Month: December 2009


RETHINKING RISK TOLERANCE


The turbulent stock market of the past two years has investors and financial planners alike rethinking the way they assess and manage risk tolerance. According to a recent Brinker Capital poll, 76% of financial advisers stated that they needed to reassess how they measure risk tolerance. The flaws of a plain vanilla approach to risk management — relying on age-based portfolios (or other products that oversimplified the issue of risk) — have been exposed. Have you reassessed how you measure and manage investment risk?

While the plunging stock market has been painful to investors (even with the monumental rise in the market since March, we are still SUBSTANTIALLY below the November 2007 record levels), there have been some valuable learning opportunities, particularly in regard to risk management. Historically, risk tolerance has largely been established by time horizon (how long do you have until retirement to ride out the ups and downs of the market?). The assumption was that if you had enough time, you should be more heavily invested in stock (which is sound in theory). The problem? Queasy stomachs! Many people can't handle volatile fluctuations in the market and the result is selling at inopportune times. A recent Money Magazine article (November, 2009) reported findings by FinaMetrica:

Only 7% of investors can stand to have more than 75% of their total investments in stock, and only 1% can handle more than 87% in stocks! Also, according to Vanguard, 42% of their 401(k) accounts held more than 80% of portfolio in stock investments, while it is estimated that roughly 4% of investors can tolerate a portfolio that is more than 80% in stocks.

Like any other financial information, take it with a grain of salt, but it is definitely worth some thought and some personal examination of one's investments relative to risk tolerance. Consider not only how much risk you should be taking when you invest, but how much pressure can you handle before cracking? Don't put yourself in a vulnerable situation.

Some other valid points from the Money article …

Don't take risk unnecessarily. If you are a good saver and put away a large percentage of your income, you in turn can afford to take less risk to accommodate the same goal as someone saving less money. Just because you're comfortable with risky investments doesn't mean you need to (or should) invest in that manner.

Consider your appetite AND capacity for risk. Most of the tip has addressed one's appetite/comfort with risk. To understand capacity, again consider data supplied by Vanguard … In 2007, 35% of 401(k) participants over the age of 55 had more than 80% of their accounts in stocks. Even if we were to assume that these individuals had the appetite for risk (didn't make emotional decisions when the market bottomed), did they really have the capacity for the risk? Could they really afford to have lost 50% or more of their nest egg at that stage of their lives?

Comfort with risk doesn't mean you'll achieve your goal. Yes, it is important to find out what your appetite for risk is and invest accordingly. You need to realize that doing so, however, can wind up putting you short of investment goals if you are risk-averse. You can save more or pare down your goals … an answer that sounds a lot like dealing with a budgeting shortfall – you can spend less or earn more money.

Unfortunately, most (easily available – online) measures of risk are not extremely helpful. They may serve to help you think about your comfort level with risk, but will not help you make decisions regarding asset allocation or appropriately managing risk. For example, Kiplingers Magazine, a very popular Personal Finance magazine provides an online tool to assess risk. If you go to the link you'll see that there are only 6 questions – the time horizon for a 25 year old and 50 year old would be treated the exact same — 15+ years!! Not a perfect tool by any stretch … it is free if that is any consolation. The risk tolerance quiz provided by MSN Money provides a questionnaire that is a little more in depth. Just for fun, I googled investment risk tolerance quizzes – and of the 20 that I looked at, only 3 had more than 6 questions that were posed!

How do you assess your own risk tolerance? If you work with a financial advisor/planner, how well do they understand you and your tolerance for risk …?

SHOULD YOU CONVERT?


ROTH CONVERSION.

There has been A LOT written in the past few weeks in financial publications regarding the opportunity for those that have been previously unable (because of income restrictions) to take advantage of Roth IRAs to now convert retirement savings (regular IRAs) into the tax free growth provided by the Roth IRA. Although the income limits on contributing to a Roth account will not go away next year, the limits on converting to a Roth will. The upside to doing so could be substantial — tax free account growth and no required minimum distributions at 70 1/2 most notably. The decision, however, will ultimately be a personal one, dependent upon your financial situation. There are no “blanket” answers.

Some food for thought… Is it right for me?

– Do you think your tax rate will be higher (or lower) in retirement?

– Can you pay the tax 'bill' with money outside of the retirement assets?

– How long will the money be left in the Roth account to grow?

– Are your current retirement account values depressed?

– Do you have heirs you would like to leave tax free money?

Given an option that financial professionals know will likely be a wildly popular opportunity, many firms have already established helpful educational resources (including calculators) on their websites to help you dissect the issue and better understand the potential costs and benefits of the Roth Conversion. Here are a few to get you started.

Roth Conversion Resources.

—> Fidelity Resources

—> Roth Conversion Calculator

—> Schwab Resources

—> Vanguard Resources

Assuming you're not one of the 13+ million Americans that will find the Roth Conversion information applicable, perhaps you will be eligible for the TAX SAVERS CREDIT. This credit for qualified retirement savings contributions is available to people earning less than $27,750 in 2009 ($55,500 if married filing jointly). Instructions for determining eligibility and calculating the value of the credit can be found on IRS Form 8880. The savers credit reduces your income tax dollar for dollar (not less than zero, however). You can receive a credit of up to $1,000 ($2,000 if married filing jointly). Contributions to most retirement plans are eligible for the credit. The IRS has developed a brochure that outlines the details of the Tax Savers Credit.

BECOMING FINANCIALLY FIT


The road to financial fitness can be a daunting one. The path is not smooth nor always the easiest path to navigate. There are unexpected twists and turns and people regularly fall asleep at the wheel. Similarities are often cast between financial fitness and personal fitness.



In either pursuit, following certain key principles has consistently proven to yield success. If you feel like you are a little financially flabby, let me offer a few tips to help you become more financially fit …

HAVE A FINANCIAL PLAN.

As a financial educator, I've consistently found that this first step – developing your financial blueprint – is the hardest step. The key? Find a budgeting system/ method that will work for you and your personality. Establish goals to guide you and you'll quickly realize that meaningful, purposeful steps will make success obtainable. Numerous free budgeting resources are availablestart here.

BE PREPARED.

As an Eagle Scout, I was taught the importance of being prepared. There are several important areas of personal finance with which this motto will serve you well:

Eliminate Debt

Have an Emergency Fund

Maintain Appropriate Levels of Insurance

INVEST FOR YOUR FUTURE.

Invest in yourself – make education a lifelong process. In addition, take part in personal and work retirement programs. When possible, take advantage of any company/ employer matches. Contribute to a 401(k), IRA, and/or other investment programs that maximize the growth of your money through tax free and tax deferred savings vehicles.

START NOW!

As I've said before, start by simply doing something. Go ahead and start small. What I've learned over time is that the majority of personal finance revolves around inertia. Once momentum starts, it tends to continue rolling… not until it starts though! As with personal fitness, the bottom line is discipline

MUTUAL FUNDS (Putting the Prospectus into Perspective)


While the argument for index funds is a compelling one, there will always be investors that opt for the more “tantalizing” world of actively managed mutual funds. If you find yourself in this camp, understanding the objectives and “fit” of the fund relative to your particular goals is paramount. The mutual fund prospectus will be one of your most valuable tools to address these questions. The prospectus is a summary of a funds investment philosophy, its management, its financial highlights (and lowlights), costs, etc. It is wise to spend time perusing the prospectus prior to ever putting a dollar into a fund. The prospectus ultimately helps you to “know what you're investing in” …

WHAT AM I LOOKING FOR??

FUND COSTS. One of the first things to examine is the funds cost structure. The amount of money charged in fees tends to vary dramatically from fund to fund.

Expense Ratio – Total percentage of annual assets that a fund takes to cover operational costs (i.e., marketing, etc.). Some funds have expense ratios in excess of 2%; many, however, have expense ratios at or lower than 1%.

Loads – Sales commissions tacked onto funds – come in numerous 'flavors' – front-end, back-end, level, or no-load.

FUND SUMMARY/OBJECTIVE. What is the fund trying to accomplish? What is the philosophy of the company (i.e., value, growth, etc.)? What area is the fund focusing on – a certain sector (i.e., technology, health care, etc.); international companies; small, medium, or large companies, etc.? What are the specific risks with investing in this fund? Obviously the funds objectives are critical – I should be investing in something I understand, as well as something that will ultimately meet my [long-term] investment goals.

FUND HISTORY. How well has the fund performed over the past year, 3 years, 5 years, 10 years, and since inception? How does the fund compare with its index (and “peer” funds) during that time? How did the fund hold up during the market meltdown? How has it rebounded during the market upswing since last March? Keep in mind this is a “rear view mirror” approach to performance and doesn't guarantee that it will continue to perform at the same level that it has in the past (for good or bad).

FUND MANAGEMENT. The importance of fund management seems fairly obvious. A more challenging question perhaps is … How much of the performance should I attribute to the person(s) managing the fund? Should I sell my fund if the fund manager is no longer managing the fund? Some people prefer funds managed by a group; perhaps group management may have less volatility in the transition if someone were to leave (in theory anyway). What is the experience/ track record of the manager/ management team? Do any research on Peter Lynch during his time running the Magellan Fund at Fidelity if you don’t think the manager of a particular fund makes a difference (he averaged a return of 29% per year during his 13 year tenure)!

FUND TURNOVER. Indicates how frequently a fund buys and sells its holdings. The higher the percentage, the greater the fund's buying and selling activity. A rate of 100%, for example, would indicate that a fund essentially changes all of its holdings once a year. Typically a higher turnover rate generally indicates a more aggressive manager — engaging in more frequent buying and selling — a practice which has both pros and cons.

ADDITIONAL INFO. Some funds will also offer information from outside agencies. Companies like Standard & Poor's and Morningstar are independent agencies that rate mutual funds on numerous criteria and rank them relative to “peer funds.” Obviously there is more to fund selection than if one of these companies suggests the fund is good, but it is one more thing you can look at in the decision-making process.

GIVE IT A TRY NOW

I wanted to make this as easy an exercise for you as possible, so I have taken three mutual funds from three different no-load mutual fund companies and provided the links for you to be able to go directly to the funds prospectus. YOU SHOULD NOT VIEW THIS AS AN ENDORSEMENT OF THE FUNDS. I HAVE SELECTED THREE PROSPECTUSES FOR YOU TO REVIEW TO AID IN AN EDUCATIONAL PROCESS. You will notice that each fund has very different objectives.

Fairholme Fund

Fidelity Low-Priced Stock Fund

T. Rowe Price Mid-Cap Value Fund




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