There's been a recent upsurge in articles supporting passive
investing - the strategy of investing in index funds and exchange traded funds
designed to mirror indexes and holding on for the long term. But before
you decide passive is the answer, take a moment to walk through the realities
of index investing and then answer whether that's really a style you can stick
with for the long term.
Index investing by its very nature should be lower cost. There's
no need for highly paid analysts and trading costs are typically lower,
reducing drag on the fund's return. The lower the costs, the closer the fund
should be able to match its index in performance. But do you really want to
match the performance of the index?
A buy-and-hold position in the S&P 500 or the Nasdaq
Composite index looks relatively calm when just the last four years are
considered. Go back three more years and the picture is dramatically
different.
In 2000-2002, the S&P 500 fell more than -45%, while the
Nasdaq Composite was off by -74%. Seven years later the S&P 500 is finally
approaching its prior high. Many analysts believe we will not see the
Nasdaq retest its earlier highs for at least another decade. Would you have
been better off in a safe utilities sector? Not really, the Dow Jones Utilities
index lost -50% between late 2000 and October of 2002.
What does that mean to an investor? Well, suppose you had $500,000
invested in a S&P 500 index in early 2000. Over the next two years, you
would watch your retirement savings whittled to $270,000. A loss of $230,000. A
$500,000 investment in the Nasdaq would have lost $370,000. How long will it
take you to save a comparable amount? Would there have become a point at which
the pain was too great, at which you sold out your position, rather than see it
continue to dwindle?
Data: Yahoo Finance. Past performance is not indicative of
future returns. The S&P 500 and Nasdaq Composite are indexes and cannot be
invested in directly. Trading and management costs that would be involved in
creating a portfolio to mirror the composition of the indexes are not reflected
in the graphics.
Selling a position brings up the question, when do you re-enter
the market? Do you wait until the market has gone up sufficiently to make
you more conscious of the gains you are missing than the loss you suffered? By
then, you may have missed a major portion of the current up move.
Study after study has shown that individual investors
dramatically under-perform the indices because they buy and sell at the wrong
time. Rather than sell early in a
decline, they wait until they can't bear another down day. And then they
are hesitant to re-enter the market. They become "accidental active investors"
without a real strategy that attempts to quantify and manage risk.*
The catch in the second statement - The difficulty of active
investment approaches in consistently beating the market - is the word
"consistently." Every year there are portfolio managers who clearly excel. Over
time, however, their results tend to average out. With the additional burden of
management fees, research and trading costs, many active strategies will lag
the major market indexes at one time or another in their performance
history. Does this mean these strategies are unsuccessful? No. It comes
back to performance.
While there can be no guarantee that active management will
outperform passive management approaches on a risk-adjusted basis, and all
investments face the prospect of loss as well as gain, good active management
recognizes that markets are volatile and looks for ways to capitalize on
opportunities while minimizing losses. By acknowledging risk and looking for
ways to reduce its impact on the portfolio, there is naturally a drag on
performance. Rather than racing full out around the corners, a good
manager brakes.
When active management reduces the vulnerability of a portfolio
to bear markets, it preserves capital in down markets and helps keep investors
committed for the long term.
*Dalbar Inc., Study of Investor
Behavior, Updated 2003. Mercer Consulting, Study of Investor Behavior,
2005.
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Summer Jobs Can Pay Off with a Roth IRA for Youth:
Summer jobs offer many benefits for students, from providing
additional spending funds or savings, to helping build skills and a good work
ethic. What you may not have considered, however, is that summer jobs also
offer you an opportunity to provide a lasting gift to children and
grandchildren by matching their earnings to fund an Individual Retirement
Account.
Specifically, we'd recommend that you fund a Roth IRA for any
working children. Here's why.
Age doesn't matter when it comes to establishing an Individual
Retirement Account. The main requirement is that the individual have earnings
for the year (the exception is a spousal IRA). There are income limitations for
funding a Roth IRA, but with those limits starting at $99,000 for individuals,
most youth will not have any problems qualifying.
Contributions to the IRA don't need to come from the
individual's earnings. The important qualification 
is that the individual have earnings equal to
the contribution (annual maximum contribution - $4,000). That means a parent,
grandparent or any other individual can fund the IRA for a child.
Roth IRA contributions are made after taxes are paid, so there's
no tax deduction for the account holder. The benefit of establishing a Roth IRA
for children is that all contributions and earnings can be withdrawn at
retirement free of federal income taxes and potentially state income tax-free
as well.
Given the impact of compounding over time, a relatively small
contribution now may become a significant asset in 40 to 50 years when the
individual is ready to retire.
If the individual decides to withdraw funds prior to retirement,
earnings are subject to regular income taxes and there is a 10% early
withdrawal penalty. However, there are also exceptions to the penalties for
early withdrawals.
Roth assets can be accessed without penalty in the event of a
disability, death of the account holder, to pay un-reimbursed medical expenses
or medical insurance premiums for an unemployed IRA holder, to pay the costs of
a first-time home purchase (subject to a lifetime limit of $10,000) or the
qualified expenses of higher education for the IRA owner and/or eligible family
members. Naturally, there are specific rules that must be met in each of these
exceptions.
Funding a retirement account can also provide additional
incentive for children to find and stick with a summer job and it sets a
precedent of saving for retirement for the rest of their life.
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Time to Consolidate Your IRAs?
Individual Retirement Accounts were authorized by the Employee
Retirement Income Security Act of 1974 and the first accounts were funded in
1975, 32 years ago. Since then a number of our clients have accumulated
several IRAs from diversifying with different investment providers, rolling
over employer retirement accounts into IRAs, holding SEP-IRAs from small
business employers, non-deductible contributory IRAs, Roth IRAs and even
inherited IRAs.
If you are in a like situation, it may be time to consolidate
your IRA accounts.
Consolidation can have many benefits:
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Reduce incoming paperwork and time spent managing your assets,
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Track your investments easier,
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Minimize annual fees,
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Achieve a better portfolio balance,
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Better manage beneficiary designations and
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Simplify estate planning.
Before consolidating your accounts check with the custodian to
see what costs might be involved such as a transfer fee, commission to
liquidate positions or back end loads. This may influence when and where you
chose to consolidate.
One of the big benefits of consolidation is better control over
how your assets are invested. When assets are scattered among different
investment companies, it's easy to be invested in the same equity via four
different accounts.
The only real advantage to keeping your IRA accounts separate is
the event of bankruptcy. IRAs that hold old retirement plans (i.e. rollover
IRAs) have unlimited bankruptcy protection. "Contributory" IRAs (where you've
made contributions over the years) are limited to $1 million in bankruptcy
protection.
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Buy
a New Home Or Invest Your Money?
For many Americans, their home is their biggest single asset and
too often an asset they consider a major element of their retirement fund. But
even with the last decade of double-digit appreciation in many real estate
markets, a home has a number of drawbacks as an investment.
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A home costs considerably more than most people realize, diluting its value as
an investment.
If you financed your home with a traditional 30-year loan, you
will probably make interest payments roughly equal to or greater than the
original purchase price of the home. Even after deducting interest costs
from taxes, you've still spent a substantial amount to finance the purchase of
your home.
The costs don't end there. Every year, you pay homeowners'
insurance, property taxes, maintenance, utilities and often homeowners'
association dues. Add a few major repairs, such as a new roof, and renovations
to maintain the value of your property and the cumulative expense is more than
you might realize.
Your real profit isn't the difference between
what you purchased the home for and its current value. To reach that value you
need to add in the carrying costs you incurred over the years.
Most homeowners will argue at this point that they would have
incurred costs to rent a place to live if they hadn't owned the home. But until
you look at the actual costs of homeownership, you can't really judge how much
owning a home actually costs. Many homeowners also buy as much home as they can
qualify for regardless of whether or not they need the space, justifying the
additional expense as an investment.
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Selling your home to cash out on your equity still leaves you in need of
shelter.
While you may be able to scale back your home style sufficiently
to pocket some of the equity you've accumulated in your home, many retirees
find their dream retirement home is not the bargain they anticipated.
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Double-digit real estate appreciation is not the norm.
The U.S. historical average annual housing appreciation is 5-6%.
At these levels, it will take more than 12 years for a home to double in value
and appreciation will not necessarily be a steady upward progression.
The last big run up in housing values was the period following
World War II when the GI bill made financing a house affordable for the
returning soldiers. That surge was followed by 20 years during which the
average home price went essentially nowhere.
The housing booms of the 1970s and 1980s were followed by returns to levels
consistent with appreciation rates following the 1950s.**
As the chart Above shows, following rapid gains in the 1970s,
inflation-adjusted housing prices went sideways for 15 years in most of the
country.***
** A History of Home Values, an inflation adjusted index of American housing
prices going back to 1890, Irrational Exuberance, Robert J.
Shiller, 2nd edition 2006.
***Chart courtesy of Chart of the Day.
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When your primary retirement asset is your home, you are not diversified.
Proper diversification has one very big objective and that is to
insure that if something goes wrong with one aspect of your portfolio you have
other assets to keep you from financial ruin. A home can be a very vulnerable
asset, even with homeowner's insurance. A careful read of your homeowner's
policy will turn up a number of circumstances in which the insurance company is
exempted from coverage.
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A basic homeowner's policy doesn't cover flood damage. You need a special
policy for flood insurance backed by the federal government, with cooperation
from local communities and private insurance companies.
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Most homeowners insurance policies do not cover damage from earthquake, land
tremors, landslide, mudflow or other earth movement unless through an
additional endorsement at an additional cost.
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Insurance polices often do not cover hurricane and other windstorm damages.
Supplemental coverage varies by state, and sometimes by county.
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Deliberate damage to the home caused by an owner may not be covered.
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Wear and tear from any circumstance is generally not covered.
Even if damage to your home is covered, circumstances may delay
payment and the settlement may not fully cover the cost of replacing your home.
For example, if repairs to your home must meet stricter building standards than
its original construction, your insurance policy may not be sufficient.
If you want to buy a more expensive home, do so because you want
to live in the home. If you want to build retirement assets, set aside funds
and invest them where you understand the carrying costs of the investment, its
potential and the risks that come with the investment.
As always, you have to remember that past performance is not
indicative of future returns and that all investing carries risk. But the
greatest risk is failing to invest at all.
If you are looking for better ways to finance your retirement,
give me a call and let's talk.
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When Ownership Form Matters
While it's always a pleasure to see the asset side of your
balance sheet increase, with accumulation also comes the question of
ownership. How you title your assets will make a difference should you
die.
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Will your spouse have immediate access to your assets or will those assets
first need to pass through probate?
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Will your assets incur estate taxes?
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Which assets will be covered by your will and which will pass directly to your
beneficiaries?
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How can you assure that your assets will be distributed as you desire should
your will be disputed?
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Can you move some assets out of your ownership now to reduce estate taxes, yet
still control the assets?
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How can probate and administrative costs for your estate be reduced?
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Will the value of your assets be influenced by ownership agreements, such as
partnership buyout provisions?
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Can you prevent your heirs from losing their inheritance through poor decisions?
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How can assets such as a long-time family property be kept in the family?
The answers to these questions are all impacted by how your
assets are held. The following are the most common forms of ownership. As
you set up and modify your accounts, make certain you talk with a tax or estate
adviser to assure that you understand the ramifications of different ownership
forms and their impact on your estate.
Individual Ownership: You are the sole
owner of the asset. In the event of your death, the asset passes on to
your estate to be distributed according to your will. Under current tax law,
your heirs will be liable for estate taxes on the asset but they will pay
capital gains taxes only on appreciation while they hold the asset. This avoids
the prospect of double taxation.
Individual Ownership with a Designated Beneficiary:
An asset such as a retirement account is held in individual ownership
with designated beneficiary(ies). Upon the account holder's death, the
asset passes directly to the beneficiary(ies). While the value of the account
will be included in the estate for the calculation of estate taxes, ownership
is not impacted by an existing will or probate. Transfer of ownership can be as
simple as presenting a death certificate.Another form of designated beneficiary
is a "Transfer on Death" designation, which can be used on non-retirement
accounts, such as a brokerage account.
Tenants in Common: This is ownership in an
asset by two or more persons at the same time, not necessarily with equal
interests or rights. On an owner's death, the individual's interest passes to
his/her heirs named in the will who then become the new tenants in common with
the surviving tenants in common.
Joint Tenancy: Each joint owner has an
undivided right to possess the whole property and equal ownership interest.
When one joint tenant dies, his/her interest automatically becomes the property
of the surviving joint tenant(s). This is a common form of ownership between
husband and wife.
Trust: Assets are transferred to one or more
recipients, called trustees, who hold legal title to the assets and manage the
assets for the benefit of the owner or other named beneficiaries. Living trusts
are set up during the grantor's lifetime and may be either revocable
(changeable) or irrevocable. Living trust assets do not need to be probated and
are not subject to public disclosure. A testamentary trust is set up in a will
and becomes effective at death. It is subject to probate fees and estate taxes.
Partnership: This is an association of two or
more persons who have an established partnership agreement to conduct, as
co-owners, a business for profit. Partnership agreements typically establish
the rules for buying out a partner's interest in the business in the event of a
dispute within the partnership, death or the desire of one partner to move on.
The preceding is not intended as legal or tax advice, but rather an
introduction into different ownership forms that can be used by an
individual. Please consult with your financial, tax or legal adviser if
you have any questions about the best form of ownership for your accounts.
