Is Wandering Good?

As part of our investment philosophy, we develop a specific investment plan for each client. When we determine an allocation for each specific investment category, such as “US Small Value” or “Fixed Income” (cash, bonds, or CDs), we want the investment fund that we use, to remain pure to that classification.

With the mutual funds that we use to purchase stocks and the direct buying of fixed income investments, we have been able to accomplish that goal. Most mutual funds hold stocks across multiple asset classes, so they do not adhere to this discipline.

In an interesting article in today’s Wall Street Journal, according to an SEC filing, the world’s largest bond fund, Pimco Total Return, managed by Bill Gross, will be able to purchase as much as 10% of it’s assets in non fixed income investments, such as “preferred stock, convertible securities and other equity-related holdings, during mid-2011.  Gross has an outstanding track record and his successful is undeniable, so I’m not going to question his motives.

However, this move re-inforces the importance of truly understanding what you are purchasing, when you buy a mutual fund or any investment. When we buy a “US” stock fund, we know that all of the companies in that fund are based in the US. With many other mutual funds, you may think you are buying a US fund, but upon further examination, find out that 20% of the companies are internationally based.

This is important if you want to adopt an investment strategy, an asset allocation plan, and then really be able to monitor and stick to it. If the fund that you buy wanders off and buys different things than you originally thought, than your actual asset allocation will not be what you intended. And that could be a problem.

In this case, we believe in purity.

New Tax Law: What You Need to Know

Updated, Friday 12/17/10:  The House passed the bill that was agreed upon by President Obama and Senate. It appears that no changes were made to the bill that the Senate passed. President Obama is to sign it on Friday. The following is a summary of the legislation, but is not intended to cover all the provisions of the new law.

Tax rates:  The current rates will remain in effect for the next two years, 2011 and 2012. There will be no tax increase, even for taxpayers in the top tax bracket of 35% (for ordinary income) for the next 2 years. Note that these tax rates are not permanent, as the law only covers 2011 and 2012.

Capital gains and dividend tax rates:  Current capital gains and dividends rates of 15% remain for high income taxpayers. For those below the 25% tax bracket, the capital gains rate which is currently at 0% rate will remain.

Estate tax rates:  Major Change:  This has been the major point of contention in negotiations this week. The new law will have a $5 million per person exemption and $10 million per couple.  This is a higher level than most would have expected months ago. The exemption amounts are indexed, beginning in 2012.  The top estate tax rate will be 35% for 2011 and 2012.

The law also allows planning opportunities to shift/allocate assets between a couple, upon the first to die, to maximize the use of the full exemption for each individual.

Payroll Tax Reduction:  For 2011 only, the 6.2% social security tax will be reduced to 4.2%, for the first $106,800 of wages, which are subject to this tax. This will provide up to $2,136 reduction in social security taxes for employees whose wages are $106,800 or higher. A couple who each earns at or above $106,800 will save approximately $4,300.  Note that employers will still need to pay in the employer portion of social security taxes based on the 6.2% amount.

Alternative Minimum Tax:  Technical changes were made, so that the AMT will remain at same level as in 2010. This still has a great impact on many middle-high income taxpayers.

Addition to the Deficit:  The bill did not provide for any federal spending cuts. The bill is projected to cost the Treasury $860 Billion over the next 10 years. This does not include the cost of the 13 month extension of unemployment benefits.

Business:  As for individuals, a number of extensions of items for a year or two, through 2012, such as increased depreciation expense and research and development expense credits.

Not included:  There was no change to how private equity and hedge fund executives will be taxed. Most will continue to earn at capital gains rates, not as ordinary income rates, as once thought might be passed. Congress failed to pass any changes related to issuance requirements of Form 1099s, which will be greatly increased from provisions of the health care bill passed earlier in 2010 (don’t ask how those are tied together!) Hopefully, some of the Form 1099 rules will be modified in 2011.

Sources:  Wall Street Journal and New York Times, December 13-17

When is 3 Really 1?

A new client asked us to review three funds that he had been holding for a very long time in a retirement account.  Each of these funds were managed by the same mutual fund company, but had distinctly different names.

Upon my review, the results were not surprising to me, but startling to the client. Each of these funds were basically holding the same stocks. So while the client thought they were broadly diversified, based on the names of the different funds, the tops holdings read like three interchangeable and almost identical lists. We actually held the three top holdings lists side by side, and they looked almost the same.  Each had many of the same companies like Apple, Exxon Mobil, IBM, GE. You get the idea.

There was no effective diversification at all, if you think about effective diversification as we do. There were no small companies, there were no real estate companies, there were no small value companies. There was minimal international holdings, which is a serious problem, in our view. There were no emerging market stocks.

So while the client had 3 funds, they really just had 1 fund, with 3 different names. They had not achieved the diversification they thought they had, and knew that was in their best interest.

Separate from this client example, the current year’s worldwide stock market performance, as viewed by asset class, provides great evidence of why “effective diversification” across many asset classes is so important. A sample of some asset classes, as evidenced by DFA mutual funds for YTD through 11/30/10, makes the point:

US Large, which is similar to the S & P 500:+7.8%
US Micro Cap (very small companies)+21.38
US Real Estate+22.9%
International Small Company+11.8%
Emerging Markets Value+12.7%

Please note that the above is presented only for illustrative purposes, for an 11 month period of time, and before any advisor fees.

However, the point remains, many people have a portfolio which may hold many mutual funds or individual stocks, but if reviewed carefully, basically acts or is very similar to the S & P 500.

That is not in your best interest, over the long run, for a successful investment experience.

Purely Personal

This has been a very meaningful and eventful Thanksgiving and subsequent week, for our firm, in our personal lives.

Keith’s wife Ann had their 5th child on Thursday morning, December 2nd.  They had a very healthy beautiful girl, Olivia Brooklyn, to join her older four brothers. We congratulate Keith and Ann on the new addition to their family! They are all doing very well.

My daughter celebrated her Bat Mitzvah on Saturday of Thanksgiving weekend. This was a very meaningful and wonderful event, which I was fortunate to share with my entire extended family and friends. My daughter was incredible, and she made her entire family very proud of her accomplishments. She is an inspiration to all of us.

It is events like these that give us reasons to reflect on what is truly important in life and be thankful… for our family, our personal  and business relationships and for good health.

While we work with our clients regarding their money, we truly hope that our ability to be successful enables them to reach, enjoy and celebrate many wonderful family milestones.

As I said on Sunday, we are all very fortunate!

Long Term Care Insurance or A Thing of the Past?

Long term care insurance is a complicated, but important topic that most individuals should consider, with the assistance of a number of professional advisors.

We think the purchasing decision regarding LT care insurance falls into 3 categories:

  • those who need it, but cannot afford it,
  • those who need it, and can afford it,
  • those fortunate enough, after a proper analysis, feel they do not need this coverage.

A major development in the LT care insurance field was announced by MetLife, a major seller of LT care insurance, that they would stop offering this insurance to individuals, effective December 30, 2010. This was covered in an excellent NY Times article (see cite below). This continues a trend of dramatically increasing LT care insurance premiums, in the range of 18-44%, as well as other insurance companies not entering or stopping to sell long term care insurance.

While we feel that LT care insurance is appropriate for the group above, in the middle (people that need the insurance and may be able to afford it), the purchasing decision becomes much more difficult now. As the NY Times article clearly states, the insurance companies have underpriced this insurance in the past, due to numerous factors. Thus, if you purchase this type of insurance and pay the premiums for many years, you could then be faced with the prospect of huge insurance premium increases down the road, or having to drop the coverage because of the high cost of the increased premiums. Neither of these are good alternatives.

We would advise individuals to review whether LT care insurance is appropriate for them. It is extremely important to work together with your financial advisor, as well as an insurance professional that is well versed in LT care insurance, in analyzing this decision. Please note that LT care insurance is highly specialized, so we recommend only working with an insurance professional who is very experienced in this specific area.

As many individuals will face the possibility of huge long term care costs, potentially in the hundred of thousands of dollars, due to longer life expectancies, this is another reason for the importance of good financial planning, which addresses these type of issues.

“When a Safety Net is Yanked Away,” NY Times, November 13, 2010, by Ron Lieber

If the Pros Can’t Win, How Will You?

We provide many services to our clients. One of them is investment management. Our philosophy for implementing our investment strategy is a clear differentiator from most other financial advisors or investment professionals.

There are two main investment implementation strategies: active management or passive management. In active management, you believe that you can identify, in advance, an investment manager, who can consistently outperform his benchmark for an extended period of time. Academic research shows that this is extremely difficult to do, over a long period of time, for all asset classes, both domestically and internationally.

We believe in a passive approach, which means that we will retain an investment advisor who will purchase stocks based on their respective asset class. Academic research shows that over various time periods, this strategy outperforms “active” management, particularly when costs such as trading and taxes are included in the analysis.

Further real world evidence of this is presented in Morningstar’s “Fund Times” weekly column. In this column, Morningstar reports fund management changes. In recent issues, they have described how Vanguard and SEI (a company that selects money managers, for the various funds they manage, under the SEI name) have made significant changes to some of their largest funds.

Why is this important? This shows that companies such as Vanguard and SEI, with all of their extensive resources and research, selected money managers for their funds a number of years ago, and have now determined that those decisions were poor. The fund managers they selected vastly underperformed their respective benchmarks. After enough years of underperformance, they needed to change managers. But how can they know that the new managers will outperform their benchmarks in the future? They can’t!

Every week, Morningstar reports the numerous changes of mutual fund managers. Sometimes good managers move to other funds. In that case, future investors in that fund may purchase these funds thinking current management built a good record. But that would not be the case. In other situations, changes are made because the managers underperformed. It is a continuous revolving door, without an ability to reliably predict future sucess.

In our strategy, this is not an issue. We purchase an asset class, a set of stocks within a given criteria, such as US small stocks. Academic research shows that this type of fund will outperform most active managers, over most years. Generally, the longer the time period, the more likely it is that a passive fund will outperform most active fund managers, in each asset class.

While these concepts may be new to non-clients of our firm, we welcome the opportunity to discuss this with you further.

We focus on the big picture, your goals and how to achieve them. We want to provide our clients with clarity and a good investment experience. This important implementation aspect is critical to the long term success of our investment philosophy.

Tax & Estate Planning Update

As a result of Congressional inaction since late 2009, the country faces continued uncertainty regarding future individual income and estate tax rates. The purpose of this post is to briefly explain what is known and unknown, and provide an analysis of how these issues may be resolved.

Income tax rates:

At the end of 2010, the “Bush tax cuts” expire (enacted earlier in the decade), and individual income tax rates would increase at each level. For top taxpayers, the rate would raise from 35% to 39.6%. For lower brackets, without any congressional action, rates would increase a few percent, respectively. The rates for dividends would increase significantly, from 15% to ordinary income tax rates (so as high as 39.6%, for taxpayers in the top bracket). For long term capital gains, the rate would increase from the current 15% to 20%.

Congress will not be addressing this issue until after the November election, and based on most estimates, probably not pass any legislation on this matter until just before Christmas. At a conference that we attended last week, the thought from a top Washington political strategist was that Congress would most likely extend the “Bush tax rates” across the board, for all taxpayers. Thus, income tax rates in 2011 would remain at current levels. This analysis is based on anticipated results in the November election and pressure not to increase tax rates, as it would be a negative factor for the economy.

What we recommend to do now:

In most years, the tax strategy is to delay income and accelerate deductions. For 2010, we recommend the opposite, to accelerate income into 2010 and delay deductions into 2011. We advise this now, as there is no way to know when the tax rate issue will be resolved. It is pretty clear that rates will not be lower than they are now in 2011, particularly at the higher levels. If rates are to increase for 2011, it would likely be for only the top tax brackets.

Estate Tax:

The estate tax expired as of 12/31/09, so there is no estate tax in effect for 2010. For 2011, per current law, the estate tax rate would be 55% for a large estate, with only a $1,000,000 per person exemption.

There are no reasonable projections of when Congress will enact new legislation for the estate tax or at what tax rates. It is possible that this legislation will be enacted as part of the income tax legislation that is discussed above, and occur sometime between the November election and Christmas.

As a purely speculative guess, it would be reasonable for the estate tax to be re-enacted for 2011 at a top rate of 35-45%, with a personal exemption in the range of $3-5 million. However, there is no clear indication of this, or when Congress will address this matter.

If you have questions about any of these matters, or how they impact your personal situation, please contact us. If you have a significant issue, it would be important to consult with us, along with your estate planning attorney.

What we recommend that you do now:

As has been advocated throughout 2010, your estate plan should be reviewed if you are married, as the formulas that are the basis for marital allocations may be distorted, due to the lack of 2010 estate tax. If someone in your family is very sick, we recommend that you consult with a well-qualified estate planning attorney, as there are important steps that may be advantageous, even though there is no estate tax in 2010. While this may be emotionally difficult to do, it is important for your family.

Our Role as an Advisor: Getting Started

A number of months ago, we met with another professional at his office, to discuss our business and his. During the course of the meeting, he asked what differentiated our practice from other advisors. We discussed a number of items, but we knew the best way would be for him to really experience our services himself.

So, after a number of discussions, he and his wife met with us, at our office. We talked about their past investment experiences, their lack of a financial plan (“I just pick stocks and have mostly not done too well”), how they now really want to get serious about their investments and feel they need professional advice. We asked them questions. Like many clients, their desire was in line with our fundamental goal, to have a greater sense of financial comfort and security, as well as clarity.

During our discussion, they asked us questions, which we answered in plain English. I drew some pictures and sketches on a legal pad, to explain our investment philosophy. Their conclusion: our philosophy is logical and makes sense. They liked that we are globally diversified, and realized that their current portfolio had almost no exposure to international stocks at all. We feel that international investments should have a significant place for almost all investors.

We recommended that we evaluate their current investments, which we call a “portfolio review.” The emphasis of this analysis is not on performance, it is on how one’s investments are allocated. We base our investment decisions on academic research, which teaches us that investment returns are based mostly on investment asset allocation, not individual stock picking. We will present this information in a clear, easily understood manner.

As part of the discussion, we all came to the conclusion that this couple had “made it” financially. They had accumulated adequate assets. However, they were risking this comfort by allocating so much of their assets to stocks (say 60- 70%). This was an uncessary risk for them. In our role as advisor, we recommended that a much more conservative asset allocation made more sense, given their age and financial assets. The primary goal should now be to preserve the majority of their assets, to provide them the comfort and security they desire.

We then talked about the allocation to fixed income, the assets I refer to as “the foundation.” We talked about why it made more sense for their fixed income investments to be in individual bonds or CDs, to be generally held to maturity, and not in bond funds (as I’ve blogged about a number of times). For this, and most others we meet with, this advice is new (and quite welcome). They did not realize that they could be at great financial risk, if interest rates eventually rise, with their bond funds.

Finally, we talked about another potential investment they are considering, an annuity product another person had recommended to them. We are analyzing this product, with very surprising results. What the couple understood to be the great advantage of the annuity product (the terrific guaranteed return), did not turn out to be what they thought. The guaranteed return only represented a small part of the total investment, and only if certain conditions were met. The annuity had very high fees, withdraw restrictions and surrender charges. Investments that we recommend have none of these. We are fee-only advisors, and our fees are clearly explained.

This is a typical example of how we begin to work with a new client. We meet with them a number of times. We want our clients to understand how we work, how we invest, what our philosophy is. We want them to be very comfortable with us. We want them to understand that we clearly understand their needs. To realize that we will utilize our extensive financial experience as CPAs to assist them with their investments and financial planning, as well as their tax and estate planning, along with their other advisors.

Many Quick Thoughts

With the great assistance of my son, and others, I’ve tried to adopt and learn about new technologies, including what is referred to as “social media” (which is what this blog is). This can be a great way for us to communicate our thoughts to clients and others in the community.

In addition to blogging, I’ve begun to post thoughts on Twitter, over the past month or so. Many people post multiple times a day and include all kinds of personal information. That is not my intent. I’ve tried to write selectively, as a way to quickly inform others of financial information or present our investment philosophy in quick bits.

For those of you unfamiliar to Twitter, each post can only be 140 characters. As I enjoy writing, it is actually a unique challenge to say something meaningful in that short space.

What follows is a sample of some of my Twitter thoughts. If you want to follow me, my “Twitter” name is “wassermanwealth.”

Recession ended in June 2009. Announced today, 15 months later, by Natl Bureau of Econ Research. Very timely. And stock market soars. Logic? (9/20/10)

Recession ended 6/09. More evidence of why you cannot predict the future, or rely on those predictions for your investment strategy. (9/20/10)

One day interest rates will rise. Then, bond prices will fall. Bond funds will get hit hard. We have a different strategy. Are you prepared? (9/16/10)

Financial risk and return are related. The greater potential return, greater the risk. How much risk do you need to take? Do you know? (9/16/10)

With uncertainty & media pessimism, stock markets up in 3rd Qtr. That’s importance of remaining disciplined & sticking to investment plan (9/15/10)

Are you focused on positive or negative? Looking LT or ST? Warren Buffett, Monday:”This country works. The best is yet to come.” Retail sales+ (9/14/10)

US National Debt almost $14 Trillion. That is $155,000+ per US family. Congr Bud Office says 2020 largest budget item will be interest pmts (9/13/10)

WSJ survey of top schools 25 for recruiting: 6 are in Big Ten. Univ of Michigan # 5 with #1 Business School, # 6 Engineering. ((9/13/10)

Warren Buffet turns 80 today. For his investing success and then charitable giving to Gates Fdn, he will impact the world for generations. (8/30/10)

Before today, all US asset classes were negative for 2010. Could you have predicted which one was positive? with a double digit increase? (8/27/10)

Only US asset class with positive 2010 returns is real estate. Evidence that you cannot predict markets. Re-emphasizes our philosophy. (8/27/10)

If Congress does not act by 12/31, LT cap gains rates increase 15 to 20% and dividends become ordinary, meaning from 15% to as high as 39.6% (8/26/10)

Morningstar study confirms that lower a mutual fund’s cost, greater likelihood of it’s success. This has been one of our core beliefs. (8/26/10)

Stocks down in June. Up in July. Down in Aug. Does it affect your LT goals? In 5, 10 years will you remember? Do you have solid foundation? (8/25/10)

Volatility of past months is reminder that no one can predict market moves. So plan and focus on long term. Key to success is discipline. (8/25/10)

How Bonds can be Painful

We have written on numerous occasions about the “risk” that many investors may be subject to, when they think they are investing safely. The Wall Street Journal published an article today, titled “Treasurys Can be Painful, as History Shows,” which clearly states the same point.

For investors that are purchasing or holding bond funds, and particularly bond funds that hold securities with maturities that are longer term, of greater than 5 years, they may face significant investment losses in the future, when interest rates rise.

As the WSJ article stated, as the stock markets have risen in September, 10 year Treasuries have lost 2.2% and 30 year bonds are down by 6.9%. Note that if interest rates rise, the price of bonds fall. If you own a bond to maturity, this should not be a major concern. If you own bond funds, this is a major problem, that should be discussed with us and corrected.

As we base our investment decisions on our understanding of how financial markets work, and not on predictions, we try to learn from the past to prevent current or future problems. In 2003, the 10 year Treasury bond yield increased by one percent in a two month period. This resulted in an 8.2% loss in that two months. During a 13 month period beginning in October 1993, 10 year Treasuries rose 2.4%, which resulted in a 10.6% loss for investors of these bonds.

On Friday, the 10 year Treasury yielded 2.746%. When the economy improves, and if yields rise to 4%, bond fund investors would lose approximately 7%, for that maturity. Holders of bond funds with maturities of 20-30 years could face losses of at least 10%. We feel the losses could be much more severe, as it is likely that investors will flee bond funds all at once, which would further exacerbate the losses, as funds are forced to sell securities en masse to meet redemptions.

The fixed income component of an investor’s asset allocation is critical to their investment success. To truly provide a client with comfort and security for the long term, given that interest rates are at all time lows and in the mid-long term will likely increase, we feel that investors would greatly benefit from holding individual fixed income investments, usually to maturity. This would prevent the losses described above.

See also post dated August 18, 2010, on the same topic.

Source: Wall Street Journal, 9/20/10, Treasurys Can Be Painful, as History Shows