We’ve written before in our blog (http://opyourmoney.blogspot.com/, “A Better Way to Give”, December 8, 2009) about the first “D-word” - donor advised funds. Most large financial brokerage houses administer donor-advised fund accounts. Donor-advised funds are independent 501(C)(3) public charities that administer donors’ charitable gifts.

Investors can open charitable gift fund accounts and easily transfer cash and securities to the accounts. Once transferred, the gifts are irrevocable and qualify for a tax deduction in the year of transfer (with some limitations). Any gains on securities transferred avoid taxation. Therefore, assets with large capital gains tax liabilities allow individuals to give more by avoiding the potential capital gains taxes.

Donors decide how aggressively the assets they have gifted are to be invested. With professional management, donors have the possibility of seeing their accounts grow, providing the possibility of increasing the amount they can give to charities. Gifts must be made to IRS qualified public U.S. charities.

A gift fund provides a way to reduce taxes in a year of unusually high-expected income. By bunching several years of gifts together, one can meet gift fund minimums and receive a tax deduction for the total amount gifted in one year. The funds gifted can then grow tax free in the gift fund account and then be distributed to charities over the following years. Often donors feel more comfortable giving larger gifts and more gifts, since the impact on the donor’s finances is no longer a consideration.

The second “D-word” is due diligence. Maximize your giving by making sure your gifts go to quality charitable organizations that effectively utilize your gifts to benefit the intended recipients. Unfortunately, far too few individuals do any research on the organizations to which they are giving.

In a recent article in Bloomberg Business Week titled “Rethinking How To Give” by Amy Feldman, February 8, 2010, Ms. Feldman reviews a number of Internet web sites that evaluate the effectiveness of charitable organizations. She says that one of the most commonly used web sites is Charity Navigator (charitynavigator.org):

“It gives ratings – going from zero to four stars – to nearly 5,500 charities, and its site gets some 4 million page views annually. Those ratings have focused largely on financial yardsticks. For instance, it has given charities high marks for low overhead, but research shows that metric is not as helpful as others in evaluating a nonprofit’s work.”

Therefore, she goes on to say, “Charity Navigator ….. is devising a system that will still go from zero to four stars but will include measures of financial strength, accountability and effectiveness.”

Other sites mentioned in her article were: GiveWell (givewell.net), GreatNonprofits (greatnonprofits.org), GuideStar (guidestar.org), Partners for Change (partners4change.org), Philanthropedia (myphilanthropedia.org) and Root Cause (rootcause.org).

In summary, donor-advised funds allow you to accelerate tax saving on the gifts you make and allow your gifted funds to grow tax free. The websites mentioned above will allow you to do your due diligence and help you to better choose charitable organizations that effectively use the funds you give. Utilization of these two tools can help you maximize your charitable donations.

When we help clients develop their investment strategy, we always emphasize that higher returns are typically accompanied by higher risk. It is important to keep this fact in mind when considering new investments that seem to provide an unusually good return.

A case in point that illustrates how important this is was just published in the Sarasota Herald Tribune on March 19th. (A similar scheme was reported about two years ago in Sarasota.) According to the Tribune’s article, “….. many elderly investors were persuaded to liquidate annuities on the false promise of a guaranteed investment yielding 7% annual interest. They were told that ‘100 percent of your money goes to work for you’, when in fact funds were diverted to personal use, consulting fees, salaries paid to the defendants and sales agent commissions, according to the arrest warrant.” The article went on to say that the defendants: “attracted business with advertisements that touted high-interest using government-backed certificates of deposit. But when investors walked through the door they were steered instead to high-risk unregulated securities.”

It’s not unusual to see ads in the newspaper offering very high-paying CDs. We suspect that more often than not, the CD offer is merely a come-on to get investors attention. Once in the door, a switch is made to a high commission product or in some cases as in Sarasota, to some type of fraudulent product.

Another approach to be wary of impacted Michigan investors a couple of years ago. Investment seminars are offered, free of charge, as a way for investment advisors to acquire new clients. Often, a nice lunch or dinner is included at a well-known restaurant. Several years ago my wife and I received an invitation to a seminar at a nearby restaurant. One of our friends had mentioned that he had attended an earlier seminar by the same advisor. We decided to attend to see what the individual had to offer. It was a fast-paced presentation with slick slides and humor. There was little time for any in-depth questions. We were reminded of the loud, car commercials you often see on TV.

What was even more interesting was the fact that his literature stated that he had been a member of the Certified Financial Planner® (CFP) Board of Standards. I thought that to be a bit fishy since he didn’t claim to be a CFP practitioner. After checking to see if he was listed on the CFP website, it was clear he was misstating his qualifications. I was not surprised to learn later that the individual had been named in an investment scam lawsuit and was under investigation. Investors had been taken in a “Ponzi” scheme not much different than other Ponzi schemes of late. Many of his clients reportedly lost their life savings.

It’s very important to determine the background and qualifications of anyone you trust with your money. If it sounds too good, it most likely is. As the old saying goes: “There’s no such thing as a free lunch!” (Or a free dinner, for that matter)

Numerous articles in the newspapers, financial magazines and on the Web are touting the great opportunity we have this year to convert our IRAs and other retirement accounts (401(k)s,
403(b)s, etc.) to Roth IRAs. While there are significant benefits to Roth IRAs, the issues involved are more complex than first meets the eye. Conversions are not for everyone and perhaps for fewer people than most originally thought.

The Roth IRA is a wonderful concept. While no tax deduction is allowed for contributions as with a regular IRA, the account grows tax free and qualified distributions are tax-free. What’s more, there are no minimum required distributions for Roth IRAs as there are for regular IRAs,
401(k)s, etc., when one reaches the age of 70 and ½.

Prior to 2010, individuals with modified adjusted gross incomes (MAGI) greater than $100,000 could not convert to a Roth IRA. Starting this year, that restriction is eliminated. What’s more, the tax on the income from converting to a Roth can be either paid in 2010 or spread equally over 2011 and 2012. Sounds like a great deal? It may be and then again it may not. It all depends on your particular situation.

Delaying the conversion taxes until 2011 and 2012 sounds like a good deal until one considers that Congress may likely allow the Bush tax cuts to expire at the end of this year. Therefore, it may or may not be better to pay the taxes over 2011 and 2012.

Two key considerations for determining if it’s wise to convert are:

(1) Will your tax rate in the future at the time you take distributions from the Roth be greater than the tax rate on the conversion income? If not, the benefits of converting may not be that great.
(2) Can you pay the conversion tax from non-retirement accounts and without triggering substantial capital gains.

If the above conditions can’t be met, the benefits of conversion may be minimal at best. With our current economic crisis and mounting national debt, it seems like a given that taxes will increase for everyone going forward. Yet that may not be the case for all taxpayers.

Benefits also depend on how long it will be before distributions are taken from the Roth. The longer one can wait before taking distributions after conversion, the better the benefits. Conversely, if you will need to withdraw a significant amount of the Roth to live on soon after converting, it likely will make little sense for you to convert.

A key assumption in converting to a Roth IRA is that they will forever grow tax free and yield tax-free distributions. This may be a false assumption, according to Edward F. McQuarrie, Ph.D, a professor at Santa Clara University’s Leavey School of Business. In an article in the December 2009 Journal of Financial Planning by Richard Stolz titled “Bonanza or Bust?, Roth Conversions in 2010”, Mr. Stolz quotes Mr. McQuarrie as follows:

“The idea that Congress will never change today’s Roth provisions for the worse, for the
rest of your life and the life of your heirs, requires more faith than reason, and a
naiveté that would be touching if it wasn’t so dangerous to your financial well being.”

Mr. Stolz went on to say in his article that McQuarrie has outlined a number of ways Congress could affect the tax-free status of Roth IRAs. One in particular, is what McQuarrie called “excess Roth accumulations”. McQuarrie was quoted as saying in a March 5, 2005 article titled “Breaking Faith in Savings is Very Easy”, that “Congress could look voters in the eye and say we’re not taxing your Roth – all you have to do is take a big enough tax-free distribution each year to keep your account balance below the excise tax threshold."

There are a number of other issues to consider when making a decision about Roth conversions. It’s not as simple a decision as it may seem. We highly recommend you consult with a knowledgeable advisor before converting to a Roth IRA.

Time and time again people argue over the effectiveness of a buy and hold strategy. There are different approaches to buying and holding just as there are many alternative strategies. Many believe they can effectively time the market, specific sectors or asset classes. Technical analysis utilizes charting to trigger buying and selling. Everyone is looking for the silver bullet or the next craze to sweep Wall Street. This is especially true now after the losses most people experienced over the last couple of years.

Two recent Wall Street Journal articles give credence to the effectiveness of the buy and hold approach. The first was an article by Jason Zweig in his Intelligent Investor column dated Saturday, March 6, 2010, titled “A Star Trader Who Rarely Ever Traded”. The article was about John Laporte who retired from managing the T. Rowe Price New Horizons fund. Mr. Zweig noted that “An investor who put $10,000 in the fund when Mr. Laporte took the helm, three weeks before the crash of 1987, now has $78,000; the same investment in the Russell 2000 Growth index of small-company stocks has grown to just $ 52,000.”

Mr. Zweig wrote that Mr. Laporte seldom traded, holding the average stock for four years, whereas the typical small company stock fund traded stocks every nine months! Mr. Zweig went on to say that the New Horizons fund held two thirds of its top twenty holdings for at least five years each. He summed up his article by saying:
“… many individual investors try to beat the pros at their own game – a fruitless effort, since fast trading is a game even most of the pros can’t win.” As Mr. Laporte’s career has shown, less is more.

The second article that supports the buy and hold approach was written by Sam Mamudi in the Fund Track column of the Wall Street Journal on March 5, 2010, titled “Buffett’s Gains Beat Every Mutual Fund”. In Mr. Mamudi’s article he reports that Warren Buffett said his Berkshire Hathaway stock has returned 22 percent annualized gains over the last 45 years! Mr. Mamudi says that the two closest funds returned 16.3% (Fidelity Magellan) and 13.4% (Templeton Growth Fund), not even close to Warren’s performance. According to the article, the 22 percent gain is based on market price but Mr. Buffett prefers to use book value to calculate gains, putting the return at 20.3 percent since 1965.

The article goes on to say that $10,000 invested in Berkshire Hathaway on October 1, 1964 would be worth $80 million today, whereas $10,000 invested in the Fidelity fund would be worth only $9.1 million today. The article discusses the advantage that Berkshire has because it can take a long-term approach on its investments whereas mutual fund managers are often pressured to buy and sell more often in order to achieve good yearly performance. Warren approaches investing as though he is an owner of the companies he invests in and not just an investor. This long-term view has served him well.

There are some managers who can time the market, at least in the short-term, but few who can continue to do it over the long haul. For most, a buy and hold strategy seems to be most effective. It’s tough to ignore the success of Mr. Laporte and Mr. Buffett whose long-term, buy and hold approaches speak for themselves.

Note: Inclusion of any particular mutual fund in this article should not be construed as a recommendation by Patterson Advisors. We recommend readers seek the guidance of their own investment advisor before considering any investment.

Two of our recent blog articles outlined factors to consider when picking a mutual fund (Tips on Picking a Mutual Fund Part I and II). We included the Morningstar® stewardship grade, which is based on five components: regulatory history, board quality, manager incentives, fees, and corporate culture. A good stewardship grade helps you pick funds that, on the surface at least, have a tendency to focus on investors’ best interests. The manager incentives component of the stewardship grade considers the extent to which the managers invest in their own fund. Unfortunately, many funds are not yet given a stewardship grade by Morningstar®.

In 2005, the Securities and Exchange Commission began requiring mutual funds to disclose manager investments. Manager investments must now be reported in broad bands up to $1 million. Clearly, it would be more meaningful if the requirement exceeded $1 million but it seems logical that a million dollars should be sufficient to motivate most anyone.

Several articles we’ve come across have reported the results of a 2009 Morningstar® study regarding managers’ ownership in their own funds. According to those articles, that study indicated that less than 50% of stock fund managers invest in the funds they manage.

A July 6th, 2008 article by Chuck Jaffe of MarketWatch, stated that “Russel Kinnel, director of fund research for Morningstar®, said that he believes there is a direct correlation between investing in a fund and performance.” Jaffe went on to say that “Kinnel pointed out that in Morningstar’s fund analysis’ ‘picks’, the average investment by managers was $370,000, compared with $54,000 for the average analyst’s ‘pan’.”

There can be many reasons a fund manager would not want to invest a significant amount of money in a fund he/she manages. They may be relatively young and not have a lot of discretionary cash to invest or they may be managing a target date fund for seniors much older than they are. A manager may manage a municipal bond fund from a state other than the state he resides in. For more narrowly focused funds, managers who want to be broadly diversified would want to limit their exposure in a sector or niche fund. Nevertheless, the lowest band for reporting to the SEC is $0 to $10,000. In most cases, managers could improve investors’ confidence by at least investing the minimum band amount.

In a recent article in Business Week by Lewis Braham titled “Betting Their Own Money” (January 25th, 2010), Mr. Braham quoted a 2009 Morningstar® study that “managers with more than a $1 million stake in their own funds beat 58% of peers, on average, over the past five years. Funds with no manager investment beat 46% of peers.”

According to Braham’s article, Fidelity encourages its managers to invest in at least one fund they manage. Nevertheless, he says, most of Fidelity’s managers are compensated by fund performance. The article goes on to discuss several fund companies that require their managers to have significant investments in the company’s funds. Included were Royce & Associates, Southern Asset Management, Janus, T. Rowe Price, Davis Advisors and Dodge and Cox, to name a few.

Braham’s article includes a table of funds with “A” stewardship grades whose 10-year annualized returns beat from 83% to 99% of their peers. Since many funds do not have stewardship grades assigned by Morningstar®, Braham suggests that you may want to check the Statement of Additional Information included with a fund’s prospectus.

There are many important criteria to consider when picking a good mutual fund. Taking a bit of time to ferret out fund managers’ stakes in the funds they manage may well be worthwhile.

Note: Fund companies mentioned in this article and indirect references to funds mentioned in Mr. Braham’s article should not be construed as a recommendation by Patterson Advisors. We recommend readers seek the guidance of their own investment advisor before considering any investment.

Probably one of the biggest detriments to individual finances has been the introduction of the credit card. If you couple credit card abuses with home equity loan abuses, the result is an America where the average adult has a very low or negative net worth. Most people today carry significant balances that result in high interest costs and that require years to pay off. When credit was easy, many took advantage of home equity loans to pay off their credit card debt. Few learned their lessons and proceeded to run up their credit card debt once again. When the housing bust occurred, they found themselves deeply under water.

Contributing to the problem have been exorbitantly high interest rates and somewhat abusive practices by the banks. In an effort to protect consumers, Congress passed the Credit Card Accountability Responsibility and Disclosure Act of 2009. Under the new law, credit card companies are required to inform customers how long it will take to pay off their balances assuming they make only minimum payments. They also cannot raise the interest rates on cards without giving cardholders a 45 day notice.

The new law includes a number of other new rules that are meant to protect cardholders. Those new rules, however, will result in a significant decrease in revenue for the banks. As a result, cardholders will see many new fees aimed at recovering that lost bank revenue.

A recent article in the Wall Street Journal by Robin Sidel (“Credit-Card Fees: The New Traps”, February 10, 2010) outlined many of the changes taking place. A couple of examples from her article include:

(1) Citigroup will provide a 10% discount on interest charged if cardholders pay on time, but will charge 29% if the customer doesn’t pay on time.
(2) Some companies are introducing variable-rate cards. Even though interest rates are low now, these cards will make it easier for banks to charge a higher rate in the future as rates rise.
(3) Companies are increasing fees on foreign transactions and for extra services such as year-end statements.

The bottom line is that unless consumers pay close attention to communications from their credit card companies, they may end up paying even more in the future than they have in the past. How often do you open up a letter from your credit card company with print so small you need a magnifying glass to read it? How often do you just toss such letters in the waste basket? If you don’t pay attention in the future, your use of credit cards may be far more costly than in the past.

Congress’ attempt to protect consumers and lower the costs of credit cards may have the opposite effect. It’s somewhat similar to taxes. Whenever Congress attempts to “simplify” taxes, the tax code just gets more complex.

For more information on what to expect, we highly recommend you read the entirety of Ms. Sidel’s article.

Americans are brought up to be achievers. The youth of today are taught to win at little league sports, get all A's in school, become eagle scouts, make the cheerleading squad, etc. etc. Winning is ingrained in us at an early age. Little wonder then that, as adults, we focus primarily on how much our investments earn each year. We like to tell everyone at dinner parties about our winners while we take pains to ignore our losers. We chase the latest, hottest new investment, giving little thought to the downside risks.

Malcolm Gladwell’s recent best seller “What the Dog Saw” (Little Brown and Company, 2009) includes an article he wrote in The New Yorker (April, 2002) that shows the downside of relentlessly pursuing big returns while ignoring the risks involved.

The article was titled “Blowing Up – How Nassim Taleb Turned the Inevitability of a Disaster Into an Investment Strategy”. The article focuses on two very different investment managers, Nassim Taleb, a relatively new up-and-coming money manager back in 1996, and a well known money manager named Victor Niederhoffer. The two met at Niederhoffer’s estate at Niederhoffer’s request. After spending much of the day with Niederhoffer and watching him trade, Taleb left, more than ever convinced that he didn’t want to be like Niederhoffer, in spite of his respect for the man. Taleb was concerned that his approach to investing, although very successful, might be due to nothing more than luck.

Basically, Taleb believes that stock returns do not behave consistent with a normal distribution used by statisticians. He believes, on the other hand, that catastrophic market events occur more often than a normal distribution would predict. Like Niederhoffer, Taleb runs a hedge fund and uses stock options in his investment approach. Unlike Niederhoffer, however, Taleb only buys options while Niederhoffer buys and sells options.

Without going into the nitty gritty of the two approaches, one could say that Taleb is taking a conservative approach that can ultimately pay off big when the next market crisis occurs. Niederhoffer’s approach often makes big market bets under the assumption that significant market events have a low probability of occurring.

Taleb’s belief in a higher probability for the rare market crash, according to Gladwell, stems, in part, from his personal childhood experience with the crisis in Lebanon which took place unexpectedly (at least for him and his family) in a matter of months. His experience with throat cancer, a disease most people consider rather rare, also made him more cognitive of the possibility of market “black swans” as he calls them (He has published a book titled “The Black Swan”).

According to Gladwell’s article, Taleb’s team uses complex quantitative methods to buy stock options with the majority of his fund’s money invested in safe U.S. Treasury securities. Taleb’s approach, unlike most investment strategies, often loses money on a daily basis. By design, however, it won’t “blow up” like Niederhoffer’s approach can, as well as those of many other hedge fund managers. When a market crisis occurs, it will however, likely pay off big for Taleb’s fund. According to Gladwell, “Taleb, by contrast, has constructed a trading philosophy predicated entirely on the existence of black swans, on the possibility of some random, unexpected event sweeping the markets.”

Following that 1996 meeting, Niederhoffer lost everything in 1997. For Taleb, Gladwell states that “the financial crisis of 2008-2009 made a staggering amount of money for his fund”, Gladwell went on to say: “Niederhoffer, by the way has lost and made and lost a number of other fortunes in the intervening years”.

Unfortunately, because most of us want to be winners, we want to see regular positive returns from our investments. We have great difficulty waiting for the big payoff inherent in Taleb's approach. According to Gladwell, experiments by behavioral economists have shown that “because we’re more willing to gamble when it comes to losses, but are risk averse when it comes to our gains, we like small daily winnings in the stock market, even if that requires that we risk losing everything in a crash.”

So what’s the lesson for the average investor? In some respects, Niederhoffer’s and Taleb’s approaches might be considered the two extremes of investing. The average investor, we believe, will best be served by adopting a broadly diversified target portfolio and rebalancing at regular intervals. They should expect periods of negative returns and avoid chasing the latest hot assets. They should understand that avoiding large losses is just, or even more important, than making big gains. Winning all the time isn’t everything!