Let’s Get Radical

We’ve noted a number of articles lately about the prospects for rising retirement ages for the baby boomer generation. It’s all over the media these days. Some articles now estimate many boomers may be working well into their 70s. To anyone who has given it much thought recently, this should come as no surprise. The facts are pretty sobering:

§  The Federal Reserve recently reported that the median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed to maintain its standard of living in retirement.

§  The Fed reported that the median 401(k) plan held only $149,000, according to the Center for Retirement Research, an amount that would be virtually impossible to retire on.

§  AARP recently reported that one in four older workers exhausted all their savings during the recession with a growing number of older Americans facing bankruptcy.

§  Recent studies have estimated Social Security will run out of money by 2033.

This situation has several implications from a financial planning perspective:

1.        It is obvious that extending the retirement age will have to be an option for many Americans and that the notion of an easy life of leisure after age 65 is probably now a pipe dream for many if not a majority of baby boomers (one problem with this: it is unlikely the economy can create enough jobs to support all the boomers who will need one). 

2.        “Radical” notion: traditional asset allocation models may be a thing of the past.  The traditional strategy of transitioning a portfolio to bonds in retirement will not provide the returns necessary to enable retirees to meet their spending goals. People will need more growth investments in retirement, which means holding more equities in retirement than has traditionally been the case. This implies retirees are going to have to stomach greater portfolio volatility which many may find distressing.

3.       Global balance with emphasis on large, quality companies. The not so radical notion from an investment perspective is to increase portfolio emphasis on large, quality, globally diverse companies that can capture growth of faster-growing economies and translate that into higher earnings, dividends, and cash flow for investors.

4.      Increase cash flow from your investments. Cash flow has become a new mantra in the investing world and for good reason: it pays the bills. Creating greater cash flows in portfolios can accomplish several things at once: a) increase spendable income; b) reduce portfolio volatility; c) create a rising income stream through dividend increases.

5.       Another “radical” notion: save more, spend less. Granted, this is easier said than done, but this discipline will have to be embraced given the prospect of lower stock returns and Social Security cutbacks. Without a grasp of what is realistic, the American “dream” is turning into a nightmare for many. With proper planning and renewed saving and spending discipline, many people can achieve a comfortable retirement. But the boomers have always changed the rules, and this generation will probably change the rules that have defined “traditional retirement”.

Europe Again ?

The stock market has taken a bit of a breather during April due to concerns over corporate earnings, moderation in economic growth, and concerns over the potential for a repeat of the last two years in which the market peaked in April. So far this month, corporate earnings have been good with about 80% of reporting companies exceeding analyst forecasts. Also while some recent economic indicators have been a touch softer, it is normal for economic data to modulate throughout a cycle and the data would not portend a new recession or serious slowdown.

The other problem? Investors have begun to fret again over the European financial situation. This started several weeks ago when both Spain and Italy experienced a significant increase in interest rates in issuing sovereign bonds. Spain recently indicated that its fiscal deficit this year would be higher than expected. Greece downgraded its forecast for economic growth. Political developments in France have raised concerns that potentially new leadership there would not be as supportive of austerity regimes in Euro countries.

While investor concerns regarding Europe are warranted, in our opinion, they may be overdone. Let’s look at a few facts:

1)      U.S. combined import/export trade with EU countries is about 4% of U.S. GDP and about 13% of total U.S. import/export trade. These are not levels which have the potential to dramatically impact U.S. growth or drag us into another recession by itself.

2)      The U.S. economy is large, diverse, and resilient enough to generate self-sustaining growth without high levels of demand from Europe.

3)      The U.S. is experiencing rising export demand from developing and emerging economies.

4)      The IMF and World Bank have recently boosted the European financial rescue fund to $1.7 billion (increasing protection for European banks).

5)      Many economists believe Europe could emege from recession by early 2013.

6)      The outlook for corporate earnings in both the U.S. and many developing countries remains positive.

From a financial planning perspective, one of the best ways to insulate against the risk of the European crisis is to properly diversify portfolios by both asset class and by country and industry sectors. Underweighting exposure to the Euro countries is still appropriate, in our view. Overweighting exposure to areas like emerging Asia, Latin America, and the U.S. can provide portfolios adequate exposure to growth. Also, a good financial plan takes into account the fact that there will undoubtedly be good and bad periods for which one can plan. In addition to proper portfolio diversification, tools like Monte Carlo analysis and gaining a deeper understanding of client risk tolerance can increase confidence in a plan during periods of volatility while capturing returns in more attractive market and geographic sectors.

The Income Conundrum

We recently held our first quarter investment committee meeting. From a macro perspective, we continue to believe the near term outlook for interest rates and inflation remains relatively benign. While we believe inflation will eventually accelerate, given continued high unemployment, low wage growth, accommodative Federal Reserve policy, and slack capacity utilization, we believe the prospect for a significant acceleration in inflation is still a ways off.

With respect to equities, we remain generally positive. We see further evidence of improvement for the U.S. economy reflected in recent employment growth, retail sales, consumer confidence, and durable goods orders. Additionally, the U.S. housing market appears to be in a bottoming process and Europe’s recession appears to be milder than expected. Large corporations continue to generate high profit margins and cash flow, which we believe will continue to support capital investment, dividend increases and share buybacks, all positive for U.S. equities. A couple of macro risks that bear watching include the potential for an escalation of the situation in Iran as well as slowing of the economy in China.

An interesting feature of the current environment is the very low yield on bonds. This has created a conundrum from a financial planning perspective for people who have counted on bonds to deliver a steady stream of retirement income. With yields so low for bonds, alternatives to bonds may have to be considered. These alternatives include equity securities such as preferred and utility stocks, high dividend stocks, and high yield bonds, all of which entail higher volatility (risk).

So the question becomes “are we in an environment in which people must take on more risk to achieve their income goals?” Perhaps, but there are ways to improve portfolio income (and growth) without having to take on significantly more risk. How can this be done? In a word, “diversification”. Through diversification a portfolio can be structured that is appropriately allocated with respect to major asset classes (stocks, bonds, real estate, etc.) but that also provides a higher income component through incorporation of higher dividend stocks and higher income alternatives to bonds.  In this way, the potential for higher volatility arising from holding more equity-type investments can be offset by asset class and geographic diversification and by holding a diversity of asset types that have low correlation to each other.

Warren Buffett: Stocks Are The Safest Asset ??

Warren Buffett recently penned an interesting article for Fortune Magazine discussing his thoughts on why stocks present a better long-term opportunity than gold or bonds.  The article was such as gem because it provides great insight into Buffett’s way of thinking about investments. His point in a nutshell is this: the most important element of a sound investment is its ability to enable the owner to maintain long-term purchasing power (i.e., stay ahead of inflation). He also points out that the “risk” of an investment should not be measured by its volatility but rather by the probability that it fails to maintain or increase purchasing power over the expected holding period. This is not the way most people look at investments.

He believes owning stocks of quality, dividend-paying businesses (both public and private) are the best way to achieve the objective of maintaining long-term purchasing power. Gold can’t do this because it does not produce anything, such as a cash dividend. Bonds can’t do it now because of the fixed nature of their cash flows and very low returns currently. Therefore, to Buffett, stocks offer the “safest” investment because they have the highest likelihood of delivering returns that will maintain or increase the owner’s long-term purchasing power.

For financial planners, Buffett’s concept of investing has important implications. One of the most important objectives in planning and investing for clients is maintaining purchasing power over long periods, in many cases, decades. We do this through owning equities (common stocks), just as Buffett points out, because they deliver the elements important in maintaining purchasing power. We also invest in stocks because they are highly liquid and provide flexibility in customizing and fine-tuning portfolio investments and providing adequate diversification. Another important aspect of Buffett’s philosophy is the need to plan and think for the long term. By thinking long-term, as Buffett does, the client has a much-improved chance of achieving his/her financial goals and mitigating the impact of short-term market fluctuations.

We would hasten to point out, however, that as financial planners, we do believe bonds and commodities, such as gold, play an important role. Why? Because these assets have low correlations with stocks and thereby offer the benefits of diversification. By incorporating stocks and bonds together in a diversified portfolio, you can provide the growth necessary for a successful plan, while reducing the volatility of the portfolio.

If you have a chance to read the article, we would highly recommend it. Here is a link to it: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/

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20-Somethings Worried About Retirement ????

……………In Our Continuing Series: “Am I Prepared?”

CNBC ran an interesting article recently that discussed concerns surrounding retirement savings for young people in their 20s and 30s. A few of the key findings in the article:

·         Gen X’ers (people in their 30s and 40s) are less prepared for retirement than baby boomers

·         Young workers do not have a great deal of knowledge about the basics of investing

·         Many younger people are not confident about investing their money or the ability to grow their retirement assets through investments (or should they even invest at all ?)

Given the worrisome projections for social security, the weak economic recovery, and watching their parents’ portfolios implode twice in the past 12 years, the concerns of this age group are understandable. But despite the recent negatives, the options are not as “dire” as many in this age group may currently believe. Here are few reasons why:

·         Time is on their side: people in their 20s and 30s have investment horizons of 30-40 years. This long time horizon mitigates risk by ameliorating the impact of short term market volatility.

·         Most of the world is still focused on growth and prosperity. Global growth of capital investment and business should be positive for global stocks, which provide a source of growth for investments.

·         Valuations for quality stocks are now at multi-decade lows. This implies that the risk/reward for investing in equities is attractive.

·         Despite the market volatility of recent years, over the long-term, planned and intelligent investing has delivered good returns (for example, over the past 100 years, large-cap stocks have delivered annual returns of about 10%).

·         There are many resources available both on-line and off that can help these individuals better understand their options for retirement savings and investments.

Now, about that plan………

Just as in starting a business or performing at your job, creating a simple plan can make a big

difference in getting you closer to achieving your retirement goals. What can you do to get into action ?

·         Start saving now: do a simple budget and determine what you truly need to live on and what you can save. The goal of saving 10% of your gross income is a good one. If you can’t save 10%, try for 5%.

·         Educate yourself. There are many resources now available on line that can provide a good basic understanding of the fundamentals of investing. Investopedia.com has some great information and investing tutorials that are very helpful in gaining a basic understanding of investing.

·         Contact your plan sponsor. If you have a 401k plan at work, the plan sponsor is required to provide ongoing education to its plan participants. Education should be available to you through your plan sponsor’s website or service representative or your HR department.

·         If you truly cannot get help or are completely befuddled as to where to start, you may want to contact a financial professional in any number of venues such as banks, brokerage firms, or financial advisory firms.

As financial planners, we design and implement comprehensive financial plans for all our clients. True, most of our clients are further along in their “investment lives” and may be older and have different needs than people in their 20s and 30s. However, the discipline of having a strong financial plan (or a “plan”) and sticking to that plan for the long term is essential for our clients to reach their goals. The benefit of having a plan is no different for someone in their 20s and 30s. That age is a great time to begin investing and there is every reason to be optimistic that by spending a little time educating oneself and establishing a savings and investment plan in one’s 20s and 30s, they will reap the long-term rewards they are seeking.

Another way in which we at our firm can help a younger investor is through a concept we call “vertical planning”. This is where we will take on as a client a relation or family member of an existing client even if the new clients’ assets fall significantly below our minimum. The established relationship with the existing client (who is a family member) gets them “in the door”. If a young person has a relative or family member that has an existing relationship with a financial advisor, this may be an avenue for that person to obtain assistance and education in beginning a life-long investment program and financial plan.

In our next post, we will elaborate a bit more on the importance of portfolio diversification, asset allocation, and investment horizon and how these impact the retirement and investment planning process and outcome.

Improving Transparency

The Federal Reserve today, for the first time, provided guidance on interest rates and an official estimate of inflation as part of its regular FOMC meeting. The Fed announced that, given its expectations for continued sluggish economic recovery and elevated unemployment, it does not expect to raise interest rates until 2014. The Fed also provided for the first time a specific inflation target of 2%.

There are a few important messages in this announcement. From a purely economic perspective, it is clear the Fed remains concerned about the pace of economic recovery and, at least for now, it does not view inflation as a problem. From the perspective of “communications”, there are also a couple of important messages. The Fed is trying to provide improved “transparency” to investors which, in turn, it believes will increase confidence in businesses’ willingness to make capital investments and hire new employees. Improved transparency should foster a higher level of trust in the Fed, or at least reduce the level of conjecture and uncertainty surrounding Fed policy which has greatly added to market volatility over the years. The idea here is improved transparency may reduce systematic risk to some degree.

So if the Fed is correct in its forecast for interest rates, there are number of issues that come up from a financial planning perspective. Sustained low interest rates reduce returns available from bonds which hurts individuals who may need higher levels of bonds in their portfolios. Lower returns may also force investors to rely more on certain equities for income, which could increase portfolio risk

As financial planners we can mitigate these risks in a number of ways. Investing in bonds issued by certain foreign countries can be a source of higher yields. For example, bonds issued by certain emerging market countries offer good credit quality at significantly higher yields than investment grade U.S. bonds or Treasury bonds. Certain categories of corporate bonds can also offer higher yields than U.S. Treasury or agency bonds. Investing in certain sectors of the equity market, such as preferred stocks, utility stocks, REITs, and quality high dividend-paying equities can also be a way to enhance portfolio cash flow or meet portfolio income requirements in the situation of very low bond yields, which we are experiencing now.

Striving for improved transparency has implications for financial planning as well as Federal Reserve policy. Greater transparency of things like plan goals and objectives, investment strategies, custodial relationships, financial statements, and accessibility, goes a long way to enhancing trust between client and financial planner. Given the headlines of the past few years, we can understand why people would be looking for greater transparency from their financial advisors. As the Fed is realizing, improved communication with important constituencies can not only increase trust, but also reduce risk.

Risk Management

……In Our Continuing Series “Am I Prepared?”

The past several years have been trying for many people planning for or entering retirement. The volatility of the financial markets has created angst and fear as people have watched the value of their capital fluctuate. Additionally, many peoples’ portfolios have not recovered fully from the 08-09 bear market. What these conditions have really driven home is the element of risk in investing, in this case, downside volatility. The great bull market of 1980s and 1990s created an environment in which risk was all but forgotten or downplayed. The focus then was a pro-risk, gain or greed environment, typical of bull market psychology. Now the focus is on risk avoidance driven out of fear of capital loss.

What is risk ?

Most of us would consider “risk” in the context of potential for downside or loss, in this case capital. There are a numerous factors that contribute to risk in investing, not all of which can be easily quantified. Some of the more common “macro” risks include economic risk, geopolitical risk, country risk or industry sector risks, interest rate risk, currency risk, inflation/deflation risk, valuation risk, etc. On a more “micro” level, some of the more common risks include company-specific risks or portfolio exposure risks. All of these factors create volatility in the markets.  

How do we deal with risk ?

 As financial planners, one of our most important responsibilities to our clients is to properly assess and manage risk in their investment portfolios. We do this by taking time to understand clients’ needs, goals, and lifestyle preferences, and carefully assessing their attitude and tolerance towards risk. This has an important bearing on the allocation of the assets in their portfolios which, in turn has an important impact on portfolio volatility (or risk).

Other ways in which we assess and address risk include: diligence in studying and understanding the overall market environment and the economic factors driving the markets; portfolio diversification; reducing exposure to company-specific risk through the use of index and/or exchange traded funds; portfolio hedging; and developing a sound financial plan. As we’ve said before, a sound plan helps to keep a client’s investments on course to achieve long term goals and reduces the risk of buying or selling at exactly the wrong time (otherwise known as “human emotions” risk).

Risk is part of investing, there is no way to get around this (even bank CDs have risk, albeit small). And there are always going to be major events and surprises that none of us can predict. In the end, the best way to mitigate risk is through proper portfolio allocation, understanding your risk tolerance, understanding and accepting what you don’t know, having a plan and sticking with it, and working with a professional you trust. By the way, you might want to ask your financial advisor how he/she is managing risk in your portfolio and have him explain it in a way that you understand and that makes sense to you.