 years until the market bottoms out. Then you will have paid out $80,000 in carrying costs. Now it will have to appreciate 30%-40% per year for the next two years for you to pay 2 more years of carrying costs plus ‘catch-up’ appreciation for you to break even. To expect this spectacular market turnaround is na├»ve. You’re better off selling the home for $350,000 now, and in two years you will have avoided $80,000 in carrying costs.

Living in a home you can’t afford, or trying to rent it out, doesn’t change the math much either because the carrying costs don’t take into account the continuing drop in home values in most areas. In many areas there are huge inventories of unsold homes in foreclosure, and we are facing another tsunami of homes likely to go into default in the next year or two as all the of 5-year adjustable mortgages from 3-4 years ago are reset.

Keep in mind if you use any of the techniques in this article, under a new federal law you will not be able to obtain a new mortgage for 4-7 years. If you lost your job, or had a catastrophic illness, this disqualification period is shortened to 2 years.

Of course, each situation is different. It is advisable to get professional advice from someone whose compensation is not dependent on the outcome of your decision. The upside is that, if you are buying a home, you will very likely find a great bargain once this housing bust ends!

*AK, AZ, CA, CT, FL, ID, MN, NC, ND, TX, UT, WA – laws vary by state.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY., as well as the fact-checking of Terry Fraser (Mackinac Bank), and Trevor Smith (Incline Village Real Estate), and blog editing by Susan Stanley

Thursday, April 8, 2010

What’s Next: Inflation or More Deflation?

Bert Whitehead, M.B.A., J.D.


Excessive government spending fueled by ‘printing more money’ or selling Treasury Bonds always raises the specter of runaway inflation. Inflation causes prices to rise rapidly, and is measured by the Consumer Price Index (CPI). Since the current downturn in 2008, the CPI has barely risen, and some measures of CPI actually indicate deflation (which is why retired folks didn’t get a CPI increase in their Social Security benefits this year).

Financial journalists, who write articles and commentary, as well as advertisements selling gold as an investment, often predict future inflation and point to reckless federal spending that erodes the future value of the dollar. Some suspect that government believes it can solve our economic issues by adding programs that will eventually pay for themselves (even though they never have in the past). These commentators may well be right. Inflation is created by too many dollars chasing too few goods. As the money supply increases on a vast scale many armchair economists are convinced that run-away inflation is inevitable.

The economic environment of the 1970’s is often offered as an example of government bungling that poisoned the financial markets. The 70’s remind us of wage and price controls, gas rationing, and oil prices increasing at the whim of the oil cartel. Yet these aren’t pertinent to today’s issues (so far). There are some parallels to the ‘guns and butter’ deficits (i.e. Vietnam and expansion of social services), distrust of government leaders, and the federal government artificially holding down interest rates. So while rampant inflation is a potential outcome, today’s economy doesn’t compare exactly with the 70’s. Inflation is not the only possibility.

Another possibility is the opposite of inflation, or deflation, which is characterized by too few dollars being available to purchase the goods and services being produced. If there is not sufficient ‘velocity’ in an economy to maintain ongoing economic growth, then prices, wages and employment can all decrease. I am more concerned about deflation than inflation in the future because deflation hits suddenly, whereas inflation typically increases gradually.

The Great Depression is the most common example of the deflation vortex. It was very difficult to obtain bank loans, so businesses had to scale back production and inventories. Lower sales created more layoffs, leaving even fewer people to buy goods and services. Deflation, once ignited, can become a voracious beast that sucks the life out of an economy.

Some economists believe the programs initiated by FDR pulled us out of the Great Depression. Others believe that the federal intervention created ‘make-work’ programs that made the situation worse. They note that we didn’t recover until we went into World War II. World wars are a horrible way to create full employment.

But what about today? As in the past the government is intent on increasing the money supply to help the economy move forward. Is deflation a possibility? I think so. There are at least three current phenomena, which can deflect the impact of increasing the money supply, and result in deflation rather than inflation.

The first is productivity, which measures G.D.P. This is the output of goods and services produced per worker. If productivity increases while the money supply is increasing, the impact of inflation can be nullified. Generally, recessions are initially accompanied by increased productivity as firms lay off the least efficient workers. This, of course, creates higher unemployment and puts downward pressure on prices. During the current ‘recession,’ productivity has steadily increased.

When the government creates ‘make-work’ jobs, which do not increase G.D.P., economic activity may be propped up temporarily. But this approach is not sustainable and could ignite inflation. If it were to continue, the economy would reach the point where virtually everyone worked for the government, as in Russia during the Cold War. But these daily lives without private incentive ultimately create economic collapse, sometimes expressed by the Russian saying: “We pretend to work and they pretend to pay us!”

The second factor is personal savings. If the personal savings rate increases in step with increases in the money supply, then less money is being spent. As monetary velocity drops, there are fewer buyers, and eventually fewer workers. Japan experienced this during the ‘Lost Decade’ of the 1990’s when they did not address the core problems with their banking system. As the Japanese government tried to “paper it over” by printing more money, people who increased their savings thwarted its efforts. It should be noted that the personal savings rate in the U.S. has increased from 0.5% at the beginning of this recession to 6.0% currently.

The third factor that comes into play is the global economy. Alan Greenspan, the former Chairman of the Federal Reserve, commented as he stepped down from office that he had been baffled by the low inflation in the 90’s despite large increases in the money supply. But by the end of his term he had identified that the expanding global economy enabled production to move to the least costly sites, which offset inflationary pressures.

Consider a ‘Perfect Storm’ of higher government spending and expansion of the money supply, offset by 1) higher productivity with high unemployment, 2) increased personal savings rates generated by widespread fear, and 3) protectionism exacerbated by a cycle of retaliatory tariffs strangling the global economy. This could create a much more destructive deflationary spiral than creeping inflation.

I am not forecasting this outcome for our economy. But it is a significant possibility that concerns me. That’s why we continue to structure our clients’ net worth using the guidelines of Functional Asset Allocation. This approach is designed to hedge against both inflationary and deflationary environments, as well as provide for long-term portfolio growth whenever we are fortunate enough to return to a period of prosperity.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

Tuesday, March 2, 2010

Roths Now Make the Tax Code Your Friend!

Bert Whitehead, M.B.A., J.D.©

Starting in 2010, the Tax Code opens up vast opportunities to increase Roth IRA participation for many taxpayers. As I will explain, you will need to consider at least 11 issues or possible strategies to make the most of this and determine the final formula that will reduce your long-term income tax bill and address other financial goals. But I caution you from the outset…Roth conversions are a hot topic with brokers and investment advisors who want to use this as an asset gathering gimmick or earn commissions from transactions. It is a complicated opportunity, and demonstrates how a comprehensive Financial Advisor who handles your taxes, investments, and estate planning is able to add value.

Here’s a review of some Roth IRA basics.

You probably know that if you work and your overall income is low enough, you can contribute to a Roth IRA as one of your annual IRA contribution choices. Your contribution is taxable (that is, you cannot deduct it on your tax return) when it is made. Age 70 ½ distributions are not required and, if taken, withdrawals in later years are totally free from income tax. Depending on your circumstances, this can be a huge advantage. A Roth IRA contribution of $5,000 can grow to $80,000 if invested at 7% over your working career, and you would save taxes on $75,000!

The only way to fund a Roth IRA other than an annual contribution based on earned income is to “convert” an existing IRA (or similar pre-tax retirement account) to a Roth IRA and pay tax on the current IRA distribution now rather than at age 70 ½. . In the past, your total adjusted gross income (AGI) had to be under $100,000 to avail yourself of this option. This is the big change this year.

Starting in 2010, you can convert any of your IRA’s to a Roth IRA no matter how high your income. While you do have to pay the income taxes now, remember that future withdrawals from your Roth IRA are tax-free! The reason why 2010 is a big year is two-fold; 1) there is special relief when paying the income taxes that result from any 2010 Roth conversion and 2) we are all facing the threat of rising income tax rates.

Here are some points to ponder and strategies to consider. Again, these can be complicated so you should expect to discuss whether these apply to you during the year when you do tax planning with your ACA advisor (i.e. a member of the Alliance of Cambridge Advisors).

#1: Got negative tax? A Roth conversion creates taxable income because of the IRA distribution that funds the Roth, so it certainly is advantageous to convert whatever amount you can if you have negative taxable income. It’s an opportunity to declare income and pay no income tax.

#2: Defer taxes…again! There is a quirk in the law for 2010 that lets you choose to either pay taxes on the 2010 conversion as 2010 income, or pay half the taxes of the 2010 conversion in 2011 and the other half in 2012. There is no interest or penalty to doing the latter, so it would generally be a good option.

#3: Automatic extension. If you are unsure whether your tax rate will be increased in 2011, you can convert to a Roth in 2010 and then file an automatic extension in 2011 so you don’t have to file until October 15, 2011. Then you may know whether your tax bracket has increased or not. If your bracket is being increased you can elect to pay taxes at the 2010 rate.

#4: How much to convert? If you aren’t sure how much to convert, keep in mind that you must make the 2010 conversion before 12/31/2010. However if you convert too much, you can elect to ‘recharacterize’ part or all of your conversion up until you file your 2010 return (i.e. until 10/15/2011) and put it back in your IRA without penalty. So you should always covert too much rather than too little!

#5: In-kind. When converting an IRA to a Roth, you can transfer your IRA investments ‘in kind’ to the Roth without having to sell them and buy them back. If you have a broker, make sure you let him or her know that you know that you don’t have to “sell” (pay a commission”) to convert.

#6: Outfoxing Mr. Market. If the investments drop after you convert them, you still must pay taxes on the value of the holding when converted. How do you preserve the value of the investments that you converted? For many clients, we are setting up 2 Roth IRA accounts: one for bonds and one for equities. We will transfer the full amount to be converted to each Roth IRA, using Stripped Treasuries to go into the bond Roth, and stocks or equity mutual funds into the stock Roth. Then in October of 2011, if stocks have dropped, we will recharacterize that account back to an IRA and do likewise with the bond account if stocks rise.

#7: Asset Location. To optimize ‘asset location,’ Roth investments should be in assets with the highest potential returns, such as small cap or international mutual funds. If using #6 above, and the stocks are recharacterized back to the regular IRA, they should be sold to buy back the bonds and the bonds in the remaining Roth account should be sold to buy back the stocks.

#8: Efficient cash flow. Long-term tax management and tax efficient cash-flow strategies are enabled through the use of Roths. Since there are no minimum required distributions for Roths, taxable distributions are reduced and Roth distributions can be used to maintain cash flow while keeping taxes low in retirement.

#9: Coordinate with charitable contributions using Donor Advised Funds. If you intend to include charities in your will, consider gifting stock now to your Donor Advised Fund in about the same amount that you are converting to your Roth. The tax deduction for the charitable contribution can then offset most of the additional amount of taxes due to the Roth conversion.

#10: The Next Generation. This is an unprecedented opportunity for intergenerational planning. The beneficiaries (spouse, children, etc.) of Roth accounts have the same advantages of taking tax-free withdrawals. If you don’t need the IRA money during your lifetime consider the benefits of not paying income taxes on many years of compounded investment growth.

#11: Reduce onerous estate taxes. Using assets to pay income taxes now reduces your estate for estate tax planning and provides a way you can pay the future income taxes for your children or grandchildren now. (note: as of the date of this blog there is no estate tax. Rules are in flux but it’s a good bet that they’ll return in the future.)

Although it may be obvious, note that Roth conversions also appeal to the federal government because they can tax your pre-tax IRA money now, rather than in 20 or 30 years! But that’s why it’s important to at least review the above points to see how the current legislation affects you. Since your ACA Advisor knows your comprehensive financial plan more intimately than anyone, there may be even more points and issues to discuss.

Be sure to look at these ways to make the Taxman your friend in 2010!


I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

Monday, February 1, 2010

How Do the Wealthy Get That Way?

Bert Whitehead, M.B.A., J.D.

Unless you are in the wealth category of Bill Gates and Warren Buffet, you probably realize that many people are richer than you are. So how did they get that way?

• Did they have the advantage of a large inheritance?
• Was it because they were self employed?
• Could they have married into a wealthy family?
• Were they “penny pinchers” for their whole life?
• Did they have high I.Q.’s?

None of these reasons fully explain the ‘millionaire’ phenomenon. I have read the popular books on this topic (The Millionaire Next Door, The Automatic Millionaire, Rich Dad, Poor Dad, etc.) I have also reviewed academic studies on this topic. But most of my insights come from working with clients for over 30 years, many of whom did become millionaires. These are my observations and conclusions:

1. Wealthy people are made, not born. 80% of millionaires are the first generation of their family to become wealthy. Interestingly, most of the very wealthy families leave a major portion of their estates to charity. Children, who inherit significant wealth, without achieving it on their own, seldom manage money well. As one wealthy man told me, “If money comes too easily, it isn’t properly respected.” A large inheritance can often undermine the character of the recipient because they don’t need to focus on adding value to the world. This often happens when parents continue to support adult children.

2. Self-employed people are more likely to become wealthy. Overall 20% of our population is self-employed, while 75% of millionaires are self-employed. This high percentage is largely attributable to self-employed professionals like attorneys and physicians. The others, who are entrepreneurs, are as likely to go bankrupt as they are to become wealthy. Those entrepreneurs, who do accumulate wealth, as well as the professionals, have other attributes.


3. Most millionaires became wealthy because they picked a spouse who helped them realize a dream. Seldom do people become millionaires totally by themselves. On the contrary, one of the significant obstacles to accumulating wealth is choosing partners poorly, especially spouses. I call divorce “the process of mutual impoverishment.”

4. Some wealthy people are very frugal, even to the point of being penny pinchers. Popular writers often glorify this trait as the path to riches, urging readers to forego lattes, drive old cars, and to never move to better neighborhoods. While living within one’s means is critical, as discussed below, developing a penurious character is a form of financial dysfunction. Misers never know ‘how much is enough’ and develop an obsession to save more money. In my opinion this trait is a barrier to good socialization and prevents people from enjoying the wealth they do accumulate.

5. The people that I have seen become wealthy are smart – but not necessarily the kind of “smart” measured by an I.Q. test. They have come to recognize and appreciate their unique gifts and advantages, and use their abilities to create value for others. When a high I.Q. is coupled with an expectation that one deserves special treatment, it is a hindrance to achieving wealth.

How much does it take to be wealthy? I think that financial wealth is measured by a balance sheet listing assets vs. liabilities, rather then an income statement because it demonstrates the resources that can be put to work to create more money. Statistically only 3.5% of the 115 million households in this country have net assets of over $1 million. 98% of those have a net worth between $1 million and $10 million. The 2% who are ‘super-rich’ are not addressed in this blog.

I have noted two attributes which apply to most millionaires. The first is that they value education, and are generally well educated themselves. As my mother often said, “Investment in education is the best investment that can be made, because it can never be taken away from you!” Education is the strongest predictor of future earning capacity.

A high income alone doesn’t make someone a millionaire. There are many athletes, movie stars, gamblers (including lottery winners), and highly paid executives who never are able to accumulate wealth. The reason is that they keep ratcheting up their standard of living to keep up with their income. So when their income drops, they don’t have the financial resources to provide the cash flow to maintain their life style.

This doesn’t only apply to high income people; many low income people stay poor because they live beyond their means. I find that the easiest way to tell whether a new client is living within their means is to examine their credit card statements. If someone consistently carries a balance on their credit cards, they are living beyond their means.

Thus the second attribute of the wealthy is their ability to live within their means. This translates into a life-long habit of always saving at least 10% of their income. Even those who aren’t fortunate enough to have a good education can become financially independent if they consistently live within their means and save 10% of what they make starting at an early age.

It’s that simple: to help your children become wealthy, make sure they get as good an education as possible, and teach them to save a dime of every dollar that they earn starting with their first allowance!

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

Friday, January 8, 2010

Lessons from the ‘Lost Decade’

Bert Whitehead M.B.A., J.D.

The ‘Dow’ and the ‘S&P’ are the most common indexes of U.S. large company stock valuations. At the end of 2009 they closed lower than their opening values at the beginning of 2000. As a result, many economists have dubbed the ‘aughts’ (2000-2009) the ‘Lost Decade.’ They claim that there were no investment gains in the large cap stock market for these past 10 years.

Active money managers will point to the performance of these indexes to crow about the futility of ‘buy and hold’ investing. These managers insist that they are able to add value to an investment portfolio by buying low and selling high, instead of just holding onto stocks. This observation is, of course, tainted with self-interest.

Many ordinary people have sworn off stock market investing because they lost so much money during this period. And with current short term interest rates so close to zero, they are tempted to simply invest in junk bonds or municipal bonds, ignoring that these may be today’s outsized risks.

The truth is that the loss of 8.7% in the Dow during the ‘Lost Decade’ is mostly attributable to the selection of the “starting line.” The beginning of 2000 was near the peak of the ‘dot-com’ bull market. If you start the chart just two months later at the end of Feb. 2000, “voila!” … the market shows a gain! Start the chart two years later in Feb. 2002 and there is a 30+% gain by the end of 2009.

The S&P index outperforms 85% of money managers in the large cap arena over most any 20-year period. The reason? Money managers keep cash in their portfolios, whereas indexes are by definition fully invested. Therefore, managers tend to underperform less in bear markets, and underperform more bullish markets.

If there are any lessons to be learned during the ‘Lost Decade’ it is not about the investing prowess of the active money managers but rather: 1) the advantage of dollar-cost averaging (DCA), especially in down markets; and 2) the necessity of having a diversified portfolio.

DCA is a strategy by which you invest new money on a regular basis, usually monthly, instead of investing all your cash at once. It protects you from investing at the WRONG TIME because you are investing all the time. Most people use their 401Ks or other retirement accounts for their primary investing activity, so they use DCA by default. Investing a fixed sum each month helps you buy more shares of a stock when the price drops. Investing $1,000 per month (plus dividends) over the past ten years would have resulted in a small gain (3.2%) rather than a loss.

Diversifying your holdings beyond large cap stocks protects you from investing in the WRONG TYPE of investment. You shouldn’t invest in any one thing but, rather, in everything. For example, during the past 10 years, small cap and foreign stocks on average appreciated over 30% including reinvestment of dividends. The Vanguard REIT (Real Estate Index) was up over 50%. 20-year Treasury bonds had an average yield of over 5% increasing over 60% during the period.

Dollar Cost Averaging and Diversification are the two primary strategies you can use to avoid investment mistakes. But having said that, the average annual return of a well-balanced portfolio from 2000-2009 (6-7%) fell short of returns for similar prior periods. We usually use assumptions of 7-8% returns for conservatively balanced portfolios over the long term.

Interestingly, the return of a conservatively balanced portfolio achieved the 7-8% long-term return if you start the chart 15 years ago…there’s that starting line issue again.

All of this is small comfort if you bought a home five years ago. Depending on location the value of your home may have dropped over 50%. This is made even worse if your 401Ks have decreased in value despite your contributions over the past ten years. If you lost your job on top of these other setbacks, the last ten years have been ruinous.

No matter what your level of loss, beware the temptation to offset your losses by timing the stock market. It only aggravates your misfortune. Studies repeatedly show that, on average, individual investors who buy and sell stocks in their portfolio underperform the market by a wide margin of 5-7%. They constantly fall prey to trying to select the best time to invest and the best type of investment. It’s far better to avoid this situation by not capitulating to your fears when the market drops, only then having to face buying in a greedy frenzy when the market rises quickly.

The final lesson of the Lost Decade is that it’s merely a story line for writers and editors who need to sell their publications with “new ideas” and “what to buy now!” insights. The Lost Decade is merely the last decade. Select a different time to measure and you come up with different results and story lines.

Unfortunately, the most boring story of all, that consistent investing during good times and bad, is also the most successful for those willing to stick to it. The only problem with it is that it just doesn’t sell this month’s magazine!


I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.