Americans are known to be hard working people. Compared to many other nations, Americans work harder and take less vacation. Yet when it comes to managing our money, all too often, we don’t spend the time we should. More often than not, new clients come to us with substantial amounts of cash sitting in checking and savings accounts earning next to nothing.

A recent article in the Wall Street Journal (“Savings Accounts Beckon Investors with Better Rates”, June 3rd, 2009) outlined a number of options for achieving better returns for your cash. In many cases, the article said, savings accounts now beat out many money market funds. The reason is that many banks are using “teaser” rates on their savings accounts to attract new customers. In the past, this has been a common practice with bank CDs. Since the savings accounts are insured by the FDIC (up to $250,000 until 2013), the savings account option is safer than uninsured money market accounts (although money market accounts have a history of being quite safe).

Some bank savings accounts are paying up to 2.25%, with many money market funds paying just half that amount or less. If you’re sure you won’t need any cash for a year or more, one-year CDs can also be a good option for some of your excess cash (not your emergency fund).

Whatever you do, take the time to shop around for a good rate for your checking and savings cash. You work hard for your money; make your money work hard for you too!

After the tech stock bubble in 2000 and our recent real estate debacle, it’s natural to begin wondering about what the next market bubble might be and when it might occur.

The recent bank, automotive and insurance bailouts coupled with the $700 plus billion stimulus package, expanded Federal budget and plans for what will surely be a costly national health care system have raised fears about higher interest rates and inflation. As a result, there’s lots of talk about gold as the investment of choice. It’s quite common to see gold being hawked on TV and to hear people boast at cocktail parties that they’ve taken a position in the precious metal!

Studies have shown that owning commodities can reduce portfolio volatility while at the same time increasing returns. All too often, however, investors get burned by following the hoards chase the latest hot investment, buying more and more as the price soars higher and then lose a substantial portion of their investment as the price comes crashing down.

To avoid getting caught in the next bubble, make sure your portfolio is well diversified. Set target allocations for each asset class and target prices for any individual stocks you own. When target allocations are exceeded, trim back holdings to the target level (i.e., sell high) and when target prices for stocks are reached, sell those holdings. If you can be disciplined to follow these guidelines, it will go a long way to reduce the impact of the next market bubble, whatever and whenever it may be.

Last fall a client called and wanted our opinion on buying GM stock. He said the price was so low and it had to be a great buy... and surely the government wouldn’t let GM declare bankruptcy?

We told him at the time that we wouldn’t invest in any automotive related company, that the risk was too great. We said that unfortunately, bankruptcy was probably the only way GM would survive long term. The client didn’t want to hear what we had to say. He brought up the fact that the government saved Chrysler from bankruptcy years ago and surely they would do the same for GM.

We told him that there were many other ways to invest his money in good companies that weren’t in financial trouble, companies that were in industries that were less volatile. Why pick a company with all the problems GM has?

The Wednesday before GM declared bankruptcy, a client was referred to us by a local attorney. The client, a widow, still held GM stock and her son-in-law (who supposedly was managing her portfolio) called her to tell her to sell the stock. Why did he wait so long? Did the son-in-law think she could do better holding on to GM stock than taking the loss and reinvesting in something with a positive outlook? We helped her sell her stock on the Thursday before GM declared bankruptcy. She received approximately $ 1.29 per share. Days later it would have been virtually worthless. We wonder who bought it from her. It was probably someone who said: “surely the government won’t let GM declare bankruptcy”.

Another client who noted that Ford had so far avoided bankruptcy asked my opinion about buying Ford. Surely it must be a good buy at such a low price? A couple of years ago, before Ford’s stock price took its plunge, we had convinced her to sell her Ford stock. She had been reluctant to do so because the stock had been in her family for many years and she was emotionally tied to it. Ultimately, she was very happy she sold when she did. “But isn’t it a great buy at its current low price”, she said? While it might well be a great buy, we pointed out to her that Ford has something like $30 billion in debt, currently. If the recession lasts for an extended time, Ford might yet have more serious problems. We told her we felt the risk was too high.

The bottom line is that just because a stock has a very low price doesn’t mean it’s a good buy. Sure, sometimes companies rally back and see their share price substantially increase. But all too often, a company’s stock price is low because the company has some serious problems. Betting on one company’s severely depressed stock with the hope of a miraculous recovery is akin to gambling. There is no silver bullet in investing.

In previous posts, we discussed two items that can help you avoid a personal financial crisis: establishing an emergency fund and ensuring your portfolio is well diversified.  There are several other key things you can do to protect yourself from crises like we are currently enduring as well as to strengthen your financial foundation.

 First and foremost, make every effort to eliminate all credit card debt.  If you have multiple car loans and a home equity loan, work toward eliminating them as well.

 Second, make sure you have adequate insurance policies for health, life, auto, home and disability.  Too often, our clients don’t have long-term disability policies, yet you are more likely to become disabled on a given day than you are to die!  Also consider buying a long term care policy and an umbrella liability policy.  With our highly litigious society, an inexpensive umbrella liability policy could quite possibly save you from a disastrous lawsuit. 

Once you have addressed the above basics, focus on increasing your savings.  Review your spending and cut out unnecessary or frivolous expenditures.  Make sure you are investing the maximum in your employer’s 401(K) or 403(B) plan.  Take advantage of any retirement plan matching provided by your employer.

 Finally, consider improving your marketability.  Go back to school for another degree or advanced training.  Consider positioning a hobby or a long-held dream to become a future avocation or business.  The days of thirty-year careers with one employer appear to be gone forever.  The likelihood of losing your job due to outsourcing, merger or corporate bankruptcy is greater than ever.  Even if you stay employed, preparing for a second career can position you for an early “semi-retirement” doing what you love.  More and more people are working part time in retirement.  They enjoy keeping busy pursuing their dreams while the extra income reduces the amount of retirement funds required.   Preparing for a second career provides all that and a possible fall-back position should they lose their job before retiring. 

 We will certainly see more uncertainty in the future.  It is important to position yourself to weather whatever storm comes your way.

In our last post, we discussed the importance and benefits of portfolio diversification. A recent Wall Street Journal article (June 1, 2009) highlighted a number of individuals who have been affected by the GM bankruptcy.

A mechanic in southern California sold his small repair shop four years ago in preparation for retirement. He then moved to Kingston, Tennessee where he bought a small house on a lake for $ 70,000 – “nothing fancy”, he said. His one luxury was a new Corvette. He put the remainder of his money in GM bonds, all $800,000 of it. He thought he was making a safe investment because he was avoiding stocks. At the time, he thought GM was a solid company. When the bonds dropped significantly in value, he made a common mistake – he bought some more bonds.

With the bond holders due to get only 10% of GM’s remaining value, the mechanic’s retirement is in serious jeopardy. All too often investors place too much of their portfolio in one investment, in one asset class or with one advisor.

Other recent examples of poor diversification include the clients of Bernard Madoff who ran the biggest Ponzi scheme of all time. Madoff made a name for himself on Wall Street and gave millions to charities in an effort to gain investors’ confidence. He played “hard to get” so that investors had to know someone close to him in order to invest their money with him. Well-heeled investors, who should have known better, placed nearly all of their capital with Madoff, hoping to make a killing.

At the same time in Sarasota, Florida, Art Nadel, a hedge fund manager was doing the same thing as Madoff. Nadel’s scheme was on a much smaller scale – only $400 million! Like Madoff, Nadel was well known for his charitable contributions, including huge gifts to the local YMCA foundation, but with the stipulation that all the YMCA gifts be invested in Nadel’s funds. As with Madoff, numerous investors were wiped out because they placed too high a percentage of their portfolio with one investment manager, Art Nadel. Other Ponzi schemes have recently surfaced with similar modes of operation and similar results.

As we noted in our previous posts, diversification is crucial to investment success. It helps increase investment returns and reduces volatility. More importantly, however, as the above examples clearly show, diversification can protect you from a once-in-a-lifetime financial crisis or an unscrupulous investment manager.

Diversification Really Does Work

 In our last two entries, we discussed that one important step to avoiding a personal financial crisis is to make sure you have a satisfactory emergency fund.  A second step is to make sure your portfolio is well diversified.

 Whenever we write about investing, we always talk about diversification and how important it is.  Over and over again we tell our readers and our clients that being broadly diversified is critical to their investing success and to protecting their hard-earned savings.  Diversification increases portfolio returns while at the same time lowering risk (as measured by portfolio volatility).

Normally, higher returns come with higher risk.  If someone is claiming they can ensure unusually high returns, it’s almost certain that the investment is highly risky, or possibly even, a scam.  Yet with the proper amount of diversification, one can actually increase returns and at the same time lower risk.

 Diversification doesn’t mean just holding ten or twelve stocks.  Sure, ten or twelve stocks provides more diversification than just two or three stocks.  To be broadly diversified, however, you need to hold a broad array of distinct asset classes whose returns are uncorrelated.  And for even further diversification, within those asset classes, you need to invest in broadly diversified mutual funds, exchange traded funds (ETFs) and index funds.

 We have modeled our investment strategy after the approach presented in Roger Gibson’s book Asset Allocation, 4th Edition.   Consistent with Gibson’s approach, we recommend that our clients’ portfolios include nine different asset classes.  Inluded are cash, short-term, intermediate-term and high-yield domestic bonds, international bonds, large and small domestic stocks, international stocks and real estate equities via domestic and international real estate investment trust (REIT) mutual funds.

The returns of these different asset classes have varying correlations. This means that during normal markets, some asset classes will have positive returns and others negative returns.  Thus, when some assets classes are down in value, others will be up.  This tends to moderate losses and helps to improve overall returns while reducing portfolio volatility.

 In extremely poor markets like we have experienced recently, nearly all asset classes will be down in value.  Nevertheless, some do better than others and a diversified

portfolio overall will perform better than a non-diversified portfolio.  Instead of being down 30% to 40% overall, a diversified portfolio may only be down 15% to 25%.

 If your portfolio is not adequately diversified, we highly recommend you seek competent professional help to make the changes necessary.

Our last entry discussed the need for an emergency fund and how large it should be. A minimum of three to six months of living expenses should be set aside in a safe, liquid asset (cash or cash equivalent). Some special situations deserve more discussion.

With married couples, even though both spouses have good paying jobs, their financial situation may dictate a much larger emergency fund. Consider the example where a dual income couple is able to meet monthly payments but has taken on two large car loans, a large home-equity loan, and has numerous credit card balances. If one of the spouses suddenly loses his or her job, their need for an emergency fund is even greater than what the general guidelines call for.

While it might sound extreme, it is not out of line to suggest that married couples should live on just one spouse’s income unless they have substantial savings to fall back on. With today’s turbulent economy, even the seemingly safest job can disappear over night. Young, newly married couples can easily fall into the two income trap. They get used to two incomes; buy a larger house, two brand new cars and end up forced to use credit cards to pay ordinary bills. Their budget gets even tighter when they have a baby and one of them decides to work part time. Medical expenses, diapers, baby furniture and clothes add to an even tighter budget. Without an adequate emergency fund in place, they can get into big trouble if they do not make the necessary budget adjustments in time.

Finally, college graduates should be especially aware. Often, they go overboard with the sudden availability of cash from their new job. They buy a new car, flat screen TV, new clothes, etc. If they are not careful to hold off on some of these items and establish an emergency fund, they may be setting themselves up for a serious debt problem.

Our economy is undergoing some major changes that are impacting us all. Credit is not as readily available to us and the need to pay for unexpected expenses will have to come from cold hard cash. What’s the bottom line? Don’t ignore your emergency fund and make sure it’s big enough to handle the problems you least expect.

As we noted in our last entry, lack of an adequate emergency fund can result in excessive use of credit cards and the associated high-interest-rate debt. Having an adequate stash of cash on hand can prevent personal financial disasters.

 

Financial planners typically recommend that an emergency fund equal to three to six months of fixed and variable living expenses be maintained in liquid assets (cash or cash equivalents).  This is to avoid having to liquidate investments at a possible loss as a result of an emergency. 

 

An adequate emergency fund for many will easily top $10,000 to $ 20,000 or more depending on your situation.  Often, we are amazed to see that clients have placed their emergency fund in a bank savings account earning a fraction of a percent in annual interest.  With a little effort you should be able to find safe money market or money-market-like fund that pays two to three times what most bank savings accounts pay.

 

The exact amount of emergency funds you should have can vary based on your personal situation. An emergency fund of three months may be sufficient for families with both spouses earning a solid income with good job security or retirees with guaranteed pension and social security income.  On the other hand, if you’re either unmarried or married and only one spouse works, or job security is an issue, then it’s important to have at least six months of living expenses socked away.   People with highly variable income stream (such as sales people whose earnings primarily consist of sales commissions), should allocate even more.  Individuals working in highly volatile or cyclical industries should also set aside more in their emergency funds.  In some cases, we would recommend an emergency fund equal to a full year’s needs.  If you’re unsure of how much to put aside, err on the high side.  We’ll talk some more about emergency funds in our next entry.

 

In our last entry we discussed the external economic factors that contributed to the current financial crisis.  Today, we want to discuss the things that many of us have done or not done with our personal finances that have contributed to the overall financial crisis and to our own financial problems. 

 

Everyone always wants to blame others for their problems.  More and more it seems that people don’t want to take responsibility for anything.  Individual Americans have also contributed to the financial crisis by not having their own financial houses in order.

 

We’ve been overspending and under saving.  It’s amazing how many people do not have an adequate emergency fund.  An emergency fund can help people survive a temporary job loss and avoid foreclosure on their home.

 

Over-spending has led to excessive credit card debt, which in many cases has led to excessive home equity debt.  Home equity loans coupled with low or no down payments on homes and the sudden drop in home values have left people little or even negative home equity in many cases.

 

Two-income families often take on more debt than they can properly service should one of the two lose their job or become disabled.  If a job loss is coupled with an inadequate emergency fund, high credit card debt and little or no home equity, it can be a disaster!

 

To top it off, all too often, new clients come to us thinking that their investment portfolio is broadly diversified.  In many cases, we see portfolios with 80% to 90% invested in the stock of large domestic companies.  While the clients hold a variety of mutual funds, they are often highly concentrated in U.S. stocks and thus are not truly diversified.  Even though almost all types of investments have dropped with the recent market declines, a more broadly diversified portfolio would have loss less than one concentrated primarily in U.S. stocks.

 

So while it’s common to want to place all the blame for crises such as this on others, we need to also look at what we could have done to prepare ourselves to better weather such an event.  Our future BLOG entries will discuss many of these areas in more detail. 

 

 

We felt it was appropriate in our first BLOG entry to spend some time talking about the external factors that have brought about the current financial crisis.  We believe it is unfair to point to any one individual or group as the cause of the crisis.  Many factors contributed to the mess we’re in.

 

We believe that low interest rates established to fight the recession caused by 9/11 and the tech stock bubble in 2000 contributed to the housing bubble that followed.  Congress, in an effort to provide more housing for the less fortunate prodded Fannie Mae and Freddie Mac to provide low cost mortgages to individuals who really couldn’t afford them.  Some mortgage sales reps accepted applications they knew were false.  In order to maintain their competitive position, company management backed the employees’ actions.  Some appraisers over-valued homes to allow individuals to take out larger mortgages than were justified.  Real estate speculators added fuel to the fire.

 

Bad mortgages were packaged together and sold to investors.  These securities were then insured via credit-default swaps.  Credit-default swaps are actually a type of insurance.  Insurance companies are required to maintain reserves to cover possible losses from their insurance policies.  Unlike regular insurance policies, credit-default swaps required no reserves and Congress failed to regulate them.   Financial institutions sold billions of dollars of credit-default swaps.  When the real estate bubble burst and home prices dropped, there were no reserves to cover the financial institution losses.  Banks stopped lending and our entire economy came to a screeching halt. 

 

As you can see, there were many contributors to our current problems.  We’ve probably missed a few in our short explanation.  No one person or group is to blame.  Yet there’s another side to this story.  It’s what the American people have done (or not done) to contribute to the problem.  We’ll discuss that in our next blog entry and later discuss what you should be doing to restore/strengthen your financial foundation.

 

 

Welcome to “Your Money”, our new BLOG with the Oakland Press!  We thought a brief overview would be appropriate.  We are a father/daughter team of Certified Financial Planner^® licensees, doing business as Patterson Advisors LLC. Our clients reside primarily in Oakland County, Michigan but also in several other states.  More information about our firm can be found on our website: www.pattersonadvisorsllc.com

 

We previously wrote a column titled “Your Money” for about a year in an Oakland Press weekend supplement titled “The Oakland Insider”, which was distributed to Waterford and Clarkston residents.

 

We plan to provide interesting thoughts, news, and recommendations covering a wide range of personal finance topics. Included will be general financial do’s and don’ts, advice on insurance, investments, budgeting, retirement planning, investing, estate planning and taxes.

 

We consider ourselves to be quite conservative, so if you’re looking for a silver bullet to recover quickly from recent market losses, you won’t find that kind of advice here.  We will focus on the same kind of advice we think is best for our clients.

 

We’ll start off tomorrow talking about the current financial crisis and why many people have faired much worse than others.  We’ll then provide our thoughts on what individuals should do going forward to better protect themselves from future crises and how best to recover from recent losses.

 

We hope you’ll enjoy our commentary and look forward to your comments.