Narrowly Framed Questions Fail to Meet Life Goals (2006-10-30)

Narrowly Framed Questions Fail to Meet Life Goals

(2006-10-30) by David John Marotta

The marketing of financial products has caused investors to focus too narrowly on the details of specific investments. As a result, most investors fixate on asking the wrong questions and fail to ask the strategic questions necessary to tailor their investments to best reach their life goals.

The financial services industry has been largely built around selling financial products. This is an unfortunate history and has produced financial salesmen who are sometimes more interested in describing the attributes of their newest 5-star mutual fund or top-rated annuity contract than in listening to your life goals. And, even those who do listen can rarely meet your goals using only their commission-based wares.

A good advisor begins comprehensive financial planning by understanding your personal goals, attitudes, and values. Every financial decision and investment should be made within the bigger context of your life's goals.

Financial planning begins with the question "What are your life goals?" We have clients who answer that question in very different ways. As a result, we structure their finances differently.

For example, a client may be interested in having enough assets at age 50 to leave their job and become an entrepreneur. Another client may be most interested supporting specific charities. A client with a successful family business may want to structure their estate to preserve the value and integrity of that business for future generations. Another client may wish to provide an endowment to cover college education costs for their grandchildren.

Each of these clients would need different investment vehicles, asset allocations and specific investments to best meet their objectives. Purchasing investment products in isolation from the larger context of your specific life goals is like pushing random buttons on a vending machine in order to provide a Thanksgiving dinner for your family.

In financial psychology terms, this error is called "narrow framing." If your investments are not tied directly to your life goals, you and your advisor could be making this common mistake.

Letting your goals drive your investment decisions will mean you stop asking shortsighted questions like: Is this stock/fund a good investment? What industry is set to do well in the next year? Where is there real money to be made?

Instead, you will start by asking questions that are specific and personal such as: Am I saving enough each month? What target asset allocation will best help me meet my financial goals? How much I can safely spend this month and still have money when I reach 100? What has been the time-weighted return on my investments over the past few years?

If you don't have a target asset allocation tailored to meet your goals, or if you haven't rebalanced to that target recently, you may need some objective strategic advice that isn't driven by selling you more products. If you know how the individual investments you own are doing, but you don't know the time-weighted return of all your investments as a total portfolio for the last year, you may need to step back and look at the bigger picture.

Our firm resists giving advice about specific investments without first understanding the big picture. You should seek professionals who provide comprehensive advice in the strategic context of your specific situation and objectives.

If you put too much focus on picking the right investments, you are liable to do the wrong thing with your portfolio as a whole. It is easy to be like a gambler who regrets betting so much on an individual hand of poker rather than regretting sitting down at the table in the first place.

Strategic financial planning begins with your specific life goals. These could be as simple as wanting to retire at age 55. Most likely your goals are much more complex and detailed. Only after your goals are understood, should your advisor begin tailoring an asset allocation to meet your goals.

Once your asset allocation strategy is mapped out, then specific asset classes can be put into action. Certain types of investments are better suited for different types of accounts. From there, the blend of different individual investments can be selected in each specific account to keep expenses, taxes, and volatility low - and returns high. For large accounts, a blend of stocks, exchange traded funds, mutual funds, and other types of investments are likely in order.

A vendor of specific financial products is ill-equipped to provide that kind of financial planning, selection and implementation. And, without a concern for the big picture, your investments decisions will likely be shortsighted. Just rambling in the general direction of your goal isn't a good financial plan.

To find a comprehensive financial advisor in your area who will sit on your side of the table and act in your best interests visit the National Association of Personal Financial Advisors at www.napfa.org, or call 1-800-366-2732.

from http://www.emarotta.com/article.php?ID=202

Bond Basics (2006-10-23)

Bond Basics

(2006-10-23) by David John Marotta

Bonds are boring. But smart investors use them for diversification. Understanding some basics will help you evaluate the risks and rewards of owning bonds in your portfolio.

What is a Bond?

A bond is essentially an "IOU." You become a bondholder when you lend money to the government, a corporation, or a municipality. In exchange for your money, the bond issuer promises to pay interest periodically and repay principal equal to the bond's face value at the end of a specific time period.

Consider a company that needs to build a new facility costing $2 million. The company decides to borrow the money to fund construction by issuing 2,000 bonds for $1,000 each to investors. In this case, $1,000 represents the "face value" of each bond. Prior to issuing the bonds, the company takes into account market factors and establishes an annual interest rate, or "coupon," that it will pay on each bond to entice investors to purchase them. The company also determines the bond's "maturity," the date when it will repay the face value to the bondholders. So, if the company decides to issue 5-year bonds paying a 6% coupon, then each holder of a bond can expect to receive $60 per year in interest income ($1,000 face value x 6% coupon rate) plus the $1,000 face value at the end of five years.

The Bond Market

When an entity such as a corporation issues bonds to raise money, it does so through an initial offering in the primary market. Most bond buyers at the primary offering are large institutional investors such as broker-dealers and mutual funds. After the initial offering, bonds trade freely between investors in the secondary market much like stocks do. As an individual investor, you are usually buying your bonds in the secondary market from another investor who wishes to sell before maturity. A bond's price in the secondary market fluctuates daily around its face value to reflect changes in market interest rates.

Consider a bond from our example above. At the initial offering, its face value is $1,000. If you missed out on the initial offering and want to buy this bond in the secondary market, you may be able buy it for its $1,000 face value. More likely, you will be buying it at either a "discount" to face value or at a "premium" to face value depending on whether market interest rates have gone up, down, or stayed the same since the initial offering.

For example, the same $1,000 face value bond could now be valued at $900 (at a $100 discount) or valued at $1,100 (at a $100 premium) in response to interest rate changes. However, regardless of its current price, the bond still pays $60 in annual interest. The fact that you can buy a bond in the secondary market at a price different from its stated face value is one of the main sources of confusion about bonds.

Bond Prices and Interest Rates

Bond prices fluctuate daily in response to both changes in market interest rates and the credit quality of the underlying issuer. As a bondholder, the most important concept to be aware of is that the price of a bond has an inverse relationship to changes in the market interest rates. If market interest rates rise, then the price of an existing bond will likely fall because it pays a lower rate than you can earn by buying a new bond in the market.

Let's say your $1,000 bond paying 6% matures in 5 years. One year after you buy it market interest rates rise to 7%. Your bond is now worth $966. Why? If you now want to sell your bond in the market, the price must fall to a point where another investor can earn 7% by buying it and holding it to maturity in 4 years.

Conversely, if market interest rates fall, then the price of an existing bond will likely rise because it pays a higher rate than you can earn by buying a new bond in the market. Using the example above, if market interest rates fall to 5% one year later, your bond is now worth $1,035. You can sell it for a capital gain or keep it and earn 6% until maturity.

Changes in interest rates do not affect the prices of all bonds equally. The longer it takes for a bond to mature the more sensitive the bond price is to interest rate changes. The longer your interest rate is locked the better or worse it is when interest rates change. Therefore the price of a 20-year bond moves up and down more than a 2-year bond when rates change. If you plan to hold your bond to maturity, these changes are on paper only and represent the value of your bond in relation to the new bonds you could invest in.

Bond Risks & Returns

Bonds are not risk free. When you loan your money you have three risks. First, your purchasing power could be lost through inflation by the time your bond matures and you get your money back. Second, your bond could be worth less than your purchase price if you need to sell your bond before maturity and interest rates have risen. And third, the bond issuer could default, stop paying interest and fail to return your investment. Each of these risks can be reduced through diversification just as diversifying your stock investments reduces risk. Diversification of don investments is done by purchasing bonds with different maturities, credit qualities, industries and countries.

Bonds are like the iron rods put in the bottom of sailing ships. They don't make the ship go faster, but they do keep the ship from capsizing in stormy weather. Bonds can keep a portfolio afloat in stormy markets, and can actually boost return in volatile markets. A financial professional can help you navigate the complex world of bonds and tailor your bond allocations to best meet your financial objectives. To locate a fee-only planner in your area, visit www.napfa.org.

from http://www.emarotta.com/article.php?ID=201

NAPFA Consumer Education Foundation (2006-10-16)

NAPFA Consumer Education Foundation

(2006-10-16) by David John Marotta

Americans need financial advice they can trust. Given the complexity of the financial world and the shell game of financial salesmanship, it is no wonder so many Americans are confused. When it comes to financial planning, few industry professionals actually sit on their client's side of the table and uphold a fiduciary responsibility to help clients determine which choices are truly in their best financial interest.

If you have questions about your finances, the non-profit NAPFA Consumer Education Foundation is offering a series of monthly presentations in Charlottesville, beginning this Saturday.

The NAPFA Consumer Education Foundation is a new forum designed to help you make these important financial decisions. The Foundation is dedicated to bringing consumer financial education to communities across America. The core focus of the seminars is to represent the best interests of community participants by providing an educational setting that engenders sound decision-making about important matters of personal finance. Each month, an industry expert (most of whom are fee-only financial planners and fiduciaries themselves) will provide an interactive question-and-answer forum covering a broad range of financial planning topics.

Statistics show that fewer than 20 percent of investors are literate about important investment concepts. On average, women are less knowledgeable than men about matters of personal finance, and older investors are often less informed than younger investors.

In consumer studies, most investors did not understand the basics about the fees associated with "no-load" funds, the purpose of diversification, or the relationship between interest rates and bond prices. Most investors had never prepared a financial plan or checked out the track record of their broker or financial advisor. And, most did not understand how their financial advisor was actually being compensated.

Many professionals in the financial services industry are salesmen and have no legal fiduciary responsibility to act in your best interest. Financial advice is often little more than a sales pitch for a financial product that turns out to be counter-productive to helping you achieve your goals.

As recent reports have shown, many Americans are in for a rough retirement. A few decades ago, company pension plans would cover most of an employee's financial needs in retirement. Today, most companies have switched from a defined benefit plan to a defined contribution plan.

Poverty in retirement can be a living hell. Many families spend more time each year planning for their summer vacation than they do for their financial future. By your retirement age, if you have not secured the financial means necessary to support you for the rest of your life, you are not likely to get a second chance.

Sadly, few employees are fully participating in their employer's plan. In fact, few employees even know how much they should be contributing each month to meet their retirement goals. Most employees do not attend financial seminars even when they are offered in the workplace. They are skeptical, often for good reason, that the advice is a thinly veiled sales pitch.

According to the Jump$tart Coalition for Personal Financial Literacy, high school graduates possess very little knowledge about personal financial skills. School systems do not require that their graduates know and understand the financial concepts of earning, spending, saving and investing. And, parents often avoid talking to their children about subjects such as budgeting and saving, in part, as a result of their own failure to apply sound money management principles at home.

Although it is designed for adults, the new series of talks sponsored by the non-profit NAPFA Consumer Education Foundation is also an opportunity for parents to bring their teenage children who have shown an interest in gaining the financial literacy that will make the difference between living in poverty or prosperity in the future.

Earning a paycheck is not the same as being able to make informed, responsible decisions about what to do with your income. As a result, those who practice sound financial planning principles get wealthier and those who turn a blind eye often wind up getting either bad financial advice or none at all.

The upcoming series of presentations is an opportunity for community members of all ages to learn about important financial skills such as how to invest in your 401(k), how to allocate contributions between the various tax-deferred retirement plan options, how to save for college through a 529 plan, how to analyze the costs and benefits of paying down your mortgages, and how to effectively build up savings in your taxable investment accounts.

I have the honor of making the first presentation this Saturday, October 21, 2006, from 12:00 p.m. until 1:30 p.m. at the Northside Library meeting room in the Albemarle Square Shopping Center. I will be speaking on "The Three Most Important Things You Can Do to Maximize Your Financial Well-Being." The first discussion will provide a general framework and overview of the presentations to follow in succeeding months.

On November 11, 2006, Blaine P. Dunn, CFP, will be speaking about "Budgeting Like a Millionaire: How to Grow Wealthy Saving and Investing." And on December 9, 2006, John G. Bowen, CPA, CFP, AIF, will be speaking on "Year-end Tax Planning."

All presentations will be held at the Northside Library meeting room in the Albemarle Square Shopping Center from 12:00 p.m. to 1:30 p.m. All presentations are free and open to the public. You are encouraged to attend and to bring your financial questions.

If you would like a schedule of upcoming talks, visit the Charlottesville NAPFA Consumer Education Foundation website at http://www.napfa.org/consumer/NCEFCharlottesville.asp. To put your name on the mailing list for notification of future meetings, send an email to Charlottesville at NAPFAFoundation.org.

from http://www.emarotta.com/article.php?ID=200

The Dow Jones Industrial Average (2006-10-09)

The Dow Jones Industrial Average

(2006-10-09) by David John Marotta

The Dow set a new all-time high last Tuesday. While most investors follow the numbers from the Dow Jones Industrial Average index, they are most likely invested in funds that mimic the S&P 500. However, neither index represents a diversified portfolio. Diversified investors often see positive market returns, even when these indexes are struggling. Understanding just how the Dow works allows savvy investors to see past this index when evaluating the performance of their investments.

The Dow is the oldest market index still in existence. It was created on May 26, 1896, by Charles Dow, co-founder of Dow Jones & Company and The Wall-Street Journal. In the original index, Charles Dow simply picked a dozen significant stocks which represented different industries, added their prices together, and divided by 12. Thus, the Dow was born, weighing in at the starting value of 40.94.

The fundamental method for computing the Dow hasn’t changed much in the last 110 years. The number of stocks in the Dow increased to 20 in 1916 and then to 30 in 1928. Today, the movement of the Dow represents the price changes of 30 significant stocks. Of the 30 stocks in the Dow today, only one was in the original 12—General Electric.

Sometimes, changes in the composition of the Dow adversely affect the index. At the end of 1999, the Dow changed four components at exactly the wrong time. It replaced Sears, Goodyear, Chevron, and Union Carbide with Microsoft, Intel, SBC Communications and Home Depot. As a result, the Dow did not grow with the bubble when Microsoft, Intel and SBC went up, but it did drop sharply as a result of the bear market correction.

The Dow struggles when used as an accurate financial barometer for a couple of reasons. It is comprised of a limited number of stocks, and the movement of each stock in the Dow does not affect the index equally.

For example, if a stock which usually trades for $10 per shares goes up by $1, it has the same affect as a $100 stock that goes up $1. Thus, the percentage movement of a stock which sells for $100 per share has ten times the effect on the index as the $10 stock. If the $100 stock splits and its share price drops to $50 per share, the Dow adjusts its multiplier to negate the effect of the split. But, future price movements of that stock will have only have half of the effect that they would have had before the split.

This computation is called a “price-weighted” average. If you followed my example, you can see how this method of computing an average might have been a good way of getting a handle on the markets in 1896, but it doesn’t make any sense in the 21st century.

From 40.94 in 1896, the Dow climbed to 381.17 on September 3, 1929. After that, the Dow declined all the way back to where it started, closing at 41.22 in 1932. The bear market lasted 18 years until the post-World War II boom began in 1949. Over the next 17 years after the war, the Dow increased from 150 to 995.

The next bear market, which spanned 1967 to 1982, saw the market go sideways as inflation ate up more of investors’ purchasing power every year. Everything from wage controls to price controls to the 70% top marginal tax rates doomed the efforts of small businesses to generate sustainable wealth.

In 1980, Reagan was elected. Reagan, with the help of Fed Chairman Paul Volcker, broke the back of inflation by tightening the money supply and by cutting the top marginal tax rate from 70% to 33%. Initially criticized as a tax cut for the rich, Reagan’s economic policy actually increased tax revenues by encouraging more Americans to take risks and to start businesses of their own. What followed was a renewed spirit of capitalism and a boom in small business growth, which then fueled a boom in the economy as a whole.

From 1982 through 1999, the Dow experienced phenomenal growth, closing at a high of 11,722.98 in January of 2000. This was the period when it seemed that the markets only went up, except for one year. The biggest percentage drop in the Dow during the last 50 years occurred on “Black Monday” October 19, 1987, when the Dow fell 22.6%. This 554.26 point drop turned out to be a great buying opportunity in the middle of a long-term rally. The biggest one-week drop came on September 17, 2001, when the stock markets re-opened after the 9/11 attacks. During that one week, the DJIA dropped 1369.7 points.

On Tuesday, October 3, 2006, the Dow closed at 11,727.34 breaking its previous high of 11,722.98 achieved on January 14, 2000. The S&P 500, however, is still 12% off its high and the NASDAQ is still a whopping 55% off its high – even after more than 6 years! If your portfolio has barely recovered, your portfolio probably isn’t well diversified. Now would be a good time to closely examine your portfolio. For a contrarian, when financial markets make the news headlines, it has historically been a good time to rebalance into overlooked and underloved investments.

Truly diversified investors are accustomed to experiencing positive returns even when indexes like the Dow and S&P 500 are struggling. Commentators in the mainstream new media may be going crazy over the new record high for the Dow, but if your portfolio has gone nowhere in the last six and a half years, maybe it is the right time to consider a more diversified approach. Diversified portfolios recouped their bear market losses much faster and gained their highs well before 2006.

If you not sure what annual return you are making on your investments, you want to consider a comprehensive portfolio analysis. While the Dow’s record-setting performance provides an upbeat financial news event, it only matters to your financial health when your portfolio is setting new highs. Make sure that you are measuring the progress made each year toward reaching your financial goals.

from http://www.emarotta.com/article.php?ID=199

P/E Ratio (2006-10-02)

P/E Ratio

(2006-10-02) by David John Marotta

Stock brokers and investors often look at certain fundamental information about a stock when determining if that stock is a good stock to purchase. One of those fundamental indicators is the "P/E ratio" of a stock. While we favor low P/E stocks, often called value stocks, buying a stock simply because it has a low P/E is like assuming a car is fast because it has racing stripes and a number on the side.

The P/E ratio is the ratio of a company’s share price (P) to its earnings per share (E). The most common way of computing this number is by taking the current share price and dividing by the earnings per share from the last 12 months. This is known as the trailing P/E because it uses the actual historical information from the last four quarters. For example, recently General Electric (GE) was trading at 34.44 and had earnings per share (EPS) the previous year of 1.61 for a P/E ratio of 21.4.

Now, imagine a company—we’ll call it "Old-Fashioned" — whose stock is trading at $40 and has trailing earnings of $4 a share. This company’s P/E ratio is relatively low at 10. Assuming that the company’s earnings did not change, it could afford to pay a dividend of $4 a year per share. Even if the stock’s share price did not appreciate, shareholders would receive 10% of their investment back every year in dividends. In ten years they would be repaid their original investment and still own their shares of stock.

In very simplistic terms, a stock’s P/E ratio is a measure of how long it would take at the current level of earnings to be repaid for your investment. Said another way, the P/E ratio tells you how many dollars you have to invest to receive $1 in earnings.

Imagine another company—we’ll call this one "New-Fangled" — whose stock is trading at $40 and has trailing earnings of only $1 per share. This company’s P/E ratio is relatively high at 40. Assuming the company’s earnings did not change, it would take 40 years for the earnings to justify the stock’s purchase price.

Let’s assume that New-Fangled’s sales are projected to double each year for the next ten years. Although last year’s earnings were only $1 a share, next year they are projected to be $2 a share. The leading or projected P/E, which uses the estimated earnings expected over the next four quarters, would be 20. And if the doubling of earnings each year actually happens, the stock’s purchase price would be more than compensated in five years.

In fact, even if New-Fangled’s earnings only double for the next two years and then stops, it will end up with a P/E ratio just as good as Old-Fashioned’s P/E ratio.

While both stocks are trading at $40 per share, Old-Fashioned is assuming flat or declining sales while New-Fangled is assuming a measure of growth in company earnings. Given everything that is know about these two companies, the market has priced each stock appropriately.

However, if Old-Fashioned maintains its market share, or if it doesn’t decline as much as was expected, the stock price could go up with the realization that earnings won’t be declining. On the other hand, if New-Fangled reports earning growth of 30% when the markets were counting on 50%, the stock price could plummet.

Each stock ends up trading at where the markets find equilibrium. Investors are willing to pay more for the earnings from companies with better growth prospects. That’s why investors may be willing to pay $40 for every $1 of earnings that a growing company generates.

P/E is a better indicator than stock price of how cheap or expensive a company’s stock actually is. Stocks with high P/E ratios are expensive, even if their share prices are low. A stock’s share price changes with splits and reverse splits, but these do not change a stock’s P/E ratio. The P/E ratio is a better indicator the cost of buying an earnings stream.

Stocks with a rising P/E ratio could be considered more or less speculative depending on your perspective. Stocks with a constant low P/E ratio have no prospects for growth and are risky because they are unlikely to improve their earnings per share. Stocks with a high P/E ratio, on the other hand, are considered by investors to have good prospects for growth. They are risky because there is a chance they won’t deliver the growth of earning that investors are counting on and then their share price will plummet.

Since a company’s prospects for growth affect the multiple of earnings that investors are willing to pay for a stock, some industries have lower average P/E ratios. The growth of gas utility companies is very limited; hence the average P/E ration of that industry is currently 9.8. Internet Information Providers, on the other hand, have an average P/E ratio of 54.

This explains why companies like Google (GOOG) and Yahoo (YHOO) have P/E ratios of 59 and 30 respectively.

On July 19th, Yahoo’s stock price fell 21.8% in a single day even after announcing solid second quarter results that met analyst estimates.

The drop caused a corresponding drop of Yahoo’s P/E ratio as investors lowered the expectation that Yahoo will be able to keep its market share. Yahoo still has a larger share of the Internet audience but Google is gaining ground.

Yahoo makes more money than Google in visual advertising, but search advertising has become the larger market. Investors are betting on Google. Currently Google gets 49% of the Internet search engine traffic verses Yahoo’s 24%. That’s why the value of Google’s stock is about $124 billion, over three times Yahoo’s value of $35 billion.

On the other end of the spectrum, Exxon Mobil (XOM) had a P/E ratio of 10. Chevron (CVX) had a P/E ratio of 8. Conocophillips (COP) had a P/E ratio of 5. Although the oil and gas industry has had phenomenal profits in the past year investors don’t think they will last. The markets have discounted the value of these past profits and are pricing these companies as though they expect their earnings to shrink.

While we recommend over-weighting stocks with low P/E ratios, your portfolio should include a broad spectrum of stocks, including a generous helping of growth-oriented stocks. Balancing your portfolio can be a simple and straightforward process, if you have the tools and experience. On your own, it may be as difficult as using a hammer to adjust your car’s timing belt. To have a fee-only financial planner tune your portfolio to get you where you want to go, visit the National Association of Personal Financial Advisors at www.napfa.org.

from http://www.emarotta.com/article.php?ID=198