Articles

• The Cost of Bad Advice

• Why Investors Earn Below Average Returns

• The Golden Goose Retirement Income Plan

• DFA: How the Really Smart Money Invests

• DFA:  Never Heard of It

• How to Maximize Your Employee Stock Purchase Plan

• Short-Term Retirement Planning

• Ten Mistakes to Mutual Fund Investing

The Cost of Bad Advice

Do you believe stockbrokers and investment advisors both have the same responsibility to act in your best interests? Would you be surprised to find out that there are two different legal standards that apply to the delivery of financial advice?

One standard is called “suitability”. The other standard is that of a fiduciary 

Currently, stockbrokers and registered representatives are held to the suitability standard; this means their recommendations must be suitable for you based on your age, risk tolerance and financial situation. If they have their choice of several products which are all suitable for your situation, they may recommend the one which pays them the most in fees and commissions. Keep in mind, this may not be the product that is best for your situation, but as long as it is suitable, that’s ok. They do not have an obligation to educate you about other choices you may have. 

A registered investment advisor must meet a more stringent standard; that of a fiduciary. A fiduciary has the responsibility to make recommendations in your best interest in all aspects of the financial relationship.

One couple, not understanding this difference, picked the wrong advisor and in less than seven years it cost them over $150,000 in fees and missed investment returns.

The advisor they picked worked for a large national brokerage firm. He did not take the time to educate the client about risk and return and the benefits of a diversified portfolio. Instead, he put them into a product that met their expressed need. A few years later when they were not happy, he put them in to a different product. A few years later, once again, a new product. All of these products met the suitability standard 

The client had invested $500,000. The result of all those transactions: over $75,000 of commissions to the advisor. The result to the client: they did not lose money, but they did not make much either. Their account grew at about a 2% rate of return to a total of $575,000 after seven years

An investment advisor with a fiduciary obligation to the client would likely have taken the time to educate the client and direct them toward a more diversified approach, even though that was not initially what the client thought they needed. This diversified approach, following a conservative allocation, would have meant a rate of return net of fees of 6%, meaning their account would have grown to $750,000. This couple certainly experienced the cost of bad advice.

Where can you find advisors that are held to a fiduciary standard? One resource is NAPFA, a national association of fee only advisors (advisors who can not accept commissions). You can search for a NAPFA advisor at www.napfa.org.

Another organization called Paladin Registry pre-qualifies all of their advisors and matches you to an advisor appropriate for your needs. You can search for a pre-qualified advisor at www.paladinregistry.com.

When searching for advice, a good rule of thumb to follow is simply to ask your advisor how they get paid. That will tell you where their loyalty lies.

It is certainly worth a bit of extra time to research and interview several potential advisors. After all, it’s your money and if you are like most people, you can’t afford the cost of bad advice

Why Investors Earn Below Average Returns

Dalbar Inc. is a company which studies investor behavior and analyzes investor returns. The results of their research consistently show that the average investor earns below average returns.   From 1986 to 2005 the S&P 500 Index was up 11.9%.  The average investor earned only 3.3%.

 Why is this?

Study after study shows when the stock market goes up, people pour money into equity mutual funds, and when the market goes down, they pull money out. They buy high and sell low. They chase trends, focused on what is happening right now. 

What would cause investors to exhibit such poor judgment? After all, at a 12% return, their money would double every six years.  Rather than chasing performance, an investor could simply have bought a single index fund and earned significantly higher returns. The problem is, although true, this does not make for exciting headlines.

Instead, we see headlines describing “A World Meltdown” published at a time when the market is down. People panic and sell at market lows. When the market reaches all-time highs the headlines read, “Tech Stocks: Everyone’s Getting Rich, Here’s How to Get Your Share.” People feel like they are missing out; they rush to invest, buying at market highs.

The hype and sensation created by such headlines is difficult to ignore. Some investors decide to try to play these market highs and lows. Dalbar has determined that these market timers fare even worse than most investors, having an average return of -2.8%.

Investors would be better served by developing a long term investment strategy based on academic research. As famed economist Gene Fama said in a 2003 interview, “Since we believe markets work well, we don't try to anticipate or forecast events. We read the papers, but we don't use them to form long term policy.”

What principles should be used to form long term policy? A good start would be following Modern Portfolio Theory, developed by Harry Markowitz. His research on diversification and risk won the Nobel Prize in Economics in 1990. Simply put, you invest your funds in several different asset classes such as large cap stocks, small cap stocks, international stocks and bonds. The amount of money you invest in each asset class depends on the return you want to earn and the level of risk you are willing to take. Once you develop your strategy, you let the markets do the work. You leave your funds fully invested throughout the ups AND the downs.

It’s been academically proven that this disciplined approach to investing delivers results. Yeah, it’s boring, but it works. The more you try to work your money, the less it will work for you. So turn off CNBC. Ignore the headlines. Develop discipline. Build a sound investment strategy and stick with it for the long run. Start following these principles now and years down the road you can be on of the few investors earning above average returns.

The Golden Goose Retirement Income Plan

You’re counting on your retirement plan to be your golden goose; the question is how many eggs can you take without killing the goose? A recent study shows most upcoming retirees have little idea how much money they can safely withdraw.

The latest research provides an answer and set of clear cut rules to follow to give you the greatest probability for success. What happens if you follow the rules? You may be able to withdraw as much as 6 – 8% of your initial portfolio value, or $6,000 - $8,000 per year for every $100,000 you have invested.

So what are these rules?

First, you must use a multi-asset class portfolio. This means you have funds invested in cash, fixed income, U.S. large cap value, U.S. large cap growth, U.S. small cap value, U.S. small cap growth, real estate and international asset classes.

Second, your portfolio must have a minimum equity exposure of 50% and a maximum equity exposure of 80%.

Third, when you take withdrawals your income must come from the following sources in descending order:

• Cash from rebalancing over-weighted equities

• Cash from rebalancing over-weighted fixed income

• Withdrawals from remaining cash

• Withdrawals from remaining fixed income

• Withdrawals from remaining equities to be taken from the top performing funds or asset classes first.

• No withdrawals from equity classes with negative returns if cash or fixed income are sufficient

Fourth, although the rules typically allow you a raise to keep pace with inflation, to protect your portfolio from eroding you must follow a two part capital preservation rule. The first part of this rule simply says you don’t get a raise after a year with a negative total return.

The second part of the rule is a little more complex. It is triggered when your current withdrawal rate would be 20% greater than your initial withdrawal rate. If this occurs you must reduce your current year’s withdrawal by 10%. (Example: You start withdrawing 8% ($8,000 per $100,000). The market goes down for several years and your portfolio value is now at $83,000. The same $8,000 withdrawal is now 9.6% of the current portfolio value, a rate which is 20% greater than your initial withdrawal rate. 

The fifth and final rule is most people’s favorite. Exactly the opposite of the capital preservation rule, it is called the prosperity rule. It says that as long as the portfolio did not have a negative return in the prior year you may increase your withdrawal in the amount of the CPI (consumer price index).

Following these rules takes discipline. If you don’t follow the rules, however, you may be killing your own golden goose. If you are not comfortable applying the rules yourself, consider seeking the services of a qualified fee-only financial advisor who is familiar with this latest research study.

 (Study results published in the March 2006 issue of Journal of Financial Planning by Jonathan T. Guyton and William J. Klinger.)