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Financial Recordkeeping – How Long Do I Keep This??

put your records on by Hryck. I often get the question – how long should I keep my _________ (fill in the blank)? So I thought I’d put together a list of the most common types of documents with some guidelines as to how long you should keep those documents. I’ll try to keep this as simple as possible – but obviously, if you have other documents that I have not covered here, please contact me and I can give you a recommendation for your particular situation.

Keep in mind that these are only guidelines. If you have a special situation, such as a lawsuit (even if it’s been settled) or a sticky inheritance or insurance claim situation, you should probably keep that sort of documentation forever plus 1 day. You just never know when it will be necessary to dredge up that information again to prove how it was handled, when it was handled, or who was involved, as well as the circumstances.

With litigation and insurance claims especially, it is helpful to put all of the pertinent documentation into a larger folder, envelope, or other self-contained filing apparatus, along with a brief description (in your own words) of the circumstances and the outcome. This information would go in your permanent file. Unless the documentation takes up too much space, you can get a fairly inexpensive fire-proof safe to hold this kind of information, along with the permanent documents that I’ll list below.

The Financial Stuff Organizer (FSO)

If you’d like a head start on gathering and organizing all of this information, I have a set of templates (written in Microsoft Word for easy editing) that you can customize to create your own Financial Stuff Organizer (FSO). A colleague of mine created these templates several years ago, and I think you’ll find the FSO pretty useful as you organize your financial documentation. Just let me know if you’d like a copy and I can email it to you.

Permanent

Your permanent file should either be stored in a fire-proof safe in your home or place of business, or in a safe deposit box at your bank. In your permanent file, you’ll want to keep the following documents:

Social Security card(s)
certified copy of your birth certificate(s)
passport(s)
life insurance policies in force
homeowner’s insurance policies in force
auto insurance policies in force
liability insurance policies in force
annuity policies
wills and trusts, including living wills
community property agreements
prenuptial agreements
military discharge papers
marriage certificates
death certificates
divorce decrees and related paperwork
power of attorney documentation (healthcare and otherwise)
citizenship paperwork
copies of property deeds and descriptions, along with mortgage closing documentation, title insurance, and records of major improvements to the property
any litigation-related or complex insurance claim-related information as mentioned above
retirement plan documentation, including beneficiary designation forms (a copy of the form submitted to the custodian)
personal health record – including dates of any procedures or major illnesses and treatments
any bond, stock or other investment documents that are original certificates – such as Series EE or I savings bonds
any partnership agreements, buy-sell arrangements or other continuation documents
automobile titles
union cards
deeds to cemetery plots, along with any pre-arrangement information
adoption papers
diplomas
licenses that you don’t need to carry
documentation on any property inherited – including fair market value assessment, and any other information used to establish the basis for the inherited property

In addition to these specific documents, it is a good idea to have copies of the front and back of your credit cards, driver’s licenses, and any other hard-to-replace documents that you carry in your wallet or purse. This way, if your purse is stolen, you have ready access to the emergency phone numbers to report the stolen information and to request replacements. The permanent file, if located in your home, is also a good place to keep the key to your safe deposit box.

Long-Term (7 to 10 years)

Your long-term file will ideally be a filing cabinet in your home or office and your computer. When you first start scanning your important documents into the computer it will take a while, but if you set aside a few hours and do it in batches, you’ll soon have everything you need copied. Then you can scan the documents into your computer when you receive them. Your computer records should be backed up at least quarterly, as well as any time you add new information to the file. Backup the computer files onto an inexpensive flash drive and keep the flash drive in your permanent file, safe deposit box, or perhaps at a relative’s house. In general this long-term file will include the following documentation:

tax returns – if you use a tax preparer (like me, for example) your returns and copies of all supporting documentation will be kept for at least three years by law, and the really good preparers (like me, for example) will keep all of your documentation permanently
documentation used to create the tax returns, including:
- W2′s
- 1099′s
- canceled checks and bank statements
- credit card statements (if used for deductible items, such as charitable contributions or medical expenses)
- year-end brokerage statements
- rental property documentation
- self-employed business documentation
- major home improvement documentation
health insurance records – claims, policy information, premiums paid and reimbursements
home insurance records – policy information, payments, and claims
home repair bills and contracts for major repair/remodel projects
warranty documents and manuals for all home appliances (keep until you no longer use the appliance)
realty and personal property tax assessments
rental agreements
receipts for high-dollar items (keep these until you dispose of the item)

Short-Term (1 to 3 years)

Your short term file can also be a filing cabinet – and in general these documents won’t need to have a computer scanned copy. This sort of documentation can be readily re-created if necessary, and has a much shorter useful life. Keep the following information in your short-term file:

loan payment records (non-mortgage)
pay stubs – keep the last one from each year, for a reference to compare with your W2 if necessary.
year-end bank and brokerage statements. These are usually available from the company, but this way you’ll have the document on hand when you need it.
budgets and actual results – many folks don’t track their expenses very closely, but if you do, it’s a good idea to save previous years’ final results to compare and see how you’ve done with regard to the budget over the years.

Close At Hand (Reference file)

It’s also a good idea to have a ready binder that has some critical information documented for your family members in the event of your incapacitation. Depending upon the nature of the information that you keep in your Reference, you might want to store this folder with your permanent files. Keep the following information in the close at hand Reference file:

health-care providers, including phone numbers and specific health matters dealt with
financial professionals – accountant, insurance professionals, attorneys, financial planners, bankers, tax preparers, stock brokers, etc.
emergency instructions for death or disability, including who to contact to deal with various situations
all family names, addresses, Social Security numbers, birth dates, and driver’s license numbers
contents of your safe deposit box and/or permanent file – including where the file is located, how to access it, etc..
a brief “What’s Where?” document which explains how to locate various documents that may be required in the event of your incapacity
description of and passwords to your various computer files relating to important documentation
any loan documents – including personal “word of mouth” loans made to or by you by or to others
current and past resume’s

What You Don’t Need to Keep

We often keep lots of extra “stuff” around that we just don’t need to keep. Hopefully this list will help you to eliminate some of the excess junk and open up space for some of the really important stuff. I would get a paper shredder that you can use to destroy these documents, as you don’t want even the smallest amount of personal information floating around in these days of identity theft. You can eliminate the following documents from your personal “paper farm”, keeping only three months’ worth:

utility bills (unless you need them for tax documentation)
credit card bills
bank statements
pay stubs
bank deposit slips and ATM slips
receipts for small items (check against your credit card or bank statement, then pitch)

There you have it. Don’t let the length of this article cause you to throw up your hands in despair at the size of the task – it doesn’t have to be daunting. You probably have much of this information pretty well organized already. Just go at it in batches and get everything in it’s place. And if you’d like a copy of the FSO I mentioned earlier to help you with the process, feel free to give me a shout.

Photo #1 by Hryck.

Photo #2 by kthypryn

Photo #3 by sidewalk flying

What Can a Broker Do For You?

Nov 15th, 2009

by jblankenship.

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You have choices when it comes to investing. You can go directly to a mutual fund company (such as Vanguard or T. Rowe Price) and choose investments yourself, or you can use a fee-only financial advisor to assist you in choosing investments. But by far the most common method is to work with a broker. Brokers are companies like Edward Jones, Ameriprise, and AG Edwards Wachovia Wells Fargo, plus many, many other companies, including insurance company brokerage divisions, banks, and the like.

What’s the Difference?

chuck babbage's difference engine by Marcin Wichary You’re probably wondering – what’s the difference between a broker and, for example, a fee-only advisor? You’re right to be confused, because until you start working with one or the other and you know what the difference is, they look pretty much the same from the outside. Here’s the difference:

Brokers are salesmen. It is their job to sell you an investment product, and that’s how they get paid. They are required by law to ensure that the product is “suitable” to your situation.

Fee-only advisors are advisors. Fee-only advisors are bound by law to act as a fiduciary. It is their job to advise you on the appropriate strategies and tactics – investment moves that are in your best interest.

That’s a pretty big difference in itself – but since that differential makes the fee-only advisor look SO much better (and since this writer is a fee-only advisor), I wanted to point out what research has born out to be true about the recommendations that you get from a broker.

What Can a Broker Do For You?

There is a study done by researchers at Harvard and the University of Oregon (Bergstresser, Chalmers, and Tufano), which strives to identify the possible benefits to the consumer of financial services in purchasing investments via a broker. They looked at five possible benefits:

Assistance in selecting funds that are harder to find or evaluate.
Access to funds with lower costs excluding distribution costs.
Access to higher performing funds.
Superior asset allocation.
Attenuation of behavioral investor biases (in other words, saving the investor from himself)

Ultimately, the researchers “found it difficult to identify the tangible benefits delivered by brokers.” But that’s getting ahead of ourselves. We’ll take each category separately and briefly describe the findings.

Assistance in selecting funds that are harder to find or evaluate

It is true that brokers often direct investors into smaller, younger funds that have less track record or are not covered by major rating services. The costs (especially in time) to the individual would be enormous in researching these funds. If the other benefits are brought about by utilizing these harder to find or evaluate funds, then there would be a benefit to working with the brokerage. What we’ll see is that the rest of the evidence doesn’t bring that conclusion.

Access to funds with lower costs excluding distribution costs

The researchers found that the funds sold through the broker channel do not have lower costs excluding distribution fees. In other words, even if funds exist that are of a lower cost, the brokers are not (in general) directing investors to those funds. Across the board, the annual cost of a brokered stock fund was on average 2 basis points (bp) higher (.02%), not including commissions or 12(b)1 fees. And the average annual cost of a bond fund was an amazing 23bp higher, and money market funds were on average 4bp greater.

Access to higher performing funds

The overall return, as well as the risk-adjusted return, is lower for the funds that the broker chooses, versus funds that are directly purchased via other channels (e.g., a fee-only advisor or through personal research by the investor). Stock funds underperformed direct-purchased funds by an average of 7.5bp (.075%) – and using risk adjustments caused these figures to get even worse. Bond funds underperformed as well, but money market funds did provide a slightly better return, by a total of 18bp on average.

Superior asset allocation

While a broker’s asset allocation recommendation is different from that of other investment channels, over time the outcome is pretty much the same for either type of investor. The difference is that, on average, the broker tends to direct a higher percentage of investors into bonds (as opposed to stocks). Since stocks, over a long run, outperform bonds and bonds demonstrate lower risk (as measured by standard deviation), this difference in allocation weights tends to even out between the two.

Attenuation of behavioral investor biases

Lastly, the research shows that most broker-driven investors are much more sensitive to short-term performance in the market than other investors. This leads to “performance chasing”, which in general does not bear greater returns, while at the same time increases incremental transaction costs. Transaction costs benefit the broker, of course.

But wait, there’s more!

broker by kevin_oneill In addition to the research summarized above, you need to know about how a broker is typically paid. I already mentioned that the broker is paid to sell the investor products – how does that work? There are many types of fees which can impact an investor’s account:

Front end loads: this is a commission charged when you purchase the fund. Typically these can be anywhere from 3% to 5% or more of the purchase, although at much higher balances the fees can be reduced and even eliminated.
Back end loads: this is a commission charged when you sell the fund. Often, this is used to keep an investor in a fund for a specific period of time, during which other fees can be transacted from the account. After a period of time, these back end loads are waived.
Annual loads: this is an annual commission based on the holdings in the account, and can be one of the most expensive ways to hold investments.
12(b)1 fees: this is also an annual fee based on the holdings in the account, and often is the most elusive to identify – while representing the greatest drain to the investor. This fee is usually pretty small in relation to other fees (sub 1%) but it is charged across all classes of funds, whether a front-end, back-end, or annual load. What really hurts is that the 12(b)1 fee is specifically for marketing the underlying investment. In other words, as an investor in the fund, you’re paying to help bring in more investors.

While it’s not conclusive, some of the results found in the research paper indicate what you might expect: that brokers sell the investments that pay them the most. For example, as the front-end load or 12(b)1 fee increases for a particular fund, there is an attendant increase in the sales of the fund. Not unexpected, it’s basic human nature.

Conclusion

The research shows no tangible benefit to working with a broker – in fact, results are often worse with a broker. Add to that the costs of working with a broker, above and beyond the dismal results that you achieve, a conclusion isn’t hard to come by: it makes more sense to either do the research on your own and purchase funds directly, or to work with a fee-only financial advisor who will do the research and operate as a fiduciary to ensure that the investment choices you make are in your best interests.

Photo #1 by Marcin Wichary

Photo #2 by kevin_oneill

Facing the Possibility of Incapacity

Oct 15th, 2009

by jblankenship.

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Incapacity means that you are either mentally or physically unable to take care of yourself or your day-to-day affairs. Incapacity can result from serious physical injury, mental or physical illness, mental retardation, advancing age, and alcohol or drug abuse.

Incapacity can strike anyone at anytime

Even with today’s medical miracles, it’s a real possibility that you or your spouse could become incapable of handling your own medical or financial affairs. A serious illness or accident can happen suddenly at any age. Advancing age can bring senility, Alzheimer’s disease, or other ailments that affect your ability to make sound decisions about your health, or to pay your bills, write checks, make deposits, sell assets, or otherwise conduct your affairs.

Planning ahead can ensure that your wishes are carried out

Designating one or more individuals to act on your behalf can help ensure that your wishes are carried out if you become incapacitated. Otherwise, a relative or friend must ask the court to appoint a guardian for you, a public procedure that can be emotionally draining, time consuming, and expensive. An attorney can help you prepare legal documents that will give individuals you trust the authority to manage your affairs.

Likelihood of Suffering a Disability by Age 50

Source: 1985 Comimissioner’s Individual Disability Table A (most recent data available)

Managing medical decisions with a living will, durable power of attorney for health care, or Do Not Resuscitate order

If you do not authorize someone to make medical decisions for you, medical care providers must prolong your life using artificial means, if necessary. With today’s modern technology, physicians can sustain you for days and weeks (if not months or even years). If you wish to avoid this, you must have an advanced medical directive. You may find that one, two, or all three types of advanced medical directives are necessary to carry out all of your wishes for medical treatment (make sure all documents are consistent).

A living will allows you to approve or decline certain types of medical care, even if you will die as a result of the choice. However, in most states, living wills take effect only under certain circumstances, such as terminal injury or illness. Generally, one can be used only to decline medical treatment that “serves only to postpone the moment of death.” Even in states that do not allow living wills, you might want to have one anyway to serve as evidence of your wishes.

A durable power of attorney for health care (known as a health-care proxy in some states) allows you to appoint a representative to make medical decisions for you. You decide how much power your representative will have. A Do Not Resuscitate order (DNR) is a doctor’s order that tells all other medical personnel not to perform CPR if you go into cardiac arrest. There are two types of DNRs. One is effective only while you are hospitalized. The other is used while you are outside the hospital.

Managing your property with a living trust, durable power of attorney, or joint ownership

If no one is ready to look after your financial affairs when you can’t, your property may be wasted, abused, or lost. You’ll need to put in place at least one of the following options to help protect your property in the event you become incapacitated.

You can transfer ownership of your property to a revocable living trust. You name yourself as trustee and retain complete control over your affairs as long as you retain capacity. If you become incapacitated, your successor trustee (the person you named to run the trust if you can’t) automatically steps in and takes over
the management of your property. A living trust can survive your death. There are, of course, costs associated with creating and maintaining a trust.

A durable power of attorney (DPOA) allows you to authorize someone else to act on your behalf. There are two types of DPOAs: a standby DPOA, which is effective immediately, and a springing DPOA, which is not effective until you have become incapacitated. A DPOA should be fairly simple and inexpensive to implement. It also ends at your death. A springing DPOA is not permitted in some states, so you’ll want to check with an attorney.

Another option is to hold your property in concert with others. This arrangement may allow someone else to have immediate access to the property and to use it to meet your needs. Joint ownership is simple and inexpensive to implement. However, there are some disadvantages to the joint ownership arrangement. Some examples include:

your co-owner has immediate access to your property,
you lack the ability to direct the co-owner to use the property for your benefit,
naming someone who is not your spouse as co-owner may trigger gift tax consequences, and
if you die before the other joint owner(s), your property interests will pass to the other owner(s) without regard to your own intentions, which may be different.

Why We Use Timber in an Investment Portfolio

Sep 15th, 2009

by jblankenship.

2 comments

Continuing with the series we started some months ago, today we’ll talk about why Timber is a viable and important asset class to include in your portfolio. If you’ll recall, in previous discussions we talked about Real Estate as an asset class, and then we discussed the merits of Commodities as a broad asset class for your portfolio. Timber is an asset class that is not well-represented in the broad Commodities indexes, and (at least as of this writing) there is no index fund tracking what is considered the benchmark for the US-based timber industry, the National Council of Real Estate Investment Fiduciaries (NCREIF) Timber Index.

Timber as an Asset Class

Timber is typically not well-represented in other Commodities indexes. The nature of timber as an asset doesn’t lead it to treatment the same as most other commodities, due to its unique 3-part return generating process. Returns are generated by 1) cutting and selling the timber itself; 2) increases in demand for timber, which tends to follow the growth of the GDP; and 3) inflation in the cost of timber, which over time has tended to slightly out-pace inflation in the general economy. Capital appreciation in the timber asset class is generated by the increases in the value of the underlying land, plus the natural growth rate of the trees.

The risks associated with the asset class include primarily demand-side risks. Since supply-side inputs are primarily “free”: sun, soil, and water; risks in generation of the product are relatively small. In the management of the product there are costs and minor risks – that of land management, lease and/or other acquisition costs and taxes, and the risks of climate change, fire damage, and other biological damage. These management risks are deemed to be relatively small (much less than 1%).

On the other hand, the demand-side risks are many: demand for lumber can vary dramatically with the economic cycles, but some demand is always present. In addition, if the volume of available finished product is too great for the demand, price volatility can be present to erode returns.

Over the past 40 years, depending upon the benchmark in use (I used the Hancock Global Timber Index), the yield on timber as an asset class was in excess of 9%, with a standard deviation of roughly 12.5%. Recent calculations of future returns for timber indicate anywhere from a 6% to a 7.5% return for the near term. Longer term calculations quickly become invalid due to the dependency upon the global GDP estimations.

And lastly, given the compelling return predictions, one of the critical factors that we look for when choosing additional asset classes to invest in is low correlation to the remainder of our portfolio. In this case, timber fits the bill quite well – when compared to fixed income, equities, foreign equities, other commodities, and foreign-currency bonds, the correlation falls well below .25. This means that, for example, any movement (positive or negative) in the underlying value of our timber proxy has historically reflected other asset class movements at less than a 25% rate. In other words, if the domestic equities asset class experienced a 10% correction, historically speaking, you would expect less than a 2.5% “reflective” correction in the timber asset class.

So, all in all, it seems to make a great deal of sense to have a small exposure in our portfolios to Timber as an asset class when seeking additional non-correlated returns beyond the more common asset classes. Timber is not always present in the portfolios that I develop, but it is quite often included, for the reasons stated above.

Why is Index Investing a “No Brainer”?

Aug 15th, 2009

by jblankenship.

4 comments

For those of you who have read much of my writing on the subject, you’ll recall that I always recommend working with index investments when we have them available. In this article I will do my best to help you understand some of the reasons why I make that recommendation.

What is Index Investing?

In order to understand why indexes make the best investments, I need to explain first what I mean by an index. In general, an index investment is a representative investment covering a market, sector, or asset class. The S&P 500 is an index, representing the asset class of the 500 largest publicly-traded companies in the US marketplace. The Vanguard Total Market Index is an index that represents the entire spectrum of domestic (US) publicly-traded companies. There are many other examples, including the Lehman Brothers Aggregate Bond Market Index (all publicly-traded bonds in the US marketplace) and the Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East (EAFE) index – which includes the entire markets of the following countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, The Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Since these indexes represent the entire marketplace, they are used as the benchmark against which managed funds are measured.

There are mutual funds and exchange-traded funds that track these various indexes. If you’ll recall, one of the first tenets of successful investing is to diversify – don’t put all of your eggs in one basket. By investing in one of those vehicles, the investor is taking an ownership stake in all of those companies at once. What a great way to diversify!

These indexes do not change, and do not require a professional manager to oversee them, because they represent an entire marketplace. Because of this, there is very little overhead (fees and expenses) to reduce your return. Also, since we aren’t changing investments by selling a company’s stock that is out of favor and buying one that we think might provide better returns in the future, transaction costs are nil, and excess taxation is eliminated from the mix.

What Are Managed Investments?

On the other side of the coin from Index Investments is the group of mutual funds called Managed Investments. These are investment vehicles where a manager (or team of managers) chooses a group of companies (or bonds) to invest in. Over time, this group of investments must be monitored to ensure that the individual companies are producing the expected results. If a company appears to be underperforming, that stock is sold and another company is chosen to replace it in the fund. All of this analysis requires lots and lots of research, review, and just day-to-day management. And that management costs a lot of money – often upwards of 1% of the fund’s holdings each year – as opposed to less than ¼% for many indexed funds.

7276279 The idea is that the professional management team is a bunch of very smart guys and gals, and being very smart guys and gals, they can get you a better return than you could get by just buying an index fund. Care to guess how often that happens, consistently? Less than 5% of the time, according to records, and that doesn’t include all of the funds that are eliminated or merged due to underperformance.

So – the first “wrong” with investing in managed mutual funds is that you’re taking a chance that your smart guys and gals (the managers of the fund you’ve chosen) will happen to be in that top 5% that beats the index investment. And you’re paying something like four times (or more) in expenses to get there. But people still love a gamble, and so managed funds remain very popular. But why?

Under The Covers

Let’s take a look at why some managed mutual funds appear to be a good gamble, when in fact they’re really just fooling you.

Mutual fund companies introduce lots of funds every year. As an example let’s say a fund company introduces ten new funds in the year. Each fund has a fair-haired boy (or girl) managing the fund, and the manager does his or her level best to produce a good return. For the most part, since these funds haven’t been marketed to the public, the fund company puts some of their own money in the fund; this is called “incubation”, it’s a way for a fledgling fund to build a track record before investment of a lot of money in marketing. At the end of the year, nine of the ten new funds have poorly underperformed, but one of the funds outperformed the indexes by a wide margin – let’s say it’s by more than 20%.

The nine poor-performing funds’ monies are merged with the one winner fund, bolstering it’s asset size, and the marketing begins. Investors hoping for that “one in a million” investment are drawn to this new fair-haired investment manager because of the fantastic return that her guidance produced in the past year. Now is when it gets interesting…

The Interesting Part

Remember when I mentioned before about how less than 5% of all mutual funds consistently outperform the entire market index? That’s because it is very difficult to individually pick and choose 50 or 100 companies that will do better than the market. The entire market has a track record of increasing in value over 80% of the time, year in and year out. Imagine trimming that 10,000+ group of investment choices to a manageable group of 50 to 100 stocks (or bonds) that will do better than everyone else! It’s very, very, difficult, indeed – and most managers do not do this – and certainly not consistently.

So, what happens is that after the fund has had it’s initial “home run” season, where it outperformed the market by 20% or more, is that the fund attracts all kinds of attention and investors. So in the second year, lots more money pours into the fund, and the manager does her best to reproduce the result from the previous year. Amazingly enough, she does it, but this time only by about 2% overall – and the expense ratio of the fund eats one percent right away. But look at her track record: over the span of two years, she’s outperformed the index by an average of 11%! Why would you NOT invest in this fund??

After the second year where the manager just squeaked out a positive result, not wanting to lose investors’ funds, she becomes more conservative – now she begins to more closely track the index against which her fund is compared, rather than whatever magic was used to produce the first year’s stellar results. At the end of this year, the fund doesn’t quite meet the index’s return, but it’s pretty close (until you take out the additional 1% of expenses). But again, the marketing points out that, over a three-year period, this manager has outperformed the index by almost 7%. Again – you’d be a dummy to not invest with that kind of result, right?

And so it goes… eventually this fund’s returns each year are always coming up just short of the index, and after a good run of five years, the fund is folded into the next best thing. Lather, rinse, repeat…

Backing Data

I wanted to give you some additional data on the above activity, so I ran some screens using readily available tools (like Yahoo! Finance, Morningstar, etc.). The results were quite interesting: on one screener I looked for funds that had been in the top 20% of all funds for each of the past five years. Result? Zero. No fund in the investing universe was in the top 20% for five years running.

So next, I looked at all funds created during calendar year 2003, and took their rankings for 2004, 2005, 2006, 2007 and 2008. Not one of the funds that was in the top 50 for 2004 repeated for all five years, and only 1/3 of that top 50 ever showed up again in the top 50 for the succeeding four years.

Lastly, I took that same group of funds created in 2003, and compared results against the S&P 500 index’s returns for each year, 2004 through 2008. Not a single fund was present in more than one of the years as an index-beater.

Of course this isn’t definitive research – I’ve found it doesn’t pay off to spend too much time checking these things out, because the result remains the same.

One other item that was not factored in is called survivorship bias. This is the phenomenon that occurs because only the surviving funds, those that had good performance, are available for result comparison. From our example, nine of the ten new funds created by our fictitious mutual fund company were shut down after the first year. So now, being non-existent, the poor results that those funds brought forth are not included in any screening reports, making the results (of only the surviving funds) look much better overall.

Bottom Line

At any rate, I wanted to provide you with this explanation of yet another problem seen in the investing world. I think it can best be summed up by comparing investing with gambling at a casino. Everyone knows that gambling odds are always in favor of the “house”. The individual gambler might hit it big once in a blue moon, but in general the gambler pretty much always comes out on the short end. On the other hand, with the odds in the favor of the casino, owning a casino can be a pretty good way to make a lot of money.

In the investing world, it pays off to own the “casino” – that is, to own the entire marketplace – instead of playing the games of managed mutual funds. Owning the marketplace (via an index) gives you the benefit of an 80% opportunity for an increase in your holding each and every year, for a very low expense ratio.

Photo 2 by jimg944

Why We Use Commodities in Investment Portfolios

Jul 15th, 2009

by jblankenship.

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Continuing the theme we used last month, that of exploring the components of a properly-diversified portfolio, we now turn to Commodities.

What Are Commodities?

wheat corn and sky by smoorenburg First of all, let’s talk about the nuts and bolts of commodities as an investment. These are among the oldest type of investments in our financial marketplace, and the trade of commodities grew out of the need by both producers and consumers of various goods to reduce price risk into the future. It could be a farmer hoping to nail down a price for his crop in advance, or a convenience store chain locking in a price for gasoline… the idea is to reduce risk of volatility in prices when either the need to consume is ripe, or when the product is ready to be delivered. This is accomplished at a cost to the producer and/or consumer – known as a risk premium – that allows the buyer (or seller) at the other end of the transaction a potential profit benefit for taking on the risk.

Put simply: if a farmer has a potential 10,000 bushels of grain that will be available for delivery in three months, he seeks to lock in a price for his grain that represents a profit against his expenses. He sells his grain in the future (actually purchases an option to sell) at a specified price. The seller of the option has taken on the risk that the price of grain will be lower at that point in time (when the contract matures), since he is in essence taking responsibility for that grain when it is delivered. On the other hand, if the price of the grain at the time of the contract maturity is higher, the option seller stands to make a profit from the transaction. (It should be noted that the seller of the contract makes a certain amount, the risk premium, either way – but if the current price of the commodity is considerably lower at maturity of the contract, he’d still lose money on the deal.)

It works similarly on the consumption end – continuing our example of the grain above: if a bakery wants to lock in the cost of grain to make flour three months in advance, he might enter into a contract to buy grain at a certain price. (Keep in mind, the price that the farmer sells the grain and the price that the bakery buys the grain will not be equal – hence the risk premium.) The seller of the grain (could be the same guy) takes on a risk that the price of the grain at delivery is higher than the contract price, while vice-versa, would stand to make a profit should the price of the grain come in lower than the contract price at delivery.

Of course, the real world isn’t as simple as my example – because that guy who sold the options to the farmer and the baker? He’s likely to change his mind about how prudent those choices were when he made them, and look to find someone else to take on the contracts. He might sell them for less than he got for them (if he believes that the end result would be worse!) or he might envision a higher value for his option contracts (and get it) if the market will bear his selling at a higher price. And so it goes…

Note – I know that there is bound to be a commodities-trading guru out there who’ll look at my explanation and say “that’s pretty dadgum oversimplified” but the spirit of the concept is correct enough for this article, so calm down, would ya?

Why Do We Include Commodities In Our Portfolios?

Wait a second, we’re not quite ready to answer that question – first a word about correlation… no, wait – how about some examples of various commodities first, then correlation?

Examples of Various Commodities

There are lots of different commodities, but some of the major ones are:

Crude oil
Natural gas
Gold
Soybeans
Copper
Aluminum
Corn
Wheat
Live cattle
Pork bellies
Frozen Concentrated Orange Juice (FCOJ*)

Correlation

If you’ll recall from previous conversations, the reason that we have more than one type of asset class in our portfolio in the first place is to diversify. And in order to be diversified, our various asset classes must not mirror rises and falls in the values of the other asset classes in our portfolio. This “not mirroring” is known as non-correlation – in other words, if two investments (or asset classes) always go up and down in similar proportions at the same time they are said to be correlated. If, however, when one investment or asset class goes up the other asset class either stays the same, goes down, or goes up but not at the same ratio, the two classes are exhibiting non-correlated behavior.

Of course by sheer happenstance there will be times when both assets move up in the same ratio as one another, but if we studied them over long periods of time we’d see the degree of correlation that they have to one another. If the two asset classes always move the same way in the same amounts they would have a correlation ratio of 1. If they always move in opposite directions in the same amounts, the correlation ratio is -1. Anything in between those two would be represented by a decimal (either positive or negative), expressing the degree to which the two asset classes were correlated. If the two show no relationship whatsover to one another, correlation is said to be zero.

Are We Ready to Answer the Question Now?

Yes, now we’re ready. In case you forgot, the question was “Why do we include commodities in our portfolio?” The answer is that commodities have, over significant periods of time (and shorter-terms in case you’re wondering) displayed a negative correlation to the stock market – both US domestic and foriegn – while at the same time maintaining a positive correlation to inflation.

What this means is that when we have investments in both equity (stock) and commodities, we can expect to have a portion of our portfolio on the increase any time the other portion of our portfolio is decreasing. Sounds like the best of both worlds, right? This is the benefit of diversification in action. We can add commodities to a portfolio quite simply, by using a mutual fund or exchange-traded fund (ETF) that follows a commodity index.

Now, obviously we wouldn’t just have the two asset classes in a portfolio, although you could do much worse, I suppose. No, in general our portfolio should include both domestic and global equities, including emerging markets, plus a portion of fixed income (generally domestic, government and global), along with commodities, real estate (domestic and foreign) and timber. Varying the proportions of these asset classes is how we increase our risk and therefore our potential for reward. We’ll talk about Timber as an asset class next month.

Photo by smoorenburg

* one thousand extra points to the first person who leaves a comment with the title of the movie in which FCOJ played a major role.

Why We Include Real Estate in Investment Portfolios

Jun 15th, 2009

by jblankenship.

3 comments

We construct portfolios out of various asset types in order to diversify, or spread out our risk associated with any one asset type. Most often these asset types include equities (stocks) and fixed income (bonds), which provide for basic diversification. Quite often we include additional asset types in order to achieve further diversification. Examples of additional asset types include commodities, foreign equities, foreign-denominated bonds, timber, and real estate.

It is important to keep in mind as we review various asset classes for inclusion in our portfolio, that we must achieve appropriate return for the inherent risk associated with the specific asset class in question.

Why Include Real Estate?

prime-real-estate-by-thelizardqueen It is for that very reason that we choose to include real estate as a component of the well-rounded portfolio – due to real estate’s ability as an asset class to deliver a greater reward-to-risk ratio than most any other asset class. This goes, in general, for both personally-owned real estate and real estate owned via Real Estate Investment Trusts (REITs), which are a sort of mutual fund of real estate holdings, primarily commercial real estate holdings.

During periods of high inflation (as many folks expect that we may experience again soon), residential real estate has always provided a good hedge against rising inflation – even in these times when some residential real estate has lost value. The fact remains that, although many folks have been hit and hit hard by having purchased real estate at grossly-overvalued prices, present value is generally expected to appreciate at a greater pace than inflation in the long run. On the downside, commercial real estate doesn’t necessarily share residential real estate’s inflation-hedge benefits.

However, global commercial real estate will provide the opportunity to benefit from currency gains where domestic inflation is higher than that of the countries that you hold property in. This is a similar benefit to owning foreign-currency bonds.

In a period of deflation, another similar benefit is found, although it is more related to the appreciation of foreign currencies due to appreciating yields. But the greater benefit during deflationary periods is found because commercial property rental rates tend to lag the market, which in turn produces real gains to the owner of commercial property.

As we know, during a normal (not inflationary or deflationary) economic period, residential property (directly owned, as in “your own home”) provides both an economic benefit and many emotional ones. Commercial property on the other hand, provides not only a generally more stable return with less risk than equities, but a higher return than can be found with bonds. In other words, the reward-to-risk ratio that you achieve with real estate is greater than with bonds or real estate, although the risk is different.

Correlation

We use a term – correlation – when describing how various asset types are affected by similar circumstances. If, for example, when one asset increased in value by 10% and a second asset class always increased by the same amount, 10%, then we would indicate that the two asset classes are perfectly correlated. If another asset class only followed the first asset class about half the time, sometimes increasing more, sometimes less, or even decreasing when the first increases (or vice versa), then we might indicate that this third asset class is 50% correlated to the first asset class. (The math is much more complex than this, but I wanted to give you an easy-to-follow example.)

By investing in the first and third asset classes in equal amounts, it stands to reason that we’d benefit by having different sorts and degrees of risks that affect our investments, and not all of our funds would be negatively impacted at any one time. Real estate is just such an asset class, when related to equity or stock investments. Historically speaking, real estate in general is only about 40% correlated with equities, making it a very good diversifier.

Bottom Line

I realize that you may not necessarily agree with all of this in light of what we’ve seen happen lately in the real estate world, but there is reason to believe that the same sorts of returns will continue in the future for commercial real estate. Plus, it is very important to keep in mind that real estate is only a small part of your overall allocation – in no case have I recommended more than a 5% allocation to this investment class, and many times we’ve avoided it altogether (eg., last couple of years). But now, valuations should be in a good position to bring this asset class back into your portfolio – to do the job of diversification that we expect.

Photo by TheLizardQueen

Making an Income For Yourself, Part 2

May 15th, 2009

by jblankenship.

3 comments

In Part 1 of this series, we talked about the initial steps you need to take as you plan your income stream, especially in retirement. In this second section we’ll talk about how to develop an income stream from your assets.

But first, we need to get an understanding of just how much income we’ll need. In the example that we started with in Part 1, the expenses totaled at $2,975 per month, and our income from pension, Social Security, an annuity, and rental income totaled $2,000, leaving us with an unmet need of $975 per month, $11,700 per year.

sustain-ability-by-gaborbasch Also, earlier in Part 1, we totaled up all of our investment accounts: IRAs, 401(k)s, taxable accounts, savings accounts, and the like. Time to put those calculations to work. As a general rule, which we can address further at another time, you can usually count on being able to withdraw up to 4% of your portfolio per year, and as long as the investments are properly diversified, this rate of withdrawal should sustain over your lifetime. (Keep in mind that this is only a general rule of thumb and each individual’s situation is different, requiring review of risk tolerance and year-by-year investment experience.)

Sustainable Withdrawals

So if we use a 4% rate of withdrawal, we need to have approximately $292,500 in investments in order to generate the additional income stream that we calculated earlier ($11,700/year). We get this number by dividing the needed income by the withdrawal rate ($11,700/4% = $292,500). Simple enough, right?

Let’s say you indeed have a total of $300,000 in your accounts. For now, we won’t get into which account to draw from first, let’s assume that you’re over age 59½, and that all funds are available to you for withdrawal. Furthermore, we’ll assume that none of your funds are in Roth-designated accounts (but taxes are not considered in this example).

The Portfolio

How does one concoct a portfolio that will provide the required income stream, while at the same time generates growth and protects the principle? Start with the amount required in income – this amount goes into a money market account with checking privileges. Secondly, a similar amount, representing the following year’s income needs, is invested in short-term Treasury bonds of 1-3 year duration. This has covered the investment of a total of $23,400 of your portfolio.

The remainder of your funds, $276,600, should be invested in a broadly-diversified portfolio, approximating no more than a 50% exposure to equities, and including domestic and foreign debt instruments, commercial property (in the form of REITs), and various commodities, in order to ensure that the portfolio is well rounded and contains enough non-correlated asset classes to protect your capital.

Each year, as you need the funds, you draw from the money market account. At the end of the year, you replenish that account with the proper amount for the coming year – if necessary from the short-term Treasury holdings, but most likely from income/dividends generated by the remainder of the portfolio. In years of lean growth, more will need to be drawn from the short-term portfolio, but in years with more growth, the “investment” portion of your portfolio will grow and should outpace inflation.

But There’s Not Enough!

The question comes up though – what if you didn’t have a portfolio of $300,000 (from our example)? What if the portfolio only amounts to $100,000? The sad truth is that you’ve got some tough decisions to make… Maybe you will need to delay retirement for several years in order to build up your portfolio. Another option would be to take a part-time job that pays at least your “unmet” amount after tax for several years, in order to make up the difference.

You may have to look long and hard at your expenses and make some dramatic cuts to your lifestyle goals. Maybe it would make sense to downsize your home, assuming that you have equity built up, and thereby use some of the excess cash to bolster your investment funds.

Oooh, but not an annuity!

There is one option that may sound very tempting at this point, especially if you’re much closer to the full amount required from your calculations, but still just a bit short – an immediate annuity. Under one of these plans, you are trading flexibility and a considerable amount of expense for a guarantee that you’ll always have an income stream – even if it’s a little less than you had planned for originally. The expense amounts to anywhere from 2% to 3% of your portfolio, and the flexibility is huge: if you decided that instead of the lifetime income you’d prefer to make a large charitable gift (perhaps a health issue has developed) – you’ve pretty much lost that option if you’re stuck in an annuity.

Photo by gaborbasch

Making an Income For Yourself, Part 1

May 14th, 2009

by jblankenship.

No comments yet

One of the really critical aspects of financial planning that often is overlooked in the early stages is planning your income during retirement. It’s really not just a matter of withdrawing money as you see the need – there’s a benefit to planning it out and having a strategy as you create your income stream.

First of all, as with any planning activity, you need to determine a couple things: where you are now, and what your goal is. The first part, where you are now, is simple if you’ve got a handle on your overall portfolio… if not, you may need to spend some time organizing things.

mountain-stream-by-jasonb42882

Where You Are Now…

Split your portfolio into two categories: income and assets. So, if you have a pension plan at work that will be providing you with $x of income, count that in your income stream, along with annuities, rental and/or royalty income, and the like. Include any part-time income that you intend to receive as well. Total up all of these income items.

In another list, tally up all of your assets: IRAs, 401(k) plans, the value of your vacation home, rental property, cash value of life insurance, savings accounts, and any other accounts or assets you might have. Total these up as well.

Lastly, add up all of your liabilities – any loans, debts, or mortgages. Break this list into two parts: consumer or short term debt, and mortgages. Tally up the two lists.

We won’t go into a lot of detail on the debt issue for now, but suffice it to say that if the short term debt category is significant (you define it – what percentage of your annual income is required to service the debt?), you’ll really should spend some time whittling that down before going into full retirement.

Where You Are Going…

The next piece is to quantify your goals – quantified to understand the income stream that is required to support your retirement lifestyle. Tally up the cost of housing, taxes, insurance; hobbies, travel, and gifts for grandchildren; healthcare, transportation, and home improvement… you get the picture. The idea is to be as complete and realistic about your income requirements as possible.

This is a good time to sit down with your spouse and talk about what really matters to each of you: those life goals that you’d like to accomplish, and how important each item is in the overall scheme of things. Perhaps you already know these things about one another, but then again, you may not. Take the time to listen to each other and learn.

With your list of lifestyle costs, you should be able to easily break this down into “required/fixed costs” and “variable cost/optional” categories. An example of a required expense for most folks would be the electric bill. This is also generally considered a fixed cost as well (even though it may vary over time, it’s difficult to reduce the figure appreciably if necessary). A variable/optional cost might be fuel for your vehicle. If you have public transportation available, you could impact that expense considerably. Tally up the “required” category and prioritize the “optional” items in a separate list. Add the two lists together for a starting point for your monthly expenses.

The Bottom Line

Now that we know what our monthly expenses are and have tallied up our income streams, it’s time to bring the two together. Look at the table below for an example:

Expenses
Mortgage	$ 1,000.00
Insurance	75.00
Taxes	200.00
Auto	200.00
Fuel	100.00
Food	800.00
Travel	500.00
Charitable Contributions	100.00
Total Expenses		$ 2,975.00

Income
Pension	600.00
Social Security	400.00
Annuity	500.00
Rental Income (less expenses)	500.00
Total Income		$ 2,000.00

Difference		$ (975.00)

As you can see, our income estimate comes short of the requirement in expenses. At this stage two things can be done: Either expenses can be reduced, or you can increase your income (if you have a way of doing so) – and most likely it will be a combination of the two.

The first method, reducing expenses, is why we prioritized the variable or optional expenses. Take a look at your list, and see if there are any items that you truly don’t need or are not high enough on your priority list. Put those items on the back burner for now, and re-total your table. Chances are, you haven’t been able to trim things enough to get your income to match up with your expenses.

In Part 2, we’ll get into how to create an increase on the income side of your sheet, in order to balance things out.

Photo by jasonb42882

401(k) Plan Tweaks

Apr 15th, 2009

by jblankenship.

2 comments

How many times recently have you heard the line “Well, I looked at my 401(k) statement and now it looks more like a 201(k). Hahahaha!” ? And are you getting pretty sick of that line like I am? I mean, for cryin’ out loud, there’s not even a §201(k) in the Internal Revenue Code! How ridiculous is that!? Heh… heh. Well, that line kills ‘em at the accountant’s conventions, trust me.

But seriously – we’ve all been hurt, hurt bad, by the market downturn that occurred late last year. And it’s not just 401(k)’s that were hurt: IRAs, taxable accounts, Roths… everything has been spanked. But the 401(k) is a dominant type of account that millions of Americans own and are painfully familiar with, and so this type of account has garnered special attention of late, by our nation’s lawmakers.

Tweaks For 401(k) Plans

You see, it has been a topic of conversation in Congressional committee circles of late, that the 401(k) is the root of all the pain we’ve been experiencing, and as such, being “broken”, someone needs to “fix” it.

What’s Wrong?

By all rights, the mere existence of the 401(k) plan probably has a lot to do with the specific pains many investers are feeling: without the 401(k) (and lots of ancillary 401(k)-like accounts such as the 403(b), the 457, etc.) most Americans would have little if any involvement in investing decisions. After all, the lion’s share of the IRA market is made up of IRA rollovers from these qualified defined contribution plans – and therefore individual investment (brokerage or mutual fund) account ownership used to be a fairly insignificant percentage.

When the 401(k) plan was introduced, its primary function was to take the place of the costly define benefit pension plans that corporations were beginning to abandon. The thinking was that, instead of using corporate monies to fund the pensions, employees could defer current income into an account, which would grow over time and provide a source of retirement income, replacing the pensions.

The concept itself isn’t bad – a benefit is that the employee now had much better insight into his or her own retirement, therefore having an incentive to save. The company benefits because it doesn’t have the liability of the pension to provide for the lifetime income stream. The employee benefits further because the company increases his income or matches his contributions, plus, the employee can opt out of the plan if he chooses, providing more disposable income. The end result though, is that the employee takes on nearly all the risk, with little, if any guidance.

The Root Problem

The problem that wasn’t addressed is the root of the issue: the pension plans were being abandoned because it was so costly to provide a guaranteed lifetime income stream, in part because managing the pension trust fund, investing the inflows and planning the outflows, requires the expertise of a fiduciary advisor.

As originally envisioned, the 401(k) plan participant would use his financial advisor to help him with investing decisions. The problem is that the average worker doesn’t have a financial advisor that he works with, and so this critical advisor was replaced with documentation, seminars, and training that has been woefully inadequate. The average 401(k) participant blindly chooses investments from the paltry choices allowed, not really understanding the concepts of diversification, risk/reward matrices, or general allocation principles.

One of the options that has been discussed in Congress lately is to further incent employers to provide investment advisors to employees, in order to help the employee with the process of investment management. The Pension Protection Act of 2006 had a provision that opened the door for this sort of assistance from employers, but an incomplete definition of “independent investment advisor” has kept most employers from acting.

Current thinking is that new regulations will be put in place that will give greater incentive to employers to implement an advisory program – as well as to define “independent investment advisor” as an advisor who has no vested interest in any investment choices by the employee-invester. this conflict-free advisor would also be required to operate as a fiduciary for the employee.

Another possible option that could be implemented is investment alternatives that would provide a conservative choice, possibly a lifetime income stream option, such as an annuity. The primary downside to annuities has always been the high costs and “black hole” nature of the underlying investments.

In order for this to work, the annuity products would need to be aggregated in very large numbers in order to reduce the overall cost structure enough to be viable. In addition, the providers will need to give much more transparency to the process in order for the advisors to be capable of assessing the option as an alternative.

The conclusion is that the 401(k) is not broken – it just needs some tweaks. And from what I’m hearing about current discussions on Capitol Hill, it sounds like the tweaks being suggested are a definite step in the right direction.

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