Safeguard #3: Insist on Publicly Priced and Traded Investments (2009-01-26)

Safeguard #3: Insist on Publicly Priced and Traded Investments

(2009-01-26) by David John Marotta

To protect our money, several safeguards are advisable. They aren't always necessary, but they are certainly safer than the alternative. One of these safeguards is to insist on investing only in liquid assets. Investors undervalue liquidity 99.9% of the time. You need to be in the other 0.1%.

Liquidity refers to the ability of an asset to be easily sold without losing value in the process. Imagine starting with a pile of money, buying the asset, holding it a week and then trying to sell it again. If you get back a much smaller amount of money, the asset is illiquid.

Because illiquid investments are hard to price, it's also difficult to compute what return you've received. I analyzed a real estate investment for a couple who had held it for 20 years. It was valued at $60,000 and paying a $6,000 return every year. I kid you not. It was paying a 10% dividend.

The investment had been illiquid for a long time, but now the general partners were offering to buy out any investors who wanted to sell. Alternatively, they were putting together another real estate deal in which you could invest additional money. Finally, if for some strange reason you liked your current investment but did not want to invest any additional money, you could neither sell your share of the old deal nor invest more money in the new deal.

The couple thought they had received a great rate of return. And believing no investment could be better than a 10% dividend, they were ready to sink more money into a similar investment.

Again, even with perfect hindsight, it is often difficult to recognize if illiquid investments have been a good investment because you may not be able easily to compute what return you've received.

In a simple analysis, it looked like a $60,000 investment was now paying a 10% rate of return. And so it was, but only after two decades of a zero percent return. Shares in the investment were not actually worth $60,000 because they were not traded in a public market. Without such a market to value the shares, their worth was at least questionable.

The fact that the general partners were now finally willing to pay $60,000 for the shares only meant they were worth at least $60,000. The fact that they were purchased for $60,000 some 20 years ago and were now paying a $6,000 annual dividend meant they were probably worth a lot more.

Even at a small 8% annual rate of return, the couple's $60,000 investment should have grown to at least $279,600. Perhaps the investment was indeed worth over a quarter of a million. Maybe that explained why the general partners were willing to pay $60,000 for the investment.

Assuming the investment has achieved an 8% return, the dividend is paltry. If the investment is really worth that much, the $6,000 dividend is only a 2.15% return, not a 10% return as previously supposed. Because of the illiquidity of the investment, nothing about it is attractive. The truth lies somewhere between these two extremes: the investment having absolutely no appreciation in 20 years and currently paying a 10% dividend and the investment having a decent 8% return over 20 years but only paying a 2.15% dividend. The illiquidity of the investment obscures the real return.

And that's the problem with investments that aren't publicly priced and traded. Because your investment can't be converted into cash, even after two decades you may still not be able to evaluate it. In this case we were able to determine that the investment wasn't worth selling for $60,000. The stream of $6,000 annual income was worth more than that. But it also was a mistake to invest any additional money in similar investments.

This situation illustrates a common dilemma with illiquid investments. Because they aren't easily sold, they often are not worth selling. Therefore it isn't worth buying them in the first place. That is the definition of illiquid: not worth buying and not worth selling.

Liquidity is a continuum. On one end, cash defines liquidity. Many investments, such as stocks, exchange traded funds and mutual funds, are so publicly priced and traded that their price is published in the Wall Street Journal every day. These are sufficiently liquid and can be realized in a matter of days. Holdings that have well-established public markets with adequate volume make buying and selling easy.

Even individual bonds fall in the middle of the spectrum. If you buy an individual bond this week and then try to sell it next week, it will lose some of its value. Bonds, unlike stocks, do not have a smooth and liquid market. You have to put a bond out for bid and then decide if you will accept the best price you are offered.

So even for bonds, it is best to structure your portfolio to hold them until maturity when the bonds pay back their principal. In the recent credit crunch, bonds that fell from investment grade to junk status were suddenly extremely difficult to sell. As a result, the price you could get for them dropped more sharply than it might have otherwise.

Real estate is another illiquid asset. Flipping real estate for a profit is usually not possible. Sales commissions and closing costs consume over 6% of the sales price. It has to be an extraordinary real estate market if you can buy a house one week and sell it for a 6% profit a few weeks later. Starting with a 6% loss because of illiquidity costs is a steep headwind to overcome quickly.

Moving further toward the other end of the spectrum are investments that are even more difficult to buy or sell. These have even higher spreads between their purchase and sale price, and even more return must be made just to overcome the spread between the bid and ask prices.

Real estate, hedge funds and private equity deals belong in this category. Some purposefully lock up your money and prohibit sales for several years. For others, something like a market exists for them but with very little volume. Finally, they may have capital calls where not only can't you sell, but you are required to invest more money in them. They all may have the allure of exclusivity, but they lack liquidity. Here is the critical question: "When you go to spend your money, will it be easily available?"

You need your money to be there when you want it. Therefore, use liquidity as one way of avoiding investments you should not be making in the first place. Remember, it is to the advantage of agents who sell such investments that their products remain illiquid. Therefore avoid going to them for so-called free advice as well. Even a negative return in the markets is better than no return of your investment.

from http://www.emarotta.com/article.php?ID=321

Safeguard #2: Walk Away from "Too Good to Be True" (2009-01-19)

Safeguard #2: Walk Away from "Too Good to Be True"

(2009-01-19) by David John Marotta

In addition to the all-important fiduciary requirement, you should insist on several other investment safeguards. Safeguard #1: Do not allow your financial advisor to have custody of your investments. The second safeguard: Avoid any investment opportunity that sounds too good to be true.

I learned this principle in a practical way from my father when I was 13 years old. One of my brothers had a friend whose father was doubling his money in an investment company that was importing Portuguese wine. They were selling it for more than twice what they had paid for it and making money hand over fist.

But they needed cash to buy the wine. After having the wine shipped from Portugal and distributing it around the Washington, D.C., area, they were paying 50% interest. Because orders had already been taken, it was touted as a sure thing. My father, George Marotta, was asked to invest in the next shipment.

His response was right to the point. He just said, "It sounds too good to be true." That was it. No looking into the matter, trying to determine where the catch was. He simply refused to waste his time on it.

My brother wanted to take the money my parents had saved for him and invest it in the Portuguese wine deal. Why not, he reasoned. It was guaranteed, wasn't it?

Again my father refused to allow my brother to invest anything. He explained that they couldn't be making 50% interest every six months. There had to be a hidden difficulty or complication.

Six weeks later the scandal broke on the front page of the Washington Post. There was no wine. Families lost their life savings and their children's college funds. It was all a Ponzi scheme. They were paying early investors with the money taken in by subsequent investors. Without any real returns, all Ponzi schemes eventually run their course and then implode.

Nothing really changes. For many people, greed can block common sense. This natural but deadly impulse is one you must learn to overcome.

Shortly after my father's wisdom was vindicated, it was suggested he give his sons some practical experience in investing by finding a good pick for us, some penny stock that was going to two pennies without very much risk.

My father again replied wisely, "If I knew a penny stock that was going to two pennies without any risk, I would invest our life savings and double our money. Such an investment doesn't exist."

Here's the hard lesson: There is no such thing as a sure thing, and if something sounds too good to be true, it is.

I used to analyze offers to find the proverbial catch. I would scrutinize the small print and find where they were going to make their money. Curiosity drove me to know, and in the process I learned a great deal about the dishonest methods companies use to separate fools from their money: bait and switch, allure of exclusivity, guarantee or your money back, limited time horizon and automatic charges.

And then there were the handful that really sounded too good to be true. And it struck me that they were blatantly lying. Nothing could be found in their literature to determine where the snag was because they simply were not telling the truth. And that is part of the lesson to be learned. You don't need to know where and how they are lying. But if it sounds too good to be true, it probably is.

Madoff Securities was recently caught in the largest Ponzi scheme in history. For years, Bernie Madoff collected assets with returns that seemed amazing. Hedge funds fronted for his investments, putting their own private label on his $50 billion scam.

Madoff was known as the guy who never seemed to lose money. It was implied he was subsidizing down months in the markets, a common rationale around Ponzi schemes. There has to be some reason given in a Ponzi scheme for the total lack of volatility, and the rationale commonly offered is that the company eats its losses during down months.

But it is a securities fraud to misrepresent either an investment's returns or the volatility of those returns. We are always reminding our clients and our readers that the markets are inherently volatile. Despite this tendency, they have also been profitable, even taking into account the significant drop in 2008. You should expect to see and understand the risk you are taking. Don't be mesmerized either by the promise of a high return or a sure thing. Even Treasury bills carry the inherent risk that you will lose your buying power to inflation.

Although the preceding may sound cynical and paranoid, many posing as financial advisors really do try to separate you from your money. Fortunately, only a few do it fraudulently. Others may do it legally in small amounts through hidden fees over a long period of time. Both may be actively calculating how to maximize their portion and minimize yours and how to hide how much they are keeping and the real return you are receiving.

So the challenge for investors seeking financial advice is clear. Where is the moral high ground? How can investors avoid as much as possible the conflict of interests inherent in many compensation schemes and find an advisor who simply helps clients meet their goals?

The National Association of Personal Financial Advisors (www.napfa.org), created in 1983, is an industry association of firms that provide independent financial advice. Their compensation is not clouded by the purchase or sale of a financial product.

You have a right to be proactive and ask the right questions. It is up to you to know how your advisor is compensated and how your investment return is calculated. And if past returns sound too good to be true, don't believe them. Visit http://www.napfa.org/tips_tools to learn more and become a truly savvy, and safe, investor.

from http://www.emarotta.com/article.php?ID=320

Safeguard #1: Do Not Allow Your Advisor to Have Custody of Your Investments (2009-01-12)

Safeguard #1: Do Not Allow Your Advisor to Have Custody of Your Investments

(2009-01-12) by David John Marotta

I was recently asked if investors should trust their financial advisors. And my short answer, you may be surprised to hear, was no.

Given all the greed and deceit revealed last year in the world of financial services, this question of trust could not be more timely.

If your advisor is not a fiduciary, he or she has no legal obligation to act in your best interest. Only about 7% of those working in financial services are fiduciaries, so the odds are your advisor is probably not.

Simply put, the term "fiduciary" applies to those who have the legal responsibility to manage other people's money. Fiduciaries are required by law to act in the best interests of their clients, beneficiaries or retirement plan participants.

Both the National Association of Personal Financial Advisors (www.napfa.org) and the Center for Fiduciary Studies (http://www.fi360.com) require its members to sign and uphold a fiduciary oath. In contrast, brokers and agents are not fiduciaries and often must disclose the following in writing: "Your account is a brokerage account and not an advisory account." And "Our interests may not always be the same as yours."

Being a fiduciary is the bright white line that separates those who sit on your side of the table and legally must act in your best interests and those who sit on the other side of the table and have no such obligation.

In addition to the all-important fiduciary requirement are several other safeguards that you should insist on. Foremost among them is that your financial advisor should not also have custody of your investments.

Custody refers to the entity that is legally responsible for holding your investments and keeping them safe. In the old days, custody literally meant keeping the paper certificates secure. In contrast, a contemporary custodian offers a range of services that investors commonly take for granted.

When securities are bought or sold, the custodian delivers or receives ownership of the shares in exchange for the agreed amount of money. This process, called "settlement," usually takes one to three days after the purchase or sale.

At one time the physical certificates had to be transferred. But U.S. legislation in 1975 enabled markets to use the Depository Trust Company (DTC), a unified central securities depository. Holding securities electronically or in "street name" makes it easier to transfer and keep track of them. Now the certificates do not move physically. Instead they are transferred via book entry settlement between securities account holders called "members" or "participants."

While the securities are being held for you, your custodian provides asset services, which amounts to exercising rights and obligations on your behalf.

Custodians collect all the dividends and interest accrued by the investment. They relay any corporate information or actions that affect your investments and provide a standard and streamlined way for you to receive information, exercise rights or vote proxies.

Having a financial advisor who does not have custody of your assets gives you an extra layer of accountability and oversight. Fiduciaries review potential custodians to determine the best one to house their clients' assets. They analyze the fees and expenses charged in exchange for the services offered. Then fiduciaries keep an eye on the chosen custodian on behalf of their clients.

With a hedge fund or private equity, there is much less accountability. No one--except the individual investor--is watching to see if fees and expenses are reasonable. If the managers of a private equity pay themselves well, their salary is simply an added expense.

The safeguards and monitoring of advisor and custodian work mutually. The custodian sends its own set of statements, a way for you as the investor to double-check what your financial advisor is telling you. Being defrauded is much less likely when you are receiving independent statements.

The custodian also prices your investments, ensuring that everything is really worth what your advisor says it is. When advisors provide their own valuations, they might use the opportunity to manipulate client investments.

Imagine a hedge fund or private equity investment where contributions and redemptions must be requested ahead of time. If net investment flows are into the fund, illiquid assets can be priced high so that investors buy fewer shares. But when net investment flows withdraw money from the fund they can be priced lower, so investors receive less money. If management is also invested in the fund, they can do the exact opposite when moving their own contributions and withdrawals to maximize their profits and minimize that of other investors.

It is even more frustrating when your investments are unknowingly leveraged in nontransparent hedge funds or private equity. Much of your investment may be used as collateral against speculative investments in the hopes of a profit great enough to break high-water marks and justify bonus fees. You may or may not understand these investments. Nor may you understand if they are in your best interest or only in the best interest of your advisor. Using a reputable third-party custodian can help ensure that reporting about your investments is transparent.

Not having custody of your investments may limit some of your advisor's services. So be it. Your advisor can help you with the paperwork to transfer money in or out of your investments but should not handle the money itself. Always make the check out directly to the custodian, never to your advisor.

You can give your advisor limited power of attorney to makes trades on your behalf and take out a fee, but your custodian should both watch out for excessive fees and make withdrawals by your advisor impossible. Your advisor may be able to transfer money between your accounts but only between those you own completely.

Do not allow your advisor to pay bills on your behalf. If paying bills is required, use a third-party service and ask your advisor to make sure it is reputable and honest.

As fiduciaries, we put all of these safeguards into practice to help secure our clients' investments. We instigate these because part of being a fiduciary means avoiding conflicts of interest and implementing secure practices. By separating your custodian and your advisor, you'll have peace of mind, knowing that the fees you are paying are reasonable and your assets are secure.

from http://www.emarotta.com/article.php?ID=319

Compute Your Net Worth Once a Year (2009-01-05)

Compute Your Net Worth Once a Year

(2009-01-05) by David John Marotta

Last year's markets took a heavy toll on your financial plan. You may have been on track at the beginning of the year, but now you must reevaluate. The storm has blown you miles off course, and not making any adjustments is destined to end in a shipwreck.

Everything in the financial markets has changed: energy, financials, real estate, bonds, equities, even the dollar. If you are within 20 years of retirement (age 45 to 65), it's critical to get your retirement planning updated. Computing your net worth annually is like taking a sextant reading to chart your course toward financial security.

Net worth gives you a snapshot of how much money would be left if you converted everything you owned into cash and paid off all your debts. Compute your net worth by creating four lists.

Liquid assets: An asset is something you own that has significant value. A liquid asset can be sold in a matter of days. Include personal bank accounts (checking, savings and money market), certificates of deposit, bonds, mutual funds, stocks and exchange-traded funds. Use values as of December 31 of the previous year so all of your amounts are calculated on the same day.

Nonliquid assets: Nonliquid assets are those things you own that incur a penalty when they are sold. Include the value of your retirement accounts (IRAs, 401ks, 403bs, SEPs, profit-sharing plans and pension plans). Add real estate investments as well as the market value of your home. Use the assessed value.

Other nonliquid assets may include proprietorships, partnerships or company stock in a firm that is not publicly traded. Add the cash value of any life (nonterm) insurance. Some people include jewelry, collectibles, cars and boats in this category. Although these items often have a high retail value, their true worth is often a small fraction of their initial cost. I do not recommend including personal property.

Immediate liabilities: List what you owe to creditors. Immediate liabilities include credit card debt, car loans, student loans, other loans and any bill or debt that must be paid within two years.

Long-term debt: For most people, long-term debt is primarily their home mortgage, but it may encompass other real estate or business loans.

The first time you gather all of this information will be challenging, but it gets much easier each subsequent year. By keeping an annual record of your net worth, you're creating a valuable financial planning tool.

Next compute three additional values. For your total assets, add your liquid and nonliquid categories; for your total liabilities, add your immediate liabilities and long-term debt; and finally, for your net worth, simply subtract your total liabilities from your total assets.

Use these net worth numbers to compute other values useful for reaching your financial goals. For example, your emergency reserve (liquid assets minus immediate liabilities) should be at least half your annual income. Any extra can be invested more aggressively for appreciation. Your debt load ratio (total liabilities divided by total assets) should be under 35%, with your home mortgage comprising most of your debt.

If you are trying hard to pay off your mortgage ahead of schedule instead of making a huge effort to save and invest, your attempts are laudable but mistaken. The quickest path to wealth includes holding a home mortgage you could pay off but you choose not to in order to take advantage of the tax benefits. The rich leverage wisely and invest.

A net worth statement helps you measure your progress toward retirement. At age 65 you can only withdraw 4.36% of your portfolio to maintain your lifestyle. In other words, to keep the same standard of living, you will need about 23 times what you spend annually.

Take your net worth and divide it by your annual take-home pay. The result shows you how many times your annual standard of living you have amassed in savings. If you are younger than 40, the number probably comes to less than five, which is adequate for now.

Progress toward retirement is not linear. This equation, determined by quadratic regression, estimates how much of your current net worth you should have saved given your age. It gives you a benchmark for determining if you are on track to retire by age 65:

Savings should equal 0.0125 x^2 - 0.5746x + 7.4668, where x is your age in years.

The result should be between zero and 23. That number tells you how many times your current annual income you should be worth. The formula is most accurate between ages 45 and 65.

By age 45, you should be worth about seven times your annual spending. More sophisticated retirement planning includes the difference between taxable, tax-deferred and Roth accounts as well as Social Security guesses and defined benefit plans, but the method described here will approximate your progress. This table shows by what age you should have saved different multiples of your annual spending.

If your net worth is higher, congratulations! You may be able to retire earlier than 65. For every 1 unit you are over, you could consider retiring about a year earlier. Conversely, for every 1 unit you are under your age's benchmark, you may have to work an additional year beyond 65.

Between ages 40 and 50, your net worth should increase by 1 unit of your annual spending every two years. That means your current net worth divided by your take-home pay should be 1 unit greater than it was two years ago. And if you are between age 50 and 65, your net worth should have increased this year by one times your take-home pay.

Want to retire younger? Try lowering your standard of living. Most retirees spend about 70% of the gross salary they earned while working. If you can live off 50% of your take-home pay, it's not as essential to save as much.

Need to catch up? Save more than 15% of your take-home-pay. Determine how far you are behind and what additional percentage you can save each year. For example, at age 30, you should be worth 1.5 times your annual income. If your numbers don't match that ideal, an additional 0.3 times your annual income will help you get there. You could save an additional 10% of your income (for a total of 25%) for three years. If that's too much, try saving 20% (an additional 5%) for six years.

Money makes money. By the time you reach your 40s, you should have enough investments to be earning about half of your annual spending each year. Early in life what you save is most important for building wealth, but as you approach age 40 what you earn on your investments becomes critical. While you are young, the best advice a professional can offer is to "save." As you amass significant wealth, it is more pressing to "manage" well what you already have.

All financial planning begins with a clear understanding of your net worth. A PDF template on our website (www.emarotta.com/budget) can help you compute and keep track of your net worth each year. Contact us or visit our website to download a free copy.

from http://www.emarotta.com/article.php?ID=318