Blogs > Your Money

Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Thursday, April 29, 2010

Retirees Need to Focus on Net Worth

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.


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