THE HAFT
        OF IT
    A collection of the most popular
     financial planning newspaper
               columns by
	
...
© 2007 by TriMark Press, Inc.

This book is intended for general information purposes only. While the
publisher and author...
CONTENTS




About the Author

Introduction

Chapter 1: Retirement Planning
 Five Common Investment Mistakes.................
Chapter 2: Investing (continued)
    Evaluating Performance .................................................................
Chapter 6: IRAs
 Frequently Asked Questions .......................................................................       ...
Chapter 10: Long-Term Care
    Long-Term Care Insurance .....................................................................
ABOUT THE AUTHOR


Alan Haft is a nationally recognized investment advisor who has been
featured in a variety of media out...
PREFACE


As a financial advisor, I find many of the questions investors ask
generally fall into four main areas:
        ...
0


This book is a collection of columns I wrote. Out of all the columns I’ve
written, those found in this book are the on...
INTRODUCTION


Most of us have been on a road trip at some point in our lives. The
trip may have focused on business, or i...
goals. While you may likely have a long-term goal in mind (such as
retirement), you may also have several short-term, inte...
retirement vehicle or at least information covering some of its “basic”
parts. This “how-to” troubleshooting guide will as...
necessarily fit everyone, even though they may be retired. Just because
you’re at the same point in your life – when you s...
ONE
RETIREMENT PLANNING                               CHAPTER              




       Five Common Investment Mistakes
   ...
RETIREMENT PLANNING



of the markets. But you probably know all that, even if you’ve put off
planning.

What you may not ...
RETIREMENT PLANNING                                                        


3. Not calculating your savings needs.
   Mo...
RETIREMENT PLANNING



5. Putting other financial goals first.
   Saving for retirement probably isn’t your only financial...
RETIREMENT PLANNING                                                      




           Considering a Financial Advisor?
...
0                                                     RETIREMENT PLANNING



1. What do the acronyms following the advisor...
RETIREMENT PLANNING                                                       


    How do you know if someone only has an in...
RETIREMENT PLANNING



6. How is the financial advisor paid?
   Some financial advisors are paid by commission, that is, t...
RETIREMENT PLANNING                                                 


                      Financial Designations
CFP – ...
RETIREMENT PLANNING



RR – Registered Representative
RRs have passed a qualifying exam administered by the National
Assoc...
RETIREMENT PLANNING                                                    




   Interviewing Your Next Financial Planner
  ...
RETIREMENT PLANNING



These two topics are more difficult to discuss because financial
planning services vary widely. Som...
RETIREMENT PLANNING                                                


making any recommendations? Does he or she clearly e...
RETIREMENT PLANNING




           Custodial Accounts and Trusts
            Using them to avoid estate taxes
If you have ...
RETIREMENT PLANNING                                                   


One way to make a gift like this is through the u...
0                                                    RETIREMENT PLANNING



You can avoid any possibility of these problem...
RETIREMENT PLANNING                                                     




     Employer-Sponsored Retirement Plans
    ...
RETIREMENT PLANNING



1. A rollover IRA may provide better investment options.
   Some people feel that keeping retiremen...
RETIREMENT PLANNING                                                      


3. The mutual funds available through your cur...
RETIREMENT PLANNING




              Year-End Checklist
  The top 10 money matters you don’t want to miss
Wait! Hold off ...
RETIREMENT PLANNING                                                


    withdraw the remainder of the total RMD amount f...
RETIREMENT PLANNING



6. Think about gifting.
   At the time of this writing, you can gift up to a total of $11,000 per
 ...
RETIREMENT PLANNING                                                    


10. Make your IRA contributions.
    You can mak...
RETIREMENT PLANNING




                Will Your Well Run Dry?
                 Preparing for retirement
Baby boomers – t...
RETIREMENT PLANNING                                                     


previous Federal Reserve Chairman Alan Greenspa...
0                                                      RETIREMENT PLANNING




So how can you solve the problem? How can y...
TWO
INVESTING                                      CHAPTER                 




           The Benefits of Diversification...
INVESTING



Different asset classes – such as domestic stocks, international stocks,
bonds, real estate, commodities, and...
INVESTIN G                                                                            




 Year        Best Performer    ...
INVESTING



Let’s say that you and your financial advisor agree that a 60% equity/40%
income split is appropriate for you...
INVESTIN G                                                           


standard asset classes, and make sure to rebalance...
INVESTING




                   The Index Advantage
           and Exchange-Traded Funds
         Play the market with le...
INVESTIN G                                                               


health care stocks and real estate investment ...
INVESTING



one example). One thing you’ll want to watch out for, whichever you
choose, is the fees. Before you invest, c...
INVESTIN G                                                             




                Small Company Stocks
         ...
0                                                                 INVESTING



the economy than larger companies can (whic...
INVESTIN G                                                             



               Market as a       Large-Cap Stoc...
INVESTING




            Real Estate Investment Trusts
                    Is the boom over?
Real estate investment trust...
INVESTIN G                                                            


Like most securities, REITs have historically exp...
INVESTING



Regardless of which asset class or REIT sector you’re looking at, you
always want to buy out-of-favor compani...
INVESTIN G                                                            




                Evaluating Performance
        ...
INVESTING



Market capitalization, a measure of a company’s size, is the total dollar
value of all outstanding shares of ...
INVESTIN G                                                        


Russell 1000 Growth Index
   Measures 1,000 large-cap...
INVESTING




               Portfolio Rebalancing
     A declining market presents good opportunities
With the domestic s...
INVESTING                                                            


There are any number of circumstances that could p...
0                                                               INVESTING



If you do sell some of your investments, you’...
INVESTIN G                                                           




                6 Things Dating Teaches
        ...
INVESTING



     car he drove had a weird putter that attracted nothing but aliens
     from the evil Planet X. While at ...
INVESTIN G                                                              


     fees you were paying, only to realize the ...
INVESTING



4. Cut the losers, ride the winners
   Dating: The first handful of dates were the stuff legends are made
   ...
INVESTIN G                                                             


     So you rolled the entire 401(k) into an IRA...
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Haft of it

  1. 1. THE HAFT OF IT A collection of the most popular financial planning newspaper columns by ALAN HAFT
  2. 2. © 2007 by TriMark Press, Inc. This book is intended for general information purposes only. While the publisher and author have utilized their best efforts in preparing this book, they make no claims or warranties with respect to the accuracy or completeness of the contents. The information may not be applicable to you and is intended for general demonstration purposes only. There are many exceptions to the general principles stated herein. Before you apply or act on this or any other legal, investment, funding, tax, insurance or other financial information, you should consult with a financial planner who can evaluate the facts of your specific situation and advise you on the proper course of action based on that evaluation. All rights reserved. No portion of this publication may be reproduced or transmitted in any form or by any means, electronic, mechanical or otherwise, including photocopy, recording, or any information storage or retrieval system now known or to be invented without permission in writing from the author, except by a reviewer who wishes to quote brief passages in connection with a review. Requests for permission should be addressed in writing to the author. ISBN: 978-0-9767528-7-5 Published in Boca Raton, Florida, by TriMark Press, Inc. 800.889.0693 Printed and bound in the United States of America. Alan Haft alanhaft.com 800-809-4699 DISCLAIMER Everyone’s personal situation is uniquely different. Investments, taxes and estate planning concepts addressed during the course of the book are complex subjects. With this in mind, please be sure to consult with a qualified tax, estate and/or investment advisor(s) before any action is taken. Furthermore, because articles in this book are reprints from various newspaper columns, some of the information might be outdated.
  3. 3. CONTENTS About the Author Introduction Chapter 1: Retirement Planning Five Common Investment Mistakes............................................................... 15 Considering a Financial Advisor? ................................................................. 19 Interviewing Your Next Financial Planner ..................................................... 25 Custodial Accounts and Trusts ...................................................................... 28 Employer-Sponsored Retirement Plans .......................................................... 31 Year-End Checklist ........................................................................................ 34 Will Your Well Run Dry?............................................................................... 38 Chapter 2: Investing The Benefits of Diversification ....................................................................... 41 The Index Advantage and Exchange-Traded Funds....................................... 46 Small Company Stocks .................................................................................. 49 Real Estate Investment Trusts ........................................................................ 52
  4. 4. Chapter 2: Investing (continued) Evaluating Performance ................................................................................ 55 Portfolio Rebalancing .................................................................................... 58 6 Things Dating Teaches Us About Money .................................................... 61 7 Ways to Save $100 per Month ................................................................... 66 Chapter 3: Income More Income, Less Risk ................................................................................ 71 Build a Bond Ladder ..................................................................................... 75 The Power of Dividends ............................................................................... 85 Preferred Stocks ............................................................................................ 88 Real Estate Without the Headache ............................................................... 91 Government-Backed Mortgage Securities ..................................................... 94 Chapter 4: Bonds Understanding the Effect of Interest Rates..................................................... 97 The Attraction of Bond Funds ..................................................................... 101 Chapter 5: Annuities Index Annuities .......................................................................................... 105 Variable Annuities ...................................................................................... 110 When You Need the Cash Now ................................................................... 113
  5. 5. Chapter 6: IRAs Frequently Asked Questions ....................................................................... 117 Converting to a Roth IRA............................................................................ 120 Liquidate Your IRAs? .................................................................................. 123 Beneficiaries and Required Distributions .................................................... 127 Extending the Life of Your IRA ................................................................... 130 Create Your Own Private Pension Plan ....................................................... 132 Self-Directed IRAs ...................................................................................... 137 Chapter 7: Taxes Understanding Tax Efficiency ..................................................................... 141 Taking Advantage of the 2003 Tax Act ....................................................... 144 The New Tax Law ........................................................................................ 147 Reducing Capital Gains and Estate Taxes ................................................... 150 How Will You Spend Your Tax Refund? ....................................................... 153 Chapter 8: Economy Not Concerned about the Federal Budget? ................................................... 157 Currency Values .......................................................................................... 160 The Price of Crude ...................................................................................... 163 The Threat of Inflation ................................................................................ 166 Chapter 9: Estate Planning Isn’t a Will Enough? ................................................................................... 169
  6. 6. Chapter 10: Long-Term Care Long-Term Care Insurance ......................................................................... 173 Medicaid Eligibility .................................................................................... 176 Medicare Prescription Drug Plans ............................................................. 179 Chapter 11: Gifting The Gift of a Lifetime ................................................................................. 181 Chapter 12: Education Not for School Only ................................................................................... 185 Chapter 13: The 10 Commandments of Investing .................................................................................................................... 189 Conclusion .................................................................................................................... 193
  7. 7. ABOUT THE AUTHOR Alan Haft is a nationally recognized investment advisor who has been featured in a variety of media outlets including Money Magazine, Forbes, Morningstar, BusinessWeek, The Los Angeles Times, The Chicago Tribune and many others. His financial column“The Haft of It”appears in a variety of newspapers around the country and he has two books soon to be published including “The 10 Most Common Mistakes People Make With Their Money… and how to avoid them” and “You Can Never Be Too Rich… simple and essential investment advice you cannot afford to overlook”(John Wiley Sons, November 2007). With his partners, he has conducted hundreds of financial planning seminars and workshops. The firm currently services retirees and pre- retirees in southeast Florida, southern California, the New York Tri- State area and many other areas around the country. For more information, please visit www.alanhaft.com
  8. 8. PREFACE As a financial advisor, I find many of the questions investors ask generally fall into four main areas: • How do I keep my money safe? • How do I keep my money growing ahead of inflation? • How do I minimize taxes for myself and for heirs? • How do I make sure I do not outlive my money? These concerns kept arising during many conversations with clients and over the years, I felt I should create some type of written material to answer them. I felt if I could just address the most frequent concerns and misconceptions about various financial topics, I believed a lot of people could benefit from some informal handouts. So that’s what I did. I wrote a few answers to the “frequently asked questions” and put together some handouts for people coming into our office. One of the individuals who came in to meet with me had a contact with a local newspaper and as a result, he asked if I’d be interested in providing information in the form of a column. That’s when my financial column – “The Haft of It” – was born. A positive response from readers led the newspaper to ask for more content and pretty soon, other papers were carrying the columns as well. Using the feedback I received after the publication of my first few columns, I wrote the next set. Whether readers wanted to know how dividend- paying stocks worked or where they could get a better return on their CDs, I answered their questions with more and more columns. Eventually, the columns were distributed in papers and various media outlets across the country.
  9. 9. 0 This book is a collection of columns I wrote. Out of all the columns I’ve written, those found in this book are the ones that generated significant feedback, questions, and, quite frankly, the most “thanks for writing that” comments. Some issues are timeless, while others will one day become outdated. Regardless, for now and the foreseeable future, these issues underscore the importance of understanding what’s happening with your money even if you’re looking to others for advice. *Note to readers: Everyone’s personal situation is uniquely different. Investments, taxes and estate planning concepts addressed during the course of the book are complex subjects. With this in mind, please be sure to consult with a qualified tax, estate and/or investment advisor(s) before any action is taken. Furthermore, because articles in this book are reprints from various newspaper columns, some of the information might be outdated.
  10. 10. INTRODUCTION Most of us have been on a road trip at some point in our lives. The trip may have focused on business, or it may have been for pleasure. In either case it required preparation and much of that preparation is similar, regardless of the trip’s purpose. If you want your trip to be successful and uneventful, there are always a few necessary steps to take before you hit the road. Of course, the first step you must take before setting out on your journey is to first determine your intended destination. It may be across the border into another country, into another state or down the block. But even if it’s local, you still need to plan your route. Whenever you’re headed into an area that you’re unfamiliar with, you will likely need some sort of road map. Longer journeys will require plotting out highways and other major thoroughfares. Then, once you get into an unknown city or town, you will most certainly need a more detailed street map to get you to your destination. Now, what about your vehicle or how you’ll actually get to your destination? The make and model doesn’t matter so much as does its condition. Is it in good shape? Are all of its systems operating correctly? Do you have a full tank of gas? Have you checked the oil and tire pressure? You need to make sure all of the parts of your vehicle are operating before you head out on your trip. You certainly don’t want to break down somewhere along the road. Your financial future is really no different. Your first step is to at least have some idea of where you’re going or, better stated – your financial
  11. 11. goals. While you may likely have a long-term goal in mind (such as retirement), you may also have several short-term, intermediate goals. You may wish to purchase a second home, help your children with various expenses or make donations to charities. With proper foresight, you can arrange to arrive safely at both your long-term and short-term destinations. Yet besides knowing your destination, or goal, you’ll also need a good road map and a sound vehicle. Many of my clients are retirees or they’re near retirement. When they’ve arrived at their destination – in this case, retirement – their lifestyle changes and so must their route, or their investment strategy. They’ve been accustomed to investing for growth and wealth accumulation, making as much money as possible so they could live off their portfolio in retirement. But many times, once they retire, they often forget that their destination has changed – they’ve already reached retirement. Now that they’re in their retirement years, their plans for getting to their destination and the investing habits and strategies they’ve been using need to change as well. The bumpy dirt roads they’ve traveled in the past should be replaced with paved freeways. They must make the transition from wealth accumulation to wealth preservation and in later years, the focus should be on wealth transfer. Most importantly, your vehicle must be prepared for retirement, since once you arrive at retirement years, you’ll be driving this same vehicle presumably for the rest of your life. Most of us won’t have much of an opportunity to build additional wealth, and that’s not what retirement is about anyway. If you’re like most people, you’ll want to be able to enjoy your post-work life as much as you can and make certain you can afford ongoing living expenses as well as have money for the things you’d like to do and were probably looking forward to for all those working years. What good is it to have a retirement vehicle if you can’t play a round of golf every once in a while or go off on some of those adventures you’ve been thinking about? That can only happen if you have at least a basic understanding of how your vehicle operates. Wouldn’t it be helpful if you had a manual of some kind so you could at least become familiar with your retirement vehicle? Consider the columns that follow – and this book – as a helpful manual for your
  12. 12. retirement vehicle or at least information covering some of its “basic” parts. This “how-to” troubleshooting guide will assist you in steering through the years up to retirement and making sure your retirement vehicle itself is kept in good working order. While this book is not meant to be an encyclopedia of retirement that covers all issues, The Haft of It columns were created to help clients understand some of the basics of what drives an investment vehicle. These are the areas I’ve received many questions about and the columns that resulted in the greatest amount of feedback. They will help you learn how to monitor the gauges and what to look for while you’re on the road, to make sure your engine isn’t low on oil or you don’t run out of gas. The following chapters cover a variety of subjects. After all, to build a well-performing vehicle, you cannot only focus on the fuel. You need to consider the oil, transmission, steering system, air filter, spark plugs, belts, tires, radiator, etc. Ignore one thing and the entire vehicle could easily break down. These components together drive your retirement vehicle. Although all of the parts are important, the columns are grouped by subject matter and are not necessarily in any order of priority. Not only are investments covered in this book, but other areas of financial planning as well. If properly monitored and adjusted, they will also help you get to where you want to go. Parts of your retirement vehicle include money, taxes, fees, estate planning, medical planning and a long list of other things.You don’t need to know who makes your radiator coolant, however, you do need to know when you’re having a problem that involves your radiator. That means monitoring your dashboard gauges to make sure your vehicle isn’t overheating. And if something does break down, you need to be able to pull out the manual from the glove compartment to get a better idea of what’s going on. When a prospective client asks “What can you do for me?” I answer that I can help them very clearly define their financial goal, or destination, and then help them match that goal as precisely as possible with whatever products, or components, will best get them there. One particular vehicle, or combination of components, doesn’t
  13. 13. necessarily fit everyone, even though they may be retired. Just because you’re at the same point in your life – when you should be protecting the wealth you’ve accumulated – does not mean you should have the same investments, insurance, etc., as everyone else. You may need a Mercedes, while a Cadillac or Lincoln is more appropriate for someone else. One is not necessarily better than the others. All three vehicles will carry you through retirement but in a slightly different way. While there are many good “components” on the market that will help drive your vehicle, everyone’s needs are different and these parts must be considered on an individual basis. One thing in planning for retirement does not change: You’ll still need to review your map, or your investment plans, regularly to make sure you’re on course. Comparing your actual performance to what you had planned is the only way you will know whether you’re on track. Construction zones, detours, and accidents may occur over time and can delay your progress if you’re not alert. These unexpected incidents may require you to change your route, or the roads you are using to get you through retirement. Routine vehicle maintenance will also be required from time to time. But if you keep an eye on your destination, your map, and your vehicle by monitoring its gauges, you’ll be able to alter your route slightly, replace a couple of components now and then, and stay on the road. It’s only through your understanding of what’s needed and your regular involvement that you will be able to ride through your retirement years safely and comfortably. So from me to you, here’s hoping that your retirement vehicle will be able to take you on the wonderful trip you envisioned – with beautiful scenery, interesting places, and memorable people. May the operating manual provided here help ensure that you’re well-prepared for whatever you encounter. And when it’s time to hand your keys over to the next generation, may they inherit a vehicle that’s not only served you well, but one that will provide a nice ride for many more miles to come. Happy driving…
  14. 14. ONE RETIREMENT PLANNING CHAPTER Five Common Investment Mistakes How many are you making? So you think you’re ready for retirement? Don’t be so sure. With people today living longer and leading more active retirement lifestyles than in the past, you may need to set aside more money and invest differently than you had planned. You’ve probably heard the saying “people who fail to plan, plan to fail”.That certainly holds true when it comes to your retirement. To have the best chance of living in the style you’ve become accustomed to during your earning years, it’s essential that you make time as soon as you can to properly plan for the years when you won’t be actively employed. Coming up short could be a rude awakening when you’ve already decided to stop working at a certain age. Starting sooner is always better. It requires you to set aside fewer dollars at a time, gives your money a longer period in which to grow, and makes it easier for your investments to weather the ups and downs
  15. 15. RETIREMENT PLANNING of the markets. But you probably know all that, even if you’ve put off planning. What you may not know is that there are strategies than can help you maximize your investment dollars, which aren’t always so obvious. There’s also much more to retirement planning than just saving and investing. There are tax issues, estate planning, and the list goes on. Of course you can always seek the advice of a qualified financial advisor if you need assistance, yet finding the right financial advisor takes some planning too. In this chapter, we’ll cover some retirement planning points you need to know about so you can make sure that you have the retirement you deserve. We’ll start with a list of five common mistakes that people make when planning for retirement. 1. Thinking it’s too late to start planning. Once you reach your 50’s or 60’s, it may seem too late to start investing. After all, how can you possibly accumulate enough money to make a difference when you retire? Fortunately for you, thanks to the power of compounding, boosted by the tax-deferred growth offered by individual retirement accounts (IRAs), 401(k) plans, and annuities, it may not take as much as you think to build up a sizeable nest egg. 2. Underestimating your life expectancy. Although you may think you have an idea as to how long you’ll live in retirement, life expectancies are increasing and you may need to plan for a much longer retirement than you initially anticipated. Almost 20% of workers expect their retirement to last 10 years or less, while an additional 15% expect their retirement to last 11 to 19 years. But according to the 2000 Retirement Confidence Survey by the Employee Benefit Research Institute (EBRI), half of the men who reach age 65 have an additional life expectancy of approximately 17 years, while half of the women reaching age 65 can expect to live for about another 21 years.
  16. 16. RETIREMENT PLANNING 3. Not calculating your savings needs. Most financial planners will tell you to plan on needing 60% to 85% of your pre-retirement income to maintain your standard of living in your retirement years. I’ve heard another “simple” formula that merely says you should multiply your annual income requirement times 25. Yet can you really predict how much you’ll need based on general percentages or formulas? According to the EBRI survey, only 53% of those currently employed have tried to determine how much money they’ll need to save by the time they retire. And half of the workers who did try to estimate their financial requirements in retirement increased their investments or changed their asset allocation as a result of their calculations. This suggests that many people may not be correctly estimating the amount of money they’ll need when they retire. But with software and online calculators, it’s easy to work through that equation properly. Quicken offers a calculator, as do many mutual fund companies. One fund company in particular – T. Rowe Price www.troweprice.com – has some of the best tools available, such as my personal favorite, their Retirement Income Calculator. 4. Not taking inflation into account. Many investors, particularly those who are older, are uncomfortable with market volatility. As a result, they invest solely in Treasury bills, fixed-rate CDs, and savings accounts. What they may not realize is that doing so will likely eat away at most of their investment return because these vehicles tend to provide rates close to or less than inflation. As you approach retirement – and even after you’ve retired – it’s important to consider keeping some of your money in growth investments, such as stocks and low-cost stock mutual funds.You need a higher rate of return so your money will continue to grow and you can stay ahead in the investing game. Needless to say, if you are at a much later stage of retirement, vehicles such as CDs and other safe instruments are completely acceptable, especially if they are generating the income one requires.
  17. 17. RETIREMENT PLANNING 5. Putting other financial goals first. Saving for retirement probably isn’t your only financial goal. You may also be saving for your children’s or grandchildren’s college education, or for the down payment on a second home. While these other goals are certainly important, it’s not a good idea to place them ahead of a financially secure retirement. It’s easier to fund your retirement account with smaller amounts of money now than try to catch up later. You’ll also lose the advantage that comes from years of compounding and tax deferral if you wait until you’ve funded your short-term goals first.
  18. 18. RETIREMENT PLANNING Considering a Financial Advisor? Key questions to ask. According to some estimates, half a million people in the United States call themselves financial advisors. But not all are. By legal definition, a “stockbroker” is not a “financial advisor”. At the time of this writing, the definition of a “financial advisor” is very murky, and there are a lot of debates going on as to whether or not someone can use this title with only a “stockbroker’s” license. Personally, although the ability to “pick” investments does require talent, I firmly believe entrusting your retirement to a person who only has a stockbroker’s license is a dangerous proposition given, that there are so many other important parts to one’s overall retirement vehicle. So how do you know if the person you’re considering is really qualified? That’s pretty tricky. Needless to say, a great recommendation is always helpful, but from the feedback I’ve gotten across the country a “great recommendation” is often tough to find. Here are some key points to keep in mind when making your decision:
  19. 19. 0 RETIREMENT PLANNING 1. What do the acronyms following the advisor’s name (if any) really mean? It’s important that you understand the alphabet soup. The letters following a financial advisor’s name can stand for education, experience, or registration with a trade association. (See the accompanying list on page 23 for a guide to the definitions of some of the more common financial designations.) 2. Is this person really a financial advisor? Know what’s behind the “financial advisor” title. As I mentioned above, many stockbrokers call themselves financial advisors when, in fact, they are not. Generally, a Certified Financial Planner and a Registered Investment Advisor (RIA) is truly a financial advisor due to licensing and educational requirements. Personally, I would not consider anyone to watch over my investments unless they had this license or were a Certified Financial Planner (CFP). 3. What licenses does the financial advisor hold? The National Association of Securities Dealers (NASD) works to protect the public by requiring individuals to pass a Registered Representative (RR) exam before they can sell a product. The two major exams and related licenses are the Series 6 and Series 7. A financial advisor who holds a Series 6 license can sell only mutual funds and variable annuities, which is fine if that’s all you want to buy. But a financial advisor who holds a Series 7 license can sell you many types of securities – except commodities and futures – which gives you more investment options. Given someone with a Series 6 license can only sell you mutual funds or variable annuities, I would recommend considering someone with a Series 7 license to compare plans. At the far end of the extreme are individuals promoting only insurance products such as fixed annuities and/or life insurance. These people can’t recommend any securities products, such as bonds, which are often a staple of many people’s retirement portfolios.
  20. 20. RETIREMENT PLANNING How do you know if someone only has an insurance license and nothing else? Easy, check out their business card. Someone with a securities license will always have the name of their broker-dealer in the small print of the card, most of the time starting with the words “securities offered by”. Now, to make matters a bit more complicated, someone can be a Registered Investment Advisor but not have a broker-dealer. To make it simple, follow this simple rule of thumb: If there is no broker-dealer fine print on the bottom of the business card, ask the person if they are a Registered Investment Advisor. If the answer is no, then chances are very high that they only have an insurance license. Some of the best financial plans I’ve seen have come from insurance advisors who do not hold securities licenses. Yes, there are a couple of spectacular ones out there. In fact, in one chapter of this book I’ll outline an income plan that doesn’t include any securities products, and it’s easily one of the best income strategies around. 4. Have you checked out the financial advisor’s background? Before you hire a financial advisor, verify his or her credentials with the NASD. You can do this by visiting the NASD Web site at www.nasd.com. When you get to the page that shows the financial advisor’s information, you will see a section labeled “disclosure events.” If this term is highlighted, the financial advisor may have had legal problems related to his or her business or otherwise. If you request additional information about the issue, the NASD will mail it to you within 10 days. 5. Has the financial advisor explained risks and rewards? There is no such thing as the perfect investment, and a good financial advisor will explain that. Don’t agree to work with anyone who has“the perfect investment”or doesn’t very clearly explain the advantages and disadvantages of what he or she is recommending. No disadvantages discussed? Then it’s simple – walk away.
  21. 21. RETIREMENT PLANNING 6. How is the financial advisor paid? Some financial advisors are paid by commission, that is, they take a percentage of every transaction they make on your behalf. Some are paid a fee, which is often a percentage of the assets they manage for you each year. Some are paid by the hour. And some are paid by a combination of commissions and fees. Be sure you know how the financial advisor you are considering is going to be paid and how much he or she charges. A good financial advisor will also explain any additional fees, such as those you will pay for any load funds that are purchased for you. Generalizing which type of fee arrangement you should consider is very difficult. Everyone’s situation is different. What might be right for one could be entirely wrong for another. But understanding the fee arrangement and how the advisor is getting paid is critical to know before any commitments are made. More on this in the next chapter.
  22. 22. RETIREMENT PLANNING Financial Designations CFP – Certified Financial Planner CFPs have obtained three years of financial planning experience, passed several exams, and meet continuing education requirements. They can offer a broad range of advice on financial planning, investments, insurance, taxes, retirement planning, and estate planning. CFA – Chartered Financial Analyst CFAs have earned a college degree, completed at least three years of study, been tested by the Association for Investment Management and Research, and meet continuing education requirements. They are generally money managers and stock analysts. ChFC – Chartered Financial Consultant ChFCs are typically life insurance agents who have completed coursework in financial planning, passed an exam, and obtained three years of financial planning experience. They generally provide all- around financial planning with an emphasis on insurance. CPA – Certified Public Accountant CPAs are required to pass a rigorous national exam and meet continuing education requirements. They can advise you on income tax, investment and estate planning issues. PFS – Personal Financial Specialist PFSs are CPAs who have received accreditation from the American Institute of Certified Public Accountants (AICPA). This accreditation requires that a PFS prove financial planning experience, pass an exam, and submit references every three years. RIA – Registered Investment Advisor RIAs are usually financial professionals, such as accountants and insurance agents, who have registered with the Securities and Exchange Commission (SEC) or individual states. The title does not constitute an endorsement by either or require an adherence to a code of behavior.
  23. 23. RETIREMENT PLANNING RR – Registered Representative RRs have passed a qualifying exam administered by the National Association of Securities Dealers (NASD). They are generally sales representatives for a brokerage firm. Their expertise is in selecting and monitoring stocks, bonds, mutual funds, and other financial products.
  24. 24. RETIREMENT PLANNING Interviewing Your Next Financial Planner Discuss fees as well as services I believe that virtually anyone with a decent income can benefit from the services of a financial planner, and by financial planner I don’t mean a broker whose only interest is obtaining a commission on a financial product. I’m referring to a professional who will assess every aspect of your financial life – from savings to investments to insurance – and help you develop a detailed strategy for meeting all of your financial goals. It’s usually easy to find financial planners in your area. You can look through listings in the phone book or get recommendations from friends and colleagues. But how do you know which one to hire? Before deciding on a financial planner, you’ll want to interview several, and you’ll want to ask all of them questions about their education and experience. But most people know this. What’s more difficult is interviewing financial planners about their investment approach and fee arrangements – two subjects that may be closely tied together.
  25. 25. RETIREMENT PLANNING These two topics are more difficult to discuss because financial planning services vary widely. Some planners offer only investment advice, some offer estate planning, and others even do your taxes. The fee structure that financial planners use to charge for their services also varies widely. Some charge either a fixed or hourly fee for the time it takes to develop your financial plan, but they don’t sell investment products. Some simply receive commissions on the products they sell. And still others are paid by a combination of fees and commissions. When hiring a financial planner, then, it’s important to know in advance exactly what services you think you’ll need and what services the planner can deliver – and to ask how much those services cost, as well as how the planner gets paid. For example, if you need a comprehensive investment plan but are willing to invest your funds yourself, a financial planner who charges by the hour may be your best choice. After obtaining a clear understanding of your financial goals and risk tolerance, the financial planner will develop an asset allocation plan for you – that is, tell you how much of your money you should have invested in different asset classes such as stocks and bonds. He or she will then recommend some specific investments to help you achieve that asset allocation, but you’ll do the actual investing yourself. On the other hand, if you already have a number of investments with different firms, and you want a financial planner to manage your money on an ongoing basis, and maybe even do some estate planning for you, consider a planner whose fees are asset-based. In other words, you pay the planner a percentage of the assets you have invested on an annual basis, and the planner provides all the services you need. In this case, it’s important to understand what you’re getting. Exactly what services will the planner provide? How regularly will the planner provide those services? Will you always be working with the planner directly, or will other people be involved? Finally, you’ll want to listen to how each financial planner answers your questions. Does the planner seem genuinely interested in learning more about your personal situation, such as your risk tolerance, before
  26. 26. RETIREMENT PLANNING making any recommendations? Does he or she clearly express that there are no guarantees when it comes to investing? Remember, you’re looking for someone who will tailor a financial plan for you and won’t promise more than he or she can deliver. Forget about the planners that make everything sound way too easy, such as getting you returns of 12% per year without any problem. Those are just accidents waiting to happen. If you don’t feel comfortable with a planner you’re interviewing, for any reason, interview someone else. This is a person you’ll ideally want to be working with for a long time to come.
  27. 27. RETIREMENT PLANNING Custodial Accounts and Trusts Using them to avoid estate taxes If you have an estate that is large enough, a share of what you would like to leave to your heirs may go to the government in the form of estate taxes when you die. But it doesn’t have to, if you know how to make use of custodial accounts and trusts. One way to avoid, or at least reduce estate taxes is to give away some of your assets during your lifetime. However, when you give a gift, you may be subject to paying gift taxes, which are levied on yearly gifts valued at more than $12,000 per year per “giver”. But remember, gifts in amounts up to $12,000 per year, per giver, are not taxed. So if you and your spouse each transfer $12,000 annually (for a total of $24,000 per year) to a custodial account for 15 years, at the end of that time period you will have transferred $360,000 and saved over $100,000 in income taxes (if you’re in the 28% tax bracket). Even better for your heirs, if you invested that money, it will have grown to even more. Suppose you invested that $24,000 once a year and received a hypothetical annual return of 6%. That investment would be worth $558,623 at the end of the 15 years.
  28. 28. RETIREMENT PLANNING One way to make a gift like this is through the use of a custodial account, such as a Uniform Gift to Minors Act (UGMA) account or Uniform Transfer to Minors Act (UTMA) account. Both of these accounts are a type of trust set up for the benefit of a child. You can open such an account at a bank or through a mutual fund company, naming a custodian and contributing to the account. Then, when the child reaches the age of maturity, he or she is entitled to take over the account. Just to note: Technically speaking, once you’ve gifted the money, you cannot take it back for your own use. These accounts are well-suited to relatively small dollar amounts because they’re easy to set up and relatively inexpensive to maintain. However, there are some caveats to keep in mind when establishing one. First, don’t name yourself as the custodian of the account. If you do, and you die before the account terminates, the money in it will be included in your estate – exactly what you wanted to avoid! This is true even though the transfers to the account have been completed. It’s better to name someone as a custodian who will not make any gifts to the account, such as an uncle or myself (just kidding). Second of all, you may use the funds in the account for the child’s benefit, but be careful. The Internal Revenue Service (IRS) contends that if you are a parent setting up an account, you have a legal obligation to support your child, so if it appears that you are using any of the money in a UGMA/UTMA account to support the child instead of doing so yourself, the IRS may claim that any income from the account will be taxed to you, not to your child. In addition, there is little-established guidance on this issue. Some tax experts argue that the UGMA/UTMA law contains language designed to prevent parents from being taxed on custodial account income when the account is used for purposes that fall within the parent’s support obligation. Others say the law is unclear. So be forewarned that this may be an issue.
  29. 29. 0 RETIREMENT PLANNING You can avoid any possibility of these problems, and many others, by establishing a trust instead of a custodial account. Yes, there are additional costs involved, but they may be less than you expect. And if you’re dealing with a large sum of money, the advantages may far outweigh the cost. Discussing your plans with a financial advisor will help you to more fully understand your options.
  30. 30. RETIREMENT PLANNING Employer-Sponsored Retirement Plans Should you roll yours into an IRA? Around 47 million Americans are participating in qualified employer- sponsored retirement plans. Undoubtedly, these people think they’re taking control of their financial future by investing in a 401(k), 403(b), or government 457 plan. But are they? Employer-sponsored retirement plans are a great way to save for retirement. However, a problem arises when you keep accounts with several past employers. Holding your accounts in many different places can make it difficult to manage your investments effectively as your goals, and the markets, change. Whenever I encounter people in this situation, I often suggest that they take control of their retirement assets by moving them from those employment accounts to a rollover individual retirement account (IRA). Here are three reasons why:
  31. 31. RETIREMENT PLANNING 1. A rollover IRA may provide better investment options. Some people feel that keeping retirement plans with several different employers is a good way to diversify their investments. In reality, most employer-sponsored retirement plans offer very limited investment options. That limitation could put your retirement savings at risk, particularly if your savings are concentrated in just a few funds or your employer’s stock. In contrast, rollover IRAs offer a variety of investment options, allowing you to better allocate your retirement funds according to your personal investment goals. On the flip side of this, every once in a while I meet a person who has money in an employer’s retirement plan with a rate that absolutely cannot be found anywhere else. For example, the New York Teacher’s Union (at the time of this writing) still maintains a fixed account that pays better than 7% per year. A fixed interest rate such as that is impossible to find anywhere else, and it’s for this reason I would tell those people not to roll their money into an IRA because they’ll never (again, at time of this writing) be able to replace it in a rollover, self-directed IRA. It’s sad to think there are financial advisors out there trying to roll this money into an IRA for their own benefit, not the client’s. With that said, it’s very rare that I see an instance where someone cannot at least equal the returns they are getting in their employer- sponsored account, but it’s important to consider. 2. It can be difficult to manage investments spread between multiple retirement plans. If you have more than one retirement account, consolidating your retirement assets into a single rollover IRA can make managing them easier. There will be considerably less paperwork, which will aid in tracking your investments. Additionally, keeping retirement assets in one place simplifies beneficiary designations and estate planning.
  32. 32. RETIREMENT PLANNING 3. The mutual funds available through your current retirement plan may have high expense ratios. A small savings of even half a percentage point in mutual fund expenses can mean thousands of dollars more in your pocket over a few years. If you’d like to see a demonstration, try using the mutual fund cost calculator available from the Securities and Exchange Commission (SEC). Just go to www.sec.gov and click on “Calculators for Investors” under “Investor Information.” Note that when you request a direct rollover into an IRA, no money is actually distributed to you; it moves straight into the IRA. As a result, you’re not taxed (until you withdraw the money later), and 100% of your retirement assets can continue to grow tax- deferred. Keep in mind that moving assets into a rollover IRA isn’t always the best choice. For example, if you have a retirement account with just one employer, and you have numerous investment options and pay low fees, it might make sense to leave your retirement assets where they are. Should you decide that moving your assets into a rollover IRA is right for you, check with the company’s retirement plan administrator (who is typically part of the benefits or human resources department) to determine whether there are any restrictions on rollovers before you do so. If you have a retirement plan with a current employer, you may not be able to roll over assets from that plan into an IRA. Most retirement plans restrict rollovers while you are employed by the company that offers the plan. In addition, if any part of your retirement plan investment with your current employer is held in company stock, you’ll need to find out if the plan has any restrictions on selling your shares, again, by contacting the retirement plan administrator. Finally, when you’re ready to move your assets, be sure to contact a financial advisor. Many rollover IRAs are available, and a professional can help you select one that best fits your long-term investment needs.
  33. 33. RETIREMENT PLANNING Year-End Checklist The top 10 money matters you don’t want to miss Wait! Hold off for a minute. Don’t drink that champagne and sing “Auld Lang Syne”yet. It’s not too late. As the holidays approach, many people vow to get their finances in order, but few actually do so. If you’re a procrastinator, here are 10 last-minute tips to help ensure that you take at least some steps toward improving the state of your finances by the end of the year. So before popping the cork and kissing your significant other, take a moment to mull over these thoughts that could have a significant impact on your financial well-being. 1. Take your required minimum distributions (RMDs). If you’re an individual retirement account (IRA) owner age 70½ or older, and you haven’t taken your RMDs for the year, you need to do so by the end of the calendar year. Internal Revenue Service (IRS) Code regulations require that you take initial withdrawals from traditional, Simplified Employee Pension Plan (SEP) and Savings Incentive Matching Plan for Employees (SIMPLE) IRAs by April 1 in the calendar year following the year you reach age 70½ and each year thereafter. Then, on an ongoing basis, you must
  34. 34. RETIREMENT PLANNING withdraw the remainder of the total RMD amount for each year by the end of that calendar year. For example, if you reached age 70½ in 2005, your first withdrawal must be made by April 1, 2006, and you must take the rest of your total 2006 RMD for the year by December 31, 2006. If your RMD is not taken in what the IRS considers to be a timely manner, you may be assessed a 50% excise tax on the amount you should have withdrawn. Ouch! 2. Spend the balance of your Flexible Spending Account (FSA). If you participate in an FSA for either health or dependent care, check to see if the plan has implemented the new 2½ month extension provision, which allows 2006 FSA money to be used for expenditures through March 15, 2007. If the plan doesn’t have the extension, be sure to use up any balances before the end of the calendar year or they will be forfeited. One way to do so: Stock up on over-the-counter medicines for next year. 3. Make last-minute charitable contributions. Maximize itemized deductions by making donations in the form of cash, property, or appreciated stock. The latter helps you avoid capital gains taxes too. 4. Make an extra mortgage payment. Making that one extra payment will, over time, cut the amount of interest you’re paying on your mortgage and actually reduce the number of years you’ll need to make payments before your house is free and clear. It will also help you maximize itemized deductions. This could make a tremendous difference in your long- range plans. 5. Consider making deductible business purchases by the end of the year. If you’re self-employed, and know you’ll need to buy deductible business-related items in the following year, you may want to buy them now to maximize your deductions in the current year (and take advantage of holiday sales).
  35. 35. RETIREMENT PLANNING 6. Think about gifting. At the time of this writing, you can gift up to a total of $11,000 per year (per person) to as many people as you want. That $11,000 may be given to one person, or distributed to any number of individuals. Your taxable income will be reduced by the amount that you gift. 7. Review and balance your capital gains and losses. Make note of capital gains you’ve realized this year from the sale of stocks or mutual funds. Also find out if any of your mutual funds will be distributing capital gains. When you’ve added up your gains, check to see if there are any losses you can carry forward from previous years to offset these gains. If there aren’t, consider selling under-performing securities. Taxes should never be the sole reason you buy or sell investments, but it may be possible to improve your tax and your investment situations at the same time. Think of it as being a good time to “clean out the closet”. 8. Consider increasing your final 401(k) contribution. If you haven’t already contributed the maximum of $14,000 ($18,000 for those 50 and older) to your 401(k), consider increasing your contribution amount from your final paycheck. You have until December 31 to make your final contribution for the year. (Note: All figures are at the time of this writing. Check resources such as www.irs.gov for current information.) 9. Open and fund a 529 plan college savings account. A 529 plan account offers high maximum contribution limits and significant tax benefits. Money in the account can grow tax-free for years. And, withdrawals are tax-free if used for any number of expenses related to higher education. But some people are using them for estate planning as well, since the money you put into a 529 plan account is considered a “gift”. You’re allowed to contribute up to $55,000 – which is considered five years’ worth of gifting – at one time. The rule is based on a calendar year, so if you make a contribution in December, one of the five years (or $11,000) is applied to the current year. The balance of your gift will carry over and be credited in subsequent years ($11,000 per year).
  36. 36. RETIREMENT PLANNING 10. Make your IRA contributions. You can make IRA contributions through April 17th, but why not consider doing it now so you don’t forget? The IRA contribution limit for 2007 is $4,000, and $5,000 if the person is age 50 and over. One last very important point: I have known many people – especially business owners (sole proprietor, C Corporation, S Corporation, and others) – who amazingly have not set up programs such as Keoghs, SIMPLE IRAs, 401(k)s, etc. What a shame! The ability to “take income off the top” and place it into a qualified plan is a true misfortune. With enough time until the end of the year, it is still possible to set up a qualified plan. I cannot stress this enough: If you have no qualified plan for your business, you absolutely, positively need to make inquiries as to whether or not you can and which one is best for you. Speak to your accountant or a financial advisor. This could be the best thing you do for yourself before popping the cork!
  37. 37. RETIREMENT PLANNING Will Your Well Run Dry? Preparing for retirement Baby boomers – those of us born between 1946 and 1964 – are in a predicament. We’re getting ready to retire, and most of us won’t be able to afford it. In days past, when people retired they had approximately 70% of their annual pre-retirement income to live on. It was that simple, thanks to employers managing retirement plans. Today the responsibility for retirement planning has shifted from employer to the employee. Gone are most pension plans; these days, most people have 401(k) plans. You, the employee, must decide how much you’ll contribute and how you’ll invest that money. If there isn’t enough in your well at retirement, you’ll have to “rely” on Social Security. So what’s the problem? The Social Security well may also run dry soon. Baby boomers – more than 77 million strong – will start becoming eligible for Social Security benefits in 2008. But if there’s a federal budget deficit, as there is today, the government could be forced to delay benefits or even cut them, a once improbable possibility that
  38. 38. RETIREMENT PLANNING previous Federal Reserve Chairman Alan Greenspan warned of somewhat recently. That’s all bad news, because according to the Employee Benefits Research Institute, the average person in his 60’s had a balance of $105,822 in his 401(k) at the end of 2001. What does that mean? Most people entering retirement seem to be planning to rely almost exclusively on Social Security for their retirement income. And how far will that go? While people can be advised to plan better and save more, even that isn’t always enough. The answer may seem obvious, but conventional wisdom and logic doesn’t always hold true. To illustrate the point, consider Joe, a hypothetical 24-year-old who starts planning for retirement now and does everything “right”. Joe has a good job, with a salary of $35,000. He gets 6% raises each year, and he contributes 10% of his salary to his 401(k) plan every year. Joe’s also lucky with his investments: They return a solid 8% annually during his working years, and later, 5% per year after Joe retires. When our hypothetical worker reaches age 59½, he’ll be earning $253,785 a year and his 401(k) balance will be $1.24 million. He’s set, right? Not quite. Joe will need 70% of his salary – $177,650 per year – when he retires just to maintain his pre-retirement standard of living. Assuming he gets the maximum Social Security payment of $45,000 ($10,800 in today’s dollars, with a 3% annual increase for inflation), he’ll still have to withdraw $132,650 a year from his nest egg. And at that rate, he’ll be out of money by his 69th birthday! Many of you will think about this man’s situation and say that his problem is easy to solve. All Joe has to do is change his asset allocation so he can potentially earn more on the money he saves. But that strategy may not be as helpful as it was once thought to be. According to the popular T. Rowe Price Retirement Income Calculator www.troweprice. com, if someone who has $600,000 in savings and a life expectancy of 25 years at retirement withdraws 5% per month, he has only a 50% chance of meeting his retirement goals – even if he puts 90% of his money in equities. Sounds depressing, doesn’t it?
  39. 39. 0 RETIREMENT PLANNING So how can you solve the problem? How can you safely obtain significantly more income for yourself at retirement without sacrificing a future inheritance to your heirs? Several interesting solutions exist, and we’ll analyze one of my personal favorites in a few chapters to come. (Hint: Pay attention to Chapter 3’s “peanut butter and jelly”.)
  40. 40. TWO INVESTING CHAPTER The Benefits of Diversification Balance and portfolio stability There are several aspects involved in successful investing. The first, of course, is asset allocation, or determining how much of your money belongs in each asset class – equities, debt instruments, and cash equivalents. Then there is selecting specific investments, meaning individual stocks or bonds, mutual funds, money market accounts, etc. The third aspect of successful investing involves monitoring and evaluating the performance of the investments you hold in your portfolio, followed by making any necessary adjustments, either by selling poor performers, buying potential profit-makers, or just rebalancing your holdings. We’ll start with allocating your assets and diversifying your portfolio. Most investors have heard of diversification and many can explain why it’s important, but I often find that many don’t follow their own advice. So let’s review one of the most important fundamentals of smart, sound investing.
  41. 41. INVESTING Different asset classes – such as domestic stocks, international stocks, bonds, real estate, commodities, and cash equivalents (i.e., money market accounts) – perform differently in different markets. In other words, they’re usually uncorrelated. While some asset classes may be in favor and more profitable, others may be out of favor at the same time. Allocating your assets involves dividing up your investment funds among these classes. Diversification is simply the process of spreading your investments across multiple asset classes so that your invested dollars are not solely dependent on the performance of any one asset class. While diversification doesn’t eliminate the risk of loss, it can help you better manage the effects of market volatility on your portfolio. Rather than trying to guess which part of the market will be up and which part will be down in any given period, a diversified portfolio will almost always reduce the risk and stabilize your return over time. As evidence, if you look at a number of asset classes over the past 10 years – large-cap value stocks, large-cap growth stocks, small-cap value stocks, small-cap growth stocks, international stocks, real estate, commodities, and bonds – the best and worst performers have varied every year, as shown in the chart. Asset allocation can be thought of as a strategy for assisting you in achieving sensible diversification. Investors often think of a traditional asset allocation as 60% stocks and 40% bonds, but it doesn’t stop there. You will also want to spread your investments among different sectors (i.e., health care and technology), companies with varying sizes of market capitalizations, and domestic and international categories. Consider the performance of this hypothetical diversified portfolio: An unmanaged combination of indices representing 40% bonds, 15% large-cap growth stocks, 15% large-cap value stocks, 10% international stocks, 5% real estate, 5% small-cap growth stocks, 5% small-cap value stocks, and 5% commodities. A portfolio invested in this manner would have returned 22.06% in 2003, 11.67% in 2004, and 8.81% in 2005.
  42. 42. INVESTIN G Year Best Performer Worst Performer 1995 Large-cap value stocks, 38.35% International stocks, 11.21% 1996 Real estate, 37.04% Bonds, 3.63% 1997 Large-cap value stocks, 35.20% Commodities, –14.08% 1998 Large-cap growth stocks, 38.70% Commodities, –35.73% 1999 Small-cap growth stocks, 43.10% Real estate, –2.57% 2000 Commodities, 49.73% Small-cap growth stocks, –22.44% 2001 Small-cap value stocks, 14.02% Commodities, –31.91% 2002 Commodities, 32.02% Small-cap growth stocks, –30.26% 2003 Small-cap growth stocks, 48.54% Bonds, 4.10% 2004 Real estate, 33.82% Bonds, 4.34% 2005 Commodities, 25.55% Bonds, 2.43% With all those asset classes to choose from, however, allocation isn’t quite as simple as it sounds. Many investors make the mistake of being too conservative in their asset allocation. As you approach your investment goal – be it the purchase of a home or retirement, for example – of course you’ll want to take fewer risks with your money.You may allocate more money to bonds and cash, and less to international stocks and commodities. But you need to realize that it’s still important to maintain an allocation to what are traditionally considered to be more risky investments because they also bring the greatest potential for reward. If you allocate too little to stocks, your portfolio probably won’t grow enough to significantly outpace inflation. Just look at the chart and see in how many of the past 10 years bonds were the worst performers. Another asset allocation mistake is failing to rebalance your portfolio regularly. You’ve probably heard of this concept before, that of “re- balancing,” and either ignored it or didn’t understand it. But suffice it to say, it’s one of the most important concepts you can ever implement in a portfolio. Why? Well, what’s the single most desirable situation in investing? Selling high and buying low, correct? How do you do that? Easy – through rebalancing.
  43. 43. INVESTING Let’s say that you and your financial advisor agree that a 60% equity/40% income split is appropriate for your circumstances and your portfolio is balanced accordingly. Over time, two things can happen. First, your needs may change. Perhaps your tax liability has increased and you want to consider tax-exempt investments, or you’re ready to start taking income from your portfolio. Second, even if your needs have remained the same, your portfolio probably won’t stay balanced. Strength in the stock market could cause your equity holdings to swell way beyond 60%, or a disappointing performance in income investments could cause your income holdings to shrink to less than 40%. You’ll need to assess these factors and buy or sell securities as needed to stay on track with your asset allocation. So suppose your target allocation is 60% stocks and 40% bonds. For this brief chapter, I’ll keep this pretty simple, but the overall concept is very effective. Now, let’s say within that 60% stocks category, there are several “sub-classes”, one of which is in technology. And let’s say it’s the 90’s, and tech is surging beyond our wildest dreams. You wake up and find the portfolio is now 80% stocks (mostly because of tech in this example). What happens to bonds during this bull run? They usually fall in value. So now you have 80% stock, 20% bonds. If you follow a rebalancing strategy, what happens? You rebalance so that you sell off 20% of those heated stocks at a high (for a profit), and reallocating that 20% into bonds, right? And what happens when you invest that 20% into bonds? You are buying at a low. That’s precisely what every investor dreams of, and with rebalancing – I kid you not – it really can be that simple. If you’ve had the unfortunate experience of incurring significant losses in the markets, it was most likely the result of a poorly structured portfolio that was too heavily “weighted” in one sector. Those who invested too heavily in technology during the bust of 2001-2002 can probably vouch for that. To avoid market disasters, don’t ever weight your portfolio too heavily in any one sector, diversify among the
  44. 44. INVESTIN G standard asset classes, and make sure to rebalance your portfolio at least once a year. (I personally do so once or twice a year, but certain market conditions may prompt me do it more or less often.) Following these simple rules will most certainly provide you with significantly better chances for long-term investment success.
  45. 45. INVESTING The Index Advantage and Exchange-Traded Funds Play the market with less cost and risk Mutual funds, which offer professional stock selection and diversification, are popular investment options today. But they aren’t always what they’re cracked up to be, thanks to high management fees and excessive trading activity (which can result in capital gains taxes). What if you could reap the benefits of mutual fund investing without the associated costs? Well, you can – with an index fund. An index is a group of stocks selected to represent a certain portion of the stock market. The Standard Poor’s (SP) 500 Index, which consists of 500 large-capitalization (large-cap) domestic stocks, such as Microsoft and General Electric, is widely considered to be representative of the market as a whole. The Russell 2000 Index consists of small-capitalization stocks. The Morgan Stanley Capital International Europe, Australasia, Far East (MSCI EAFE) Index holds international stocks. You will find that there’s an index for just about every segment of the market, including specialized segments, such as
  46. 46. INVESTIN G health care stocks and real estate investment trusts (REITs). There are even indices for Genome companies, water companies, biotechnology, oil exploration, etc. An index fund invests in the stocks that make up a specific index. An SP 500 index fund, then, would try to replicate, as closely as possible, the allocations to stocks found in the SP 500. When you match the investments in an index, you also match the return of that index – and that’s something most mutual funds can’t do. According to investor information sources such as the Wall Street Journal, Motley Fool, and many, many others, less than 20% of actively managed, diversified, large-cap mutual funds have outperformed the SP 500 over the last 10 years. Part of the problem is stock selection; managers make mistakes and trade on emotion. But another big factor is fees and expenses. Index funds invest in whichever stocks are in a particular index, in the same allocations. They don’t hire analysts with Ivy League MBAs, and they usually don’t develop a lot of slick marketing materials to convince you that their fund is the best. This significantly reduces the operating fees the fund must charge shareholders, which leaves more of your money to grow. Moreover, actively traded mutual funds do just that, actively trade. And when a mutual fund sells stocks, the capital gains (or losses) are passed on to you, meaning you have to pay taxes even though you haven’t sold anything. Typically, trading is only done within an index fund when the composition of the index it represents changes. The result is much less of a tax bill for you, given the fact that these changes are usually quite infrequent. There are two main ways to invest in indices: Through index mutual funds and through exchange-traded funds (ETFs). Both types of funds replicate an index. Index mutual funds, as the name implies, are mutual funds. You obtain them through your financial advisor or any mutual fund company that sells directly to the public. ETFs, on the other hand, are bought and sold like regular stocks, and even have stock symbols. ETFs that track the SP 500 include Spiders (SPY) and iShares (IVV is
  47. 47. INVESTING one example). One thing you’ll want to watch out for, whichever you choose, is the fees. Before you invest, check the index mutual fund’s or ETF’s expense ratio, which is calculated as a percentage of the amount you invest. Generally, don’t invest in an index fund or ETF with an expense ratio greater than 0.40. As for performance, the returns on index funds and ETFs are almost identical. But there are a few reasons you may want to consider one over the other. Since ETFs are bought and sold just like stocks, you’ll probably pay a commission each time you buy and sell. So if you are systematically investing on a monthly basis, you would likely be better off purchasing the index as a mutual fund instead of an ETF (given that most index mutual funds will not charge you fees when adding more money). One distinct advantage ETFs have, however, is that they can be traded on a moment’s notice – “intraday” – whereas shares of a mutual fund don’t actually get sold until the end of the day. Finally, because an ETF trades like a stock, it offers yet another significant advantage: being able to set a “stop loss” that could potentially protect you by automatically cutting your losses at a predetermined dollar amount when the related index falls. So should you invest in an index mutual fund or an exchange-traded index fund? My bet has always been in favor of index exchange-traded funds. But as with any investment, make sure you understand all the facts before jumping in.
  48. 48. INVESTIN G Small Company Stocks Providing big results and portfolio balance Small-capitalization (small-cap) stocks, which typically lead the market as the economy comes out of a downturn, finished near the top of the performance charts in 2004. The Russell 2000 Index – the index that is used as a benchmark for small-cap performance – returned 18.33% that year. As a result, many investors are asking if they should move more of their portfolio into this asset class. But that’s not an easy question to answer. What exactly is a small-cap stock? If you’re considering small-cap stocks, it’s important to understand what they are. Simply put, they’re stocks of companies that have a relatively small market capitalization – market capitalization being the total dollar value of all outstanding shares of a company’s stock. There are many reasons to invest in small-cap stocks. For one, smaller companies tend to provide products and services for the domestic market, so they may be less affected by economic disturbances abroad. Secondly, their size can allow them to react more quickly to changes in
  49. 49. 0 INVESTING the economy than larger companies can (which explains why small-cap stocks have traditionally performed well as the economy is emerging from a downturn). And thirdly, they have room to grow. That said, small-cap stocks aren’t for everyone. Typically, the smaller the stock, the more risk it presents. Why? Because the management may be less experienced. Business risks, such as shrinking product demand, may be accentuated in smaller companies. Because it can be harder to find buyers for these stocks, it may take some time to sell your shares when the economy or markets perform poorly. But keep in mind that as of the latest reconstitution of the Russell 2000 Index, the average market capitalization of a company in the index was approximately $607.1 million. A business of that size isn’t exactly a mom-and-pop shop either. Overall, I like small-cap stocks. And their tendency to perform well when others asset classes are not is one of the reasons why. Investing in small-caps helps provide your portfolio with diversification. Just take a look at the chart for more evidence. So, if you can handle the risks, I think it’s a good idea to add some small-cap stocks to your portfolio. How much will depend on various factors, including your time horizon. A financial advisor can help you determine what amount may be appropriate for you to invest. And lastly, if you’re going to add small-cap stocks to your holdings, I recommend that you do so by investing in a variety of small-caps to further diversify this component of your portfolio. You can do this by selecting individual stocks, or you can purchase shares of a mutual fund that invests specifically in small-cap stocks.
  50. 50. INVESTIN G Market as a Large-Cap Stocks: Small-Cap Year Whole: Russell Stocks: Russell SP 500 Index 1000 Index 2000 Index 1993 10.06% 10.15% 18.90% 1994 1.32% 0.38% - 1.82% 1995 37.58% 37.77% 23.34% 1996 22.96% 22.45% 16.49% 1997 33.36% 32.85% 22.36% 1998 28.57% 27.02% - 2.55% 1999 21.05% 20.92% 21.26% 2000 - 9.10% - 7.80% - 3.02% 2001 - 11.88% - 12.46% 2.48% 2002 - 22.09% - 21.65% - 20.48% 2003 28.67% 29.90% 47.25% 2004 10.87% 11.40% 18.33% Index returns assume reinvestment of dividends and capital gains, and unlike fund returns, do not reflect fees or expenses. You cannot invest directly in the index. During the periods discussed, a number of index stocks could have had significantly negative performance. Therefore, it is possible for index performance to be positively influenced by a relatively small number of stocks.
  51. 51. INVESTING Real Estate Investment Trusts Is the boom over? Real estate investment trusts (REITs) have had an incredible run. For the past five years or so, they’ve earned investors 20.37% per year, as measured by the Morgan Stanley Capital International (MSCI) U.S. REIT Index. But many analysts are predicting that the future for REITs isn’t so bright. With that said, should you invest in them? First, let’s make sure you clearly understand what constitutes a REIT. A REIT is a security that invests directly in real estate, either through properties or mortgages. You can buy or sell a REIT just like you would a stock on the major stock exchanges. At the time of this writing, one of the best-known REITs is Equity Office Properties (EOP). Other popular REITs, all traded on the New York Stock Exchange (NYSE), include BioMed Realty Trust (BMR), Boston Properties (BXP), Prentiss Properties (PP), and Trizec Properties (TRZ).
  52. 52. INVESTIN G Like most securities, REITs have historically experienced cyclical ups and downs. Typically, they have performed poorly when interest rates have risen. But the past year-and-a-half has been an exception. Despite interest rates rising, the returns on REITs have been up – 17.74% over the past year – as measured, again, by the MSCI U.S. REIT Index. Some analysts think that REITs are going to continue to perform well. In a recent issue of the National Association of REITs’ Real Estate Portfolio, for example, the CEO of Vornado Realty Trust, Steven Roth, who has 40 years of experience in the business, proclaimed income- producing real estate to be in “a secular bull market – emphasis on secular”. Other analysts, however, are predicting doom and gloom for the asset class.You’ve probably heard rumblings about a“real estate bubble,”and Mike Swanson, an analyst who produces a weekly newsletter called Wall Street Window, says “the REIT bubble is about to burst”. For those of you who agree with this outlook, ProFunds has an interesting fund that will rise in value if the U.S. Real Estate Index falls. Check it out at www.profunds.com, and as with any investment, be sure to read the prospectus carefully before investing. If indeed the real estate market does go down, that shouldn’t necess- arily worry potential investors. You can still gain the benefits of REITs while minimizing your risk in a number of ways. First, you can invest in REITs in certain sectors. For example, REITs that focus on retail and self-storage have been performing well. On the other hand, REITs that focus on offices and apartments have been struggling, perhaps because the U.S. economy’s recent recovery has focused on the consumer. It’s also important to consider the quality of a REIT’s management, tenants, and underlying properties. BioMed Realty Trust, for instance, specializes in leasing lab space to tenants such as biotechnology and pharmaceutical companies. If you believe that there will be growth in the health care sector, it may also follow that BioMed Realty Trust will do well.
  53. 53. INVESTING Regardless of which asset class or REIT sector you’re looking at, you always want to buy out-of-favor companies with good potential to generate cash. That’s a basic principle of investing. Yet as with all investments, there are no guarantees. So if you’re interested in investing in a REIT, be sure to consult with a financial advisor who can help you select a REIT that best fits your desired level of risk to reward. With all this in mind, be sure to recall a very important previous chapter: That on diversification and the importance of rebalancing. A well-diversified portfolio, as far as I am concerned, should always have exposure to real estate, and for that reason, an investment in a REIT always plays a role in a balanced portfolio.
  54. 54. INVESTIN G Evaluating Performance Using market indices One pacesetter that investors often turn to when evaluating the performance of their investments is an index, such as the Standard Poor’s (SP) 500 or the Dow Jones Industrial Average. What they may not realize, however, is that these indices represent only a small slice of the market, and they may not be relevant as a comparison for their investments. The SP 500 is a good example. It’s designed to be a broad indicator of stock price movement and is the most commonly used benchmark for stock fund performance. The index consists of 500 leading companies in major industries, chosen to represent the American economy. That may seem like a big field until you consider that there are more than 5,000 stocks listed on the New York Stock Exchange, and the SP 500 tracks only a small percentage of the stocks on the market. Moreover, the SP 500 consists of essentially one asset class: Large-capitalization (large-cap) companies.
  55. 55. INVESTING Market capitalization, a measure of a company’s size, is the total dollar value of all outstanding shares of a company’s stock. Stocks with a relatively large market capitalization are considered large-cap stocks. Because the SP 500 is limited to 500 of these companies, smaller companies – which can drive U.S. economic expansion – are excluded from the SP 500. So if you have a small-capitalization (small-cap) stock or fund, comparing it to the SP 500 may not be an accurate gauge of its performance. Even for large-cap stocks and funds, the SP 500 isn’t always an accurate benchmark. That’s because the index isn’t equally weighted: The largest and often most popular stocks have a weighting several hundred times that of the less popular stocks, and thus account for the majority of the index’s performance. In fact, in a bull market year, the strength of just a few popular stocks can boost the SP 500’s return significantly. That’s just what happened in 1998, for example. The index’s stated weighted return was 28.6%, but the average SP 500 stock gained just a little more than half that – 15%. That doesn’t mean you should ignore the SP 500 and other indices. The challenge is in finding the right index to use as a benchmark, and understanding that differences in performance between your stock or fund and the index may be explained by differences in your stock or the composition of your fund versus the index. Information about which index is used as a benchmark by a stock or fund’s portfolio managers can typically can be found in the performance section of their annual and semi-annual reports. But of course it’s not just the SP 500 Index that’s used as a performance benchmark. A few of the other indices you may see listed include:
  56. 56. INVESTIN G Russell 1000 Growth Index Measures 1,000 large-cap growth stocks Russell 1000 Value Index Measures 1,000 large-cap value stocks Russell 2000 Index Measures 2,000 small-cap growth stocks Russell 3000 Index Measures the performance of the 3,000 largest U.S. companies based on total market capitalization MSCI EAFE Index Measures the performance of the developed stock markets of Europe, Australasia, and the Far East Lehman Brothers Aggregate Bond Index Measures U.S. government, corporate, and mortgage-backed securities with maturities of up to 30 years
  57. 57. INVESTING Portfolio Rebalancing A declining market presents good opportunities With the domestic stock decline in May 2006 (the time of this writing), it seems increasingly likely that the market is headed for a correction, which is defined as a 10% drop. While most investors view that as bad news, it does present some opportunities. One of them is the chance to rebalance your portfolio, and perhaps buy stocks at lower prices. Most financial advisors agree that setting asset allocation targets and occasionally rebalancing your portfolio as part of investment maintenance is a good idea. But different advisors recommend different time frames for rebalancing. On one end of the spectrum, some say you should do it every month. On the opposite end of the spectrum, others say you should do it every few years. I take the middle ground and say you should rebalance whenever changing circumstances make it necessary.
  58. 58. INVESTING There are any number of circumstances that could prompt you to take another look at your portfolio. As you move through life, meeting some goals and creating new ones, your financial needs will change. Perhaps your tax liability has increased and you want to consider tax-exempt investments. Perhaps you’re ready to start taking income from your portfolio. Or perhaps your threshold for risk has increased and you’re ready to add more investments with higher reward potential. The changing circumstances of the market can also affect your portfolio. For example, let’s say that a 60% equity/40% income split is appropriate for your circumstances, and you set up your portfolio accordingly. Over time, your portfolio probably won’t stay balanced in that manner. Strength in growth stocks could cause your equity holdings to swell beyond 60%, or a disappointing performance in income investments may shrink your income holdings to less than the optimum 40% you had started with. This was covered in a previous chapter, however it is so important that I cannot help but remind you here. You may specifically want to take a look at your international asset allocation. Over the past few years, international stocks – particularly those of emerging market countries – have gained substantially. It’s likely that these stocks now make up a greater percentage of your portfolio than they ideally should, and that could increase your overall risk. It can be hard to sell a stock or mutual fund when it’s performing well. Year-to-date gains in many international markets, for instance, already exceed 20%. “Why not hold onto the stock and realize even more gains?” you might ask. But remember, it’s almost impossible to accurately predict market movements. You could miss an upturn, but you could also fall victim to a downturn. Price-to-earnings (P/E) ratios for many international stocks now exceed those of their more stable domestic counterparts – not a good sign. And if international stocks take a nosedive, they could do so quickly.
  59. 59. 0 INVESTING If you do sell some of your investments, you’ll want to replace them – and a market downturn presents a good opportunity to find some bargains. Technology stocks haven’t been doing well lately. Consider, for example, eBay and Yahoo!, which hit 52-week lows in April 2006, and are trading at P/E ratios not seen in years. A strategy of shopping for investment bargains even helps you ride out market volatility with some peace of mind. Instead of fretting about how much your holdings have declined, why not make a shopping list of asset classes that interest you, and watch to see how much cheaper they’re becoming? You may decide that a couple of them are worth picking up. Keep in mind that you shouldn’t buy a stock just because it’s cheap; it should fit into your overall financial plan. I recommend consulting with a financial advisor every few years at least, not only to develop an asset allocation plan, but to make sure you’re on track.
  60. 60. INVESTIN G 6 Things Dating Teaches Us About Money Bad date last night? Don’t despair. It’s not as bad as you may think. Here’s some good news: You may not know it, but when it comes to your money, that bad date can teach you an awful lot about successful investing. Think I’m joking? Think again. Although I was a far cry from being the King of Dating, I did have a few occasional lucky streaks in me. And looking back over those rare few times, my moderate success on the dating circuit did teach me quite a few things about prudent investing. Here’s a few quick examples… 1. Don’t judge a book by its cover Dating: The guy was over a half-hour late, his outdated shirt barely matched his Taco Bell stained pants, the rain gave him a lethal dose of bed-head and back then the busboy was making more than he was. If that wasn’t bad enough, his humor was a bit stale and the
  61. 61. INVESTING car he drove had a weird putter that attracted nothing but aliens from the evil Planet X. While at first the girl thought it was going to be a dinner date from fiery hell, little did she realize that guy was I, and I’d soon wind up being the one she’d marry. Investing: The receptionist was sure nice, but the carpets were dull and the musty furniture reminded you of grandma’s place in Brooklyn. You were ready to take your money to that Private Wealth Management Firm – the one with the white marble staircase and baby grand – but when the well-mannered financial advisor appeared, you figured you’d be courteous and give him a few minutes of time. A little into his pitch, you were most pleasantly surprised when he touted low cost, tax efficient investments with attractive rates of return that perfectly matched your goals. It was then you realized there’s a reason the furniture in his place is a bit out-dated, mainly, because the guy most certainly isn’t paying for it out of your own pocket. Lesson Learned: First impressions can easily get the best of us. Whether it’s a date or your money, taking a step back to peek behind the curtain will typically put both your money and heart in a much better place. 2. Costs count Dating: She liked Dylan Thomas, idolized Ginsberg, despised the conformists and was clinically depressed that she missed last year’s Monterey Pop Music Festival. The perfect 10 from down in the Village strummed an acoustic, wrote poetry and even donated your favorite Levis to a homeless guy on the street. While at first lust got the best of you, months after helping her pay the rent, her organic meals and for all those Andy Warhol movies you pretended to like, you were finally worn out, leading you realize that when it comes to dating, costs most definitely do count. Investing: The mutual fund was barely moving. Five years into it, you just couldn’t quite figure out why you weren’t making much money. Then, one fine day, you wisely took the time to research the
  62. 62. INVESTIN G fees you were paying, only to realize the fund was charging you well over 5% per year in annual costs and causing you all sorts of taxes. Lesson Learned: When it comes to investing and dating, costs most definitely do count. Taking the time to evaluate how much you’re paying for your dates and funds is an essential part of anyone’s success. 3. It doesn’t have to be complicated for it to be effective Dating: For many people, the best dates are the simple ones such as times spent on the couch during a cold winter night, wearing soft flannel pajamas under a fluffy blanket watching a classic Bogart movie with, of course, hot green tea and a hearty bag of Fritos nearby. While dining at Nobu certainly has its place in time, looking back on all the great dates we’ve had most likely reminds us it’s the simple ones that scored the most. Investing: When it comes to investing, many of the most successful investors I’ve helped are those with the simplest portfolios. On the other end of the spectrum are investors that spend every waking hour chasing returns, analyzing complicated charts, dissecting corporate balance sheets or scouring the market on a daily basis searching endlessly for a perfect buy. Lesson Learned: There are roughly 15,000 mutual funds in the country with approximately two professional fund managers each. Of those 30,000-ish fund managers, guess how many have beat the static, mindless SP 500 index more than ten years in a row? Answer…? …. Get this: Just one. The legendary Bill Miller from Legg Mason. Undeniable statistics prove that the SP typically out-performs over 80% of managed mutual funds year after year, leading the sharp ones to realize that when it comes to efficient and successful investing, it rarely has to be complicated for it to be effective.
  63. 63. INVESTING 4. Cut the losers, ride the winners Dating: The first handful of dates were the stuff legends are made of, but by the time mid terms rolled around, Crazy Mindy crashed my college roommate’s car, emptied his bank account, shredded his classic Dark Side of the Moon poster, caused him to miss the Macro Economics final and managed to give him one very fat lip. By the time graduation took place, my roommate ended up blowing his entire senior year trying to turn Crazy Mindy into the person she once appeared to be. Investing: On paper, the company looked like a true winner. Not only was the stock going through the roof but even Madonna used its products. At first the investment took off, but no thanks to a deadbeat CEO and a few federal regulations tossed in, the stock began its perpetual downward spiral. Convinced it would come back, you held on, only to wake up realizing you would have been far better off giving Crazy Mindy your money to invest. Lesson Learned: Crazy Mindy could care less about my roommate and likewise, stocks could care less about you. They don’t know who you are and only you can fall in love with them. Love or money, when something isn’t working, get out. Just cut the losses, move on and live to fight another day. The quicker you do that, the better things typically turn out. 5. Don’t give up on the first date Dating: Dinner at The Palm was better than if your Mets won another Series. The guy made you laugh, he held the door and a Grey Goose made him look like Brad Pitt. But back at your place, just as the room sweltered to high noon out on the Serengeti, your mother’s voice politely whispered to you, “Not on the first date.” Wisely, you pushed back and let something called “time” nurture the relationship. Investing: The financial advisor seemed like a nice guy. He showed you attractive rates of return, sported a Tom Cruise smile and even served cappuccino in fancy bone china with lace doilies to match.
  64. 64. INVESTIN G So you rolled the entire 401(k) into an IRA, only to later realize it cost you a huge up-front commission on high fee investments that caused you nothing but losses to boot. Lesson learned: Treat your money like you’d treat your body: Don’t give it up on the first date. Taking time to nurture a relationship will not only make your mother proud, but it will certainly provide you with one of the most important keys to financial and dating success. 6. Diversification is the key to success Dating: Adam looked like Alan; Alan acted like Arnold; Arnold smelled like Arnie and Arnie reminded you of Alex. And just when you thought you found the Perfect-A, Aden stood you up just like Albert and Abe once did (or was that Alfonse?). It was then, in one fleeting moment of revelation, you finally realized the problem had nothing to you, but everything to do with guys whose names start with the letter “A”. Investing: Dot-coms. … Late 90s. … Need I say more? Lesson Learned: Diversifying your investments is a critical key to investment success. Load up in one sector or stock and it’s not a question of if disaster will strike, it’s usually a question of when. Spread the risk, diversify your investments into the prudent, timeless fundamental asset classes and of far more importance, stop dating guys whose names start with the letter A. CONCLUSION Bad date? Who cares? Next time something doesn’t turn out so well, simply shake hands with your date and thank them for making you a richer person. After all, when it comes to love and money, hopefully here you’ve learned it’s all very much the same.

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