Defending Yourself Against a Market Correction

Jane Young, CFP, EA

Jane Young, CFP, EA

The recent increase in the stock market is making a lot of investors nervous about the possibility of a significant correction.  I am frequently asked what the market will do over the next few months.  In reality, no one can predict market performance, especially in the short term. Your best defense against a volatile stock market is to create a financial plan and an asset allocation that is appropriate for your financial situation and time horizon.

If your current asset allocation is in line with your financial goals, there’s probably no need to make major adjustments to your current portfolio.  Your asset allocation defines the percentage of different types of investments such as U.S. stock mutual funds, international funds, bond funds and CDs that are held in your portfolio.  You should establish an asset allocation that corresponds with the timeframe of when your money will be needed.   Investments in the stock market should be limited to money that isn’t needed for at least 5 to 10 years.  Keep money that may be needed for emergencies and short term expenses in safe, fixed income investments like bank accounts, CDs or short term bond funds.

The stock market is inherently volatile and there will be years with negative returns.  However, over long periods of time the market has trended upward with average annual returns on the S&P 500 exceeding 9% (approximately 7% when adjusted for inflation).  It’s important to consider your emotional risk tolerance in establishing your asset allocation.   You may have the time horizon to have a significant portion of your portfolio in stocks but you may not have the emotional tolerance.  Your asset allocation may be too risky if you are tempted to sell whenever the market goes down or you are continually worried about your investments in the stock market.

Establishing an asset allocation that meets your situation can help your ride out fluctuations in the stock market more effectively than trying to anticipate movements in the market.  It’s impossible to time the market and a short term increase is just as likely to occur as a drop in the market.   Although you want to avoid timing the market, you should rebalance your portfolio on an annual basis to maintain your target asset allocation.  Additionally, you will want to adjust your target allocation over time as your financial situation changes and you move through different phases of life.

Keeping other areas of your financial life in order can also help you through a major market adjustment.   It’s essential to maintain an emergency fund of at least 3 to 6 months of expenses,  make a habit of spending less than you earn, and  save at least 10 -15% of your income.

Rather than focusing on where the market is headed and what the financial pundits are predicting, maintain an appropriate asset allocation and keep your financial affairs in order.

Risk and Your Investment Portfolio – Part 1

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Deciding upon an asset allocation is one of the first and most significant decisions to be made when you start investing.  Your asset allocation is the percentage of different types of investments such as cash, bonds, stock or real estate that make up your investment portfolio.  Probably one of the most important allocations is that between investments in the stock market and investments in interest earning vehicles such as bank accounts, CDs and bonds.  An ideal asset allocation provides a balance between risk and return that helps you meet your goals but doesn’t keep you awake at night.

There is a trade-off between risk and return.  Generally, if you want a higher return you need to assume a higher level of risk.  Investment risk comes in many different forms with the most common being stock market risk.  Historically, over long periods of time, the stock market has out-performed most other investments.  However, in the short term it can be extremely volatile, including years with negative returns.  In the extreme case you could lose your entire investment in an individual stock.  To reduce risk in the stock portion of your portfolio, consider buying diversified stock mutual funds. You will still experience swings in the market but fluctuations in any one stock will have less impact.

On the other hand, interest earning investments such as bank accounts, CDs, bonds and bond funds are generally less risky and are not subject to stock market fluctuations.  Unfortunately, in exchange for this lower level of risk you may earn a much lower rate of return.

Additionally, bonds and bond funds are subject to interest rate risk and default risk.  If you purchase a bond or bond fund and interest rates increase, the value of your investment will decrease.  To make matters worse, when interest rates rise bond funds commonly experience a flood of redemptions forcing them to sell bonds within the fund at a loss.  Even if you hold on to your shares you can experience a drop in value. However, if you purchase an individual bond and hold it till maturity you will receive the full value upon redemption.   Use caution when buying low quality bonds or bond funds; you may get a higher return but you are subject to a much greater risk of default.

Many investors don’t consider inflation risk.  This results from taking too little risk with a conservative portfolio containing little or no stock.  Over time inflation has averaged about 3% annually, if you are only earning 2% on your portfolio your real return after inflation will be negative.  This is compounded if inflation rates rise significantly.  Consider increasing your allocation in the stock market to hedge against inflation risk.

In the current environment of low interest rates and high volatility it’s crucial to build a portfolio that balances risk and return to support your financial goals and provide you with peace of mind.

Patience is the Key to Successful Gardening and Investing

Jane Young, CFP, EA

Jane Young, CFP, EA

We recently built a new home and have been feverishly working on landscaping and planting new flower beds.   While going through the process of planting and nurturing my flower gardens I realized there are many similarities between gardening and investing.  I planted a lot of perennials to create a garden that will last for many years.  However, I’m anxious for the perennials to grow into the large, colorful flowers I have envisioned.  I realize it takes time and patience to develop a gorgeous garden.  To satiate my immediate need for some color I interspersed some annuals with the perennials.  The annuals will meet my short term needs but aren’t a good long term investment.  They will provide beautiful color this year but will die and won’t return next spring

To build a successful garden you have to plan ahead, prepare the earth and plant seeds long before reaping the benefits.   Investing is similar to gardening in that you need to think ahead to create a plan that will meet your long term objectives.  You have to start by planting the seeds and continue feeding and nurturing your investment plan.  After your initial investment is made, continue making contributions and annually re-balance your portfolio to be sure you stay on track.  Periodically some weeding is required to remove poor performing or inappropriate investments from your portfolio.   You may also need to add some nutrients by adding better performing mutual funds or by expanding on the categories of funds in which you are invested.

It’s essential to meet short term needs.  This year I had a short term need for some annuals to add color to the garden.    In your portfolio, you need to include short term money for emergencies and living expenses.  If short term needs are addressed you can invest your long term money more effectively with greater confidence.

Additionally, in both gardening and investing it’s important to stay diversified.  My garden has a variety of flowers that bloom at different times of the year or react differently to varying weather conditions.  Your portfolio should also be diversified with a variety of different investments that help you buffer against a variety of market conditions and changes in your personal life.

Just like perennials in the garden, investments in your portfolio need time to grow and absorb fluctuations in the market.  If you become impatient and give up before they have time to fully bloom you won’t meet your end goal.  Just as vibrant short term annuals can provide a lot of immediate satisfaction they don’t result in a garden that is sustainable over many years.

Investing, as in gardening, is a slow and steady process.  Get started, set a plan, keep a long term perspective and stick to your plan.   Patience and perseverance will help you build a gorgeous garden and a more secure financial future.

Most Effective Investment Approach Combination of Male and Female Traits

Jane Young, CFP, EA

Jane Young, CFP, EA

Numerous studies have found that men and women generally approach investing differently.  Generalizations can be dangerous but there is ample evidence to indicate there are some common gender traits that may hinder our investment performance.  An increased awareness of our potential strengths and weaknesses may help us to adjust our behavior for a better outcome.

Studies have found that men are more confident than women when it comes to investing.  According to Meir Statman, professor of finance with Santa Clara University, “Women tend to be less overconfident than men.  In the stock market, where so much is random, trying to do better than average is more likely to get you results that are below average.  This really is where all the confidence is going to hurt you”.  On the positive side confidence can prompt you to make a decision and take action, but overconfidence can result in taking too much risk and investing in things you don’t know enough about.  A lack of confidence can result in taking too little risk and a reluctance to take action.

In another study conducted by Brad M. Barber, professor at UC Davis and Terrance Odean, professor at UC Berkeley, researchers found that overconfidence leads men to trade excessively.  As a result their returns suffer more than women’s.  But women and men sell securities indiscriminately;    women just do it less often, so their performance doesn’t suffer as much.

According to the 2010 study by the Boston Consulting Group, women have a tendency to focus more on long term goals.  Their investment strategy and risk tolerance revolves around long term goals and financial security.  Men have more of a business orientation and tend to be more focused on efficient transactions and short term performance.  Men are likely to be more competitive and thrill seeking in nature which can lead to a focus on short term returns.  Women’s longer time horizon may help them to prepare for retirement but if they are overly concerned with security they may not take enough risk to earn the investment returns needed to meet retirement needs.

Additionally, the Blackrock Investor Pulse Survey of 4,000 Americans found that 48% of women describe themselves as knowledgeable about saving and investing vs. 57% of men.  Women generally felt less confident making investment decisions and investing in the stock market.  Typically women were likely to do more research, take more time to make investment decisions, use more self-control and stay the course.

Studies have also indicated women enjoy learning about investments in a group setting and men are more likely to be independent learners.  Women are also more receptive to financial research and advice.

The best approach to successful investing is a blend of habits commonly practiced by both men and women.  Identify your personal biases and tendencies and make adjustments to achieve optimal investment results.

Timeless Tips for Investment Success

Jane Young, CFP, EA

Jane Young, CFP, EA

You don’t need to employ a lot of sophisticated techniques and strategies to become a successful investor.  The most effective tools for investment success are simplicity, patience, and discipline.  Below are some guidelines to help you get the most from your investments.

Invest for the long term.  Evaluate your situation, set some goals, create a plan and stick with it.   Keep money that you may need for emergencies and short term living expenses in less volatile investments such as money market accounts, CDs and bonds.   Investments in the stock market should be limited to money that isn’t needed for at least 5 years.  If you keep a long term perspective with the money invested in the stock market you will be less likely to react to short term fluctuations.

Maintain a diversified portfolio.  Your portfolio should be comprised of a variety of different types of investments including stocks, bonds and cash.  The stock portion of your portfolio should include stock mutual funds that invest in companies of different sizes, in different industries and in different geographies.  Don’t chase the latest hot asset class and don’t act on the hot stock tip your buddy shared with you at happy hour.  Create a diversified portfolio and rebalance on an annual basis.  It’s also advisable to avoid investing more than 5% in a single security.

Don’t Time the Market.  Many studies have found that market timing just does not work and can be detrimental to your portfolio.  The so-called experts really have no idea what the market is going to do.  Many analysts earn a living by projecting future market fluctuations when in reality they are no better at predicting the future than you or me.  Peter Lynch sums it up perfectly with the following quote – “More money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

Keep Your Emotions in Check. The stock market is volatile and there will be years with negative returns.   Limit investment in the stock market to money you won’t need for several years.  Have patience and stay the course.  As experienced after the 2008 correction, the market will eventually rebound.  Don’t succumb to media hype and fear tactics claiming things are different this time. There have always been, and always will be, major events that trigger dramatic fluctuations in the stock market.  Don’t panic this will pass.  Sir John Templeton once said, “The four most dangerous words in investing are: “This Time is Different!”

Be tax smart but don’t let taxes drive your portfolio.  Where possible maximize the use of tax advantaged retirement vehicles such as 401k plans and Roth IRAs.  Place investments with the greatest opportunity for long term growth in tax deferred or tax free retirement accounts.   Save taxes where it makes sense but don’t intentionally sacrifice return just to save a few dollars in taxes.

Don’t Let Emotions Derail Your Investment Portfolio

Jane Young, CFP, EA

Jane Young, CFP, EA

Emotions may be the single biggest detriment to your investment success.  We try to approach investments from a logical perspective but we are emotional creatures and money can stir-up intense feelings. The most common emotions are fear and greed which can lead us to overreact and sell low when the market is down and buy high when the market is at a peak.  Both actions are harmful to the performance of your investment portfolio. We can’t ignore emotions but we can better understand our emotional triggers and learn how to manage them.

You can minimize emotional reactions to fluctuations in the stock market by creating a plan.   With some planning you can establish a diversified asset allocation that incorporates your investment timeframe, financial goals and tolerance for risk.  A well designed asset allocation can ensure that money needed in the short term is placed in safer fixed income investments while long term money is invested in higher return, higher risk investments like stock mutual funds.   As a general rule, money needed in the next five years should not be invested in the stock market.  If you position your short term money in safer, less volatile investments such as money markets, CDs and bonds, you will be less likely to overreact   and act on emotion.

When you invest in the stock market prepare yourself for volatility including some years with negative returns.  Over long periods of time, the average return in the stock market has been around 9%, much higher than the average return for fixed income investments.  However, stock market returns are not level.  In some years, stock market returns will be higher than average and some years they will be lower than average. If you are prepared for this and maintain a long time horizon you will be more likely to stay on course.

Be wary of sensational news reports that claim the world is coming to an end and everything is different this time.  The stock market goes through cycles and there will always be scandals, bubbles and crises getting blown out of proportion by the media, financial pundits or financial companies trying to sell you something.  An example of this is commercials that use fear tactics to encourage you to buy gold and silver. They prey on the fear and uncertainty investors experience during a significant market drop.

Buying on emotion can also be detrimental to the long term performance of your portfolio.  We have a natural fear of missing an opportunity.  Avoid chasing the latest hot asset class or following the crowd because you don’t want to miss out.  Assets performing well this year may be next year’s losers and investments with abnormally high returns aren’t sustainable.  Don’t get swept up in the euphoria, keep your portfolio diversified where assets that perform well this year can buffer against those that aren’t performing well.

Slow and steady wins every time!

Avoiding the Stock Market Can be a Risky

Jane Young, CFP, EA

Jane Young, CFP, EA

You may be hesitant to invest in the stock market because it feels too risky.  However, consider the risk you are taking with your financial future by avoiding the stock market.  The primary reason to invest in the stock market is the potential for a much higher return, especially in low interest rate environments.  Most of us need the potential for long term growth provided by the stock market to meet our retirement needs.  If you invest all of your money in fixed income you may struggle just to keep up with inflation and you run the risk of outliving your money.

Historically, stock market returns have been almost double those earned by bonds.  According to the Ibbotson SBBI (stock, bonds, bills and inflation) report, between 1926 and 2014 the average annual return on Small Stock was 12.3%, Large Stock was 10.1%, Government Bonds was 5.5%, Treasury Bills was 3.5% and Inflation was 3%.  This illustrates that investing at least some of your portfolio in stock can provide a much greater opportunity than fixed income to meet your financial goals.

Investing in the stock market is not without risk.  As with all investments, we must take on greater risk to earn a greater return.  However, there are many ways to help manage the volatility of the stock market.  Before investing in stocks make sure your financial affairs are in order.  Pay off your credit cards, establish an emergency fund and put money that will be needed over the next five years into less volatile fixed income investments.  The stock market is for long term investing.  It can provide the opportunity to earn higher long term returns but you can count on some volatility along the way.  By creating a buffer to cover short term needs you will be less likely overreact to fluctuations in the market and sell when the market is down.

You can also buffer stock market risk by creating a well-diversified portfolio comprised of mutual funds invested in stocks or bonds from a variety of different size companies, different industries and a variety of different geographies.  Investing in a single company can be very risky but investment in mutual funds can reduce this risk.  When investing in mutual funds your money is combined with that of other investors and invested, by a professional manager, into a large number of stocks or bonds.  Investing in a large number of companies enables you to spread out your risk.

Dollar cost averaging, where you automatically invest a set amount on a regular basis – usually monthly or quarterly, can also reduce risk.  Rather than investing a large amount all at once, when the market may be high, you gradually invest over time.  With dollar cost averaging you buy more shares when the market is low and fewer shares when the market is high.

Mutual Funds Probably Better Option Than Individual Stocks

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Mutual funds are a better option than individual stocks for most investors.  The decision to invest in mutual funds or individual stocks depends on the size of your portfolio, your investment knowledge, your level of time and involvement, your risk tolerance, your ability to make objective investment decisions and your tax situation.

Many investors don’t have enough money to adequately diversify their portfolio across a wide range of individual stocks.   To gain true stock diversification, you need to invest in companies of different sizes, in a wide range of different industry sectors and in a variety of different geographies. Mutual funds enable you to gain this broad diversification by pooling your money with a large number of other investors.

Additionally, mutual funds are professionally managed, making them ideal for individuals with limited investment knowledge or a limited amount of time to research and monitor individual stocks.  Most mutual fund companies have a large staff of managers and research analysts who analyze financial reports, visit companies and keep tabs on the economic and political climate.  It is very difficult for most     investors to devote the time and commitment needed to create and maintain a well-diversified portfolio of individual stocks.

Professional managers also have access to more timely information.  Many investors are tempted to buy and sell individual stock based on current events.  However, the market is relatively efficient which means it quickly responds to new information.  What seems like breaking news has probably already been factored into the price of the stock.

Unfortunately, diversification and professional management does not come without a cost.  Most mutual funds charge an annual management fee of between .25 and 1.25%.

Additionally, when investing your own money it is hard to stay objective.  We have a natural inclination to emotionally react to changes in the market and to become emotionally attached to specific stocks.  It is easier for mutual fund managers to make objective decisions.  Performance is usually better when we stay on course and history shows us that investors in individual stocks trade more frequently than mutual fund investors.

Mutual funds can also be a better option for investors who are risk adverse. By investing in a broadly diversified portfolio of mutual funds, most of your risk will come from fluctuations in the market.  A portfolio comprised of several individual stocks is generally more volatile.  It also carries a higher risk of losing money if a company, whose stock you own, has financial problems or goes out of business.

A disadvantage to owning mutual funds, instead of individual stocks can be a lack of control on when you pay capital gains. This is especially true if you are in a high tax bracket and a lot of your money is invested outside of retirement accounts.  When fund managers sell stock, gains must flow through to the investors as they are earned, not when the fund is sole.

Asset Allocation – the Foundation of Your Portfolio

Jane Young, CFP, EA

Jane Young, CFP, EA

Your asset allocation serves as a foundation from which to build your investment portfolio.  An asset allocation identifies the types of investments and the proportion of each you plan to hold in your portfolio.  At a very general level most investments are broken into three categories: stocks, interest earning, and real estate.  Each of these broad categories can be broken down further into hundreds of different options.   The two factors that usually drive an asset allocation are the timeframe in which you will need your money and your personal risk tolerance.  Generally, we strive for a diversified portfolio that provides the highest rate of return for the level of risk we are willing to take.

The first step in developing an asset allocation is to evaluate your current situation and determine when the money you are investing will be used.  Money that is needed in the short term should be placed in interest earning investments, not in real estate or the stock market.  Interest earning investments, such as money market accounts and CDs, are secure but usually provide a rate of return below the rate of inflation.  While it’s important to keep your short term money safe, too much in interest earning investments will stifle the long term growth potential of your portfolio.

Once your short term money has been secured, you can create a diversified portfolio that supports your investment timeframe and risk tolerance.   A great way to diversify is through the use of low cost mutual funds.  Mutual funds enable groups of individuals to pool their money to buy a large number of different companies or government entities.  Mutual funds enable you to maintain a diversified asset allocation by investing in funds with different objectives.  Consider selecting funds that invest in a variety of stocks and bonds in large, medium, and small companies within different industries and different geographical regions.  Your goal is to maintain diversification so that when one category is doing poorly it may be offset by another category that is performing well.   A diversified asset allocation allows you to spread out your risk so you don’t have dramatic losses if a given company or asset class performs poorly.   Additionally, by spreading your asset allocation over a broad range of investments, you may have opportunities that would have been too risky in an undiversified portfolio.

Your asset allocation is the framework of your portfolio – establish a plan that meets your objectives and stick with it!  Avoid making changes to your asset allocation based on emotional reactions to short term changes in the market.   Over time, your portfolio will get out of balance due to fluctuations in the market.   I recommend adjusting your portfolio by rebalancing on an annual basis.  In addition to keeping your asset allocation on target, the need for rebalancing will result in selling stock when it is high and buying when it is low.

Stock Market Investing Requires a Long Term Perspective

 

Jane Young, CFP, EA

Jane Young, CFP, EA

The recent volatility in the market has prompted some investors to question the future direction of the stock market.  Unfortunately, the stock market is impacted by so many factors that it is impossible to predict short term movements.  Over the long term, the stock market has always trended upwards but the path has been anything but smooth.   We could be on the tipping point before a major correction or at the beginning of a long bull market – we just don’t know. 

As a result of this uncertainty, it is impossible to effectively time the market.  Not only do you need to accurately predict when to sell but you also need to know when to re-enter the market.  Even if you select the right time to sell, there is a good chance you will be out of the market when it makes its next big move.  

To compound this issue, decisions to buy and sell are frequently driven by short term emotional reactions.   The fear of losing money can trigger us to make a sudden decision to sell, or the fear of missing an opportunity can cause a knee jerk reaction to buy.  We need to resist these very normal emotional reactions and maintain a long term focus.  The stock market should only be used for long term investing.  If you don’t need your money for at least five to ten years you are more likely to stay invested and ride out fluctuations in the market. 

If you lose your long term perspective, and react to short term emotional reactions, you can get caught up in a very detrimental cycle of buying high and selling low.  An example of a common cycle of market emotions begins when the market drops and you start getting nervous.   Over time you become increasingly fearful of losing money and end up selling your stock investments after the market has dropped considerably.   Then you sit on the sidelines for a while, waiting for the market to stabilize.  The market starts to rebound and you decide to jump back in after that market has gone back up.  Afraid of missing a great opportunity, you buy at the market peak.   This is a self-perpetuating cycle that can be very harmful to your long term investment returns.

To avoid the temptation to time the market and react to emotional triggers, keep a long term perspective.   Focus on what you can control.  Maintain a well-diversified portfolio that is in line with your long term goals and your investment risk tolerance.  Live within your means and maintain an emergency fund of at least four months of expenses.  Invest money that you will need in the short term into safer interest earning investments.   By limiting your stock market investments to long term money, you will be more likely to stay the course and meet your investment goals.

Investing in a Volatile Market

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Here are some things you should keep in mind when investing in the stock market; the market will fluctuate, there will be years with negative returns, the stock market is for long term investing, and the media and prognosticators will greatly exaggerate negative information to create news and get attention.  If you keep this in mind, you can dramatically improve your long term investment returns and sleep better at night.  Based on numerous studies conducted by DALBAR, the average investor earns several percentage points below the market average due to market timing and emotional reactions to market fluctuations.  It’s how we are wired.  When the market goes up, we feel good and we want don’t want to miss out on the opportunity to make money.  As a result, we buy stock when the market is at its peak.  On the flip side, when the market drops we worry about losing money, and sell when the market is at the bottom.  It’s hard to make money in this cycle of buying high and selling low.  When investing in the stock market, try to avoid overreacting to the inevitable short term fluctuations in the market.

Other factors that can help you ride out dramatic fluctuations in the market include establishing a solid financial foundation and maintaining an asset allocation that meets your investment timeframe.  Establish a solid financial foundation by living within your means, minimizing the use of credit, and maintaining an emergency fund of 3 to 6 months of expenses.  A strong foundation helps you avoid pulling money out of the stock market at inopportune times should an emergency arise. 

Once you have established a strong financial foundation you can start investing in the stock market.  One key to success with stock market investing is establishing an asset allocation that’s in line with the timeframe in which you will need money.  Money that is needed in the short term should not be invested it the stock market.  As a general rule, do not invest any money needed within the next five years in the stock market.  Over long periods of time the stock market has trended upward, but in the short term there have been periods with substantial drops.  Give yourself time to ride out the natural fluctuations in the market.  

Additionally, it is important to diversify your money across a wide variety of investments.  You can reduce the amount of risk you take by diversifying across different companies, municipalities, industries, and countries.  When one type of investment is doing poorly, another may be doing well.  This helps to buffer the losses you may experience in your portfolio.  An excellent way to diversify is through the use of a variety of different types of mutual funds.  Mutual funds pool your money with money from others to invest in a large number of companies or government entities based on a predefined investment objective.

Investment Risk Comes in Many Forms

Jane Young, CFP, EA

Jane Young, CFP, EA

One of the first steps when investing money is evaluating your tolerance for risk.  The amount of return you can earn is heavily dependent on how much risk you are willing to take.   We generally associate investment risk with market risk, or the possibility of losing money due to fluctuations in the stock market.   The stock market is volatile and can be a high risk investment if you have a short time horizon.  However, over long periods of time, the stock market has trended upward.  It’s important to consider your tolerance for stock market risk when building your portfolio.  However, the risk of losing money due to a drop in the stock market is only one of many risks that can adversely impact your financial security.

Although fixed income investments are generally considered safer than the stock market, they are not without risk.  Fixed income investments can include CD’s, bonds, bond funds and cash accounts such as money market or savings accounts.  The most common types of risk associated with fixed income investments are interest rate risk and default risk.

Interest rate risk is the possibility of your bonds dropping in value when interest rates increase.  When interest rates increase, the value of an existing bond decreases to compensate for higher interest rates available on the market.  Generally, if you buy and hold an individual bond till maturity, you will get back the full face value plus any interest that was earned.   However, when you own a bond fund,  you don’t have control over when bonds within the fund are sold.  When interest rates rise, bond managers may be forced to sell bonds at inopportune times due to the large number of withdrawals.

Individual bonds have less interest rate risk than bond funds, but they have a higher degree of default risk.  Default risk is the possibility of losing your principal if the bond issuer becomes insolvent.  Bond funds are able to reduce the default risk by pooling your money with others and investing in a large number of different companies or municipalities.

 Treasury bonds and FDIC insured CD’s provide what is generally considered a risk free rate.  If held to maturity, there is very little chance of losing principal.  Your investment is insured by the Federal government against default risk, and you have control over when you sell.  The primary downfall with this type of investment is the extremely low rate of return.

Investing too much in extremely safe, low earning investments often results in inflation risk.  Money placed in “safe” investments with a low rate of return can’t keep up with inflation, resulting in a negative real return.   You also lose the opportunity to earn a reasonable rate of return needed to grow your retirement account.   It’s all about balance; you need to take some market risk to build and maintain your retirement account and stay ahead of inflation.

8 Timeless Tips to Keep Your Investments on Track

  1. Keep It Simple – Don’t invest in anything that you don’t understand.   Most investments aren’t that complicated. Be very cautious if you are considering an investment with pages and pages of difficult to understand legal verbiage.  You can bet the small print wasn’t added for your benefit.
  2. Pigs Get Fat, Hogs Get Slaughtered – The biggest risk to sensible investing is fear and greed.  If it sounds too good to be true, it probably is.  Don’t fall for offers with exceptionally high returns. If someone promises you a return significantly higher than the market rate, there’s a catch.  It’s either a scam or there are huge risks involved. Perform some due diligence to understand why the returns are higher than normal.
  3. Keep Your Emotions in Check – Establish and stick to an allocation that meets your timeframe and risk tolerance. The stock market will rise and fall.  Don’t fall into the trap of panic selling when the market falls, only to turn around and buy when the market’s back on top.  You don’t make much money selling low and buying high.
  4. Diversify, Diversify, Diversify – At a minimum, your net worth should reflect a combination of stock mutual funds, fixed income investments, and real estate.  You should hold a large number of different investments within each category.  For example, your stock portfolio should be comprised of small, medium, and large companies in a variety of different industries in the U.S. and abroad.  A diversified portfolio provides a buffer against volatility.  Each category responds differently to changing economic and political conditions.
  5. Invest Based on When Money is Needed – Maximize your risk/return ratio by designing a portfolio that supports your investment time horizon.  Generally, money needed in the short term should be invested in safe, less volatile investments.  Your return may be limited, but your principal will be safe.  With long term money, you can take more risk and potentially earn a higher return.  With a longer time horizon you can ride out the fluctuations in the stock market.
  6. Be Tax Smart – Consider tax consequences when buying and selling investments, and maximize your contributions to tax advantaged retirement plans. Within taxable accounts, municipal bonds and mutual funds with a low turnover ratio are good options.  Also, watch for opportunities to harvest tax losses.
  7. Avoid High Fees, Commissions and Surrender Charges – High fees, commissions, and surrender charges can eat into your return and limit your flexibility.  Review prospectuses and investment reports to fully understand the fees and penalties associated with the funds or products you are considering.
  8. Stocks Don’t Have Memories – Don’t keep a poor performing security with hopes it will return to its original purchase price. Stock and stock mutual funds should be evaluated based their future potential.  There is no correlation between the current value of a stock and what you paid for it.

Invest in Your Career as Well as Your Portfolio

 

Jane Young, CFP, EA

Jane Young, CFP, EA

When it comes to financial planning, we generally focus on spending, saving, and investing money, and place less emphasis on career planning.  While it’s essential to properly manage the money you have saved and invested, you also need to capitalize on opportunities to enhance your earning capabilities.  Over time, investing in yourself and your career can have a significant positive impact on your net worth.  

Start by reflecting on who you are; identify your strengths, your areas of expertise and what you enjoy doing.   Identify your primary career goals; develop a personal vision statement and a personal strategic plan to help reach these goals.  Too often we leave the direction and progress of our career to chance rather than following a carefully laid out plan.  We often become comfortable and complacent in our current position, and miss opportunities to progress in our career and maximize our earnings. 

The process of investing in yourself and your career is an on-going endeavor regardless of your short term plans.   Everything you do, your relationships, behavior, and appearance all affect the success of your career.  I was reminded of this by a friend who once told me to think of myself as Jane Young, Inc.  We all have our own unique brand that needs to be developed, enhanced and reinforced. Everything you wear, say, or do creates a perception on how a potential boss or client may view you.  You need to build a brand and project an image that helps you reach your career goals.

It is also essential to nurture and grow your professional network.  Unfortunately, there is a tendency to neglect your professional network when you feel secure in a long held job.  As a result, your contacts may not think of you or may not be aware of your current qualifications when opportunities arise.  Additionally, if you unexpectedly lose your job you don’t have a solid network to tap into for help in finding a new job.

In addition to maintaining a strong professional network, it is crucial to stay abreast of innovations and changes in your career field.  Things are changing so fast that it is essential to learn new technologies and skills for your current job, as well as positions you would like to move into in the future.  You should also be taking steps to get additional education, certifications, and skills needed to meet your long term career goals.

Finally, take a proactive role in advancing your career.  You need to communicate your goals, needs, and expectations to your boss in a professional and productive manner.  Ask what is required to get a raise or a promotion, this helps establish a mutual understanding.  Be sure to consider the political dynamics within your company, and communicate your needs in a manner that illustrates the value you can provide to your boss and the firm.

You May Need to Take Some Risk to Meet Your Goals

Jane Young, CFP, EA

Jane Young, CFP, EA

Before you start investing, it is important to understand the relationship between risk and return and as well as what level of risk you are comfortable taking.  Generally, an investment with a higher return will involve taking on more risk.    If all investment opportunities provided the same return, everyone would select the least risky choice.  As a result, a more risky investment must provide a higher return to attract investors.  At the most basic level, an investment is where one party needs money and another party has money to lend or invest.  The investor does not want to lose his money, so he demands an increasing level of return as the risk increases.

There are many different kinds of risk.  One of the most common is market risk, or the risk of losing money in the stock market when the price of stock falls.  This can be caused by a change in the overall economic situation, impacting the entire market, or by a change within a specific company.  A commonly accepted practice for decreasing this type of risk is diversification into many companies in different industries and different geographical locations. 

When investing in fixed income or interest earning investments, such as bonds and CDs, the most common risks are default risk and interest rate risk.  Default risk is the risk that the bond issuer will become financially insolvent or bankrupt.  Bond issuers are rated based on their stability to help investors gauge how much risk they are taking.  Interest rate risk is the risk that interest rates will increase after you have purchased a bond or CD, resulting in a drop in the current market value. This is of greatest concern if you own a bond fund or don’t hold an individual bond to maturity.

Two additional risks that many investors fail to consider include opportunity loss and inflationary risk.  If you try to avoid risk by avoiding the stock market, you may hurt your chances to earn a decent return.  With current interest rates on CDs and Treasury Bonds so low, conservative investors may be unable to keep up with inflation and build their retirement plans to desired levels.   Volatility in the stock market can be very scary, but over long periods of time it has outperformed most other investments.  By avoiding the stock market you take the risk of missing out on the higher returns provided with a more balanced portfolio.  You may even lose money, if inflation exceeds the interest rate on your CDs.

Moderation is the key.  Investing your entire portfolio in the stock market is far too risky, but investing your entire portfolio in fixed income is also risky.  You risk losing the opportunity to earn a reasonable rate of return, to keep up with inflation and to meet your investment goals.  The best plan is a diversified portfolio that meets your investment timeframe and long-term goals.

How ETFs Differ from Mutual Funds

 

Jane Young, CFP, EA

Jane Young, CFP, EA

ETFs (Exchange-Traded Funds) and mutual funds are investment vehicles that enable investors to pool their money to buy a collection of stocks or bonds.   This makes it practical for the average investor to diversify their holdings across a large number of companies or entities.   Mutual funds can be actively or passively managed.   Generally, ETFs are passively managed and are designed to represent a specific index or category of securities, similar to an index mutual fund.   ETFs are especially useful in focusing on narrow sectors of the market that frequently aren’t offered by mutual funds.   ETFs can be especially useful to invest in a specific country or industry sector.

Mutual funds and ETFs differ in how they are traded.  Mutual funds are bought and sold through a mutual fund company.   ETFs are bought and sold on the market, between investors. Shares in a mutual fund are traded based on the price at the close of the day.   ETFs can be traded throughout the day, anytime the market is open.  This is similar to the manner in which individual stocks are traded.  

Generally, ETFs have lower fees than mutual funds because of lower overhead costs.  This is especially true when comparing ETFs to actively managed mutual funds.  However, when you purchase an ETF you must pay a brokerage fee every time a transaction is made.  Mutual funds may be more efficient if you are planning to dollar cost average, or buy shares over a period of time.

Due to structural differences, ETFs can provide greater tax efficiencies than mutual funds.  ETFs are traded on the market between investors, much like individual stocks.   When investors buy and sell shares of ETFs, shares are exchanged between one another; there is no taxable sale of stocks or bonds within the ETF.  On the other hand, mutual funds are traded within a mutual fund company.  If several investors decide to sell, the manager may be forced to sell stock or bonds within the fund to cover the redemption.  This is a taxable event that may result in capital gains that must be passed on to the shareholders.

Additionally, the structure of an ETF allows for the creation and redemption of shares with in-kind transactions.   Capital gains taxes are avoided because there is no taxable sale of stocks or bonds within the ETF when an in-kind redemption is done.

Finally, ETFs are generally tax efficient because they are passively managed, similar to an index fund.  Passively managed investments track to an index and don’t do a lot of trading.  With less trading, the investor should incur less capital gains while holding the ETF.   Mutual fund investors can also minimize their exposure to capital gains by purchasing index funds and tax efficient funds that do minimal trading.  Both Mutual Funds and ETFs that invest in bonds or dividend paying stocks must pass interest and dividend income on to shareholders.

The Pitfalls of Market Timing

Jane Young, CFP, EA

Jane Young, CFP, EA

Market timing is one of the most detrimental ways an investor can negatively impact his stock market returns. History shows that investors do not effectively time the market. For the last nine years, DALBAR, Inc., a market research firm, has conducted an annual study on market returns called the Quantitative Analysis of Investor Behavior (QAIB). This study has consistently found that returns earned by the individual investor are significantly below that of the stock market indices. The 2013 QAIB report found that during the 20 year period between 1998 and 2012, the average mutual fund investor lagged the stock market indices by 3.96%. This is a significant improvement over the period between 1991 and 2010, in which the average investor lagged the mutual fund indices by 5.1%. According to Dalbar, “No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who time the market.”
The stock market is counterintuitive in that the best time to sell is usually when the market seems to be doing well, and the best time to buy is usually when the market is doing poorly. As investors, our decisions are frequently driven by emotion rather than cognitive reasoning. We frequently overreact to emotions of fear and greed which throws numberswiki.com

us onto an investment roller coaster. When the stock market goes up we start to feel more and more optimistic, and as the market rises higher we get caught up in a state of euphoria. Our sense of greed kicks in and we don’t want to miss the opportunity to make money, so we buy when the market is high. The market may stay up for a while but eventually the economic cycle changes and stock prices start to drop. Initially we rationalize that this is temporary, or just a minor correction. As the market continues to drop we become more and more concerned. Soon our sense of fear kicks in, we start to panic and we sell at the wrong time. If we don’t recognize the dangers of this emotion driven cycle we are deemed to repeat it.
In addition to our intrinsic emotional response, we are bombarded by sensationalized news and advertising campaigns to influence us to change the course of our investment strategy. Don’t get caught up in the hype about the next big investment craze. Your best course of action is to develop and follow an investment strategy that supports your tolerance for risk and investment timeframe. The stock market is volatile and is best suited for long term investing. Time is needed to absorb fluctuations in the market. Keep short term money in fixed income investments. You will be less tempted to time the market in a well-diversified portfolio specifically designed for your investment time horizon.

Variable Annuities May Not Be Your Best Option

Jane Young, CFP, EA

Jane Young, CFP, EA


A variable annuity is an investment contract with an insurance company where you invest money into your choice of a variety of sub-accounts. Sub-accounts are similar to mutual funds, where money from a large number of investors is pooled and invested in accordance with specific investment objectives. Like mutual funds, sub-accounts may invest in different categories of stock or interest earning investments.
One characteristic of a variable annuity is the tax deferral of gains until the funds are withdrawn. However, upon distribution the gains are taxable at regular income tax rates, as opposed to capital gains rates that may be available for mutual funds. Additionally, there is no step-up in basis upon death for assets held in variable annuities.
Variable annuities are generally more appropriate for non-retirement accounts because gains within a retirement account are already tax deferred. Traditional retirement accounts and Roth IRAs meet the tax deferral needs for most investors. However, in some cases a variable annuity may be attractive to a high income investor who has maximized his traditional retirement options and needs additional opportunities for tax deferral. This is especially true for an investor who is currently in a high tax bracket and expects to be in a lower tax bracket in retirement.
When investing in variable annuities, with non-retirement money, there is no requirement to take a Required Minimum Distribution at 70 ½. However, there is generally a 10% penalty on withdrawals made before 59 1/2. Trades can be made within a variable annuity account without immediate tax consequences. The entire gain will be taxable upon withdrawal. There is no annual contribution limit for variable annuities, and you can make non-taxable transfers between annuity companies using a 1035 exchange. However, you may have to pay a surrender charge if you have held the annuity for less than seven to ten years, and you purchased it from a commissioned adviser. Before buying an annuity, read the fine print to fully understand all of the fees and penalties associated with the product. Most variable annuities have early withdrawal penalties and a higher expense structure than mutual funds.
A variable annuity may be an option for someone who wants to purchase an insurance policy to buffer the risk of losing money in the market. For many investors, due to the long term growth in the stock market, this guarantee may be come at too high a price. Some investors are willing to pay additional fees in exchange for the peace of mind that a guaranteed withdrawal benefit can provide. Guaranteed minimum withdrawal benefits (GMWB) can be very complex and have some significant restrictions. Additionally, some products offer a guaranteed death benefit for an extra fee. Read the contract carefully and make sure you understand the product before you buy.
Due to the high costs, lack of flexibility, complexity and unfavorable tax treatment variable annuities are not beneficial for many investors.

Tips to Acheive Financial Fitness

Jane Young, CFP, EA

Jane Young, CFP, EA


The first step toward financial fitness is to understand your current situation and live within your means. Review your actual expenses on an annual basis and categorize your expenses as necessary or discretionary. Compare your expenses to your income and develop a budget to ensure you are living within your means and saving for the future. The next step is to pay off high interest credit cards and personal debts. Once you have paid off your credit cards, create and maintain an emergency fund equal to about four months of expenses, including expenses for the current month. Your emergency funds should be readily accessible in a checking, savings or money market account.
Now it’s time to look toward the future. Get in the habit of always saving at least 10% to 15% of your gross income. Think about your goals and what you want to accomplish. If you don’t own a home, you may want to save for a down payment. When you purchase a home make sure you can easily make the payments while contributing toward retirement. Generally, your mortgage expense should be at or below 25% of your take home pay.
Contribute money into retirement plans, for which you qualify. Make contributions to your 401k plan, at least up to the employer match and maximize your Roth IRA. If you are self-employed, consider a SEP or a Simple plan. If you have children and want to contribute to their college expenses, consider a 529 college savings plan. Do not contribute so much toward your children’s college fund that you sacrifice your own retirement.
As you save for retirement, be an investor not a trader. Investing in the stock market is a long term endeavor, forecasting the short-term movement of the stock market is fruitless. Avoid emotional reactions to headlines and short term events. Don’t overreact to sensationalistic stories or chase the latest investment trends. Establish a defensive position by maintaining a well-diversified portfolio, custom designed for your unique situation. Slow and steady wins the race!
Don’t invest in anything that you don’t understand or that sounds too good to be true. If you really want to invest in complicated products, read the fine print. Be especially aware of high commissions, fees, and surrender charges. There is no free lunch; if you are being offered above market returns, there is probably a catch. Keep in mind that contracts are written to protect the insurance or investment company, not the investor.
It is impossible to predict fluctuations in the market or to select the next great stock. However, you can hedge your bets with a well-diversified portfolio. Establish an asset allocation that is aligned with your goals, investment timeframe, and risk tolerance. Your portfolio should contain a mix of fixed income and stock based investments across a wide variety of companies and industries. Rebalance your portfolio on an annual basis to stay diversified.

The Difference Between an Roth IRA and a Traditional IRA

Jane Young, CFP, EA

Jane Young, CFP, EA


One of the biggest decisions associated with saving for retirement is choosing between a Roth IRA and a Traditional IRA. The primary difference between the two IRAs is when you pay income tax. A traditional IRA is usually funded with pre-tax dollars providing you with a current tax deduction. Your money grows tax deferred, but you have to pay regular income tax upon distribution. A Roth IRA is funded with after tax dollars, and does not provide a current tax deduction. Generally, a Roth IRA grows tax free and you don’t have to pay taxes on distributions. In 2013 you can contribute up to a total of $5,500 per year plus a $1,000 catch-up contribution if you are over 50. You can make a contribution into a combination of a Roth and a Traditional IRA as long as you don’t exceed the limit. You also have until your filing date, usually April 15th, to make a contribution for the previous year. New contributions must come from earned income.
There are some income restrictions on IRA contributions. In 2013, your eligibility to contribute to a Roth IRA begins to phase-out at a modified adjusted gross income of $112,000 if you file single and $178,000 if you file married filing jointly. With a traditional IRA, there are no limits on contributions based on income. However, if you are eligible for a retirement plan through your employer, there are restrictions on the amount you can earn and still be eligible for a tax deductible IRA. In 2013 your eligibility for a deductible IRA begins to phase out at $59,000 if you are single and at $95,000 if you file married filing jointly.
Generally, you cannot take distributions from a traditional IRA before age 59 ½ without a 10% penalty. Contributions to a Roth IRA can be withdrawn anytime, tax free. Earnings may be withdrawn tax free after you reach age 59 ½ and your money has been invested for at least five years. There are some exceptions to the early withdrawal penalties. You must start taking required minimum distributions on Traditional IRAs upon reaching 70 ½. Roth IRAs are not subject to required minimum distributions.
The decision on the type of IRA is based largely on your current tax rate, your anticipated tax rate in retirement, your investment timeframe, and your investment goals. A Roth IRA may be your best choice if you are currently in a low income tax bracket and anticipate being in a higher bracket in retirement. A Roth IRA may also be a good option if you already have a lot of money in a traditional IRA or 401k, and you are looking for some tax diversification. A Roth IRA can be a good option if you are not eligible for a deductible IRA but your income is low enough to qualify for a Roth IRA.

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