Reflecting on 2009 Returns Provides Lessons Going Forward (2010-01-18)

Reflecting on 2009 Returns Provides Lessons Going Forward

(2010-01-18) by David John Marotta and Matthew Illian

Many are breathing a sigh of relief after participating in the largest stock market roller coaster since the Great Depression. Others bailed out at the wrong time and are unsure whether they will ever recover their nest egg. A valuable exercise in January is to review your investment returns in light of what occurred in the broader asset classes.

The unwinding of the highly leveraged real estate bubble continued throughout 2009. But flooding the markets with credit and currency commitments from central banks around the globe staved off further asset price atrophy.

In 2009 we were reminded that sometimes the greater the fall, the bigger the bounce. After hitting a low on March 6, the markets started a fierce climb. Those with nerves of steel were rewarded.

Standard deviation (SD) is a statistical measure of volatility. Although most market movement occurs within 1 SD, 2009 saw a six-month (March through September) S&P 500 growth period of 40.5%, a 3 SD event. Also called "three sigma" events, under normal conditions they are only predicted to appear once every 56 years. Although rare, stock market returns are capricious by nature and regularly exceed the statistical norms for such wild events.

Money flows from equity mutual funds suggest that investors were pulling their money out in record amounts as the market neared the bottom. Many investors were selling at the bottom! In contrast, disciplined investors stick to an established plan to rein in their emotions. Those who regularly rebalance their portfolios used the sharp decline in the markets to acquire stock investments at half the price they were going for only six months prior.

The S&P 500, which represents the largest American-based companies, finished the year up 26.46%. Smaller companies, represented by the Russell 2000, slightly outperformed, ending up 27.17%. This confirmed a long-term trend that suggests small companies tend to average higher returns than their larger counterparts.

Value stocks historically outperform growth stocks. They didn't last year, however. Both small- and large-cap growth stocks were the winners. The Russell 2000 Growth Index was up 34.47% compared to the Russell 2000 Value Index, up 20.58%. One year of outperformance, even by such a wide margin, did not reverse the long-term trend. The Value Index has a 10-year average annual return of 8.27%. But the Growth Index is still in the red at -1.37%.

Weakness in the U.S. dollar (USD) was another strong theme for 2009. Flooding the world with newly printed greenbacks and growing deficits is causing unease across international markets. Many believe the days of holding dollars as the international reserve currency are numbered.

It is difficult for U.S. investors to comprehend the effect of a devalued USD. International investors saw quite clearly the effect of a weakening dollar. Developed international investments as measured by the Europe, Australasia and Far East (EAFE) Index finished up 31.78%. A foreign investment has two moving parts. The first is the stock price, which fluctuates based on the performance of companies in their own currencies. The second part is the currency exchange. If you could strip away the currency exchange, the EAFE Index return would have only been 24.72% with the remaining 7.06% coming from a weakening U.S. dollar.

Investing in countries with a strong currency and healthy balance sheet showed particular strengths. Australian markets finished the year up 66.16% for U.S. investors but only 36.78% if measured in Australian dollars. Investors gained an additional 29.38% from the U.S. dollar weakening against the Aussie dollar.

The largest growth came from the emerging markets. They were up 78.51% in USD, triple the return of developed foreign or domestic indices. Brazil led the pack, finishing the year up 128.06% in USD and 70.48% in local currency. India, Russia and China all had superior performance.

Natural resource stocks, also called hard asset stocks, were up 37.54%. Hard assets include companies that own and produce an underlying natural resource. These include oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel and other resources such as diamonds, coal, lumber and even water. These stocks are unique in that they have a low correlation with other stocks and bonds and they appreciate with inflation.

Those who moved their investments to the supposed safety of Treasury bond investments were deeply disappointed. The Barclays Capital U.S. 1-3 Year Treasury Bond Index finished the year with a meager gain of 0.8%. The Barclay Capital U.S. Aggregate Bond Index (including corporate bonds) finished the year up 5.93%. Foreign bond performance was even better due largely to currency exchange.

Take the time to compute your 2009 returns and review your asset allocation and investment selection. Too many American investors have most of their investments tied up domestically. We suggest you expand your investment mix to include foreign bonds, foreign stocks and hard asset stocks. Adding these to a diversified portfolio of U.S. stocks and bonds will reduce the average volatility of your portfolio while boosting returns over a full market cycle.

from http://www.emarotta.com/article.php?ID=372

Last Chance for a Segregated Roth Conversion (2010-01-11)

Last Chance for a Segregated Roth Conversion

(2010-01-11) by David John Marotta

A tax tsunami is coming at the end of this year. The higher your adjusted gross income (AGI), the closer you live to the coast where the tsunami will hit. This is the last chance you will have to put your assets in a lifeboat and avoid getting swamped with taxes.

At the end of 2010, the Bush tax cuts will expire. The Obama administration is not expected to alter the rates significantly before then. They don't want to be held accountable for raising taxes before the midterm elections. And they would rather blame the previous administration for a crazy expiring tax law.

Right now, tax rates are at a historic low. But after 2010, counting all the tax changes, top marginal tax rates may rise from 44.6% to 62.4%. Thus you will only have to pay a maximum of 44.6% on income you can take before 2011, but after that you may have to pay 17.8% more in tax.

If you have an income over $100,000, this is the first year you can take money from your traditional IRA, pay tax as though that money is ordinary income and convert it to a Roth IRA. This procedure is called a "Roth conversion."

Roth IRA accounts are to your advantage if your tax rate will be higher in retirement when you withdraw the money than it was when you contributed. With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you get a bigger acorn to start with, but you pay tax on the oak. Many families have actually lost money by investing in their traditional IRA when they were young and in a lower tax bracket, only to find themselves in a much higher bracket during their retirement. A year from now, we will all be in a higher tax bracket.

If you execute a Roth conversion this month, January 2010, you do not have to pay the tax on that conversion until April 15, 2011. You also may change your mind. If you decide the conversion wasn't worth it, you can move the money from the Roth account back to a traditional IRA account. This is called a "Roth recharacterization."

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. So if you file an extension you can change your mind any time before October 15, 2011. And you can decide to recharacterize part or all of what you converted.

The upside is that you can use all these laws and changes to maximize your after-tax investments. During the next few years, tax planning and management will be a significant part of wealth management. But it needs to be put together as part of a larger plan.

Here's the timeline of how to use a Roth conversion to maximize your investments. Now is the time to do five Roth conversions of equal amounts into five separate accounts. You aren't going to keep them all, so you can convert five times as much as you want to end up keeping and actually paying tax on. Invest each Roth account in a different asset class (e.g., large-cap U.S. stock, small-cap U.S. stock, foreign stock, emerging markets and hard asset stocks).

The five accounts will appreciate differently, but the entire portfolio will be fairly well balanced. Before April 15, 2011, decide if you will be keeping only one account or more than one. If more than one has appreciated significantly, you may want to keep more than one account's conversion. Compute your tax liability for the year and pay the tax, but instead of filing your return, file an extension.

Before the October 15, 2011, extension deadline, decide which of the five accounts you are going to keep. By now, nearly a year and three quarters has elapsed. You can easily determine which account has appreciated the most. Keep that one, and recharacterize the other four. Because you only have to pay taxes on the amount you originally converted, it's like betting on the horse race after the winner has already been determined. After recharacterizing the accounts, file your tax return before October 15.

If all of the accounts decrease in value, recharacterize them all and pay no tax. Financially, you are none the worse for having filled out a stack of paperwork. If only one account appreciates significantly, you only keep one conversion. But you have increased the odds of your Roth account appreciating by five times.

The average return of the S&P 500 is about 11%, but the standard deviation is about 19%. All of the other asset classes have an even higher standard deviation. It is likely, for example, that emerging markets will be either the best or the worst performing asset class over any two-year period. Using this technique you can guarantee that the Roth conversion you keep will have been invested in the best asset class during that year and three quarters.

Segregating each of the five conversions into a separate account allows you to decide to recharacterize or let each account stand separately. The difference in returns between the average and the best account is liable to be 20% or more over the year and a half before you have to choose which accounts to keep. Coupling the 17.8% tax savings and this Roth segregation technique could boost your returns by 30% or more.

In the quite likely event that all five accounts have appreciated significantly, you may decide to keep them all. Once you have reached the maximum tax rate, the top marginal rate does not increase from there. Those most fearful of expectations of higher tax rates soaking the rich after 2010 would be those most likely to benefit from converting everything.

You are a good candidate for a Roth conversion in 2010 if you have the following characteristics. You have an AGI more than $100,000 and so have not been able to convert previously. You have a large IRA that could be converted. You expect your tax bill to be higher in the future. You have sufficient taxable assets to pay the tax. You would like to reduce the value of your gross estate and leave a tax-free asset to your heirs. You are willing to pay estimated taxes and increased tax preparation fees.

Even thought this technique could boost your after-tax returns, be careful. Executing a Roth segregation account requires professional assistance. Such a technique should be just one small part of a larger comprehensive financial plan. And you should seek the guidance of a personal fee-only financial planner and certified public accountant (CPA) who have a legal obligation to act in your best interests. The laws are changing annually, and as a result so is the optimum path.

from http://www.emarotta.com/article.php?ID=371

Compute Your Net Worth Once a Year (2010-01-04)

Compute Your Net Worth Once a Year

by David John Marotta

Since the end of last year the markets are up about 25%. You may not have been on track at the beginning of last year, but now you should reevaluate again. The wave has propelled you miles toward your goal, and at least once a year you should measure your progress.

Everything in the financial markets has changed again: 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 1 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=370

Seven Financial Resolutions for the New Year (2010-01-01)

Seven Financial Resolutions for the New Year

by David John Marotta

Financial resolutions usually don't even last until the end of January. Making a permanent change in our behavior requires both time and a steely resolve to keep the practice until it becomes habit and finally character. We can only develop financial character one action at a time. Here are seven practices that will take you from pauper to prince or princess if you add one each year.

Read through the list. If you already practice the resolution, move on to the next one. Find the first one that isn't already a practice, and make it your resolution for this year. Adding one behavioral change is labor enough for the next 12 months. If you can keep it long enough for practice to become habit, you are well on your way to developing a millionaire mindset.

Resolve to set the habit in place and keep it for an entire year. Share your resolution with everyone you meet. You are 10 times more likely to act on a goal that you have articulated to someone else. Don't wait until you have everything perfect to take ownership verbally.

First, and most critical, resolve to be and stay debt free. You are allowed to have a fixed-rate fixed-year traditional mortgage on your house but nothing else. No equity line of credit on your house. No car payments. Certainly no credit card debt. You have to learn to live within your income, which sometimes means going without. Millionaires are frugal. Learn to enjoy it.

Second, automate saving enough to get the entire match that your company's 401(k) plan offers. Usually this translates to saving 5% of your salary while the company contributes a 4% match, which is the fastest way to get an 80% return on your money. Studies show that most Americans forgo this match, believing they need to spend 100% of their salary. Don't be foolish. Learn to think like a millionaire. You can learn to live well on 95% of what you make.

Next, fully fund your Roth IRA, which in 2010 will be $5,000 for the year. If you can't manage the entire amount in January, put in $416 monthly. Saving this amount manually is too difficult. It requires remembering every month. Millionaires have their default set at saving money. They make spending money difficult, requiring a manual override.

Automating deposits in an employer-defined contribution plan is easy. Fortunately, automating saving in a Roth IRA or a taxable savings plan is equally painless. Most brokers offer an automatic money link between your checking account and an investment account. Set your savings on autopilot.

Fourth, save an additional 5% of your salary in a taxable account. Again, set up an automated transfer. If your paycheck gets deposited the first of the month, arrange for a transfer of 5% to your investment account on the second or third. You need taxable savings for a host of financial planning opportunities as well as for a plethora of life's challenges.

By now you are saving 15% to 20% of your salary and living off the remainder. Learning to live deferring many of your wants until later is a crucial habit that millionaires have cultivated. Money makes money. And the money you need to make money is called "capital." The textbook definition of capital is "deferred consumption." Money now is spent and gone. Money saved and invested works for you, adding income every year.

Fifth, save an additional 10% for charitable giving. Many millionaires might suggest that being generous with a portion of your income should be first on your list, not fifth. But I've found that until you have your own financial security on track, it is difficult to help others don their own oxygen mask.

No matter where you think charity belongs in your priorities, a sensitivity to the truly needy will change your perspective about distinguishing needs and wants. Many millionaires live simply in order that others may simply live.

Save this additional 10% in your taxable account. By now you are saving 15% in a taxable account. For your charitable giving, gift the investments from the account that has appreciated the most.

No matter which worthy organizations you support, you can donate up to 15% more if you give appreciated stock instead of cash. If you sell $1,000 worth of appreciated stock, you will have to pay the capital gains tax of 15%. If most of the stock's value is appreciation, the tax owed approaches $150, leaving only $850 for charitable giving. But if you give the stock directly to the charitable organization, you can take the full $1,000 tax deduction, and the organization will not have to pay any taxes when it sells the stock.

Up until now I expect you have been giving cash to charities. Now that you are developing some taxable savings, run your giving through your taxable investments. For every $1,000 of appreciated investments you donate, use the $1,000 in cash you would have gifted to buy additional investments. Think of this as planting the saplings you will harvest later for future gifting.

After several years, your $1,000 worth of cash should have grown to $2,000 worth of investments. Gifting a $1,000 worth of appreciated investments leaves the original $1,000 to keep increasing in value and fund future giving. This is one reason why frugal supersavers can be much more generous than those whose rich lifestyles preclude saving and investing.

Sixth, save an additional 10% in your taxable account for unknown unknowns. If your response is to ask, "Like what?" you are not understanding what I mean by "unknown." You can't plan for everything. But you can save cash for the unexpected.

Inevitably, families run up against cash flow problems because of unanticipated expenses. If you are living hand to mouth, your budget cannot handle large unplanned outlays such as the car breaking down, the roof leaking or emergency medical bills.

When a financial crisis strikes, you will be glad you have such a fund. Then, after using the money from your emergency fund, see if you could have predicted the expense, and adjust your plan accordingly. My wife and I learned this way to budget each month for the inevitable expense of buying our next car. The more you can foresee these expenses, the more this category can fund discretional big purchases instead of financial emergencies.

At this point you are saving more than 35% of your salary and living on less than 65%. This is the benchmark for a millionaire mindset. As you save and invest, the appreciation on your investments can provide income that replaces your salary, bringing you closer to financial freedom. When you can replace all of your income, you are free to retire or tackle challenges that do not make any money.

Every 25% of your salary you save replaces over 1% of your regular income in retirement. Money makes money, which then gives you the gift of financial freedom.

The seventh and final challenge is to expand this financial engine beyond 35% toward 50%. Living off half of your income requires a frugal lifestyle in comparison to your income. Impossible, you say? Unless you are among the truly needy, there are families out there living comfortably on less than half of what you earn.

And if you are among the genuinely wealthy, the only obstacle standing in your way is being accustomed to an affluent lifestyle. Learn to value financial freedom over opulence. Developing an engine of wealth production takes foresight and self-restraint in addition to time and patience. But the reward is financial peace and contentment.

from http://www.emarotta.com/article.php?ID=369