Most investors wish that they could be on a merry-go-round, not a roller coaster. Of course we know that it is not possible, but consider three different portfolios that are invested over an eight-year period.
Path #1 Path #2 Path #3
YR 1 10% 38% (22%)
YR 2 10% 23% (12%)
YR 3 10% 33% (9%)
YR 4 10% 29% 21%
YR 5 10% 21% 29%
YR 6 10% (9%) 33%
YR 7 10% (12%) 23%
YR 8 10% (22%) 38%
It’s hard to believe, but the compound annual return of each portfolio is exactly the same --- 10% for all three portfolios! Obviously Path #1 would be nice, but again, just not going to happen. Yet people consistently set themselves up for disappointment by expecting the historic “10% return” to occur year after year, only to discover that most years it’s not 10% on the nose.
Considering that we all have to endure variability of returns, which is better, Path #2 or #3? You may think that Path #2 isn’t so bad, but if you have retired at the end of year 6, it’s pretty darned painful, and it is similarly difficult to begin retirement with three nasty, down years. The one nice thing is that if you are still saving for retirement, the three down years allow you to invest in your retirement account at lower levels.
But what would happen if you were already retired in all three paths? In that case, most people would be withdrawing money from their accounts. So if the portfolio in each path is worth $1,000,000 and you are planning to withdraw an inflation-adjusted $50,000 each year, you may be surprised to see what would happen over the course of the eight years. In Path #1, after eight years, the $1million portfolio would be worth $1.6 million, in Path #2, it would be worth $1.8 million and in Path #3 it would total $1.2 million. A $600,000 differential is pretty major!
The reason that I bring this up is that when you are about to retire, rarely do results move in a straight line. Your job is to ensure that regardless of market performance, you are taking into account the various outcomes that would impact your life.
Thursday, November 15, 2007
Wednesday, November 14, 2007
The Job of Advisor
I am attending an industry meeting this week and while sometimes these things can be a bore, this group is special: everyone in the room is a Registered Investment Advisor (RIA), which means that each of us has a fiduciary responsibility to our clients and has to register with the Securities and Exchange Commission. The group gathers twice a year to talk about what we believe our clients need from us and exchange information that helps us discover new ways to serve those clients.
Individuals choose to work with registered investment advisors for lots of different reasons. Some are too busy to manage their own financial lives, while others lack the expertise to do so and then there are those who have time and smarts, but just can’t stand the emotional ups and downs of the investment world. Regardless of which category the client falls in, the answer to what they usually want is abundantly clear: “I want to make sure that I am going to be OK!”
I know that this may sound simple, but indeed, this is exactly my experience with the folks that I see in my office and talk to on the radio, regardless of whether they have $200,000 or $2,000,000 to invest. Oh sure, the point of entry may begin with a concrete question, like “Am I using the right assets in my retirement account?”, “Which 529 plan should I use for my daughter’s college funds?”, “Do I need a revocable trust?” and of course, “Can you help me reduce my tax bill?” But any advisor worth his/her salt will use these questions as a jumping off point to gain a greater understanding of the overall needs of the person asking the questions. And the real questions underlying the first round usually are: can we retire comfortably? How much do we need to sock away to be able to retire sooner? How much can we spend during our retirement years?
The ultimate goal of a fiduciary advisor is to provide not just simple answers, but a more meaningful response. Despite how much money anyone has, he wants to feel confident that he will not run out of money and he will not need to endure too much market risk to reach his goals. In the end, most people want to gain peace of mind that the advisor who is assisting them in wealth management is going to help them get to a specific destination with a reduced level of anxiety. In the end, what the people in my industry meeting seemed to share was an acknowledgment that our job is not to “beat the market”, but to help our clients relax and help them navigate their larger financial issues. It’s a pretty good job!
Individuals choose to work with registered investment advisors for lots of different reasons. Some are too busy to manage their own financial lives, while others lack the expertise to do so and then there are those who have time and smarts, but just can’t stand the emotional ups and downs of the investment world. Regardless of which category the client falls in, the answer to what they usually want is abundantly clear: “I want to make sure that I am going to be OK!”
I know that this may sound simple, but indeed, this is exactly my experience with the folks that I see in my office and talk to on the radio, regardless of whether they have $200,000 or $2,000,000 to invest. Oh sure, the point of entry may begin with a concrete question, like “Am I using the right assets in my retirement account?”, “Which 529 plan should I use for my daughter’s college funds?”, “Do I need a revocable trust?” and of course, “Can you help me reduce my tax bill?” But any advisor worth his/her salt will use these questions as a jumping off point to gain a greater understanding of the overall needs of the person asking the questions. And the real questions underlying the first round usually are: can we retire comfortably? How much do we need to sock away to be able to retire sooner? How much can we spend during our retirement years?
The ultimate goal of a fiduciary advisor is to provide not just simple answers, but a more meaningful response. Despite how much money anyone has, he wants to feel confident that he will not run out of money and he will not need to endure too much market risk to reach his goals. In the end, most people want to gain peace of mind that the advisor who is assisting them in wealth management is going to help them get to a specific destination with a reduced level of anxiety. In the end, what the people in my industry meeting seemed to share was an acknowledgment that our job is not to “beat the market”, but to help our clients relax and help them navigate their larger financial issues. It’s a pretty good job!
Tuesday, November 13, 2007
I got sssssssteam heat…
As the price of crude oil nears $100, my thoughts wander to…a Broadway musical! This could be a stretch, but in “The Pajama Game” there is a song called “Steam Heat,” with an almost-perfect hook: “I got sssssssteam heat…But I need your love to keep away the cold!” As the winter months near, Northeasterners should be reminded of this song.
According to the Department of Energy, Northeastern states use 76% of the nation's heating oil and almost of a third of households in the region use oil heat. Unfortunately, the price for heating oil has risen about 2.5 times faster than for gasoline in recent weeks because heating oil and related products, such as diesel oil, are in record demand here and overseas. As a result, Northeasterners are facing a projected increase of over 20% for heating oil—ouch!
The spiking costs are the continuation of a multi-year trend: from ’00-05, the average cost in New England for a winter's supply of heating oil was $900 a household. Last year, it hit a record $1,433 and this year it could reach over $2,200. Given that we are all paying more to fill up our cars each week, it’s time to pull out the old sweater from Jimmy Carter’s “Whip Inflation Now” (WIN) and find ways to reduce your home heating bill.
1. Opt for a price cap: The way that you pay for oil could save you money. Fuel companies usually let you buy oil as you need it, but many give you an option to “lock in” a price or elect a “price cap,” which guarantees a per-gallon price that will not go higher over winter. Because the risk of rising prices is more significant than if prices drop, the capped price is one of the best ways to control your costs.
2. Install a programmable thermostat: This can save about $150 a year in energy costs if your home temperature is set back 8 degrees in the winter for an 8-hour span during the day when no one is home, and 10 hours at night. Cost: Less than $50
3. Do system maintenance: Contact your oil company or the company that installed your furnace or boiler to go over the system, which should cost $100-$150 but could save that amount and more for years to come!
4. Conduct an energy audit: You can hire an expert to conduct an "energy audit", or you can do it yourself. Go to the US EPA’s Energy Star Home Advisor web site (www.energystar.gov/homeadvisor) for tips that could help you reduce your energy bills by up to 25%. Enter your ZIP code and the type of heating, cooling system and water heater you have, and you will receive a customized list of recommendations — from caulking doorways to adding more insulation to the attic.
5. File for an energy tax credit: Replacing an old furnace, boiler, or water heater with energy-efficient units can save you money on your taxes, too. Installing new storm windows and insulation can also help keep your house warmer. Look for products with the ENERGY STAR logo. The EPA says they’re designed to use 10-50% less energy and water than standard models. File Form 5695, Residential Energy Credits, with your 2007 Federal Income Tax Return.
And on top of these ideas, the tried and true methods prescribed in “The Pajama Game” are probably a little more fun.
“But I can't get warm without your hand to hold.The radiators hissin’ still I need your kissin’ to keep me from freezing each nite.I've got a hot water bottle, but nothing I've got'll take the place of you holdin’ me tight.”
According to the Department of Energy, Northeastern states use 76% of the nation's heating oil and almost of a third of households in the region use oil heat. Unfortunately, the price for heating oil has risen about 2.5 times faster than for gasoline in recent weeks because heating oil and related products, such as diesel oil, are in record demand here and overseas. As a result, Northeasterners are facing a projected increase of over 20% for heating oil—ouch!
The spiking costs are the continuation of a multi-year trend: from ’00-05, the average cost in New England for a winter's supply of heating oil was $900 a household. Last year, it hit a record $1,433 and this year it could reach over $2,200. Given that we are all paying more to fill up our cars each week, it’s time to pull out the old sweater from Jimmy Carter’s “Whip Inflation Now” (WIN) and find ways to reduce your home heating bill.
1. Opt for a price cap: The way that you pay for oil could save you money. Fuel companies usually let you buy oil as you need it, but many give you an option to “lock in” a price or elect a “price cap,” which guarantees a per-gallon price that will not go higher over winter. Because the risk of rising prices is more significant than if prices drop, the capped price is one of the best ways to control your costs.
2. Install a programmable thermostat: This can save about $150 a year in energy costs if your home temperature is set back 8 degrees in the winter for an 8-hour span during the day when no one is home, and 10 hours at night. Cost: Less than $50
3. Do system maintenance: Contact your oil company or the company that installed your furnace or boiler to go over the system, which should cost $100-$150 but could save that amount and more for years to come!
4. Conduct an energy audit: You can hire an expert to conduct an "energy audit", or you can do it yourself. Go to the US EPA’s Energy Star Home Advisor web site (www.energystar.gov/homeadvisor) for tips that could help you reduce your energy bills by up to 25%. Enter your ZIP code and the type of heating, cooling system and water heater you have, and you will receive a customized list of recommendations — from caulking doorways to adding more insulation to the attic.
5. File for an energy tax credit: Replacing an old furnace, boiler, or water heater with energy-efficient units can save you money on your taxes, too. Installing new storm windows and insulation can also help keep your house warmer. Look for products with the ENERGY STAR logo. The EPA says they’re designed to use 10-50% less energy and water than standard models. File Form 5695, Residential Energy Credits, with your 2007 Federal Income Tax Return.
And on top of these ideas, the tried and true methods prescribed in “The Pajama Game” are probably a little more fun.
“But I can't get warm without your hand to hold.The radiators hissin’ still I need your kissin’ to keep me from freezing each nite.I've got a hot water bottle, but nothing I've got'll take the place of you holdin’ me tight.”
Monday, November 12, 2007
Engineering Portfolio Returns
Engineers are a special breed of investor—at least the engineers that I have seen in my career. These detail-oriented creatures show up at the office, armed with spreadsheets of cash flow, net worth and of course, portfolio allocation --- color pie charts at no extra charge! With all of their great knowledge of numbers and their organized minds, why do engineers need investment advice?
The answer to that question was revealed to me when “John,” a civil engineer, wanted to discuss his retirement accounts. I smiled as he unpacked what looked like a suitcase full of financial projections and balance sheets. After reviewing the numbers, I concurred with John’s belief that his goal of retiring in two years was indeed attainable. “That’s what I keep telling my wife, so I’m glad to hear it.”
I then pointed out that the only way that the 55-year old couple might run into a problem is if they incurred heavy losses in their portfolios at the wrong time, “so let’s take a look at how you are invested right now.” The first graph was an asset allocation pie chart that showed a fairly significant overweight in stocks. The total portfolio was 82% stocks, 12% bonds and 6% cash. That seemed a tad bit aggressive for a couple that wanted to retire in two years, but it wasn’t the biggest problem.
When I reviewed the holdings, I saw that of the total assets invested for retirement, 75% was in-the-money stock options of one company---the company for whom John worked! Of course John knew that this dangerous, but his problem was that his engineering brain was stuck in a loop. He kept trying to figure out how he could avoid taxes when he exercised and sold the position. And in the year that he has been trying to figure it out, the stock price has been rising, so it has not hurt him to drag his feet in the process.
While I think tax reduction is important for all investors, the risk that John was assuming so near to his desired retirement age seemed enormous. He said that when he thought about paying taxes, it felt like he was losing “40% of the gains”. I reminded him that at least 15-18% of the gains absolutely belonged to the federal and state governments. The remaining taxes due would be realized depending on the timing of the sale (whether the proceeds would be taxed at long or short-term rates). “The main question to consider is how you would feel if the stock went down and instead of paying 20 cents on the dollar in taxes, you would be eating 100 cents of every dollar as the stock dropped.”
John was stymied. He wanted to find a solution that would satisfy the need to diversify and to reduce taxes. Like so many others, he really wanted rewards without risk. Unfortunately in the emotional world of investing, this is usually impossible. No matter how hard we try, there is a tradeoff. Each individual must clearly understand and weigh both the risks and rewards involved in every investment decision to determine the most reasonable action necessary. Sometimes you can’t engineer the portfolio returns that you want, even when armed with information.
The answer to that question was revealed to me when “John,” a civil engineer, wanted to discuss his retirement accounts. I smiled as he unpacked what looked like a suitcase full of financial projections and balance sheets. After reviewing the numbers, I concurred with John’s belief that his goal of retiring in two years was indeed attainable. “That’s what I keep telling my wife, so I’m glad to hear it.”
I then pointed out that the only way that the 55-year old couple might run into a problem is if they incurred heavy losses in their portfolios at the wrong time, “so let’s take a look at how you are invested right now.” The first graph was an asset allocation pie chart that showed a fairly significant overweight in stocks. The total portfolio was 82% stocks, 12% bonds and 6% cash. That seemed a tad bit aggressive for a couple that wanted to retire in two years, but it wasn’t the biggest problem.
When I reviewed the holdings, I saw that of the total assets invested for retirement, 75% was in-the-money stock options of one company---the company for whom John worked! Of course John knew that this dangerous, but his problem was that his engineering brain was stuck in a loop. He kept trying to figure out how he could avoid taxes when he exercised and sold the position. And in the year that he has been trying to figure it out, the stock price has been rising, so it has not hurt him to drag his feet in the process.
While I think tax reduction is important for all investors, the risk that John was assuming so near to his desired retirement age seemed enormous. He said that when he thought about paying taxes, it felt like he was losing “40% of the gains”. I reminded him that at least 15-18% of the gains absolutely belonged to the federal and state governments. The remaining taxes due would be realized depending on the timing of the sale (whether the proceeds would be taxed at long or short-term rates). “The main question to consider is how you would feel if the stock went down and instead of paying 20 cents on the dollar in taxes, you would be eating 100 cents of every dollar as the stock dropped.”
John was stymied. He wanted to find a solution that would satisfy the need to diversify and to reduce taxes. Like so many others, he really wanted rewards without risk. Unfortunately in the emotional world of investing, this is usually impossible. No matter how hard we try, there is a tradeoff. Each individual must clearly understand and weigh both the risks and rewards involved in every investment decision to determine the most reasonable action necessary. Sometimes you can’t engineer the portfolio returns that you want, even when armed with information.
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