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The Sky Is Falling! Why You Shouldn’t Panic About the Stock Market

The drop in stock prices yesterday was quite dramatic. With that, all the “gloom and doom” pundits came out to play and the media has the latest crisis of the day to cling onto. Am I worried? I have three words for you: Not one iota. This is why you shouldn’t worry:

-This is Normal: Over time, the stock market periodically suffers declines such as this. And this is nothing. For example, since 1979 the S&P 500 has lost over 5% in one month on average once every 13 months. It happens a lot more than you think.

-This is Natural: Periodic declines are natural in the stock market and it’s a good thing. Why? If there was no risk in investing in stocks, accordingly we wouldn’t be adequately compensated for taking the risk.

-You Can’t Predict or Control It: Who predicted that the Dow would drop 400 yesterday? No one did. And no one can predict when the right time to get in or out of the market is. No one can predict what is going to be the “next hot thing.” It’s funny just to see the news commentary; one article quoted an institutional investor that cited a technical indicator last week and claimed that this was a precursor to the trouble. This stuff is silly; if the person could predict good and bad things to come on a consistent basis, they would be independently wealthy and working for themselves. The financial media absolutely does a horrible job of making people focus on these issues; the culture of selection and timing. And it does more to erode wealth than any of our politicians can conjure up.

-You’re OK – As Long As You're Doing Things Correctly: If you truly are investing, you have an ongoing discipline that takes into account the periodic downturns in the market. This means having an adequate defensive reserve on hand to cover short-term needs to tide you over during market downturns. For the individual who is still working, this is having an adequate emergency cash reserve as well as cash funds earmarked for large expenses anticipated in the near future. For the retiree, this means having cash, bonds or other risk controlled investments to cover the next two years of cash flow needs that aren’t covered by your pension or Social Security. These are for when things go wrong. If you couldn’t afford to lose the money that you lost yesterday, you aren’t investing – you’re speculating.

The overriding theme that I want to convey is:

If you are doing things right, what happens today, tomorrow or in the short-run has no bearing on your long-term results.

Who knows what today will bring for the global stock markets. I have my guess and so does everyone else. The thing is that you shouldn’t let the markets lead you by the nose. You should base your asset allocation; the dominating factor within your investment strategy that dictates performance over time on your needs. Being proactive about your needs will always win in the long run. Being reactive and a slave to irrational “Mr. Market” only creates a lot of emotional and financial pain. In the end, I will continue to be as well as be rewarded for being an optimist.

The Eight Great Investing Mistakes

A few years back, a Dalbar study was conducted to determine the average return of equity mutual funds compared to the performance of the average equity mutual fund investor. From 1984 to 2003, equity mutual funds earned an average compound return of 10.2%. The average investor earned a pathetic 3.5%. Where did the 6.7% go? I have eight good guesses. Below is what I like to call the eight great mistakes of investing. Do any of these look familiar to you:

1.) Over-Diversification: this is where the investor fears missing out on the next big thing. So they hedge their bets and end up with a wide collection of mutual funds. What they fail to recognize is that all of their holdings represent a great deal of overlap and redundancy. The result is a large, expensive, and inefficient index fund.

2.) Under-Diversification: This is where an investor will progressively shed the funds they own, discarding recent under-performers. This ultimately leads to holding funds that are in the same "hot" category over time, usually when the over-performance of the fund is yesterday's news. This is great for talk at the cocktail party, but provides little future reward.

3.) Euphoria, Over-Confidence, or if you split the difference - Greed: This was the poster child of the late 90's. After seeing internet stocks soar through the stratosphere, technology and the internet seemed like the logical choice. Just invest and you become rich! For the ones that actually did pretty well in the beginning, they placed too much weight on their implied skill and less on just being lucky. In the end, only a few of the euphoric investors can sincerely claim they got out at the right time.

4.) Fear: Investors always seem to over-react. Investing hasn't changed much over the years, but outlets like CNBC need to create content on a daily basis and the "crisis du jour" is an ongoing event. The risk averse are more unnerved by this; and the insurance industry profits very well from fear based selling.

5.) Speculation: This is the failure to recognize that your investment strategy is only a legal form of gambling. And the house always has the odds on their side. If your portfolio is a collection of ideas whether self derived or advised and does not involve an asset allocation strategy based on needs, risk tolerance and capacity for risk; you are essentially gambling.

6.) Borrowing to Invest: investing on margin has always seemed to look rational in a hard numbers. But the logic always seems to fly out the door the first day someone ever receives a "margin call". A strategy that is good in theory, but one I have never seen anyone do successfully.

7.) Chasing Yield rather than Total Return: Dividends and interest provide little return after inflation and taxes are factored in. The risk averse can get short-sighted and have the ingrained belief of never drawing on principal. With retirement lasting several decades instead of several years, growth in a portfolio is a necessity, making the concept of the all income portfolio archaic. Seeking total return including capital appreciation is the best defense against inflation over time.

8.) Letting Taxes Dictate Decisions: This one is a two way street. For the investor with large capital gains, they are averse to selling because of the tax implications even though they bear the risk of having an under-diversified portfolio. The focus should be on maximizing after tax returns, not minimizing taxes. The person selling at a loss is more reluctant as it really is an admission of making a mistake, even though it may make sense to cut your losses.

Any of these sound familiar? It seems that the buy and hold strategy is the way to go, but unfortunately many people are a victim of their own bad behavior and there is a price to pay. The average person who invested $1,000 in stock mutual funds in 1984 would have ended up with $1,990 at the end of the period. The average equity mutual fund would have ended up with $6,976; a whopping three and half times more. Looking back, I am sure that there are quite a few investors that wished they had performed in line with the averages.

This was originally written in May of ‘05

We Work, We Plan & We Strive For This?

I remember when my folks retired. They had it all figured out; they moved from their Pennsylvania home to a nice little gated community on the Gulf Coast of Florida. They stopped working and planned to spend their time enjoying the better weather, the new activities and social events with each other and the friends they made along the way. The result: It didn’t work out as planned.

With Baby Boomers entering their freedom years, we are going to be hearing a lot of this: The retirement transition is a huge one and some people are ill-prepared to adjust to it. This isn’t about funding or investing strategies during retirement, that’s a component within itself; it’s simply how you want to live the rest of your life. Some examples of transitions:

-The small business owner who sold out: When you sell out on the belief that this is what you are “supposed to do?” The pay-off may be a nice dose of quick exuberance, but it can fade quickly. The responsibilities and relationships that you had to your customers, employees and to your vendors: Where is that now?

-The corporate executive: One day you are the big shot, the next day you get the gold watch, the following day? It’s going from “Big Shot” to “Joe Schmoe.” Think about the loss of power and control you once had. If you don’t have something to fall back on, this can be a very empty after-match.

-“I’m going to golf”: Some people lose the challenge that work provides them and look to the golf gods to save them. The sad irony is that in some cases, golf becomes work. If your handicap becomes a chore, you have some issues.

-Re-discovering your spouse: As we grow older, we change. Between the craziness of raising children and focusing on careers, we forget to recognize that you and your better half changed. Once you decide to stop working and the kids are out of the house, all of a sudden you are going to have to face each other again. In a recent discussion with Ray Inglesi, who developed Core Themes™, a life-career planning program. He felt in the coming years, we will see a high rate of divorce with individuals entering their initial retirement years.

-The means, but not the end: I’ve met many individuals who were highly dedicated to funding their retirement when they initially met me. The problem is that they spent little or no time thinking about what they want to do when they get there. They probably have spent more time figuring out their next vacation rather than their future. It’s almost like we are hardwired to forget about tomorrow to take care of today’s business. Over the years we forget about our true values and interests we had when we were young and you almost need to rediscover them when we retire.

The lesson is that this transition can leave a significant void in your life. Many times I have asked individuals, “How do you want to live the rest of your life?” And they had no idea how to answer the question. They either have to think long to answer it or simply shrug their shoulders and say, “I don’t know.” There is one thing you should get out of this is: take the time to think about yourself and what you are going to accomplish today, tomorrow, the next day and the day after that. It is critical that you revisit this for your long term well being. I spend several hours each month thinking about what I want out of life and what I can be doing to get closer to living a better life.

My parents, they ended up figuring it out. My mother, the former self employed cornice maker had a big problem with the change. With nothing to do, she climbed the walls and my father was the victim. Meanwhile my father totally embraced the change. The entrepreneur started up her business again. She totally enjoys the interaction, the challenge, and the fulfillment and she will be 78 years young at year end. My father is much happier as well! Meanwhile, my mother in law has been retired for seven years now. And from day one, she has said, “I don’t know how I ever had the time to work.” Go figure, but you better figure this out before the day comes.

Quick Tip: Raise that Deductible

Whenever I see it, it makes me want to pull my hair out: A deductible on an auto or homeowners policy that is $500 or less.

Why is it a problem? It’s a Catch-22. For most people who opt for the low deductible, you would think that paying a higher premium will be rewarded by having a lower out of pocket outlay if you made any claims. The problem is that if you have a history of a lot of small claims, the insurer is likely to raise your premium or even worse, deny your future coverage. More often than not you actually end up paying a lot more in total premiums and claims by opting for a lower deductible. Insurance should be used for financial risks that you can not afford to lose. You should be basing your deductible on that, not trying to avoid all financial risk. And I suspect that many of you could afford a loss that is higher than $100, $250 or $500 (it wouldn’t be fun, but you could afford the loss without financial catastrophe).

So take a look at your auto and homeowners policies. If you opted for the lower deductible, I suggest pricing out a higher deductible amount; you may be very surprised on how much you can save. In some cases, people just buy the policy without even being advised on the trade-offs between premiums and deductibles; it’s likely your deductible is minimal. It makes an awful lot of money for the insurance company, but it’s something you are better off without.

Death & Taxes: Why the Roth May Be Better

One of the greatest gifts that Congress has given us is the Roth account; this can come in the form of a Roth IRA and now the Roth 401(k) or 403(b). You don’t get an immediate tax benefit for your contribution, but these contributions are allowed to grow; eventually withdrawn tax free if it is a qualified distribution. Still many people opt for making contributions to Traditional IRA’s, 401(k)’s or 403(b)’s. And it’s simply for the benefit of having these amounts removed from your taxable income in the year of the contribution. These accounts grow tax-deferred over time with qualified distributions taxed as ordinary income. If you are one of those people who opt for gratification of immediate tax deferral, I would think twice. This is why the Roth may be the better alternative:

Lower Tax Bracket Assumption: The main rationale that people have for contributing towards a tax-deferred account is that they will be in a lower tax bracket during retirement and saving money by being taxed less at a later date. But are you really sure that you will be in a lower tax bracket when you withdraw these funds? With our federal tax structure, I believe that if taxes are going to change in the future, they will probably be higher rather than lower. If Congress continues to sit on their hands without making practical reform in our entitlement system, will we definitely be paying more. So there is political tax risk with deferred accounts. Even if taxes aren’t higher, do you know with certainty that you will be in a lower tax bracket? If you significantly funnel most of your investments in tax deferred accounts, it’s likely that you will rely primarily on them for your future cash flow needs. Just the pure need may bump up your taxable income in a higher bracket or even trigger most of your Social Security income to be taxable. And if you wait to take distributions, you could be subject to make higher Required Minimum Distributions (RMD’s) that may push you in a higher tax bracket as well. So I would think twice about assuming that immediate benefit/tax deferred nature of traditional retirement accounts are going to be better off than the no immediate benefit/tax free nature the Roth has to offer.

More Flexibility: Roth IRA’s have far more flexibility than Traditional IRA’s. Contributions (and conversions if held for a certain period of time) can be removed from a Roth without taxes or penalty. You didn’t have any tax benefit up front, that’s why the government can’t penalize you for taking out what you never benefited from. Non-qualified distributions of earnings from a Roth are taxable and subject to a penalty (with some exceptions). But here’s the trick: When you are withdrawing funds from a Roth IRA, total contributions are considered first, conversions are considered next, and earnings last. So it’s certainly possible to withdraw funds from a Roth IRA without tax consequence. The nice thing is this serves as a safety valve, an emergency fund of last resort. It can be used as an auxiliary fund use to augment your children’s education costs if you didn’t fund enough in a 529 or Coverdell IRA because you were worried about over-funding these accounts (and paying a penalty for it). With a Traditional IRA, you pay taxes on any withdrawal and unless you do this after age 59 ½ (or under one of the several exception items), you will pay a 10% penalty along with it.

Less Rules: Roth IRA’s aren’t subject to required minimum distributions (RMD’s) where tax deferred options are (the Roth 401(k)/403(b) are subject to RMD’s, but this can be alleviated by rolling them into a Roth IRA with certain requirements). Also, a person can contribute to a Roth IRA after age 70 ½ while you can’t do that with a Traditional IRA.

Better Estate Planning: Some heirs have an unpleasant surprise when they inherit a tax-deferred account; they are required to pay income taxes on the withdrawal. So the benefit may not be as large as they think. Or it may put them in a real egregious tax situation if they were already in a high tax bracket or live in a state with high taxes (yes, this includes Maine). With an inherited Roth’s, they have similar distribution requirements as their corresponding tax deferred alternatives, but these withdrawals are tax free to your beneficiaries.

I’m a very big proponent of Roth options; and I eat my own cooking as I’ve contributed to them since they started and converted a significant amount of previously tax-deferred accounts as well. But they aren’t for everyone; some people aren’t eligible for contributions and/or conversions or their employer hasn’t adopted a Roth option. If you were in a severe tax situation where you are bumping up against the alternative minimum tax (AMT) or are subject to significant phase-outs of deductions or credits, the benefits tip in favor of tax-deferred options. But in many ways, tax-free Roth options provide one significant factor: more control over your future by eliminating the uncertainty of taxes. And putting more power in your own hands is never a bad thing.

Quick Tip: Check Your Credit Report in Increments During the Year

Once every twelve months you are entitled a free credit report from each of the three major credit reporting companies Experian, Equifax and TransUnion. Want a nice strategy to keep tabs on your credit report over the year? Simply request a credit report from one of the three reporting companies every four months and rotate this in order. Rather than getting all three reports at once, this is a nice way to periodically check on your activity throughout the year.

To get started, go to https://www.annualcreditreport.com/cra/index.jsp

Or call 1-877-322-8228

While you are at it, to reduce the amount of pre-approved credit offers you receive, call 1-888-567-8688 to opt out. It won’t totally eliminate these offers, but they should reduce them.

To get your name off of mailing lists, go to the Direct Marketing Associations website at: https://www.dmaconsumers.org/cgi/offmailing

To get your name off telemarketing lists, go the Federal “Do Not Call” Registry website at: https://www.donotcall.gov/default.aspx

What’s Wrong With This?

Like the rest of you, I get a bunch of garbage e-mails and since I’m a financial planner, I get a lot of solicitation from vendors that end up in my spam filter. I’d like to share you one of those e-mails that I received yesterday:

Hi, I'm John Doe, with XYZ Sales.

We are hosting a short training teleconference tomorrow - Thursday, February 1st at 12 Noon EST (11:00 AM CST, 10:00 MST, 9 AM PST). If you would like to attend, please click here to register

What’s the matter with this? Only 50% of the above (1 & 3) are a benefit to the client. A penalty for early withdrawal I don’t consider a benefit to either side (although the advisor may possibly get some of the penalty proceeds), that’s why I didn’t count this one either way. Strategically placed at the end (5 & 6), the other 33% solely is a benefit to whoever ends up selling this product to you.

The thing that troubles me is what is the motivation for the person selling this to you? Is it the beneficial features for the client or how the salesperson is getting compensated? And if someone is trying to sell this to you, how can you tell? The three questions you can ask are:

-Do you have a fiduciary obligation to put my interests ahead of your own?

-Are you willing to disclose any potential conflicts of interest you have when dealing with me?

-How are you compensated for the advice you are providing me? Are there any soft-dollar benefits that you receive as well?

The advisor should be trying to find the best solutions to fit your needs before addressing their own. In the end, both sides would benefit more over the long run. But be careful, there are a lot of people out there who have done a good job of convincing themselves there is a rationale for selling almost anything.