Welcome Back! We've wrapped up another strong quarter for financial markets which has helped ease the pain of 2008 and early 2009. We'll cover a quick review of the 3rd quarter and an outlook for the 4th quarter. We'll cover the concept of risk and discuss Roth IRAs. Finally, we'll also discuss the value of a financial plan and point to options to help build your plan.
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Happy, Happy, Joy, Joy?!
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The third quarter was another positive quarter for financial markets as a record percentage of companies met or exceeded their earnings estimates. Further, economic data, for the most part, exceeded expectations as well. All of the good news lead many investors to conclude the worst of times were behind us and good times lay ahead! The S&P 500 advanced roughly 15% and is up roughly 19% year-to-date. So we're almost back to where we were prior to the sell-off that began in mid September of 08. In fact, the S&P is down (6.79%) for the last 12 months - remember it was down (37%) for calendar 2008!
However, it is entirely rational to remain skeptical about the prospects for strong future growth. The global economy still has much room for improvement and stiff headwinds to fight. Consumers, which drive much of the growth domestically and globally, remain highly leveraged. Currently, the level of debt relative to disposable income (in the U.S.) is roughly 125%. That is double the level maintained from the early 1960's through the early 1990's. So, consumers are still in the process of "de-leveraging" their personal balance sheets. That means consumers are unlikely to be the key driver of GDP growth, at least in the U.S., in the near term. Further, companies are also "de-leveraging" to improve their balance sheets and maintain their global competitiveness. Thus, recent good news is unlikely to be matched in the near term, read next 12 months. I've predicted a close at 950 for the S&P 500 since January. I continue to believe that is a reasonable target, though it would mean a 10% correction in the 4th quarter.
I would prefer the news continue to be good and that financial markets continue to advance, but, I also believe a healthy skepticism is valuable when investing. Give yourself the ability to benefit if news remains good but guard against the "bubble" bursting by hedging your portfolios.
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What is Risk and Why is it Important?
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Few terms in personal
finance are as important, or used as frequently, as "risk."
Nevertheless, few terms are as imprecisely defined. Generally, when financial
advisors or the media talk about investment risk, their focus is on the
historical price volatility of the asset or investment under discussion.
Suppose
that you had invested $10,000 in each of two mutual funds 20 years ago, and
that both funds produced average annual returns of 10 percent. Imagine further
that one of these hypothetical funds, Steady Freddy, returned exactly 10
percent every single year. The annual return of the second fund, Jekyll &
Hyde, alternated--5 percent one year, 15 percent the next, 5 percent again in
the third year, and so on. What would these two investments be worth at the end
of the 20 years?
It seems obvious that if
the average annual returns of two investments are identical, their final values
will be, too. But this is a case where intuition is wrong. If you plot the
20-year investment returns in this example on a graph, you'll see that Steady
Freddy's final value is over $2,000 more than that from the variable returns of
Jekyll & Hyde. The shortfall gets much worse if you widen the annual
variations (e.g., plus-or-minus 15 percent, instead of plus-or-minus 5
percent). This example illustrates one of the effects of investment price
volatility: Short-term fluctuations in returns are a drag on long-term growth.
(Note:
This is a hypothetical example and does not reflect the
performance of any specific investment. This example assumes the reinvestment
of all earnings and does not consider taxes or transaction costs.)
Although past
performance is no guarantee of future results, historically the negative effect
of short-term price fluctuations has been reduced by holding investments over
longer periods. But counting on a longer holding period means that some
additional planning is called for. You should not invest funds that will soon
be needed into a volatile investment. Otherwise, you might be forced to sell
the investment to raise cash at a time when the investment is at a loss.
In general, the more risk you're willing to take on (whatever type
and however defined), the higher your potential returns, as well as potential
losses. This proposition is probably familiar and makes sense to most of us. It
is simply a fact of life--no sensible person would make a higher-risk, rather
than lower-risk, investment without the prospect of receiving a higher return.
That is the tradeoff. Your goal is to maximize returns without taking on an
inappropriate level or type of risk.
The
concept of risk tolerance is twofold. First, it refers to your personal desire
to assume risk and your comfort level with doing so. This assumes that risk is
relative to your own personality and feelings about taking chances. If you find
that you can't sleep at night because you're worrying about your investments,
you may have assumed too much risk. Second, your risk tolerance is affected by
your financial ability to cope with the possibility of loss, which is
influenced by your age, stage in life, how soon you'll need the money, your
investment objectives, and your financial goals. If you're investing for
retirement and you're 35 years old, you may be able to endure more risk than
someone who is 10 years into retirement, because you have a longer time frame
before you will need the money. With 30 years to build a nest egg, your
investments have more time to ride out short-term fluctuations in hopes of a
greater long-term return.
Don't
put all your eggs in one basket. You can potentially help offset the risk of
any one investment by spreading your money among several asset classes.
Diversification strategies take advantage of the fact that forces in the
markets do not normally influence all types or classes of investment assets at
the same time or in the same way. Swings in overall portfolio return can be
moderated by diversifying your investments among assets that are not highly
correlated--i.e., assets whose values may behave very differently from one
another. In a slowing economy, for example, stock prices might be going down or
sideways, but if interest rates are falling at the same time, the price of
bonds likely would rise. Diversification cannot guarantee a profit or ensure
against a potential loss, but it can help you manage the level and types of risk
you face.
In addition to
diversifying among asset classes, you can diversify within an asset class. For
example, the stocks of large, well-established companies may behave somewhat
differently than stocks of small companies that are growing rapidly but that
also may be more volatile. A bond investor can diversify among Treasury
securities, more risky corporate securities, and municipal bonds, to name a
few. Diversifying within an asset class helps reduce the impact on your
portfolio of any one particular type of stock, bond, or mutual fund.
This approach to
investing is not new but has generally been treated as an after-thought as
investors stretched for return. Yet, longer-term, this approach may be more
beneficial. We build portfolios by first determining the acceptable level of
volatility. Then we attempt to construct a portfolio that maximizes return
given that level of volatility. The resulting target return may be less than
the investor desired but the portfolio is more likely to satisfy the investor's
risk tolerance and that should mean fewer sleepless nights wondering how to
make back lost money.
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To Roth or Roth Not
Truly a Burning Question!
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With the lure of tax-free distributions, Roth IRAs
have become popular retirement savings vehicles since their introduction in
1998. But if you're a high-income taxpayer, chances are you haven't been able
to participate in the Roth revolution. Well, that's
about to change.
There are currently three ways to fund a Roth IRA--you can contribute
directly, you can convert all or part of a traditional IRA to a Roth IRA, or
you can roll funds over from an eligible employer retirement plan (more on this
third method later.)
In general, you can contribute up to $5,000 to an IRA (traditional, Roth, or a combination of both) in 2008 and 2009. If you're
age 50 or older, you can contribute up to $6,000 in 2008 and 2009. (Note,
though, that your contributions can't exceed your earned income for the year.)
But your ability to contribute directly to a Roth IRA depends on your income
level ("modified adjusted gross income," or MAGI).
Regardless of whether you contribute directly to a Roth IRA, if your MAGI is
$100,000 or less, and you're single or married filing jointly, you can convert
an existing traditional IRA to a Roth IRA. (You'll have to pay income tax on
the taxable portion of your traditional IRA at the time of conversion.) But if
you're married filing separately, or your MAGI exceeds $100,000, you aren't
allowed to convert a traditional IRA to a Roth IRA.
In 2006, President Bush
signed the Tax Increase Prevention and Reconciliation Act (TIPRA) into law.
TIPRA repeals the $100,000 income limit for conversions, and also allows
conversions by taxpayers who are married filing separately. What this means is
that, regardless of your filing status or how much you earn, you'll be able to
convert a traditional IRA to a Roth IRA. The bad news? This provision of the
new law doesn't take effect until 2010.
Even though the new rules don't take effect until 2010, there are steps you
can take now if you want to maximize the amount you can convert at that time.
If you aren't doing so already, you can simply start making the maximum annual
contribution to a traditional IRA, and then convert that traditional IRA to a Roth in 2010.
Your ability to make deductible contributions to a traditional IRA may be
limited if you (or your spouse) is covered by an employer retirement plan and
your income exceeds certain limits. But any taxpayer, regardless of income
level or retirement plan participation, can make nondeductible contributions to
a traditional IRA until age 70½. And because nondeductible contributions aren't
subject to income tax when you convert your traditional IRA to a Roth IRA, they
make sense for taxpayers contemplating a 2010 conversion even if they're
eligible to make deductible contributions.
If you've made only nondeductible contributions to your traditional IRA,
then only the earnings, and not your own contributions, will be subject to tax
at the time you convert the IRA to a Roth. But if
you've made both deductible and nondeductible IRA contributions to your
traditional IRA, and you don't plan on converting the entire amount, things can
get complicated. That's because under IRS rules, you can't just convert the
nondeductible contributions to a Roth and avoid
paying tax at conversion. Instead, the amount you convert is deemed to consist
of a pro-rata portion of the taxable and nontaxable dollars in the IRA. For
example, assume that in 2010 your traditional IRA that contains $350,000 of
taxable (deductible) contributions, $100,000 of taxable earnings, and $50,000
of nontaxable (nondeductible) contributions. You can't convert only the $50,000
nondeductible (nontaxable) contributions to a Roth.
Instead, you'll need to prorate the taxable and nontaxable portions of the
account. So in the example above, 90% ($450,000/$500,000) of each distribution
from the IRA in 2010 (including any conversion) will be taxable, and 10% will
be nontaxable.
You can't escape this result by using separate IRAs. The IRS makes you
aggregate all your traditional IRAs (including SEPs and SIMPLEs) when
calculating the taxes due whenever you take a distribution from (or convert)
any of the IRAs. But for every glitch, there's a potential workaround. In this
case, one way to avoid the prorating requirement, and to ensure you convert
only nontaxable dollars, is to first roll over all of your taxable IRA money
(that is, your deductible contributions and earnings) to an employer retirement
plan like a 401(k) (assuming you have access to an employer plan that accepts
rollovers). This will leave only the nontaxable money in your traditional IRA,
which you can then convert to a Roth IRA tax free. (You can leave the taxable
IRA money in the employer plan, or roll it back over to an IRA at a later
date.) But even if you have to pay tax at conversion, TIPRA contains more good
news--if you make a conversion in 2010, you'll be able to report half the
income from the conversion on your 2011 tax return and the other half on your
2012 return.
For example, if your only traditional IRA contains $250,000 of taxable
dollars (your deductible contributions and earnings) and $175,000 of nontaxable
dollars (your nondeductible contributions), and you convert the entire amount
to a Roth IRA in 2010, you'll report half of the income ($125,000) in 2011, and
the other half ($125,000) in 2012.
As with any investment with tax
consequences, consult your tax advisor before taking action.
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Feel free to forward this bulletin to anyone you believe may find it useful. I welcome new subscribers! Also, please visit my blog, Brighton Perspective, for frequent short commentary on current financial news.
Finally, please feel free to contact me if I can be of service
Sincerely,
John P. Middleton, CFA, CAIA
Brighton Financial Planning, Inc.
john@brightonfinancial.com
908-892-5958
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Do You Know Where You're Going?
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If you're heading out to a place you've never been, you probably either use the GPS in your car or you map the trip on-line before you leave. This way you don't have to worry about getting lost along the way.
Yet, if you're like many, you haven't "mapped" your trip to college, retirement or any other significant life event. If we're right, why not? Planning these trips is just as important, if not more so, than the next vacation trip. The good news is there are many options to correcting this oversight.
If you're a do-it-yourselfer, consider using software such as Quicken or Microsoft Money. You can also use websites such as Mint.com or Wesabe.com. All will help you gain a better understanding of your current situation and enable you to "map" your trip more effectively.
If you're not a DIY'er, you can use the services of an advisor. The advisor can provide cash flow analysis as well as full financial planning services. Most use very robust software and provide a deeper level of detail than the DIY options.
Either way, if you don't know where you are today, you'll have a tough time navigating to your future goals!
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