More Fundamentals Of Financial Planning

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
January 10, 2006

IN THIS ISSUE:

1.  Building On The December 27, 2005 E-Letter

2.  Buy A House As Soon As You Can

3.  Maximize Tax-Qualified Savings

4.  Roll Over Retirement Plan Distributions

5.  Begin A Regular Program Of Investing

Introduction

In my December 27, 2005 E-Letter, I discussed some of the very basics of sound financial planning.  I was actually surprised by the number of readers who responded to that article thanking me for the advice.  Some even said they were going to send it on to friends and family who could use the information. This is not at all what I expected from an E-Letter that hit e-mailboxes during the Christmas holidays.

However, I guess I shouldn’t have been surprised at the response in light of all of the events of 2005 that had the potential to affect the economy and markets.  Hurricanes, floods, sky-high oil prices, idling of refineries, pension problems and Alan Greenspan’s warnings about a “housing bubble” all worked together to create a year of great uncertainty.

As a result of these and other factors, the stock market moved in a generally sideways direction, leaving many investors pretty much where they started in January of 2005.  From all indications, 2006 looks like it could be a repeat of 2005, so investors are seeking out information as to how they should position themselves to meet their future financial goals.

In this week’s E-Letter, I’ll expand upon the basic financial planning advice I covered in the December 27th issue.  Where my first article focused on setting goals, saving and debt management, this next set of fundamental planning tips will delve into slightly more advanced topics such as home ownership, tax qualified savings opportunities and how to start a program of investing.

Buy A House As Soon As You Can

“Now wait a minute!” you may be saying.  “Didn’t you just mention Greenspan’s warning about a housing bubble?  How can you start out this E-Letter recommending the purchase of a house if there’s a housing bubble going on?”

Good question.  In several of my E-Letters late last year, I warned about the real estate/housing bubble, and I have recommended taking some profits and lightening up on investment real estate.  That was some very good advice, especially in many parts of the country where we are now seeing weakness in real estate values.

The gloom-and-doom crowd, of course, assures us that the housing boom of the last several years is a bubble that has peaked and home prices will plummet in 2006.  Never mind that these crackpots have been saying this for the last 20 years or longer.  But now, even some more mainstream analysts are worried about a housing bust just ahead.  Some are even recommending that you sell your personal home now and rent.  I disagree, and I have never recommended that you sell your personal home and rent. 

Over the years, I have heard from many individuals who have gone so far as to sell their homes in favor of renting in anticipation of a setback in the housing market.  People get worried about recessions or other concerns – or listen to the never-ending drumbeat of the doomsday crowd – and sell their homes, hoping to buy another one at a significant discount later on.  Rarely is that a good idea, and usually, it is a disaster!  Historically, home prices have rarely fallen significantly, nor for very long, and home prices have a remarkable track record for rising significantly over the medium to long-term.

For example, I recently heard from one of my readers who had moved from Virginia to California about eight years ago.  At that time, a relatively small house in CA was priced at over $200,000, and this reader felt that housing was in a bubble and put off buying at that time.  Now, eight years later, the same homes are selling for $500,000 or even more.  Thus, my reader missed out not only on a less expensive home, but also the real estate appreciation that occurred.

One reason why housing prices are more stable and less likely to fall significantly is the fact that shelter is one of the basic needs of life , and a home is typically the largest purchase most people ever make.  Notice that I didn’t say the largest “investment” most people ever make, because a home is not really an investment to most people.  Most so-called investments: 1) move in and out of favor from time to time; 2) fluctuate rather significantly in price from time to time; and 3) can generally – but not always - be relatively easily liquidated in favor of other investments, or simply cashed out if you need the money.

But if you sell your home, you have to immediately start looking for alternative shelter.  In addition, while many people have homes that have appreciated significantly through the years, most will die in their homes without cashing out this significant increase in value.

Even though I do not consider a home to be an investment per se, I do believe that you should purchase your own home once you have sufficient income and assets to do so.  That way, you begin to build equity with part of the monthly budget that formerly went to rent expense.  Home ownership also has major tax advantages, as well as more intrinsic values such as putting down roots and becoming part of a community.  Since a home is usually a long-term commitment (studies show homeowners stay in their homes an average of 12 years), it’s very likely that prices will be higher by the time you want to sell.

Various studies have shown that home ownership is not only a good financial decision, but can also lead to other benefits such as family stability, neighborhood improvement and increased civic involvement.  While these latter social benefits seem to be intangible, a study by the University of Tennessee reported that home ownership can lead to real results.  The study showed that children of homeowners are 25% more likely to graduate high school, 116% more likely to graduate college and 59% more likely to become homeowners themselves. (Source: Boehm & Schlottmann, University of Tennessee)

Homebuilders, real estate agents and the banking industry are all still telling us that now is the perfect time to buy a home.  On the other hand, there is the gloom-and-doom crowd, and even some in the mainstream, that are warning of a housing bust.  So, who’s right?

I do NOT expect a bust in the housing market.  Neither does The Bank Credit Analyst, as I reported to you in last week’s E-Letter wherein I summarized BCA’s latest forecasts.  While we are seeing signs of softening of home prices, especially in the hottest markets, I do not see a wholesale retrenchment or a bust.  As I noted last week, BCA expects US home prices are more likely to stagnate temporarily, rather than decline significantly.

So my advice, especially for those looking to become homeowners, is that you use the period just ahead to look for reasonable bargains and buy a home.   I do NOT recommend that you sell your home, thinking that you will be able to replace it  later at a significant discount.  History is not on your side.

Obviously, if you are looking to buy a home, the ideal time to do so is when both housing prices and interest rates are accommodating.  Currently, interest rates are still very low, although some believe mortgage rates could fall marginally in the next couple of months. As noted above, home prices may soften a bit more just ahead, especially in some of the hottest markets, but in the long-term, home prices are likely to be higher, perhaps much higher.  Thus, waiting for this perfect alignment of the moon and stars may mean that you miss out on an ownership opportunity.

Caution: I do NOT advise buying a home if your credit rating is impaired to the point that you will be paying a much higher rate of interest than the going rate.  I know of some people who were paying double-digit interest rates on homes even while long-term rates were at their lowest.  In such cases, they are paying the bank or mortgage company a premium to compensate for their lower credit scores.  It is my opinion that you should clean up your credit and then look for a home, rather than the other way around.

For potential home buyers, the next few months may be an excellent time to purchase a home.  Some homebuilders are reducing prices and/or increasing incentives, especially on houses that have been in inventory for a while.   There are instances where lenders will allow little or no money down to facilitate the sale of a home. 

Other sources of good deals may be foreclosures, individuals who have been transferred and need to sell quickly, or homeowners who want to move up to a larger home and need to access the equity in their old home soon to close on their new home.  There should be some very good deals in the next few months. The key is not to be greedy and do not wait too long. 

There is obviously a LOT more I could write about buying a home, but space does not permit.  While this advice regarding buying a home is not intended to be exhaustive, it does reinforce the many benefits of home ownership. 

Maximize Tax-Qualified Savings

In my December 27th E-Letter, I advised establishing a cash reserve and eliminating installment debt, or at least getting it under control.  Once you are well on your way to obtaining these goals, the next step is to maximize your participation in tax-qualified savings plans provided by your employer.  The term “tax-qualified” simply means that you receive special tax treatment on contributions and/or earnings within these plans.  There are various types of contributory plans available to employers such as the 401(k) plan, Thrift Plan, or SIMPLE IRA.  All of these programs allow you to save for your retirement on a tax-advantaged basis, and you should take maximum advantage of them.

Here is how most of these plans work: you agree to have a specified amount of your compensation placed into the plan, preferably the maximum amount allowed.  In most plans, every penny you put in is on a pre-tax basis, meaning that you do not pay current income tax on the portion of your pay that you elect to defer.  So, in effect, the government is temporarily subsidizing your retirement savings. 

The contributions go into your account and are invested according to your instructions.  All earnings (investment profits) your contributions receive are also not currently taxed.  In addition, many employers match part of their employees’ contributions, creating an automatic increase in your account.  Some employers, such as my company, match 50% or more of employee contributions, subject to certain maximums.

All of the money you contribute, plus the earnings on your investments in the plan, grow tax-deferred, typically for a period of many years during a career. At retirement, you will pay taxes on the amounts you withdraw from the plan.  However, there are a number of alternative ways to withdraw your money, so you can select the option that best fits your personal financial situation.

Beginning in 2006, employers are also allowed to offer Roth 401(k) contributions, where your contributions are after-tax, but there is no tax on investment gains if held for a sufficient period of time.  While the taxation of contributions and earnings are somewhat different in this type of arrangement, the basic need to maximize your contributions is the same.  Employers are not required to offer Roth 401(k) accounts, so check with your human resources department to see if this option is available to you.

Some employers sponsor more traditional kinds of pension plans where employees are not required to contribute part of their pay to receive retirement benefits.  In such cases, some of these plans allow you to contribute after-tax dollars that grow tax-deferred.  There are also retirement plan alternatives for self-employed individuals that allow entrepreneurs to defer more than they can in an IRA, even if they have no other employees.

Once you determine what tax-qualified retirement plans are available to you, maximize your contribution to these plans in order to get the most benefit.  This is especially true if your employer matches part of your contributions.  Employees over 50 years of age are also allowed to make “catch-up” contributions that increase the maximum even more.

If you would like to put more money into your retirement plan, but cannot do so because of the applicable maximum contribution limits, consider opening an IRA account.  Your contribution may or may not be deductible, depending upon your level of income, but the earnings in the IRA grow tax deferred until you withdraw them at retirement.  An even better solution might be to consider a Roth IRA in which contributions are not tax deductible, but earnings may be withdrawn tax-free under certain conditions.

If your 401(k) plan allows you to direct the investment of your own account, another thing to consider is how much to allocate to the stock of your employer, if this option is available.  Some employees feel that it is disloyal to invest in anything other than the stock of their employer.  However, my advice is to avoid putting all of your money into any one basket, especially employer stock.  Sure, many of the employees at Dell and Microsoft got rich, but the ones at Enron and Worldcom didn’t.  So, diversify your investments unless your employer’s plan doesn’t allow you to do so.

Keep in mind that maximizing your contributions to a retirement account does not necessarily mean you are saving enough to fund the kind of retirement you want.  You need to compare your current retirement plan savings to your future needs.  There are a number of excellent retirement calculators on the Internet that will allow you to project the value of your current contributions, and then compare them to your target retirement goal.  I have listed a few of these online calculators in the Resources section below.

Many retirement calculators factor in an assumed level of Social Security benefits when determining the amount of money needed for a comfortable retirement.  I think that’s a mistake, unless you are within 10 to 15 years from retiring.  While the most recent debate regarding major changes to the Social Security program did not result in any modifications, I do not think it will look the same in 15-20 years as it does today. 

Therefore, I recommend that my clients under age 50 ignore any potential Social Security benefits, and plan to meet their retirement needs solely from employer-provided retirement plans and/or their own personal savings and investments.  That way, if they end up getting any Social Security benefits in the future, that’s gravy.

Roll Over Any Retirement Plan Distributions

On the subject of retirement plans, statistics show that you may work for several different employers during your working lifetime.  Each time you change companies, you will likely receive a distribution from your retirement plan with that company.  Normally, you receive a lump-sum payment of all your money that was in the company’s plan, and you have a specified amount of time to reinvest that money in another tax-deferred plan.  

Unfortunately, statistics show that many employees who change jobs and receive retirement plan distributions spend them rather than rolling them over into their new employer’s retirement plan or a “Rollover IRA.” You should never - NEVER EVER - take these funds and spend them.

In my December 30, 2003 E-Letter, I gave an example of a “million dollar boat.”  The idea was that spending what seemed like a small retirement plan distribution could cause the recipient to miss out on what those distributions could grow into had they been rolled over and wisely invested over the years.

If you receive a distribution from a retirement plan, no matter how small it is or how young you are, you should NOT spend that money.  Rather, you should roll that money over into your new employer’s plan, or into a Rollover IRA to maintain tax deferral.  These funds could be essential for your retirement.

Whenever possible, you should elect to have the distribution sent directly from your old plan to your Rollover IRA or your new employer’s plan.  You can have a check made payable to you for your distribution and roll it over in 60 days, but doing so requires your former employer to withhold 20% of your distribution and send it to the IRS.  You can still roll over the entire amount, but you’ll have to replace the 20% that was withheld from your personal savings.   Sure, you’ll get the 20% back, but only after you file your taxes and get your refund.

Retirement plans are very complex and sometimes the materials furnished by employers to explain the plans are as confusing as the plan itself.  If you have questions regarding your retirement plan, you need to discuss them with your employer’s human resources department or your employer directly if they do not have an HR dept.

If they are unable to help, feel free to call any of the knowledgeable Investor Representatives at ProFutures.  These members of my staff are familiar with the various types of retirement plans and can help answer many retirement planning questions.  You can reach them by calling toll-free 800-348-3601.

In most cases, this advice is free of charge, with no obligation.

Begin A Regular Program Of Investing

Once you are maximizing personal and tax-qualified savings, begin a program of investing your after-tax savings.  However, this doesn’t mean that you should suddenly convert all of your cash reserve and savings to investments.  Since investments have varying levels of liquidity and risk, you need to maintain your cash reserve in a risk-free, liquid account.

It is also important to note that saving and investing are not the same thing.  If you take part of your savings and put it into a certificate of deposit (CD), that’s not investing - it’s just saving in a different type of vehicle.  Savings usually refers to risk-free alternatives that provide little or no growth over and above inflation.  Investments , on the other hand, typically target growth above inflation, with the potential for returns that are generally proportional to the amount of risk taken.  In other words, investments with higher potential returns also carry the risk of larger potential losses.

For the beginning investor, I believe the investment focus needs to be narrow.  The worst thing that can happen, in my opinion, is for a new investor to take on too much risk and lose all or a substantial portion of their investment.  This could have repercussions on all future investments and lead to a lifetime of risk avoidance and lower than needed returns.  Therefore, my general recommendation for beginning investors is to stay with mutual funds since there are a wide variety of funds available at all different risk categories.

However, before embarking upon any investment program, you first need to know what your goals and risk tolerance are.  Since I covered setting goals in my first installment of this series, I’m going to assume you know what those are.  However, knowing your own risk tolerance will help to identify the best investment alternatives to get you to your goals.

When talking about risk tolerance, what I mean is how much money could you lose without it affecting you emotionally.  Some people cannot stand the risk of losing any of their investment principal, while others are willing to risk larger losses in exchange for the potential for larger returns.  Just remember that most investments will lose money at some time, so you need to set your risk tolerance at a realistic level, so that you are not continually switching investments because of small losses.

Risk tolerance is an individual thing and must be measured on a case-by-case basis.  My company has developed a detailed questionnaire that helps us determine an investor’s risk tolerance and investment expectations.  We start the process by entering the answers into our sophisticated computer software.   After that, our experienced staff reviews the questionnaire and computer output in detail, and then we have a telephone consultation with our client to discuss the results and our recommendations. 

If you would be interested in knowing how your risk tolerance compares to your investment goals and expectations, click  HERE to download a copy of our confidential Risk Analysis Profile.  Once completed, you can mail it back to us, or fax it to us at (512) 263-3459. 

Once you know your risk tolerance, it’s time to select some investments.   As I said above, I believe that mutual funds are the best alternative for beginning investors.  However, I will not mention any particular mutual fund or family of funds since doing so might be seen as an endorsement.

There are a number of fund families that offer low initial investment minimums as well as monthly investments via automatic withdrawals from your checking or savings account.  I have also included some websites to help you with mutual funds in the “Resources” section at the bottom of this E-Letter.

In order to find the best alternative, should you decide to try this on your own, you can go to a mutual fund information source such as Morningstar’s website ( www.morningstar.com ) and seek out fund families with low minimum investments.  Then, it is important to carefully review the available funds to select the best one(s) for your situation and risk tolerance.  Warning: this is not easy.  Also, it is generally not a good idea to invest in the latest “hot” funds, especially those with a limited past performance record.  The latest “hot” funds can go cold and lose money just as fast (or faster) than they rose to the top!

Rather, you want to research a fund’s track record to see if it has consistent performance over a number of different time periods.  Consistent performance over three, five and 10 years is far more important than one year of outstanding performance.  For example, if a fund has performed in the top half of its category over 1, 3, 5 or even 10 years, then chances are that it will continue to be a consistent performer in the future.  Of course, there is no guarantee that this will happen.

Once you are able to narrow your focus to a group of funds with consistent performance, it is important to check to see if any of the funds have had a recent manager change, or if the fund(s) is managed by a team.  The replacement of a sole manager could have negative effects on performance.  You will also want to see how much of the manager’s own money is in the fund he or she is managing (you may need to dig deeper than the prospectus information to find this one).

The next item to check is the amount of risk associated with this investment and compare it to your own risk tolerance.  There are various measures of risk used in the financial services industry, with “standard deviation” being the most common.  The annualized standard deviation is a tool that can estimate how much a fund may go up or down during any given year, but this is not always a measure of downside risk.  If a mutual fund continues to post positive gains, it might have a high standard deviation and yet still be a desirable investment.

There are other various measures of risk in addition to standard deviation, such as maximum drawdown (worst losing period), Sharpe Ratio, Ulcer Index, Morningstar Risk Rating, etc.  Explaining each of these would be too involved to go into in this E-Letter, but it will serve you well to become familiar with all of these measures of risk.  The Internet sites I have listed below all have helpful information to help educate you on risk.

Remember that historical statistics show only what an investment has done in the past, and its future performance could be very different.

You will also want to determine the level of fees charged by the fund.  Some mutual fund advisory services say you should only go with “low-fee” funds, and I agree with this if you are investing only in mutual funds that track an index like the S&P 500.  However, there are professionally managed funds with higher expense ratios that also provide returns which, in many cases, more than justify their increased fees.  So, don’t rule out a fund just because of fees, but make sure the manager is providing additional value for the higher level of fees charged.

Once you have determined the potential risk of a particular investment or portfolio of investments, you should compare that to your risk tolerance.  It is important that you not allow a high historical return to cloud your vision in regard to the risk you are taking to get that potential return.   Everyone wants an investment with 20% annual gains and no risk of loss, but such an investment does NOT exist (despite what some of the Internet hucksters say). 

The S&P 500 Index has a long-term average annual gain in the 10%-11% range, but with a worst losing period of almost -45%.  It is because of the inherent, occasional large downside in traditional investments (and others), that I believe strongly in “active” professional management.   I will discuss this more in upcoming E-Letters.

The point is, to get the potential upside of any investment, you must understand and be comfortable with the downside potential as well.

After making your investments, it is also important to monitor them closely to make sure they remain within the risk and reward parameters you have set, and to make sure there are no manager changes that might affect future performance.   Investments are not a “set it and forget it” arrangement.   

Conclusions

I hope that this basic information will help you in your financial planning activities.  Always remember that financial planning is a process, not an event.  It requires continual monitoring and adjustment as time goes by and your personal situation changes. 

In this Internet age, there is no shortage of financial planning information, but you do have to be careful about the motives of those who bring it to you.  Much of the financial advice of today is driven by an ulterior motive of a product sale.  When financial advice is “customized” to fit a particular product sale, then it is suspect.

In the spirit of full disclosure, here is my ulterior motive.  Since I am in the investment advisory business, I have a desire to see as many of you become my clients as possible.  Thus, by providing this basic financial planning information, it is my desire that you follow it and someday reach a point where we can do business together.

Since the programs I typically recommend have minimum investments of $15,000-$100,000 or more, that means that you will need to have become a successful saver and goal setter to be able to participate in these programs.  Thus, following this advice can result in a win-win situation for all of us. 

As I said in my first financial planning article, it is important that you start your journey to financial independence NOW!  The sooner you start saving and investing, the more time you have for compound returns to work their magic for you.  For those of you who have already been following successful financial planning fundamentals and have accumulated a significant level of assets, you need to give us a call at 800-348-3601 so we can discuss how we can help you continue on the path to financial independence.

If you have any questions regarding any of the fundamental concepts I have listed, or if you need assistance when it comes time to diversify your investments, feel free to give us a call at 800-348-3601 and speak to one of our Investor Representatives.  You can also reach us by e-mail at mail@profutures.com.

Very best regards,

Gary D. Halbert

 

SPECIAL ARTICLES

Dems Off To Bad Start At Alito Hearings
http://www.suntimes.com/output/osullivan/cst-edt-osul10.html

Alito's Strength Is He's Mainstream
http://www.newsday.com/news/opinion/ny-oppin104582205jan10,0,1749851.column?coll=ny-viewpoints-headlines

The Real Surveillance Scandal
http://www.opinionjournal.com/editorial/feature.html?id=110007791

Ignoring Protests, Iran Resumes Nuclear Program
http://www.iht.com/articles/2006/01/10/news/web.0110iran.php

 

RESOURCES:

Calculators for projecting future needs and estimated accumulations:

The following calculators are available on the Internet and will help you to project the amount of money you will need to meet your financial goals, as well as the amount you will need to save to get you there.  Just copy the website addresses into your browser window.  Be aware that you will need to input assumptions about future investment earnings, wage increases and inflation, which will be guesses, at best.  It’s usually best to be conservative when projecting investment growth since future returns are not guaranteed.

http://www.bankrate.com/brm/calculators/investing.asp

http://partners.financenter.com/kiplinger/calculate/us-eng/retire02a.fcs

http://www.nolo.com/lawcenter/calc/index.cfm/catID/84404409-3882-4800-81764383AA66993B

Help with mutual funds:

For those of you interested in learning more about mutual funds as well as help with selecting the right fund for your situation, the following websites may be helpful.  Just copy the website address into your browser window.  Be aware that these websites can help you pare down your choices, but the final decision will be up to you.  Make sure you read the prospectus of any fund you are considering as well as all marketing materials related to it.  Also remember the cardinal rule of investing – Past performance does not necessarily mean an investment will continue to do well in the future.

            Yahoo Finance - http://biz.yahoo.com/funds/

            Morningstar – http://www.morningstar.com

            Kiplinger - http://www.kiplinger.com/tools/fundfinder/


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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