Bert Whitehead

Is It Time to Panic Yet?

2012-01-25T11:08:00.000-08:00

By Bert Whitehead M.B.A, J.D. © 2012

Some days it seems like our economy is improving, then you turn the page and major world problems (Mideast, Europe, Korea, etc.) are just getting worse.

So what if you are a baby-boomer (or older) and are starting to think that your retirement isn’t going to be as joyful as you expected? Or maybe you are younger than that but wonder about your ability to take care of your parents, put your kids through college, and ever have enough money to retire yourself?

To evaluate yourself financially you need to answer four basic questions:

1)Are you living within your means?
2)Are you saving at least 10% of your gross income?
3)Are you covered for possible catastrophes in your life?
4)What is your ‘Plan B?’

You will note that these four questions have nothing to do with the worldwide currency crisis, the future of the stock market, or the political outcome of the next election. Instead, they refer to issues that you can directly control.

1)Are you living within your means? I have a short cut to figure this out. Do you pay off your credit cards in full every month? If you do, you are generally living within your means. If not, or if you have to take out loans (home equity, more credit cards, etc.) to pay off your credit cards, you are living beyond your means.

If the latter applies, you are probably spending more than your take-home pay and the shortfall shows up on your credit card. If you have tried to restrain your spending and have not been successful, it is usually because you have ratcheted up your standard of living beyond what you can afford. Being ‘house poor’ often causes this. That means that you have too much house, and to cut your spending you will have to downsize. Downsizing is much easier if you are relocating into another housing market.

2)Are you saving at least 10%? When we talk about ‘saving’ in this context, we are talking about long-term permanent savings, i.e. your investment portfolio. People sometimes emphatically assure me that they have been saving money regularly for years, but they have not accumulated an investment portfolio. They confuse ‘saving up to spend later’ with ‘saving for long-term investments.’

The financial objective of long term permanent savings is to invest enough during your working years so that later in life you can live off the money your money makes, rather than from the sweat of your brow. This is required if you are to be truly ‘free.’ Those without an investment portfolio are destined to have to work their whole lives, depend on the benevolence of others, or live in poverty.

3)Have you protected yourself against catastrophes? The best-laid plans can be derailed by unexpected calamities. Sudden medical conditions or disability, loss of car or home, unexpected death, lawsuits, etc. are all dangers than you seldom have to deal with, but they do happen and they can be devastating.

Basic insurance coverage and simple estate planning can shield you from these hardships. Although you might set these protections up, it is easy to forget about reviewing them. Then when you need them, they may be stale or inadequate. Make sure they are updated at least every five years, or whenever your life situation shifts (marriage, children, family deaths, etc.).

4)Do you have a ‘Plan B’? Even when people have done everything ‘right’ (i.e. #’s 1, 2, and 3 above), life can present unexpected challenges that they can never prepare for. Even with a college education, you will never be certain to have a job. You may take risks that flop, like starting a business. Shadowy medical conditions, like depression, might go unrecognized and can be debilitating.

For some younger people, Plan B is moving back with their folks. For some older people, Plan B is moving in with their adult children. Plan B might simply entail a willingness to drastically reduce your living standards so you can maintain your independence.

Sadly, my experience has shown me that many people live lives of quietly repressed panic, with an intangible sense of deprivation anxiety. They may not recognize it themselves, but a sense of financial foreboding shadows their lives every day. This can lead to behaviors like intense miserliness or as denial expressed by mindless spending. Others distract themselves by focusing on the possibility of widespread debacles due to economic and social issues. They spend their time playing “Ain’t it awful…” with their comrades in fear. They may overreact by radically altering their financial positions (“gold and canned goods.”)

I find that our present times have not changed much from past times. I recently saw the movie “The Iron Lady” which reminded me that we were dealing with the same issues 30 years ago as we are now. Somehow we, as a people, are able to rise up and defeat fear.

The real danger is not outside of us in the economy or the country. Our biggest danger lies within ourselves. We cannot control our individual destiny by anxiously reading the papers and watching TV. After all, magnifying the negative is much more profitable for journalists than reporting slow, steady progress.

Review your own situation and make the changes you need to make so that you can answer ‘Yes!’ to each of the four questions above. Then I can assure you, it is not time to panic!

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

How to Get the Best Mortgage

2011-11-02T09:17:00.000-07:00

By Bert Whitehead M.B.A, J.D. © 2011

The most popular client questions these days are about what kind of mortgage they should get. If you are somewhat knowledgeable about mortgages and just want the bottom line, you can skip to the last paragraph of this blog. If you are interested in a more detailed explanation, please continue reading.

Not only are mortgages more available now for new homes, but current mortgage holders can also find great opportunities to refinance at a lower rate. The federal government has just announced a new refinancing program for homeowners who are “under water” on their homes (i.e. they owe more on the house than it is worth). The last two similar programs never got much traction, and it is doubtful that the new program will bring serious relief to many people.

To get a new mortgage or refinance at the lowest rates you have to be able to show that you “qualify” for the mortgage. Here is a quick summary of the standards banks seek:

1. Clean credit record (FICO = 700+).
2. 80% loan-to-value (LTV). The mortgage should be less than 80% of the value of the home.
3. Currently employed.
4. Monthly payments on current debts (including mortgage) less than 40% of income.

There are some exceptions to these standards, e.g. if you replace a mortgage on your primary residence and you have always made the payments, some banks let you refinance 90-100% of the home’s value. But, in general, you won’t get the best rates available unless you meet the above criteria.

Mortgage financing is a very competitive field so you should check with at least 3 banks or mortgage companies. Rates move daily, so it’s preferable to call all three institutions on the same morning. I suggest that clients request a quote on “a 30-year fixed rate mortgage with no points, no prepayment penalty, and with the closing costs rolled in.”

Be aware that even with no points and no prepayment penalty, there will still be certain costs that you are expected to pay at the closing. The appraisal fee, for example, is an out-of-pocket cost to the lender. Property taxes also have to be paid as well as interest payable from the date you close to the beginning of the next month. Many people prefer that property tax and insurance costs be “escrowed” so that an amount is added to the monthly payment to pay for these costs as they come due.

Having your closing costs “rolled into the mortgage” means adding any costs that are normally due at closing to your mortgage balance. The cost of those will be covered by your monthly payment. You should ask each lender to email you a “good faith estimate” of the mortgage they propose. Then you can verify that the terms offered are those you requested and compare the closing costs.

The most common stumbling blocks encountered by clients are:

1. The house doesn’t appraise high enough. You can get your own appraiser to see if the bank’s appraisal is wrong, but they won’t accept it to lend you money. If it is under-appraised significantly you might apply at another lender and they will have it appraised again. While there can be wide variations in appraisals, there are no guarantees.
2. Unanticipated black marks appear on your credit score. You have to contact the credit bureau to correct these.
3. Your income is insufficient. This often happens to retirees who live on investment income. We have clients set up a monthly transfer from their investment account to their checking account for the same amount each month on the 1st of the month. If you do this for a couple of years, lenders will accept these transfers as a reliable stream of retirement income.

Don’t let lenders talk you into a shorter-term or adjustable rate mortgage, which can be more profitable to the mortgage institutions. Other mortgage options may seem attractive have a lower interest rate. But a 30-year mortgage has three huge advantages:

1. You receive the lowest payments so you have more cash flow. If you regularly invest this extra cash, preferably in a retirement account, you will earn more in a balanced portfolio than you will save in interest when compared to other mortgage options.
2. Since mortgage interest is tax deductible, a longer mortgage provides more tax shelter than shorter-term mortgages at a lower rate.
3. Most importantly, a 30-year fixed rate mortgage is your best protection against inflation. If interest rates stay stable for the next 30 years, your worst case is that you break even plus a bit more. But if interest rates drop, you just refinance and your monthly living expenses drop. If we have a return of high inflation (as occurred in the 1970’s) – you win! You have borrowed thousands of dollars at a low fixed rate, your money market rate increases to 8%, 10%, or even 15%, AND you get to repay with cheaper dollars!

Summary: Call three different mortgage companies on the same morning to ask for quotes (we can suggest a couple and your Credit Union may be a good source). Get a 30-year fixed rate mortgage with no points, no prepayment penalty, and have closing costs rolled into the mortgage. Have each institution email you a good faith estimate. Each estimate should show no closing costs paid out of your pocket, except to fund escrow. By comparing the monthly payments, you can easily determine which is the best deal.

By the way, if any of the offers sound too good to be true, then that likely is the case. But be sure to pay attention to any offers made by your current lender. They want to keep their customers happy…so you might find some excellent offers made by a relationship that is already in place!

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

What's the Worst Case?

2011-10-06T12:17:00.001-07:00

By Bert Whitehead M.B.A, J.D. © 2011

Headlines scream doomsday to us: “The Dow is down 14%!” “Who can fix Europe?” “Even gold is crashing!” “Could the Dollar become worthless?”

I have been hearing concern from clients lately, especially since it looks like we are headed for a ‘double dip’ recession. Other than Treasury bonds, all other investment options --- from stocks to junk bonds to real estate --- look awful, except to those few among us who can stand the risk of buying into a downward spiraling market. And with the 30-year Treasury yielding less than 3%, forget about finding a safe haven. So what is the worst that could happen?

Right now there are few signs of near-term hope anywhere in the globe. Worldwide manufacturing is down, and even China is facing the possibility of explosive inflation and rising unemployment. Greece and other weak EU countries have imposed severe austerity programs, but still can’t balance their budgets. Understandably, their EU partners are more and more reluctant to lend them more money. While the US dollar is still the world’s reserve currency, it is universally acknowledged that our country is significantly less credit-worthy than anytime in the past 75 years.

While we complain about gridlock in our federal system, there is a wide chasm of disagreement among intelligent, reasonable people as to whether the right approach is strict austerity, or more stimulus. Even the ‘balanced’ proposals clearly lean sharply toward one side or the other.

Greece gives us a glimpse of the worst case. They avoided cutting their spending for decades and now the forced austerity measures require cutting pensions, reducing bloated government employment, and clamping down on welfare, etc. Greek citizens are spooked by large tax increases and concern that Greece will be expelled from the European Union. These extreme reactions are creating civil unrest including riots, attacks on banks and bank employees, strikes, and more backlash across the country.

Since Greeks don’t have enough Euros to sustain themselves, local alternative currencies (dubbed ‘TEM’ ) have sprouted. Basically this is a hybrid of a local currency and a barter system. Used most heavily in personal services, people are paid in TEMs for baby-sitting, computer support, language services, and they may receive discounts at some local stores. They sign up online for accounts that track their transactions using a data network firm. Since these local financial systems provide many social services, the government has given them encouragement and non-profit status.

Pensioners, unemployed people, and even children are now tending gardens to produce food to sell, opening bicycle repair shops, expanding open-air markets, etc. Individuals perform many social services that the state can’t pay for. In short, Greeks are able to create their own jobs and increase national productivity by tapping individual initiative. All of this is ‘under the table’ so taxing these transactions to support critical government services, like police and fire departments, has become a problem.

This approach has elements that appeal to both sides of the political spectrum. It bypasses the government, bank and corporate ‘establishment’, it is viewed as energy-efficient, and it mends the social network. On the other hand, it champions entrepreneurship, ducks government regulation, and is a primitive nursery for laissez-faire capitalism while promoting individual freedom. What’s not to like?

This system is likely to work more smoothly in small towns than in large cities despite the fact it carries the dangers of insufficient regulation (e.g., contaminated food, untrained doctors, etc). Furthermore, it does not provide capital necessary for investment in mass production, so in the long run many people would suffer a reduction in their standard of living (only 3 pairs of shoes, smaller variety of food choices, forced to use public transportation, etc.).

While playing out in Greece now, this scenario could spread to other countries that are on the brink of economic collapse.

The worst case in the US at this point is rising unemployment, lower wages, and a return to the discomforts our forefathers experienced during the Great Depression. This is far from likely. And while the dollar is not very desirable internationally, every other currency alternative is even less desirable.

The thing to remember is that, at the end of the day, your individual future is more likely to be affected by endogenous factors: the health of you and your family, your personal employment situation, and living within your means. Your real ‘worst case’ is to spend days fretting about what’s on TV or in doomsday newsletters, and then deciding to pursue some extreme reaction such as putting everything in gold, or putting the cash under the mattress.

This blog is intended to assure you that even in the worst case, the sun will rise tomorrow. It is unlikely that the dire consequences outlined above will occur, but the transition from where we are back to ‘happy days are here again!’ may be challenging for us. Nonetheless, what we do in our own lives is more important than whatever ‘they’ are doing.

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

Why Not China?

2011-09-12T13:12:00.001-07:00

By Bert Whitehead M.B.A, J.D. © 2011

With virtually all investment options so sour these days, clients are increasingly interested in the opportunities offered by investing in China. The stock market is totally unpredictable and, for many people, downright scary. Interest earned on savings accounts at banks is next to nothing, and now banks actually charge fees to large cash depositors (like corporations) for just accepting deposits. U.S. Bond returns are the lowest in history, making junk bonds tempting even though they yield less than Treasuries did 10 years ago.

So China’s economy seems like the bright spot in an otherwise bleak investment landscape. The People's Republic of China (PRC) has ranked as the world's second largest economy after the United States since 2010. It is one of the world's fastest-growing major economies, with consistent growth rates of 5% - 15% over the past 30 years. Many investors believe that the Chinese economy is poised for continuing growth, even in the face of economic downturns in other parts of the world.

However, there are some serious dangers that cannot be ignored when you consider investing in China. The principal dangers are debt and inflation. Keep in mind that the ‘Cultural Revolution’ ended 30 years ago and the recent 30 years of growth started from a very low base. Since then, China has become the largest exporter to the world (as well as the largest importer). To accomplish this China lent massive amounts to its cities and provinces for huge infrastructure development. Many of these projects have not worked out as expected, e.g. the bullet train project recently derailed. A notable cause of these problems is the rampant corruption in Chinese government.

Although China’s large low-paid labor pool is a huge advantage, government spending has also created very high rates of inflation. Inflation rates have been running at 6.5% nationally but reach 20-25% in urban areas. As a result, Chinese workers have been on strike in major industries, often forcing wage increases of 50-100%. That caused labor intensive industries to begin moving out of China to lower cost countries like Vietnam, Indonesia, and Malaysia.

From an investment point of view, China does not offer any of the market disciplines and infrastructure offered in developed countries. It is difficult to be sure that the stock you bought is actually registered in your name. And a dictatorial government can nationalize and seize ownership of companies and whole industries at the whim of the ruling class.

Socially, China’s ‘one child’ policy is now coming back to haunt them. Over the past 30 years over 400,000,000 girls have not been born, often through selective abortion. This is more than the entire U.S. population. As a result there are now 118 men for every 100 women. This imbalanced sex ratio can be a social scourge, which forces the government to rein in the excess testosterone. Societies with a high male sex ratio have historically been prone to war, and often exhibit leadership by severe autocratic rulers (such as in the Middle East where polygamy is the rule for the most powerful). China’s demographic projections likewise are dismal. Current population distortions make it a near-certainty that in the next 30-40 years, four younger workers will be required to support each person over 65.

While concerns have been raised about China’s military prowess, particularly its ‘Million Man Army” (which is now actually 2.8 million), these fears are unfounded. The Chinese are than woefully unprepared for their own defense, much less aggression. They spend less than 2% of their budget on defense. More importantly, there is not a single officer (or enlisted person) in the huge Chinese army who has any experience whatsoever in battle. China’s last battle with a worthy opponent was 60 years ago when it was allied with North Korea.

China will pay a steep environmental price for trying to sustain its growth. Like all Communist countries, economic progress trumps their environmental concerns. Their garbage problem is totally unmanageable, the air is hopelessly polluted, and the water in most rivers and streams is virtually toxic. China’s primary competition is probably India, which also has over one billion people. India’s growth rate has been more restrained, and it has a better democratic foundation despite the problems peculiar to its society. Interestingly, India has the largest population of English speaking people in the world (over 500,000,000)! India also attracts much more Research and Development employment due to its advantage in education. Over the past 10 years U.S. companies have switched to investing in India rather than China due to the Chinese government’s overbearing demands that they be privy to US trade secrets.

All in all, investing in China is far from a sure thing. It may provide higher returns in the short term but remember that there is always a tradeoff between risk and return. Don’t overlook that your potentially high returns exist because China is one of the riskiest major country in which to do business. To my mind, its much-reported progress has the sound of another bubble getting ready to burst.

Investing in today’s environment is challenging, particularly because there are so many economic variables. The Mideastern societies are being reshaped, the European Union is teetering on the edge of insolvency, and many countries including Japan and Mexico are dealing with unprecedented turmoil. It is tempting to reach out for some arcane investment strategy like currency trading just because the alternatives are so unsatisfactory.

In this situation, Ockham’s Razor suggests that when there are many competing variables, the simplest course of action is generally the correct one. This would suggest that with current economic variables in the investment arena the most correct approach is simply maintaining a balanced and diversified portfolio. It can be foolhardy to take rash action in these times and try to ‘hit a home run’ to salvage your portfolio by putting everything in gold, burying it in the back yard, or buying Chinese Yuan. As Warren Buffet has noted: “Investors have lost more money chasing high yield than at the point of a gun!”

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

Smart Moves vs. Stupid Moves

2011-08-05T19:59:00.000-07:00

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

Financial chaos is so annoying. We are going along, wary but hopeful, and suddenly everything in the financial arena comes crashing down. The stock market drops 500+ points, the Euro tumbles, oil gets hit hard, and even gold is dropping. What are you going to do?

What Smart People are Doing: Really smart people aren’t doing anything right now; their portfolios are already prepared for this possibility. This may be hard to believe, but the only investment going up is U.S. Treasuries! Smart people (who of course include all of our ‘compliant clients’) have solid bond ladders, particularly if they are retired. This is the bedrock of safety which is the result of long-term, patient financial planning. If we slide into long-term deflation, this is your only safe haven.

Smart people are also dollar-cost-averaging into the stock market. Especially for younger people, this is the time to be buying stocks on a regular basis – not trying to time the ups and the downs. Looking back 20 years from now, it will be clear that this was your opportunity to be building an enjoyable retirement. For retired people it is important to keep a balance between bonds and stocks so that your bond ladder can be replenished when the economy comes up for air. Stocks are your assurance of long-term prosperity. Over time the stock market will continue to go up as long as we can maintain our productive and innovative heritage to compete in world markets.

Smiling people have a healthy mortgage on their house, on which they can comfortably make their regular payments. If there is enough equity, it is time to check on refinancing since mortgage rates are falling. When you refinance, you essentially cut your cost of living. Now is not the time to pull more money out, or pay off part of your mortgage if your appraisal comes in too low.

Stupid Moves People Do: Selling all your stocks in a panic, or because you think you can time the market. If you have already done this, now you have to decide when to buy back into the market – so you will have had to make two decisions right to come out ahead! The result usually is that market-timers become obsessed with the market which is a waste of time and produces needless anxiety for no long-term gain.

People who don’t have enough liquidity (i.e. cash) can easily be wiped out if hit with personal setbacks (illness, lay-off, etc.). It is also dysfunctional to hold on to too much cash, frozen by fear of loss if it is invested. You’re not making any progress if you have been sitting on excess cash earning 0.25% for the last couple of years. You would be much better off having bought long-term Treasury bonds 2-3 years ago with a fixed rate of 3.5%-4.0%. Even though those rates seemed ridiculously low then, you would have been much better off now, and this condition may well continue for a few years.

Having a home all paid off is psychologically appealing to people, especially when times get bad. It is counter-intuitive, but it is imperative now to protect yourself against future inflation which eventually will come roaring back! A 30 year fixed rate mortgage is your best protection against inflation. It will also give you additional cash for liquidity, to build your bond ladder, and to start or increase dollar-cost-averaging into today’s market, where all the stocks are on sale!

ACTION ITEMS: Contact your ACA fee-only financial advisor to:
• Make sure you have adequate liquidity
• Start/increase your bond ladder
• Start/increase dollar cost averaging into the stock market
• Get a mortgage on your home (yes, the interest can be deductible if you use it for investments!) or check into refinancing.

In my last blog, I correctly noted that the debt-ceiling fiasco panic would likely be the Y2K non-event panic of this decade. The outcome of this controversy, however, highlighted the severe problems in our national economy. We seem to be sucked into a vortex of malaise, as Jimmy Carter called it, with employment and housing stuck in a inexorable downslide. The government’s application of Keynesian tactics has reached the point of miniscule marginal utility.

This financial reaction is reflective of a genuine concern on Wall Street about the increase in overspending in the past couple of years. The federal government is borrowing 40 cents of every $1.00 it spends. The economic collapse and impending defaults in many over-spending European countries may foreshadow our own fate. It is politically debatable as to the cause of the widespread lack of confidence, and economic imbalances have a way of being self-correcting in the long run, but the US probably deserves to have it’s credit rating downgraded.

The lesson to be learned here is our own challenge. We can’t do anything about the national economy; it is our job to get our own house in order. Households cannot spend more than they earn. Your future depends on your saving 10% of your income and keeping a balanced and diversified portfolio, not on whatever the economic commentators argue about.

I am convinced that the contribution of professional financial advisors to our clients lies not in feverishly buying and selling securities, but helping clients do smart things in their own lives, and helping them avoid doing stupid things.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY and my partner Pamela Landy, M.B.A., J.D., C.F.P.

The Debt Ceiling Fiasco

2011-07-22T10:42:00.000-07:00

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

Politicians are commanding center stage as they debate the best way to keep the country from defaulting on our debt, and how to change the government’s finances to control the deficit. The play-by-play progress (or lack thereof) is amplified by the media. This leaves financial commentators foisting their favorite last chance investment strategies for people to avoid the worst case dreaded outcome.

The investing public is understandably alarmed and confused by these developments. We get questions from clients who have started thinking they should sell all their investments and put everything in cash. Others seriously ask if they should switch most of their investments to gold. Some are wondering if they can realistically plan on retiring when they planned.

I would like to suggest that this has been blown out of proportion. It is a perfect opportunity for the media to sell more newspapers and attract more viewers. Just like the Casey Anthony debacle, the media is impelled to fan the flames of this story, running interviews, cameo performances by ‘experts,’ and endless repetition of every piece of the story ad nauseam.

Of course this is an extraordinary opportunity for politicians to parade their platforms and get their faces on TV and on page one. Suddenly talk show hosts, movie stars, as well as professors have an opportunity to explain economics to the masses.

This issue is much ado about nothing. Those who want to raise taxes, at least a little bit, want to use this to further their agenda. Others insist this isn’t a revenue problem, but rather is a spending problem – they insist on pure spending cuts. Every vested interest wants to protect their turf, whether it is their cherished entitlements or their industry’s tax loopholes.

At the end of the day, everyone knows that default would be self-sabotage for our economy. What will happen is this: when we are near the precipice, there will be some sort of compromise which will enable all sides to take credit, and then this will be forgotten just as past games of deficit brinkmanship have become forgotten asterisks of the past.

Yes, the market will bounce up and down as market timers try to grab an advantage. The president and congress will likely kick the can down the road for awhile more to milk this panic for all they can. But in the end they will come to some resolution which will satisfy no one, but which everyone will take credit for.

I advise my clients to keep focused on their own business, and the endogenous issues that actually have an impact on their lives. None of us can do anything about the debt ceiling fiasco. The best thing we can do for our peace of mind is simply to stop watching the news on TV.

Long-Term Treasuries vs. Inflation

2011-06-10T09:36:00.000-07:00

By Bert Whitehead, M.B.A, J.D. © 2011

The federal government has been grappling with ballooning debt as the cost of government programs and entitlements outstrip tax revenue. Politics will ultimately determine whether to cut spending, increase taxes (or both) to solve the problem. This blog is not political commentary, but rather a response to the media’s concern about how these deficits, and the corresponding debt increases, will impact the financial markets.

Will U.S. Treasury Bonds become worthless?

Historically, the danger of not backing paper money with gold or silver is that governments will spend more than they can afford to repay over the long term. To cover the accumulating debt, the easy solution is to print more money to pay back borrowers. But the result is that the currency becomes inflated and prices rise as the value of the currency shrinks – the result of too many dollars chasing too few goods. The most recent global example of this took place in Zimbabwe, which ended up printing $100,000,000,000,000 bills (that’s 100 trillion dollars) that would buy about $5 worth of goods in US dollars.

History is replete with examples of countries that inflated their currency to the point that citizens insisted on being paid with gold, another country’s money, or else they resorted to bartering. This included the notorious Weimar Republic in Germany after World War I, as well as most South American countries (called “banana republics” because they used locally produced bananas to settle their debts). Even in the U.S. there have been four instances in which the government suspended backing of the US dollar. This resulted in financial panics, probably aggravated the Great Depression, and triggered ‘stagflation’ in the 1970’s.

As dismal as this background is, there is no attractive alternative. The US dollar is well entrenched as the world reserve currency. China and other foreign countries are owed more than half the US debt. But they can’t dump it on the White House lawn and insist on gold…dollars are not backed by gold. They can sell dollars and buy Euros, or Yen, or British Pounds, but those currencies are as bad as the US dollar. The Swiss Franc and currencies of other fiscally conservative countries are not ‘deep’ enough, i.e. not available in sufficient quantities to support world commerce.

How do you protect yourself from inflation?

Many countries (including the US) have significant stores of gold, and this reserve is attractive to many citizens. But now that gold shares can be bought and sold on stock exchanges, buyers don’t have to take actual delivery of the gold. As a result, the price of gold has become very volatile and is probably in a bubble now as speculators trade gold frenetically. I should note that inflation was not offset by the stock market in the 1970’s and the price of gold was basically flat for the 20 years from 1980 to 2000 while inflation increased over 100%.

There is some protection against the falling dollar when you buy mutual funds that invest in international stocks and do not hedge the dollar. We have used this approach for many years to temper the impact of the dollar’s devaluation. As we increase our participation in the global economy, currencies of other countries (many of which are backed by dollars) have tended to track the dollar’s value.

Interestingly, real estate has historically been considered an inflation hedge, but current worldwide prices are either very depressed (as in the US) or have wildly increased (e.g. Canada).

The absolutely best protection against inflation is to have a long-term mortgage at a fixed rate on your home. Many people flinch at the thought, but it is a huge advantage to owe a couple hundred thousand dollars at 5% fixed for 30 years if we see inflation mushroom over the next 5-10 years. Not only will your money market rates increase to 7-10% on money that is costing you 5%, but you are also repaying the mortgage with cheaper money.

The beauty of a long term fixed mortgage is that, if interest rates go down, you can just refinance and reduce your monthly living costs (which protects you from deflation). The worst-case scenario with a mortgage is when interest rates stay the same. Even then, on an after-tax basis, your return is about the same as your cost so it is a breakeven.

Now back to those Treasuries: the trading value of all bonds, including Treasuries, varies inversely with interest rates. So the market value drops when interest rates go up. Interest rates can rise very rapidly during times of inflation. However, we recommend that clients hold Treasuries to assure cash flow in later years, not to maximize yield. My mantra when it comes to bonds is: “Safety Trumps Yield!” Holding on to long-term Treasuries in a balanced portfolio protects you against deflation…which is still a significant danger. Regardless of short-term price moves, hold a Treasury until maturity and you will get your money back, including accrued interest. Your investment is insulated against inflation.

Holding cash in money markets will usually stay even with inflation, since the increase in interest rates will offset inflation. The worst mistake is to try to ‘chase yield’ by always seeking bonds with a higher rate. As Warren Buffet once commented: “People have lost more money chasing yield than they have at the point of a gun…”

At ACA, we use the principles of Functional Asset Allocation and design your portfolio to protect you during times of inflation (using cash and a long-term mortgage on your home). We maintain properly diversified stocks so that you will gain during times of prosperity. And we still recommend that you hold long-term Treasuries to protect you against deflation and assure cash flow during retirement.

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

Financial Advisors vs. Money Managers

2011-05-24T11:51:00.000-07:00

By: Bert Whitehead, M.B.A., J.D. Copyright 2011

Recently an ACA member’s client emailed me to comment that we were being paid to manage assets – stocks, bonds, real estate, etc. - and that I should be suggesting some opportunities to help increase his portfolio during these exciting times. This is a widespread attitude among clients, and I think it is a fair comment and merits addressing.

There is a significant difference between ‘Money Managers’ (or ‘Investment Advisors’) and ‘Financial Advisors’ (or ‘Financial Planners’). Money Managers generally charge based on the size of a client’s portfolio, i.e. assets under management (AUM). They claim to add value by finding ‘opportunities’ for clients and timing the market. Some claim they also advise clients on insurance, estate planning, taxes, etc., but they generally are not adequately trained in these areas. Moreover, people generally do what they are paid to do, and if they are paid based on AUM, they focus on gathering assets and new, exciting investments.

Financial Advisors take a much more comprehensive approach. We are trained and credentialed to coordinate all of the financial aspects of a client’s life, with a focus on meeting their life goals. Certainly investments are an important part of this, and our job is to recommend and monitor suitable Money Managers for clients. To do this we use the principles of “Functional Asset Allocation” (FAA) and eschew the ‘carnival barker’s’ approach of touting the ‘next hot stock’, or the next investment “frontier”, or other market timing approaches.

Many new advisors start out with the belief that they can add value by selecting investments. I’ve been at this for 39 years, and when I started out I tried to convince clients that I could add value by my superior investment knowledge. I managed portfolios of covered options, came up with strategies using fundamental principles for building portfolios, used technical analyses to determine when clients should switch asset classes, etc.

In my early career, I did beat the market a couple of years in a row…and then I got whipsawed and was grateful to be able to get my clients’ funds out while they were still ahead. Given that there are thousands of professional investors in the market, the theory of large numbers will always produce some who consistently beat the market year after year.

Indeed, Peter Lynch managed Fidelity Magellan for 13 years and reportedly beat the S&P for 11 of those for an average 29% annual return. The smartest thing he ever did was to quit while he was ahead. His successors used his same formulae and strategies and have underperformed the market ever since.

(It’s also worthwhile to note that during those years the S&P index was the highest performing general index for only one year. For four of the 11 years the small cap index dominated, international stocks won in 5 of those years, and bonds won out the other 3 times.)

Interestingly, most ‘financial advisors’ are really ‘investment managers.’ Their proposition is basically: “Give me your money and I’ll make you rich!” When I look up and down the street, from small financial firms to large wire-houses, they all make the exact same claim: “We’re smarter! We know how to beat the market!” As a matter of fact, most newer advisors, as well as day-traders, stockbrokers and insurance sales people, ultimately pin their success on their ability to convince themselves and their clients that they can produce superior results.

At some point we have to realize that we don’t live in Lake Woebegone, where all the children are above average. Every investment guru in the phone book can’t be beating the market at the same time unless they have a Madoff scheme.

I happened to visit Wall Street during Lynch’s era and saw the office buildings filled with people and computers. They spent most of their working lives trying to figure out the best investments. How would I ever be able to outsmart them? When I researched this more closely, I was struck by the fact that the S&P index outperforms 85% of large cap money managers!

When I delved into managers who claimed to beat the market and carefully analyzed their performance, I noticed that their success was based on fudging the indexes or benchmarks they used. Many managers today are ‘closet indexers’ who invest most of their clients’ money in line with an established index but with small modifications that, they hope, will help outperform the index.

I finally realized that most investment managers were charging extremely high fees because they could convince their clients – and their clients wanted to believe – that they produced higher returns. John Bogle’s new book (“Enough: True Measures of Money, Business and Life”) is a classic expose of how the financial industry has overcharged consumers by creating the myth that there really are gurus out there who can improve investment performance because of their advanced understanding of markets.

Take note that, of the thousands of studies done in academia, and by pension funds and investment houses, there has never been a single study that has shown that any market-timing scheme worked consistently. All the credible studies have shown that the keys to investment success are consistent investment, reinvesting profits, and basic diversification. Investors who jump from one investment to another, or even one asset class to another, consistently show lower returns than the market. Much of these inferior results are due to excess transaction costs, taxes, and not being invested during up-markets because of wrong decisions based on fear and greed.

This is when I developed FAA. I found I didn’t have to decide what the next hot stock was, or if interest rates were going up or down, or if small cap stocks were going to beat large cap stocks. All I had to do was balance my clients' portfolios to include a range of large cap, small cap, and international diversified no-load mutual funds or index funds. This portfolio features a rock solid bond-ladder as a foundation to keep clients from jumping in and out of the market every time they listen to Jim Cramer tout the stock du jour on his nightly investment circus.

The real value added by FAA is due to the comprehensive approach used to grow client portfolios. Real estate is regarded as a key asset, clients are coached to not do stupid things, inflation is dealt with intelligently, a bond ladder is used as a hedge and to assure consistent cash flow, wealth is preserved by cutting losses, behavioral obstacles are addressed, and tax strategies are employed to improve overall investment return.

The key advantage for my clients is that, no matter what new investment frontier is touted as “hot”, our clients are already invested in it because they stay balanced. When I look back at the thousands of successful investors I have known, none of them did it by ‘smart investing.’ Most wealthy people attain wealth by investing ‘sensibly’ and avoiding stupid mistakes. The worst stupid mistake is to start believing in carnival barkers.

The unique perspective of ACA members comes from being able to advise a client from a comprehensive view of their situation, which requires a higher level of credentials than is available in a field dominated by sales people. We can include tax advice along with investment strategies, sensible insurance approaches to enhance estate planning, etc.

The major problem in financial advice is not the lack of ideas about new opportunities. The fact remains that the majority of financial advisors are not true fiduciaries and are incentivized to give advice that is better for their own pocketbooks rather than their clients’.

Note: This review has been helpful in that it made me realize that many of the strategies we do use are unique and don’t require market timing (e.g. Cambridge Index, the no-lose Roth conversion, etc.) I will elaborate more on those in the future.

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

Surviving World Upheaval

2011-04-06T09:38:00.000-07:00

By Bert Whitehead, M.B.A., J.D. ©2011

We are witnessing two astonishing world events that erupted in the past three months, both of which were unpredictable. Since the revolutions in the Mideast and the nuclear crisis in Japan both involve significant energy resources worldwide, the impact may be staggering. It is interesting how quickly we normalize the impact of such calamities, perhaps because we don’t think we are directly affected. After all, these things aren’t happening here: they are half a world away.

Of course it is entirely possible, maybe even probable, that everything will work out fine. The Middle Eastern tribal structure will give way to real democracy, without needing dictators to keep folks in line. Japan will mop up their nuclear reactors, and we all will find a way to counteract the spread of radiation before any real harm is done.

But this is not the only possibility. For all we know, the amount of damage could be astounding and may permanently affect the way we live our lives. These events will likely cause major shifts in the way we produce energy as well as the way we use electrical and mechanically driven power.

The situation in the Arab world is evoking keen uncertainty. It certainly will not result in more oil becoming available from that part of the world. Current prices, near $110 per barrel, reflect the market’s concern that the supply of oil will be interrupted. The political outcome is unknowable, and our range of options as the primary consumers of oil is probably nil, or extremely limited at best.

Providing cover for Libyan revolutionaries was intended as a humanitarian gesture. But if the effect of NATO’s intervention actually prolongs and intensifies the conflict, we are caught in the dilemma of watching the human slaughter continue in slow motion, or committing more military support. Then there’s a significant problem in that we don’t really know who we want to win control of the country. We are likely to be disappointed based on the options available to the people of Libya.

Regardless of how the Libyan adventure plays out, we are starting to realize that this is a very long string of dominos just starting to fall. The revolutionaries in all seven-plus other Arab countries will certainly expect support for their fledgling democratic efforts, yet it is not likely that the people in the NATO countries have much of an appetite for more wars.

The bottom line in the Mideast is that the world’s largest suppliers of oil are all on the brink of collapse. They could be replaced, but even if there is the political will to ‘drill, baby, drill’ it will be a couple of years after our strategic reserves are exhausted to even start replacing this supply vacuum.

Then we get to Japan. No matter where it goes from here, it will be a long time before anybody builds more nuclear reactors. Japan must plan to import all the oil it can to just replace the power plants they have lost. So the restrictions on the availability of energy will compound exponentially while the demand increases.

But of course that can’t happen, because we will have to act before it all caves in. I’m not hyping this scenario, but it is possible and the effects are likely to affect our lives endogenously. It will affect the way we live.

What’s the smart thing to do? Well, first, don’t do anything stupid! You’re not going to save your skin by buying oil futures, or oil stocks, or gold. The markets will sort out these problems; government intervention may be more of a hindrance than helpful. The advice you get from the media is likely to be self-serving for the provider. Don’t count on ‘alternative energy’ during our lifetimes – too many problems/costs with infrastructure and storage issues. We will have to turn to more coal and natural gas.

So start looking at sensible things you can do in your life to reduce the amount of energy you need. This goes beyond turning out the lights when you leave a room; change the light bulbs! The energy credits mostly expired last year, but this is the time to look at the energy we use in our households from a purely financial perspective. If you’re buying a car, maybe it makes sense to get one that is energy efficient. The ‘pay-back’ period for energy savings is likely to shrink from today’s period of 10-15 years to only 5-7 years, and that shrinkage may happen sooner than later.

The reality of our brave new world is that we will be paying much more for energy of all kinds. It’s not a question of “If…”, but a question of “When…” And this short survey of today’s World Upheaval suggests that, during the past three months, we may have moved much closer to having to do something about it ourselves!

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

Tony’s Story

2011-03-20T11:49:00.000-07:00

By Bert Whitehead, M.B.A, J.D. © 2011

Some of the most important lessons I have learned didn’t come from classrooms or continuing education sessions, but rather from observing real life experiences of my clients. One such lesson I learned 35 years ago was from Tony. It was very impactful for me, and so I have decided to share it.

Tony was a 30ish manager who worked for a large Detroit corporation. He was raised in the ghetto, but managed to struggle through college and earned an M.B.A. He was recognized as a rising star in his company, and in our relationship he was what we term ‘a compliant client’ – which is an understated high praise. He regularly saved 10-12% of his earnings and invested prudently.

At one of our appointments, which he had been forced to reschedule, he explained that his father had died the month before. He was the beneficiary of a life insurance policy for $25,000. This was a tidy sum in the early 1970’s, equivalent to about $100,000 today. He wanted advice on how best to invest it, since it basically doubled his investment portfolio.

His father lived in Seattle. While he didn’t know him as a child, they became close later in life. He was somewhat embarrassed to admit that he had already spent $5,000 on a first class ticket to go to his father’s funeral (this was before airline rates were deregulated). I was startled by this, and mentioned that spending that much money on a plane ticket was quite a splurge.

Tony felt it was important to explain himself. He confided that he didn’t see his dad much while he was growing up, but he and his father had grown very close since he graduated from high school. His dad, who never graduated from high school, would always brag of his achievements.

His dad was so proud of him that he flew back to Detroit to attend both of his college graduations. The last time he saw his dad, his dad had told him that when he was boarding his last flight, walking through the first class cabin, the thought came to him that someday his son would be able to fly first class.

So that was why Tony decided to fly first class to his dad’s funeral.

Interestingly, less than a year later, Tony came home from work exhausted and laid down on his bed and died. He was 33. The cause was something related to a congenital heart problem he didn’t even know he had.

A few days after his death, I had vivid memories of going to his funeral and seeing him laid out. As I sat through the ceremony, it occurred to me that I was really glad that Tony had decided to buy that first class ticket.

That’s when I learned that how clients decide how to use their money is ultimately a very personal decision that reflects their deepest values. It is not my job to set their priorities on how they spend their wealth. As long as a client is saving 10% of what they earn, come what may, it will accumulate and compound through the years to assure they can maintain their lifestyle after they retire.

Through life, I have seen the importance that clients use their surplus however they deem appropriate. Some do save it. Others use it for their kids’ educations. Or perhaps they take their family on trips and invest in memories. The point is that as we live our lives, financial planning isn’t a process of sheer deprivation.

Sometimes it is important to splurge on a first class ticket.

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

The New Normal

2011-02-15T07:26:00.000-08:00

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

A number of clients have expressed alarm at the recent clamor of commentators who have been predicting a cataclysmic economic change worldwide. These pundits claim that we are facing an economic “New Normal” and express concern that the ‘old’ economic rules on which we rely no longer operate.

Their conclusions? Drastic changes are needed in our lives and investments to accommodate the “New Normal!”

Usually they question the viability of the U.S. dollar and offer the possibility that China, or perhaps a block of other nations, are somehow positioned to ‘take over’ the U.S. because they hold so many U.S. bonds. Another variation of this calamity centers on the recent collapse of the real estate market, the precipitous drop in the stock market, and extraordinarily low interest rates. Taken together, these developments presage the end of American prosperity for our children and ourselves.

Of course these apocalyptic pronouncements are more effective if they are tied to some political viewpoint, the more extreme the better. More often than not, far right political viewpoints proclaim that doomsday is the certain result of left-wing politics. Leftist views generally emphasize the inevitable revolution that suppression of the masses will cause.

(Note to “Investment Advice” file: Never let your politics drive your investments!)

It’s time to confront these ridiculous assertions. Yes, it is true that the investment and economic travails of the past decade have been severe and have impacted many people worldwide. Some of these changes have not occurred before during many of our lifetimes. It is enticing to point the finger of blame and shame at our financial, economic, investment and political leadership. But that is not the whole story.

The power of momentum in democratic economies is easily underestimated. Although dramatic from time to time, the impact of severe financial shifts must be kept in proportion and viewed within a broader historical perspective. We need to recognize that most extreme economic shifts are self-correcting.

Even with unemployment at over 9%, over 90% of our citizens are employed. Real estate crashes, weather-related disasters, stock market crashes, low interest rates, etc. have all happened before. Indeed the damage done by seismic economic shifts during the Great Depression, the severe stagflation in the 1970’s, and the collapse of S. & L.’s in the 1980’s were all worse than we have seen today…and all of these are relatively minor when compared to the disruption of the financial markets in the 19th century. And whatever happened to the “New Economy” theory that gave rise to the ‘dot-com’ frenzy of the 1990’s?

It is folly to fret about how much of our debt is owned by the China (interestingly, Japan owns nearly as much U.S. debt as China, even though that fact is not usually noted). What can the Chinese do with our debt? They can’t dump it on the White House lawn and demand to be paid off with gold. They can’t go on the world markets and exchange dollars for Euros or Yen, or even buy gold. Any of these moves would be self-defeating because dumping huge amounts of money in any market would decrease the value of their remaining dollars. Actually, their only realistic option is to spend it in the U.S.!

There is a concern that the U.S. dollar is at a “tipping point” and will soon lose its status as the world’s reserve currency. But no other currency is in a position to take its place. The Euro’s stability is much too questionable. The Yuan doesn’t have a long enough history to be relied upon, especially when a dictatorial government can arbitrarily determine its value. Neither these nor other ‘respectable’ currencies such as the Yen, the British Pound, the Swiss Franc, etc. have enough depth to support a global economy.

Those who espouse extreme economic outcomes are invariably selling something. Usually it is their newsletter or book, or some strategy to beat the market, or gold itself. The most eminent economists in the world have never been able to predict any economic cycle with a meaningful consensus. Why should you believe the extreme voices of charlatans who use their advanced marketing techniques to dupe the fearful?

What can you do? I suggest that you sit back and follow sensible advice. The Functional Asset Allocation model, which is used by nearly 200 fee-only members of ACA (Alliance of Cambridge Advisors), focuses on the basics.

Consider this…there are only three possible economic scenarios: we can have inflation, deflation, or prosperity. It is a waste of time to try to determine which is coming next. The prudent approach is to be prepared for all three possibilities. As the ancient wisdom of the Torah exhorts: “Invest a third in land, a third in business, and a third in reserves!”

Today, that translates into a balanced portfolio of real estate, equities (i.e. stocks in companies), and cash and bond reserves. Trying to market-time and pick the next ‘hot investment’ is foolhardy. If you allow the vagaries of global economics, i.e. exogenous factors, to be the focus of your attention, you risk making decisions based on emotion rather than rational thought. In truth, it is the ‘endogenous factors’ in your life that determine your financial future.

As Pogo once said, “We have met the enemy, and he is us!” Instead of dithering about what will happen in the Mideast, or where interest rates are headed, or when will real estate level off, look at the things in your life that make a difference. Are you saving at least 10% of your gross income? Are you living within your means? Do you have enough liquidity to ride out a financial setback? Do you have a long-term fixed rate mortgage to protect you from inflation? Do you have government bonds to weather another bout of deflation?

Obsessing about the various complexities and possible outcomes in today’s global economy inevitably leads to rash and unwise leaps. Keep an eye on the issues within your reach! It is the key to a confident journey and a serene financial future.

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

Cut Your Losses!

2011-01-07T17:02:00.000-08:00

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

When should you sell an investment if the value drops?

Investors agonize over this and often let themselves be guided by the old adage: “Buy low, sell high.” Based on this logic, they decide they will hold any investment they buy until they can at least break even. Once a client adopts this mantra, it is difficult to convince them to sell their holding at a loss, even when it keeps dropping in price.

There is a strategy of ‘averaging down’ when an investment drops in price. For example, suppose that you buy a mutual fund or stock when it is $20 a share and then it drops to $15 a share. If you had decided it was a good buy at $20 then, logically, you should buy more because it is even a better buy at $15. And if it drops to $10, then buy even more.

This is an aggressive strategy, and requires undaunting confidence in the investment. It can work out, but it often doesn’t. When it doesn’t, the results can be catastrophic. Employees who buy their company stock are particularly prone to make this mistake. I have seen situations where clients have stubbornly held on to Pan Am, GM, Chrysler, Enron, etc. and continued adding to their holdings only to end up losing it all. On the other hand, Ford shareholders have done well using this strategy over the past few years.

A more sound investment approach is to decide that, when you buy an investment, you will reevaluate it if it drops. You evaluate the losing investment with other investments, and then make a “keep or sell” decision. For example, let’s go back to your $20 per share stock. Rather than wait until it drops to $15 you could have decided that, if it drops 10% or 15% (i.e. to $18 or $17), you will reconsider the investment. If there are other investment options with better upside potential, sell your loser and reinvest in something with better prospects. This prevents you from blindly holding on to the shares hoping they will go back to $20.

For many people, selling a loser means they made a mistake, and they are adamant about not losing money on their investments. The blatant truth is that holding on to the stock means you still have a loss, you just haven’t ‘realized’ it yet.

One technique I have used with some success is to explain to clients that by selling the stock, they are ‘harvesting’ their losses for tax purposes. The tax loss will save them tax dollars by offsetting other gains, thereby reducing the capital gains tax. It often gives them an additional $3,000 deduction against other ordinary income, which can save them about $1,000 in taxes at the 33% tax bracket.

The beauty of this is that the client can buy the stock back after 31 days. If bought back sooner, the ‘wash sale rule’ precludes them from taking the tax loss. It’s interesting to note that, no matter how resistant the client was to selling the stock at a loss initially, once they sell it they never buy it back!

Of course we do not recommend ‘market timing.’ When managing clients’ portfolios we take into consideration other factors such as the overall balance of the portfolio, the amount of the single investment relative to the total portfolio, as well as tax issues and clients’ long term goals.

For example, we don’t sell stripped Treasuries in a client’s ladder just because the market value drops. The function of this investment is to assure that the maturity value provides the cash flow necessary for spending goals (usually in retirement), without fail. We know and expect that the market value will fluctuate in the meantime, but the ending value is government guaranteed.

On the other hand we don’t hesitate to sell a mutual fund that has underperformed its peers significantly for two or more quarters in a row. We also take losses in the Cambridge Index Portfolio when we can capture them as short-term, which are the most tax advantaged.

Cutting losses isn’t limited to securities like stocks, bonds, and mutual funds. A huge concern of many clients today is whether they should ‘dump’ their real estate in this depressed market or wait until they can ‘get their money back out.’ This issue is more complex, but here are some guidelines I consider.

If the home is your personal residence, and you like it and can afford the payments, keep the house unless you have to move (e.g. new job, changing neighborhood). If it is a vacant house or vacant property, it is generally better to sell (even at a loss) because the carrying costs of keeping vacant property and running the risk that the value will continue to drop generally makes this type of real estate a bad investment at this time. You may want to review my previous blog of April 29, 2010 titled “What To Do When Your House Is Underwater.”

The issue of when to “cut your losses” is also perplexing when applied to employment and other relationships, but my expertise in these areas is limited (though I have done a lot of research…). The best approach usually is to get a therapist!

In any situation, cutting your losses sooner rather than later is usually the better course of action. Not only does it minimize financial losses, but it also reduces stress. Continually dealing with these kinds of decisions is emotionally toxic.

So make a New Year’s resolution to cut your losses in three areas that have been plaguing you. Get the monkeys off your back, and get on with a rich fulfilling new year!

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

Five Awful Investments to Avoid in 2011*

2010-12-16T06:50:00.000-08:00

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…

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

2010-10-05T12:46:00.001-07:00

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

Affordable College: Don’t Pay Retail!

2010-09-15T12:53:00.000-07:00

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

How Long Will My Money Last?

2010-07-23T10:24:00.000-07:00

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.

The Gold Frenzy

2010-07-02T07:11:00.000-07:00

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

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

2010-05-14T07:42:00.000-07:00

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

What To Do When Your House Is Underwater

2010-04-29T09:05:00.000-07:00

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 naïve. 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

What’s Next: Inflation or More Deflation?

2010-04-08T12:45:00.000-07:00

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.

Roths Now Make the Tax Code Your Friend!

2010-03-02T12:07:00.001-08:00

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.

How Do the Wealthy Get That Way?

2010-02-01T08:19:00.000-08:00

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.

Lessons from the ‘Lost Decade’

2010-01-08T11:03:00.001-08:00

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.

How to Spot a Bubble

2009-12-08T12:17:00.001-08:00

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

If you are younger than 40, you will likely be telling your kids and grandkids about the ‘Great Recession’ of 2007-2009. Our recent experience is likely to impact your investment decisions for the rest of your life. So what advice will you give the next couple of generations?

I’d suggest you start with: “Beware of Bubbles!” Hindsight is a huge advantage in recognizing dangerous financial bubbles. We are all familiar with the stock market crash which kicked off the ‘Great Depression.’ If you are over 40, you probably remember your elders caution to ‘Stay out of the Stock Market!’ That was the wrong lesson; the real lesson is to be wary of leverage. The stock market then was a huge bubble, aggravated by the ability of even small investors to leverage stock purchases on margin requiring an investment of only 5%.

Surely over-leveraged investments, spurred by easy credit is a hallmark of bubbles. In the 1970’s however, bond investors lost their shirts and inflation ravaged the stock market. It’s not so clear that leverage aggravated that recession as much as excessive government spending, high oil prices, and built-in cost-of-living increases which contributed to spiraling inflation. But when the fed raised interest rates, the reduced leverage eventually sucked the air out of the economy and resulted in new federal reorganization of the banking system. The S&L collapse soon followed.

The ‘Dot.Com’ bubble in the 90’s was fueled by an astounding amount of capital chasing new ideas. Tech stocks soared to incredible heights and seemed to be invulnerable to fundamental requirements. They had no P/E ratio because they could sell stocks without a revenue, much less profit. Those entrepreneurs failed miserably at being able to leverage the capital effectively.

In our current situation, there’s no question that easy money accessed by low mortgage rates and virtually no vetting of borrowers artificially inflated housing prices, and the financial industry tanked taking down the rest of the economy. It’s by no means certain that the government spending intended to create employment will solve the problem, and there is a real danger that excessive government debt will create worse problems down the road.

Looking at our present worldwide condition, there are at least three possible bubbles on the horizon: China, Gold, and most recently the financial disruption in Dubai and other closely allied emirates in the U.A.E.
The red flags in all three situations are all related to the same phenomenon: unsustainable rapid increase in expansion.

China, and many other emerging nations, have experienced a growth in production capability which carries the danger eventually of excess capacity. Hundreds of millions of Chinese moved to the cities for employment. Now they are without jobs because there simply isn’t enough worldwide demand to keep the factories operating. In the process China basically subsidized exports by keeping its currency, the Yuan, pegged artificially low to the dollar.

This enabled them to keep prices of exports low, so US purchasing essentially provided the capital for Chinese expansion in their private sector. The anomaly is that that the US has begun using Chinese lending power to fuel its public sector. This is ripe to start unraveling with unforeseen consequences, but the fallout will surely hurt investors who have rushed in to make a quick buck in China.

Gold is now at record highs. Since 2000 the price of gold has jumped from $252 to $1,100 per oz. and has been touted as the best antidote for inflation which has increased about 18% during that period. But it hasn’t fared so well in the past: the price of gold dropped the beginning of the 1980’s through the 1990’s (from $934 to $252 per ounce) while inflation surged 50%. Since there hasn’t been an increase in demand for production, the recent price increase is likely due to speculation. Gold ETF’s became available, which buy actual gold to hold for investors. So instead of having to buy gold, have it shipped, and then store it, speculators can buy and sell positions in one day’s trading. Bubbles that are created by speculative demand are very likely to collapse, even faster than their rise.

Recent news that Dubai is defaulting on $80 billion in debt has spooked the worldwide markets and undermined the assurance that Oil Sheiks would step in to back any debt. The massive construction in Dubai, which dwarfed the construction bubble in Las Vegas, was based on a conviction that ‘if you build it, they will come.’ Well it turns out that they’re not coming. There is no financial underpinning for a new city built in a desert without any existing industry or commercial basis.

What China, Gold, and Dubai have in common is that they experienced such spectacular growth that financial realities were increasingly ignored. A naïveté around basic economics inexplicably overtake even seasoned investors, then speculators start rushing to cash in the new hot investment, and finally the small investors pile on. Bubbles are built on an irrational belief that ‘this time it’s different’ and the balloon will never burst.

We have learned a valuable lesson, and bubbles will continue to form regardless of government regulation and our supposed increased financial sophistication. Our experience should be passed on. So be sure to lecture your children and grandchildren to “Beware of Bubbles!”

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

What Deflation Looks Like

2009-11-19T12:31:00.000-08:00

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

For years we have been told about the evils of inflation. But now we are witnessing deflation, which most people have never experienced since 1950. What does deflation mean for you today? How is the economy affected? How bad can it get?

Inflation is an economic phenomenon that has been described as too many dollars chasing too few goods. Deflation occurs when the opposite happens -- too few dollars are being used to buy the available goods.

For most of this decade credit has been abundant and too much money was lent, especially to people without a strong financial foundation. It was easy to buy houses, cars, take trips, etc. As borrowers defaulted en masse on mortgages, student loans, car loans, etc., the banks and other lending institutions curtailed lending to consumers and to businesses. This resulted in an alarming drop in sales of cars, houses, etc. Retail sales across the board have shrunk as people became very frugal.

The downturn is compounded by a significant increase in the average family savings rate from about 1% of household income a few years ago to 6%+ now. The stock market dropped to the lowest level in 50 years, which caused working people to be alarmed about their retirement prospects. Seeing your house drop in value along with your 401-k is gut wrenching. So people are improving their “balance sheets” by paying off debt and increasing their savings at a feverish pitch.

These developments are good in many ways because we are weaning ourselves off the spending binge that lasted until about 2007. The downside is that companies have trouble making a profit because they have to cut their prices so much to sell their goods and services. This impacts suppliers. New orders for their products drops. To survive, all businesses are cutting staff. Then unemployment rises, there are even fewer purchasers, and people refrain from buying things because they either don’t have the money or they expect prices to drop further. This cycle creates a vicious vortex which sucks the wind out of our economy and causes deflation.

The big danger is that this downward spiral can worsen over time. As more people lose their jobs they can’t buy goods and services, sales continue to drop, and employers lay off more people, etc. Economists call this a drop in ‘velocity of money’ and, if it continues, it could cause a severe depression. At that point, it is very difficult to regain economic momentum. The Great Depression of the 1930’s only ended when we went to war in 1941. War increases employment, and creates a strong demand for armaments (which keep getting blown up and have to be replaced).

Deflation also causes the value of our dollar to drop against other currencies. For American workers, this means that the price of imports and the cost of travel abroad increases. For non-U.S. residents this situation is a bonanza: for example, Europeans can not only buy more dollars with each Euro, but those dollars will buy more U.S. goods, and travel to the U.S. is a real bargain. As foreigners buy more U.S. goods and services and travel here to spend their money our balance of trade is favored.

Swings in economic activity are often self-correcting. As prices drop during deflation, the value of the dollar for U.S. residents actually increases and we can buy more for less money. For example, the price of real estate has plummeted in many areas, the negotiated price of cars has dropped, and most retail stores, restaurants, etc. are offering enticing specials.

The U.S. is not the only country facing this situation: the whole world is experiencing deflation. But a free market economy like ours is affected sooner because a higher degree of our spending is non-governmental compared to many other mature economies. To address the danger of deflation, the U.S. government had to inject money into the economy using stimulus spending. Most countries have a stronger social ‘safety-net’ like unemployment benefits and free health care. They have decided that, for now, additional government spending in the form of a stimulus is not necessary.

Most of the U.S. stimulus money, however, is being spent on government jobs that do not create additional employment. The ‘TARP’ money earmarked to shore up our banking system isn’t being lent out by banks to create economic activity, as was expected, but is rather being used by the banks to repair their own balance sheets and recapitalize. So the ‘law of unintended consequences’ has kicked in to further complicate the situation.

Investors are faced with very low interest rates on their savings. Series I Savings Bonds, which accrue interest on an inflation-adjusted basis, are now paying zero interest due to deflation. As you well know, it’s all but impossible to find bank savings accounts or money market accounts that even pay 1%!

What can you do to combat deflation? The best hedge is U.S. Treasury bonds, which have a fixed interest rate over the life of the bond and are non-callable (i.e. cannot be paid off earlier than the original maturity date). Including them in your portfolio preserves your purchasing power when equities in your portfolio decline.

Although infrequent, deflation has its particular perils and it is important that you build protection into your portfolio to shield you from its devastating effects. It is actually more important to protect a portfolio against deflation with fixed rate Treasuries than to try to sidestep inflation by filling a bond portfolio with TIP’s (inflation adjusted Treasuries) that leave no defense against deflation.

We are a resilient nation, and we will survive this economic cycle. Indeed there are simple, sensible approaches you can take to ready yourself for all economic environments - deflation, inflation, or prosperity. The key is to build and maintain a balanced approach that positions you for any economic scenario. You’ll be able to stop trying to predict what might happen because you’ll know that you are prepared to face whatever does happen. Isn’t that one of the best “returns” your portfolio could ever provide?

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

Once Burned, Twice Shy

2009-10-14T07:38:00.000-07:00

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

Investors are feeling almost euphoric. While the market hasn’t rebounded to a Dow topping 14,000 (where it was in Oct, 2007), it is up 58% flirting with 10,000 from the 6,500 bottom we experienced on March 9th of this year. This sharp rebound is a relief but can be scary in its own right.

SELL NOW! Many investment gurus are predicting another round of market
setbacks. P/E ratios (i.e. the relationship of earnings to the price of stocks) are high at about 20. (15 is considered normal.) Their observations focus on the negative realities we are still experiencing, such as unemployment, the housing collapse, and unprecedented government spending and impending inflation. The ‘smart money,’ they say, is going into hibernation or reinvesting in exotic currency and commodity offerings.

BUY, BUY, BUY! Other investment mavens are optimistic. On this side the ‘smart money’ notes that the steepest market drops are historically followed by higher and higher stock prices. The market is a leading indicator and is looking ahead 9-18 months. The stage is set for a global recovery and owning stocks is the place to be.

Who can you believe? Keep two things in mind: 1) the ‘smart money’ in both groups represents only 5% of the traders but accounts for 95% of the stock transactions every day, and 2) every day a ‘survey’ is taken, and 50% of the ‘smart money’ thinks the market is going up while the other half thinks it’s going down. It has to be that way, because for every buyer there must be a seller – and one of them is wrong!

It is enticing to try to forecast what will happen next, and the experts can be very convincing. Usually they focus on one or two factors that support their conclusion, and their position appeals to one of the two most dangerous emotions for investors: Fear and Greed.

Fear made some people jump out of the market at the end of last year or the start of this year. They panicked and sold all of their stocks. Perhaps they felt burned, yet satisfied knowing that they were ‘right’ as the market tumbled downward until March 9. Now many of them are kicking themselves for turning shy and not getting back in as they watched stock prices spiral upward. They wonder if they should buy back into the market now is it too late? Is the market due for a correction?

This is the market timer’s dilemma: they first have to decide when to sell. Then they have to decide when to get back in. So both decisions have to be right. Statistically, they will get both right 25% of the time; the other 75% of the time they will make an error.

If Greed wins out and they put everything back in the market now, they run a 50% chance of being ‘whipsawed.’ As soon as they buy back in, the market nosedives. So their Fear kicks into gear and they sell out again and take a large loss to avoid a huge loss. Then, of course, stocks skyrocket. I have experienced this myself. It is a very depressing experience.

Market timers can get so caught up in their timing schemes that the market takes over their whole lives. They constantly watch ‘the market’ and listen to talking heads expound while reading about the latest investment fad. In the end, they would be better off financially and emotionally if they had a clear plan and stuck to it.

We use Functional Asset Allocation, an investment strategy format that is designed for real people. It incorporates real estate as well as stocks and bonds/cash. We seek to balance the portfolio in relation to total net worth, rather than try to time the market. As we balance our clients’ investments, we want to lower their investment costs, reduce the overall volatility of the portfolio, and, especially, make their portfolio tax efficient. We make decisions about things we can control by understanding the difference between what is certain and what is speculation. We position clients to enjoy a ‘market rate of return.’

By using a 15year bond ladder with Treasury bonds, we provide clients with a safety net so they don’t have to time their investing activity. They keep their real estate, even when the market tanks. They continue to dollar cost average into the stock market when it falls and rises. By maintaining a balanced portfolio, our clients are always positioned for any economic environment. They have investments to hedge against inflation, deflation and to participate when prosperity returns.

An investment advisor once commented to me that we could get a much higher rate of return by using municipal bonds and junk bonds instead of U.S. Treasuries. I acknowledged that, if an investor can time interest rates successfully over a long period of time, the gains might offset the extra taxes and transaction costs involved. But I explained that all our clients need to do is to get a market rate of return. We don’t take the extra risks that are required to try to ‘beat the market.’ We sell sleep.

You may be a bit shy about getting back into the stock market now because you got burned badly during the last downturn, which was the worst in the last 50 years. The key to not getting burned is to adjust your expectations and have a balanced portfolio that is geared for your particular situation. It’s the best way to experience the rewards of long-term investing and protect yourself against emotion-induced investment losses.

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

The Inflation Bogeyman

2009-09-22T09:44:00.000-07:00

Bert Whitehead, M.B.A., J.D. © 2009

“Inflation Adjusted” projections are the standard in the financial planning industry. I don’t use ‘inflation adjusted’ numbers, and haven’t for over 20 years. This raises eyebrows and sparks wonderment.

It’s not that I deny that prices increase over time and that the dollar becomes less valuable. The point is that inflation is not the key economic driver for real people, except perhaps those who are living at a subsistence level (keep in mind that the average household income is ~$50,000 per year). When gasoline prices spiked to over $4.00 a gallon, it is likely that you complained about it, but it didn’t really affect your lifestyle. But, if you were living on a subsistence level, expensive gasoline probably did take a toll.

Inflation adjustments became the rage in the 1970’s when oil prices, wages, and expectations devastated the value of the dollar. The financial planning industry, which encompassed mostly life insurance sales people at that time, found a terrific tool. By simply adjusting the inflation assumptions upward by 2-3% and projecting out over 30-40 years, it was easy to make a convincing case that you needed to buy more life insurance!

It’s like holding a yard-stick level while grasping one end in one hand. If you barely move your wrist so the stickmoves up by a teeny amount near your hand, the ‘long-term’ end of the yardstick jumps up a foot or two. Very scary.

Back then inflation was raging at 14-15% a year. Most financial planners made their projections using a 10-12% inflation adjustment. Being conservative, I used an 8% per year inflation adjustment. Some of my clients then are still my clients…so, tell me: was an 8% assumption too high or too low?

Most people, including professionals who have the benefit of a rear-view mirror, quickly respond that 8% was much too high. If compared to the actual annual increase in the Consumer Price Index (CPI), it was indeed too high – the actual rate of inflation over a 30-year period starting in the late 1970’s was in fact only 3.7%!

But when I meet with clients now who were clients then, their own ‘standard of living’ increased at about a 10% rate. Why? Because one spouse went to law school and the other became a tenured professor at a college, and their increasing affluence enabled them to move from a Chevy to a Pontiac to a Cadillac. Now they vacation in Europe instead of trekking ‘up north’ to camp. So the ‘inflation rate’ is not the predictor of future living expenses: it’s the increase in your standard of living that matters.

“But the dollar won’t buy as much in my retirement as it does now!” exclaims a client. Yes, that is true for the most heavily weighted goods and services in the CPI calculation. But when you are retired, you don’t need to worry about rising costs in education, real estate, or medical (assuming you have insurance or Medicare).

In my experience, retired clients in their late 70’s or early 80’s actually see their living expenses shrink – even if the CPI is increasing. Why? Because they have ‘been there, done that, and have the T-shirt.’ As we age we generally become less mobile. Keeping up with the latest fashions is no longer an imperative. Our cars last longer, and we keep our outdated computers and telephones longer, dreading the ordeal of having to ramp up another learning curve. Recent industry studies have confirmed this phenomenon.

Again, the real driver in financial projections for real people is your standard of living, not the U.S. CPI. Once you accept that fact, a key endogenous reality becomes apparent … financial independence depends on your own spending habits. Handling this is not difficult. Usually your earnings outpace inflation while you are working, and if you save 10+% of your earnings, your savings and market increases in a well-balanced portfolio will more than offset inflation.

There is a problem, of course, if your income increases substantially and you increase your standard of living accordingly. Movie stars, rock bands, athletes, etc. with meteoric incomes often don’t moderate their standard of living. They think their popularity will never end. When their gravy train stops, they are faced with bankruptcy.

The reason we focus on clients’ net worth rather than the return on their investments (ROI), is because it is net worth that should correlate with increases in standard of living. The rate of return on your investments is one variable that can affect your financial success. But other more important variables include how much you save (yes, even when you are retired!), how you manage debt, your spending patterns, and certainly how much you earn.

Money managers focus on quarterly investment returns (inflation adjusted, of course). They evaluate returns on their investment portfolio in relation to various stock indexes to justify their value-added in a client relationship. They are not comprehensive financial advisors and, to our way of thinking, they are tracking the wrong variable. Real people are impacted much more by how much they pay in taxes, how much they save, real estate decisions, and their spending patterns than by their investment ROI.

We focus on achieving market returns in a client’s overall portfolio. A market rate of return is usually all a client needs if they live within their means. Our “value-added” certainly includes keeping clients’ portfolios properly allocated with solid investments. But we concentrate first on what we can help clients control by helping them pay less taxes, manage their debt, recognize the risks they are taking outside their portfolios, and warn them about dangers they may face.

This is a long way from figuring out how much your inflation adjustment should be. Indeed, the Inflation Bogeyman is not as scary to your financial future as most people think!

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

Getting the Highest Yield Today

2009-08-26T07:48:00.000-07:00

Bert Whitehead, M.B.A., J.D. ©2009

How can you expect to make money with your money when short-term interest rates are lower than you have ever seen? Short term Treasury Bills (T-Bills) for 30-90 days pay virtually zero percent. Lock in your money for 1-2 years and you can expect 0.5% to1.0% these days. As with every investment, higher returns mean higher risks. Let’s review your alternatives.

Bank C.D.’s – There is a significant spread in yields offered by various banks. Today you will find FDIC insured banks paying 1.0 to 2.0% on 1-2 year C.D.’s. This is twice as much as Treasuries are paying, and your money is still guaranteed by the US government, right? So what’s the catch?

There are a couple of minor considerations, e.g. interest from Treasuries is exempt from state income tax but interest earned on CD’s is not. Also, if you cash in a CD early, you are charged a penalty equal to 3 months interest. A short term ‘T-Bill’ cashed in early may be sold at a small premium or discount, depending on which way interest rates move – so this is generally a small overall advantage of T-Bills.

The biggest danger with high-yield CD’s is that the best yields are generally offered by the weakest banks. If the bank fails, the FDIC moves in and takes over and usually sells it to another bank. You are guaranteed to get back the balance of your account including accrued interest to the date the bank is closed (up to $250,000 now). Normally this takes only a short time, like a couple of weeks or less. But if there are problems (bad record keeping, fraud, etc.) your money could be tied up over a year – and you are not paid any interest from the time the FDIC shuts the bank down.

There can be other inconveniences, such as ATM’s shut down, checks not honored for awhile, etc. but that would not necessarily affect you if you only have CD’s at the bank.

Money Market Funds – These funds buy very short term commercial paper (30-90 days) and have been long considered very safe as they are committed to maintained $1.00 par value ( so you couldn’t lose your principle). But a large fund (Reserve) ‘broke the buck’ last year and the net asset value dropped to $.93. This set off a panic, so the feds stepped in and guaranteed deposits up to $250,000 until Sept. (since extended…probably forever). These funds are immediately available, but are paying generally less than 0.10% -- so on $1,000 you would earn $1.00 in one year.

Municipal Money Market Funds -- These funds hold very short term municipal bonds (less than one year maturity). Many municipalities have huge unfunded pension liabilities and are facing lower tax revenues, and so are considered ‘junk bond’ quality. They are paying less than 0.25% - so they really aren’t usually worth the bother for the extra risk/reward ratio.

Short Term Muni Bonds – these pay somewhat higher yield than muni money market funds, currently around 0.5-1.0%. Usually clients don’t have enough money to diversify buying individual bonds, so diversification provided by short term muni bond funds is attractive…of course the fund passes on their expenses so the yield is less. I consider this very risky because bond funds generally add lower quality in their mix to improve their yield. These bonds are so risky that current issues are not insurable. Consider that the state of California has had to resort to sending IOU’s to their citizens for tax refunds because they don’t have enough money.

Other High Yield Offerings – We are always glad to review investment options for clients, Most of the time there is significant risk involved in these offering. Some however merit consideration. For example, Schwab Bank is offering FDIC insured savings accounts that pay 1.35% (guaranteed up to $250,000).

Obviously Schwab only offers this to its own best clients, so they aren’t tempted to switch their deposits elsewhere. So you’re not likely to see it advertized to the general public. We can provide information and assistance to client who is interested in reviewing this option.

One advantage is that you can get a Schwab Bank checking account along with it so the funds are easily transferable on-line to other Schwab brokerage accounts or by writing a check to other institutions as desired. Keep in mind however that this is likely a ‘teaser rate’ and so it may be reduced without notice.

In summary, there are few good options to invest short-term cash. Unless you have a very large sum of cash I don’t think it’s worth the bother to hop from one bank to another to chase an extra ½% for three months. We do stay on top of this for you and monthly update the ‘Cash Options’ we maintain to give clients advice on current rates. If you have any questions or concerns, please contact your Cambridge Advisor.

Is Now the Time to Buy Commodities?

2009-07-30T06:40:00.000-07:00

Bert Whitehead, M.B.A., J.D. ©

Commodities are hot! When is the best time to buy?

Most of us are inclined to try to figure out the best time to buy an investment. However, studies by academicians, pension funds, and other objective sources, however, have shown that market timing never works. It is useful to know the three rationales for market timing to better understand why it is futile: the Past, the Present, and the Future. We also explain the alternative to market timing.

The Future: Doomsday scenarios are generally based on some ‘inevitable’ future event which is unprecedented although it may have some basis in truth. Buy commodities because the world is running out of oil! Buy gold because China has too much of our debt! Inflation will cause worldwide financial collapse…so buy commodities! Timing systems based on outlandish possible scenarios sell investment newsletters, and get headlines.

Sometimes a prediction will actually come true, e.g. in the early 90’s globalization and computerization were predicted to dramatically drive the stock market up. That did happen, but the Dow never got to 36,000 as some predicted. There are too many countervailing forces in the economy to predict the future, and exaggerated claims don’t come true because they are offset by other economic changes.

Real estate was supposed to crash by the end of the 1990’s because of demographic trends, e.g. the end of the baby boomer house-buying era. Instead, real estate boomed because more boomers bought 2nd homes, households became smaller, people live longer, immigration swells our population, etc. These other factors offset the expected drop in demand for housing. When housing did crash about 10 years later, it was totally unexpected by the experts – and caused by artificially low interest rates!

The Present; The ‘recency effect’ occurs when you expect that what ever is happening now, or has been happening, will continue to happen. When the stock market is falling, people generally believe it will continue dropping and run for the exits. When it is rising, people become convinced it will always keep rising and pile investment dollars on just as the market peaks.

The market seeks balance by testing extremes. If anything, it is likely that whatever is happening now will not continue, certainly not indefinitely. Again, other economic factors come into play that offset existing trends. Relying on current trends to continue is a financial recipe for heartburn.

The Past: Our whole investment industry is predicated on analyzing past performance of a stock, or group of stocks, or a money manager to determine future performance. As you probably know the tagline on every investment recommendation is: ”Past performance is no guarantee of future returns!”

There are long-term 15-20 year trends in the markets that are remarkably consistent over any 15-20 year period. For example, a portfolio of 50% stocks and 50% bonds over the past 80 years has averaged 8.2%. Interestingly, most of the 15-20 year periods during that time frame show an annual return in that range.

That is no guarantee that this long-term historical trend will continue, but it is useful for long-term planning purposes. Most importantly, a 15-20 year trend offers no clues about how you should invest your money now.

The Alternative: So if market timing based any of these three rationales is unreliable, how do you know whether you should invest in commodities now? We espouse an approach based on balancing your portfolio according to your particular situation. We do not predict or rely on timing of any exogenous factors such as oil prices, the likelihood of war, the possibility of a California earthquake, etc.

What is important is that your portfolio takes into account the endogenous factors in your life. This includes job stability, how many kids you have to send to college, the amount of risk you take outside the portfolio (e.g. owning a business, real estate investments, etc.). A key factor is: “How much risk do you need to take to reach your goals?” If you are comfortably retired, it is ridiculous to measure your portfolio’s suitability based on your rate of return…it’s more important to make sure you don’t lose what you’ve got!

Our approach is known as ‘Functional Asset Allocation.’ It addresses the reality that there are only three possibilities that your portfolio has to deal with: Deflation (what we are experiencing now); Inflation (which we may have to deal with next); and prosperity (which hopefully will return soon).

Treasury bonds are the absolute best protection against deflation. Yes, they always have a very low yield, but when deflation hits – ‘safety trumps yield.’ A good mixture of large cap, small cap and international stocks has proven to be the best approach in times of prosperity. Inflation is hedged by having sufficient cash reserves (since short term interest rate increase during inflation), having a long-term fixed rate mortgage, as well as unhedged foreign mutual funds or gold which protect against a drop in the dollar.

With these simple investments in your portfolio, you don’t have to guess what will happen next. Whatever happens, your portfolio will be able to handle and grow. This approach runs counter to the advice you get from the media and most investment advisors because they base their theories on the assumption that you want to get the best rate of return you can…and only they can help you time the markets. Maybe that is true of billion dollar pension funds, but for real people it is nonsense because you have a finite lifespan. Your portfolio has to reflect the realities in your life.

So what exactly is the function of investing in commodities? For ordinary people, investing in commodities is actually dysfunctional – it doesn’t reliably protect against inflation, deflation, or necessarily rise during prosperity. It is a gamble, pure and simple. I suggest that it is preferable to take the $25,000 you have been told to invest in commodities and take it to the craps table in Las Vegas. At least there when you lose it, they give you a really nice room and free dinners. Charles Schwab never does that…

What Have We Learned?

2009-07-15T11:23:00.001-07:00

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

Who knows what will happen in the next few weeks, but the markets have bounced off their lows from March (except real estate…). Some say we are in recovery mode, but I’m not so sure. Maybe it’s time we take a deep breath and ask ourselves what we have learned from this experience. Here are 5 lessons most of use should have learned before, but had to re-learn.

1) This recession caught everyone off guard. Most economists didn’t see it coming, nor the government, not even the money managers who are always bragging about their superior market timing. There were a couple of experts who now are claiming that they did indeed predict this, and it is inevitable that some did accurately predict this.

So can we conclude that we should find out who these prescient money mavens were, and start doing what they tell us to do?

I think not. To begin with, market predictions are a lot like fortune cookies: usually they are a bit vague and so, after the fact, can be construed to be ‘right on the money.’ For example, a forecast in 2007 noted that “the market near-term can be expected to be very volatile and the winners will be not the stocks you would generally predict.” Looking back, that seems to be what happened…but it is hardly specific (or maybe you have to subscribe to the newsletter to get the specifics!).

It is obvious that if a newsletter publisher could predict the market, they wouldn’t be spreading their secrets – they would be making a killing trading stocks. “There is no ‘guru’ and many false prophets.”

2) When we think back to the earlier part of this decade, we all knew that the government was stretching to make mortgages affordable to increase the percentage of homeowners, a noble social goal. Maybe we shook our heads at how much the standards had changed, and how easy credit was to obtain. Of course the banks certainly knew what they were doing.

Now it is easy to see how this house of cards couldn’t last. But few could see the huge impact it would have in the financial markets. Most stock brokerages and financial advisors don’t even advise their clients on real estate. To them, the world of finance was all about stocks and bonds. Most consumers have to rely on commission-driven mortgage brokers. So that’s one thing we have learned: “Real estate is an important financial asset and people need good independent advice to make sound decisions.”

3) When interest rates started to rise, especially ‘safe bonds’ like municipal bonds, or GM bonds, it seemed to be very savvy to start chasing yields. Then we find out that these high-flying securities are much more risky than they used to be. This shouldn’t be a new lesson: “Higher returns always mean higher risks.” Often we just have to learn it again every ten years or so (remember dot-coms?).

4) Everywhere we turned frantic financial advice abounded: “Get out now, the market is going to tank!” “Now’s the time to buy – stocks are very undervalued!” When people ask me where the market is going, I review last week’s survey results of the 5% of the money managers who do 95% of the trading. Exactly half of them were convinced the market was headed up, and half were sure the market was going to drop.

The survey is run every day, and the results are always the same. Why? Because for every buyer there always has to be a seller…and one of them is wrong! It’s not the smart people selling to stupid people, because these 5% of the traders do 95% of the trades. The media is like financial pornography. They get you excited, and encourage you to act on impulse; you act on your ‘gut instincts.’ Then you are inevitably disappointed and discouraged with the result. Another lesson re-learned: “To be a successful long-term investor, you must ignore the investment media hype.”

5) If you were a prudent investor, you would analyze every investment or have your advisor do it professionally. There is historical data going back decades, and it is much easier to see the trends when the data is displayed in colorful charts and graphs. Alas, none of those trends forecast what would happen in the past 2-3 years. Could this be a new lesson learned(?):
“Past performance does not guarantee future results.”

Many investment models, including many derived from Modern Portfolio Theory, proved useless in this market. In our next blog we will review the defeats and successes of current investment theories…unless a more critical development arises which requires comment.

Maddoff Schemes and 5 More Financial Pitfalls

2009-06-22T13:36:00.000-07:00

Bert Whitehead, M.B.A., J.D. © 2009

You probably know someone who knows someone who invested in Maddoff’s Ponzi Scheme. These ‘investments’ pay handsome returns, but not because the money is actually invested, but because investors who cash in on their ‘profits’ are paid off with cash received from new suckers.

With the recent market collapse, we are hearing of more and more of these frauds. That’s because these scams run out of cash when people take money out faster than new ‘investors’ are putting new money in. As Ben Bernanke quipped, “When the tide goes out, we can see who’s naked.”

This blog will discuss the Maddoff scheme as well as other classic ways investors lose money in investments -- and how you can protect yourself. Some of the safeguards I will discuss have been outlined in a series of articles by my colleague, George Marrotta, a Research Fellow at Stanford’s Hoover Institution which I have linked if you are interested in perusing.

1) The simple rule that Maddoff’s investors ignored is: “Don’t Let Your Advisor Have Custody of your Investments.” Maddoff’s investors sent their money directly to him; the paper statements they received were made up by him and his staff. Using Schwab or other independent custodians allows you to review your statement directly on-line at any time. Always make out your checks to Schwab with your account number on it, and check your statements to make sure the deposit was received. Cf. www.emarotta.com/article.php?ID=320

2) Even with the safeguard of having an independent custodian custody your assets, it is still possible to get embezzled. There were recently two cases which individual advisors stole several million dollars from client accounts. In these cases, the advisors had very elderly clients and instructed them to sign transfers from their Schwab accounts to the advisor’s account, or the advisor had check writing authorization on their account.

This of course could happen to any of your accounts at a bank. The safeguard is simple: Make sure you review your bank and brokerage statements yourself every month and review withdrawals and transfers out to make sure you know what they were for and you received the money.

3) As we get older, it is much more difficult to keep track of everything in our lives. Your finances are one of the first areas impacted by old-age forgetfulness. If you find yourself becoming confused and forgetful with your finances, it is important to have someone in your life that you trust to review your finances with you. They can double-check to make sure mistakes aren’t being made. Where we notice that a client is becoming forgetful, we will bring it up and suggest a neurological exam, since this condition can greatly impact your financial situation if not dealt with appropriately.

4) The biggest scam I see our clients exposed to are private investment ‘opportunities.’ These usually have very nice glossy sales brochures and a salesman/organizer with a smooth line of snappy patter. These often involve unregistered securities which are virtually impossible to evaluate because there is not adequate financial information, disclosures, conflicts of interest, etc. to work with. We suggest you don’t even consider unregistered securities, even with (or especially with) friends and family. Time-shares are one of these scams.

5) If offered the opportunity to get in on the ground floor, ask them to email you a prospectus or ‘offering memorandum.’ I review a number of these deals every month for clients. Then I explain the risks involved, how the money is being used including payment of the organizers, the conflicts of interest involved, etc. This is the information which is technically ‘disclosed’ but that most people don’t read or understand. Once these factors are explained, clients generally take a more sobering approach to these deals.

6) It is also important to recognize and avoid financial hooks. In many investments the salesperson earns hefty commissions. This is disclosed in the fine print which no one reads. One clue is that you are charged a hefty surrender charge or penalty to get out in the first 5-10 years. For more information, go to www.emarotta.com/article.php?ID=324.

I do believe that a financial advisor should save a client more than the advisory fee charged. Often the savings in taxes, lower investment costs, avoiding commissioned products, insurance evaluation, getting better mortgage deals, etc. produce savings which are readily apparent.

But over my 37 years of doing financial planning, I think I have saved clients even more money by talking them out of inappropriate investments and keeping them from getting scammed.

If you have been dissuaded from an investment by your advisor, I’d like you to let me know about it. I’d like to do a blog someday on ‘Investment Horror Stories!’

How Long Does It Take to be a Long-Term Investor?

2009-06-03T08:40:00.001-07:00

Bert Whitehead, M.B.A., J.D. © 2009

This year’s market bottom in March wiped out all the market gains in your portfolio since 1996 (13 years)! This has left many commentators sniveling about the stock market as an inferior investment vehicle. But I’m sure everyone reading this has consistently been told that you have to be a ‘long-term investor’ to profit in the stock market.

So if 13 years isn’t long enough, how long is long enough?

When I started as a Financial Advisor in 1972 we were in the recession that started in 1967. The Dow hit 1000 in 1967 and didn’t get beyond 1000 again until 1982 (15 years). There was a widespread belief in the 70’s that the market could never go over 1000.

The financial pundits at that time subscribed to the theory that whenever stocks went beyond 1000, companies would always issue more stock. The additional supply would force the stock prices down, So the supply/demand curves intersected at 1000.

This year the market bottomed at 6600 in March ‘wiping out all the gains’ since 1996! But if you look at the peak in 1982 when the Dow was at 1000 and compare it to the peak in 2007 when the Dow hit 14,000, the market rose 9.8% per year ‘peak-to-peak over that 24 years. Clearly the ‘permanent market cap’ at 1000 the academicians theorized has been discredited.

Even measuring the ‘trough-to-trough’ bottoms from 607 in 1974 to 6600 this year (25 years), the market increased an average of 10.0% per year. On top of this add in the 4-6% in historical dividend payouts and the total average annual returns are easily over 12%.

The stock market has consistently been the most accessible investment over the long term! These kinds of returns are available to every person by simply consistently dollar-cost-averaging into a large cap indexed mutual fund over the long term.

Deciding not to invest in the market now, especially for younger people, could be the worst financial decision you could make in your life. And remember: you are younger now than you will ever be for the rest of your life .

This analysis explains why Cambridge Bond Ladders are for 15 years, rather than the 5 years many other advisors suggest. Fifteen years cash flow will last you through any recession. To fully reap the profits of the stock market an investor should have a 25 year horizon. That’s how long is long enough!

Inflation:The Next Scourge?

2009-05-12T06:00:00.000-07:00

Bert Whitehead, M.B.A., J.D. © 2009

The stock market (S&P 500) closed on May 8 ahead of where it was at the beginning of the year. Since the low point on Mar. 9 it has risen 37%. Keep in mind that the stock market is a leading indicator. If recent trends are not a ‘false bottom’ the recession should end in 9 to 18 months, based on historical performance. Of course, we have been reminded that history is not a trustworthy predictor of future results…

There are other signs that the economy is starting to bounce back. Unemployment isn’t rising as fast as it has been, some companies are showing a profit. Consumer confidence is rising. Those are positive factors.

Nonetheless, we are still mired in deflation. Prices are actually dropping (social security recipients are startled that they are not receiving a cost of living adjustment this year). Every month there have been fewer people employed. More companies are going broke, real estate is still in crisis, banks and other financial institutions still haven’t been resuscitated. Now we are seeing state and local governments get in line for federal bailouts. The rest of the world also seems to be caught in this deflationary vortex.

Just as it seems like we might be turning the corner, the pundits are already spooking us about inflation. Inflation may be our next challenge, but further deflation is more likely for the near term and very possible for even the next 10 years. It looks like two of the auto companies are going to end up being owned by the unions and the government, and the financial industry has been in effect ‘federalized.’

Skeptics question whether business decisions will now be politicized, and determined by political considerations rather than by market forces. This could result in many new cars built to be small and energy efficient, which the government wants. But in the past buyers have spurned those in favor of larger vehicles. Will overseas auto companies move in to fill the demand? Unless gasoline prices go back to $4-5/gallon, most Americans want to buy their SUV’s. If Detroit won’t make them, someone else will.

If everything keeps falling in place, and recovery is in sight, we will have to deal with the trillions of dollars in government debt. The fed has been issuing a huge increase in Treasury bonds to fund the Stimulus programs. The concern is that, if and when we do pull out of this deflationary spiral, the world will be awash in US dollars.

This could result in higher interest rates which the government would have to pay to induce people to buy US bonds. Right now, the feds are buying bonds themselves to keep long-term interest rates (and hopefully mortgage rates) down. But at some point we will have to pay the piper. That means that this increase in the money supply will create higher inflation. Or will it?

As with most economic issues, there are too many variables to predict with certainty the outcome. If the dollar drops relative to other currencies, which we would expect with inflation, our goods become cheaper for people in other countries and our exports would increase. Because imports would be more expensive here, we would reduce our trade deficit.

During the 90’s Greenspan was baffled by the low inflation we experienced relative to the growth in the money supply. When he left office, he pinned it on the higher productivity the US enjoyed because we were able to outsource low productive jobs abroad. Generally high productivity which we typically see during recessions holds down inflation. During our current recession we have seen productivity increase, as companies shed less productive jobs.

Another factor is the savings rate of citizens. Japan had virtually no inflation in the 90’s when they increased their national debt exponentially to stimulate their economy. But because their savings rate increased, the extra money supply wasn’t spent and prices stayed level. We are now experiencing a significant increase in consumer savings, and we see a reduction in debt (partly because it’s too hard to get a loan now!). Unless the increased money supply is actually spent, there aren’t more dollars chasing too few goods.

The reality is that inflation will be our next threat if the government keeps spending at the rate they have been. There are factors which may absorb the impact of inflation, so it is not certain how much it will affect us.

In balancing portfolios to protect clients against inflation, we focus on the asset classes which provide the best buffers. Cash and inflation adjusted savings bonds are effective as their yield increases along with inflation. Mortgaged real estate is one of the best protections. While real estate is a long-term inflation hedge, it is too regional to reliably provide much protection unless it is mortgaged at a long-term fixed rate. Unhedged foreign equity mutual funds can be a buffer, except (as we have seen lately) world currencies have been moving up and down together. In some situations we recommend clients buy gold bullion coins.

Inflation is likely to drive interest rates higher, so some clients become concerned because the nominal value of their Treasury bonds drop. Not to worry: the bond will be worth its face value on maturity, and that is what we count on to provide the guaranteed cash flow for your retirement.

Many clients are taking advantage of the lower stock prices now to increase their dollar-cost-averaging into stocks. We are recommending to others that it is a good time to refinance their homes at lower rates to decrease their needed cash flow. When we meet with you next we will look forward to reviewing your portfolio relative to your current situation. We are proud that our clients’ portfolios have weathered this ‘storm of the century’ relatively unscathed and look forward to moving on with you on your journey to “FIPOM” (Financial Independence and Peace of Mind)!

Are We Turning The Corner Yet?

2009-04-27T10:28:00.000-07:00

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

Finally we have seen some positive news on the financial front, and many optimists think we have hit the bottom and the stock market bounced off its low-point. It’s nice to be able to take a breath from the brutal onslaught of bad news over the past year.

We have been preaching about the dangers of being out of the market, even when it is falling, While it has been psychologically stressful to maintain equity positions over the past year, recent market activity points to the reason to refuse to market-time.

Interestingly, the average gain for the S&P 500 in the 1 year following the low close for the 8 bear markets that occurred in the last 50 years is +36.5%. The current bear market is the 9th bear market of the last half century. The closing low point (so far) of this 9th bear market was 677 and it took place 7 weeks ago on 3/09/09. In the last 7 weeks, the S&P 500 has gained 28.5% (not counting the impact of reinvested dividends.

Our clients pay us to ‘watch their backs.’ So without being an outright pessimist I think that we are still in a perilous financial situation. The future of the auto industry is teetering and we may see 2 of the ‘Big 3’ bite the dust in the next few weeks. The economic reality goes even deeper than that. We are restructuring our national economy to be able to participate in a global economy.

Our prosperity over the past 15 years was based on a world-wide spending spree, fueled by cheap credit and over-leveraged real estate. The current government nostrums are designed to spur more spending, but no meaningful programs have addressed the banking and real estate collapses. We see the impact of these issues everyday in the ‘For Sale’ and ‘For Lease’ signs in almost every neighborhood and commercial area.

Each client’s situation is different, and so the approach best suited to you depends more on what is going on in your own life. If the breadwinner in your family is out of work, or you have kids in college, or are faced with disability, or are retired (or hope to be soon) – these are the key factors in your investment allocation. While the stock market may look great, it is a mistake to be kicking yourself for having missed out on the steep increase recently.

For clients in transitional or distressed situations, we want to maintain an extra cash cushion. If your life situation is stable and your bond ladder is on-track, dollar cost averaging into the stock market is very advantageous. Now that tax season is over, we have scheduled appointments with each client to review your portfolio and make adjustments as appropriate.

It is a mistake to conclude, based on the past 2 months market activity, that you should now jump in with both feet. It is likely that we may not hit bottom until next year, and then it may take a couple of years to fully recover. Market timing is a futile waste of energy.

Treasury bond rates are low, and the feds are buying bonds to keep long term rates down, so it will be advantageous for many clients to refinance at lower rate (unless you owe more on your house that it’s worth). Jumbo mortgages (i.e. more than $417,000) however still carry very high rates and it is seldom worthwhile to refinance those.

This experience of living through the worst economic period since the Great Depression of 80 years ago will have a lasting positive impact on most of our clients. The losses will ultimately be recouped, and we are able to outlast even a continuing downturn. More importantly it has made many of us aware that we were frittering away money on things we didn’t really value. This lesson I think has to be re-learned by each generation as we discover that our Schwab statements aren’t the scorecard for our real wealth.

Best Case vs. Worst Case April 2009

2009-04-08T09:17:00.000-07:00

Bert Whitehead, M.B.A., J.D. ©2009

How will this recession play out? I like to ask people that question (although many of them think I should know). I have noticed a strong correlation between a person’s economic outlook and their political leanings. The extremists on both sides focus on certain factors in the global meltdown to support their point of view. I’d like to examine the extremes on both sides and explain why both an extreme positive or negative outlook is at best a very remote possibility.

The Best Case: The Stimulus plan works as designed world-wide and the economy bottoms out at the end of this year. The rebound is very rapid so that the stock market is back up to 13,000 by the end of 2010 and unemployment drops to 5% and we all sing “Happy Days Are Here Again!” The government devises regulations for banks and oil producers with congressional oversight to control their profits and pricing. Taxes are raised on businesses, investors, and high income earners to pay for energy, education, and health care services while lowering the deficit with the increased revenue. Increased government spending causes inflation which threatens to get out of control.

The Worst Case: The worldwide economy reels toward collapse with the US government selling bonds to provide money to support an ever-expanding list of government-provided entitlements, bailouts, and subsidies. More pressure is applied to other countries to follow our lead, resulting in rising stagflation worldwide and hyper-inflation in some countries threatens to spread globally.

Gross Domestic Production world-wide drops precipitously. Higher tax rates to target the most productive sectors of the economy result in less total government revenue as sales and incomes drop. Small businesses close, or start operating under-ground. Unemployment rises and pushes the world into a global depression. Protests and crime increase as populations become more impoverished. War looms.

The Truth: Neither of the two above scenarios are going to play out to the conclusion. This economic cycle will end and we will recover at some point. Stimulus programs may do more harm than good, but we are not going to become a socialist country. The dollar will not collapse and putting all your wealth in gold or another currency to avoid being wiped out is nonsensical..

There are simply too many economic factors at work to be able to determine the outcome. Most changes in a free market are self-correcting, e.g. as the dollar weakens, more foreigners want to buy US goods, services and real estate, which ultimately strengthen our economy and the dollar rises again. Supply and demand result in short-term price swings as markets seek balance by testing the extremes. Lower beef prices mean more people will start eating beef, and then ranchers will grow more steers. The outlook is further clouded by completely unexpected events such as a California earthquake, or a war in the Middle East that shuts down 50% of the world’s oil supply.

Most readers of this blog have already been impacted by this recession, and those who haven’t yet are likely to be in the next year. The worst reaction, however, is to bank on an extreme scenario. It is just as foolish to sell everything you own to buy gold because some writer ‘proves’ that hyperinflation is inevitable. It is folly to put all your assets into real estate because it’s so cheap now, and you believe that the big turnaround has already begun. Home prices are still dropping, and I remember the wisdom of my father: “Son, never try to catch a falling knife!”

The proponents of both extremes have personal agendas that focus their paradigms. Politicians and government economists want us to believe that the trillions we are spending is a brilliant idea. Those who predict doom-and-gloom profit handsomely as stoking fear sells their books and newsletters. Emotionally it is easy for us to assume the short-term upswing in the stock market means the recession is over, or seeing the market drop 25% in a couple of months means we are headed to Armageddon.

The final outcome of this historical financial crisis will likely to take 3-7 years to work out, and I doubt that we will bottom out before 2011 or 2012. Political agendas of both parties were a factor in creating this circumstance. Many regulations now scorned were once endorsed by both parties, e.g. encouraging mortgages to provide home ownership for all Americans. This seemed like a good idea at a time but most see that financial regulations need to be adapted to suit a society where many people are very naïve in financial matters.

People on both sides of the aisle should be concerned and active in this conversation. Our political process depends on our input. But don’t let it ruin your life. Don’t let the extremists in the political arena and their counterparts in the financial media lead you to take precipitous moves with your investments.

Functional Asset Allocation takes your personal situation as the primary driver in allocating your investments. While changes will need to be made this year, we want you to be able to survive any economic trend. Our job is to make sure you can sleep at night.

Have the Rules Changed?

2009-03-13T10:04:00.000-07:00

Bert Whitehead, M.B.A., J.D. © 2009

We are experiencing the worst economic crisis since the Great Depression, and we are likely to see further erosion. It’s a perfect storm brought on simultaneously by a financial crash, a real estate crash, and an economic crash. Investors who have always ‘played by the rules’ by diversifying their portfolios are confronted by the reality that all asset classes are collapsing, except for long-term Treasuries and perhaps gold. Small businesses are closing, real estate across the nation has tanked, and even the safety of banks and insurance companies are questionable.

So have the rules changed? Many investment strategies which have long been considered sacred don’t work anymore. The basic principles which we use in Functional Asset Allocation, however, are sound. That means that investment portfolios should be based on ‘endogenous’ factors that reflect the client’s individual circumstances.

Most investment strategies have been based on Modern Portfolio Theory. This assumes that the correlations of investment performance should be the dominant consideration in constructing and managing a portfolio. Investment managers all promised they could ‘time the market’ to take advantage of the next asset class which would out-perform the market.

Those strategies are always based on ‘exogenous’ factors such as interest rates, historical performance of stocks, oil prices, etc. Long-term US Treasuries have never been considered as the core of a portfolio, because brokers don’t make any money on Treasury bonds unless they are constantly being traded.

For our clients, we are re-evaluating the appropriate investment risk exposure based on each individual situation. The ‘invisible hand of the market’ has radically rebalanced our portfolios so that most are now heavily weighted in bonds and cash vs. stocks. We do not slavishly sell out bond ladders to boost the client’s exposure to stocks.

The current economic cycle has magnified the risks clients are exposed to. Job security is questionable, real estate values have plummeted, and businesses across the board are faltering. In reviewing clients’ portfolios we take we consider three primary risk factors:

1) How much risk does a client need to take to achieve financial independence, i.e. how much is enough? If you already have enough to survive this financial cycle, we will recommend that you take less risk in your portfolio than previously.
2) How much risk are you already taking? If you have your own business, or are subject to being laid off, or are concerned about becoming disabled, it is appropriate certainly to take less risk in your portfolio since these risks are greater now than last year.
3) How much risk is appropriate for your situation? If you have dependents, kids to send to college, too much leveraged real estate, etc. your portfolio should be more conservative. If you are single with a good job and in good health, you may want to be more aggressive. Note that this has nothing to do with ‘risk tolerance’ which is an unreliable and irrelevant factor when balancing a portfolio.

We generally try not to reduce clients’ exposure to market risk by selling off stocks and equity mutual funds despite market drops. This cycle will pass eventually and maintaining a position in the market is critical to rebuilding your portfolio. Clearly younger clients have a once-in-a-lifetime opportunity to achieve financial independence by dollar cost averaging in the market now through their 401-K’s and other pension options.

When extra cash is available, we want to reinforce or add to clients’ bond ladders where appropriate. And in today’s markets, a heavy cash position is often appropriate. We are also cognizant that the government stimulus, which is being funded with a flood of Treasury debt, will likely cause serious inflation down the road.

The problem is that the current deflationary cycle may last 1-2 more years, or possibly 5-10 more years. Rather than selling Treasuries, we are positioning clients for inflation by increasing their cash cushion (which will earn higher interest in inflationary cycles) and urging clients to remortgage their homes with 30 year mortgages if they can do so for a rate that is 1.0% or more less than their current rate.

We are monitoring the investments which are held by our clients, and may make short-term suggestions during your tax appointment or by email. After tax season we will be reviewing your portfolio with you in depth to identify the appropriate amount of risk we suggest in your circumstances and the corresponding rebalancing required in your portfolio. The market is so volatile and unstable currently that we are avoiding unnecessary market moves.

Occasional market rebounds, as we recently have seen, don’t indicate that this economy has turned around. A single swallow doesn’t mean spring is here. While most polls indicate that the general public is optimistic about the federal government stimulus and other bold intervention, the overwhelming consensus of the business and financial communities is very negative. Market reaction has exacerbated fear and panic among investors.

The concern is that government reaction to the crisis is not focused on the central problems: financial institutions and housing. It is the uncertainty whether massive splintered federal spending, knee-jerk regulation, and laws targeted to special interests is doing more long-term harm with little to show in short term gain. This recession is world wide with most countries even worse than we are, and international markets are now increasingly concerned about the stability of Treasury debt.

As a result we really don’t know which way the market and the economy is headed. Many government economists are confident that the recovery will begin this year, though more stimulus spending may be needed. Wall Street is generally more pessimistic, expecting this downhill slide to last 5 years or more. That would mean even lower interest rates, further stock market drops, and real estate stagnation. It is not prudent to guess at this point which way the economy will go over the next 3-6 months and make major shift in portfolios.

No matter what happens, we want to take whatever steps are needed to protect you financially. The rules of Functional Asset Allocation haven’t changed, but it is likely that your world is changing and we will make sure your portfolio is adjusted accordingly.

Five Stupid Things Smart People Are Doing With Their Investments

2009-02-27T10:54:00.000-08:00

Five Stupid Things Smart People Are Doing With Their Investments

Bert Whitehead, M.B.A., J.D. © 2009

The collapse of the financial markets has sparked terror for many investors. It’s hard to watch your regular 401-k contributions invested in solid mutual funds, and then vanish each month. If you are laid off, the fear of depleting your savings is gut-wrenching. If you are retired, unless you have a bond ladder, you may be thinking of going back to work. If you were planning to retire soon you may be postponing those plans. None of these options are very desirable.

People being people, our financial decisions are often based on how we feel rather than a rational process. Often these times lead people to take drastic action. They hope to reclaim all of the money they have lost in one brilliant financial move. The problem is that such approaches to investing are blatantly stupid, and I have seen the wreckage caused in the past when clients decided to ‘go for broke.’ This is the Gamblers Last Gambit: one last grasp to win all the losses back in one grand stroke. Here are five ways I’ve seen this happen with investors:

1. In 2002, a client who had lost a sizable portion of his money on the dot-com bust, sold every stock he had left and put it in cash. Vowing never to invest in the stock market again, he stayed on the sideline in 2003, when the market increased 30%, and missed the chance to have his portfolio recover.
2. Just recently a woman left her stockbroker who had her over-exposed to financial stocks which lost 80% of their value. Then she took the rest of her money and decided to buy puts and calls herself to make up her losses. In less than 6 months, she’s lost most of what she had left.
3. Another couple last year decided to sell their Treasury bonds last year, because they had appreciated so much. They planned to hold on to the cash and buy the bonds back when interest rates went back up. Meanwhile they have been earning less than 1%, and interest rates continue to drop and they can’t afford to buy their bonds back.
4. Then there’s the fellow who withdrew all his IRA savings and bought lottery tickets so he could retire early. (OK, he had brain cancer, so that’s an excuse).
5. Finally, there was a very smart financial advisor I knew in the 1990’s. He became a fan of the doom’s-day prophet of the time, and convinced his clients to sell all their assets and buy gold. He also did this with all his investments. (Not a good move in the ‘90’s!)

Now financial gurus are touting gold, or risky investment strategies, playing on investor’s fears to induce them to pay them for their secrets. Every stockbroker wants people to sell their Treasuries and let them invest the money = “Give me your money and I’ll make you rich!”.

Your situation is unique. We understand the broad context of your life situation and tailor your investments accordingly. It is futile to try to ‘hit a home run’ in this economic environment.

It takes patience. That’s why stocks are called long-term investments. For younger clients this is the best opportunity for you to guarantee your retirement. With stocks so low, continuing to dollar-cost-average now is a once in a life-time chance. For retirees with bond ladders, you have a 15-20 year investment horizon if you just wait for the economy to rebound. Taking sudden action now is folly.

The best thing to do is to stop listening to financial news on TV, reading the ‘ain’t it awful headlines’ and always looking for a guru to tell you the key to financial success. If anyone knew that, which there isn’t, they wouldn’t tell you because if everyone did it, their strategy wouldn’t work anymore. Face it: they make money selling newsletters to incite greed and fear. If you want to get rich quick, start your own newsletter!

“Fools rush in where Angels fear to tread.”

Danger: Inflation/Stagflation Ahead?

2009-02-17T13:21:00.000-08:00

Danger: Inflation/Stagflation Ahead?
© 2009 Bert Whitehead, M.B.A., J.D.

Now that the ‘Stimulus Bill’ is in place, how is the government going to pay for all of these new programs and tax cuts? Anticipating the need for additional funds, the Treasury has already begun to issue more Treasury securities* and has scheduled more auctions. So if the government piles on more debt, does this increase in the money supply mean we are on the brink of hyper-inflation, or a return of the ‘stagflation’ of the 1970’s?

Not necessarily: if our nation’s productivity increases in tandem with the money supply, inflation is not likely. In the ‘70’s we had declining productivity combined with entrenched inflation, and the result of high unemployment and high inflation was dubbed “stagflation.” Normally in the beginning of a recession, there is an increase in productivity since production does not drop as fast as employment. For example, in the last quarter of 2008 productivity rose 3.2% in the nonfarm business sector, as hours fell faster than output.

As new employment is stimulated, the plan is to be able to increase productivity simultaneously. There is some concern that, since the jobs initially funded will all be in the public sector, productivity will fall (since productivity only measures business, non-farm business and manufacturing output). Keynesian economics, which is the theory this strategy is based on, projects that the stimulus to the public sector and government spending will ignite private investment and job creation. There is broad disagreement as to whether this worked for FDR in the 1930’s, since the depression didn’t actually end until we entered WW II.

If it doesn’t work, we may well go into a prolonged recession, like the ‘lost decade’ discussed in my last blog. If it does well, the business sector will hopefully recover in a couple of years and start creating new jobs and we will again enjoy prosperity. But government does not create new jobs. If the jobs which are funded are to continue, the government has to keep funding them.

So the danger of inflation will depend on whether we end up becoming dependent on deficit spending. If our economy is worse in 2-3 years, there will be many who will argue that we didn’t spend enough, and insist on increasing government subsidies. This would be aggravated if businesses can’t get back on their feet and unemployment increases. This could produce very painful stagflation.

We don’t know if we face inflation/stagnation, or recession and a dead decade, or reignited prosperity. We don’t do market timing; we seek balance. Our clients are protected by long-term Treasuries if deflation continues. We keep our clients’ positions in equities so when the economy does recover, they will participate in prosperity. So now we are reviewing our client’s portfolios to make sure they will withstand inflation.

Gold and unhedged international mutual funds in the past were bulwarks against inflation. Now gold can be easily traded through ETF’s and so it has become very speculative, which would not be dependable in inflation. Being diversified with international holdings may not be effective since inflation would likely be worldwide.

Having a fixed rate mortgage on your residence is a very effective offset to inflation. Interest rates parallel inflation, so even if you parked the mortgage proceeds in a money market fund, high inflation would raise money market rates. Plus there is an advantage in paying off your mortgage with cheaper dollars.

In recent years, the US Treasury has started issuing ‘TIPS’ (Treasury Inflation Protected Securities). The interest rate on these varies based on the inflation rate. These are not a good replacement for your bond ladder, since they don’t offer protection against deflation. A strong strategy to protect against inflation, if you don’t have a mortgage on your house, is to take out a $300,000 mortgage and use the proceeds to buy TIPS.

Finally we recommend that clients keep an extra cash cushion in this volatile economy. While short term interest rates are low now, cash does provide insurance against higher inflation since interest rates would increase in lock-step. Clients with uncertain job prospects or high expenses looming should maintain additional liquidity. Cash also enables clients to be nimble in these uncertain times and handle unforeseen emergencies without decimating their portfolios.

If you would like to discuss these issues more to see how your portfolio would be affected, feel free to call your Cambridge Advisor for an appointment.

*Treasury Securities include:
Treasury Bills = 1 month – 2 years
Treasury Notes =2 years – 10 years
Treasury Bonds = 10 years – 30 years
This is the only distinction between Treasury bills, notes, and bonds.

Past Performance is No Guarantee

2009-02-02T09:41:00.000-08:00

Past Performance Is No Guarantee…
by Bert Whitehead, M.B.A., J.D. © 2009

In the past 75 years (1934-2008) the S&P stock index has suffered total return losses of more than 20% in four different calendar years, the most recent was last year’s 37.0% decline. In the year after the three previous 20%+ declines, the index gained an average of 32%.

The danger of liquidating stocks now is when the market does turn around it will likely be very sudden. Investors who seek an all-cash haven will miss out on the growth

Most clients have bond ladders with US Stripped Treasuries that have appreciated significantly. It is tempting to sell the treasuries to reap the capital gain now, and plan on buying them back when interest rates go back up.

We don’t recommend selling as the bond ladder gives you certainty. If this recession comes to an end soon, increases in stock values will allow your portfolio to correct itself. If the recession persists, however, you will not be able to replace your ladder for the amount you sell it for now.

There is a 20-30% chance that we may be facing a ‘Dead Decade.’ This financial phenomenon is rare, but it does occur. Japan went through a ‘Dead Decade’ in the 1990’s. The Nikkei stock market dropped from 37,000 to 10,000 and never closed above 15000 for 10 years. At the same time, interest rates dropped in Japan to 1.0-2.0% even for long term government bonds.

We don’t try to time the market, and are not predicting that a ‘Dead Decade’ is in store for the US. However, we do plan for a prolonged economic squeeze, which may well suppress interest rates even below current levels. This is the most dangerous possibility we may face.

While the changes we are experiencing are exogenous, many clients are feeling the effects endogenously. We are stressing to keep high liquidity during this post-election turmoil, and not selling long-term investment assets. Each individual’s situation is different, so your investment portfolio must take into account the risks which you may face.

It is easy to believe that the past will be repeated, but when it comes to the market, history is not a reliable predictor of future performance.

The Root of the Problem

2008-11-30T16:08:00.000-08:00

The Root of the Problem

Bert Whitehead, M.B.A., J.D.
© 2008

Five ‘up-days on the Dow’ gives us a chance to catch our breath and ponder: What is the root of the problem? Three considerations come to mind.

1) Mortgages made too easy to provide affordable housing has resulted in too many families having to go back to renting. The root problem in real estate is too many houses: population shifts and housing speculation has resulted in having more houses than we have people to live in them. The housing glut means that real estate will be depressed for at least a couple more years.

From an endogenous standpoint, that means if you have a vacant house, cut the price until you can sell it. The root of the continuing housing problem is that too many people don’t price their vacant houses realistically. The price has to go down to the point that it makes financial sense for investors to buy them and rent them out.

2) The root problem with the stock market is that investors have reacted with sheer panic to the liquidity problem (caused by too many non-performing mortgages). The primary valuation indicators show that the worldwide stock market is underpriced. Governments are acting in concert to add liquidity, which is a very complex undertaking. Mistakes have been made with the bailouts, but eventually they will get it right. FDR didn’t get it right to start with when he battled the Depression, but he did engender confidence in people that the problem was being addressed. Confidence in our leadership will suffocate rampant panic.

Expect the stock market to rebound before real estate. It’s not a given that the market increases over the past 5 trading days signal the end of the bear market. The market will turnaround before the economy starts to recover, and when the market does turn around it is likely to increase very rapidly. That’s why we don’t want you to panic and sell off your portfolio, especially now.

3) Being ‘rich’ means having enough money to buy and do whatever you want. Being ‘wealthy’ means being rich enough to take time to enjoy life. It doesn’t take a lot of money to be rich, and it is too easy to focus too much on ‘rich’ rather than ‘wealth.’ The current problems in our economy remind us how transient our stacks of money are, whereas wealth is within our control. The root problem of feeling poor is our own mindset.

Thanksgiving is a wonderful time in our culture to reflect we are indeed wealthy, even if we are not as rich as we could be.

How Bad Can It Get?

2008-10-27T09:55:00.000-07:00

It’s time to get our heads out from under the covers and face our worst fears. The financial crisis is world-wide, and the U.S. is actually better off than most countries. Iceland is bankrupt, and others (including Russia) are teetering. What happens when a crisis turns into a complete collapse?

Keep in mind that the worst possible outcomes are short-term. We’ll take a look at those and then look at the reality of the long-term.

Short-term Possibilities:

Scenario #1: Complete Financial Collapse. Likelihood = 1% - 2%. This could rival the Great Depression scenes we see in old movies with bread lines, tent towns of homeless, etc. You’re not able to use your credit cards, or write checks. In the worst case, where faith in US dollar evaporates, bartering or using gold becomes the basis of commerce.

This extreme outcome could be produced in our current economy if one or two extremely destructive exogenous events occur in the next year or so. These traumatic events could be anything from a huge California earthquake, Al Qaeda usurping power in Saudi Arabia and strangling the world’s oil supply, or severe weather changes brought on by global warming, etc.

We have suggested that clients who are genuinely concerned about this worst-case scenario keep 1-2% of their portfolio in gold bullion.

Scenario #2: World-wide Deflation. Likelihood = 5-20%. Countries try to protect their economies using tariffs, which sets off retaliation in other countries so global commerce dries up. Shortages become a way of life. Widespread deprivation kindles violence, terrorism escalates, and a large scale war may loom.

Even in this case, the dollar would likely be the world’s safe haven. Decreasing prices enable those who have cash or U.S. Treasury bonds to survive and prosper.

Scenario #3: Recession Reaction. Likelihood – 15-35%. Panic sets off contraction in consumer spending which cascades through the economy. Classic recession response, including lay-offs, unemployment of 10-15% in US, higher in other countries. The Euro may be destabilized by conflicts in monetary policies of member nations. Cutbacks in inventories closes factories; bankruptcies increase. Portfolio Panic Reaction leads many people to take foolish risks.

We work closely with clients to manage their endogenous risks, rebalance portfolios accordingly, make sure that adequate liquidity is maintained.

Scenario #4: Volatility Eruption. Likelihood = 25-40%. We are likely experiencing this phase now. Market prices in securities, commodities, housing, etc. take huge swings in waves of panic trading. Investors retreat to the sidelines, so trading volumes vacillate. This is how the market finds price balance, by testing the extremes. This could be a relatively short phase followed by onset of recession which could be severe, or gradually recover as markets begin to bounce back.

This is most difficult time for investors. In today’s economies this scenario usually stirs government intervention in the markets. This brings the danger that the money supply is increased faster than productivity gains which can trigger spiraling inflation. Having a long-term fixed rate mortgage is the best protection against inflation. Survival in this phase requires clients to turn off the TV.

Scenario #5: Bounce Back. Likelihood = 15-35%. If governments are successful in shoring up confidence in their economies, and adequate liquidity is available in capital markets, stable commerce will again emerge. Housing prices will drop to the point where entrepreneurs can buy up excess inventory and rent out homes with a positive cash flow. New business formations provide most new employment opportunities.

The stock market is likely to start rebounding a year or so before this phase kicks in. Clients guided by Functional Asset Allocation, which we preach, will prosper in this stage since they will not have sold off their stock holdings. Those who have continued dollar-cost-averaging, (e.g. through their 401-k’s, etc.) will enjoy rapid accumulation in their portfolios.

Long-term Outlook. Likelihood – 98-99%. As this downturn is relatively severe, it may take another 2-3 years to substantially recover. Then we will enjoy approximately 5.5 years (on average) of prosperity, which we will soon take for granted. On the next downturn, we will be again surprised. We will go through though another down-cycle as we have for the past century. Again we will think that ‘it is different this time.’ A year or so into that downturn we will again anguish about “How Bad Can It Get?” Then I will send out this blog again, as I did seven years ago in Nov. 2001…

Sleep well tonight! Bert

© Bert Whitehead, M.B.A., J.D. 2008

What Are Your Options Now?

2008-10-13T06:37:00.000-07:00

Last month we could take some solace comparing the current bear market to past recessions. Last week, though, was the worst week ever for stocks, dropping 22% over eight trading days. The market is down 36% YTD and the Dow is back where it was in 1998. Even though this recent drop is due to irrational panic, is it time to switch gears?

Before outlining your options, it is still important to keep some historical and global perspective. So far there have been steeper market declines during the 1972-1974 recession and during the 2000-2002 dot-com bust. We are not on the brink of another Great Depression, when the market lost 93% from 1929-1932. Unlike the past, this market cycle is global and the markets in Japan, Britain, Germany, Australia, Hong Kong, India, China and France are all down well over 40%.

Here are your basic options, followed by our commentary:

1) Buy more stocks all at once

2) Buy more little by little (dollar-cost-average)

3) Hold everything to see what happens

4) Hold market position but review and reallocate investments

5) Sell some/all stocks for now and keep in cash, or buy bonds

6) Sell everything and put it in gold or under the mattress.

1) If you are a Gambler, you could take extra cash, or take out a home-equity loan (now offered at 3.99% through Schwab), and put it in the market as fast as you can. This is basically ‘market-timing’ which is always a mistake in the long run, but gives you bragging rights if you are correct (otherwise don’t tell anyone). If you are driven to do this, only do it with a small amount of money (5% or less of your portfolio) and don’t sell your bond ladder to get the cash.

2) Taking extra cash, or using your current 401k contributions, to dollar-cost-average into the market is actually the best option. If you are young enough this is a once-in-a-lifetime opportunity to provide for your retirement so you won’t even need to worry about Social Security (which you may not get anyway).

3) If you are retired, or need some cash flow from your portfolio, holding on to what you have provides peace of mind (assuming you have a balanced portfolio with a 15 year bond ladder with Stripped Treasuries). It is tragic to see how many people are letting money ruin their lives now by watching the news all the time, talking to everybody about how awful it is, mired in angst about whether they should buy or what they should sell. In the long view this will have as much impact on your life as last year’s Super Bowl.

4) Hold but review and reallocate as needed is a great idea. Of course you pay us to help you with this strategy. so we are biased toward this option. We have let you know when major shifts are called for (e.g. sell muni bonds) and can help you execute these changes. We are now reviewing our current portfolio holdings to see if there are better money managers in various asset classes, and will advise you as appropriate. If you are feeling very anxious, it may be a subtle psychological clue that you should have a lower risk portfolio due to endogenous changes in your life (e.g. employment, health, business/real estate risk). If this fits you, please call us to see if your portfolio should be reallocated.

5) Sell! Put it in the bank or buy bonds. This is folly because you are letting your emotions dictate your investments. This is one of the stupid things some smart people are doing with their money. Not only do you have to decide when to sell, but also when do get back in to the market. So you live out the next couple of years on the edge of your seat watching the market. When it goes up, you jump back in, but then get whipsawed as it drops again. So you sell and take your loss. On the next uptick, you lie awake every night wondering if you should buy this time. Get a life!

6) Sell everything and buy gold or put it under your mattress. This is one of the stupid things that stupid people do with money. Sure, keep some cash or gold within reach (not more than 2% of your portfolio) to hedge against financial Armageddon if that is comforting, but it is not an investment strategy.

We hope this outline of your basic investment options will strike a chord with you, and confirm that you are on the right course for your particular situation. If it is unsettling, please email us so we can set up a time to discuss further.

PS The Cambridge strategy of using the 15 year Treasury bond ladder is impacting the industry. See this Oct. issue of Money Magazine:
http://money.cnn.com/galleries/2008/moneymag/0810/gallery.crisis_pros.moneymag/18.html

© Bert Whitehead 2008

Regards,
Bert Whitehead, MBA, JD

Time to Act!(?)

2008-10-07T11:04:00.000-07:00

If you haven’t been stewing about the market, don’t bother to read this. If you have been losing sleep over the market’s ups and downs, we hope this will put it in perspective. We had a conversation this morning with over 75 members of the Alliance of Cambridge Advisors (ACA) across the country to discuss the situation and appropriate action clients could take.

As of this morning the Dow was down about 25% YTD, and the European Markets are down over 30% YTD. The impact of the bailout won’t be felt for at least a month, and we are likely to see significant market volatility at least until the end of the year.

To put this in historical perspective, the Dow dropped 25% in one day in 1987. In the last recession, from 2000-2002, the market was off 45% at the bottom in 2002. A number of clients jumped out of the market in 2002 because they couldn’t stand the thought of losing half of their portfolio.

Alas, once burned, twice shy = so they were hesitant to put money back in the market when it started to recover, worrying it would drop again. During 2003, the market soared over 30%, and by the time they got back in during 2004 they were never able to make up for the loss they experienced from jumping out.

This market presents both dangers and opportunities for investors. Below we review actions you might consider depending on your stage in the ACA Life Cycle, as well as specific advice if this market is now impacting your cash flow. We have included all of the stages, not just yours, because many clients like to share this information with their friends and family.

1) Foundation - ages 20-30: This is a great time to buy your starter home. You have to shop for foreclosures and short sales though, or you might buy a house you could buy for half the money next year. If more than 10% of the home sales in your area are foreclosures, they are driving the market price, so hold back, no matter how tempting it is to jump in. In the meantime, pay off your credit cards and accumulate cash. Keep contributing to your 401k, since you can borrow this money for a down payment if you have to.

2) Early Accumulation - ages 30-40: Since by now your net worth should be 1 to 3 times your annual income, and you have a home, save-save-save. Hold off on home upgrades and renovations until you have built up a cash reserve of at least 20% of your mortgage balance. Split your 401k contributions 50/50 between cash/stable value funds and equity mutual funds.

3) Rapid Accumulation - ages 40-55: Your net worth is now 3-10 times your annual income so invest aggressively in your equity mutual funds to bring them to at least 60% of your portfolio. This is a great time to buy stocks using Dollar-Cost-Averaging (i.e. buying some every month). Doing this now will guarantee you a great retirement, and you will look back in 10 years and be amazed at how low the prices were. However if you are in danger of losing your job, see the section below on “Cash Flow Problems.”

4) Financial Independence - ages 55-70: At this point you are still working but supplementing your income with investment earnings. This is a dangerous stage right now. You want to make sure you don’t deplete your investment portfolio!
Either work more to increase your income, or cut your living costs.

5) Conservation - ages 70-85: You are probably now retired and should have your ACA Bond Ladder complete. It is critical to make sure you continue to live within your means. Excess spending means your portfolio will be depleted to quickly. Keeping to your spending plan will assure we will be able to replace the rungs you are using from your ladder when the economy turns around.

6) Distribution - ages 85+: Many clients in this stage are distributing their largess. We suggest holding off on additional gifts to children or charities for 6-12 months. You want to gift your largess, but you don’t know what that will be until this financial crisis ends.

For a more complete discussion of these life stages, we would suggest re-reading chapter 7 of “Why Smart People Do Stupid Things With Money” by Bert Whitehead, MBA, JD, who founded ACA.

Cash Flow Problems? Special consideration should be given in situations where a client is laid off or their business is losing money. You should contact us before taking any action. However, here are the sources of cash we suggest in order:
a) Cash: conserve it, and if you have depleted your cash to below 4 months living expense, consider borrowing money on your home equity line of credit (banks only lend you money if you don’t need it, so don’t wait until then).
b) Bonds: sell bonds which are not in a qualified (i.e. pension) account.
c) Stocks/Mutual Funds: sell equities which are not in a qualified account. At this point it is likely you will have a very low taxable income this year. If the stocks are at a gain, you may not have to pay capital gains tax if you are in a 15% bracket. If there’s a loss, you can use $3000 each year after offsetting capital gains and carry forward the loss to future years.
d) If you are anticipating a negative taxable income, we may want to use the opportunity to convert IRA’s to Roths.
e) If things get this bad, you may have to consider cashing in Savings Bonds.
f) If you end up having to live on your credit cards, we should be doing bankruptcy planning with you.

The economic situation could worsen substantially, particularly if there are compounding exogenous events like terrorists setting off a Middle Eastern war which interrupts the world oil supply, or a severe California earthquake, or a global health plague. These however are very remote. There is nothing you can do about these possibilities.

It is more likely that your endogenous situation could change due to a disability, layoff, divorce, etc. In these cases we should rebalance your portfolio accordingly, so give us a call to set up an appointment.

Finally, if you find yourself often anxious about the world financial situation, do yourself a favor and stop watching TV news or listening to the radio. The media has been hyping this issue to increase ratings, and of could all the politicians are bellowing about it to get votes. Most of them don’t really know what to do about it and just rant. Stop listening!

Warren Buffet is a calm, collected buyer in this market; Jim Cramer is jumping up and telling people to sell now! Warren Buffet is one of the richest men in the world; Jim Cramer earns a living with his antics. Who do you want to emulate?

Regards,
Bert Whitehead, MBA, JD

Getting Out of Egypt

2008-10-06T07:16:00.000-07:00

The Red Sea hasn’t parted, but at least the bail-out gives us some boats. Our problem now is to realize that the leadership skills needed to get out of Egypt aren’t the same ones needed to get to the Promised Land.

It is expected that the congressional action will have a calming influence on the markets. The next few weeks will be telling. Markets are still likely to show some volatility, so just remember that roller-coaster rides are always scary, but only dangerous if you decide to jump out (especially when going downhill…).

We are continuing to monitor the situation and will keep you informed. The greatest danger in this situation is that it could be aggravated by other events. Major financial catastrophes usually are due to a ‘perfect storm’ of exogenous events. For example, the Great Depression is variously thought to have been caused by the Smoot-Hawley Tariff act (which caused global retaliation and crippled our exports), or the run-up in the stock market due to low margin requirements, or the government not stepping in to save the banking crisis. In my opinion, the Depression was due to all three happening at once, and then compounded by the severe drought of the 30’s.

Serious exogenous threats would surely aggravate the situation today, like a major Calif. earthquake, Mideastern war, terrorist disruption of oil supplies, etc. However these are improbable possibilities which we can’t do anything about, except complain and worry.

The real threats in this environment are endogenous threats which you may encounter, like losing your job, or emerging health issues, or problems in relationships or with children. These endogenous events can be exacerbated by the current financial situation. I believe that these are times when a professional fee-only financial advisor offers the most value and can provide you with peace of mind. If you are losing sleep due to this situation, please let us know. We can help you figure out a plan to find the Promised Land.

Regards,
Bert Whitehead, MBA, JD

How Safe Are Money Market Funds?

2008-09-26T06:47:00.001-07:00

As you may have heard, the Federal Reserve has said that it will guarantee investors have in money market funds (MM) for the next 12 months. This was prompted by one of the largest and oldest money market funds ‘breaking the buck’ = i.e. the net asset value of the fund dropped from $1.00 per share to $0.97 per share last week. In the past, MMs have diligently maintained the net asset value at $1.00, even when they had to add their own funds. Due to this limited drop, many investors became concerned about the money they had invested in MMs and started withdrawing funds. To avoid a run on these account the Feds stepped in less than 24 hours later and issued the guarantee.

The question is: is this guarantee enough?

I am personally concerned that the ‘bail-out’ package now before Congress is being politicized by both sides of the aisle. I think much of the problem is caused by media-generated hysteria magnified by politicians on both sides during this election cycle. There is nonetheless a serious problem which demands action by our leaders. Government regulation is tricky: if too little, it doesn’t address the problems adequately; if too much they trigger the ‘Law of Unintended Consequences. ‘There are two dangers: 1) that delaying the bill beyond the end of the week will precipitate a liquidity freeze and market impact; and 2) by adding too many provisions to the bill will lessen the ability for the Fed to address the liquidity issue. Personally, I have more confidence in Paulsen, Bernanke, & Co. than in Congress.

Based on research Jason and I have done, I believe that Schwab is very sound, since they have avoided investing in sub-prime mortgages and related products. We have reviewed the holdings of the regular MMs offered by Schwab. They are well diversified and not exposed to the default risks other brokerages have taken on to increase yield. They will be participating in this new guarantee of MM funds offered by the Feds, as it will be funded by the brokerages who participate.

There are some unanswered questions, however.

How much of an investor’s deposits will be covered? We assume the minimum coverage will be $100,000, similar to FDIC coverage, but it may be more like $500,000 similar to current SIPC coverage (not gov’t. guaranteed).

Will this cover deposit by foreigners? Generally the Fed’s don’t guarantee funds of foreigners. If that is true, it may be expected that foreigners will withdraw funds from the MM funds which could trigger a run.

How much will be covered? Right now, there is $50 billion set aside to cover these guarantees. The problems is that the total amounts in MM funds is $3.5 trillion, so less than 2% is covered. It is likely that the bailout bill would give the Fed more flexibility, which is one reason for the urgency expressed by Bush and his economic advisors.

What are the alternatives for clients? Schwab offers a Treasury Money Market, which invests only in Treasuries. The current yield on this MM is 0.56% as compared to 2.04% on the regular money market.

The answers to these questions will be more clear once the bailout bill is worked out. For now our recommendation generally is that Schwab’s regular MM fund is suitable for our clients. However we are aware that a number of clients are very concerned about absolute safety, so the Treasury MM fund is recommended if you are losing sleep over the safety of your savings. Also, if you have over $100,000 in MM funds, we recommend you consider moving the amount you have in excess of $100,000 to the Treasury MM.

If you would like us to make a change in the money market in your account, please send an email to your Cambridge Team, and we will handle it for you. Also, let us know if you have any further questions regarding this.

Regards,
Bert Whitehead, MBA, JD

Holding Down the Fort When It's Raining Shoes

2008-09-20T17:53:00.000-07:00

I started to write this update every day this week, and then another shoe or two would drop, so I keep starting over. Since this is a very fast-moving financial transition, I’ll strip this to the important details. Pam is also composing another email to all clients with a more general review of the situation.

Dangers: The biggest danger to clients individually is to panic. Mistakes of the past are unraveling, but this downturn is actually normal for a functioning economy with global growth. On average we have a recession every 5.5 years. We went through this in the 70’s with the S&L crisis, the market fell 25% in one day in the 1987, there was a real estate and international meltdown in 1992, then the dot-com bust in 2000-2002. Now, 5-6 years later, it’s time for another one. We have successfully survived financial upheaval before and we will survive this one.

For Wealth Management Clients, we are monitoring specific risks to your portfolio and acting when necessary. For example, when financial stocks are on the brink of collapse, we take discretionary action to sell them before they stop trading to assure that you will have a tax loss (if the bank goes into bankruptcy, you can’t take the loss until the stock is totally worthless which may be a couple of years). We have sold Fannie Mae stock, Lehman and Merrill Lynch in the past week in clients’ portfolios accordingly.

Other stocks, such as AIG and various money market funds, are being analyzed to determine what action is called for. At the current time, we are keeping Fannie and Freddie bonds in portfolios, as will as annuities, insurance, etc. held by AIG, and money market funds as it appears the feds are taking action to support these securities.

We are ‘watching your back’ continually, so you don’t have to worry about this, and we will continue to update you as needed.

Opportunities: We are generally recommending that clients with extra cash start Dollar-Cost-Averaging into the market. While we don’t know how low the market will drop, most assuredly we will look back in five years and recognize that today’s market was a terrific buying opportunity. It is not appropriate for all clients to be buying stocks now as individual situations may call for more liquidity (see below). Dollar-Cost-Averaging is overwhelmingly more profitable than trying to do market timing.

While US markets are down ~17% this year, international markets are down 25-30%, with virtually every country down over 25%. The Cambridge Global Growth Portfolio by comparison (down 18% YTD) demonstrates the advantages offered by FIM money management. The Cambridge Index Portfolio is tracking the US large-cap markets (such as the S&P 500) as they were designed to do. Unless there is a substantial market turnaround, we will likely have losses to reap which will carryover to future years

We are also cautioning clients in general to maintain liquidity by avoiding illiquid investments (e.g. real estate, partnerships, paying off mortgages, etc.). Because of the credit crisis, some banks are cancelling lines of credit and credit cards, not because the customer has been at fault, but because financial institutions themselves are having difficulty raising capital. We expect this will continue for the next 6-18 months and will advise clients on this individually.

Strengths: U.S. financial and economic foundations are strong, despite what the press says. Foreign markets in general have dropped twice as fast as ours as their economies adjust to new global realities. As Americans, we have unparalleled strengths in terms of education, innovation, and perhaps most importantly = experience. We have been through these crises before and have the leadership in economic matters (e.g. Paulsen, Bernanke, etc.) to respond appropriately. The solutions they have been implementing will not bankrupt the US – keep in mind we have had government intervention in the financial markets before, e.g. during the Great Depression, the RTC to buy assets of S&L’s in the 80’s, the loan to Chrysler in the past decade.

Of course it is a political football, which heightens public paranoia to attract votes. I don’t think that the politicians have a clue about these economic matters = interesting that no one on either side of the aisle saw this trainwreck coming a year ago! While our financial and economic leaders aren’t elected, they aren’t totally immune from political pressure. One of our society’s strengths is that we have very capable people in these key positions who are generally supported by both parties.

As your fee-only financial advisors, we are experience and knowledgeable, and know your personal situations. We have been planning for this possibility all along, which is why virtually all of our clients have US Treasuries in their portfolios to assure them of ample cash flow for 15 years. Interestingly, Treasuries have increased in value by a staggering 15.7% year to date during this market chaos as investors worldwide flock to them as the ultimate in safety. Yes, they have very low yields, but for this part of your portfolio, “Safety Trumps Yeild!”

Using Functional Asset Allocation concepts, you will also be in good shape to profit from the rebound. We do not sell off equity positions during market downturns, so when the market turns around, you will be poised to participate in the following prospertity. It is important to realize that market turn-arounds typically are leading indicators and begin 9-18 months before the economy starts to recover. Thus it is folly to try to guess when the market will shift: by the time you see the change in economic measures the market will have already bolted ahead.

We hope this update is helpful and comforting for you. If you have any questions please call us…we sell sleep, and if you’re losing sleep over this, we’re not doing our job!

Regards,
Bert Whitehead, MBA, JD

Another Shoe Drops

2008-09-12T10:58:00.000-07:00

The failure of Fannie Mae and Freddie Mac has resulted in an interesting bailout. Basically , the feds are now explicitly backing the bonds which Fannie and Freddie have issued, and throwing the shareholders under the bus.

Not to worry: none of our clients held any of their stock, at least in Schwab portfolios. If you have these stocks at another brokerage company you should call them. The shares dropped over 80% this week.

The feds actually had to back up the bonds because so many of them are held by foreigners, especially the Chinese, who were concerned about the safety of the bonds. Previously , the feds only provided an ‘implicit’ guarantee of the bonds. So to keep all the foreigners from dumping their bonds on the market, which would create major chaos, the feds have agreed to ‘explicitly’ guarantee the bonds.

We became wary of these agency bonds over five years ago, and have not purchased any for clients’ accounts. However, some clients have Fannie and Freddie bonds which were purchased earlier. With the ‘explicit’ guarantee, we are recommending that clients keep those bonds for now. There is a wide spread currently, which would mean a 10-20% loss if sold now, whereas the feds are on the hook for the full face amount if the bonds are held to maturity.

We will review this on an ongoing basis, and review your individual situation at your next appointment. At some point we expect that the spread will narrow enough to enable us to swap these bonds for treasuries, once the markets settle down.

If you have any questions about the current market situation, feel free to call your Cambridge Advisor. If you are in the Detroit area, you might be interested in a live seminar I am giving for PBS on Saturday, October 11 th , at their new Wixom facility. The seminar will address: “Yikes! What Do We Do Now?” Call Carrie if you want to attend = there is a $40 donation to PBS.

This is at least the third shoe to drop during this economic upheaval…how many feet do Financial Grinches have?

Regards,
Bert Whitehead, MBA, JD

Looking for the High Ground July 2008

2008-07-18T11:26:00.000-07:00

Looking for the High Ground

The faltering financial sector has raised awareness of the importance of keeping our money safe. This email will review the safety of brokerages as well as banks, with Treasuries as the benchmark. We are primarily looking at short-term options, comparing relative safety with yield.

Attached is a recent analysis to compare yields of various short-term options for cash which Chad Silver prepared in our office.

In comparing CD rates offered by various banks, keep in mind that the shakiest banks offer the highest rates. We use www.bankrate.com to evaluate the soundness of banks, if you are interested in using it. The CD’s we list are examples offered by banks rated 4 and 5 stars (5 is the highest rating). They are all available through Schwab and are still FDIC insured if held in your Schwab account.

Since some clients use brokerages other than Schwab, you might be interested in this analysis which Jason Moore prepared, comparing stock prices of various wirehouses. A steep drop in stock value doesn’t necessarily mean the company is headed for bankruptcy, but companies which go bankrupt all have dropping prices.

July 13, 2007 July 14, 2008
Charles Schwab $22.22 $19.04 -14%
Merrill Lynch $86.54 $25.93 -70%
Citigroup (Smith Barney) $52.52 $15.47 -71%
E-Trade $1.41 $.25 -82%
Morgan Stanley $73.26 $32.25 -56%
UBS $61.49 $18.72 -70%

All major brokerages, including those above, are covered by SIPC insurance. In the past 50 years, no customer of a brokerage company has lost money due to failure of the company which wasn’t covered by SIPC. Brokerages which failed and required SIPC to pay off their customers are usually small companies with bad recordkeeping, or tainted by fraud.

The only way you could lose money or securities in your Schwab account is if securities were stolen, and Schwab went bankrupt, and SIPC was unable to cover the losses. This is extremely unlikely. (Note that than limited partnerships, futures, foreign exchange transactions, commodity contracts, precious metals contracts, etc. are not considered securities).

Our general recommendation for clients is to use a FIDC insured checking account for general cash needs, and an SIPC insured money market for other cash reserves. For short-term cash, generally we only use Treasury Bills for very large amounts of money which would be beyond FIDC or SIPC limits.

We hope this information is helpful to you. Please let us know if you have further questions.

Regards,
Bert Whitehead, MBA, JD

The Bear has arrived (supplement)

2008-07-07T12:12:00.000-07:00

Now, however, we are in a global economy so it is instructive to note how the US compares to other countries’ markets (on a YTD basis through 7/3/08 except as noted). I have also noted how the holdings in most of our Wealth Management portfolios have performed.

US Markets:
Dow = -14.4% (large cap)
S&P 500 = -14.0% (large cap)
Nasdaq 100 = -12.9% (large cap)
Russell 2000 = -13.1% (small cap)
S&P 400 - -8.3%
S&P 600 = -10.9% (small cap)

International Markets:
MSCI EAFE = -15.6%
Dow Jones World Index = 13.7%
DJ Euro Stoxx = -25.0%
DJ Asia-Pacific = -11.0%

Popular BRIC ‘Emerging Markets’
Brazil = -7.3%
Russia = -11.2%
India = -33.7%
China = -46.8%

Typical WM Holdings:
Cambridge Index = -14.1% (large cap)
Cambridge Active = -7.9%* (mid cap)
CGGP (Cambridge Global Growth Portfolio) = -8.7%* (small cap + intl)
*(as of 6/30/08)

10 yr. US Treasury = +14.03% (52 wk. average).
Gold = + 9.0%
CGM Focus = +11.2%
CGM Realty = +3.1%

Utopia Growth = -10.1% (small cap and intl)
Royce Value Plus = -6.0% (small cap)
First Eagle Overseas = -4.2% (intl – unhedged).

Virtually all equity classes (i.e. stock market indexes) are down in the double digits YTD. The stock holdings in most of our WM portfolios are down considerably less than their corresponding indexes except for the Cambridge Index. In large cap, the Cambridge Index is mirroring the three large cap indexes as it was designed to do.

We are concerned about Utopia fund, which has fallen over 10% YTD. However, since all of this drop occurred in the last month, we are not recommending any changes at this point.

In summary, your overall portfolio is performing as it should. Overall the losses in values of stocks have largely been offset by increases in the value of Treasury bonds. We do not believe that any changes need to be made due to market conditions.

As your investment managers, the hardest recommendation to make in times like these is to “do nothing.” But, as the data shows, we are weathering the storm. I have found that reacting to short-term moves in the market is seldom worthwhile, and only increases investment expenses and taxes.

However, if you are feeling particularly uncomfortable with your investments right now, we should discuss your situation. I have found that often when clients are upset with their investments, they are experiencing endogenous changes in their life. These need to be addressed and if may well be appropriate to review your overall investment allocation to take into account other changes in your life.

Please let us know if we can talk about this, either at our next phone call or regular appointment. If you want to talk sooner, just let us know.

Warm regards,

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

The Bear has arrived

2008-07-07T12:11:00.000-07:00

It’s official now: we are in a bear market, i.e. the Dow closed down more than 20% from it’s peak in October 2007. Interestingly, it was at this level in Oct. 2006.

As your financial advisors, we’re keeping a close eye on what’s going on. After a comparison of the market in general to the funds we recommend, we would not suggest changes at this time.

Stocks are down across the globe, with most indexes down in the double digits. The worst hit, as usual, are those that were the ‘hot’ markets in the past couple of years, e.g. emerging markets. This is why we don’t try to chase performance, or ‘shoot where the rabbit was,’ in structuring your portfolios. Our investment selection are performing as well as or better than their corresponding indexes.

Often clients who once thought they had a ‘high risk tolerance’ suddenly want to dump all their stocks in a bear market (which is officially where we are now). This is a principle reason we don’t base your asset allocation on ‘risk tolerance.’ Rather we try to structure your portfolio so that it is congruent with other risks in your life, and advise you on how much risk is appropriate in your portfolio.

For clients in retirement, who have followed our recommendations, you will see that there has not been much change in the total value of your portfolio over the past year, even if you are taking distributions from your investments. This is because 40%-50% of your portfolio is in Treasury bonds, and the increase in their value is largely offsetting losses in the stock portions of your portfolio.

For clients who are in the “accumulation” stages, this is the time when you are in the best position to significantly strengthen your portfolio. Not only should you stay in the market, the best move you can make in these times is to continue to add money to your stock portfolio. “Dollar-cost-averaging” (i.e. investing some money each month automatically on a monthly basis) is the best way to take advantage of a bear market.

Five years from now, you will look back and see that the investments you made during this period are among the best investments you will ever make in your lifetime.

However, if your personal circumstances have changed it may be appropriate to re-evaluate your asset allocation. If you feel ‘stock market anxiety’ right now, give your Cambridge advisor a call to review your personal situation.

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

Economic Predicament (April 2008)

2008-04-14T09:21:00.000-07:00

If It's Not One Thing, It’s . . .

. . . three or four things to make a real economic mess. What has caused the economic predicament we face today? Politicians are all pointing fingers, blaming the "Sub Prime Mortgage Fiasco," or the bursting of the housing bubble, or the falling dollar. It may be instructive to understand how these economic scenarios blow up from time to time.

The 'Great Depression' was variously blamed on Hoover/Rockefeller for not maintaining liquidity in the financial markets when runs started at banks. Others pin the fault on the Congress for the Smoot Hawley Tariff act, which raised our tariffs to protect American jobs, but set off a wave of retaliatory tariffs by other countries that decimated our exports. Often the stock market bubble of the 20's, where stocks were bought with only 10% margin, is fingered as the problem. The truth is, I think, that none of these events by themselves caused the Great Depression, but rather a 'perfect storm' where all these events happened in the same time period. Of course the record 'Grapes of Wrath' drought in the Midwest and plains states in the early 30's exacerbated and prolonged the depression.

This is true of other recessions too. In the 70's, the stock market also ended a record run-up at the end of the 60's, plus the Vietnam War was a huge financial drain. Inflation started rising rapidly, and was likely accelerated by Nixon's Wage and Price controls in the early 70's. Those factors were then aggravated by the increase in oil prices by the oil cartels, as well as the strategy of the Federal Reserve to cut interest rates to head off a recession. The result was 'stagflation' and the death of Savings and Loan companies, salvaged by the RTC.

There were mild recessions too. The late 80's had a brush with the junk bond collapse, compounded somewhat by the stock run-up in the Reagan years. But there were not enough negative whirlwinds to create a major recession. Housing hit some bumps in the early 90's, but again the national economics wasn't impacted by other forces, and in fact the increase in globalization and computerization propped up prosperity.

We were hit very hard in 2000-2002, when Greenspan finally broke the back of stock market’s 'irrational exuberance' which was then soon followed by 9/11. The dot.com era came to an end, impoverishing many nouveau-riche millionaires and decimating portfolios. It was the effect of these events happening together that produced the severe economic downturn, which in turn created huge unemployment.

Today we can see the bond market, which had become enamored of 'collateralized debt obligations' which were foisted on the investing public. This created another liquidity crises, and the stock market dropped as companies and individuals found they had committed to more debt than they could handle. The housing market, buoyed by speculators collapsed and now almost every region has a surfeit of excess housing inventory.

Will it get better? Yes, but maybe not right away . . . if there are other set-backs, we could face worse times. For example, if there is a string of
Municipal bond defaults, due to the overwhelming unfunded pension liabilities. Or even a severe earthquake along the California coast, or the overthrow of the Saudi Kingdom or other Middle Eastern political shift which interrupts the world’s oil supply. The economy can withstand one or two of these setbacks and recover quickly as it did in the 80's and 90's. However, if there are three or four of these storms which occur in the same period of time, we could see our economic situation seriously worsen.

The problem is that it is impossible to figure out the timing. It is a mathematical certainty that municipalities are not going to be able to pay the pensions they have promised to the baby boomers and beyond. Scientists agree that a major earthquake in California is inevitable. But no one knows when.

For each of us personally, we can protect ourselves from these outcomes by keeping a diversified portfolio. Treasury bonds are the stalwart buffer against deflation. If we encounter rising inflation and associated high interest rates, a long-term mortgage is our best protection. We will eventually see the dawn of prosperity again, and maintaining a diversified stock portfolio is what allows prudent investors to participate in long term growth.

So, even if it's not one thing, but three or four bad things that make a perfect storm, it's not a good idea to jump ship.

Regards,
Bert Whitehead, MBA, JD

Is US Banking System a House of Cards? (March 2008)

2008-04-02T09:05:00.001-07:00

Is US Banking System a House of Cards?

Bear Stearns, one of the largest wirehouses (i.e. stock brokers) in the country tanked this past weekend. That means their stock ended up being worth a little more than a penny on a dollar, dropping from ~ $170 to $2 per share. Shareholders, 1/3 of whom were employees, basically lost everything as JP Morgan bought up the pieces for peanuts.

This raises some questions inquiring minds want to know:

1) Is the US Financial structure about to fold like a house of cards? No. None of Bear Stearns clients lost any money in their brokerage or money market accounts (unless, of course, they owned Bear Stearns stock). Customers’ accounts were transferred intact to JP Morgan. Federal regulations require that clients’ accounts be segregated from firm assets, and are protected by creditors. Details of additional insurance coverage were reviewed in my last email. I personally spoke to Schwab’s compliance attorneys and am satisfied that our clients accounts are well protected. It is large financial institutions that incur the losses with these failures; retail customers such as our clients have never lost any money through the failure of large brokerages.

2) Where should I be investing now? Interest rates have been falling, real estate went bust in most locales, the stock market trends down (although it was up 400 points on Tuesday), gold appears to be in a speculative bubble. Cash looks pretty good right now, even as money market rates are just over 3%. I think dollar-cost-averaging into the stock market will pay off long term. Avoid making any illiquid investments (e.g. real estate, business ventures, etc.).

3) Are the days of a comfortable retirement gone for good? No = the key is balance. A portfolio properly balanced with bonds & cash, real estate, and a diversified stock portfolio will endure. You are protected against deflation, inflation, and still poised to participate in times of prosperity.

4) How long will this last? I’m not a market timer. I am concerned about clients surviving the downside. Things could get worse economically if the municipal bonds market collapses, and there are indications it may. So balance is more important than ever, and trying to guess which way to jump not only produces insomnia, but has been shown to be an almost certain road to lower investment returns. Over the past 20 years, as the market has risen 12%+ per year on average, the average investor has only earned 8% on their stock portfolios. The lower returns are contributed to by higher costs and higher taxes, but most of all are due to clients jumping in an out of the markets. The real costs are in the angst and anxiety of focusing on ‘the market’ rather than ‘the future’ = that’s why you have Stripped Treasury Bond Ladders!

Remember, if you decide to get out of a dropping market, you have to make two decisions right: when to get out, and then when to get back in. Clients who just stay put don’t have to agonize about either, and ten years from now will be farther ahead. Please call us if you have any questions or want to discuss your situation.

Regards,
Bert Whitehead, MBA,JD

Could Chicken Little Be Right? (March 2008)

2008-04-02T09:04:00.000-07:00

To: Cambridge Connection Clients
Could Chicken Little Be Right?
Being a long-term investor is like being on a roller-coaster: The ride up is exhilarating, but the ride down is scary! Here are the answers to some of the questions you may be thinking:
1. Is my portfolio safe? Yes, because you have a substantial amount of your portfolio in US Treasuries. They are very strong, and increasing in value, because there is a world-wide flight to safety. Treasuries are the ‘high ground’ in the investment world…actually more like the top of Mt. Everest.
2. What should I do about the falling dollar? Your portfolio includes a significant allocation of foreign stocks, which are not hedged. All other things being equal, the value of these increases when the dollar falls. This protects you some degree against the falling dollar, but not against a world-wide recession.
3. Almost all my money is at Schwab: is it safe? Your accounts at Schwab are protected by SIPC insurance of $500,000, plus additional insurance on $150,000,000 ($600,000,000 in aggregate) provided by Lloyds of London. They are not government guaranteed, but the only way you could lose anything is if a) Schwab become insolvent, and b) your securities were missing, and c) your accounts exceed the insured amounts. This is highly unlikely = you have a better chance of winning the Big Lottery.
4. What is the most important thing I should do right now? Don’t panic. This is a normal market cycle. The worst thing to do is to jump out. The stock market is volatile, and we will be advising some clients to start ‘Dollar Cost Averaging’ into the market since prices are so low. But of course we don’t know how low they could go.
5. Should I buy gold now? Many of our clients do own gold, but it’s not the right investment for all clients. Give your Cambridge Advisor a call if you would like to consider it.
Rest assured that we are watching this situation continually. We are concerned about the safety of municipal bonds, but we moved those out of client’s account a couple of years ago. Call us if you have any questions.
PS Schwab has lowered the minimum grant for Donor Advised Funds to $100 from $250. The minimum to set up an account has also been lowered to $5,000 from $10,000.

Regards,
Bert Whitehead, MBA,JD

Got Treasuries? (January 2008)

2008-04-02T09:02:00.000-07:00

To: Wealth Management Clients

Subject: Got Treasuries?

Just a note on the current volatility of the world markets (which means stocks across the globe are getting hammered). We generally don’t comment on market moves, as we are not market timers. We do know, however, that many clients may be concerned about their portfolios, and looking for guidance. Here are a few points to consider:

• Your portfolio is protected by your Treasury Bond Ladder. Virtually all of our WM clients have a significant portion of their portfolio in Stripped Treasuries. Many clients doubted the wisdom of buying Treasuries last year, or 3 years ago, or 10 years ago because ‘rates are too low!’ I have a saying: ‘Safety Trumps Yield.’ Your Stripped Treasuries are now keeping your portfolio buoyant. Your yield is locked in while current yields are falling further as there is a world-wide flight to safety in the financial markets.
• No, it is not a good time to bail out of stocks. Your bond ladder assures you 15 years of cash flow guaranteed by the US Treasury. History, documented in many studies, has repeatedly shown that jumping out of stocks in a bear market results in long-term portfolio loss. Stocks are a long-term investment; ask yourself: where will the market be 5 or 10 years from now? Plus, if you get out now, you have the problem of deciding when to get back in. As dramatic as this downturn is, the upturn will be just as sudden and dramatic. You are better staying put with your treasuries than losing sleep over when to get out, and then when to get back in.
• How long will this bear market last? Historically, down markets recover in a couple of years after hitting the nadir. This one could be longer, however, as the specter of municipal bond defaults due to unfunded pension liabilities haunts the market. Many muni bonds which were AAA insured were considered safe. But now the insurance companies that ‘guaranteed’ the bonds are being downgraded as they have lost so much in the subprime debacle. Many municipalities, no longer rated AAA, are not able to raise taxes enough to cover the looming avalanche of baby-boomers pension payouts. Since these pensions are not federally insured, defaults in the muni markets could provide a double whammy to the financial markets. This could delay recovery for as long as 5 years. Which is why your bond ladders are built out for 15 years…

Rest well: we’ve got your back covered!
Regards,
Bert Whitehead, MBA, JD

Market Watch (January 2008)

2008-03-27T12:45:00.000-07:00

Market Watch

For those of you who are watching the financial markets, this is a must read. For those who have learned to be comfortable tuning out the markets, you can disregard this…

Recently the world markets have been very volatile, trending downward in stocks with unusually wide swings almost every day. Politicians and the news media have turned their attention from the war situation to the economic arena. Clients may be bombarded with advice from all quarters urging them to take action now: Buy! No, Sell! Get into Asia! Get out of all stocks! Don’t buy bonds now, the yield is too low!

We have used the principles of Functional Asset Allocation through the ups and downs of market cycles (see ch. 8 in “Why Smart People Do Stupid Things With Money”). Understanding how to apply the principles during times of market turmoil strips decisions of emotional content and relieves the tendency to believe whoever we talked to last. Here are some pointers:

Your portfolio has been structured by your Cambridge Advisor to achieve balance. Your bond portfolio, especially a treasury ladder where you have sufficient assets, protects you from deflationary times like these.
Your real estate, especially if you have a fixed rate mortgage, protects you against inflation (which is still increasing!).
Your stocks and equity mutual funds propel your portfolio during times of prosperity.
The balance of these three asset categories is based on an assessment of your personal risk profile, not exogenous changes in interest rates, stock market moves, the value of the dollar, etc.

Don’t even think of jumping out of the stock market. Generally the right thing to do is to continue ‘dollar cost averaging’ (adding a set amount each month) into the stock market, keeping large cap US, small cap domestic, and international stocks in proportion. If the stock market continues to drop, know it will eventually turn around and the stocks you buy now will be among the best investments you make in your lifetime.

Even though interest rates seem low, continue building your bond ladder. This is especially important if you are past the accumulation stages of the financial life cycle.

If you have a vacant house, stop ‘trying to sell it.’ Cut the price and get it sold. Your carrying costs will bury any additional money you think you might get by holding onto it.

That having been said, if you are losing sleep over your financial situation, now is the time to call your Cambridge Advisor for a consultation. We have found that often when clients get upset about the ‘market,’ they are actually concerned about changes in their personal situation (e.g. getting laid off, unforeseen medical expenses, etc.) which warrant an update of their risk assessment. In these cases, a shift in your portfolio may be advisable.

We hope this Market Update will calm your concerns: we are watching your investments on an ongoing basis. Nonetheless, please call your Cambridge Advisor if you have concerns because of changes in your personal situation which may need to be reflected in your portfolio.

Regards,
Bert Whitehead, MBA, JD