Diversification: A Failure of Fact or Expectation?

Posted on January 10, 2013 | Financial Planning

The bear market of October 9, 2007, through March 9, 2009, witnessed not only a 57% decline in U.S. equity prices, but also the demise of many investors’ faith in the volatility-reducing effects of diversification. Fortunes were wiped away in this 17-month mega-meltdown that was triggered by the simultaneous popping of the commodity, credit, real estate and emerging equity market bubbles.

During this most recent bear market, which was the second-deepest in the past 80 years, but only the ninth longest of 15, nearly all asset classes—be they U.S. or foreign equities, real estate or commodities—exhibited the glide path of a crowbar, slumping in unison, particularly during the final six months of the bear. Today, as a result, many wonder if traditional “buy-and-hold” investing should be replaced with “run and rotate.” They also question if previously uncorrelated asset classes will now forever move in lockstep. Other investors, however, believe that during periods of financial crises, it is typical that equity-oriented or economically sensitive assets will experience positive correlations during these market downturns, only to revert to previous appreciation trajectories once the crisis has passed and they are able to relax once again.

Today, one can unemotionally sift through portfolio embers for clues to seemingly unprecedented asset class performances. We at Standard & Poor’s (S&P) conclude that diversification didn’t fail investors. Rather, allocation did do its job—a typically balanced portfolio’s (60% U.S. large-cap equities and 40% long-term government bonds) 13.1% decline in 2008 was less than the 14.8% fall seen in 1974 and much better than the results of 1931 (–22.2%) and 1937 (–19%).

However, investors’ expectations or memories failed. We also believe that many investors simply went too far out on the risk curve, embracing inappropriate equity exposures for their age groups, risk tolerances, or trading acumen. Hopefully, these errors in memory and expectation have been adjusted.

Investor Misjudgments of History

Why did investors hold on so long?

During this sixth “mega-meltdown,” or bear market in excess of 40%, in the past 80 years, many investors simply closed their eyes to the financial carnage and maintained their equity exposure as the S&P 500 eventually fell 57%. Allocations were never adjusted, just net worth. We at S&P believe one reason investors—as well as their advisors—chose to do nothing is because many advisors were ardent students of stock market history and, as a result, trained their clients too well, encouraging a “buy-on-the-dip” mentality during all types of market declines.

Yet two mistakes were made along the way. First, we assumed that the financial carnage that occurred prior to World War II was an anomaly and would never be repeated in our lifetime. Second, many believed that “black swan” events, like 100-year floods, occurred so infrequently that they wouldn’t happen again. Unfortunately, 100-year clocks don’t get reset annually.

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Immediate or Income Annuities

Posted on November 12, 2012 | Financial Planning

An annuity is a contract, purchased from a life insurance company, that provides for a set stream of payments or income for a set length of time, usually until the death of the annuity holder.

The concept of an annuity can be confusing because life insurance companies use the term to describe two different types of contracts: deferred annuities and immediate annuities.

Deferred annuities allow investors to put away money on a tax-deferred basis so that a lump sum can be accumulated at a later date; that lump sum can then be used to fund an annuity (the stream of payments), although many investors choose to simply withdraw the accumulated amount as a lump sum rather than use the annuity feature.

An immediate annuity has no accumulation period—an investor simply pays the insurance company a lump sum, and then receives the stream of payments for the set time period.

Annuities are primarily used as a means of securing a steady cash flow during retirement.

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Lifestyle Changes: Misconceptions About Life in Retirement

Posted on November 7, 2012 | Financial Planning

Retirement is a passage from one lifestyle to another. One way to think of the term “retire” is by placing a hyphen between the ‘e’ and the ‘t’ and creating a new term—re-tire: To put on new treads.

Those who take the voyage seriously and do the right kind of planning usually have a smoother trip and more fun.

Discussions with seasoned retirees indicate that there are many myths and misconceptions about retirement. Often you will hear these myths stated as fact. Here are some of the most common ones.

Some people, including women, continue to believe that only men retire. This misconception ignores the career women who have the same retirement adjustment problems that men have. Also, it falsely assumes that women not holding down 9-to-5 jobs cannot retire. This may stem from the old saying: “A man’s work is from sun to sun, but a woman’s work is never done.” Homemakers often have a more difficult voyage than those who retire from a job. Women who have been homemakers all their lives need to insist on being a full partner when their spouses retire.

One reason the myth may continue is that women sometimes lose their spouses early. The transition of widowhood is so traumatic that it hides the equally important second passage that must be made.

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What to Look for When Selecting a Trustee for Your Estate Plan

Posted on October 23, 2012 | Financial Planning

Selecting the people to carry out the provisions of an estate plan is one of the most important and difficult tasks involved in the estate planning process. It is impossible to make a proper selection of any member of the estate planning team without understanding, in general terms, what it is the individual should be doing and how that person interacts with others who have important roles to fulfill.

A trustee is the person or institution named in a trust agreement to carry out the objectives and follow the terms of the trust. A trustee can be a non-professional individual, a professional individual (such as an attorney, an accountant or an investment adviser), or a corporate fiduciary (such as a bank or corporate advisory firm). They need not be related, and in some circumstances it is inadvisable to select a close relative.

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Dogs of the Dow

Posted on October 19, 2012 | Financial Planning

Every January, Dogs of the Dow draws attention. The strategy is simple. At the start of every calendar year, sort through the 30 stocks in the Dow Jones Industrial Average and buy the 10 with the highest yields. An equal dollar amount is allocated to every stock and the portfolio is held for the entire year. On the first trading day of the next calendar year, repeat the process.

The idea behind the strategy is that every year a new portfolio will be created. This portfolio is designed to be held for 12 months. Investors should profit by purchasing supposedly out-of-favor stocks whose relative yields suggest their valuations are attractive.

The idea of buying the 10 highest-yielding Dow components was popularized by Michael O’Higgins and John Downes in “Beating the Dow” (Harper), first published in 1990. In the 2000 edition, the authors also discussed implementing the strategy at different times, such as in October or mid-December.

In actuality, there may be no benefit to buying stocks on the first day trading day of the New Year as opposed to, say, the day after Thanksgiving. While studies have shown that the markets tend to perform better between November and April than between May and October, last year “selling in May and going away” would have caused you to miss out on a rally that sent the Dow higher by more than 18%.

Yield is the amount of dividends paid relative to a stock’s price. The calculation is simple: total dividends expected to be paid over the next 12 months divided by current share price. For example, let’s say a company has historically paid a quarterly dividend of 25 cents per share and is expected to continue to do in the future. If the company’s stock trades at $40 per share, the yield would be 2.5%. (Total expected dividends of $1 per share divided by a $40 share price equals 2.5%.)

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Personal Finance Library

Posted on October 15, 2012 | Financial Planning

The AAII Personal Finance library was developed by the editors at the American Association of Individual Investors. It is designed to serve as a starting point for anyone interested in learning to become a better and more profitable investor. This library is open to the public and covers the following investing topics: portfolio management, personal finance, stocks, bonds and mutual funds.

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Optimizing Your Retirement Income: What Works Best and Why

Posted on August 17, 2012 | Financial Planning

With the oldest baby boomers hitting 62 this year, and more than 70 million of them likely to enter retirement over the next 20 years, the hard truth is that only a small minority are accumulating enough savings to provide for their income needs during decades in retirement.

This uncomfortable reality is particularly true given the overall rise in life expectancy, sharply rising medical costs, the trend toward more active and costly retirement lifestyles, and, not least, the relentless toll of inflation.

For the financially fortunate with sufficient personal savings, Social Security benefits, and corporate pensions to meet all their retirement income needs, the main financial challenges of retirement are how to invest and spend wisely and perhaps provide for their heirs as well.

However, more than 75% of all workers age 55 or older report having less than $250,000 in investments apart from their homes and pensions, according to a recent survey by the Employee Benefit Research Institute (EBRI). At a recommended initial withdrawal amount of 4%, that provides an income from their investments of just $10,000 in the first year of retirement. Nevertheless, those approaching retirement can improve their income and financial security in retirement depending on their flexibility and their approach to four big decisions that are usually under their control:

Generally, no single decision will improve pre-retirees’ potential retirement security as much as continuing to work even a few more years beyond the anticipated retirement date.

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New Rules for Converting to a Roth IRA

Posted on August 2, 2012 | Financial Planning

Prior to January 1, 2010, only taxpayers who met certain income requirements were allowed to convert funds in a tax-deferred account (e.g., traditional IRA, 401(k), 403(b), 457, SEP-IRA) into a Roth IRA. Now this restriction has been removed. Since you will still have to report the converted funds as income and pay the associated taxes, you need to consider whether converting funds to a Roth IRA is beneficial for your particular financial situation.

There are several factors that could influence your decision to convert funds.

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Due Diligence: 10 Steps to Avoiding Ponzi Schemes and Financial Fraud

Posted on July 27, 2012 | Financial Planning

Bernie Madoff is now behind bars. But the uncovering of his enormous and long-running Ponzi scheme, and the fraud committed by several other financial hucksters, highlight the importance of asking the right questions and doing your own due diligence before selecting an advisor or participating in an investment.

What areas should you focus on when performing a due diligence review?

Here are 10 basic steps all investors can take—as well as certain indicators that should serve as red flag warning signs of the potential for trouble down the road.

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The 10 Myths of Retirement Planning

Posted on July 18, 2012 | Financial Planning

Retirement planning requires a clear-eyed analysis of future needs and income. Yet many individuals view retirement through rose-colored glasses.

Here are some of the most common myths and how you can bring reality into focus.

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