Our previous post discussed the fact that the high reached by the Dow Jones Industrial Average on Friday, August 21st may motivate some people to invest more in large U.S. stocks when they actually should take a pause and rebalance their portfolio (see our post titled: “Time for a Portfolio Rebalance?”).

But what if you panicked last year and pulled everything out of the market? Should you get back in now? Or is it too late? You clearly need to get back in sometime soon, if you want to keep up with future inflation.

Before you do, however, you need to take a new look at your risk tolerance. You need to determine the proper mix of stocks and bonds that will allow you to stay in the market regardless of what is going on. That way you won’t miss the market rebounds when they come (It’s very tough to time the market!).

How to decide what level of risk is right for you can be difficult. In our opinion, rules of thumb based on your age don’t typically jive with one’s emotional makeup. Often, risk questionnaires lead to an incorrect assessment of your personal ability to tolerate risk. We show our clients target portfolios along with statistically generated ranges of returns (based on historical data) that those portfolios may receive going forward. This helps clients visualize the gains and losses a given target portfolio might achieve in the future. However you determine your risk tolerance, we suggest you seek the help of a professional advisor. This step deserves significant thought before diving into the market.

Once you’ve determined the appropriate level of risk, we suggest you reinvest utilizing a dollar-cost-averaging (DCA) approach. Although we’ve seen studies that conclude it really doesn’t make much difference if you reinvest everything at once or utilize a DCA approach, we believe the DCA method works better from a psychological standpoint.

A recent Wall Street Journal article titled “The Mistakes We Make – And Why We Make Them”, August 24, 2009, states that “Dollar-cost averaging is not rational, but it is pretty smart.” Generally speaking, if you dollar-cost average you’ll feel good no matter what the market does. If the market goes down, you feel good that you still have money on the sidelines. If the market goes up, you feel good that you invested some of your portfolio.

So, if you pulled everything out of the market because you couldn’t handle the stress of the crash, dollar-cost averaging can provide a way for you to get back in that makes you feel good no matter what the market does. Lastly, it is extremely important to know exactly how to allocate your money when you go back in; it will help take the emotion out of investing.

Last Friday, the Dow Jones Industrial Average ended up 155.91 points at 9505.96, for a yearly high. Many investors may be tempted to move more money into large domestic U.S. stocks to avoid missing out on the current rally. Unfortunately, this may be exactly the wrong thing for them to do!

We help our clients select a target portfolio that consists of nine distinct “asset classes”. They include: cash or cash equivalents, short-term bonds, intermediate high-quality bonds, international bonds, high-yield bonds, large domestic stocks, small domestic stocks, international stocks and real estate equities (via REITs). For all asset classes, we recommend low-cost, no-load mutual funds. Each asset class has a target percentage for that part of the portfolio.

Once our clients achieve their target portfolio, we recommend they rebalance it at least once a year. Rebalancing involves bringing each asset class back to its target percentage. That involves selling those assets that are over-allocated and buying those that are under-allocated. This forces our clients to buy low and sell high, versus the “typical” investor who buys high during market rallies and sells low in market crashes.

If we assume that you have selected a target portfolio consistent with your risk tolerance and periodically rebalance it, it is likely that you now have a larger percentage of equities (including U.S. domestic stocks) than you previously targeted. If you add more, now, you will be taking on more risk in your portfolio than you originally were comfortable with. Instead of buying more large domestic stocks, you should sell some and reinvest the proceeds in the other under-allocated asset classes.

If you worry that the current rally will continue and you will miss out, keep in mind that you will still have a significant position in U.S. large stocks, which is consistent with your desired level of risk. If the market continues its rally, you’ll benefit. If the economic recovery slows and U.S. stock prices take a dip, the impact will be reduced by the fact that you moved some of your money to other asset classes.

A disciplined investment strategy that includes periodic rebalancing can help you avoid letting your emotions drive your investment decisions. Buying into a rally may not be the best thing to do.

The old expression “There’s no such thing as a free lunch.” is most always true. Usually there is some catch involved, a hidden fee or an ulterior motive. Most people, at one time or another, have received an invitation to a “free” luncheon or dinner by an investment advisor, insurance salesman or what have you. Most claim to be selling nothing. If that were the case, why would they do it?

A few years ago, a friend of mine told me about a dinner seminar he had attended. He said the presenter had some very interesting investment opportunities and that I should attend one if I had the opportunity. About a week later, I received an invitation in the mail. My wife encouraged me to sign up, so I could see, firsthand, what one was like.

So my wife and I went. The dinner was just OK. The speaker was slick; I’ll give him that. He talked so fast, though, that it appeared he didn’t want anyone to ask any questions. I found myself being skeptical of everything he said.

His handouts indicated that he had been a member of the Certified Financial Planner® Board of Standards, yet he didn’t claim to be a Certified Financial Planner licensee. A later check on the Internet proved that he wasn’t. He showed up the next day at a Financial Planning Association (FPA) of Michigan luncheon. I reported him to another FPA member who had ties to the CFP Board.

A little over a year ago, I was not surprised to see that he was reportedly involved in a Ponzi scheme here in Oakland County! Of course, it’s not fair to judge all investment seminars or the presenters by my one experience. There are many honest advisors out there who hold investment seminars and have the attendee’s best interests at heart.

Nevertheless, if you do attend a “free-meal” seminar, you need to do your homework before signing up for any products or services. In a recent “Ask Encore” Wall Street Journal column, a reader asked: “Do you recommend ‘direct-participation programs’ for retirees?” (Note: direct-participation programs are typically used for investing in real estate investment trusts or REITs.) The reader had attended a presentation by a broker. The broker emphasized the return of 7% but didn’t mention the high commissions involved or the fact that direct-participation programs typically lack liquidity.

The article went on to say that: “Advice you get at seminars could be great or not so great. Securities regulators who examined a series of ‘free lunch’ seminars in 2006 and 2007 found that half of such seminars ‘featured exaggerated or misleading advertising claims and 23% involved ‘possibly unsuitable recommendations’.”

Again, we don’t want to paint all seminar presenters with the same brush. Just be sure to do some due diligence if you attend a “free-lunch” seminar. Otherwise, your lunch could be very expensive!

In a recent newsletter to our clients, we included an article titled “Keep It Simple Stupid (KISS)”. We’re sure you’ve all heard of that expression. The gist of that article is that we shouldn’t invest in assets that we do not fully understand. We have found that when investments are more complex, they often contain hidden fees or in some cases, carry higher risk.

In our newsletter article, we noted Warren Buffett’s views on investing in assets you don’t understand. If you haven’t heard of Warren, he’s one of the greatest investors of all time. We said:

“One of the reasons Warren Buffet has been such a successful investor is that he avoids investing in things he doesn’t understand. Back when the tech stock bubble burst in 2000, Warren and his Berkshire Hathaway company were criticized for not including tech stocks in their broadly diversified portfolio. He told everyone that he didn’t invest in tech stocks because he didn’t understand them. We think that’s good advice. As it turned out, Berkshire Hathaway did quite well by avoiding tech stocks.”

Today, we noticed an article in the August 17th edition of Business Week, titled “Old Banks, New Tricks”. The article says that “Lenders haven’t sworn off risky financial products - they’ve just come up with different ones”. The article discusses new products for consumers, companies and small investors.

On the consumer front, “pay-day” loans used to be offered by small lenders. These advances on consumers’ paychecks are now being offered by big banks at rates reportedly as high as 400%! Even though the states have cracked down on these types of loans, the banks are “skirting the state laws” the article said. For example, Ohio recently capped the interest rate for such loans at 28%, yet Fifth Third bank introduced its “Early Access Loan” with an interest rate of 120% after the rate was capped. How they did so was unclear to us.

For small investors, brokerage houses such as Morgan Stanley, Smith Barney and UBS are offering “structured notes”, a type of debt instrument. Over $15 billion were sold in the second quarter. These notes are basically what are known as “derivatives”, where the value of the investment is derived from the value of some other investment. Some of the basic versions are OK for some investors but others are quite complex and include a substantial amount of risk. Many include double-digit teaser rates for the first couple of years. When those rates disappear, investors can realize huge losses.

The bottom line is to take time to understand the financial products that come your way. If they seem too complex or you’re unsure of what the costs really are, pass them by. Keep things simple, and you’ll be making a smart decision.

Most everyone pays off their mortgage by making monthly payments. It’s possible to make bi-weekly payments instead. For many, who are paid on a bi-weekly basis, bi-weekly mortgage payments can be made very conveniently.

Mick Morrow, President of Professional Mortgage Associates, LTD., in Clarkston, Michigan (email: mickpma@sbcglobal.net), advises that by making bi-weekly payments, your mortgage can be paid off approximately six years earlier than by making monthly payments.

A bi-weekly mortgage calculator is available at the website www.bankrate.com. Utilizing the calculator, you can quickly see the benefits of bi-weekly payments:

With a $200,000, 30-year, fixed-rate mortgage at 5.5% interest, the monthly payments would be $1,135.58. Bi-weekly payments would be $567.79. The bi-weekly mortgage would be paid off in 24 years with a total interest cost of $165,880.50, versus a total interest cost of $208,808.08 for the monthly payment plan, a savings of nearly $43,000!

So what’s the downside? According to Mick Morrow, many of the bi-weekly mortgage programs charge hefty fees, either an upfront fee or monthly transaction fees. While the savings clearly could justify such fees, Mick says that you can achieve similar results at no extra cost by paying a bit more with each monthly mortgage payment.

If you receive a bonus or large tax refund, you could also just add the equivalent of an extra payment once a year to one of your scheduled monthly payments (the earlier in the year, the better). You can do either without paying the mortgage company an extra fee.

(Note: if you’re receiving large tax refunds, you’d be better off to reduce your withholding and add the reduced amount to your monthly mortgage payments. Otherwise you’re giving Uncle Sam an interest-free loan.)

If you’re paid bi-weekly (26 times per year) and take half of your monthly mortgage payment out of each check, you’ll have enough extra (savings from 2 extra paychecks) to make the equivalent of an extra monthly mortgage payment, each year. As you can see from the math above, the benefits are huge. Bi-weekly payments, or as we have shown, the equivalent of bi-weekly payments, can build your equity faster and yield a fully paid-off mortgage years earlier than a monthly-payment plan would.

It’s fairly typical that most investors focus primarily on investment returns. Certainly, returns are important. Yet many investors fail to look at two other factors that can significantly impact their net return. Investment fees and taxes can take a huge bite out of your earnings. We’ll focus, today, primarily on the various investing fees that reduce your bottom line.

First and foremost are management/advisory fees. Investment advisors typically have three ways of charging for their fees: commissions, fee-based management and hourly or fixed fees.

Most everyone is familiar with commissions. If you sell a stock, you must pay the broker a commission. The commission can vary from a few dollars at a discount broker to substantially more at a full-service broker. Some mutual funds charge commissions (known as loads) either up-front at the time of purchase (Class “A” funds), or when you sell (Class “B” funds). There are numerous other classes with varying fee arrangements too numerous to detail in this post. No-load funds charge no commissions.

Regardless of whether or not mutual funds charge commissions, they all charge management fees. You can check out a fund’s fees or “expense ratio” by visiting the Morningstar™ website. Fees typically vary from a fraction of a percent for a low-cost index fund to 2.0% or more, annually, for a proprietary, actively-managed fund.

Studies have shown that lower-fee funds typically perform better than higher-fee funds.
Obviously, the downside of an advisor being compensated via commissions is that they may be motivated to suggest you buy the higher commission investment. Commissions can also lead to “churning”, where the advisor recommends changes to the client’s portfolio more often than necessary, in order to boost the advisor’s earnings.

Generally considered better than paying commissions, is a fee-based approach, where the investor pays a percentage of the assets managed, on an annual basis. Often, these fees average about 1.0% of the assets managed. In some cases for large portfolios, you might pay less than 1.0%. The advantage to this approach is that the advisor is motivated to grow your assets, and therefore recommend the best investments for you, not an investment that increases his income (due to a commission received). The downside is that your fee continues to grow as your portfolio grows, even though the work required of the advisor is essentially the same. There can also be an incentive for the advisor to focus their energy on gathering new business over servicing their existing business. Lastly, under this approach, you are usually required to move your assets to the advisors’ preferred brokerage house.

Finally, there are advisors who charge by the hour or quote a fixed fee for their services. The advantage here is that the fee does not grow as the portfolio grows ands the advisor’s advice is not influenced by commissions tied to products or to relationships with brokers and dealers. Investors have a clear picture of what their fee will be, which promotes a foundation for trust in the advisor/client relationship. Advisors who sell products will always be subject to the temptation to recommend products based on the potential revenue or influences of their broker dealers. We believe the fixed fee or hourly fee arrangement is the best approach for investors.

The bottom line is that you can improve your investment results, substantially, by paying attention to the fees involved. Many people have no idea what their paying. Take some time to find out. You may be surprised.

It’s hard to imagine that there’s anyone who didn’t have their portfolio take a big hit the last couple of years. Now that the market seems to be recovering, everyone is starting to get more comfortable with investing again and trying to figure out how to invest their cash.

With big losses to make up, it’s tempting to turn to the latest hot assets. Three that you hear a lot about at cocktail parties and over the backyard fence are gold, emerging markets and commodities. Gold and commodities are hot because a lot of investors fear that we are headed for high inflation due to the extraordinary high levels of government spending, both planned and committed. Emerging markets are hot because investors are betting that the higher growth in emerging markets (compared to the U.S.) will lead to higher earnings.

A recent article by Jason Zwieg, in the Wall Street Journal (“Under the Emerging Curtain”, July 25th, 2009) discussed the recent frenzy for emerging market funds and how investors were likely to be disappointed. As of the end of July, the MCSI Emerging Markets index was up over 45% for the year, versus 9% for U.S stock funds. Jason noted that investors had poured over $10.6 billion into emerging market mutual funds so far this year. That was, he said, more than 34 times the total they added to U.S. stock funds.

The reason for this difference, Jason said, was because the emerging market economies were growing significantly more then the U.S. economy. “Unfortunately”, Mr. Zwieg noted, “high economic growth doesn’t ensure high stock returns.” He went on to note that a study by Elroy Dimson of London Business School and a leading authority on financial markets had found in a study of 53 countries over many decades, that countries of high economic growth have lower stock returns than countries of lower economic growth. In other words Mr. Zwieg said: “ Over the long run, stocks in the world’s hottest economies have performed half as well as those in the coldest.”

So what causes this apparent phenomenon? It’s caused by investors’ expectations that they will earn more by investing in these hot economies. Unfortunately everyone else does too and this results in the emerging market stocks being over-priced. Then when things cool off, everyone gets hit hard.

Unless you are a very early investor and are smart enough to get out early, you will likely pay a steep price to buy into any hot asset class. And, if you’re like most investors, you hesitate to sell your winners and will be likely to hold on too long. The result – a poor return or perhaps even a big loss when the bubble bursts.

For the average investor, you’ll be better off with a diversified portfolio of lower risk asset classes that you periodically rebalance in a disciplined manner. Avoid chasing the latest “hot” investments and you’ll likely do better in the long run.

Often, when we tell people what we do, they say “Well, when I get a lot of money, maybe I’ll come see you.” It’s understandable that some people might think this way. Many people, when they hear the words “financial planning”, seem to immediately substitute the words “investment management” for the words “financial planning”.

For some people, who hold themselves out as financial planners, this is probably true. There are all kinds of “financial advisors” out there who call themselves “financial planners” but do little more than manage investment assets. On the other hand, Certified Financial Planner® licensees who display the symbol CFP® after their name are trained in a broad range of disciplines. Included are budgeting, insurance analysis, tax planning, estate planning, retirement planning and investment analysis.

Of course some Certified Financial Planners only practice a few of these disciplines. Some brokers, insurance agents, attorneys and CPAs obtain the CFP certification to enhance their mainline business qualifications and don’t do comprehensive financial planning. Yet there are many Certified Financial Planner licensees who do help people develop comprehensive financial plans.

What people don’t realize is that a financial planner who does comprehensive financial planning can help people of modest means increase their wealth and financial security. Regardless of the size of your investment portfolio, you can benefit from help with budgeting, a review of your insurance policies, some basic estate planning, help with your 401(K) choices and the development of an investment strategy to guide you as you increase your savings.

Yes, it costs some money, but for many, in the long run, having a financial plan can help them achieve greater wealth and security than if they just continued plodding away on their own with the hope that they are doing things right.

Comprehensive financial planning involves much more than just helping people with their investments!

We hope you all are finding our posts of value. Please let us know what you think of our blog. If you have any specific issues you’d like us to address, please let us know. If there’s something we can do to improve our blog, send us your suggestions. And, of course we’d like to hear your comments and questions concerning the issues we write about.

If you like what you’ve been reading, please let your friends and family know about our blog. And, you might want to visit our website (see link below), where we have about a year’s worth of articles we wrote for the Oakland Press’ Oakland Insider weekend supplement. There are also a number of useful links to financial websites that you might find helpful.

Link to our Website: www.pattersonadvisorsllc.com

Our last post discovered the importance of taking the time to carefully check out an investment advisor before turning over your hard-earned money for them to manage. This post provides a list of questions to ask yourself about your current and past investment advisors. This list was previously published in an article we wrote for the Oakland Insider insert about a year ago. Many of you may have already seen it. Regardless, it’s good to periodically reassess your investment advisor’s performance.

- Have your investment advisors spent time trying to understand your overall financial objectives?

- Did they clearly and completely explain how they are being compensated? If an advisor says to you “I don’t make money unless you do”, we’d suggest you run for the nearest exit. We are unaware of any fee arrangement where that statement would be true.

- If they recommended that you purchase mutual funds, did they explain the differences between Class “A”, Class “B”, Class “C” and other classes of mutual funds? Did they explain the commission and fees involved with each?

- Did they make you aware that investing larger amounts of money may qualify you for discounts when buying “A” shares of mutual funds? Or, did they just recommend class “B” funds without explaining that they include back-end fees for several years (usually five or more), while at the same time carrying higher annual management fees than class “A” funds?

- Did they make any attempt to explain all the different types of risks involved in investing?

- Did your advisors make any real effort to understand your risk tolerance? Or did they just ask if you wanted to be conservative, moderate or aggressive? These are very subjective terms that mean different things to different people. Understanding one’s tolerance for risk requires a more in-depth approach.

- Did they explain the different types of investments that are available, along with the pros and cons of each?

- Did your advisors make any attempt to provide real diversification in your portfolio? Having three or four different funds does not provide the needed diversification when they are all domestic, large-company funds. And, if they only handled a portion of your portfolio, how could they provide the overall diversification that you needed?

- Are the investments your advisors recommended in sync with your risk tolerance? Recently, the portfolio of one of our clients contained a “Diversified Futures Fund”, a highly-risky fund that invested in all types of futures and/or derivatives (investments whose values depends on or are derived from the price of other assets). These types of investments are highly speculative. What’s more, the fund had to earn 8.5% just to cover its expenses! And, to make matters worse, our client had indicated to his advisor that he was a moderate-risk investor.

- If your advisors have recommended that you place your investments in a “managed account”, with the investments overseen by various asset managers, was the cost clearly disclosed to you? This type of account can typically cost 0.5% to as much as 2% or more of your account’s value, per year. That may be OK if the managers do a really good job.

- Has it been ages since you’ve heard from your advisors? Do they make an effort to keep your portfolio balanced, or are they more interested in getting new clients? If they have not recommended any changes in the last couple of years, something is likely wrong. On the other hand, if they call every month and recommend a new hot stock, they may be trying to churn the account to generate commissions.

- Have your advisors recommended buying an annuity for your IRA account? The main selling feature of annuities used to be their tax-free growth. But IRA accounts already grow tax free. Therefore, one of prime benefits of an annuity has no value in a retirement account. Annuities often have surrender fees starting at 7% or 8% and then declining to zero over six or seven years (sometimes longer). Advisors often never mention surrender fees. Surrender fees act as a deterrent to moving one’s assets elsewhere and therefore reduce one’s flexibility.

- Finally, have your advisors really listened to you when you talked to them? Did they speak in language you could understand? Did they have your best interests at heart?

The above items address some of the major issues investors should be aware of. We highly recommend you take time to answer them to make sure your advisor is acting in your best interest.

You’ve spent substantial time going to school to learn your vocation. That may have included undergraduate college, graduate school, a trade school, or extensive, on-the-job training. Then when it comes to investing your hard-earned money, you give the responsibility to an investment advisor after a short one-on-one meeting with him or her. The biggest mistake you can make as an investor is not taking the time to check out the advisor’s credentials, reputation and capability.

We are skeptical every time we hear someone talk about how happy they are with their investment advisor. They say: “Oh he’s so nice!” They don’t talk about his qualifications or reputation --- just that he’s nice. What’s the chance they spent any time really delving into his background? Does it make sense to turn over $100,000, $200,000 over a half-a-million dollars of your hard-earned money without carefully researching a potential advisor’s qualifications?

The recent economic crisis has exposed a number of “Ponzi” schemes where investment advisors use the principle of new investors to pay the investment returns of earlier investors. Bernard Madoff cost investors some $50 billion! Art Nadel, in Florida, soaked investors for $350 million. And just recently another $53 million Ponzi scheme in Michigan was discovered. It’s typical for the creators of these schemes to be very personable, promote their schemes through “friends” and to be huge contributors to charities. Therefore, you need to be very careful about relying on friends’ recommendations.

If you manage your own funds, be honest with yourself. Are you really qualified to do it? Do you have the time to do it? Another big problem with individuals managing their own investments results from making decisions based on emotions. There’s a whole new field called “Behavioral Economics” that deals with the psychological problems inherent with investing. Individuals typically hold on to both winners and losers too long. A professional investment advisor can help avoid the emotional hurdles of investing.

So how do you go about checking out an investment advisor? Start with asking about his training and credentials. There are a myriad of designations used but perhaps the most recognized is the CFP® (Certified Financial Planner) awarded by Certified Financial Planner Board of Standards. Check with registration and regulatory agencies to find these types of advisors and to see if there are any reported problems with the advisor. Following are a couple of useful web sites:

http://www.cfp.net/ Certified Financial Planner Board of Standards
http://www.finra.org/Investors/ToolsCalculators/BrokerCheck/index.htm FINRA
(Financial Industry Regulatory Authority) Broker Check
http://www.bbb.org/us/find-a-bbb/ Link to Better Business Bureau locator

Ask the advisor for their Form ADV- Part II that all investment advisors are required to give prospective clients. Ask for references. Check the local Better Business Bureau. Ask the advisor how he/she is compensated. Do they receive commissions? Are they fee-based advisors who receive a percentage of assets under management? Or, do they charge a fixed or hourly fee? Do they sell products?

The above is a good starter list to check out a prospective advisor. In our next post we will provide a list of questions to ask yourself about your current investment advisor (assuming you have one). It was previously published in the Oakland Press’ Oakland Insider insert about a year ago. It’s worth repeating, as many of our current readers may have missed it.

The bottom line is that you should have a nice investment advisor, but being nice should certainly not be the top requirement. Take time to check out your financial advisor carefully and you’ll avoid the biggest mistake investors can make.

So it’s been three years since you met with your attorney. He drew up wills, trusts, powers of attorney, health-care directives and trusts. It was time consuming and rather expensive. But that’s now behind you. You don’t need to think about it anymore! Wrong!

We find that with a high percentage of our clients, a review of their estate plans uncovers numerous problems and/or “to do’s”. In many cases, those issues are related to the implementation of revocable living trusts. Not everyone needs trusts, of course. But if you have trusts, you too may need to address some issues.

Having an attorney create revocable living trusts for you and your spouse is just the first step. You must then take steps to fund the trusts. This involves deciding which assets should go into each trust and then re-titling the assets in the name of the respective trust.

The next most common problem involves beneficiary designations on life insurance policies and retirement plans. In many cases, life insurance policies should designate the insured’s trust as beneficiary. Retirement plans often designate the spouse as primary beneficiary and the trust as secondary. We say “many” and “often” since those are probably the most common cases. Nevertheless, you need to consult with your attorney and/or financial advisor if you are unsure.

Another common problem with titling results from new accounts created after the estate plan was finished. Clients invest in CD’s with several different banks or inherit Aunt Lillie’s portfolio. They title the new accounts in their individual names, instead of their trusts.

A number of other issues can arise that require adjustments to your estate plan. Congress may change the estate tax laws; beneficiaries may die; children marry or have serious issues to deal with; trustees may prove to be undesirable.

All of the above need to be addressed in a timely manner. Make it a point to have your estate plan reviewed every two or three, at the most, or whenever a significant event occurs that impacts your estate plan.