We often tell clients that they need to focus on their net worth and not just on income. Often, older clients view touching principle as a mortal sin. They either experienced the great depression or were influenced by their parents who repeatedly schooled them on the evils of touching one's principle. While it would be great if you had enough money to do this, it can cause a number of problems if you don’t.

First, many retirees’ focus is too short term. They know how much they need to spend now to get along, but tend to underestimate the effects of inflation. They invest too great a percentage of their portfolio in safe, fixed-income assets that won’t be able to keep up with inflation.

Focusing too much on interest and dividends can inhibit your ability to properly diversify your portfolio. It can cause you to avoid some of the riskier asset classes that are needed to keep up with rising prices. While on the surface, this seems to increase one’s risk, broad diversification is needed to reduce risk. What retirees often ignore is the risk of inflation eating away at their purchasing power.

Focusing too much on income can also cause you to pursue the latest high-yielding assets. It’s not unusual to see investors jump on the high-yield bond bandwagon when high-yield bonds get hot or municipal bonds (which have been popular recently). These assets can carry considerable risk. Some retirees structure their entire portfolio around high-dividend-paying U.S. stocks. They need to be careful, however, since the high dividend yield could be an indication of underlying company problems. This is also indicated by their low stock price.

While conserving principle is a key motivation in pursuing income, unless investors are careful, chasing high income may actually result in increased risk and loss of principle.

We encourage our clients to use a tool such as Quicken® to manage their overall finances. It’s easy to enter all of your assets, including your real estate, investment accounts, mortgages and car loans. It’s easy to quickly see an updated report on your net worth. Net worth takes into consideration all of the aspects affecting your financial situation – your income, capital growth and debts. We need to focus on all of these to really manage our finances.

If you net worth is growing sufficiently, there is nothing wrong with tapping into your principle to meet your needs. By doing so, it can take pressure off your search for high-income-producing assets that can lead to higher risk taking.

Some may argue that your real estate (home) may give you a false sense of how much you really have to meet ongoing needs. If that bothers you, focus on your overall investment portfolio and your total return, instead of net worth. However, if you have a second home that you may ultimately sell to meet future needs, or your home could be downsized in the future, your real estate should be considered in your assessment of the resources available to meet your future needs.

Your focus should be on growing your net worth, not just growing your income. This can best be done by investing in a broadly diversified portfolio (to lower risks) tuned to your risk tolerance and periodically rebalancing by selling over-allocated asset classes and buying under-allocated asset classes (selling high and buying low). Over time, the rebalancing will force you to replenish your cash and short-term bond positions that you need to live on. Yes, you’ll have to tap into some principle to do this, but you will be improving your overall returns, while at the same time reducing risk.

The recent news about Goldman Sachs being charged with fraud reminded us of the importance of understanding what it is you’re investing in and avoiding complex investments.

A Wall Street Journal article titled “U.S. Charges Goldman Sachs With Fraud” (Saturday, April 17th), stated that Fabrice Tourre, a Goldman Sachs’ Vice President was responsible for creating a complex financial product called “Abacus”. The article reported that the Securities and Exchange Commission (SEC) found that Mr. Tourre had written in an email that “the whole building is about to collapse anytime now” and that Tourre described himself as “the only potential survivor, the fabulous FAB…. Standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

Investors in the “Abacus” product reportedly lost one billion dollars. Very likely, some of them were looking for a silver bullet and blindly invested in a complex product that carried more risk than they realized.

Just before the tech-stock bubble burst, Warren Buffet was criticized for not including tech stocks in his Berkshire Hathaway portfolio. The price of his “A” and “B” shares dropped accordingly. When asked about why he didn’t invest in tech stocks, he stated that he didn’t invest in them because he didn’t understand them. He’s a firm believer of understanding the businesses he invests in. Many of the companies in the Berkshire Hathaway portfolio are anything but flashy, high-tech companies. His long-term returns were recently reported to be better than 20% annually for the last 40 years!

When hedge funds became the latest craze, we avoided investing in them ourselves and never recommended them to clients. To be honest, we have never felt we fully understood how they operated. The lack of transparency, high fees and lack of regulation added to our concerns.

We believe most investors will do well to avoid investing in anything complex. Having a knowledgeable financial advisor can certainly help, yet great care must be taken in choosing someone truly knowledgeable that can be trusted to act in your best interest. (See our previous blog titled “Is Your Financial Advisor Acting in Your Best Interest?”)

In summary, keeping things simple can avoid lots of problems and make life less stressful. Most assuredly, there are financial gurus out there designing the next exotic complex investment that will be hailed “a sure thing”. Our advice: Avoid it like the plague!

Now that the health care bill has been passed, Congress has turned its attention to financial-regulatory reform. As with the healthcare legislation, the Republicans and Democrats appear to be in agreement about very little, other than something needs to be done. Most Americans seem to want significant reforms to help prevent another crisis like we’ve just experienced. Clearly, Congress will do something, since both sides need to take some action before the November elections.

Whatever they do, one thing seems very clear. There will still be financial crises in the future. There will still be market bubbles. There will still be serious recessions. And, there will still be Ponzi schemes and fraud committed by financial and non-financial institutions alike. The best we can hope for is that the revised regulations allow for earlier recognition of problems while at the same time avoid stifling the operation of our markets.

Probably the biggest reason reforms will have limited success is their inability to deal with individual human greed and incompetence. A recent article in the Saturday Wall Street Journal titled “Report Says Regulators Missed Shots at Stanford” by Michael Crittenden and Kara Scannell (April17, 2010), stated that “The Securities and Exchange Commission suspected Texas financier R. Allen Stanford of running a Ponzi scheme as early as 1997 but took more than a decade to pursue him seriously, according to a report further tarring the agency that missed Bernard Madoff’s huge fraud.”

The article went on to say that “SEC examiners concluded four times from 1997 to 2004 that Mr. Sanford’s businesses were fraudulent, but each time decided not to go further. Reports about the Madoff Ponzi scheme indicated that the SEC also failed to adequately investigate his operations.

There will always be greedy people. There will always be those who overlook the obvious or have conflicts of interest that motivate them to overlook the obvious.

A number of factors have been said to contribute to the crisis of 2007 and 2008. Low interest rates fueled the housing market. Warnings about problems at Fannie and Freddie were ignored long before the crisis started. Congress itself pushed the mortgage industry to give mortgages to low-income people who really couldn’t afford them. The financial institutions created complex financial instruments that few really understood. Individual Americans ran up their credit card bills and took out second mortgages to buy things they really couldn’t afford. There are many to blame for the crisis – probably others not mentioned here.

So whatever Congress does in the way of regulatory reform, it’s not likely to prevent another crisis down the road. We can only hope that it provides for earlier recognition of problems and helps reduce the magnitude of the resulting damage.

With April 15th just behind us and all the related news about taxes, it has become quite clear that we most certainly will all be faced with bigger tax bills down the road. We learned that nearly 47% of Americans pay no income tax at all. With Congress on a continued spending spree, there’s little doubt there will be new taxes to deal with and likely fewer people paying them.

The trend of just raising taxes on the rich just won’t meet the growing spending needs. A recent article in the Wall Street Journal titled “To Fix the Deficit, Tax Man Must Knock on Many Doors” (John D. McKinnon, April 12th, 2010), discussed the results of a recent study by the non-partisan Tax Policy Center. The study, according to the article: “found that to reduce the federal budget deficit to a sustainable 3% of gross domestic product, the government would have to find an average of about a half a trillion dollars each year in new revenue (or spending cuts).”

The article went on to say, that according to the study: “To cover that amount through tax increases on the top two brackets – roughly families with more than $209,000 in taxable income – top rates would have to go from the current 33% and 35% to 72.4% and 76.8%.” Clearly that seems more than unreasonable. So what will Congress likely do?

We expect you’ve all seen articles about the likelihood of a new national sales tax, better known as a value-added tax, also known as a VAT tax. Most of the European countries, as well as Canada, have a VAT tax. A VAT tax to replace our overly complex income tax might not be a bad idea. Yet it seems more likely that we will have a VAT tax on top of our income tax.

A recent editorial (“Europe’s VAT Lessons”) on the Opinion page of the Thursday, April 15th Wall Street Journal, discussed the introductory VAT rates and current VAT rates in European countries and Canada. Introductory VAT rates averaged from 3% to 17.7%. Current VAT rates average from 5% to 25%. The United Kingdom went from 8% to 17.5%, France from 13.6% to 19.6% and Germany from 10% to 19%. (It should be noted that the only country listed in the article with a current VAT rate lower than the introductory VAT rate was Canada (from 7% to 5%)). What’s more, the top income tax rates in the United Kingdom, France and Germany are respectively 50%, 45.8% and 47.5%.

Is there any doubt that a VAT tax in the United States would increase over time? And, according to the article, “VAT proponents aren’t calling for a repeal of the 16th Amendment that allowed the income tax – and, in fact, they also want income tax rates to rise.”

So get ready for more taxes. There’s little doubt they are coming. In a future blog we’ll discuss some things you should do to help minimize the impact of taxes on your financial well being.

All may not be as it appeared in the news on the Goldman Sachs fraud charges by the SEC. An interesting editorial by the Wall Street Journal (“The SEC vs. Goldman”, Monday, April 19, 2010) points out that the investment in question did not hold any mortgages but was a “synthetic” collateralized debt obligation (CDO). The investment allowed investors to bet on the future value of certain mortgage backed securities without actually owning them. Major investors involved in the investment knew they were gambling on the mortgage market. The article stated “The existence of a short bet wasn’t Goldman’s dark secret. It was the very premise of the transaction.”

According to the article, the SEC claims Goldman let Paulson & Co. dictate which mortgage-backed securities would be involved in the speculation and then didn’t disclose he was involved. Yet, according to the Journal, “The SEC complaint itself states that ACA (ACA Management was the largest investor on the other side of the deal from Paulson) had the final word on which assets would be referenced in the CDO.” The article states that at the time Paulson was not well known. He only became famous after he profited from the investment. His involvement at the time the investment was formed, therefore, would have made little difference to other investors.

The article points out that Goldman was also a loser in the investment, to the tune of $90 million. If they thought Paulson’s involvement was such a risk, why would they bet against him?

The article also questions the timing of the suit. Could it in any way be related to the Senate debate over financial reform?

It was also interesting to see another separate article in the same Journal that discussed the fact that Goldman previously knew it was being investigated by the SEC (Silence Was Goldman; Will a Price Be Paid”) yet refrained from disclosing the fact to its investors. According to the article, Goldman was not legally required to notify its investors. Its stock took a hit, however, to the tune of a drop in market capitalization of $12.4 billion. Disclosure of the investigation could have mitigated such a decline. Perhaps Goldman thought the potential suit by the SEC had little merit and that’s why they didn’t disclose the investigation?

Obviously, there may be more evidence not disclosed by the SEC. Nevertheless, on the surface it seems that the suit may be questionable. Time will tell.

Dollar cost averaging (DCA) is a technique often used by investors to reduce the risk of buying into an investment at a high price. It involves spreading out your purchases over time by investing fixed amounts at pre-determined, fixed intervals. For example, if you planned to purchase $60,000 of a real estate mutual fund, you could DCA by buying $15,000 a quarter for four quarters or $10,000/mo. for 6 months. If the price of the fund dropped during that time period, you would buy more shares as the price dropped, resulting in a lower average cost than if you purchased $60,000 in a lump sum.

In a recent article in Financial Planning magazine titled “Set Investors Straight” (February 2010), author Dan Moisand points out: “The longer clients use DCA, the greater the odds that the averaging will actually work against them. This is because markets rise more often than they fall.” Mr. Moisand goes on to say: “Here’s proof: Pick any month between January 1926 and August 2009 as your start date. Fast forward to one month later, and the U.S. stock market will have risen in 62 out of 100 instances.” And, he points out that the longer the time frame the more likely it is that prices will rise.

It seems to make sense, therefore, to not use DCA when investing. If you’re a long-term investor, and believe the market will rise over the long haul, then DCA should be avoided. Even though this makes sense, there are some people who have a difficult time investing large sums of money. Getting them to act at all can be difficult. If you’re this type of person, DCA can help you get over that hurdle and at least take action. While perhaps not the best way to invest, DCA can help you diversify your portfolio and avoid leaving your money sitting on the sidelines earning a paltry quarter of a percent in some money market or savings account.

There may be other instances where DCA could make sense. If one was planning to invest in an asset class that has been on a recent tear with shares considered by many as over-priced, DCA may be a prudent way to slowly take a position. While this smacks of market timing (which we believe is difficult to do), it can help investors get past emotions that keep them from investing wisely.

On another note, there are times too when reverse dollar cost averaging (RDCA) can be used to help investors reduce holdings that need to be pared for a variety of reasons. The holding may be over-priced, it may constitute too great a portion of their overall portfolio or there may be a poor outlook for the asset. Obviously, if the holding is likely to depreciate in value for whatever reason, it makes sense to sell the required shares in one transaction, ASAP.

It’s not unusual, however, for investors to resist selling. Sometimes they don’t want to pay capital gains taxes. Other times, the stock was passed down to them by their Aunt Lillie. How could I sell that? Seller’s remorse is a common hurdle (They are sure the price will rise as soon as they sell). Selling portions over time can get you past these road blocks. If the asset goes up in value, you feel good because you still own some. If it goes down, you feel good because you didn’t sell it all. While perhaps not the best strategy, RDCA can get you off dead center and at least get you going in the right direction. Progress, while not perfect, is better than no progress at all.

During a recent, long-planned overseas trip I was shocked at how expensive everything seemed to be. I thought about why this might be. My wife says that I’m in a time warp when it comes to prices. I don’t like shopping, so when I do go I’m always amazed at what things cost. That could be part of the problem. Or, maybe it’s just the effect of the drop in the value of the dollar over the last couple of years. We’ve done most of our travel in the U.S. the last two years, so we haven’t experienced the dollar decline until now. Then again, maybe it’s a result of creeping inflation. Certainly that would explain at least part of the increased cost – though there have been great deals on cruises, with the world economies all suffering the last couple of years. Most likely, it’s a combination of the items noted and perhaps something else I haven’t thought about.

The point of all this is that travel in the future will most assuredly cost significantly more than today. With the extremely high U.S budget deficits on the horizon, the dollar will continue to be under pressure. Airplane fuel expenses and labor costs will certainly continue to rise as well.

With the economies of China and India on the rise, we will likely see the standard of living in those countries increase substantially. This will lead to more travel for their more affluent citizens, just as it has for Japanese citizens in the past. This will potentially increase demand for foreign travel and a corresponding increase in travel expenses.

It’s likely therefore, that any retirement travel expenses you are contemplating could be increasing at a rate that exceeds the rate of inflation you might normally assume for your retirement years. We encourage you to plan for higher expenses than you might otherwise anticipate.

Consider too, taking your overseas trips in your early retirement years when they will be less expensive and when you are physically better able to survive a 24-hour plane trip, physically demanding excursions and the pressures of coping with different cultures.

Another factor that supports the argument for taking your overseas trips early in your retirement years is the cost of trip insurance. For expensive trips, it makes sense to take out trip insurance to cover the cost of cancellations, delays, lost luggage, medical problems, etc. Trip insurance becomes very costly as you age though, since the likelihood of medical problems is increased.

There are a number of ways to reduce travel costs. You can stay at hostels and B&B’s, or book last minute reservations. Many airlines offer special rates to seniors. Find a compatible companion or couple to travel with and share the costs of renting a car or villa for a week. Consider planning your own trip - it’s amazing what you can do on your own at a reasonable cost. Utilize the Internet to search out all sorts of ways to save.

One thing is perfectly clear – the cost of travel will continue to rise, especially overseas travel. Expect travel costs to increase faster than many other items in your retirement budget. Plan to take your long overseas trips early in your retirement and seek out ways to cut the costs without sacrificing comfort.

Too often investors spend their time focusing on the wrong things. Too many are trying to find a silver bullet or time the market. We all tend to be too impatient, especially after the down markets we’ve experienced in the last decade. We hold on to our winners to long. We hold on to our losers too long. We let our emotions get in the way of doing what’s best. We let taxes keep us from selling when it’s prudent. We do all sorts of things that are detrimental to our financial success.

It’s very tough to consistently time the market. Timing requires being right twice, when to buy and then when to sell. It very difficult to do one of these right, let alone both. Identifying the next big winner is also tough to do. About the time we read about the latest hot asset, it’s likely already over-priced. We hold on to our winners too long because were sure they’ll continue to go up and we would feel so bad if we sold too soon. We hold on to our losers too long because we’re sure they’ll recover, even when there many other investments with much better prospects. So what should we do?

We can’t control the market and we have a hard time controlling our emotions. Below are things we can control that can have a significant impact on our investing success:

(1) Find an advisor who cares about you and is motivated to grow your portfolio. How often we’ve heard people say how “nice” their advisor is or how their advisor offers to take them out to lunch or pay for a round of golf. Well it’s nice to have a nice advisor but wouldn’t you rather have a quiet, frugal one who really cares about doing the best for you. See our past article titled “Is Your Financial Advisor Acting in Your Best Interest?”

(2) Make sure you have a broadly diversified portfolio. We utilize eleven asset classes for our clients’ target portfolios. Included are cash, short-term bonds, intermediate-term bonds (including TIPs), international bonds, high-yield bonds, large cap domestic stocks, mid and small cap domestic stocks, international stocks, and real estate equities. We include a small amount of commodities related stocks as well.

(3) Rebalance your portfolio at least annually. This involves selling the over-allocated asset classes and buying the under-allocated asset classes. If you do this with discipline, it can eliminate the psychological factors that cause us to do things at the wrong time or for the wrong reason. The “typical investor” buys high and sells low. Periodic rebalancing results in buying low and selling high.

(4) Pay close attention to costs, both those of your advisor and those of the funds you invest in. If the funds your advisor recommends have an average expense ratio of more than 1%, you should look for another advisor. A hundred basis points can make a huge difference in your wealth over a twenty to thirty year period.

(5) Pay close attention to taxes. Index funds and funds with low turnover ratios will typically result in significantly lower taxes. Place dividend paying assets in your retirement accounts and growth funds in your taxable accounts (they will typically generate long-term capital gains currently subject to the low 15% long-term capital gains rate).

The above five items are things you can control if you take the time to pay attention to them. And, if you’re spending your time doing that, you probably won’t have time to spend on things you can’t control such as timing the market or letting your emotions get you into trouble.

As the baby boomers prepare for retirement, many worry about having the financial resources needed to live a comfortable lifestyle. The recent turmoil in the financial markets, the burst of the real estate bubble and the credit crisis have everyone unnerved. While there’s hope that the worst is behind us, many worry about the commercial real estate market, other global economies, the declining dollar and a possible double-dip recession. Traditionally, those nearing retirement have focused primarily on the financial aspects. In today’s chaotic economy, the emphasis on financial needs is probably even greater. Many are scrambling to recover from horrendous losses in the market.

Yet financial preparation, as important as it is, is but one aspect you need to plan for as retirement nears. According to an article published on the American Psychological Association (APA) web site: “You also have to plan in terms of developing other interests and making a gradual transition in terms of where you derive your self esteem.”

Nancy K. Schlossberg, EdD, author of Retire Smart, Retire Happy: Finding Your True Path in Life, published by the APA, says there are three basic areas of change at retirement:

1. Change in identity - when people retire, they often have to change how they define themselves.

2. Change in relationships – social interactions at work will be replaced with new relations outside of work. Your spouse may find it difficult having you around more. Close work friends may have years until retirement and be unable to spend time with you.

3. Change in Purpose – the office no longer needs you. You need to develop a new sense of worth through new activities.

You can see that you need to give serious thought to what you will do when you retire. Many retirees we know claim that now that they are retired they are so busy they wonder how they ever managed to get anything done around the home when they were still working. Yet others have few, if any hobbies. Their work is their life.
One of our clients recently expressed how she felt immediately after retiring. She said:
“I was like a fat lady who was let out of her girdle and couldn’t get it all back in.”

We all have known people who became ill soon after retiring and in some unfortunate instances have died. We wonder if this is caused, in some cases, by the combination of the drastic lifestyle change coupled with the added stress of no longer receiving a paycheck each week.

Before retiring, give some thought to what things you are passionate about. What have you always wanted to do but never had the time? Read some books or take a course or two in those areas of interest. Perhaps you’ll be able to start a business or work part time doing something you truly love to do. This will help you adjust to the loss of self esteem from your job and at the same time, perhaps, generate some extra income to lessen the worry about running out of money.

Give consideration to volunteer work and take the opportunity of having more time to lose a few pounds. According to the APA, “A balanced portfolio of activities is important –travel, hobbies, volunteer work, exercise, continuing education, are all activities that retirees find rewarding. “

Whatever you do, don’t wait until six weeks before retiring to plan for the non-financial aspects. With corporate buyouts so very common, a hobby you love just may become your next job when your employer suddenly downsizes and you are forced to retire early.

Note: We originally published this article back in June of 2008. We feel the issues are even more important today as more people have been forced into early retirement in an incredibly stressful environment. We updated it to reflect recent events and concerns.