Diversification is more important than style

A long-standing argument in the investment community has been whether active management of a portfolio can actually produce better investment results than a passive portfolio. And with the volatility of the markets in recent history, this conversation seems to have moved to the forefront.
An actively managed portfolio uses the skill of a single, or team of managers that use technical analysis, research and their personal judgment to determine which investments (we’ll use stocks for this example) to buy and hold, or sell within a portfolio. The manager(s) typically operate within a specific discipline, i.e. large cap growth, small cap value, international, etc. Those who subscribe to this method of money management do not buy into the efficiency of markets. They believe there is enough inefficiency and imperfect information that it is possible to profit from identifying mispriced (either too high or too low) securities.

Passive investing can also be described as “indexing”.  Subscribers to this approach of investing believe that markets are efficient and that all information that is available on a specific stock is known and built into the price of the security. These folks believe that in the long run, parking money in an index, such as the S&P 500, would yield better investment results than actively trading and picking specific stocks within the index. The argument becomes more compelling when you consider management fees and trading costs in the actively managed portfolio that can drag down performance.

And of course, it is also possible to be an active trader of passive investments, such as exchange traded funds, or ETF’s, which have become wildly popular with good reason. This investment is low cost, liquid, and is easily traded like  a stock. An ETF can be tied to one asset, i.e. gold, or a group of assets, like dividend paying stocks.

What is sometimes missing in this conversation is the notion that according to the widely accepted 1986 study by Brinson, Singer,and Beebower, asset allocation of a portfolio accounts for 91% of the long term performance of a portfolio. Market timing and stock selection are considered to have far less impact.  So even if you choose the passive route, it is unwise to think you can put all your eggs in one basket, or one index, like the S&P 500 and think you will have long term success.

Diversification, which is choosing the right mix of asset classes, whether it be large companies, medium companies, or small, domestic or international, developed or emerging markets, traditional asset classes or alternatives, just to name a few – is a far more important decision than whether to hire money managers, use indices, or a combination of both. And with all the available investment products and solutions, even self-proclaimed passive investors need professional advice to get it right. And don’t forget that the “right” portfolio, or asset mix, is never “one size fits all”. It is what is right for you at this moment- and can change as your life circumstances change.

A credible Europe solution would aid markets

Over the last 10 years investors have certainly had many issues facing them as they make long term decisions regarding their investment strategy. The most recent issue impacting the markets is Europe (although the budget debate in the U.S. is a close second).

We see trends improving in the U.S. economy so why isn’t the U.S. stock market booming?

In a nutshell, investors are worried that a meltdown in Europe will create a worldwide financial contagion, impacting the global stock markets. If a credible solution emerges from the negotiations currently underway, it is expected that our stock market will show some attractive returns, as corporate earnings and balance sheets are quite strong and stock valuations, in terms of Price/Earnings ratios, are below historic averages.

Investors saw what happened in the U.S. in 2008 when the sub-prime mortgage crisis created a financial contagion, and they fear that Europe could be 2008 all over again. By way of some background – Europe is in a very difficult situation now for some basic reasons.

When the Euro was created, the idea was to unite the 17 nations economically so that they became united politically. Europe had been devastated by war over the previous 100 years and this was the basis of a solution. A common currency certainly united them from a monetary perspective, but there was no fiscal unity.

There are 300 million people in Europe and it was thought that having a united economy would give them an opportunity to better compete with the United States. It was expected that over time, the economies of each of the individual European countries would converge. However, this did not occur as each of the countries had widely diverging economic growth – Germany having enjoyed the strongest economy.

So, to keep up with their neighbors, some of the smaller countries, most notably Greece,resorted to government spending (read large government payroll) to stimulate their economies. Over time, Greece built up huge budget deficits which should have made holders of their sovereign debt quite nervous.

Greece and other smaller countries (Ireland, Portugal) required bailouts. When Italy (they have had the smallest economic growth of any country since the implementation of the Euro) surfaced, it became clear there was a need for a comprehensive plan for all of Europe.

The support of Germany and France, and probably the UK, is needed for this plan to work. The European Central Bank (ECB) is providing liquidity through long term repurchase operations (LTRO), which has helped alleviate pressure on European banks holding sovereign debt.

Ultimately, though, the long term viability of the EU rests on the ability of leaders to reach an agreement on fiscal restraint. Germany is the major player here and they are playing hard ball, indicating they won’t support bailouts unless other countries agree to spending cuts.

I think Germany will have no choice but to participate, especially after what happened in the U.S. in 2008 with Lehman Brothers’ failure. A “bazooka” is needed, similar to our TARP
program.

Study all of your options for long-term care

A friend of mine moved his elderly mother into an assisted living facility last week. It was a difficult decision for the family to make, but a necessary one given the human and financial resources required for her to continue to live on her own.

This scenario is played out daily in families all across the country – and a reminder that while medical advances have prolonged life expectancy, there is no guaranty that the quality of life will be ideal. While the decision to transfer an aging loved one to an assisted living facility is difficult, the nursing home decision can be even harder.

It is estimated that approximately 70% of people over age 65 will require some type of long term care (LTC). And while we typically associate the need for LTC with the elderly, injury and disease can trigger a need at any age. Christopher Reeve, who became a paraplegic at age 42 as a result of a riding accident, is one of the most glaring examples.

While we are accustomed as a society to insuring our homes, our automobiles, our lives and, increasingly, our pets, the need to insure the cost of long term care is not so clear. As a result, families are absorbing these significant costs of care.

According to an AARP study, in 2009, about 42.1 million family caregivers in the United States provided care to an adult with limitations in daily activities. The estimated economic value of their unpaid contributions was approximately $450 billion in 2009, up from an estimated $375 billion in 2007.

There are basically four ways to pay for LTC: Medicare, Medicaid, self-insure, or LTC insurance.

Medicare is a federal program that has fairly stringent requirements and little flexibility in the type of care provided. Medicaid is designed for low income individuals. For those with options, these alternatives may not be the most advantageous.

The decision to self-insure, purchase long term care insurance, or a combination of the two, requires planning, and a good working knowledge of the costs of various types of care (institutional, assisted living, home health care), local costs, and your particular preferences.

There are many different LTC insurance products on the market today. Many are traditional- the owner of the policy pays for the coverage annually. If LTC benefits are needed, a claim is made against the policy. If no benefits are needed, the policy expires unused, much like auto insurance.

There is another product available, which is a life insurance policy, where portions of the death benefit can be used for LTC needs. So – if there is a LTC need, the funds are available. If there is NOT a LTC need, then the life insurance policy pays a death benefit to your beneficiaries. In effect, you are repositioning a portion of your investment portfolio to protect the rest of your portfolio.

Your insurance advisor or financial planner can help you sort out the options and determine the best solution for you and your family.

Is your financial plan on track for 2011?

The holiday season is upon us, which for many, means time spent with family and friends reflecting on the blessings in life and those we hold dear, and thinking ahead to the coming year. It is a good time to do a year end check-up to make sure that our financial plan is on track and ensure that your actions reflect your values.

Some things to think about as 2011 comes to a close:
Are you maximizing your IRA, 401K and/or 403B contributions? The 401K contribution limit for 2011 is $16,500 with a $5,500 catch-up provision if you are age 50 or older. Remember that these are IRS limits; your plan may have different limits- consult your plan administrator.

The holidays often make us feel more charitably inclined. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 can make giving this year a little more attractive for seniors. In 2011, owners of IRA accounts who are over 70 ½ years of age can make a charitable contribution to a qualified charity of up to $100,000 directly from their IRA up to December 31.

The amount contributed will not count as taxable income, and the contribution will not qualify as a deduction from income. The amount transferred may count as the minimum required distribution for tax year 2011. This opportunity ends after 2011, so check with your advisors to see if this strategy will work for you.

Have you taken full advantage of the annual gift tax exclusion amounts for 2011? Each taxpayer is allowed to gift $13,000 to any individual in 2011 without having to pay gift tax. For a married couple, the combined maximum gift is $26,000. This is an excellent wealth transfer strategy, effectively reducing the net worth of the giver with potentially no tax consequences to themselves or the recipient. Given the state of the economy, a gift of cash may be particularly welcome this year.

Remember that if you are paying education expenses on behalf of someone else, that amount is outside of the annual exclusion amount. There is no limit on what you can pay for someone else’s education, as long as the payment goes directly to the educational institution. Check with your tax advisor to make sure you understand the tax impact of gifts you make.

Beware of the mutual fund tax trap as year-end approaches. Most mutual funds pay out the majority of their distributions (which are taxable unless owned in qualified retirement accounts) close to year end – some as early as November. The distributions are generally divided equally among all shareholders as of a certain date, and does not take into consideration how long each investor has owned the fund. Buying a fund close to this date at year end could throw you into the unfortunate situation of paying tax on a year’s worth of gains on a fund you only owned for a few days. Check with your advisor – taxes should not be the only consideration in making a wise investment decision.

This article is not intended to be tax advice- please consult with your tax advisor for specific guidance for your situation.

Investors: Be aware of new cost basis rules

The Emergency Economic Stabilization Act, more commonly referred to as the bailout of the U.S. financial system, was enacted by the U.S. Congress and signed into law by President Bush in 2008.

Part of the legislation includes new rules to ensure the accurate reporting of gains and losses of securities by investors on their personal tax returns.
Prior to this legislation, financial service firms were only required to report gain and loss information to the investor, who was responsible for including this information in their tax filings. Only gross proceeds of the sale were reported to the IRS.

Beginning in tax year 2011, financial services firms are required to report cost basis to the IRS as well as to the investor for equities acquired on or after January 1, 2011.

This reporting expands to mutual fund, exchange traded fund (ETF), and dividend reinvestment plan (DRIP) shares acquired on or after January 1, 2012.

Finally, cost basis reporting to the IRS will be required for fixed income, options, and other securities acquired on or after January 1, 2013.

So what is cost basis, you ask? It is the original price you paid for a security, plus commissions and any other fees. Seems simple, except that it is the adjusted cost basis that is used to determine the capital gains or losses of an investment for tax purposes. The longer an investment is held, the more likely it is that the original price will need to be adjusted to reflect changes over time.

These changes include wash sales, amortization and accretion, or corporate actions such as capital returns, stock splits and dividend payments. The actual calculation can therefore become quite complex. The good news is, the law requires that your financial service provider prepares the calculation.

To further complicate matters, investors now have a choice of several methods for calculating cost basis. Your investment advisor has likely already discussed these with you, but if they haven’t or you can’t remember, this would be a good time to have that conversation. Together you can determine the appropriate cost basis method for your unique situation.

How to put cash on the sideline to good use

You’ve no doubt heard that there is a lot of “cash on the sidelines”, both corporate and personal, as people wait for the most opportune time to leap into this highly volatile stock market.

My firm belief is that the time to invest is when you have the money and the time to sell is when you need the money. However, if you are one of those hoarding cash and are not comfortable investing in traditional assets, you may be wondering if there are alternatives to parking in a money market earning next to nothing. There are.

First, remember that good financial planning prescribes that you keep four to six months of living expenses easily accessible in a liquid bank account should the need arise. This is especially important now when unemployment remains high and many folks are concerned about job security. If you have that need taken care of, and you still have some idle cash, consider the following.

Are you maxing out your 401K and IRA contributions? While these contributions would be considered market investments, they have the added potential benefit of a current year tax deduction, and earnings in these investments accumulate tax deferred. With the ongoing problems with Social Security, taking responsibility for your own retirement has never been more critical.

Consult with your tax advisor and 401k or 403B administrator on the maximum contribution you can make in 2011 and when those contributions need to be made.

Another critical reason to max out your 401(K) or 403(B) contribution is that many employers offer some type of matching contribution. Whatever the match amount, this is "free" money to you that you can rely upon to increase your retirement savings.

Pay off high interest credit card debt. Carrying credit card debt is, in most cases, a bad idea. If you have balances and idle cash, this is a “no-brainer”. The interest rates are likely high, 20 percent or higher in some cases, and are generally not deductible, so there is no economic advantage to carrying a balance on these cards.

Should you pay down or pay off your mortgage? The answer to this is not as clear.

The interest on mortgage loans up to $1.1 million are generally deductible (check with your tax advisor), so if you pay taxes at a 30% federal marginal tax rate, and you have a mortgage at 5% interest, your after tax interest rate is actually 3.5%.

In this scenario, if you believe you can earn more than 3.5% in other investments (like the stock market), then paying off the mortgage may not be the best use of these funds. Consult your advisor to determine if this strategy makes sense for you.

Finally, if you have idle cash, then you may want to consider sharing your blessings with others. Many of our neighbors are in desperate need of food, shelter, and access to health care. It may be that investing in your community is the best use of your idle cash.

Charitable contributions may be tax deductible (consult your tax advisor for rules and limitations), and the feeling of helping out a neighbor in need is priceless. There are many local resources to help you decide which charitable organizations might be a good fit for you.

With advisors, do put all your eggs in one basket

I was struck recently by a radio ad for an insurance company where the narrator described a situation where a patient went to two different doctors and received two medications. When the patient went to the pharmacist to have the prescriptions filled, he was informed that the combination of drugs could be detrimental to his health.

Unfortunately, far too many people have a similar approach to investing. They hire multiple advisors so as not to keep “all their eggs in one basket”, yet the potentially conflicting recommendations that could be harmful to their financial health go undetected because there is no financial pharmacist to alert the investor to the danger.

This is not to say that diversification is not important - it is critical. The asset allocation of a portfolio determines more than 90% of the returns. Stock selection, market timing and other factors account for the rest in very small proportions. So what’s the problem with having multiple advisors?

First, by employing multiple advisors, an investor loses an economic advantage of having all of their investments combined for fee purposes. Advisors need to get paid for the service they provide which typically is in the form of an advisory fee. The fee is typically a percentage of the portfolio being managed, and often is reduced based on the size of the portfolio. If you have multiple advisors, you are likely paying more in fees, which will drag down the overall return.

Second, think about why you hire an advisor. To get the best return possible? How would you know if you were? Smart investors hire an investment advisor to manage risk. This means having an advisor that can build a customized portfolio that reflects the risk you are willing to take, while achieving long term returns commensurate with an appropriate benchmark. If you have multiple advisors, there is a good possibility that they are not working together. The portfolio construction could be overlapping or conflicting. So who is really managing the risk in your portfolio? You are - and paying handsomely for the privilege.

In years past, when investment advisors were more specialized and technology and investment products were more limited, having multiple advisors made some sense. Today, it is possible to achieve broad diversification using multiple money managers and strategies through a single advisor. The advantage is that you have one person overseeing the entire process, keeping the risk, and the fees, in check.

Often I hear that people hire multiple managers to keep their advisors “honest”. Trust is a key component to any advisory relationship and you should feel confident that your advisor takes the time to know you, understands your needs, and has your best interest at heart. If you don’t feel that way, regardless of the great performance you think you’re getting, it’s time for a new advisor. I also hear that pieces of a portfolio are being managed by friends or family as a favor. I am not against having friends or family as advisors - who better to trust? But if you are not willing to put all your money with them, then it’s better to put nothing. Find another way to find favor.