Many of you are probably aware of the so-called “flash crash” that occurred on May 6th causing some shares to drop in value to as low as one penny in a matter of minutes. As of this writing, according to a Wall Street Journal report on Wednesday May 19, 2010 (“Flash Crash Plan: Circuit Breaker for Every Stock” by Fawn Johnson and Kristina Peterson), “regulators are exploring six hypotheses about the sudden plunge but haven’t pinpointed a single cause.”

Could another “flash crash” happen again? As noted in the aforementioned article, regulators are considering circuit breakers that would pause trading in any stock whose price dropped 10% or more in five minutes or less. Since the cause of the flash crash is yet undetermined, it’s unclear if the proposed circuit-breaker fix would actually prevent another similar incident.

It’s seems likely to us, that whether or not we have another “flash crash”, we can most certainly expect significant market “crashes” of one sort or another in the future. They might not be as severe in such a short time but they most assuredly will be gut wrenching.

So what should you do to prepare for whatever type of “crash” we experience down the road? Two things come to mind that we think make the most sense.

First, avoid getting caught up in the frenzy of a severe market downturn. Stay calm and let it happen. Don’t panic and sell in fear. Many who sold during the “flash crash” had their losses locked in as the market rapidly recovered. Timing the market is futile. We often see significant market drops followed a couple of days later by a similar–sized rally.

Second, when you sell stocks or exchange-traded funds (ETFs) , avoid using stop-loss orders. When the stop-loss price is reached, the order becomes a market order. During the “flash crash”, buy orders dried up, causing rapid drops in market prices, resulting in big losses for many stop-loss orders (in some cases 60% or more).

No matter what controls are put in place, we will continue to see substantial volatility in the markets, going forward. Keeping your emotions in check and avoiding the use of stop-loss orders should help you weather the storm.

If you’re having nightmares about losing all your money in the stock market, you’re probably not alone. It’s understandable too, given the wild volatility we’ve seen since the crash in 2000. The “flash crash” a couple of weeks ago would give anyone pause for concern.

And on top of all that, we’ve had to deal with one of the worst economic crises most of us have ever experienced. And, just as our economy seems to be making a recovery, we have unrest in the European economies. If that wasn’t enough, the volcano in Iceland has been seriously disrupting European air travel; there have been earthquakes around the world and a disastrous oil spill in the Gulf of Mexico that threatens a substantial portion of our economy. And finally, there’s the ever present worry of another terrorist attack. If we weren’t optimists, we’d be totally depressed!

But are things really that different than in the past? A week ago our firm was updating a chart that showed large U.S. stock annual returns versus T-Bill annual returns from 1926 through 2009. One might think that the chart from the year 2000 through 2009 would look much different than from 1926 through 1999. Yet there was little difference. Yes, the return for large U.S. stocks in 2008 was the second worst on the chart, but from a distance, the 2000 through 2009 part of the chart didn’t stand out.

The point is, we’ve had many severe market downturns in those 84 years. And more often than many would expect, the market recovers in a fairly short period of time.

And while there’s much to worry about (including the specter of high interest rates and inflation as a result of the mounting U.S. debt), does it make sense to get out of the market and put all your assets into seemingly safer money markets, CDs and TIPs? If you are a multi millionaire, perhaps you can afford to do that. On the other hand, if you’re a typical investor, you must not forget about the effects of high inflation eroding your purchasing power.

To reiterate, there are two main types of risk you need to worry about: inflation and volatility. Unless you have more money than you know what to do with, if you ignore either, you will have difficulty meeting your long term goals. We wrote an article in October 2008 titled “Risk Has Many Faces” that discusses these issues in more detail. We wrote:

“Losing purchasing power due to inflation can be just as devastating to your
retirement plans as a big market downturn. The difference is that markets
recover while prices continue to rise. Therefore, those of you who avoid
investing in equities could be in substantially more trouble than those who are
aggressively investing in the market.

Many people who avoid investing in the market have been told that they need equities in their portfolio to keep up with inflation, yet they still choose to shun the
market. Why do they do this? We can get some insight from the book
“Your Money and Your Brain” (Simon and Schuster, 2007), by Jason Zweig, a senior
writer for Money Magazine. Mr. Zweig points out that people are extremely
averse to suffering any kind of loss. Worse still, are losses that result
from them taking some specific action, such as buying a stock or mutual
fund. Therefore, they are more comfortable doing nothing (e.g. keeping all
their assets in safe bank accounts and CDs), even though it may result in an
even more disastrous consequence, a substantial reduction in their purchasing
power. They need to realize that by “doing nothing” they are really
avoiding an alternative (i.e. taking an action) that in all likelihood will be
good for them in the long run.”

If you are tempted to pull everything out of the stock market, keep the above points in mind. If you focus only on volatility risk, you will find that the risk of inflation can be just as detrimental to your financial plans. You need a diversified portfolio that includes both fixed income assets and equities. If it’s broadly diversified and you rebalance on a regular basis, you should be able to weather the market storms of the future.

Last Friday’s blog titled “Stay the Course”, encouraged investors to avoid panic in light of Thursday’s 375 point drop in the DOW. Yesterday, the market was down just under another 127 points and international markets took a big hit last night. We are writing this just prior to today’s market open. Stock futures are down significantly, portending another bad day ahead.

We still encourage everyone to resist panic. On this morning’s TV news, a commentator made a good point. Do you remember where the market was a year ago? The Dow Jones Industrial Average (DOW) was 8473, That’s nearly 1600 points lower than yesterday’s close. And, in March 2009, just 14 months ago, the Dow fell to a low of near 6,500, some 3,500 points lower than yesterday’s close! Another point the commentator made was that today our economy has improved significantly from a year ago.

Yes, Europe is having a fallout similar to what we recently went through and that could affect us. Nevertheless, markets are resilient and often recover losses much faster than we think they will.

A Morningstar® video report last Friday, May 22, titled “Five Upsides to the Downturn” also helps keep things in perspective. Jeremy Glaser of Morningstar discussed five things we might consider the “silver lining” of the recent downturn. The first was that the downturn has created some good opportunities to buy quality companies whose prices are now depressed.

The second was that with our portfolios down, it’s a good time to rethink our risk assessment. Have we been too aggressive? Do we have too little in cash to live through such downturns comfortably? Or do we have too much cash on hand and should take advantage of the current lower prices to buy some good stocks at cheaper prices?

The third point was that due to the European crisis, it’s likely that the Federal Reserve will continue to keep interest rates low. That’s good for those who want to refinance their mortgage or take out a loan on a new car or for some other purchase.

The fourth point was that with the Euro trading much lower compared to the dollar, now may be the time to take that long-planned-for European trip. However, you better check on the volcano in Iceland before leaving.

The fifth point isn’t really worth mentioning. Jeremy’s interview was the week’s edition of Morningstar’s “Friday Five” and it appears Jeremy had to stretch things a bit to make his fifth point.

In summary, it’s always good to look at the “glass is half full” view of any situation. It’s easy to be depressed about the stock market of late. Nevertheless, all is not bleak. We need only look for the bright spots.

With the market declines that we’ve experienced in recent years, there’s been a silver lining. Mutual funds haven’t been distributing much in the way of capital gains. That may soon be coming to an end, however. Even though we’ve lost much of the gains from earlier this year, the market has advanced quite nicely from its low point in March 2009. At the time of writing, in spite of the recent market gyrations, nearly all asset classes are up for the year.

In a recent article in the Wall Street Journal titled “Tax Bomb Threatens Funds” (Saturday, May 15, 2010), author Eleanor Laise warns that funds may be distributing significantly more taxable dividends and capital gains this year than last. This, of course depends to some extent on what happens in the market for the rest of the year.

Ms. Laise article noted: “Many funds that looked benign from a tax perspective a year ago or so now look less friendly. Fidelity Dividend Growth Fund’s potential capital gains exposure in late 2008 was -73%”. She went on to say: “After a 51% return in 2009 the fund’s potential capital gains exposure has flipped into the black, with 1.9% of assets representing gains not yet distributed to shareholders.”

Only time will tell whether the average fund will distribute capital gains this year. Regardless, it makes sense to plan for such a possibility. You can avoid tax penalties if you have enough being withheld from your paycheck or make large enough estimated tax payments.

The IRS rules state that, generally, you won’t owe a penalty for 2010 if any of the following apply:

(1) The total of your withholding and timely estimated tax payments equals or exceeds your total 2009 income tax due. If your Adjusted Gross Income exceeded $150,000 in 2009, then your withholding and estimated payments for 2010 must equal or exceed 110% of your total 2009 income tax.
(2) The tax balance due on your 2010 return is less than 10% of your 2010 tax and you paid all of your estimated payments, if any, on time.
(3) Your total 2010 tax, less withholding is less than $1,000.
(4) You had no tax liability for 2009.

We’ll have to wait to find out what the mutual fund distributions will be this year. We usually call our mutual fund companies or check their web sites for expected capital gains distributions in late November or early December, to avoid any surprises. The bottom line is that a little bit of tax planning can often save you from an unexpected tax penalty.

After yesterday’s 376 point drop in the Dow Jones Industrial Average, it’s understandable that you may be a bit uneasy about the markets and your portfolio. The worst thing you could do right now, however, is panic and pull out of the market. If you just can’t sleep at night, then it’s likely that your portfolio is too aggressive, with too much allocated to stocks.

It’s important too, to have enough allocated to cash and short-term fixed-income assets to meet short-term goals and to allow you to ride out these down-market periods. For example, if you are retired, you should have at least two to three years (perhaps even five years) worth of cash and short-term securities to meet your living expense needs. If you also need money for a major project, daughter’s wedding or new car, that money too should not be invested in equities.

If you haven’t set aside enough, you might want to consider delaying the project or new car (you probably won’t be able to postpone the wedding) until you can get your portfolio straightened out.

We’ve seen lot’s of market corrections like these in the past and will likely see more and more of them in the future. Although inflation is almost insignificant at the present time, it most assuredly will raise its ugly head not too far down the road. It will be important to have some equities in your portfolio to maintain your purchasing power (unless you are so wealthy that you your funds will last no matter what the affect of inflation). Over the long run, stocks have consistently proven their superiority to bonds.

Remember that you want to buy low and sell high. Now is not the time to be selling.

We’ve commented in previous articles that too often people spend the majority of their time on earning money and little to no time on how to manage their money. (See our blog titled “The Biggest Money Mistake You Can Make”, posted in November, 2009.) If you are not familiar with the word “fiduciary” you need to understand it and use it as a guidepost for choosing your investment advisor.

According to Wikipedia, “A fiduciary duty is a legal or ethical relationship of confidence or trust between two or more parties. A fiduciary duty is the highest standard of care at either equity or law. A fiduciary is expected to be extremely loyal to the person to whom he owes the duty (the 'principal'): he must not put his personal interests before the duty, and must not profit from his position as a fiduciary, unless the principal consents." If your financial advisor is acting as a fiduciary, he is acting in your best interest. If he or she is acting in a fiduciary capacity as your advisor, he (she) will clearly disclose all means of compensation and any potential conflicts of interest.

Clearly, it makes sense to seek out an advisor who will act as your fiduciary when helping you invest your hard-earned money. You need your advisor to put your interests first and his or her’s, second. When searching for an advisor, you need to find out how a prospective advisor is compensated and what relationships they have with others. We believe that advisors who sell products have a higher hurdle to get over to prove they meet the fiduciary requirement. Fee-based advisors who are compensated based on a percent of assets managed and not via commissions would certainly seem preferable to commissions-based advisors. However, being fee-based doesn’t guarantee the advisor will act as a fiduciary.

In a recent article in the Wall Street Journal by Jason Zweig titled “Holding Brokers to a Higher Standard”, May 15, 2010, Mr. Zweig discusses the financial reform legislation being considered by Congress. At one point, according to the article, the proposed legislation contained a requirement that all “investment advisors” be held to a fiduciary standard.

Mr. Zweig reported that: “Many brokers and insurance agents are obligated only to have reasonable grounds for believing that any investment they recommend is ‘suitable’ for you. They need not inform you of conflicts of interest that might bias their judgment; you might never find out, say, that they sold you a particular fund primarily because it paid them a fatter commission than others would have.”

Currently, the bill has been changed from its original draft to only include a requirement to “study whether current standards are adequate”. It would behoove us all to encourage our senators and representatives to add the fiduciary requirement back into the reform bill. And, in your own best interest, check to see whether your investment advisor is acting as your fiduciary. Or, if you don’t have an advisor, place the fiduciary requirement at the top of your list of requirements when selecting one.

Note: The article was originally published in the Oakland Press back in the fall of 2008. We feel the information contained here is more important than ever for those planning to retire in the near future. We’ve modified the original article slightly.

At some point in everyone’s life, they begin to think seriously about retirement. We’ve written several articles on various aspects of retirement (past articles are on our website: www.pattersonadvisorsllc.com) but have yet to discuss some of the more technical factors that can impact the quality of your retirement planning.

Numerous websites have retirement calculators to help individuals determine whether they will have enough money in their senior years. Some of our clients who have used some of these tools have expressed a lack of confidence in the results, due to the high variability of results from one calculator to the next. Much of the variability is likely due to differences in the assumptions each tool uses. A small difference in tax rates, the assumed inflation rate or expected rate of return for investments can yield significantly different results.

Perhaps some of you may have read an article or two discussing a “rule of thumb” regarding 4% withdrawal rates. Basically the rule says that at the beginning of retirement you can take out 4% of your total portfolio balance (including both principle and earnings) in the first year, then the first year amount adjusted by inflation the following year, and so on. According to the rule, following this approach will result in your funds lasting 20 to 30 years through all types of economic cycles. How long your funds last depends on the percentage mix of stocks and bonds in your portfolio. Using this approach to plan for a retirement years down the road still requires making assumptions about inflation, taxes and rates of return. So while this “rule of thumb” approach seems easy to apply, it can still require some complex forecasting.

And what if four percent of your savings won’t meet your retirement needs? How do you know what to do to fix the problem? You could save more, work longer, plan to spend less in retirement or be more aggressive with your portfolio.

A number of financial planning software programs in the marketplace analyze one’s ability to retire by creating detailed cash flow projections until life expectancy. The resulting projections represent one scenario based on one set of assumptions. While most planners are careful to be conservative in the assumptions used, it is difficult to predict how a projection will hold up in the myriad of possible future scenarios. This type of retirement planning is limited, since it only gives you a black and white answer to whether or not you can afford to retire.

More sophisticated financial software programs are now available to planners. Instead of doing just detailed cash flow analysis, some software programs on the market now offer goal-based planning tied into full cash flow analysis at retirement. It provides planning for multiple financial goals and the ability to add, remove or reprioritize goals easily. These programs also offer an extensive offering of assumptions that can be changed so that multiple scenarios can be quickly analyzed with little effort. Rather than answering a cold-hard “Yes” or “No” to the proverbial retirement question, these programs are able to work with you to show what it takes to get to “yes”. They can even give you the confidence that you can afford to spend a bit more!

As an example of how such a software program might work, let’s suppose that besides achieving a comfortable retirement, you have the additional following goals, in order of priority:

1. Take a trip every year in retirement
2. Make a home improvement every three years
3. Buy a second home in South Carolina
4. Help fund your grandchildren’s education

An initial projection might indicate that you will not likely be able to afford three of your goals. After discussion with your financial planner you decide that it would not be a big problem to work another couple years (to save more in your 401k and increase your pension payment), take a smaller trip than you originally planned every other year, and only make home improvements every four years. With those changes, a new software projection indicates that you now have a very high probability that you will meet ALL of your goals! What was unworkable becomes workable with a few “reasonable” modifications!

What’s even more important is that these advanced software programs provide the ability to do what is called Monte Carlo analysis. Monte Carlo analysis shows the probability that your retirement plan will be successful using statistical data. It does this by running thousands of iterations of your plan while varying the investment returns year-by-year. Another useful feature that some programs have is the ability to do stress testing, which re-runs plan scenarios using variable year-by-year returns, to see the effects certain market scenarios have on the results.

The bottom line is that whatever approach you take in your retirement planning, it needs to be sophisticated enough to determine a high probability of a successful retirement and should also allow you to easily evaluate a variety of retirement scenarios. With the right financial advisor and the right tools, you can have the financial peace of mind for every retirement decision you need to make.

Our world seems to get more complex every day. The recent financial crisis was caused, in part, by exotic, complex financial transactions that few understood. We have repeatedly written about avoiding complex investments that so often seem to crash and burn (See our recent blog article titled: “Goldman Sachs: The Lesson to be Learned”).

Thousands have lost their homes in the recent financial crisis and thousands more foreclosures are expected in 2010 and 2011. Many bought homes they couldn’t afford and ran up credit card debt they could pay off. It seems like nearly everyone wants a bigger house, new cars and all the latest in toys and technology.

At the same time, few have saved sufficiently for retirement; college and health care expenses continue their meteoric rise and governments around the world are going bust. In the U.S., budget deficits threaten our future and higher taxes and inflation seem a certainty.

We seem increasingly vulnerable to Mother Nature, when an unexpected volcano can shut down Europe’s airports for nearly a week, and is currently causing more problems. Recent earthquakes have caused disasters around the globe. All this, as an oil slick threatens the coast of the U.S. We can imagine a world crisis caused by any number of factors. How can we prepare for an unknown future?

While our ingenuity has allowed us to grow and prosper, we know our natural resources are limited. We must find new energy sources and new materials to meet our needs and protect our environment. It seems that we need to change our ways.

An article we read recently in Real Simple magazine titled “Happily Ever After in 351 Square Feet” (May 2010), suggested a possible solution. The article told the story of Ren and Natale Marasco, a couple who returned home after Ren’s 31st birthday celebration to discover their 1400 square foot ranch home burning to the ground. They salvaged little and were not fully insured. Natale lost his garage workshop from which he ran his business, in the fire.

They considered many options but loved their property and jobs, so decided to stay where they were. They decided to combine two 1940’s era cottages they had previously acquired for free from local developers. They dug a foundation, moved the cottages in place and planned for maximum use of the space, a total of 351 square feet! They had two rooms, a kitchen dining area combined, a bedroom with a queen-size bed and small sofa, and an area for a tub, toilet and sink. Careful planning was needed to maximize their space.

Their life by necessity had to be simpler. They buy only what they need to eat in the next few days and waste less. They have little room for storage, so give away magazines soon after they are read. They store more info on their laptops (bank statements, photos and recipes).

The article sums up their “new normal”: “Surviving the tragedy of the fire aged our relationship, but in a good way. It goes on to say: “And being in such close proximity as we are in the house has deepened our connection. As a result, the pair, who don’t plan on having children, are in no hurry to move on to bigger digs.”

We’ve read of builders planning to build smaller houses. The scarcity of natural resources and tighter budgets may force us to return to lifestyles reminiscent of our ancestors. We may find that a simpler life provides more meaning and enjoyment as it seems to have for Ren and Natale Marasco. Perhaps simpler is better?

After reading the Wall Street Journal (WSJ) this morning, it raised concerns we’ve had for some time now, that while many believe our economy is finally emerging from the financial crisis of the last few years, we will, not too far down the road, face another financial crisis of significant magnitude. Today’s WSJ Review and Outlook editorial titled “The Real Euro Crisis”, makes a solid case for the fact that “The EU’s bailout postpones the day of fiscal reckoning”.

We believe that the European Union bailout announced over the weekend will have the same affect as the bailouts in the U.S., the last couple of years. We are concerned about the level of U.S. debt resulting from bailouts, the new healthcare programs and other continued spending by Congress. While the economy may improve in the short term, we worry that we will see significantly higher interest rates and inflation in a couple of years along with higher taxes that will stifle economic progress and potentially bring about another severe recession.

The WSJ editorial summed up the Euro crisis as follows: The real euro crisis, in short, is one of overspending and policies that sabotage economic growth. Sunday’s shock and awe campaign has merely postponed that reckoning – and at a fearsome price. Much the same could be said of our Congress’ bailout of the U.S. Economy.

Another WSJ article about Fannie Mae added fuel to the fire. Titled “$145 Billion and Counting”, the article discussed Fannie Mae’s announcement yesterday of its “11th consecutive quarterly loss of $11.5 billion—and asked for another $8.4 billion in taxpayer assistance.” The article went on to say: “Once the checks from the Treasury clear, Fan and Fred (Fannie Mae and Freddie Mac) will have consumed a combined $145 billion in taxpayer cash, and the end is nowhere in sight.” To make matters worse, the financial regulatory bill being considered by Congress has no provisions related to Fannie and Freddie.

Another article by Zachary Karabell titled “the World’s Dollar Drug”, discusses the fact the dollar is the world’s reserve currency and “remains the linchpin of the global system”.
Other countries depend on the dollar and need to buy dollars to do business. The article states: “The dollar’s dominance has short-term benefits for the U.S……… when the American federal government wants to take on additional debt, it has the advantage of a world that must buy dollars” Mr. Karabell goes on to say: “The U.S. government also has the ability to print that global reserve currency when dire straits demand it. That gives the U.S. considerable latitude to spend its way out of a crisis without confronting real structural changes.” We worry that we can’t continue to avoid addressing the structural changes needed and that down the road there will be a severe price to pay.

We hope our assessment is wrong but it sure seems that spending our way out of trouble avoids the root causes of our economic problems and may in fact make them worse.

Some years prior to the 2000 stock market plunge, Dave had an opportunity to participate in an offsite meeting for General Electric employees at a golf resort in Northern Michigan. Most of the meeting was focused on business issues but part of the session also covered employee personnel and benefit issues.

Dave’s brother, an attorney, gave a talk on basic estate planning issues and Dave gave an overview on basic financial planning issues. One of the presentation slides talked about a number of financial pitfalls to avoid. One that we always include in such presentations, is that one should avoid accumulating too much of their employer’s stock.

There are a number of good, solid reasons for this advice. First of all, it is not wise to too own much of any one stock. Ideally, we recommend that our clients keep holdings to less than 5% of their investment portfolio value. This limits the impact of company-specific problems on the overall portfolio. We’ve all seen stocks plunge 50% in a short period of time for a variety of unexpected reasons. If your holding is no more than five percent, then a 50% drop in value results in a 2.5% hit to your total portfolio.

Another reason for avoiding too much of your company stock is that when companies experience hard times, it’s often during severe recessions. Tough times lead to layoffs and early retirements. If you happen to be on the layoff or early retirement list you’ll need all the resources you can muster. Your company’s stock value will most assuredly be depressed. Minimizing your company stock holdings will position you to better cope with your possible loss of employment.

As for the presentation to the GE employees, Dave’s advice was poorly received. At the time, GE had a long history of stellar earnings and rising stock price. Who could imagine anything else? A GE Vice President, at a subsequent presentation of the entire group, made a somewhat snide comment about the advice. You could probably bet that no one paid any attention to the recommendation.

A recent article we read (we don’t recall the title or source) questioned whether GE could resume its solid, consistent growth of the past. On March 4, 2009, GE’s stock closed at an unbelievably low of $6.69. It’s currently trading in the $18.00 to $19.00 range, still significantly below its past highs. The article pointed out that GE had layed off a substantial number of its employees. This is one such example of the risk of being too concentrated in your employer’s stock. Too many eggs in one basket, more often than not, ultimately leads to problems. Don’t let your employer stock holding get too high – you may very well regret it.

As most everyone knows, yesterday was a wild day on Wall Street, with the Dow Jones Industrial Average (DOW) plunging in a matter of minutes in mid-afternoon. The drop of nearly 1,000 points was followed by a rally, with the Dow ending the day down some 347 points (but up over 600 points from the low of the day). At the time of the severe drop, the market was already down significantly due to concern that the economic crisis in Greece could spread to much of Europe.

Newspaper reports indicate that a clerical error in one trade may have triggered computer trading systems to rapidly sell. It was reported that a trade for $16 million dollars was erroneously entered as $16 billion.

So what can we learn from what happened yesterday? Clearly, there were investors hurt as they panicked and sold at the bottom, locking in their losses, only to see the market recover a short time later. Others may have profited by buying at the bottom. If you consider yourself a long-term investor, however, you need to stay calm and ignore what’s happening in these market swings.

We’ve written time and time again that it’s very tough to time the market. You have to be right twice. You have to know when to get in and when to get out. Making that call just once is very tough to do, especially in the volatile world we live in.

Just think of all the unusual events that have occurred recently that could have significantly impacted world economies. We’ve had earthquakes, volcanic dust, an oil spill that is threatening the entire Gulf Coast, and now, unrest in the European economies. These events come and go. History has shown us that in times of crisis, the market usually recovers quite quickly.

If your emotions cause you to panic and sell in such a situation, you likely have too much invested in the stock market or don’t have your goals aligned with your portfolio. Money needs to be set aside in safe, short-term securities to meet short-term goals. If you are trying to juice your returns by increasing your investments in riskier assets, you will likely find it difficult to ignore wild market swings.

Investors need to have their portfolio risk tuned to their risk tolerance and goals in order to avoid letting their emotions drive their investment decisions. Broad diversification with periodic rebalancing (at least annually) should serve you well. Rebalancing helps you buy low and sell high. With the appropriate risk tolerance, aligned goals and some discipline, you can avoid letting events such as yesterday’s wild market cause you to let your emotions get the best of you.

When clients come to us, most have automobile, homeowner’s and medical insurance policies. There are three policies, however, that they often don’t have that may be needed to protect them from events that could seriously impact their future finances. Often not considered are long-term disability insurance, umbrella liability insurance and long-term care insurance. While these policies may not be needed, everyone should, at a minimum, make an informed decision as to the suitability of each policy for their particular circumstances.

It is very important to have long-term disability insurance, since you are, on a given day, more likely to become disabled than you are to die. Some people are provided this coverage through their work. Even if you already have coverage, you need to be sure that the coverage is for your “own occupation” and not “any occupation”. It is very difficult to collect benefits with “any occupation” coverage, since one must be unable to perform any occupation in order to be considered disabled.

Adequate “own occupation” coverage should provide benefits equal to 60% to 70% of your salary. Note that you cannot generally acquire coverage higher than 60% to 70% of your salary since a higher coverage would eliminate the incentive for you to return to the work force.

With our litigious society today, you may also want to acquire an umbrella liability policy to protect you from a lawsuit. These policies typically provide additional liability coverage in million dollar increments. You are required to have a minimum amount of underlying liability coverage with your homeowners and auto policies (usually $300,000 to $ 500,000). This type of insurance can typically be bought for $ 250 to $ 300 a year per million dollars of coverage. If you had $ 300,000 liability with your auto policy and a $1 million umbrella policy, you would have a total of $1.3 million liability coverage, in the event of an auto accident. For the cost, this type of insurance makes a great deal of sense for many individuals.

Finally, more and more people are considering long-term care insurance. There are many people now saying that long-term care is the real health care crisis in the United States. Long-term care insurance generally provides for a variety of services for people with a prolonged physical illness, disability or cognitive disorder. It often includes nursing home care, home care services and adult day-care services. To qualify, one must typically be unable to perform two of six activities of daily living (known as ADLs: eating, dressing, toileting, bathing, continence and transferring). This does not apply to those with cognitive disabilities such as Alzheimers. Some companies recognize five activities of daily living and do not include bathing, typically the first activity an elder person cannot perform. One should look for policies that include all six ADLs.

Some consider the odds to be about 50/50 that one will need long-term care. One national study predicted that about 60% of those age 65 or older will enter a nursing home at some time during their life. The chances are greater for women to spend time in a nursing home than men, since women typically live longer. Average stays are generally short, usually less than three years, often much less.

Many falsely assume that Medicare will provide for long-term care needs. Medicare will not meet an individual’s long-term care needs. Medicare provides up to 100 days of skilled nursing care but only following a hospital stay. Medicare also will provide for very limited home health care. Medical supplements to Medicare will not cover long-term care costs, nor will traditional health care insurance. Medicaid will cover long-term care but typically only for individuals with less than $ 2,000 in total assets.

Nursing home care can easily run $75,000 a year or more. The price of a policy depends on the features selected, your age and health condition. Those aged 55 to 60 could expect to pay $2,000 to $3,000 a year, or more. When considering long-term care insurance, there are many issues to consider, such as your family medical history, support structure within the family, available resources, etc. Some may have enough assets in the future to self-insure. However, if you should decide to acquire a long-term care policy, the sooner you purchase it, the better.

The above three insurance policies can provide important protection that is often overlooked. With budgets tighter than ever, we’re sure the added cost can be a hurdle to overcome. Whatever your situation, we hope that making you aware of these exposures will allow you to at least make an informed decision on whether or not to protect yourself.

In our recent blog titled “Get Ready for More Taxes”, we discussed the fact that higher taxes are most assuredly in our future. And, with the high level of government spending we are currently seeing, it seems very likely that the future will also bring us higher inflation. It will become increasingly important therefore, to pay close attention to investment costs and taxes in order to avoid a decrease in our net income going forward.

For those who invest primarily in mutual funds, we’ve outlined below some things you can do to minimize the taxes generated by your portfolio:

(1) Pay attention to your mutual funds’ Morningstar® Tax Cost Ratio (TCR) and Potential Capital Gains Exposure (available online at Morningstar.com). The TCR represents an estimate of the percentage-point reduction in an annualized return that results from income taxes. The Potential Capital Gains Exposure (PCGE) is an estimate of the percent of a fund's assets that represent gains. It measures how much the fund's assets have appreciated, and is therefore an indicator of possible future capital gain distributions. The lower the TCR and PCGE are, the better, when it comes to taxes.
(2) Morningstar also ranks funds on tax efficiency in their respective category. Called the % Rank in Category, it is a fund's tax-adjusted total-return percentile rank for the specified time period relative to all funds that have the same Morningstar category. A rank of “1” is best, “100” the worst. A low rank is more meaningful, the more funds there are in a category. While a fund may be best in its category with respect to tax efficiency, it doesn’t necessarily mean it is tax efficient. Nevertheless, if your asset allocation requires an investment in a specific category, it’s best to find a fund that rates well compared to its peers.
(3) Pay attention to your mutual funds’ turnover ratio. A turnover ratio of 50% indicates that half of the funds portfolio is replaced annually by other stocks. Turnover can result in higher taxes (though not necessarily) and certainly can lead to higher transaction costs.
(4) Consider using index funds in your portfolio. Since index funds trade less often than actively managed funds, index funds tend to have significantly lower expense ratios and often trigger lower taxable income.
(5) Consider using exchange traded funds (ETFs) in your portfolio. Since ETFs trade like a stock, you can minimize the capital gains generated by the ETFs, whereas mutual funds pass through capital gains annually to shareholders. A recent article in the Wall Street Journal, however, points out some problems with some types of ETFs. Readers may want to review the article titled “Hidden Tax Traps Inside ETFs” by Jason Zweig, April 17, 2010. The article suggests that investors be sure to review the tax considerations detailed in the ETF prospectus prior to investing.
(6) Place income-producing assets (i.e. bond funds, dividend paying stocks and funds, and REITs) in your retirement accounts and place non-income-producing assets in your taxable accounts (index funds, tax-efficient funds, growth stocks and growth mutual funds).


If you are a do-it-yourself investor who has the time and knowledge to pick your own stocks, you can eliminate the pass through of capital gain distributions that result annually from mutual funds. We believe, however, that for most investors the benefits of professional management and broader diversification of mutual funds (including index funds and ETFs) will serve them well.

Paying attention to fund expenses and taxes, while important now, will become even more important in the future to keep up with inflation and rising taxes.