Gold Mining Companies Glitter More Than Bullion (2008-03-24)

Gold Mining Companies Glitter More Than Bullion

(2008-03-24) by David John Marotta

Last week gold broke $1,000 an ounce. Gold advertisers and gold investment newsletters are touting their wares as though gold only goes up in value. Nothing could be further from the truth. Gold may glitter, but it is still better to own the mine.

Keep in mind that investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility, whereas buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power, and the goods and services we buy cost more. Commodities as an asset class generally maintain their buying power in terms of dollars. Stocks as an asset class, in contrast, generally appreciate over inflation after factoring in dividends. And recently, hard asset stocks such as precious metal mining companies have been appreciating nicely.

Jeremy Siegel, author of the book "Stocks for the Long Run," analyzes investments over the past 200 years. Gold, on average, maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation, it would be worth $1.07 today. Because of inflation, a dollar today would only have had the buying power of about 7 cents back then! However, the stock market, on average, has been appreciating about 6.5% over the long-term rate of inflation. Hard asset stocks give you the best of both worlds: the stability of a real asset plus higher market returns.

The beauty of hard asset stocks is that they are not highly correlated to U.S. large-cap stocks as a whole. The correlation between the Goldman Sachs Natural Resources Index and the S&P 500 Index is only 0.49. Importantly, the correlation between the Goldman Sachs Natural Resources Index and the Lehman Aggregate Bond Index is even lower at –0.26. A negative correlation means that bonds and natural resources, as separate asset classes, are often moving in opposite directions. Balancing a bond portfolio with hard asset stocks can help hedge the risk that inflation poses to a bond portfolio.

Natural resource companies sell valuable tangible commodities. Thus their earnings are tied to inflation because their resources are worth more as the dollar declines in value. This situation can occur in times when the supply of money and credit is increased to fund government spending and budget deficits.

Consider a gold mining company in 2001 whose expenses and overhead allowed it to pull gold out of the ground for $290 per ounce and sell it for $300 per ounce, making the company a $10 per ounce profit. As the price of an ounce of gold rose 3.3% from $300 to $310, the company's profit doubled from $10 an ounce to $20 an ounce--a 100% jump--which caused the company's earnings and stock price to soar. Now that gold is more than $1,000 per ounce, the current price level of gold stocks is much higher than it was in 2001.

Therefore, we segment hard asset stocks into their own asset class because they have a unique set of characteristics. First, the movement of hard asset stocks generally correlates less with the movement of other asset classes such as bonds. Second, hard assets react in a unique (and positive) way to inflationary pressures. And third, in certain periods in the longer term economic cycle, including hard assets helps boost returns.

Direct investments in gold react a little differently, however. The correlation between the price of gold and the S&P 500 is nearly zero, lower than hard asset stocks at –0.02 instead of 0.49. But the correlation between the price of gold and the Lehman Aggregate Bond Index is also nearly zero at 0.09 instead of –0.26. In truth, the price of gold does not fluctuate with investments because it is simply holding its value.

But although it is true that gold generally holds its purchasing value, it still fluctuates wildly based on other factors of supply and demand. While it does so, the part of these movements that is not just random noise is simply an inverse reaction to the value of the dollar.

In January 1980, gold reached its high of $850 an ounce. The following year my wife and I became engaged and chose modest wedding rings that were still very expensive. Note that $850 in 1980 had the same buying power as $2,184 in today's dollars. Gold trading at $850 an ounce then was like gold trading at more than twice its current price. Those people who purchased gold in 1980 have lost over half their buying power during a 28-year investment.

In August 1998, gold reached its low of $356 an ounce. So those who had invested 18 years earlier at $850 an ounce had lost 79% of their purchasing power. By 1998, an ounce of gold should have been worth $1,682 just to keep up with inflation, but instead it had dropped dramatically.

A small percentage of your portfolio should be in precious metal mining companies. It provides a balance to your portfolio that you cannot gain by investing directly in gold.

Here are three mutual funds we have used for investing in precious metal mining companies. We look for a low expense ratio, a turnover ratio of under 50% and returns that capture the lion's share of the sector's returns.

Vanguard Precious Metals and Mining (VGPMX) earned 36.13% during 2007 and has had an annualized return of 35.28% for the past five years. It is up 12.74% for the first two months of 2008. It has an expense ratio of 0.35% and a turnover ratio of 24%. Although closed to new investors, VGPMX is probably one of the best funds.

U.S. Global Investors World Precious Minerals (UNWPX) earned 23.02% during 2007 and has had an annualized return of 36.66% for the past five years. It is up 15.05% for the first two months of 2008, with an expense ratio of 1.01% and a turnover ratio of 54%.

American Century Global Gold (BGEIX) earned 15.12% during 2007 and has had an annualized return of 20.53% for the past five years. Although it underperformed relative to other funds last year, it is up 16.52% for the first two months of 2008. It has an expense ratio of 0.67% and a turnover ratio of only 3%.

Because of the negative correlations, our firm uses these investments and others in this sector for a small percentage of a balanced portfolio. Diversified and negatively correlated investments can help your portfolio maintain its equilibrium when the U.S. markets are losing money.

from http://www.emarotta.com/article.php?ID=276

Life Insurance: Determining Your Need

(2008-03-17) by David John Marotta and Bob Arms

You may have heard that "Life insurance is a gift of love." But if you bought a $100,000 whole-life policy because you wanted to build some cash value when you should have bought a million dollars of low-cost term insurance to meet the survival needs of your family, your well-intentioned effort was not an act of love.

Objective life insurance advice is hard to find. Prior to joining the National Association of Personal Financial Advisors (NAPFA), Bob Arms, CLU, ChFC, AIF®, coauthor of this week's column, sold life insurance for 26 years. He is currently licensed as a life insurance consultant, a fiduciary whose legal obligation is to represent the client first.

The first step toward representing your best interests entails an in-depth discussion of how much life insurance you might or might not need. The formula is Future Financial Needs minus Current Assets equals Your Current Risk. How much you want to provide for your loved ones should you predecease them (A) minus how much you have that could be used to provide for the survivors (B) equals your surplus or shortage (C).

To the extent that a gap exists between your financial needs and your current assets, life insurance is the most efficient product available to provide tax-free dollars exactly when you need them. As you go through the life changes of marriage, children, and career, you should recalculate your need and revisit the life insurance you own.

When members of a young family are making a decision about life insurance, six line items are significant.

1. Debts: The baggage of debt makes the journey toward financial success difficult. Avoid debt if possible, but if you have any, don't burden your family with it after you are gone. Being able to liquidate all credit card debt and car, home equity, and personal loans will give your surviving family the best chance at success in life.

2. Mortgage: Carrying a long-term fixed-rate mortgage keeps more money invested in the markets and qualifies you to enjoy a tax deduction on the interest. Leverage is a popular financial strategy of the rich. But if you would sleep better at night without a mortgage, sleep is more important. Either way, you need enough insurance or investments to pay off the mortgage.

3. Educational and child-care expenses: Depending on the age of your children, multiple expenses must be considered. If your children are preschoolers, the cost of child care may make it impractical for the surviving spouse to return to work. Consider the math. When the children are school age, will you want them to attend private school? Call the schools in your area and work the numbers. What percentage do you want to help with college? In-state tuition, room, board, books and transportation for college presently averages $6,185 annually. Private schools cost about $23,712 per year. Which do you want to fund?

4. Final expenses: Include a small amount for your funeral, approximately $10,000. The average funeral today costs $5,000 to $7,000, but expenses can exceed $10,000.

5. Family income: Estimating a young family's income needs is very challenging. To ease the mental strain, use seven times your adjusted gross income as a rule of thumb. A more accurate prediction requires either a financial calculator or a computer program.

6. Emergency fund: No one can forecast the exact amount a surviving family will actually need, but this category does absorb a potential miscalculation. Most gaps are filled by using 10% of the total of the other five line items: debts, mortgage, education, final expenses and family income.

Now that you have an estimate of how much your family needs, compare the total with your current assets. Include only the assets the surviving spouse can use for expenses. So do not include your house because your spouse needs someplace to live; your car because transportation is essential; or your retirement assets, which the surviving spouse will need during retirement. Nor should you count any inheritance. The old adage is true: Don't count your chickens before they hatch. This category is the total of your current life insurance and all investment assets.

The easiest math remains: Your Total Future Financial Needs minus Your Current Assets equals The Current Risk you may want to insure against. To determine how much life insurance the other spouse should carry, trade places as the first to die and rerun the numbers. Clearly, if the bottom line is positive, you've done something right and either you have enough life insurance or you are self-insured. Congratulations. If the bottom line is negative, thankfully you still have time to take action.

Financial planning is a lifelong process that covers multiple areas, including investments, insurance and taxation. Reviewing all of your financial affairs periodically with a trustworthy advisor who sits on your side of the table will ensure that you achieve your financial goals.

For more information about life insurance--how to shop for it, what to buy, what to do with what you have or other questions--you are invited to attend the NAPFA Consumer Education Foundation meeting. Bob Arms, CLU, ChFC, AIF®, will present a talk, "Straight Talk about Life Insurance," on Saturday, March 22, noon to 1:30 p.m., at the Northside Library in the Albemarle Square shopping center.

For more information, call (434) 244-0000 or e-mail
charlottesville@napfafoundation.org.

To learn more about the NAPFA Foundation, visit http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm. All presentations are free and open to the public. You are encouraged to attend and to bring your financial questions.

from http://www.emarotta.com/article.php?ID=275

Remember to Fund Your Roth IRA (2008-03-10)

Remember to Fund Your Roth IRA

(2008-03-10) by David John Marotta

If you are eligible, make sure you fund your Roth IRA or your Roth 401(k) this year with the maximum contribution possible. It may be your last chance to pay a reasonable tax rate before the prevailing winds of class envy swamp your retirement sailboat.

Although a traditional IRA and a Roth IRA share some features, they differ significantly in the way they are taxed.

Money put in a traditional IRA comes out of your paycheck before paying taxes, so your contribution reduces your taxable income this year. Traditional IRA investments grow tax free. But you must pay ordinary income tax rates when you take the money out in retirement, on both what you contributed and on the growth in the account.

In contrast, the money you put in a Roth IRA comes out of your take-home pay after you have paid taxes. So your contribution does not reduce your taxable income this year. Like a traditional IRA, your Roth IRA investment grows tax free. But because you have already paid tax on the money, in retirement you won't be obligated to pay any additional taxes.

So you can pay now on what you contribute to a Roth IRA, or you can pay later on the value that has accrued in your traditional IRA.

The standard wisdom favored funding the traditional IRA. Assuming your tax bracket would be lower in retirement, it thus would be advantageous to avoid the higher tax rate now and pay at the lower rate later. But for many retirees, this advice has proven misguided.

Employees typically contribute to a traditional IRA or 401(k) from the day they start working. Of course their starting salary is relatively low compared with what they earn later in their career. Thus an increasing number of employees find themselves in a higher tax bracket during their retirement than they were when they were contributing to a traditional IRA or 401(k). This phenomenon has produced some strange economic results.

Some workers have lost money, but the government has gained. As people have contributed to their traditional IRAs and 401(k)s, the government has given up a little revenue. But workers have invested that small amount and grown their money, thanks to the magic of compounded returns. Now the government is anticipating a windfall of taxable income as the baby boomers withdraw these investments during retirement.

The good news for the government is that budget projections do not include any of these retirement withdrawals. Thus taxes on traditional IRA distributions should cover about a third of the existing federal deficit.

But it's not your job to help the government get out of debt. Tax rates today are at an all-time low, but the political climate makes tax hikes much more likely in the next administration. Kennedy lowered the top marginal rate from 90% to 70% in 1964. Then Reagan lowered it from 70% to 50% in 1981. And in 2003, Bush lowered the top rate from 39% to 35%. Historically, income taxes have not been this low since 1931. So pay as much tax now as you can and fund a Roth IRA rather than deferring your taxes until later when the rates are higher.

As long as you (or your spouse) receive a paycheck, you are eligible to open a Roth IRA. Account owners may contribute $4,000 per year in 2007. Contribution limits rise to $5,000 in 2008. All account owners age 50 and older are permitted an additional catchup contribution of $1,000 annually.

Unlike a traditional IRA, you are not obligated to begin required minimum distributions at age 70½. As a result, a Roth IRA can help fund the end of your retirement.

And if the tax benefits of a Roth IRA aren't enticing enough, the estate-planning benefits are amazing. Leaving a Roth to your heirs can be likened to setting up a lifetime tax-free stream of income. Because Uncle Sam has already taken his cut of the principal when you put the money in, withdrawals can be made tax free, either by you or by your beneficiaries.

With a traditional IRA, you must begin distributions at age 70½, whether you need the cash or not. But when you do this each year, you put the brakes on the snowball effect of compounding interest. Plus your required withdrawals deplete the account, making it difficult to control what you actually leave to your beneficiaries.

A Roth can help you keep more of your money by sheltering your investments from capital gains and from minimum distribution requirements during your lifetime. Spouses who inherit a Roth can also forgo taking distributions, preserving the account's ability to grow unchecked year after year.

Only when members of the next generation inherit a Roth IRA must they begin taking distributions, and then they are withdrawn based on the beneficiary's age. By taking the smallest required distribution each year, the beneficiary achieves the maximum tax-free growth of tax-free income.

No traditional IRA can offer that kind of benefit to your heirs. If they were to inherit a traditional IRA of equal value to a Roth, the former would run dry long before the latter. The required minimum distributions for a traditional IRA are based on the original owner's age, not the beneficiary's, so required withdrawals are larger in the next generation. Also, because taxes are due on withdrawals from a traditional IRA, larger amounts must be taken out to match the tax-free sums taken from the Roth. Those hefty withdrawals from the traditional IRA eventually drive it to zero. Meanwhile the Roth account would still be growing and withdrawals could continue to be made.

If you already own a regular IRA, you may have the option to convert it to a Roth. You pay taxes now so your beneficiaries won't pay later. Even if you inherited a traditional IRA from your spouse, it is still not too late to convert to a Roth.

Converting may be a smart move, especially if you plan on leaving more than $2 million to your heirs. Paying taxes for the conversion will mean you reduce the size of your estate and thus its tax liability. Your heirs will pay less estate tax, and they will inherit a tax-free income stream.

The option to convert to a Roth currently is limited to those with an AGI less than $100,000. If your income exceeds that number, current law does not allow Roth conversions to all Americans until 2010. By then, significant tax hikes may have been implemented.

A Roth in itself cannot provide a complete answer to your estate-planning needs. Seek the advice of a financial planning professional who can provide you with a comprehensive financial plan. To find a fee-only financial planner in your area, visit www.napfa.org.

from http://www.emarotta.com/article.php?ID=274

Loss Aversion (2008-03-03)

Loss Aversion

(2008-03-03) by David John Marotta

Even with a brilliant investment plan, it takes diligence to overcome our emotional biases and avoid making investing mistakes. Here is the wisdom that both advisors and investors need to bear in mind to avoid succumbing to the fallacies of behavioral economics.

It doesn't take extensive research to determine that we are much happier when our portfolio values go up. When they go down even slightly, however, we are tempted to make poor choices. To avoid these unfortunate choices, we need reassurance and a sense of how our instincts can deceive us.

The tendency to experience significantly more discomfort with slight losses than to experience happiness with large gains is called "loss aversion."

Psychologists suggest we feel a loss about 2.5 times as much as an equivalent gain. That means if you see an equal number of ups and downs, you feel miserable. You feel some pleasure when the markets move up and a great deal of pain when the markets move down. But most of the daily and weekly fluctuations in the markets are just random noise.

Therefore, the more frequently you look at the markets, such as daily or weekly, the more discouraged you get. And even if you have a well-crafted investment strategy, you may be tempted to make changes in order to alleviate your suffering. Every study shows that loss aversion actually causes greater than average losses.

Consider that over the past decade, the daily movement in the markets was positive only 52% of the time. That means if you watched the markets every day, you were content on 190 days and despondent on 175 days. Because you grieve the down days 2.5 times as much as you celebrate the positive ones, on the average day you're glum, and instead of remembering the reality that the markets dip 48% of the time, you feel as if they go down 70% of the time.

If you only look each week your odds of happiness rise slightly to 54%, but your misery remains low, still feeling like they go down 68% of the time. The monthly odds of happiness are 62%, but you still like they go down 64% of the time. Quarterly returns go up 68% of the time, but your average emotions tell you they only go up 55% of the time.

Even though the vast majority of calendar quarters in the market are positive, it is the shortest time period in which, on average, we won't be disappointed. Only if you can refrain from looking at the markets for an entire year, will you be more likely to feel satisfied. Annually you get happy news 77% of the time, although you only perceive it as 62%.

These are the best case scenarios, assuming you have an outstanding investment plan. You may feel much worse whether you have a poorly designed portfolio or a well-designed one. Here’s why.

A poorly designed portfolio is typically laden with fees and commissions, putting a drag on your returns. It may also be inadequately diversified and oscillating with an even higher noise-to-performance ratio than necessary. In this case, your odds of happiness are slim indeed.

But even if you have a well-designed portfolio, your may feel unsettled. Being diversified means always having something to complain about. You must recognize the difference between a poorly designed portfolio and a well designed portfolio. You must know when to heed the warning signs and when to ignore the noise.

If you own a handful of mutual funds that are commission-based A, B or C shares, you probably have a reason to be discouraged. If that is the case, first set a diversified asset allocation that has the best chance of meeting your goals with a fiduciary financial advisor who sits on your side of the table. And second, relax and enjoy life 364 days out of each year.

from http://www.emarotta.com/article.php?ID=273