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, September 30, 2010

Tempted by Gold?

On Tuesday gold jumped above $1,300 an ounce for the first time. On the surface, it seems as if gold will continue skyrocketing upward with no end in sight. Many are tempted to buy now, afraid to miss out on this “sure thing”.

In our blog article back in June (Differing Views on Gold, June 2, 2010 ), we quoted a Wall Street Journal article by author Jason Zwieg titled “Why One Legendary Investor Is More Worried Than Ever”. Mr. Zweig explained how Seth Klarman (president of Baupost Group, a firm in Boston that manages $22 billion of investors’ money) views the current market situation. Mr. Zweig stated in the article that:

“Mr. Klarman specializes in buying securities that nauseate other investors….” Mr. Zweig pointed out how worried Seth is about the world economy, in general. And how does Seth feel about gold as a hedge against the problems of the future? According to Mr. Zweig, Seth believes that all the obvious hedges are already extremely expensive, including gold. Seth was quoted as saying that gold is “Near its all-time high, it’s a very hard moment to recommend gold.”

At that time the price graph of gold’s rise reminded us of the typical graph of an asset bubble. The further it rises, the more so it looks like a bubble waiting to burst. If you must buy, limit your exposure to a small percentage of your portfolio and set a price at which to sell. Then, don’t hesitate to sell if gold reaches that price.

We believe it’s still a hard moment to buy gold. In fact, for us it’s even harder. Sure, gold may well continue its meteoric rise. And if it does, you can rightly say we were wrong. On the other hand, if it crashes, we can say we told you so. Remember our blog post from last week “Words of Wisdom from Warren”, in which we quoted one of Warren Buffet’s famous quotes: Rule # 1: Never Lose Money. Rule # 2: Don’t forget Rule # 1.

Tuesday, September 28, 2010

Do You Really Know Where Your Money is Going?

We often do comprehensive plans for our clients. We emphasize to them that besides establishing meaningful objectives, the most important factor in creating a meaningful plan is to properly document how they are currently spending their money and then projecting what their expenses will be in retirement (in today’s dollars).

This sounds pretty straightforward, right? In turns out that this is the biggest problem we have in doing comprehensive plans. If we don’t have an accurate assessment of where a client’s money is going and what they will need in retirement, we can’t complete a meaningful plan.

The typical scenario we run into is this: After signing up for a plan, our clients fill out a detailed questionnaire that includes detailed spending information. Invariably it seems, when we enter the data into our software, we find that when we compare what the client says they are currently spending to their current income, our software indicates a surplus of hundreds or even a thousand dollars, or more. They just don’t know where their money is going.

We strongly believe that the vast majority of our readers also don’t really know how much they are spending on many of their budget items. Yet they worry constantly about their investment returns. If they have given serious thought to their financial objectives (and many have not), there is no way that they can be spending in an optimal way to achieve their goals, if they can’t even document where their money is going.

If you are like many out there, who have not made it a point to track where they are spending their money, we strongly suggest you make it a priority. Software packages such as Quicken® or the website can help you manage your money. If you don’t think you can do it yourself, seek professional help.

Sunday, September 26, 2010

Will the Market Rally Following the Election?

We wrote back in July in a blog titled “Don’t Miss the Party” that a substantial amount of cash was on the sidelines waiting for the right moment to invest. We wrote:

“An article in the July 12 –July 18, 2010 issue of Bloomberg Businessweek titled When Cash Takes a Vacation by Roben Farzad, reported that ‘American Households are sitting on nearly $8 trillion in cash – money that’s earning virtually no return because people are so wary of additional losses.’ The article also reports that non-financial U.S. corporations had $1.4 trillion of cash on hand in the 1st quarter of this year. That was a 27% increase over 2007. At some point, the low returns this cash is receiving will motivate corporations and individuals to deploy it elsewhere.”

In our blog, we noted that being out of the market when a big rally takes place can be detrimental to your financial future.

In our opinion, the current problem with the economy seems to be more a problem of uncertainty and lack of confidence than anything else. Businessmen, bankers and investors are afraid to invest because they are uncertain about taxes, new regulations and the new healthcare plan. Banks are afraid to lend and businessmen are afraid to borrow. Providing them more money to invest doesn’t seem to be the answer. They need a reason to feel confident. A considerable number of people are unhappy with their government.

It seems probable that a substantial number of incumbents will find themselves without a job following the upcoming election. It may be that a significant change in Washington across both parties could spark a market rally.

An article in this weekend’s Wall Street Journal titled “Will Post-Election Bounce Happen This Year?” by Ben Levisohn, notes that historically markets rally after mid-term elections. The article quotes an average gain of 17.1% in the Dow Jones Industrial Average following mid-term elections.

The article explains that sitting presidents typically try to stimulate the economy in their third year in an effort to help their prospects of re-election. In many cases, the article says, the Federal Reserve has often lowered interest rates in the third year by an average 0.3%. With interest rates currently so low and all the controversy about the administration’s stimulus plans to date, it seems unlikely that the administration can utilize those tools. Therefore, the article states, a post-election bounce may not happen this time around.

Yet, for the reasons noted above, we believe the election may give confidence to bankers and investors alike, that the issues they are concerned about may soon be resolved. This could result in a market rally. The Journal article states that some believe the recent run-up in the market is in fact due to anticipation of a Republican takeover of the House of Representatives. Whether or not a rally occurs following the November elections remains to be seen. Timing the market is tough. We don’t recommend placing a big bet on such a speculative outcome. Never the less, it’s interesting to think about.

Friday, September 24, 2010

Words of Wisdom from Warren

We like money quotes from famous people and often include them in our client newsletters. Most people know who Warren Buffett is and we often quote one of many of his quotes: Rule # 1 is: Never lose money and Rule # 2 is: Don’t Forget Rule # 1.

In case you aren’t quite sure of who Warren is; he is one of the wealthiest people in the world who learned about investing and started investing at a very early age. In college, he studied under the famed investor Benjamin Graham who wrote the classic book on investing titled “The Intelligent Investor”. Using what he learned from Graham, Warren started his own investment firm, now known as Berkshire Hathaway.

Warren is now worth billions of dollars and plans to leave the vast majority of his assets to charity, when he passes on. He has become close friends with Bill Gates and made headline news in June, 2006, when he announced that he would join forces with Gates by leaving the majority of his fortune to the Bill and Melinda Gates Foundation... Recently Warren and Bill Gates secured the pledges of numerous other billionaires to leave at least 50% of their fortunes to charity.

Warren’s quote reminds us of the importance of protecting our principle when investing. Too often, investors look only for investment return, often chasing the latest hot investments. They overlook the fact that high returns bring high risk. Steady growth over time is what is really important. Losses are difficult to make up. A 10% loss requires and 11% gain to get back to where you were. A 25 percent loss requires a 33 percent gain and a 50% loss requires a 100% gain, just to break even.

We believe that many of these money quotes help teach a lesson often overlooked by investors. We plan to include more of these “Words of Wisdom” in our blog and hope you enjoy them.

Wednesday, September 22, 2010

The Biggest Mistakes People Make

Our last blog talked about the best money advice people have received. It caused us to think about the mistakes we’ve seen our clients make. We thought a summary of some of the common mistakes people make would be beneficial to our readers. Here’s a list of some we believe to be most detrimental to your financial well being:

(1) Running up too much credit card debt – Nearly everyone is aware of this problem. It’s so easy to pull out that credit card and buy whatever you want. If you’re not paying off your balances each month, you’ve got a problem. Seek help if you don’t know how to eliminate it.

(2) Lack of financial goals – Everyone’s budget is limited. Therefore you need to sit down and decide what’s important to you. Take time to analyze where you are currently spending your money and then re-align your spending to address what’s really important to you.

(3) Lack of an emergency fund – We used to recommend three to six months of living expenses set aside in liquid assets. With the recent volatility in our economy, we now believe that nine months to a year of living expenses might be more prudent.

(4) Lack of saving - Too many people focus too much on investment returns, when the best way to increase their net worth is to reduce their spending and save more. Benjamin Franklin’s saying “A penny saved is a penny earned” is just as valid today as it was back then. And, there’s no tax on the dollars you save. That’s a big benefit!

(5) Lack of portfolio diversification – We recommend eleven different asset classes for clients to invest in. Having five different large stock mutual funds provides large stock diversification but not true portfolio diversification. And having five large stock mutual funds most assuredly results in significant overlapping of the same holdings. True diversification across a variety of uncorrelated asset classes can increase your portfolio returns and lower your portfolio risk. If you don’t know how to do this correctly, seek professional help.

(6) Lack of basic insurance protection – An accident, sickness, death, disability, fire or lawsuit could wreak financial havoc. You need adequate medical, home, auto, disability, life and umbrella liability policies to protect you and your family. You want adequate coverage with deductibles designed to protect you against the large loss. Assuming the cost of small losses keeps your premiums down and will save you in the long run.

(7) Lack of focus on investment fees and taxes - Too many investors focus only on investment return. They forget that with high promised returns comes higher risk. Don’t ignore investment management fees, fund expenses and taxes which often significantly reduce returns. Investors frequently have no real idea of what fees they are being charged. Make it a point to find out what you are really paying.

(8) Letting emotions or taxes drive investment decisions - Investors are loss averse. They hold on to their losers too long and hold on to their winners too long. They are always “just sure” their poor investment will return to its former value. When an investment has a poor outlook you are better off selling it, write off the loss on your tax return and invest in something else with good prospects. When you buy a stock, set a target price at which to sell and then sell when it reaches that price. And don’t let taxes get in the way of selling. You will ultimately have to pay them anyway, so if it makes sense to sell, do so and pay the taxes. Many bad things can happen if you delay just because of taxes.

(9) Lack of estate planning – many people have not taken the time to even create a basic will. If you die without a will (intestate), state laws will determine the distribution of you assets. You may not like how the state does it. And if you have children, who will have custody if something happens to you and your spouse? Many clients come to us with detailed estate plans that include revocable living trusts. It’s very common for the trusts to be unfunded (e.g. the trusts contain no assets because the client failed to re-title their assets.) It’s also common for beneficiary designations to be incorrect. If you have no estate documents or it has been some time since they have been reviewed, we highly recommend you seek professional help.

Keep these in mind and you will be well on your way to personal financial freedom.

Sunday, September 19, 2010

My Best Advice

The October issue of Real Simple magazine included readers’ thoughts on what is the smartest money advice they had ever received (“This Month’s Question” in the Your Words section). The advice people had received was very diverse and caused me (Dave Patterson) to ask myself the same question. In my case, it was probably not some specific piece of advice someone gave me but rather the example set by my parents in how they managed the family’s finances. Clearly, they had been affected, like many, by the experience of the great depression.

I can still remember vividly, the little black notebook that my mother kept to log all of their expenses. I remember the stories my dad told of working in the potato fields for 15 cents a day and how they had only a dollar or so for gasoline each week, when they were first married.

I began saving at an early age. Someone gave me a “piggy” bank that took only quarters, inserted one at a time. As each quarter was placed in a slot in the bank, I had to pull a lever that inserted the money and registered the current total in a small window on the front of the bank. It held a total of $25.00. What was really cool was that the bank had a key that opened a little door on the bottom to empty the bank of its precious contents. I became almost obsessed with the bank. I couldn’t wait to earn another quarter, so I could see my savings rise. I asked for jobs to do and eventually delivered papers to earn money.

When I finished college, married and started working, I made it a point to direct nearly all of any net pay increase I received to savings. As a result our retirement savings grew rapidly.

If you were to ask me what my “best” money advice would be, I’d probably tell you to make saving the highest priority. Once you are making ends meet, direct any raises and bonuses to savings. After all, if you’re getting by on what you make and get a raise, you don’t really need that extra money to live on. If you want to really get ahead, take the opportunity to direct the extra cash to savings. Sure, it’s OK to spend a bit of it on yourself or to help you achieve a goal that was previously unattainable. Saving the majority of it, however, may be the only way you’ll truly get ahead in this tough world we now live in.

There are lots of people making big bucks who spend everything they make. They have the fancy cars, big homes and all the toys. What they often don’t have, is any significant savings. They may appear to be wealthy but aren’t saving for the future.

My best advice to you is to make saving a top priority. If you do, you’ll be making a wise investment in your future.

Friday, September 17, 2010

When Should You Start Taking Social Security - Part II

Our last blog (Part I) discussed the various issues involved in deciding when to start taking your Social Security benefits. This blog discusses how those who already started to receive Social Security can potentially increase their lifetime benefits by “resetting” those benefits.

We believe that most people have never heard about resetting Social Security benefits. So what’s involved? To reset your Social Security benefits, you basically pay back the government all the benefits you’ve received as of a certain point in time. This is called a “Withdrawal of Application”.

To initiate this process, you must file form SSA-521. You can obtain a form online. The instructions on the form state: “This procedure is intended to be used only when your decision to file has resulted, or will result, in a disadvantage to you”. It’s not clear what criteria the Social Security Administration applies in approving a Withdrawal of Application, but if a withdrawal results in potentially increasing your lifetime benefits, it seems like that should be reason enough. At some point in the future, you would then re-apply for Social Security and begin receiving larger benefits based on your then current age. Obviously, the longer the period since you originally applied, the greater the benefits will be.

Once the request is approved, you are required to pay back all benefits previously received. No interest is charged on the repaid amount and your Medicare status is unaffected. You will receive a form SSA- 1099 that indicates a negative net benefit amount. You can either deduct the back taxes or receive them as a credit on your current year’s tax return.

An obvious question is: under what circumstances does a reset of Social Security benefits result in greater lifetime benefits? We noted in our last blog that actuarially, the present value of the stream of benefits you receive should be the same regardless of when you start taking payments, assuming you live to your projected life expectancy.

Those who believe that they may live substantially longer than their expected life expectancy because of their health and family longevity history, may well benefit from a reset. Additionally, married couples where the lower-income spouse is significantly younger (or healthier) than the other major wage earner of the household, may find a reset to be of value since the increased benefit can continue as a larger survivor benefit through to the life expectancy of the younger/healthier spouse.

In an article in the Journal of Financial Planning titled “Social Security Reset: When Does it Make Sense?”, by Charles Ryan, CFP® (June 2010), Mr. Ryan also points out that: “After repaying benefits, time must elapse before the retiree breaks even on the transaction.” If the retiree dies earlier than expected, the benefit of the reset may be lost.

Mr. Ryan also points out in his article that retirees who are considering the purchase of an immediate annuity may find that they will receive a much greater benefit amount if they use the cash they have on hand to fund a reset of their Social Security benefit.

If you think a Social Security reset may benefit you, we strongly urge you to seek professional advice before filing out an application.

Wednesday, September 15, 2010

When You Should Start Taking Social Security - Part I

We assume that many of our readers are already retired and collecting Social Security payments, or soon will be. Our clients often ask us when they should start taking their benefits. What few people know, however, is that after you have started receiving Social Security payments, you can still change your mind. It’s called Social Security “reset”. In some cases it may make sense. We’ll discuss that in our next blog – Part II of this series.

First, let’s talk about when you should start taking your Social Security payments. Obviously, the longer you wait the greater your monthly payments will be. If you start receiving payments at age 62, you will receive an amount that is less than what you would receive if you wait until your full retirement age (FRA). If you outlive your life expectancy, then waiting till FRA could be very valuable. On the other hand, if you wait until your FRA and then die soon after, you may come out on the short end.

The Social Security system is set up so that from an economic standpoint, it should make no difference when you start receiving your Social Security benefits. Actuarially, the present value of the stream of benefits you receive should be the same regardless of when you start taking payments, assuming you live to your projected life expectancy.

To start with, you should consider your health and family history. If everyone has lived well into their 90’s and you are in top notch health, you should consider waiting until you reach FRA. On the other hand, if you are not very healthy and your family has no history of longevity, you might want to consider starting your benefits at age 62.

Also, if you plan to work full time until FRA in order to have enough funds for retirement, you would be best to wait on starting benefits, since they would be reduced by one dollar for each two dollars you earn above the current limit of $14,160. Once you reach FRA, there is no reduction in benefits received. If you work part time while receiving benefits, there is no reduction as long as you earn less than $14,160.

Obviously, if you are forced into an early retirement and need the Social Security benefits just to survive, you may have no alternative but to start receiving benefits at age 62. If your health outlook and longevity are good, and you have other sources of income you can rely on (including the possibility of part-time income), you should wait as long as possible in order to maximize the amount of your benefits.

If you are married and one spouse is significantly younger than the other major wage earner of the household, it likely makes sense for the major wage earner to wait until FRA or longer before starting benefits. Assuming the older spouse dies first, the lower-earning surviving spouse will receive a significantly higher spousal survivor benefit over the remainder of his/her life expectancy. Health and longevity outlook of both spouses still need to be considered.

One final consideration that is difficult to evaluate, is how legislation may affect the decision of when to start taking benefits. With Social Security System funding in question, future benefits could be cut, FRA’s extended and Social Security taxes increased by coming legislation. While it’s unknown what the impact might be, one could argue that taking benefits earlier rather than later might be advisable.

If you are unsure of what to do, we recommend you discuss the issue with a financial advisor.

Sunday, September 12, 2010

When Should You Take Your Annual IRA Distribution ?

In a recent meeting with a client we were asked whether it was better for them to take their IRA required minimum distributions early in the year or towards the end of the year. Seniors who have reached the age of 70 and ½ must take their first IRA distribution by April 1st of the year following the year they reach age 70 and ½. For the years thereafter, they must take their minimum distributions by December 31st of each year.

The required minimum distribution (RMD) each year is based on the IRA balance on December 31st of the previous year and the life expectancy the IRA owner reaches in the year of distribution.

Obviously if funds are needed to live on, the distribution should be taken whenever it’s needed. Generally, however, it makes sense to leave assets in an IRA for as long as possible, so that they can continue to grow tax free. That assumes, of course, that over the long run, the value of the assets will grow.

On the surface, for the distributions required in a given year, it seems that it probably doesn’t make that much difference whether the distribution is taken early in the year or later, unless the distribution is reasonably sizable. Even then, it would be better to take it earlier, if the market dropped significantly during the year, and better to take it later, if the market rose during the year. But who can predict what will happen at the beginning of any given year?

Given that over a very long time horizon, market values have increased, it probably does make sense to take distributions later in the year rather than earlier. While any yearly gain from waiting may be minimal, and some years may result in losses, over a retirement of twenty or more years, there should be some benefit to taking the distributions later in the year.

Confused yet? To make matters more complex, a recent MorningstarAdvisor online article titled “IRS Stepping Up IRA Enforcement” (9-10-10) by Natalie Choate, considered the “guru” of retirement benefit distribution planning, warned that the IRS is going after those who fail to take their required minimum distributions. The penalty for insufficient withdrawals is 50%. In order to minimize the chance of an audit, Natalie’s article concludes that those reaching the age of 70 and ½ are best to take their first distribution in the year they turn 70 and ½, rather than delaying to the year following (prior to April 1st). She also points out that those nearing their expected life expectancy (who can be sure of that?) can minimize audit possibilities by taking their distributions early each year.

Clearly, if you take care to withdraw the proper amount, you have no fear of an audit (unless you’ve stretched other IRS rules). In any case, if you are unsure of how much to withdraw or when, seek professional help.

Thursday, September 9, 2010

Naming a Trust as Beneficiary of Your IRA

In December 2009 we wrote a blog titled “Don’t Overlook Beneficiary Designations”. We noted in that article that it if you are married and have established revocable living trusts, with your spouse as primary beneficiary, it may make sense to name your trust as a contingent beneficiary. Doing so may allow your spouse to disclaim (refuse) all or a part of the IRA distributions in order to “fund” your trust, should pre-decease your spouse. (Note: “Funding” a trust involves re-titling assets in the name of the trust and or designating the trust as a beneficiary of insurance policies or retirement accounts).

Revocable living trusts can be set up for many reasons, but commonly are used to avoid costly estate taxes. At the present time (2010) there are no estate taxes, since Congress let the estate tax expire at the end of 2009. It is expected that Congress will enact a new estate tax by year-end. If not, estate tax law will revert back to a one million dollar exemption per person with the highest estate tax rate exceeding 50%. We can be quite sure, therefore, that there will be an estate tax in our immediate future.

With properly executed revocable trusts and proper titling of assets, a couple can protect two times the estate tax exemption from estate taxes. With a one million dollar exemption, that would mean a married couple could therefore shelter two million dollars from estate taxes. If, however, the majority of your assets are held in IRA accounts with your spouse as beneficiary, those assets would not be included in the trust. The trust might therefore not be fully funded, resulting in an estate tax liability.

By specifying the trust as a contingent beneficiary, the spouse can disclaim some or all of the IRA funds, if necessary, to fund the trust. While distributions from the IRA might be taxable at the trust’s higher tax rate, estate tax rates are typically much higher than income tax rates. Therefore, significant taxes may be saved by diverting some or all of the IRA to the trust. We highly recommend discussing the tax issues with a CPA prior to disclaiming any benefits.

If an estate tax liability is unlikely and you have children you want to be contingent beneficiaries, it is generally better to actually name them as contingent beneficiaries, even if they are the beneficiaries of the trust. Naming the children as contingent beneficiaries of the IRA will allow the IRA to be split into separate IRAs upon your death so that each child can take distributions over their individual life expectancy. Separate IRAs also provide more individual flexibility with respect to distributions for the children.

If the IRA is paid to the trust as contingent beneficiary, with your children beneficiaries of the trust and certain conditions are met, the distributions may be paid out over the life expectancy of the eldest child. If the trust does not meet those conditions, the IRA will have to be distributed within five years, thereby eliminating the ability to allow the IRA to continue to grow tax-free.

The tax rules involving retirement plans and trusts can be quite complex. We highly recommend you seek the professional advice of a CPA, tax attorney, estate planner or financial advisor, if you have any questions.

Monday, September 6, 2010

Maybe It’s Time to Diversify Your Skills

We are always emphasizing that investors need to make sure their portfolios are adequately diversified. Proper diversification can help increase returns and lower the volatility of your portfolio.

With Labor Day upon us once again, we couldn’t help but think about the fact that another type of diversification could serve investors well. Acquiring new skills can position you to weather tough economic times like we are now experiencing. Unemployment is currently at 9.6 percent. Well in excess of fourteen million people are unemployed in the United States.

Having a diverse skill set can help mitigate that unexpected pink slip. You may even find a job that you find more enjoyable, even though it may not pay as much as your old job. A part-time job can supplement your emergency fund (You do have an emergency fund, don’t you?) to help you bridge the unemployment gap.

Consider pursuing your passion. It’s not unusual for people to work their entire life at a job they don’t really enjoy. They are stuck in a rut and afraid to try anything else. Take a hobby to the next step by starting a part-time business. Take a course or two at your local community college. Go back to school to get an advanced degree or finish that degree you never completed.

Even if you never lose your job, you will be positioning yourself to make a job change that might just change your life for the better. You may be preparing yourself to pursue your passion in retirement, doing what you love and at the same time supplementing your retirement income. With the Social Security system stretched and high inflation likely down the road, it will be tougher and tougher for people to save an adequate amount for retirement. Having the skills to supplement your limited retirement funds may make all the difference to what otherwise might be a stressful time.

While working at Pontiac Motor Division I (Dave) went back to school at nights
to obtain a business degree. There’s no doubt in my mind that doing that helped me advance my career and helped me obtain a better job when I needed a change. More importantly, during my business classes, I took a course on investing that led to my interest in financial planning. Little did I know that seeking new job skills would lead to a new career that has made it possible for me to work part-time well into my retirement years.

Diversifying your skill set will give you added flexibility to weather whatever storm comes your way while at the same time enriching your life experiences. It might be just as important as having a diversified portfolio.

Sunday, September 5, 2010

So You Think You’re Diversified?

Probably the most important thing to remember about investing is that high returns generally involve higher risk and taking on lower risk generally results in lower returns. That raises the question: Is there a way to increase returns without increasing risk? The answer is: Yes, there is. It’s called diversification.

Properly done, diversification can increase the returns of your portfolio and at the same time, lower risk. In his book, Asset Allocation: Balancing Financial Risk (Dow Jones- Irwin, 1990), author Roger Gibson gives examples of the returns of what he calls traditional portfolios (consisting only of T-Bills, long-term corporate bonds, and stocks in the S&P 500) versus more broadly diversified portfolios (that additionally include international bonds, small domestic stocks, international stocks and real estate investment trusts).

Over 10-year periods ending in 1985, the traditional portfolios returned 13.9 percent while the more broadly diversified portfolios returned 15.3 percent with significantly less risk, as calculated by the statistical measure known as standard deviation. Over the sixteen-year period ending in 1985, the return of the more broadly diversified portfolio was even better, with lower risk.

Obviously, there are limits to how much you can increase returns while at the same time lowering risk and there is no guarantee that in the short term every approach to diversification will result in higher returns with lower risk. Never the less, broader diversification over the long run, if done properly, will likely yield positive results. It is important, therefore, to make an effort to effectively diversify your portfolio.

Effective diversification requires that your portfolio include a number of distinct asset classes. Our client portfolios, for example, include eleven asset classes, including cash equivalents, short-term bonds, high-yield bonds, large-cap domestic stocks, international stocks, to name a few.

We often hear people say: “I don’t invest in mutual funds, I only invest in stocks”. Many financial advisors generally consider eight to ten large-cap stocks to provide adequate diversification for that asset class. However, in order to include small cap domestic stocks and international stocks requires that you research twenty-four to thirty stocks in total, to be broadly diversified in just three asset classes. That’s a lot of work and requires skills that the average investor lacks. Exchange traded funds (ETFs) and mutual funds can provide a way for the average investor to achieve diversification.

In order to include eight to ten diversified asset classes in your portfolio without using mutual funds or ETFs, you would have to research eighty to a hundred different individual investments. For the do-it-yourself investor, this can be quite a daunting task.

When clients come to us, they often have a rather large number of mutual funds in their portfolio. Often there are multiple large company domestic stock funds, multiple international stock funds and so on. They believe they are broadly diversified but in reality may only have three or four distinct asset classes in their portfolio. Certainly, this is better than just a couple dozen stocks and a few bonds, but it doesn’t constitute broad diversification. Multiple large stock funds often include many of the same stocks. This can lead to higher-than-desired concentrations of several stocks and can add significant risk to your portfolio.

In summary, broad diversification across multiple asset classes can help increase your returns and lower risk. To do so however, it must be done properly. If you are unsure of how to do this, we recommend you see a competent professional advisor.