Warren Buffett, arguably the most famous investor in the world, believes there are only two rules to investing: 

• Rule #1: Don’t lose money, and
• Rule #2: Don’t forget rule #1.

These rules serve as the premise for a new book by Phil Town entitled “Rule #1” (Crown Publishers, 2006). Town, a former Green Beret and river guide turned investor, believes that individuals can follow Buffett’s Rule #1 of investing by investing in wonderful companies at attractive prices. Following the principles of Rule #1 Investing, Town claims to have turned $1,000 into $1 million in five years.

AAII has developed a new screen based on Town’s methodology as outlined in his book. The screen is part of the AAII Stock Screens series. On a monthly basis, AAII.com lists the companies passing the AAII Stock Screens, and tracks their performance in hypothetical portfolios. [If you are interested in a detailed discussion of developing this screen with a computerized stock screening service, especially with Stock Investor Pro, you may wish to read the article in the September/October 2007 issue of Computerized Investing.]

The Philosophy

Town believes that many individuals have been “scared off” from investing their own money. Instead, they choose to invest their money with professional money managers, typically in the form of mutual funds.

According to Town, this has come about because the financial services industry perpetuates three myths to protect their business:

1) You have to be an expert to manage money;
2) You can’t beat the market; and
3) The best way to minimize risk is to diversify and hold for the long term.

However, Town feels that the Internet “has changed everything,” and that today individual investors can find accurate and timely information on-line, often for free, which eliminates the need for a professional money manager. In addition, he feels that individual investors are better equipped to react to the market, given that they do not influence the market with their buys and sells.

Town points out the profound impact mutual fund managers have on the overall market and on individual stocks: With trillions of dollars under their control, they effectively are the market.

As a result, in Town’s opinion, investing in a large, diversified mutual fund actually increases an individual’s investment risk: If the market were to fall sharply, investors would start withdrawing money from mutual funds, which, in turn, would force the managers of these funds to sell stock to cover withdrawals, adding further downward pressure on the market.

Given these circumstances, Town believes that individual investors following the Rule #1 Investing approach-buying a few choice businesses in different sectors at attractive prices-should be able to outperform with reduced risk.

Rule #1 Investing Criteria

In “Rule #1,” Town outlined several specific guidelines to follow when trying to identify wonderful businesses with attractive prices:

1) The “Big Five”: Town believes in searching for companies with wide moats (see sidebar above), but it is important that the wide moat be sustainable going forward. To find companies with wide sustainable moats, Town looks for the Big Five, which should all be equal to or greater than 10% per year for the last 10 years:

• return on invested capital (ROIC);
• equity (or book value) per share);
• earnings per share growth;
• sales growth; and
• free cash flow growth.

2) Manageable Debt: Rule #1 investors are trying to find stable, predictable companies. For companies saddled with a high debt load, a downturn in the economy or any other “blips” could force the company to sell off assets to cover its debt obligations, which could have a negative impact on the company’s future. Ideally, Town would like companies to have no debt, but he is more interested in whether a company can pay off its debt quickly. As a rule, then, he feels that a company has a “reasonable” level of debt if its current annual free cash flows can pay off its long-term debt obligations within three years: In other words, long-term debt divided by annual free cash flow is less than or equal to three.

3) Margin of Safety: After finding wonderful companies, the next step is to find those that offer a sufficient margin of safety. Town does not want to pay more than 50 cents for every dollar of a company’s value. He estimates a company’s fair value by calculating what he calls the “sticker price.” Town then only buys those companies whose stock price is no more than 50% of its sticker price.

4) Adequate Liquidity: Town warns against attempting to buy or sell illiquid stocks. Ideally, he would like to see a stock have an average daily trading volume of at least 500,000 shares.

Monitoring & When to Sell

Once Town finds a wonderful company with an attractive price, he does not immediately buy its stock. He also uses charting and technical analysis to determine the right time to buy. In addition, he uses these same tools to trade his Rule #1 stocks-selling when they become overbought and buying when they become oversold.

Ultimately, however, he believes that there are only two instances when you should abandon a Rule #1 company for good:

1) When the business ceases to be wonderful, or
2) When the market price is above the sticker price.

Town believes that the biggest reason why a once-wonderful business ceases to be wonderful is when its moat is threatened. The other reason, according to Town, is when the CEO stops being on the shareholders’ side. Over time, problems with the company will appear in the Big Five numbers. When they do, it is time to sell.

When the stock price reaches the sticker price, it no longer provides a margin of safety and it is time to sell. However, it should also mean that you have a nice gain since you bought it at less than 50% of the sticker price. For Rule #1 stocks, Town sells because their price reaches the sticker price, but he does allow for a violation of his 50% margin of safety. Assuming all of the other numbers pass muster, he will buy back in when it drops 20% below the sticker price.

The AAII Screen

For the AAII screen, we used AAII’s Stock Investor Pro fundamental stock screening and research database program. Stock Investor Pro covers a universe of almost 9,000 NYSE, Amex, and NASDAQ stocks.

Figure 1 reports backtesting results that show the Rule #1 Investing screen outperformed the S&P small-, mid-, and large-cap indexes since the beginning of 1998. However, it only has a slight advantage over mid-cap stocks and has greatly underperformed the typical exchange-listed stock over the same period. Between January 1998 and the end of August 2007, the Rule #1 Investing screen returned 164%. By comparison, the S&P 500 index gained 51.9% over the same period.

Figure 1. Performance of Rule #1 Investing Screen CLICK ON IMAGE TO SEE FULL SIZE.

Profile of Passing Companies

Table 1 presents the characteristics of the companies passing the Rule #1 Investing screen as of September 7, 2007. The Rule #1 Investing screen looks for companies with strong income statements and balance sheets that are also trading at a discount to their fair value or sticker price. Therefore, it may not be surprising that the current group of passing companies has a median price-earnings ratio (11.7) that is significantly lower than the median price-earnings ratio of 18.5 for all exchange-listed stocks.

The current passing companies, as a group, have no problem exceeding the requirement that the average annual growth rate in earnings per share be 10% or higher. The median earnings growth rate of 79.3% easily surpasses that of all exchange-listed stocks, which is 15.4%. Looking forward, analysts expect robust growth from the current Rule #1 Investing companies, as they have a median forecasted earnings growth rate of 21.2% versus 14.6% for all exchange-listed companies.

In order for a company to pass the Rule #1 Investing screen, its current price must be no more than 50% of its sticker price-an estimate of the company’s fair value. The current passing companies have stock prices, which, on a median basis, are only 25% of their respective sticker prices. In contrast, the typical exchange-listed stock has a current price that is almost 66% of its sticker price.

Lastly, the companies currently passing the Rule #1 Investing screen have not fared very well relative to the overall market over the last year. The companies have underperformed the S&P 500 on a median basis by 11.5% over the last 52 weeks, while the typical exchange-listed stock has underperformed the S&P 500 by 4% over the same period.

Passing Companies

Table 2 lists the eight companies passing the Rule #1 Investing screen as of September 7, 2007. We ranked these companies in descending order by their five-year average return on invested capital (ROIC). Town says that if he were to choose only one of the Big Five numbers, it would be ROIC, since in his opinion it indicates how well the company is being run.

Odyssey Re Holdings, a casualty and property insurance provider, barely cleared the 10% hurdle for average ROIC at 10.6%. For 2005, the company had a return on investment of -5.5% after suffering significant losses from hurricanes Katrina, Rita, and Wilma. In 2006, however, the company was able to rebound to post its highest ROIC over the five-year period of 19.6%.

Northwest Airlines owned Pinnacle Airlines Corporation, the parent company of Pinnacle Airlines and Colgan Air, until 2003, when Pinnacle went public with an initial public offering. Prior to Northwest’s transferring control, it entered into two non-cash transactions whereby Pinnacle “paid” Northwest $215.5 million in dividends. As a result, Pinnacle’s retained earnings fell from $476.9 million in 2002 to a deficit of $133.6 million at the end of 2003. In turn, the company’s shareholder’s equity was deficient $48.4 million. However, the company’s earnings performance since 2003 has allowed it to expand its equity to the point where it meets the growth requirements for this screen.

While not part of the actual screen, we did include the 10-day average trading volume of each of the passing companies in Table 2. Town says he would like to see average daily trading volume of at least 500,000 in stocks he is looking to buy. However, many daily trading volume statistics, including those in Stock Investor, tend to be erratic because they only cover the last 10 trading days.

Based on Reuters’ data in Stock Investor, Travelzoo has the lowest average daily trading value among the passing companies at 176,000 shares. However, Google Finance lists Travelzoo’s average daily trading volume at 335,000 shares and Yahoo! Finance has it at just over 182,000 shares. For this reason, it is a good idea to consult multiple sources for this information.

We also list the number of insider sell transactions over the last six months for each of the Rule #1 Investing companies, although we did not use this in the screen either. Town warns against investing in companies where insiders are selling significant portions of their holdings, and the data in Table 2 tells us whether there is need for additional investigation.

First Marblehead has had the highest number of insider sells, with 43. However, a single director made the vast majority of these sales. Among key executives, the CFO sold 1,548 shares in August but still holds over 93,000 shares. In addition, between May and August of this year, the company’s chief administrative officer exercised options for 12,000 shares and sold 3,810 shares. These were the first shares she had held over the last two years, so these sales do not appear to be significant.

Finally, in order to provide what he considers to be an adequate margin of safety, Town only initially buys company’s whose current stock price is less than or equal to 50% of its sticker price. See the box below for an example of how to calculate the sticker price.

Table 2 shows the current stock price as a percentage of the company’s sticker price. These values range from a low of 2.1% for First Marblehead to a high of 45.9% for Odyssey Re Holdings, just below the 50% cut-off.

Conclusion

Town’s approach of finding companies with solid income statements and balance sheets trading at a perceived discount has been the cornerstone of numerous successful investment strategies.

However, even if a company meets all of the Rule #1 Investing requirements, it does not mean you should automatically buy it.

Stock screening is only a starting point in the investment process. Ultimately, you want to identify stocks that match your investing tolerances and constraints before adding them to your investment portfolio.

Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.

© 2009 AAII Journal PRINT

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

There is a common notion that stocks, at least if held for a long-time, usually outperform other assets, so that stocks should be the cornerstone of any long-term portfolio.

If, when this idea is presented, you protest: “Wait a minute. Stocks are also risky!” the reply is either, “Stocks have done well in the past and so they will probably also do well in the future,” or “If you have a long time horizon, you’ll do well in stocks.”

However, the thoughtful investor must also wonder: “But what if stocks don’t do well? What happens then to my retirement?”

And in this self query, the more appropriate approach becomes clear: It makes more sense to think first about what risk you are able and willing to bear, and then to think about what potential investment returns you might be able to capture.

So, let’s take a step back and before thinking about potential portfolio return, think through the factors that determine a person’s ability and willingness to take investment risk.

Time Horizon and Risk

The big fallacy abroad in the land at the moment is that time horizon is a reliable and sole proxy for risk preference. In this paradigm, the longer you intend money to be invested, the higher is the appropriate risk level (i.e., stock allocation) of the portfolio.

Typically, the data used to support the purported link between one’s time horizon and optimal stock allocation shows that for successive holding periods starting in 1926 and ending in 2003, the annualized rate of return in the domestic stock market has on average been positive, and the range of annualized returns gets smaller as the holding periods rise, implying less risk as time lengthens.

But this does not tell the whole story. Stocks can be risky, even in the long run.

The fact is, lower than expected returns could happen-even for many years in a row-which is exactly what makes stock ownership a risky investment, not a certainty. Lower-than-expected returns that last for a long time and/or that are severe in nature would have the impact of dramatically lowering the ending value of your portfolio, and thus could significantly threaten your ability to meet financial goals. While the probability of such an event is low, the consequences are potentially devastating and so are worthy of careful consideration. What the current reasoning omits is the fact that as the investor’s time horizon lengthens, the range of possible ending values for the portfolio also increases, and that these widening ranges include the low, but still positive possibility of a whoppingly low actual versus expected portfolio ending value.

For the mathematically inclined, proof positive of how stocks are risky even in the long run is that if you try to insure a portfolio against a shortfall, you will find that the premium rises as the time horizon lengthens, exactly as would the price for a put option on the termination value of the portfolio.

Uncertain Returns

In sum, the uncertainty of returns is an often-underestimated risk factor for investors.

This risk is particularly daunting for investors who are moving money into or out of their portfolio. In that case, the order of the returns also becomes critically important, as Table 1 illustrates.

The order of returns-whether high returns appear early or late-makes a big difference in determining a portfolio’s termination value when money is going into or out of the portfolio during the investment period.

Table 1 shows that, regardless of the order of your returns, a particular sum (one with no additional deposits or withdrawals during the investment period) will grow to the same amount: The ending values for the No Deposits or Withdrawals columns are identical no matter the order of returns.

But look what happens if an additional $10 per year is saved (deposited). In this case, Table 1 shows how getting high returns late in the period creates a much higher portfolio termination value, in this case $328 versus $198.

Not surprisingly, the order of returns also impacts the portfolio termination value when regular withdrawals are being taken-Table 1 shows that termination value is higher when high returns come early.

Thus, one reality of investing is that when moving funds into or out of the portfolio, the actual order of returns that you experience during your time period will greatly impact how well you will meet your investment goals.

For investors then, risk considerations include not just expected return and time horizon, but also one’s ability to withstand the risk of loss created by the uncertainty of returns, and by the order of returns when cash is moving into and out of the portfolio.

Risk Tolerance

There are several factors that influence one’s ability, need, and willingness to take investment risk.

Personal Circumstances
There are times when the receipt of an extra $100 feels like a life-changing event. At other times, an extra $100 is not even noticeable in the flow of daily financial life. The same pattern occurs with millions of dollars. The first $1 million changes your life. So arguably does the second million. But at some point even an extra $1 million doesn’t change the way you think and feel about your financial goals. Once you already have sufficient wealth for your lifetime, it is often true that your interest and willingness in taking investment risk declines. It is not unusual for the very wealthy to store a large fraction of personal wealth in conservative portfolios of tax-exempt bonds.

But the converse is not necessarily appropriate. For the not-yet-wealthy, ramping up risk (i.e., the stock allocation) in order to address a compelling lifetime need for more wealth is a slippery concept when evaluated from the point of view of protecting the ending value of the portfolio. (In some sense, the same circumstances that lead to a need to build portfolio wealth are the same circumstances that lead to an inability to withstand a downturn in the markets.) But ramping up risk commensurate with one’s ability to handle losses is a reasonable way to try for an increased standard of living.

For example, a worker who can work more hours, and so earn more money, has more financial resiliency than does, for instance, an older person living on a fixed income who has little or no ability to increase income. Similarly, a family that maintains a spending level far below its regular, reliable income stream is better able to withstand portfolio losses than its more free-spending neighbors.

On the other side of the coin, workers whose income is highly correlated to the stock market, or that is highly uncertain in some other way, are not as well positioned to take investment risk as are their peers in jobs with more predictable compensation.

This interaction between one’s labor income, spending patterns, and investment wealth is of fundamental importance. But there are also other factors determining a person’s ability and willingness to take investment risk.

Investment Knowledge
Experienced financial advisers know that individuals sometimes present themselves as being highly risk-averse, but as the conversation unfolds it becomes clear that really they are simply averse to taking risk in areas in which they are not familiar. As their knowledge of investments increases, so does their willingness to take investment risk. The converse is also true. Individuals who present themselves as being highly risk-tolerant sometimes become less risk-tolerant as their understanding of investments grows.

Personal Background
Investors whose families went through the Depression or some other extremely challenging financial event tend to shy away from investment risk. In contrast, investors whose first experience in investing includes the recent extraordinary bull market are at risk for thinking that stocks aren’t in fact very risky.

Personal Preferences
Psychologists will tell you that people differ in the pleasure they take from investment gains versus the pain they feel from investment losses. But most people are asymmetric: Losses tend to hurt a lot more than gains give pleasure.

Risk vs. Return Considerations

This cursory review of the factors behind a person’s risk preference as reflected in the allocation of his or her investment portfolio highlights the fact that when managing personal investments, it’s not just about return management. It’s also crucially about risk tolerance.

And once risk tolerance is taken into account, there are instances in which even long-term investors will not choose to put a substantial portion of their portfolio into stock investments.

In sum, rather than reaching for a high stock return because it might come true, the goal of investing is better expressed as having enough cash on the day a bill comes due-for example, for college tuition for your children, and/or enough cash to maintain or improve your standard of living throughout retirement with minimal chance of having to go backward in your daily standard of living. These are the typical actual concerns of individual investors.

Against this standard, beating one’s peers or surpassing the market averages, or achieving a particular targeted rate of return all pale in comparative appeal. As the investment saying goes: “You can’t eat relative returns.”

These considerations may lead certain investors away from using stocks as the foundation layer for their portfolio toward using more stable investments-in particular, inflation-indexed bonds-as the foundation layer.

Inflation-indexed securities are increasingly and readily available to the individual investor. They include the U.S. Treasury Series I Savings Bonds and U.S. Treasury Inflation-Protected Securities (TIPS) (http://www.savingsbonds.gov). The advantage of inflation-indexed securities is that they allow the investor to protect purchasing power reliably, with minimal transaction costs and also (if purchased appropriately) with high tax efficiency. With inflation-indexed securities as the foundation layer of a portfolio, it is much safer to then take investment risk with more volatile securities such as stocks.

Inflation-indexed investment products will likely become more popular as individual investors become more aware that they can protect purchasing power with investments that are less volatile and more certain than are stock investments.

In the meantime, as you continue to be inundated with information about how much you can earn in the investment markets, remember that when determining the optimal allocation for your portfolio, it’s best to focus first on how much you are able and willing to lose.
Zvi Bodie, Ph.D., is a professor of finance and economics at Boston University School of Management. He maintains a Web site at www.zvibodie.com.

Paula Hogan, CFP, CFA, is the founder of Hogan Financial Management, a comprehensive fee-only planning firm based in Milwaukee, Wisconsin. She also maintains a Web site at www.hoganfinancial.com.
PRINT   

 © 2010 AAII Journal

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

How often have you seen a stock’s price fall after the company announced increased earnings?

Or, just recently, why did the stock of investment banking firm Lehman Brothers soar after it announced that its fiscal first-quarter earnings fell 57%?

In these instances, actual earnings did not turn out as the market expected.

In fact, expectations play a key role in determining if a stock’s price “gains” or “loses” when actual earnings are reported.

Expectations Count

The stock market is forward looking. That is, stock prices are established based on the expectations that prospective investors have for the future earnings power of the firm.

The future earnings power of any company involves the interaction of many company, industry, and economic forces. Earnings estimates embody investors’ opinions of factors such as sales growth, product demand, competitive industry environment, profit margins and cost controls. Stock prices adjust as these expectations change or are proven wrong.

Just whose expectations are we talking about?

The actual expectations embodied in a stock’s price are those of millions of investors-collectively “the market.” Needless to say, it is impossible to measure the exact expectations of all of these investors at one point in time.

The more practical proxy for the market’s expectations is analysts’ consensus earnings estimates. Many services provide consensus earnings estimates by tracking the estimates of the thousands of investment analysts who are employed by brokerage firms providing stock research for their customers. These analysts have two primary functions: to provide earnings per share estimates and to provide buy/hold/sell recommendations for the companies they track. The brokerage firm uses the research developed by their analysts to attract and retain brokerage customers and create investment banking opportunities.

Consensus Estimates

Stocks with earnings estimates may have from one to as many as 40 or more analysts tracking and analyzing them. The consensus estimate refers to the average earnings per share estimate. The number of estimates provides a feel for the depth of coverage for a company.

When examining earnings estimates, the first rule to keep in mind is that the current price usually reflects the consensus earnings estimate. For investors, there is nothing to be gained by investing in a company simply because it has a high level of expected earnings growth because of the high price you must pay for those expectations. In fact, studies show that over the long run, stocks with high expected earnings growth tend to underperform stocks with low growth rates and low expectations because it is difficult to meet and exceed high expectations over an extended period of time.

The impact on stock prices comes when actual earnings differ from the consensus expectations-that is, when there are earnings “surprises” and revisions in earnings estimates.

Earnings Surprises

Earnings surprises occur when a company reports actual earnings that differ from consensus earnings estimates. Listed companies are required to file quarterly reports with the Securities and Exchange Commission (SEC) within 40 days of the fiscal quarter end. Most companies announce earnings within one month after the end of the quarter. The fiscal periods for most companies coincide with the calendar quarters.

Institutional investors and analysts work at a frenzied pace for about three weeks starting mid-month in January, April, July, and October as major companies report their earnings from the previous quarter. During the earnings reporting season, financial newspapers and Web sites provide daily reports on earnings announcements. Firms with significant earnings surprises are often highlighted.

Earnings surprises are either positive or negative:

• Positive earnings surprises occur when actual reported earnings are significantly above the forecasted earnings per share. 
• Negative earnings surprises occur when reported earnings per share are significantly below the earnings expectations.

What is the impact on stock prices?

Price changes resulting from an earnings surprise can be felt immediately. Studies indicate that the stock prices of firms with significant positive earnings surprises show above-average performance, while those with negative surprises have below-average performance.

Although the surprise has an immediate impact on the stock’s price, it may also have a long-term effect. In fact, studies indicate that the effect can persist for as long as a year after the announcement.

That means it may not be too late to buy a stock that has had a positive earnings surprise, even though you can’t act right at the time of the initial surprise. However, it also means that it does not make sense to buy a stock after the initial price decline of a negative earnings surprise, since there is a good chance that the stock will continue to underperform the market for some time.

Not surprisingly, large firms tend to adjust to surprises faster than small firms do. That’s because larger firms are tracked by more analysts and portfolio managers, who tend to act quickly.

Earnings surprises also tend to follow the “cockroach effect”-like cockroaches, you rarely see just one earnings surprise. So, firms with a significant earnings surprise in one quarter will also often have earnings surprises in subsequent quarters.

Since both positive and negative earnings surprises have lingering long-term effects, a rewarding investment tactic would be to avoid stocks you believe will have negative earnings surprises or those that have had negative earnings surprises. Similarly, selecting positive earnings surprise stocks before and even after the earnings come in may be profitable.

Revisions

Revisions in earnings estimates reflect changes in expectations of future performance on the part of analysts. Perhaps the economic outlook is better than previously expected, or maybe a new product is selling better than anticipated.

Revisions to earnings estimates lead to price adjustments similar to earnings surprises:

• When earnings estimates are revised significantly upward-5% or more-stocks tend to show above- average performance. 
• Stock prices of firms with downward revisions show below-average performance.

Revisions are often precursors to earnings surprises. As the reporting period approaches, estimates normally converge toward the consensus. A flurry of revisions near the reporting period can indicate that analysts missed the mark and are scrambling to improve their estimates.

When examining revisions, it is helpful to focus on the number of revisions. When compared to the number of analysts making estimates, this is a confirmation of the significance of the percentage change in estimates. You can put more faith in a revision if a large percentage of the analysts tracking a firm have revised their estimates.

The number of revisions upward indicates how many analysts have revised their estimates upward in the last month. Stock prices of firms with more upward revisions than downward revisions have shown above-average returns, while those with more downward revisions tend to underperform.

Examining the range of estimates provides an indication of the consensus within the group of estimates. A wide range of estimates would point to great disagreement among analysts, indicating greater uncertainty and greater chance for an earnings surprise.

The price move can be more dramatic, however, if an earnings surprise occurs for a firm with a very tight range of earnings estimates.

Whisper Numbers

Whisper numbers garnered much attention a few years ago because of the apparent weight they carried with institutional investors. Originally, whisper earnings, or whispers, were considered to be the actual earnings expectations of the analysts tracking the company-free of any company influence. These unofficial estimates were passed or whispered from analyst to analyst and to the analyst’s best customers, but not actually posted to estimate tracking services.

Some studies found that these whisper numbers appeared to better reflect the market’s expectations of earnings.

However, the passage of the Sarbanes-Oxley Act and the tightened corporate reporting requirements has led to a change in the definition of whisper numbers, since the new regulations make it difficult for insiders to pass on insider earnings data.

WhisperNumber.com, one of the leading providers of “whisper” earnings estimates, defines them as: “an average of individual investors’ expectations in regard to public company earnings-used by investors to anticipate post earnings price movement and considered an alternative/comparative number to the analyst consensus estimates.” It states that its numbers are “collected from our registered user base (Influential Individual Investors) through polling and website submission.”

Other Web sites have also been established that try to gather and distribute whisper numbers.

How should an investor view whispers?

Whisper numbers tend to come from unknown and unnamed sources. They may come from company insiders, perceptive investors, or those who are attempting to manipulate a stock’s price. Sites that collect whisper estimates rarely disclose their sources.

While you may want to examine the numbers, you should not simply take the estimates at face value.

Looking Forward

Earnings estimates are an important element for you to keep in mind when you analyze and select stocks. They are a numerical view of expectations, and changing expectations drive stock prices.

The box below summarizes the main points to keep in mind when you are examining earnings estimates.

PRINT  © 2009 AAII Journal

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

In terms of portfolio management, it is widely agreed that the asset allocation decision is the most important one an investor will make. How you split your investment funds among stocks, bonds, and cash (that is, short-term debt) is more important than your choice of stock mutual funds.

Experts, not surprisingly, do not always agree on the precise portfolio management allocations that different types of investors should adhere to. Yet, in comparing recommendations from published advisory sources, it is clear that there exists a broad consensus about the appropriate mix among stocks, bonds, and cash for most individuals during each stage of their life cycle. Of course, all portfolio management and asset allocation recommendations carry a disclaimer that individual circumstances may dictate a mix that is quite different.

Many individual investors, though, resemble at least roughly the “typical” investor profile. This article discusses some of the general portfolio management guidelines that can be gleaned from these broad recommendations for the “typical” investor. And it notes some of the special circumstances that could dictate an asset mix that differs from the consensus.

Portfolio Management: The Broad Asset Mixes

Table 1 summarizes the recommended mix of stocks, bonds, and cash from four well-known advisory sources. The suggested asset mixes include stocks, bonds, and cash; they do not include real assets such as one’s home or other real estate. While one source explicitly assumes that investors own their home, it is most likely that the other sources implicitly make this assumption as well, and thus assume investors have a real estate exposure.

While the recommendations vary, they are more similar than dissimilar, and reflect key portfolio management investment truths. Some of these truths are self-evident, but they are so basic to investing that they are worth explicitly restating. Others are not self-evident, but they are important elements of a sound and balanced portfolio. Here is a run-down of the “investment truths” derived from the recommendations’ common elements:

• A fixed-weight strategy, with rebalancing at least annually, is an excellent strategy and should be considered the cornerstone of effective portfolio management.Each of the sources recommends specific asset mixes at different points in an investor’s life cycle. In order to maintain a given asset mix, the portfolio must be periodically managed and rebalanced. The simple idea is that a stable asset mix gives an investor a stable risk exposure that is appropriate for his or her financial needs, which are typically dictated by their stage in life.A fixed-weight strategy is a long-run contrarian strategy. When stocks rise from being fairly valued to overvalued, the investor sells the overvalued stocks and buys bonds (or cash), or when putting new money into the portfolio purchases bonds or cash rather than stocks. When stocks fall from being fairly valued to undervalued, the investor sells bonds and buys the undervalued stocks, or uses new money to buy stocks. In short, a fixed-weight portfolio management strategy allows someone to profit from market misvaluations while maintaining a stable risk exposure. 
• Effective portfolio management practices avoid market timing.Market timing calls for sharp swings in the stock/bond/cash mix based on expected near-term market prospects. For example, a market timing service may recommend shifting the stock allocation from 80% one month to 10% the second and to 60% the third. By definition, market timing advocates an unstable risk exposure. All sources are unanimous in their discouragement of market timing as part of an effective portfolio management program. 
• A portfolio’s risk can be moderated by mixing stocks and debt.Stocks are claims against real assets. Bonds and cash are debt, usually promising fixed returns. Stock and debt are fundamentally different animals and, consequently, their returns tend not to follow similar patterns to each other. Consequently, combining stocks and debt moderates the portfolio’s risk.On a broader scale, individuals who hold stocks and debt in their investment portfolio and own their own home have their broad portfolio diversified among stocks, debt, and real estate-three asset types whose returns do not vary closely together. 
• A portfolio management truism to use as a guide state that the longer the investment horizon, the larger the portion of the portfolio that should be allocated to stocks.Young investors who are years from retirement can invest more of their portfolio in stocks than the elderly. Although year-to-year stock returns are volatile, the young can be reasonably confident that the good years will more than offset the bad years over their investment horizon. As you age and your investment horizon shortens, you are less confident that there will be enough good years to offset the bad, and the recommended allocation to stocks decreases. 
• As part of their portfolio management plan, everyone should have some exposure to stocks, even a conservative 80-year-old couple.Historically, the returns on a portfolio of long-term Treasury bonds have been more volatile (that is, riskier) than a portfolio with 90% bonds and 10% common stocks. Stocks held alone are riskier than bonds held alone, but due to the magic of diversification you can add some stock to an all-bond portfolio and actually reduce the portfolio’s risk.Diversification means not putting all your eggs in one basket even if the basket looks safe. Since 1926, the volatility of an 80% bond/20% stock portfolio has been equal to that of a 100% bond portfolio. This helps explain why no one recommends a stock weighting of less than 20%.Examination of the detailed recommendations of the sources reveals other widely-held portfolio management investment truths: 
• Diversify within the stock portion of the portfolio. In particular, an investor should always have an exposure to large-value and large-growth stocks.There are two dimensions to investing in the stock market: size and style. Size refers to the size of the firm. In general, the 500 stocks comprising the S&P 500 are considered “large” stocks, which account for almost 75% of the market value of all U.S. stocks.Style refers to the investment style or philosophy to which a company is most likely to appeal. Growth investors seek growth stocks-firms with fast-growing earnings. They tend to have low dividend yields, high price-earnings ratios, and high price-to-book-value ratios. Value investors seek value stocks-firms whose shares are selling below their “real” value. They tend to have high dividend yields, low price-earnings ratios, and low price-to-book ratios.Diversification within a well managed stock portfolio would consist of investing some portion in each of these areas-large- and small-capitalization stocks (with proportions roughly equal to their weighting in the total stock market, a 75%/25% large-cap/small-cap mix), and growth and value stocks. 
• International stocks should be a part of everyone’s portfolio, with the possible exception of the elderly.Portfolio management Recommendations for international exposure start at about 15% to 20% for younger investors, and gradually decrease as one gets older. One source recommends no exposure for those who are 75 or older. 
• Young investors should put more emphasis on international stocks, small stocks, and growth stocks while older investors should put more emphasis on large-cap stocks, especially value stocks.While broad diversification is always encouraged, younger investors can take more risk, and can therefore place greater emphasis on the riskier portions of the stock market; older investors can still invest in these areas, but their portfolio management emphasis should be on more stable, large-capitalization companies. 
• Investors can avoid the emerging international stock markets.Emerging stock markets promise a wild and bumpy rise. Dramatic gains are possible, but so are equally dramatic losses. Only one source mentions emerging markets, and that source does not advocate an exposure to emerging markets for investors who are in their late 30s or older. The consensus view is than an investor can safely avoid these stocks. 
• As one ages, shift the bond portion of the portfolio from primarily long-term bonds to primarily intermediate-term or short-term bonds.Bond prices become more stable as maturity shortens. Thus the advice to shorten bond maturity as one ages is consistent with the other advice to move toward assets with more stable prices. 
• As one ages, the cash portion of the portfolio increases.Increasing cash assets is part of shortening the bond maturity for increased price stability. 
• High-grade corporate bonds and Treasury bonds of similar maturity are close substitutes.No one distinguishes between buying high-grade corporate bonds or Treasury bonds of similar maturity, because the returns on these bonds move very closely together, although high-grade corporate bonds tend to have slightly higher yields. In contrast, high-yield bonds have a much higher default risk and consequently are lower-graded; these are not close substitutes for high-grade corporate or Treasury bonds. 

Portfolio Management: Are You a “Typical” Investor for Your Age?

It is clear that there is a broad consensus about the appropriate mix of stocks, bonds, and cash for “typical” investors at different life cycle stages. But are you a “typical” investor for your age, or should your portfolio be different from the consensus portfolio?

There are at least three reasons why your portfolio may differ from that of the consensus:

• First, you may be more or less risk tolerant than most investors your age. 
• Second, your unique circumstances, especially as they pertain to your non-financial assets and liabilities, may dictate a different portfolio management style. 
• Third, today’s stock and bond market prospects may suggest a different asset mix.

How do you know if you have an average risk tolerance? While an investor’s risk tolerance is of critical concern, it is difficult to measure. Probably the best approach to this tricky issue is to examine downside risk, which indicates the amount a given mix could be expected to drop during a severe bear market. If the recommended asset mix entails too much risk, you should adopt a more conservative mix, reducing the recommended portfolio management stock allocation by 10 percentage points; if you believe you can tolerate more risk, you can increase the stock allocation by 10%.

The second factor affecting an individual or family’s target asset mix involves its non-financial assets and liabilities. These include real assets such as the family home, other real estate, a family business, and prospects for inheritance (whether certain or very likely). It also includes liabilities like a mortgage and the future costs of college education. It may also include the individual or family’s human capital (that is, future income). While there are an infinite number of potential unique circumstances that may affect one’s target asset mix, here are the most common circumstances:

• Suppose you will eventually receive the assets in a trust that holds $300,000 of high-grade bonds. This bond exposure outside of your overall investment portfolio means that more, perhaps all, of your investment portfolio can be allocated to stocks. 
• Suppose the family owns a risky business that is the main source of income for the family. The high risk of this asset may suggest less risk in the investment portfolio. 
• Suppose you have the flexibility to choose how much and how long to work later in life. You can invest more of your money in stocks and other risky assets than if you have no such flexibility. Of course, if your future income is in doubt, you should not take on as much risk in the retirement portfolio.

The third factor that may cause you to stray from the consensus mix in your portfolio management plan concerns market prospects. Recall the unanimous disapproval of market timing, which calls for sharp swings in the asset mix based on short-term market prospects. However, the current state of investment knowledge is mixed on the question of whether one should make modest changes in their asset mix based on long-term market prospects. Theory and some empirical evidence suggests that we have a limited ability to predict whether, for example, stocks will do better or worse than average over the next three years. Nobel-laureate Paul Samuelson looked at the evidence on this issue and argues that it is sufficient to warrant changing your target weights plus or minus 10% at most. However, others would strongly argue that investors should stick with a fixed-weight strategy, with rebalancing at least annually as part of their overall portfolio management strategy.

Portfolio Management Summary

A careful study of recommended asset mixes from four prominent financial firms and eminent experts indicates that they share much of the same portfolio management advice: a fixed-weight strategy is an excellent one; avoid market timing; diversify across stocks and bonds; diversify within the stock portion of the portfolio; and, as you age, shorten the maturity of the fixed-income portion of the portfolio.

The recommendations also reflect a broad consensus about the appropriate mix of bonds, stocks, and cash for the “typical” individual during each stage of his life cycle. However, there are times when an individual will not reflect the “typical” profile, and may need to stray from the consensus. An individual’s target asset mix could vary from the consensus mix due to: his risk tolerance and atypical non-financial assets and liabilities, including human capital. In addition, an investor may reasonably decide to let the actual mix vary modestly from his target mix due to market prospects over the longer term.

Most of the shared portfolio management advice is basic-it reflects common elements of a sound portfolio.

But then, most of what one needs to know about investing is basic.
William Reichenstein holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University in Waco, Texas. He thanks Burton Malkiel for helpful comments in the preparation of the article.

© 2009 AAII Journal

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American Association of Individual Investors (AAII)
625 N. Michigan Ave.
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The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Many people do not see an estate plan as necessary. Others recognize the need to plan, but have no idea whom to contact or how to begin.

Estate planning encompasses much more than simply protecting one’s assets; it provides peace of mind that your assets will pass according to your wishes at the least cost and administrative burden. Whatever one’s reasons for taking the risk of not planning, there is no doubt that it is a risk that one should not take.

Why Have an Estate Plan?

By neglecting to have even the most basic estate planning document-a will-you leave your estate planning to your state government, with possible adverse results. A local court may have to appoint an administrator to manage your estate. This person, possibly a stranger to you, must be paid. Even if the administrator named is your surviving spouse, a bond is generally required. The amount of time required to settle your estate may be unnecessarily long. Additionally, part of your estate may pass to the federal and state governments in the form of avoidable taxes. Finally, if you have children, then the court will have to appoint a guardian to care for them after you die, which will add emotional and financial burdens for the legal proceedings. Clearly, one imperative of estate planning is: Don’t die without a will.

While most people understand that a will is necessary to transfer assets at their death, they may not know its limitations. Property can actually be transferred several ways:

• By a properly executed will or trust,
• By contract, or
• By operation of law.

TABLE 1. Preserving and Transferring Your Wealth: Property Disposition CLICK ON IMAGE TO SEE FULL SIZE.

Table 1 provides some examples of how different assets are transferred at death.

Transfer by Will
As a general rule, a will provides for the transfer of property owned by an individual, including his or her interest in community property titled in the name of the other spouse. Specific bequests of tangible personal property (e.g., jewelry, furniture), may also be addressed in the will or in a separate memorandum referenced in the will, if permitted by state law. However, a will does not dispose of assets governed by contract or operation of law.

Transfer by Contract
Examples of assets that are governed by contract include annuities, IRAs, employee benefit programs or life insurance. A properly executed beneficiary designation form is necessary to ensure that these assets will pass to the intended persons. Regardless of what your will says, these assets will go to the person listed as the contract beneficiary. Additionally, your beneficiary designation may have both estate and income tax ramifications, particularly for IRAs or employee benefit programs. Therefore, it is important that the designations agree with your overall estate and financial plan.

Transfer by State Law
State law also may affect the disposition of your assets. Assets that pass by operation of law include anything that can be held in joint title, such as a bank account or a house. If you hold a house jointly with right of survivorship, then the house will automatically pass to the other person on the title at your death, regardless of what is stated in your will. In some states, you may be prohibited from disinheriting a spouse or other close relative. Additionally, if you reside in a state that follows the community property system of asset ownership, then state law will supercede the terms of your will in disposing of assets held with a spouse.

Other Estate Documents

Additionally, an estate plan includes more than disposition of your assets at death. It should also include the possible need to administer your assets or make health care decisions if you are temporarily incapacitated. Most financial planners recommend having sufficient savings to fund up to six months of your living expenses, but who would pay your bills if you are unable to do so? If you do not give someone explicit authority to do so, then even a spouse may need to seek court permission to act on your behalf. This again would cause unnecessary emotional and financial burdens at an already stressful time.

For these reasons, in addition to a will, you should consider establishing two types of powers of attorney:

1. A durable general power of attorney to delegate the ability to make and implement financial decisions, and 
2. A health care power of attorney to delegate the ability to make and implement health care decisions. The powers that can be delegated in these documents and the form of the documents differ greatly by state. A living will (sometimes called an advance directive) should also be considered to describe the type and extent of life-sustaining medical treatment that you prefer in the event that you are unable to communicate those wishes.

What Is the Estate Tax?

Estate taxes do not apply only to the very wealthy. Even relatively modest estates may be subject to estate taxes without proper planning. A typical individual with a house, a retirement plan, and life insurance is very likely to have assets that exceed the amount that is exempted from estate tax. For 2008 that amount is $2.0 million, the threshold at which you should think about doing estate planning. Therefore, it is important to understand not only federal estate and gift taxes, but also possible state estate, gift, and inheritance taxes.

The estate tax is really a transfer tax, because it applies to property transfers during lifetime (such as gifts) and at death (such as inheritances). Transfer taxes are progressive, which means that all lifetime taxable gifts are cumulative, so that over time you are subjected to higher tax brackets. Therefore, as the value of your estate increases, planning becomes more important.

The marginal gift and estate tax rates currently range from 18% to 45%. Certain credits and deductions are available to offset the tax. For example, every individual taxpayer can transfer a certain amount of property either during life or at death without paying estate or gift tax, due to a lifetime exemption amount. The lifetime gift exemption amount is currently $1 million. Additionally, transfers to grandchildren and certain other individuals are subject to another tax called the generation-skipping transfer (GST) tax that is imposed at the highest estate tax level.

For more information on the estate tax, gift tax and generation-skipping tax, go to the IRS Web site at www.irs.gov. Details can be found in Publication 950, Introduction to Estate and Gift Taxes; and Form 706 Instructions to the U.S. Estate Tax Return and Form 709 Instructions to the U.S. Gift Tax Return.

How Do I Start Planning?

Estate planning does not need to be seen as a complex set of questions. Instead, it can be a relatively easy process of six steps:

1. Identify the goals,
2. Gather the data and make assumptions,
3. Evaluate the feasibility of your goals,
4. Develop your strategies,
5. Implement the decisions, and
6. Review your progress.

In the estate planning process, these steps can be summarized as follows:

Identify the Goals
The starting point of a successful estate plan, as with any area of financial planning, is identifying and defining your goals. Here are some questions you should answer that will help you identify your goals:

• What is the most appropriate way to dispose of your assets at your death?
• Who will receive what, and when will they receive it?
• Will assistance in the management of the assets be required?
• If you have minor children, who will care for them the way you would, and with what financial resources?
• How can the costs of administering your estate, including taxes, be minimized?
• Have you appointed an agent to act on your behalf in the event of your disability?
• Will your family be adequately provided for in the event of your premature death?

Gather the Data and Make Assumptions
After you have identified your goals, you can begin to gather data. You will need to collect your current estate planning documents, including wills and trust instruments, beneficiary designations on retirement plans and insurance policies, and title documents that set out the ownership of major assets such as your home. In addition, you need to quantify the value of your assets and your liabilities. You must also consider non-financial issues, such as asset management and protection and the timing of when you want your assets to ultimately pass to your heirs.

Evaluate the Feasibility of Your Goals
Most goals dealing with the disposition of assets can be accomplished with estate planning. However, you cannot completely control how your heirs spend their inheritance. Similarly, in large estates, some amount of estate taxes may be incurred, even with planning. It may not be possible to meet goals of complete control or elimination of taxes.

Develop Your Strategies
Identify the planning documents that must be drafted or revised. Determine which tax planning strategies may be appropriate. Consider the individuals or entities to which you want to entrust your assets after your death. Assess the needs of your family members-including your spouse, parents, children, and grandchildren-in light of your death. Consider the financial security of your survivors and the adequacy of your life insurance coverage.

Implement the Decisions
Your decision is meaningless until you turn your words into deeds. In this step, you implement the strategies you developed and execute legal documents. Assign specific tasks to yourself and other family members, and determine whether professional assistance is needed.

Review Your Progress
This final step is easy to ignore, but it is among the most critical. Few decisions are static; we base our choices on a series of events and circumstances that can and do change. Every few years or after a major life event-a marriage, adoption or birth of a child, death of a child or spouse, disability, serious illness, inheritance, divorce, retirement or career change-you should reconsider the various aspects of your plan. Have your goals changed? Has the law changed? Have new or better options become available?

Conclusion

Once you have recognized the risks of not having an estate plan, and how relatively simple it can be to establish one, then perhaps you will be motivated to go through the process outlined above. At a minimum, a will and powers of attorney, coordinated with the proper titling of assets and beneficiary designations, can help you to administer your assets during life and at death.

If you may be subject to gift, estate or GST tax, then you may want to implement more sophisticated estate planning techniques, which would probably require consultation with a professional.

There is no doubt that estate planning can force some difficult decisions. However, if you ignore these issues, then you are risking not only unnecessary taxes, but also unnecessary administrative burdens or anguish for those you leave behind.
Ellen J. Boling, CFP, is director of Private Client Advisors for Deloitte & Touche, LLP, in Cincinnati, Ohio. Tracy Tinnemeyer, JD, is a manager of Private Client Advisors for Deloitte & Touche, LLP, in Pittsburgh, Pennsylvania.

© 2009 AAII Journal     E-MAIL   PRINT

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Is your old, tired life insurance policy actually worth something more than simply its surrender value?

That’s what the life settlement market, as it has evolved, would have many older insurance policyholders believe. At first glance, it would appear that the development of a secondary market for insurance policies would offer policyowners a competitive alternative for raising cash rather than simply cashing out their insurance policies at the policy’s surrender value.

For a very few policyholders, the fair market value of their policies may indeed be worth more than surrender value. But for the vast majority, the transactions make very little sense-unless, that is, you happen to be the agent involved in the sale, earning an enormous commission.

And it is those commissions that are currently driving this market. If you own a policy that could be targeted for this market, or you are approached with a life settlement offer, it pays to be wary-for the reasons outlined below.

A Little Background

What, exactly, is a “life settlement”?

A life settlement is the sale of a life insurance policy by the policyowner to a third party. The policyowner typically receives cash for the sale in an amount greater than the surrender value (or there wouldn’t be any reason to go through the life settlement process). The buyer assumes ownership and pays premiums it deems necessary to keep the policy solvent and receives the death benefit upon the death of the insured.

Generally speaking, life settlements are an option for high-net-worth policyowners age 65 or older. Independent estimates report that among this group, 20% of policies have a market value that exceeds the cash value offered by the carrier.

The market for the buying and selling of life insurance policies for investment purposes had a rational basis in the beginning.

The original life settlement business plan was to buy unwanted or unneeded policies from insureds over age 65 whose health had deteriorated by more than just the passage of time would account for, and whose policies therefore had a theoretical market value that would be greater than the cash value offered by the insurer.

This provided an arbitrage possibility on the part of purchasers-they could buy the policy at a purchase price higher than the policy’s surrender value, and receive the entire death benefit upon the death of the insured.

Institutions Enter the Picture

The major player in this business has been Coventry First, a firm that has a strong financial relationship with AIG. It is my understanding that Coventry buys policies for institutional investors, typically in a “bundled” form. In other words, the institutions are investing in a whole package of policies; they are not investing in individual policies in which the investors know the identity of the insured. In fact, Coventry has stated they have a traveling covenant that protects insureds from becoming known to individual investors. Needless to say, this protects those who are insured by policies that have been purchased by Coventry.

Another settlement firm with major institutional financial support is Maple Life Financial, although they may not feature the traveling covenant to protect insureds, as is Coventry’s claim.

The entry of players such as Coventry and Maple, who claim major institutional support, means that offers for life insurance policies should be in line with the life settlement market’s current expected yields.

Their offers are probably most accurate and likely lower than may be made by settlement brokers who package policies and sell them to smaller financial institutions and to individual investors.

Should You Sell?

But the fact that there are fair purchasers doesn’t mean that you should run off and price out your policy. In fact, it is likely that some 95% of potential policy sellers should retain them.

There are only two situations where selling a policy is the best choice:

• One is an insured who wants cash;
• The other situation is a policy with heavy surrender charges and poor pricing.

As an example of the latter, a $5 million policy we are dealing with right now has poor pricing with combined premiums paid of $225,000, but only $25,000 of surrender value. It is in the client’s best interest to replace it with a legitimately better-priced policy. A legitimate life settlement offer for this policy will be around $125,000, and this will make up for some of the surrender charge loss, with the client ending up with a much better policy.

In almost all other possible life settlement situations, a proper evaluation would result in the policyowner retaining the policy-at least until the policy will terminate.

Let’s say a policyowner named Don wanted to stop paying premiums on his $1 million universal life policy that has a cash value of $100,000.

Now 72 years old and with health problems he didn’t have when the policy was purchased at 60, Don can sell the policy for $275,000. But he doesn’t need the cash-he just wants to stop paying premiums.

The best move is to keep the policy for another five years using the $100,000 cash values to pay the cost-of-insurance.

After five years, the policy would be worth around $475,000 in the life settlement market (Don’s life expectancy is getting shorter), and there is about a 35% probability that Don will die in the next five years. Keeping the policy allows his beneficiaries to receive $1 million tax-free if he dies but even if he doesn’t, Don will very likely improve his situation if he waits and sells in five years.

High Fees

Unfortunately, the life settlement business has evolved into transactions where the main purpose is to procure obscenely high fees and commissions.

The life settlement industry and their solicitors have created the image that many policyowners often come to the rational conclusion they want to sell their life insurance policies and then contact an agent.

This is a false picture. Almost always, it is the agent soliciting policyowners to sell their policies because of the very high commissions they are paid.

In the situation described above, the agent recommending the sale for $275,000 would be paid around $55,000. That means the life settlement firm would have paid out $330,000 for the policy-but Don would not have known about the $55,000 going to the agent.

Don’t Invest in Policies!

The appetite for life settlement transactions has become very large, due to the grossly high fees and commissions, and due to the entry into the field of many smaller buying firms and settlement brokers that claim to cull through all of the offers. In fact, the need for available policies is so great that the industry no longer is satisfied having only conventionally purchased life insurance policies as possible purchase targets.

Instead, some big-shooter agents solicit wealthy seniors to actually “rent” their high net worth and life to become insured for the sole purpose of then selling the life insurance policies.

These transactions involve a third party paying the premiums and paying the wealthy senior a bonus for “renting” his life.

As my May 2006 AAII Journal column (”Why You Should Avoid Investor-Initiated Life Insurance,” available at AAII.com) shows, there is little rational math involved in these representations, and the end investor will lose a lot of money. I believe the main trick being used is to represent a shorter life expectancy than is in fact the case, and this substantially increases the expected yield-which will attract individual and small institutional investors-including, I believe, newer hedge funds.

Regulators and ethical life insurance companies are doing battle with the developers of this horrid practice of investor-initiated life insurance.

My advice: Stay away from investments in life insurance policies!

I know of three situations involving smaller settlement firms that resell their policy buys in which individual investors in these kinds of policies were sent complete information about the insured, the insurance company and the policy they have invested in or bought. In each situation, the settlement company that sold this investment denies they ever give out the names of insureds-which I believe is a lie.

If the sellers of life insurance policies knew their policy could end up “in Tony Soprano’s IRA”-as a popular characterization in the industry goes-they would be more cautious about who they sell to.

And from these investors’ standpoints, the information they are being provided is simply incorrect. In one of the above situations in which the insured’s name was revealed, an estate planning attorney had invested $50,000 in a life settlement policy based on the representation (according to the investor who contacted me) that the settlement company had a 15-year track record of providing investors with average 16% yields. But life settlements haven’t been around 15 years, and the yields are nowhere near 16%.

The most egregious situation I have seen is an agent that caused $30 million of life insurance to be placed without the client’s knowledge by paying the premiums himself and owning the policies (see www.peterkatt.com/newsletters/ATI_v7n6.html). This came to light when he tried to get the insured to agree to turn over medical records so the agent could begin selling policies. Now there is cross-litigation going on.

I hope regulators have the wisdom and courage to put the life settlement genie back in its bottle and return us to where it began.

There is a nice secondary market for the very few situations that it makes sense to sell a life insurance policy. But it pays to be very wary in the current life settlement environment.
Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advising firm located in Kalamazoo, Michigan (269/372-3497); www.peterkatt.com.
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© 2009 AAII Journal

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

By March 2009, most U.S. and international stock indexes had lost at least half of their value in the current financial crisis.

Since that time, some indexes have managed a small rally, but all remain substantially below their peak levels. In addition, banks are in lousy shape, and governments around the world are running huge deficits and trying, seemingly in vain, to cure the financial ills that beset the world economies.

There has been a litany of articles trying to lay the blame for the crisis. We do not propose to add to this literature. Rather, our primary aim is to discuss the investment lessons from the crisis, and to make positive suggestions for investors today.

As a background, we begin with a brief discussion of a few of the factors that contributed to the financial crisis. Then we progress to the discussion of investment lessons that can be learned and what investors can and should do going forward.

Contributing Factors

While this article is not intended to “point fingers” of blame, it is helpful to understand some of the factors that contributed to the current financial crisis. This is an impartial list that is included because these factors will be part of the later discussion of lessons learned and advice to investors.

Lowered Lending Standards

First, a major factor in the crisis was the government-sponsored push to vastly broaden the availability of mortgages. In this, we concur with Nobel-laureate economist Harry Markowitz who, in a major article in the Financial Analysts Journal (January/February, 2009), stated: “[A] basic cause of the current financial crisis was the mandate by the U.S. Congress for the Federal National Mortgage Association (Fannie Mae) to vastly increase its support of low-income housing. This mandate required a lowering of lending standards.”

Overly Complex Investments

Second, the lowering of lending standards resulted in an enormous number of questionable loans that were packaged into complex pools of mortgages (collateralized mortgage obligations, or CMOs). These pools were then sliced up into various combinations of principal and interest repayments, with various maturities, and then sold; the result, in many cases, was that bits and pieces of each original mortgage were spread around various mortgage pools.

In some cases, CMOs were sliced up and wrapped up into other complex and exotic pools, such as collateralized debt obligations (CDOs). For example, one slice of CDO B may contain CMO C. A major problem today is that it is virtually impossible to look inside these opaque investments to determine their value.

Excessive Leverage

Third, many investments and investment banks used excessive leverage, and thus incurred excessive risk. Due to this leverage, a small decrease in assets’ value could and did wipe out the equity at many financial firms, including the government-sponsored enterprises of Fannie Mae and Freddie Mac, and the investment banks Lehman Brothers, Bear Stearns, Merrill Lynch, and others.

Lessons From the Crisis

What should investors learn from the financial crisis? This section presents five major lessons that every investor should heed.

Lesson 1: A mix of high-grade bonds and stocks moderates portfolio risk.

Does history repeat itself?

After the last financial crisis, one of the authors (Reichenstein) wrote the article “10 Lessons You Should Learn from Recent Market History” (February 2003 AAII Journal; available at AAII.com). In the first lesson, he wrote: “High-grade bonds and stocks are fundamentally different assets. Bad years for bonds are sometimes good years for stocks. Bad years for stocks are sometimes good years for bonds.”

At the risk of sounding like a broken record, that same lesson is repeated here as the first lesson to be learned from this most recent crisis.

A key qualification is that only high-grade bonds are fundamentally different assets than stocks. And the higher the credit quality, the greater the difference.

Consider a highly rated 6% coupon ExxonMobil bond. It promises $60 in interest each year, plus the $1,000 principal at maturity. When crude prices rose to $145 a barrel, the bond holders were not promised more than $60. When crude prices fell to $40 a barrel, bond holders were still promised the same $60. The changes in crude prices affected ExxonMobil’s stock price, but not their bond prices because of the lack of default risk.

In contrast, consider low-rated Ford bonds. Due to default risk, Ford’s existing junk bonds will rise and fall in value, just like the stock value, as the firm’s prospects change.

Junk bonds behave like stocks, while high-grade bonds are fundamentally different assets than stocks, and thus provide good diversification benefits.

In the book “The Only Guide to Alternative Investments You’ll Ever Need” (Bloomberg Press, 2008) authors Larry Swedroe and Jared Kizer emphasize that high-yield [junk] bonds, convertible stocks, emerging market bonds, and preferred stocks all have stock-like characteristics that can provide some growth benefits during rising markets. Unfortunately, during bear markets, these assets still behave more like stocks than bonds. Therefore, these assets do not provide investors with protection during bear markets. For diversification purposes, the authors recommend that individuals invest in Treasury securities, government agency debt, or FDIC-insured bank deposits (for amounts within the insurable limits).

Another approach, recommended by Prof. Reichenstein, would be to limit bonds to Treasuries or high-grade bonds.

Lesson 2: Avoid complex investment products.

Wall Street likes to create complex products that appear desirable, but are designed to separate capital from investors.

David Swensen, the portfolio manager of Yale University’s endowment fund and author of the popular investment book “Unconventional Success” (Free Press, 2005), may have expressed it best:

“When a sophisticated provider of financial services stands toe to toe with a naïve consumer, the all-too-predictable conclusion resembles the results of a heavyweight champion and a ninety-eight-pound weakling. The individual investor loses in a first-round knockout.”

These complex investments may combine $97 worth of assets, but are sold for $100. Recent examples include Accumulators, Booster-plus Notes, Buffered Notes, Principal Protected Notes, Reverse Convertibles, STRATS, and Super-Track Notes.

Author Larry Swedroe has studied these products for more than a decade. In that time, he concludes that every single product that he reviewed was meant to be sold, but never bought. Investment bankers are not in the business of playing Santa Claus.

Another example: On a Saturday morning radio show in Dallas, brokers encourage individuals to attend their seminar where they will reveal the wonders of equity-indexed annuities. These assets, which were discussed in our November 2007 AAII Journal article ["Investment Products: If It Has to Be Sold, Don't Buy It!"; available at AAII.com], have hidden costs, complex features, surrender penalties, a lack of a secondary market, and more. But they pay huge commissions, and are aggressively sold.

In “An Overview of Equity-Indexed Annuities,” a 2006 working paper by the Securities Litigation and Consulting Group, authors Craig McCann and Dengpan Luo conclude that the “net result of equity-indexed annuities’ complex formulas and hidden costs is that they survive as the most confiscatory investments sold to retail investors.”

If it sounds too good to be true, it probably is.

Lesson 3: Insist on simple, transparent investments.

Individual investors can create prudent portfolios by combining stocks, bonds, mutual funds and exchange-traded funds. They do not need to resort to non-transparent products like CMOs, CDOs, hedge funds, and funds of hedge funds.

The markets for CMOs and CDOs have frozen because no one knows what is in these opaque investments.

Some hedge fund managers refuse to reveal their strategy because, they claim, they do not want other investors to learn about the market inefficiency that they are allegedly exploiting.

Bernie Madoff had a history of providing consistent stable returns before his $50 billion Ponzi scheme collapsed. Allen Stanford, head of Stanford Financial Group, and also accused of running a Ponzi-type scheme, also had a strong record allegedly built on secret strategies before the fraud was discovered.

Investors should not trust opaque strategies that seem to offer returns that are too good to be true.

Buying simple investment products provides a degree of safety against fraud that is not available in complex and opaque investments.

Lesson 4: Avoid leveraged investments.

It should be clear that there is plenty of risk in traditional stocks, bonds, mutual funds and exchange-traded funds. We suspect few, if any, individuals feel the need to leverage up their risk beyond that inherent in stocks and stock funds.

However, many hedge fund managers use substantial leverage. Hedge funds’ cost structure, where managers typically charge 2% of assets under management plus 20% of profits, encourages this risk-taking. After all, when leverage increases returns, it magnifies the managers’ profit-sharing returns, while when leverage decreases returns, the investor bears all the risk. This is a classic example of “heads” the manager wins and “tails” the investor loses. It makes sense for the manager, but not for the investor.

 Table 1. Annual Index Returns: 2003-2008

Table 1 shows the 2003-2008 returns on an HFRX index of hedge funds [HFRX indexes are published by Hedge Fund Research Inc.] and several stock and fixed-income indexes. The HFRX index indicates returns “as reported by hedge fund managers.”

These returns may have several upward biases. First, the returns are “reported” but not necessarily audited.

Second, they likely included returns from hedge funds run by Madoff and Stanford that looked good, but were fraudulent.

Third, there may be survivorship bias. Several hedge funds in existence in 2003 did not survive through 2008. When a fund dies, it usually has poor returns, and most indexes delete the historical records of these non-survivors at their death. The survivorship bias reflects the fact that the average return of investors in surviving funds exceeds the average return of investors in all funds, including those that survived and those that failed.

Despite multiple upward biases in this hedge fund index, Table 1 indicates that hedge funds had negative returns for 2003-2008, while domestic stocks, international stocks, and high-grade U.S. bonds had positive returns.

The dramatic failures of Fannie Mae, Freddie Mac, Lehman Brothers, and Bear Stearns would not have been possible without the use of excessive leverage. Fannie Mae, Freddie Mac and Lehman Brothers had leverage ratios of about 30, meaning they borrowed about $30 for each $1 of their money. (Counting off-balance-sheet obligations in the form of guarantees made the real leverage at Fannie Mae and Freddie Mac much higher, perhaps 100 to 1). So, it took less than a 4% drop in the underlying asset’s value to wipe out their equity positions.

With this level of leverage, investment bankers could not be right just some of the time. They had to be right all the time.

Lesson 5: There is no “smart money,” or investors who are consistently smarter than others.

There is the myth that there exists so-called “smart money” and “smart investors,” and if you only had access to that smart advice, you could consistently earn market-beating returns.

If only it were true!

This financial crisis, perhaps more so than any other, should dispel the myth that “smart money” and “smart investors” exist that individual investors can tap into and earn higher-than-most-anybody-else’s rates of return.

For 15 straight years from 1991 though 2005, Bill Miller’s Legg Mason Value Trust mutual fund beat the S&P 500, and he was considered by many investors to be “smart money.” However, his fund has dramatically underperformed since 2005. According to Morningstar, as of year-end 2008 his fund’s returns were in the bottom quartile of one-, three-, five-, and 10-year trailing returns among large-cap blend stock funds.

Investment banking firms have long corralled the best and the brightest. Just ask them. Indeed, they have long cherry-picked the brightest minds from universities. If ever there was a group of smart investors, they would be at investment banks.

In early 2007, Merrill Lynch had a market cap of $86 billion. In fall 2008, they were rescued by Bank of America after gaining certain Federal Reserve guarantees. Recent estimates suggest losses at Merrill might cost the government in excess of $100 billion.

Lehman Brothers is bankrupt.

Bear Stearns was rescued in the face of certain failure.

AIG, an insurance firm with a large investment arm, has been rescued from failure, and the cost of the government rescue continues to rise.

Where, then, is the smart money?

Where are the investment managers that can consistently produce market-beating returns?

Because markets are highly efficient, investors are best served if they assume that (or invest as if) there is no smart money and there are no smart investors. The reason is that, while it is easy to identify investment managers with good performance after the fact, no one has yet found a way to identify the good performers before the fact.

That is why the SEC requires the disclaimer about past performance.

What Should Investors Do Now?

The first and foremost step investors should take is to have a plan: They should have an asset allocation strategy, and they should stick to it.

Be Broadly Diversified

Investors should stay with the tried-and-true strategy of building a broadly diversified portfolio containing U.S. stocks, international stocks, and U.S. high-grade bonds.

In addition, you may want to (but do not have to) allocate a small portion of your portfolio to alternative assets such as real estate investment trusts (REITs, which own income-producing real estate such as office buildings, shopping centers, and apartments) and commodities.

The U.S stock market already contains a small exposure to REITs, so if you have investments in a broad-based stock market index, you are already invested in REITs. However, most real estate is privately owned, so if the idea is to construct an investment portfolio that mirrors the portfolio of all existing financial assets, you could easily justify a higher exposure than the one you are getting in the stock indexes-perhaps a 5% exposure to REITs beyond that already present in a stock index fund.

The same philosophy applies to commodities.

Keep It Low Cost and Tax Efficient

Since markets are highly efficient, individuals should invest in passively managed, low-cost, and tax-efficient index funds and exchange-traded funds (ETFs).

Since markets are efficient, it is unlikely financial analysts can consistently find mispriced assets and thus add to investors’ returns-especially after paying the costs of the effort. So, it does not make sense to pay the higher fees needed for an army of financial analysts to try to find such assets.

Rebalance Periodically, and Don’t Try to Time the Market

One good strategy is a fixed-weight strategy.

Suppose a couple has a target asset allocation of 60% stocks and 40% bonds. Unless circumstances change dramatically (for example, one spouse loses a job, or there is a death in the family) then periodically-perhaps once per year-they should rebalance the portfolio back to these original fixed weights, since changes in market valuations will cause the portfolio to stray from the original allocation.

There are other perfectly viable asset allocation plans. However, the main point to keep in mind is that you should resist the common practice of trying to “time” the stock market-substantially changing your exposure to the stock market based on the direction you think it may be headed. Substantial research shows that many investors enter the stock market or increase their stock exposure after the market has risen and exit or reduce their exposure after stocks have fallen-the most inopportune time for either move.

It is tough to be tenacious in bear markets and stick to your stock market holdings at a time when the valuations seem unbearably bleak. But history suggests that investors will hurt their returns if they listen to their gut and bail out, instead of listening to their mind and “bearing” with it.

Have a Plan B

In the financial community, historical returns are often used to help estimate what the future might bring.

For example, at the turn of the century, estimates might have been generated from analyses of thousands of possible 30-year scenarios, based on randomly drawing 30 yearly returns from the 1926-1999 distribution of historical returns.

These procedures are used in the hopes that they can provide some guidance about the probable distribution of future returns.

But the 1926-1999 distribution would have predicted only an extremely small chance of two separate 50% decreases in the real value of the S&P 500 this decade.

Perhaps this very small predicted chance is what actually occurred. More likely, however, the simulations underestimated the range of future possible 30-year returns.

This should serve as a cautionary reminder that there is a difference between the risk that is implied from a known probability distribution (one that has already occurred, like the 1926-1999 returns) and the risk from an uncertain probability distribution.

Unknowable factors-like 9/11 and this financial crisis-remind us that the future comes from an uncertain distribution. While past returns are often used for some guidance, don’t be fooled into thinking that “improbable” bad events can’t happen.

Since “unexpected” things can happen to good people and good plans, it is important to have a Plan B: If things turn out worse than expected, how will you respond?

• If you are still working, you may be able to delay retirement.
• If retired, you may be willing and able to return to work.
• You may have to eliminate one or more goals from your wish list.
• You may have to reduce or eliminate discretionary spending for travel and dining out.
• You may have to move in with a family member.

We all need to remain flexible in the face of an uncertain future.

For Further Reading

Link to these past AAII Journal articles for more on the topics discussed in this article.

• § Balance & Diversification in Your Portfolio
• § “The Real-World Lessons From Investment Theory,” by William Reichensten and C. William Thomas, January 2006
• § “10 Lessons You Should Learn From Recent Market History,” by William Reichensten, February 2003
• § “Basic Truths About Asset Allocation: A Consensus View Among the Experts,” by William Reichensten, October 1996
• § Complex Investments
• § “Due Diligence: 10 Steps to Avoiding Ponzi Schemes and Financial Fraud,” by Karen C. Altfest, April 2009
• § “Investment Products: If It Has to Be Sold, Don’t Buy It!,” by William Reichensten and Larry Swedroe, November 2007
• § “Hedging Your Portfolio With Mutual Funds,” by John Markese, June 2006
• § “What Are You Really Getting When You Invest in a Hedge Fund?,” by William Reichenstein, July 2004
• § Investing With Margin
• § “Margin Accounts: A Double-Edged Sword,” by John Gannon, May 2005

William Reichenstein, CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University in Waco, Texas. He can be reached at Bill_Reichenstein@baylor.edu.

Larry Swedroe is director of research and principal of Buckingham Asset Management in St. Louis, Missouri. He is also author of six books on investing, including “Wise Investing Made Simple” (Charter Financial Publishing Network, 2007), and can be reached at lswedroe@bamstl.com.

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© 2009 AAII Journal

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

 

Step 1: What Do I Need to Consider Before Investing?

There are four basic aspects that compose your personal investment profile:

• Your personal tolerance for risk
• Your return needs and whether you need to emphasize current income or future growth
• Your time horizon
• Your tax exposure

Each aspect of your personal investment profile will affect the trade-offs you are willing to make and your ability to reduce risk.

Step 2: How Do I Know How Much Risk I Can Handle?

The amount of risk you are willing to take is an extremely important factor to consider before making an investment because of the severe consequences of taking on too much risk. Risk is uncertainty-the possibility that the investment won’t perform as expected. Most investors who take on too much risk panic when confronted with losses they are unprepared for, and they frequently bail out at the worst possible time. Stock investors who panicked and sold right after a stock market crash moved out of the market at one of its lowest points. The result-buying high and selling low-is the opposite of Will Rogers’ famed investment advice, and is guaranteed to produce an unhappy outcome.

Properly assessing your tolerance for risk is designed to prevent you from making panic decisions, abandoning your investment plan mid-stream at the worst possible time. How can tolerance be measured?

While many questionnaires seek to grade risk tolerance, the best approach is to simply examine the worst-case scenario-a loss over a one-year period-and ask yourself whether you could stick with your investment plan in the face of such a loss.

Investors with a low tolerance for risk generally can sustain losses of no more than 5% over a one-year period. Individual securities with this kind of characteristic include money market funds and certificates of deposit, both of which protect the underlying principal investment with virtually no risk of loss, and short-term bond investments.

Investors with a moderate tolerance for risk can generally withstand losses of between 6% and 15% over a one-year period. Types of securities that may sustain these kinds of losses include intermediate- and long-term bond portfolios and high-quality, lower-risk dividend-paying stock portfolios.

Investors with a high tolerance for risk can generally withstand losses of between 16% and 25% annually. Security types that may sustain these kinds of losses include aggressive growth stock portfolios, portfolios of stocks of smaller firms and emerging market stock portfolios.

Note that the examples of security types are presented merely to give you an idea of the level of losses discussed. If you are drawn to one of those kinds of securities, you probably have a tolerance for risk approaching that type of security. The examples are not meant to limit investors solely to the choices within each risk level. In fact, we shall see later in the series that even a low-risk investor can benefit by diversifying into riskier investments with part of their portfolio while maintaining a low-risk profile. In addition, the losses outlined are typical for the security types as a group; individual securities within these types could sustain losses much greater than a portfolio of securities.

Step 3: How Do I Decide the Rate of Return I’m Shooting For?

Individuals differ greatly in their return needs. If you depend on your investment portfolio for part of your annual income, for example, you will want returns that emphasize relatively higher annual payouts that tend to be consistent each year and protect principal.

On the other hand, individuals who are saving for a future event-a child’s education, a house, or retirement, for instance-would want returns that tend to emphasize growth. Of course, many individuals may want a blending of the two-some current income, but also some growth.

Determining your return needs is important because you can’t have all of everything-there is no investment that offers a high certain payout each year, protects your principal and offers a high potential for future growth.

There are a number of trade-offs here, based on the risk/return trade-off. First, the price for principal protection is lower returns, usually in the form of lower annual income. There is also a trade-off between income and growth: The more certain the annual payment, the less risky the investment, and therefore the lower the potential return in the form of growth.

These trade-offs can be seen by looking at examples of individual securities from least risky to most risky:

• Money market funds, certificates of deposit and short-term bonds offer the most certain annual payouts plus protection of principal, but offer virtually no potential for growth.
• Longer-term bonds offer higher annual payouts, but less protection of principal and little growth potential.
• High-quality dividend-paying stocks offer less certain annual payouts, since dividends aren’t assured, and no principal protection, since stock prices aren’t guaranteed, but they offer considerable growth potential.
• Finally, growth stocks offer the most potential for growth, but rarely pay dividends.

Again, these securities are mentioned only as examples of return characteristics to help you identify your own needs. Individuals with specific return needs will not necessarily invest exclusively in securities with those same characteristics. Diversifying among different types of securities in the proper proportion will still allow you to meet your return needs, as long as you have identified them properly.

Step 4: Am I a Long-Term or Short-Term Investor?

The length of time you will or can be invested is important because it can directly affect your ability to reduce risk.

Time diversification is most critical for volatile investments such as stocks, where prices fluctuate greatly over the short term, but are considerably smoothed over longer time periods.

If your time horizon is short, you cannot effectively be diversified across different market environments. Longer time horizons allow you to take on greater risks-with a greater return potential-because some of that risk can be reduced through time diversification.

How should time horizon be measured? Your time horizon starts with whenever your investment portfolio is implemented, and ends when you will need to take the money out of your investment portfolio.

If you are investing to save for a specific event, such as tuition payments or the purchase of a house, your time horizon is fairly easily measured-it ends when you need the cash.

If you are investing to accumulate a sum for periodic withdrawals, such as during retirement, your time horizon is more difficult to quantify as you approach the time that withdrawals will begin. For instance, when you retire, you may need to take out only part of your investment portfolio as income each year. Your time horizon will be a blend-partly short-term, and partly intermediate- or longer-term.

What constitutes short-, intermediate- and long-term horizons?

Time diversification is directly affected by time horizon, so it makes sense to use that as a starting point. Since time diversification is most effective for the most risky investments-stocks-it sets the long-term horizon.

To diversify over various economic cycles, you must be invested through one complete economic cycle at the very least. In general, the economic cycle lasts about five years, which can be considered a long-term horizon. An even longer-term horizon-over 10 years-would cover several cycles and ensure even greater time diversification, which is useful when investing in particularly risky stocks.

What about short- and intermediate-term horizons? Since the horizon is less than five years, stocks shouldn’t be considered. In addition, the sooner you need the investment, the greater the need for principal protection and ease of selling.

A short-term horizon-under five years-effectively limits you to fixed-income securities. If you need the money within a year or two, you are limited to the shorter end of the fixed-income spectrum-money market funds, very short-term bonds and short-term certificates of deposit. A somewhat longer-term outlook-two to five years-allows you a little more room to earn higher returns using intermediate-term (less than five years) bonds and intermediate-term certificates of deposit.

Step 5: How Do Taxes Impact My Investment Decisions?

The bottom line to all investors is what’s left after taxes. The level at which you are taxed will have a big impact on the kinds of investments that will provide you with the best aftertax return.

Investors who are in higher income tax brackets need to be concerned with the tax implications of their investments. For instance, part of the return from a high dividend-paying stock is in the form of an annual dividend that is taxed each year. High tax exposure investors would want to avoid or shelter in a tax-exempt account, such as an IRA, investments that generate high annual income, and stress those that offer long-term growth, where taxes can be deferred until the investment is sold. If these investors need fixed-income securities, they would probably prefer those that offer some tax exemption, such as municipal securities.

Investors who are in lower income tax brackets need to worry less about the tax implications of their investments. Conversely, they should avoid securities that benefit high tax-exposure investors. For instance, the yields paid on municipal securities are usually attractive only for investors in the top tax brackets.

With the tax laws changing regularly, it is difficult to quantify what constitutes “lower” and “higher” tax exposure (perhaps the terms “high” and “even higher” would be more accurate). However, if your annual income level puts you within the top federal income tax categories, you fall within the “higher” category, and if your income level puts you in the lower federal tax categories, you are in the “lower” category.

Table 1 summarizes the four aspects of the personal investment profile.

Step 6: Do My Investment Needs Change as I Get Older?

Your personal investment profile will change over time. For instance, your tolerance for risk may change as you get older, or as you acquire more assets and become more financially secure. When you approach retirement, your time horizon may shift, and become a blend of long-term and medium- or short-term needs. As it does so, you will need to make revisions to your investment plan to reflect these changes.

Table 2 shows how an investor’s profile may change over time. The table also illustrates the degree to which profiles can vary.

Of course, your own profile may be very different than the one presented here; your profile may even fit one of those listed here, such as early retirement, even though you are in a different stage-perhaps early career. The table is only an example.

An effective investment portfolio is one that is based on a balance between the risks you are willing to take and the returns you need to achieve your goals.

An understanding of the various aspects of your investment profile will allow you to assess that proper balance.

The next step is to match the investment characteristics of the various asset categories to your risk and return characteristics in an efficient manner that maximizes return while minimizing risk.

 Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.