MaineBusiness.com

Good Investment Advice is Not a Commodity

Recently I’ve heard a lot of chatter in the financial planning community dismissing investment advice as a cheap commodity; something that is easily accessible where no one provider can differentiate themselves or create any additional value apart from anyone else.

Now if these proponents are talking about lousy investment advice, they are right on the mark. But if they are talking about good investment advice, they are dead wrong.

There are several reasons why the commodity rationale is off the mark, but first you have the recognize what good investment advice can not do. First off, no matter what the financial media tells you, there is no systematic way to beat the market over time unless some element of luck crosses your path. So I would walk away from anyone who promises market beating returns, it’s going to create a lot of false expectations. Second, investment strategy should always be a sub-set of a financial plan to accomplish your goals. Developing a plan and the actions you take towards accomplishing that plan will provide far more value that the investment component over time. When investment performance dictates actions and overrides your overall need, that’s when you are eventually going crash and burn.

How does good investment advice add value? In several ways:

-Controlling Bad Investment Behavior: Behavior hurts people more than they think. Research has been coming out that indicates that we are physically and psychologically hardwired in a way that helps us in certain aspects of our lives to survive, but undermines good investing discipline; especially the emotional aspect of managing your own money. Fear, greed, over-diversification, under-diversification, speculation, borrowing on margin, chasing yield or blindly avoiding taxes are these types of actions that will destroy wealth over time. In a Dalbar study a few years back; from 1984 to 2003, equity mutual funds earned an average compound return of 10.2%. The average stock mutual fund investor earned 3.5% over that same time frame. The average person who invested $1,000 in stock mutual funds in 1984 would have $1,990 at the end of 2003 where the average equity mutual fund would have had $6,976, three and half times more. Emotion is a killer when investing and if you can remove it by delegating it, you may be a lot better off because it can avoid the big mistakes that can happen.

-Truly Diversifying: I rarely see portfolio’s that truly are diversified when I initially review them. A majority of stock portfolios are a combination of holdings or collection of ideas that when put together, could simply (and more efficiently) be emulated by holding an index fund that represents the Standard & Poor’s 500. And for people with portfolios such as this, they are just returning to pre-tech bubble levels. In contrast, if you had decent exposure in smaller and international stocks, your stock portfolio wouldn’t have lost nearly half their value and you have recovered your losses more than three years ago. For individuals in early retirement, this could have been the difference between maintaining the lifestyle that you want and running out of money during your lifetime. Just like sports, defense counts and in some sports, can actually score you some points. Diversification is a great way of playing defense in your investment strategy.

-Costs Matter: Costs count and people are very unaware how they can add up. To start, the average annual stock mutual fund expense ratio is 1.5%. Then there’s the cost between the difference in commissions and the bid/ask costs in stock mutual fund transactions, which is known as the spread. According to a Wharton Financial Institutions research paper by Edelen and Kadlic, it was determined that commissions and the difference in the spreads erode .8% annually. Then there is cash drag, the need to keep cash to cover ongoing redemptions. According to Vanguard, this erodes .4% of return annually. Finally there are taxes; according to Vanguard, taxes on average erode 1.6% of return annually. Add it all up and you get 4.3%. Most investors never realize how much cost can eat away at returns. Good investment advice is very cost conscious and the cost savings involved should more than pay for the price of advice.

Although these core themes seem simple enough, but people lack the detail, time or disciple to follow through on these. It isn’t sexy or exciting although it matters. But keep in mind, if anyone is telling you that investment advice is a commodity, they are either:

Not interested in investing, thus downplaying its importance or a vendor trying to sell a turn-key investment service to a financial advisor.

Have a Custodial Account in Your Child’s Name? Beware of this

Last year, Congress blindsided those who set up custodial accounts in their children’s name. Well it looks like Congress is up to their tricks again.

In pending legislation, a provision was added to the Small Business Tax Relief Act of 2007 (H.R. 976) to discourage the practice of transferring investment assets to a child for the purpose of avoiding the parents’ higher tax rates. The new rules would apply retroactively to all sales that occurred after December 31, 2006. This provision increases the age threshold in the Kiddie Tax from under-18 to under-19 (and under-24 if a student). If a child under the age limits has unearned income in excess of $1,700, the excess is taxed at the parent’s rate.

Over the years many parents used custodial accounts to help save for their children’s education or fund other goals. These accounts have the parent as the custodian while the account is titled in the child’s name. In most cases these are known as UTMA or UGMA accounts. These accounts are mildly tax advantaged due to the “kiddie tax” rules. Under the current rules, if the child is under age 18, the first $850 of annual investment income is tax free, the next $850 is taxed at the child’s rate and anything beyond $1,700 is taxed at the parent’s rate. If played right, there would be many cases where the parent wouldn’t need to pay any tax at all or just the child’s lower rate. After age 18, income above $1,700 would be taxed at the child’s rate.

When the rules were changed last year where the “kiddie tax” age increased from under 14 to under age 18, this created several problems. Many parents who accumulated a good portion in these accounts for college usually planned to sell their high growth assets for more conservative assets when the child reaches age 14-18; lowering the risk of a market decline in the leading years before the child goes to college and incurring a capital gain at the child’s tax rate. The new rule has many parents caught in the dilemma between paying more in taxes by shifting the portfolio in a more conservative manner or “taking their chances” and sell once the child reaches age 18; hoping the stock market doesn’t take a tumble in the meantime. The change really diluted the effectiveness of using a custodial account and polarized the other options available. Saving for college costs? Now a Coverdell or a 529 Plan is most likely your best option.

Now this new pending legislation would cause another problem. If the custodial account was used for college costs, now the “kiddie tax” rules would apply if the account owner was a student under the age of 24. After last year’s changes, if the parent decided to “take their chances” and sell once the child turns 18 for college costs, then this new legislation kills that approach unless you want to defer liquidating until after the child turns 24 (and take your chances with the market for several additional years). And if you decide to hold, there are problems with this as well beyond investment risk. Since the account is considered an asset of the child, this can potentially lower their potential for college aid eligibility. Talk about in between a rock and a hard place.

What if you already have funds in a custodial account? If you are in the situation described above, you really have to decide if rebalancing the portfolio is worth the cost of the increased tax. If you have just started out, it may prompt you to sell the custodial account and place it in a custodial 529 plan. Many 529 plans allow for custodial ownership; you may have to pay taxes on gain in the regular custodial account when you liquidate, but it may be worth taking a one time tax hit for future tax free earnings if used for qualified education costs.

Although this is still pending, individuals with these types of accounts should be aware of this and plan with this in mind.

Future Boomer Stock Market Crash: I Doubt It

Recently one of my clients asked me about the predictions of the upcoming “Boomer Crash.” With the Boomers just entering their 60’s, many people have been predicting that this will create a crash of epic proportions due to this large demographic group selling out of their stock markets at the same time. Back in the late 1990’s I started thinking about this scenario when the book Boomernomics came out. The problem that I have with this prophecy is that it is portrayed in a vacuum; the sole element why the markets will come crashing down. In reality, market and economic cycles are affected by multiple factors with varying degrees of impact. I believe the boomer influence alone isn't enough to create the mass doomsday predictions that I've seen. There are many reasons why I doubt this will happen:

-The Boomers will not all cash in their stock at once: The Boomers live in an eighteen year span. They all aren't going to decide to line up at the window one day to cash in their stock.

-Many Boomers will continue to work: There’s the obvious that some Boomers simply can't afford to retire. But I've seen retiree's go back to work because they enjoy it, I've seen some retiree's start their own business during their retirement years and I've seen some retiree's go back to work (on their own terms) with their former employer because the expertise is simply hard to replace.

-Boomers can't afford to sell all their stock at once: With increased longevity, boomers will need more growth in their portfolio throughout their lives. Travel and recreation in their early years and health care in their later years are all currently growing at a rate that is higher than inflation. Growth isn't a luxury for the retiree of today; it will be a necessity to cover costs.

-Boomers who are prone to sell do not control a majority of stock. The wealthiest 10% own 90% of stock holdings; the richest 5% hold 50%. These people will not be in a position where they have to sell a majority of their holdings within a concentrated period of time and may never have to sell at all. The median boomer has only $44K in their 401(k) and 1/3rd of the Boomers don't own any stocks, bonds or mutual funds at all.

-There will still be demand for stock: The demographic groups after the Boomers are very aware of the solvency issues of Social Security, pensions becoming a thing of the past and increased health care costs. These generations are saving more as a result. Also immigration inflows and the increased wealth of developing nations will increase the demand for equities over time that will more than take up the slack left by the boomer generation.

For the reasons above, there is a very low likelihood that we will have a Boomer crash. In general, I do feel that we are in a secular or super-cycle period of lower than average market returns. I feel that stock returns will be about 3-4% better than bonds over this trend while historically we have had experienced 5%-7%. Does the boomer impact have an influence? Probably so, but I'm in the camp where I think it may lower returns by say .5% annually, but not more than that. I think issues such as a higher federal tax structure, bad monetary policy decisions, higher inflation, protectionalism and geopolitical risk would have a much larger negative influence here.

Also to note, have you ever noticed that the "doom and gloom" is coming from a source that is trying to sell something. The financial media always conjures up a crisis that usually ends as quickly as tomorrow (when they find the next new crisis) and do more harm to the public than any politician can conjure up. Some popular books have come out, like Rich Man's Prophecy, predicting this event; even well respected Wharton school professor Jeremy Siegal stated last year that the market would drop 50% from the boomer effect. Of course this is when he was promoting his book and later backed off, stating this was a prohibitive scenario. Even the insurance companies are ramping up their promotion of products with "guarantees"; unfortunately when you look under the hood and read the fine print, the cost of the guarantee doesn't really provide much benefit at all. In the end, fear sells and doom and gloom always attracts attention.

In the end, you can allow yourself to get swept away with it or you can differentiate the forest from the trees. I prefer to be an optimist and the Boomer bust is more hype that substance.

For those who are interested, I recommend that you read the report on the subject that the GAO conducted.