About the Author
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
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
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
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
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
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.
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.
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
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
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
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
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
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
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
of the markets. But you probably know all that, even if you’ve put off
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.
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
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.
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.
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
0 RETIREMENT PLANNING
1. What do the acronyms following the advisor’s name (if any) really
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.
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
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.
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
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.
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.
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
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.
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
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
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.
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.
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
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.
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.
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:
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
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
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-
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
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
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-
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).
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).
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
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!
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
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
previous Federal Reserve Chairman Alan Greenspan warned of
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?
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”.)
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.
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
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
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.
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
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.
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
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
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.
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
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
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.
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.
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).
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
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
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
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.
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
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
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:
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
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
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
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.
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.
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
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
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
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
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
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
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
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
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.
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
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.
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
After all, when it comes to love and money, hopefully here you’ve
learned it’s all very much the same.