A Message About Risk

The following is a story that was related to me by another financial planner. The message is quite remarkable – and important for all of us to understand.

A dentist, age 53, had sold his practice and partially retired. When we reviewed his portfolio, which amounted to approximately two million dollars, it became apparent that he had strong feelings regarding protection of capital. The entire two million dollars was invested in a combination of CD’s, money market funds, and short-term US government bonds.
A portfolio with this kind of makeup is considered risk averse, meaning that there is little if any risk to the capital invested in the portfolio. In other words, there was virtually no chance at all that he would ever lose money with these investments.
When asked why he chose to invest solely in these no-risk (and low-return) investments, the dentist replied that he was concerned about terrorism, specifically nuclear terrorism, that could irrevocably impact our financial markets for an extended period of time.
Due to this fear, he did not want his money exposed to the stock market, but rather wanted it solely invested in “low-risk” vehicles. This portfolio was producing an annual income of approximately $70,000, which was adequate for the dentist to live on.
What the dentist did not account for with his investment strategy was the impact of inflation. Two questions were necessary to begin to assess the situation completely:

1. What was the dentist’s degree of certainty that a terrorist event of the nature that he was concerned about, would occur within the foreseeable future?
2. What was the dentist’s degree of certainty that the rate of inflation would likely continue at the same rate in the future as it has in the past 30 years or so?

Regarding the first question, the dentist indicated that he thought there was at least a 1 in 5 chance that such an event would occur. This translates to a 20% certainty (in his mind) that he was guarding against.
On the second question, however, the advisor felt that the level of inflation from the past 30 years or so would likely continue for the next 30 years or so (his life expectancy), with a degree of certainty of 90%.
If you take those two factors alone, it becomes quickly apparent that the dentist’s “safe” investment portfolio was actually exposed to a high level of risk – inflation risk, specifically. As each year passes, his risk-averse portfolio would erode by approximately 3%, which would soon begin to dramatically impact his income. Below is a projection of the value of his portfolio, as he continued with his current value withdrawals over the next 5, 10, 20, and 30 years, as well as the proposed allocation:

CURRENT PROPOSED
Today $2,000,000 $2,000,000
+ 5 years $1,977,601 $2,083,188
+10 years $1,887,644 $2,162,303
+20 years $1,479,069 $2,080,007
+30 years $ 300,150 $1,497,260

As you can see, even when you think you’ve covered the bases by investing in only the safest investments, you still have risk to deal with.
Inflation risk is the most difficult to deal with, because it is a “silent” risk. That is, you don’t write a check for the cost of inflation, but rather, it creeps up in the rising cost of living all around you.
By keeping a portion of your portfolio invested in an inflation-hedged vehicle, such as stocks, real estate, inflation-protected issues, and other items, you can begin to protect yourself against the ravages of inflation risk.
In the case of our dentist friend, his “safe” portfolio was only protecting him against a risk that he, admittedly, indicated at a 20% certainty. At the same time, he had no protection in his portfolio against the risk that he indicated was 90% certain.
Repositioning even a minority portion of his account resulted in a dramatic improvement in the outlook. The proposed allocation illustrated above was a hypothetical investment of 25% (rebalanced every year) in an issue yielding a modest 8% return.
The lesson? There is no such thing as a totally safe portfolio. You can take certain steps that will help to positively impact the degree of all kinds of risk – in terms of reducing the risk, but risk can never be totally eliminated. A properly balanced portfolio will likely have at least one component or another that is being adversely impacted at any one time, while the remainder of the portfolio is experiencing positive impact.

FAQ - Identity Theft

Listed below are some of the questions that I’ve received recently regarding financial planning in general, my practice, and investing in general.

Q: I hear a lot about Identity Theft. What can be done to reduce the risks?
A: Several things can be done to reduce your exposure to risk of Identity Theft. Among them are:
1. Keep good records of your credit card numbers, contact information, and other important numbers. A photocopy of the card, front and back, should be kept with your other important records.
2. Safeguard your information. Keep your Social Security number to yourself, and only use it in absolutely necessary circumstances with absolutely trusted parties.
3. Never give out your credit card information to someone who calls you. If it is a necessary transaction with a trusted vendor, get a return number and call them back before handing over information.
4. Watch your mail for regularly-scheduled bills. If one is missing, track it down immediately. Oftentimes these bills contain all of the information that an identity thief needs to take over your financial life.
5. Shred your financial documents before sending them out with the trash. A recent study by a credit reporting agency determined that nearly three quarters of all households casually throw away documents with full name and address, while 40% put out documents with full credit card account information included. “Dumpster diving” has become one of the favorite methods of identity thieves for getting at your information.
6. Monitor your credit report. You should get a full credit report at least annually, and since this still leaves a perpetrator 12 months between your checkups, you might want to consider an alert service, such as the one at www.privista.com. This service will notify you any time a new account is opened under your name, as well as when a surprisingly large purchase is made on one of your accounts.
7. Be aware. It pays to do everything in your power to eliminate the potential for identity theft. Be careful when handling your card(s), ensuring that you don’t inadvertently leave one behind or leave vital information where someone else can get to it. These folks will go to great extremes to get your information, because it can be very lucrative to them. A single case of identity theft can result in thousands of dollars going into the hands of an unscrupulous individual, while your good name and credit score go down the tubes.

TIDBITS - College Savings

* Retirement vs. College Saving. Those of us who are parents know this conflict very well – should we put aside money for retirement, or for college? It may come as a surprise, but a general rule of thumb with regard to this conflict is to put money aside for retirement first, and college second.

The reason behind this is that there are literally a boatload of ways to pay for college, such as grants, scholarships, work-study programs, student loans, parent loans, etc.. With this plethora of choices, it becomes clear that your student’s college funding needs can be met from quite a few angles, none of which should have a dramatic impact on your overall net worth (or your student’s).

On the other hand, no one will give you a scholarship to retire. It is solely up to you and your savings (coupled with Social Security and any available pensions).

* Congress has, as of the end of September, begun an oversight hearing on 529 plans. It is anticipated that this hearing will cover High Fees, Disclosure, Disparate Tax Treatment, and Questionable Broker Sales Practices, according to the title of the hearing. Stay tuned, I will pass along any significant developments that come from this hearing.
Some other Illinois universities’ costs:

* www.2save4college.com –I always welcome your feedback for new information that you’d like to see on any of my web sites. Use the “Contact Us” page on any web site to provide feedback.

5 Things You Need to Know About Retirement Plans

Many of us are covered by one or more types of defined contribution retirement plans, such as a 401(k), 403(b), 457, IRA, SEP-IRA, or any of a number of other plans. What many of these plans has in common is that they are categorically Cash Or Deferred Arrangements (CODA), as designated by the IRS. Each type of plan has certain characteristics that are a little different from other plans, but most of them have the common characteristic of deductibility from current income and deferred taxation on growth.

1. Each dollar you defer is worth more than a dollar. It’s true. As you defer money into your retirement account, each dollar that you defer could be worth as much as $1.54. How, you might ask?

Since you are not taxed on the dollar that has been deferred into the retirement account, your “take home” pay only reduces by the amount that is left over after taxation. For example, if you’re in the 25% bracket, generally your income will only reduce by 75¢ for every dollar that you defer into your retirement plan. Therefore, the 75¢ that you’ve effectively “spent” is worth 33% more ($1.00) in your retirement account.

If you happened to be in the 35% tax bracket, this works out to a 54% increase in the value of each dollar deferred. This doesn’t even take into account the potential for matching dollars from you employer!

2. Matching – FREE MONEY. Well, it’s not exactly free, you must defer some funds in order to take advantage of it, but other than that, your employer is actually chomping at the bit to give you this money. The reasons can be far-reaching, but the point is that it’s literally yours for the taking. It should be noted that some companies do not match your funds at any level in a plan.

So, what should you do about this? If you aren’t currently participating in your company’s 401(k) or other deferred compensation plan and they match your funds, you are throwing money away by not participating. Depending upon the options in your plan, you could be turning your back on as much as a 100% return on your investment – guaranteed! Everyone should take advantage of AT LEAST the matched portion of your deferred compensation plan. After that, it may make good sense to put money aside in a Roth IRA (up to the maximum annual amount), before continuing to max out your 401(k).

3. Don’t Overload On Company Stock. Even if you’re in a company where the stock has experienced dramatic increases in recent history, you need to make sure that your overall exposure to any one company is limited. A rule of thumb that I use is: no more than 5% of your overall net worth in any one company. If you are inclined to have a larger stake in your company because you work there and enjoy the sense of ownership, I wouldn’t put any more than 10% in that stock. The figure is doubled for the company that you work in because, at least presumably, you are more in tune with the value and internal events of that company and could make adjustments if an event were coming up that could seriously impact your holdings.

Of course, the reason behind this is to limit your exposure to the ebb and flow of one company’s stock price. For example, if you held stock in one company that amounted to 30% of your overall net worth, and that stock took a major hit of a 25% price reduction. This one event would have the impact of yanking down your net worth balance by 7.5% - quite a serious impact, to say the least. The folks at Enron (and countless other dot-com craze companies) found out the hard way how much damage can be done by having too large of an exposure in a single company.

4. Diversify, diversify, diversify. Most of us understand the concept of diversification, but how do you actually accomplish it?

In order to properly diversify, you need to review the available investment choices in your plan, and then use those choices to spread your investments among capitalization categories (large-cap, mid-cap, and small-cap), as well as between value-oriented, growth oriented, domestic companies and international companies. You should also consider what amount of fixed-income investment makes the most sense in your portfolio.

Keep in mind, diversification doesn’t simply mean you put an equal amount of money in each available choice of investment. Each person needs to consider this individually, in respect to their overall portfolio, including assets held outside of the deferred compensation plan, such as other IRAs, or taxable accounts. As we’ve discussed on these pages in the past, you need to make a decision as to what allocation makes the most sense for you. If you’re fairly young and have a lot of years to grow your funds (as well as recover from any downturns), you can probably take on a greater amount of risk. If you’re nearing retirement, most likely your risk profile will be much less risky. (for more on Risk, see Page 4)

5. Don’t Take A Loan. No matter how tempting it is, taking a loan out from your deferred compensation plan, in more cases than not, results in derailing your hard work in saving and building up your account. Not only are you strapped with having to pay back the funds to your account (with interest), but you have also given up whatever growth may occur within your account (since the funds are being used for another purpose).

Experience tells us that you would be much better off to temporarily suspend or reduce your contributions to your retirement plan in order to save up money instead of taking a loan from your retirement plan. It may take a little while longer, but you’ll probably appreciate it a bit more as a result of your saving.

Safety in Numbers?

Alright, already - yes, it's been almost four months since I posted. Yes, I've been really really busy. Would you believe that I've been to eight states and built a barber shop since June?

Today's message is about Safety - but not things like "don't run with scissors" or "wait a half hour after eating to go swimming". What we're referring to is the old concept of having 1) an emergency fund; and 2) adequate insurance coverage. The primary thing that you should take away from this Safety portion of our discussion is Peace Of Mind.

An emergency fund is a vital component of your overall financial toolkit. You should have 3 to 6 months' worth of expenses set aside in a liquid, stable account, such as a bank passbook savings account or a money market account. By "liquid" we mean that the funds are easily valued and withdrawn as necessary. By "stable", we mean that the funds are not at risk due to market volatility, and that there is some return of interest to the account.

Why do you need an emergency fund? First of all, even though it may seem like your employment is stable - there are millions of your fellow Americans who would tell you that nothing is stable. Your employment can dramatically change from one day to the next. With an emergency account, you can face this situation with much more confidence. That's not to say that you wouldn't be seriously impacted by a layoff or cutback, but having an emergency fund will help to cushion the blow.

Secondly, if you've got an emergency fund available, the next time your car breaks down, or you need a new roof, or the washing machine shoots craps, or you need new tires - you won't have to go into debt to pay for it. And don't feel guilty about using the funds in the emergency account, that's what they're for. Just be sure that you repay them (with the funds that you would have used to pay off those credit cards!).

So that covers emergency funds. Next time, we'll discuss insurance. This discussion will likely take several days, as the topic of insurance can be quite voluminous.

'til then -- jb