When the stock market experiences extreme volatility, an investor’s best bet is to focus his/her energy on factors that can be controlled. Unfortunately, many investors panic-sell and lose their money. When the market rebounds, many investors are left wondering if it’s the right time to get back in.
Your best bet during turbulent markets is an investment of time. You want to invest in time to see where you stand now, and, if you determine changes are in order, thoroughly research your options. Here is a three-step checklist to manage your investments during turbulent markets.
Step 1: Check adequacy of cash reserves.
The best way to manage your portfolio during volatile markets is to make sure you have adequate cash on hand to cover your near-term needs. This way, your long-term stock investments can ride out the market ups and downs, but you can take comfort in knowing that they won’t affect your ability to fund short-term cash needs.
Step 2: Check your long-term positioning.
Once you've done the liquidity check, the next step is to check the asset allocation of your long-term assets. Market sell-offs can be alarming for retirees and people getting close to retirement simply because they typically have more money invested, compared with their younger counterparts. Checking your long-term positioning helps you put things into perspective so that you can make sound investment decisions for your future.
Step 3: Initiate defensive hedges with care.
During turbulent markets, investors may initiate defensive strategies like selling out of stocks and buying into the so-called “safe” investments like gold. Gold and treasuries can serve as a legitimate defensive role in a portfolio; however, these investments may have already enjoyed a sizable run-up. If you're moving into either, do so with caution, and only after you've checked your existing exposure to those asset classes.
Treasuries are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. Debt securities are subject to credit/default risk and interest-rate risk (they have varying levels of sensitivity to changes in interest rates). In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest rate changes.
Gold/commodity investments will be subject to the risks of investing in physical commodities, including regulatory, economic and political developments, weather events, natural disasters, and market disruptions. Exposure to the commodities markets may subject the investment to greater volatility than investments in more traditional securities, such as stocks and bonds.
America has long been known as the land of opportunity and the promise of a better life to people from all over the world. Recently, however, many Americans feel robbed of opportunities and better lives by the top 1% of their own. This growing income inequality has led to problems and civil unrest, as demonstrated by the “Occupy Wall Street” movement.
The table presents household income distribution data from the U.S. Census Bureau. Given that the poverty threshold for a two-member household is around $14,000, it appears that approximately 13.7% of Americans are poor. At the other end of the income spectrum, 3.9% are rich, with household incomes higher than $200,000.
Handing over a portion of your investment earnings to the IRS is never pleasant. Fortunately, a specific category of mutual funds, called tax-efficient funds, might help you keep the amount you send to Uncle Sam to a minimum. Here's how tax-efficient funds work. Mutual funds must pay you almost all of the money they make from interest, dividends, or capital gains (money made from selling stock) in a year. That's called a taxable distribution (since you must pay taxes on that money). Tax-efficient funds keep their taxable distributions as small as possible, thus lowering the amount you have to pay in taxes. Tax-efficient funds can use several strategies to keep distributions low. They avoid stocks that pay dividends. They don't sell their stocks very often. When they do sell stocks, they might also try to sell some that have lost money to offset those that have made money. They could also hold stocks for more than one year before selling, since the profits are taxed at a lower long-term capital gains rate than short-term transactions. These methods, as well as some others, keep your tax bill lower.
While tax-efficient funds seem extremely attractive, there are a few drawbacks to note.
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First, there are only a handful of these funds available from which to choose (relative to other categories).
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Second, of the funds that do exist, few have long-term investment records that you can analyze.
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Finally, most tax-efficient funds stick mainly with large-company stocks and tax-free (municipal) bonds.
That means you might have to look at non-tax-efficient funds to get exposure to other types of investments in an effort to build a diversified portfolio.
Diversification does not eliminate the risk of experiencing investment losses. Past performance is no guarantee of future results.
Five Key Questions About Long-Term Care Insurance
In addition to typical medical expenses in retirement, you should also consider the cost of long-term care arrangements should you need professional care in your later years, either in-home or in an assisted living facility. There’s a good chance you’ll need assistance, and it won’t be cheap.
According to the 2011 MetLife Market Survey of Nursing Home, Assisted Living, Adult Day Services, and Home Care Costs, the average annual cost for a private room at a nursing home in 2011 was $87,235. The national average for a semi-private room was $78,110. The national average for an individual living in an assisted living community was $41,724.
In most cases, long-term care health insurance coverage provides benefits for nursing homes, assisted living facilities, and home care. If you can afford the premiums, you may want to consider purchasing long-term care insurance. Here are some of the key questions to keep in mind.
How Likely Are You to Need It? This depends on your general health, family history, and expected longevity. For example, if your family has a history of serious medical conditions, dementia, or Alzheimer’s disease, you may have a stronger reason to consider this type of insurance.
What’s Your Asset Level? Those who come into retirement with less than $250,000 in assets will probably have better uses for their money than paying premiums for long-term care insurance; they may also be eligible for Medicaid if they should need long-term care. Those with more than $2 million in assets may be able to pay for this type of care out of pocket. If your portfolio falls in the middle of this range, however, you may be a good candidate for this type of coverage.
What Kind of Coverage Do You Need/Want? The key differentiator in the pricing of long-term care insurance policies is the amount of daily benefit you’re buying; you’ll obviously pay more for a policy that pays $150 of your long-term care costs per day versus one that pays just $100. You’ll also be able to specify whether you’d like your daily benefit to step up with inflation; even though such a feature will cost you, it’s highly advisable given that health-care inflation rates have been far outstripping inflation as a whole during the past few decades.
Another factor to evaluate is the total lifetime benefit. For example, a policy may cover $250,000 in lifetime long-term care benefits, or the lifetime benefit may be unlimited. Some policies are comprehensive, meaning the patient can obtain care in a variety of settings, from a traditional nursing home to care at home. Cheaper policies, however, will only pay for care in a traditional setting, usually a nursing home. Policy costs can also vary based on the length of your elimination period, which is similar in concept to an insurance deductible. If your policy has an elimination period of 30 days, for example, that means you’ll have to pay for any long-term care costs you incur in the first 30 days of your illness; after that period has elapsed, your insurer will pick up all or part of the tab, up to your daily benefit amount.
How Would You Like to Pay for That? Under a traditional long-term care policy, you make regular payments during the life of that policy. But you can also customize your payment program, paying for your policy in a single payment, over 10 or 20 years, or until you hit age 65. Such payment options allow you to front-load your payments and reduce your fixed costs in retirement.
How Likely Is the Company to Pay? It probably is a good idea to check up on the insurer’s financial strength. Also ask your agent about the insurer’s history of raising client long-term care premiums. Although such maneuvers can improve a firm’s financial health, they can also present a financial hardship to the insured, a lesson many long-term care policyholders learned the hard way during the past few years.
The sooner you start putting aside money for retirement, the more you might have once that highly anticipated day arrives. Saving for college tuition, purchasing a new home, unforeseen medical expenses, or life’s other necessities, surprises, or even enjoyments can cause investors to postpone saving. Starting the retirement planning process late in one’s life can be daunting, but it is by no means impossible.
Crunch the Numbers: The first step to getting back on track is to put together a budget—this will force you to focus on your financial situation and can serve as a road map to success. Once you have outlined all of your expenses, simply subtract the total from your net income. The result will give you a clear indication of how much you can potentially save, and also help you identify areas in which you may be spending too much.
Cut Any Unnecessary Expenses: There are essential expenses that cannot be eliminated: food, electricity, etc. However, most people can identify some areas, like entertainment, that are not vital to one’s existence and can be cut back on. The more areas that you can trim will lead to more money that can be earmarked for retirement.
Take Advantage of Catch-up Contributions: Catch-up contribution limits allow investors age 50 and above to increase their contribution. For example, they can make an extra contribution of $5,500 to their 401(k) in 2012, equating to a maximum contribution of $22,500. IRA catch-ups are $1,000 in 2012, leading to a maximum contribution of $6,000.
There are a number of ways you can protect your portfolio and your financial well being. Chief among them are insurance, estate planning and protection from identity theft. While nobody likes to talk about insurance (except, of course, those who sell it), some individuals should protect themselves with some basic policies. Here are a few examples.
It’s a good idea to purchase a life insurance policy when you have a child. You’ll want enough coverage to pay off the mortgage and get the kid(s) through college. Health insurance, of course, is a must. Many people jeopardize their retirement planning by not factoring in the cost of health insurance before Medicare kicks in. If you retire before age 65, be sure to investigate the costs. Disability insurance will help you get through an extended period of time without work. Long-term disability coverage typically provides 60% to 70% of your current income should you run into this unfortunate situation. Also, carrying the appropriate property and casualty insurance (homeowner’s, auto, for example) can help you avoid liability lawsuits.
Once you have insuranc
e covered, protect your estate. By neglecting the proper estate documents, you run the risk of damaging your assets. A simple will should suffice for many people. Failure to have a will in place upon your death can mean that your spouse or kids won’t get what you intended for them. An attorney can put together a will for you or provide you with more information.
And remember: Always protect your identity. We all know how bad it can be to lose a wallet. Identity theft is even worse, and the number of incidents is unfortunately on the rise. A few simple steps can help prevent this from happening: Invest in a shredder and use it on financial papers, and get a copy of your credit report and verify the information on it.
All of us who work feel the bite that Social Security taxes take out of our paycheck. Most of us take comfort in the hope that when we retire, Social Security will be there, giving back all the money that we paid into the system over the course of our careers. Isn’t that how it works?
Well, the short answer is no, it doesn’t work that way. The Social Security taxes deducted from your paycheck are not sitting in a special account someplace, earmarked to be returned to you upon your retirement. Instead, the taxes you pay today are used to pay benefits to today’s beneficiaries, just as when you retire, the benefits you receive will come from the taxes paid by people who are still working. This arrangement works as long as there are enough people sending in taxes; it doesn’t work so well if the number of current workers per retiree is decreasing.
The baby boomer generation (those born between 1946 and 1964) have started to retire in 2010. This large group’s retiring, coupled with increasing life expectancies and decreasing birth rates, means that the number of retirees will grow faster than the number of workers. According to the Social Security Administration, the number of workers sending in Social Security taxes to pay each retiree’s benefits has plummeted from 42 workers per beneficiary in 1945 to 2.9 in 2011. What is more is that this number is projected to go down even further to 2.1 workers per beneficiary by 2035. Since the ratio of workers to retirees is expected to continue declining, a shortfall in future Social Security funding is likely.
Annual cost for the Social Security program is projected to exceed non-interest income in 2011 and remain higher throughout the remainder of the long-range period. Social Security funds are projected to increase through 2022, and then to decline and become exhausted and unable to pay scheduled benefits in full on a timely basis in 2036.
What does all this mean for you? Well, that depends on how old you are and what changes the United States government decides to implement. If you are nearing retirement, it is unlikely that your Social Security benefits will change dramatically. Younger workers, however, are more likely to see sweeping changes in the way Social Security works in the form of higher taxes, lower benefits, or a combination of the two.
Bear in mind that Social Security was never intended to provide Americans with all of the income they would need in retirement. Social Security is only one leg of a three-legged stool that also includes pension plans and personal savings. With concerns mounting over the stability of one leg of the stool, you need to take control of your retirement by investing in personal savings plans such as IRAs and 401(k)s.
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ven though investors don’t always realize it, taxes can have a dramatic effect on an investment portfolio, especially in today’s relatively uncertain tax environment. The tax law enacted in December 2010 was only intended to last for two years, and new changes may be effected in 2013.
The image below illustrates the hypothetical growth of inflation and a $1 investment in stocks and bonds before and after taxes since 1926. Over the long run, the adverse effect of taxes on investment returns becomes especially pronounced. Stocks are the only asset class depicted that provided any significant long-term growth. After considering taxes, government bonds barely outperformed inflation over this time period. In a world with taxes, focusing on fixed-income assets alone has not provided investors with a substantial increase in wealth. If you desire substantial after-tax growth, you may want to consider a larger allocation to stocks. Another alternative, if you are able, is to consider tax-deferred investment vehicles.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed. Stocks have been more volatile than the other asset classes.
Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No capital gains taxes on municipal bonds are assumed. No state income taxes are included.
Stocks in this example are represented by the Standard & Poor’s 90 index from 1926 through February 1957 and the S&P 500® index thereafter, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. Government bonds are represented by the 20-year U.S. government bond, and inflation by the Consumer Price Index. An investment cannot be made directly in an index.
Assessing Risk
Investing and poker have been compared on many levels. For starters, poker is a zero-sum game—what the winner wins has to be equal to what the losers lose. But investing is not a zero-sum game because over time stocks tend to have positive returns, making it possible for investors to be overall winners.
Both, however, are games of incomplete information with unknown variables and conditions that cannot be controlled. To offset these uncertainties, it is important for players of both groups to assess and understand their appetite for risk. Doing so develops discipline, a strategy, and may help reduce unexpected setbacks.
The questions below are designed to help shed light on your risk tolerance. The questions are hypothetical in nature and are not meant to represent investment advice.
Answers are symbolic of different risk levels:
“a” conservative, “b” moderate, and “c” aggressive.
1. I am comfortable with investments that may often experience large declines in value if there is a potential for higher return.
a. Disagree b. Uncertain c. Agree
2. Suppose you owned a well-diversified portfolio that fell by 20% over a short period of time. Assuming you have 10 years until you begin withdrawals from your account, how would you react?
a. I would immediately change to a more conservative portfolio.
b. I would wait at least 6 months to one year before changing to more conservative options.
c. I would not change my portfolio.
3. Which statement best describes your investment goals?
a. Protect the value of my account by minimizing loss and accepting lower long-term returns.
b. Balance moderate levels of risk with moderate levels of returns. c. Maximize long term returns and accept large or dramatic swings in the value of my investments.
4. Portfolios with the highest average returns also tend to have the highest chance of short-term losses. The data below represents five hypothetical investments of $100,000 over a one-year time frame. Which range would you feel most comfortable with?
a. Portfolio A: $139,000 – $88,800 b. Portfolio B: $179,000 – $75,700 c. Portfolio C: $215,000 – $59,500
Now, keep in mind that these are only guidelines meant to give you insight into how you think and behave as an investor. Once you have discovered that you are, let’s say, aggressive, this certainly doesn’t mean that you now have to invest in high-risk stocks and emerging markets for the rest of your life. On the contrary, your risk tolerance may change over time, and revisiting these questions periodically may let you know if it’s time to change your investment strategy.
Diversification does not eliminate the risk of experiencing investment losses. Past performance is no guarantee of future results.
The Importance of Staying Invested
Investors who attempt to time the market run the risk of missing periods of positive returns. The image illustrates the value of a $100,000 investment in the stock market during 2000–2006, which included the bear market of 2001 and the recovery that followed. The value of the investment dropped to $57,537 by September 2002 (trough date). If an investor remained invested in the market over the next three years, however, the ending value would be $91,488. If an investor exited the market at the bottom to invest in cash for a year and then re-entered, the ending value would be $74,403. An all-cash investment would have yielded only $60,252. Even though the continuous stock-market investment did not recover its initial value after three years, it still provided a higher ending value than the other two strategies. Investors are well advised to stick with a long-term approach to investing.
