Why Investment Risk Doesn’t Always Equal a Reward

Build your investment strategy with sound advice.

Does taking a higher risk with your investments guarantee a higher return? Most people seem to think so.

Teachers Insurance and Annuity Association (TIAA) posed that very question in a survey, and 53 percent of the respondents answered “yes.”

They’re wrong, of course. A higher risk guarantees only one thing: higher risk. (You might get higher returns from taking higher risks, but it’s far from guaranteed. Just ask anyone who’s ever bought a lottery ticket.)

If high risk can’t be relied on to produce higher returns, what can be? Well, 36 percent of the respondents in TIAA’s survey said the answer is found in how an investment performed last year.

Unfortunately, that doesn’t work either. Investments that perform best in a given year almost never perform as well in the following year. (If they did, the same investment would be best year after year. There would be only one investment, and every investor on the planet would own it.) This is why developing a sound investment strategy is such a highly complex undertaking. It’s also why so many consumers turn to professional financial planners like us to help them.

And yet nearly 30 percent of those surveyed who said they want to do a better job of managing their money didn’t include financial planning in their strategy. They said they “don’t make enough money to worry about it,” according to Allianz, which sponsored the survey.

Their view is wrong, of course: The less money you have, the more important it is to manage it effectively! (We can agree that Bill Gates can squander some of his money foolishly with no adverse impact on himself or his family. But that’s not the case for someone earning $50,000 a year.)

Fortunately, many respondents said they were open to getting help with their financial decisions. Good financial advice that’s in your best interests isn’t free, of course, but the cost should be compared to the long-term benefits the advice can provide.

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Q&A: How Do ETF and Mutual Fund Share Prices Work?

The way these instruments are priced is totally different from stocks.

Ric Edelman is a co-founder of Edelman Financial Engines. The following is taken from his weekly radio call-in show.

Question: I don’t know if this is true all of the time, but it seems that when I compare the share price of an ETF to the share price of a mutual fund of the same class — say, a large-cap fund — the ETF price is usually higher. Is that because of the underlying stocks that it owns?

Ric: No. Share prices for mutual funds and ETFs are actually irrelevant. For example, when a fund company brings a new fund to the marketplace, it literally invents the share price. It can be any number: $10 a share, $100 a share, $1,000 a share — that price is utterly irrelevant because all you’re doing is creating a basis, a starting point at which the trades will occur thereafter.

The company’s decision is strictly marketing: Would investors prefer to buy shares that are $10 each or $100 each? There is no difference, because buyers of $10 shares simply get 10 times as many shares as buyers of $100 shares. Don’t let the share price sway you when buying a mutual fund or ETF.

Note: This is different from stocks. Many so-called penny stocks (actually referencing any stock priced under $5) or “pink sheet” stocks (so-called because they don’t trade on any exchanges and traditionally had their prices listed on a document printed on pink paper) are highly speculative and sometimes even scams.

Aggressive brokers pitch penny stocks by claiming that your $10,000 investment can get you 200,000 shares of a stock priced at a nickel. If the price moves just a penny, your profit is $2,000! Or so the pitch goes.
In fact, the stock is unlikely to rise a penny anytime soon, if at all — because that’s a full 20% increase. Stay away from penny stocks.

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Q&A: Poor Advice on Variable Annuity?

Sometimes it’s a good idea to get a second opinion.

Ric Edelman is a co-founder of Edelman Financial Engines. The following is taken from his weekly radio call-in show.

Question: Our financial advisor recommended that my husband and I transfer the money from our two IRAs into a variable annuity that has a minimum guarantee. He suggested this after I told him we were concerned about stock market volatility and the fact that our accounts haven’t done that well. I also told him we are concerned about the general state of the global economy. But when I looked online about the annuity idea, I found many warnings against it. What is your opinion? Did we receive poor advice?

Ric: Your advisor might have been trying to pacify your fears about the economy and your unhappiness with the performance of your IRA investments, saying in effect, “Here’s an alternative that moves the money into a vehicle that lets you continue to invest in the stock market, but which offers a guarantee so that if the stock market drops in value the company offering the annuity will guarantee that you don’t lose any money.”

So maybe he’s trying to placate your concerns. Or maybe he’s just twisting your concerns into a sales pitch so he can sell you a product that pays him a big commission. (When dealing with an advisor who makes a living selling products for commissions, you need to be sure about his motivations.)

Another reason this recommendation is suspect is that a primary benefit of annuities is the fact that profits are tax-deferred; you don’t pay taxes until you make a withdrawal. But your money is already tax-deferred because it’s in an IRA. That means you’re getting no tax benefit from the annuity. So why buy it?

It may interest you to know that the North American Securities Administrators Association, a group of state securities regulators, lists annuities as one of the nation’s top financial frauds. It’s not that every advisor who sells annuities is committing fraud, but enough of them are to warrant NASAA’s warning.

For all these reasons, I suggest you get a second opinion — this time from an advisor who is fee-based, objective and independent — to help you confirm that your advisor’s advice is in your best interests and not his.

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Q&A: Does Market Timing Work?

Can going in and out of the market give you better returns?

Ric Edelman is a co-founder of Edelman Financial Engines. The following is taken from his weekly radio call-in show.

Question: What’s your take on managing one’s 401(k), IRA or taxable account using stock charts — i.e., buying/selling ETFs or stocks based on trends, momentum of stocks, etc.? Perhaps one would not make as much money because of not being fully invested all the time in the market, but wouldn’t this method also keep you from losing large amounts in short periods, especially in bear markets? In other words, I am talking about technical analysis. If I have the time, wouldn’t this be a viable alternative to having a firm such as yours manage my portfolio?

Ric: No, it isn’t a viable alternative. If it were, everyone would be doing it and getting rich. Market timing doesn’t work, and charting/technical analysis, which is a form of market timing, doesn’t work either. You won’t be able to find anyone who consistently and over long periods beats the market that way. I know of no chartist who correctly called the 2008 credit crisis, for example.

The reason it doesn’t work: No system is capable of telling you when to get out and when to get back in. You have to be right every single time, because one incorrect call wipes out every previous correct call.

I’ve never seen any system that has been right most of the time, and even if one existed it wouldn’t matter — because the few times it erred would destroy the value of all the other times that it was right.

Here’s an example: A couple of years ago, a guy bragged to me that he correctly predicted the 2008 credit crisis, and he sold in 2007 when the Dow Jones Industrial Average was still near its high (at the time, around 11,000). I asked him when he got back in, and he said he never did.

So, he made one right call (got out at the high) but then made one wrong call (never bought back in). The result was that he was far worse off than if he had made no call at all: Staying in would have taken him down to a 6,700 on the Dow, but then he would have ridden it right back up again to today’s level of 27,000 — about twice as high as when he made his right call. So being right only once was very costly to him.

Avoid such folly and ignore the slick salespeople who are trying to convince you to engage in it.

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Q&A: Can You Outperform a Diversified Portfolio?

online money calculator investment receipts

Maybe, but there’s a few reasons you might not want to try.

Ric Edelman is a co-founder of Edelman Financial Engines. The following is taken from his weekly radio call-in show.

Question: If, over the long run, the S&P 500 will return 9% or 10% per year, and I have a very long investment horizon (say, 10+ years), am I not better off simply placing my money in an S&P 500 index fund, which will likely outperform a diversified portfolio? Yes, I’m aware of market volatility and the risk that equities can go into prolonged slumps, but even if the investment began in 2007, the return would have been great. What am I missing?

Ric: You’re assuming that a diversified portfolio will earn less than the stock market over long periods. That’s not necessarily true. Keep in mind that a diversified portfolio is designed to reduce risk (volatility), not return.

History shows that in many 10-year periods, a diversified portfolio earns as much as the S&P, but does so with less risk. Meanwhile, many people who claim they can tolerate prolonged stock market slumps discover they really can’t. Just ask all the folks who sold in 2008 as the markets fell.

But if you are certain that you have both a long time horizon — 10 years or more — and a very strong stomach, we have no problem with your owning a pure stock portfolio.

But be forewarned: In our experience, the person who claims to have both turns out have neither.

When that market downturn comes, they realize they don’t have the strong stomach they thought they had, forcing them to sell low, with big losses. Or something comes up in life unexpectedly — a marriage, a child, a job loss or a medical issue — causing their long-term horizon to evaporate. Millions, for example, lost their jobs in 2008, forcing them to sell their investments so they could pay their bills.

They didn’t plan to sell but found themselves with no choice — again, ruining their plans to stay invested for the long term. For these reasons, people who don’t start with a diversified portfolio often later wish they had. Maybe you too.

Investing strategies, such as asset allocation, diversification, or rebalancing, do not assure or guarantee better performance and cannot eliminate the risk of investment losses. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Funds and ETFs are subject to risk, including loss of principal. All investments have inherent risks. There can be no assurance that the investment strategy proposed will obtain its goal. Past performance does not guarantee future results.
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How to Keep Emotions Out of Investment Decisions

My strategy might surprise you.

Ric Edelman is a co-founder of Edelman Financial Engines. The following is taken from his weekly radio call-in show.

A caller to my weekly radio show once won the applause of the day for asking a question that might be on your mind as well:

“Ric, how have you personally learned to keep emotions out of your investment decisions?”

He found my answer surprising. Perhaps you will too.

“What makes you think I have my emotions under control?” I replied. “As a matter of fact, I’m not able to avoid emotional reactions any better than you are.”

This might seem shocking. After all, I’ve been a financial advisor for more than 30 years, and tens of thousands of people rely on me and my firm to manage their investments. So, what does it mean if I can’t manage my own emotions?

Think back to 2008, when the stock market was falling 65 percent in value. I’m sure you were scared. And so was I — how could anyone not have been frightened? But instead of selling my own investments in a panic or telling clients to do that, do you know what I did? I turned to my colleagues at Edelman Financial. We met frequently to evaluate the latest economic news and market activity, and we discovered that these group sessions created vital support for each other: When one of us was feeling shaky, others helped provide reassurance. It was almost like grief counseling.

And this was vital — because our nervousness maximized when we each started thinking about our own personal accounts. But when we focused instead on the firm’s asset base, our emotions were removed. As a firefighter once told me, “When I arrive at the scene, people are always in a panic. But I never am. After all, it’s their crisis — not mine. And becoming panicked like them doesn’t do anyone any good. So, I just go about my job, and we get through the crisis as quickly as we can, minimizing the damage.”

A similar thing happens when a loved one dies. Everyone is sad, but not everyone collapses in sobs at the same time. One moment finds you hugging a loved one; then later someone is hugging you, offering welcome and needed assurances that you’ll get through it. That’s how I and my colleagues at EFS got each other — and our clients — through the emotional stress of 2008: We relied upon each other.

And we had much more than mere emotional support to help us. We didn’t get through the crisis by singing Kumbaya, hugging each other and saying, “there, there.” Instead we gave each other an as-needed Cher-slapping-Nicolas-Cage admonition to “SNAP OUT OF IT!” along with a reminder that our disciplined investment management approach would help enable us and our clients to weather the storm. Indeed, our extensive diversification and strategic rebalancing while maintaining a long-term perspective were precisely what helped us maintain focus, and they were precisely what we were doing.

Yes, my calm colleagues were able to reassure me that our investment management program — which I’d designed, by the way — was going to help get us through the crisis. So I told myself to relax and get back to the business of reassuring our clients.

I’m not smart enough to beat my emotions. Instead, I’m smart enough to know that I can’t beat them. So I enlist support from others. And that’s what we encourage our clients to do: When you’re nervous, don’t sell in a panic like many others do. Instead, call us. We’ll help you get through it.

The message is clear: Rely on an advisor. But you must make sure that your advisor has two vital attributes: a disciplined investment approach and the experience to know how important it is to stick with it during difficult times.

If your advisor had no disciplined investment approach — if all he or she has done is sold you a bunch of investments that you were willing to buy — and if he or she didn’t go through the crash of 1987, the panic of 1994, the tech bubble of 2001 or the terror attack of 9/11 — then he or she may panic as much as you. And as our firefighter friend taught us, having two panicking people doesn’t lead to good outcomes.

Many people went through 2008 either without an advisor or with one who left them no better off than if they had been alone. In their panic they sold their investments, often at huge losses. These people are clearly acting as their own advisor. But as the adage says, a doctor who treats himself has a fool for a patient.

So are you when dealing with your own money. That’s why we’re all better off talking with an experienced advisor — one who can be objective when we’re not.

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Do You Think the Stock Market Will Rise or Fall?

Your answer might depend on when the question is asked.

Think for a moment before you answer the following question: What are the odds that the stock market will fall at least 12% in a single day at some point during the next six months?

After pondering this question, perhaps you conclude this happens occasionally. Would you say there’s at least a 10% chance?

That’s what a majority of investors said when the Yale University School of Management posed this question during a study in 2016. Based on that and related data, the Yale researchers concluded that investor pessimism about the stock market was at its highest in three years. The study was conducted in the middle of February — when the stock market had fallen more than 10% since the beginning of the year.

The researchers noted that people’s predictions about what’s likely to happen next in the market are often mere extensions of what has just happened. In other words, many investors’ forecasts are really “after-casts” — simple projections of the recent past into the future. We call this behavioral finance phenomenon recency bias.

Words charged with negative emotion — media favorites are “crash” and “plunge” — also play into this. You may remember reading or hearing those words during the first six weeks of that year. Because the market fell 10% during that period, many people likely assumed that week #7 would follow the same pattern. Instead, during the next four weeks, the S&P 500 Stock Index rose 11% — gaining back the previous losses. Had the study been conducted at that point, perhaps it would have found that investors were more optimistic than they had been.

If you think the stock market might fall 10% within six months, you should know that history says it’s very unlikely. In the 87-year period from 1929 to 2015, there were 174 six-month periods. Drops of 10% or more occurred just 1% of the time, according to the Yale finance professors.
The study also found that professional investors — including active managers of mutual funds — tend to exaggerate the odds almost as badly as individual investors do.

So instead of allowing feelings of optimism or pessimism to influence your investment decisions, the best course is to maintain perspective. Trust the statement printed on the front page of every mutual fund prospectus: Past performance is no guarantee of future results. Any assertion to the contrary is a federal offense. Don’t assume that what happened in the past week, month, quarter or year is predictive of what will happen next.

Instead, here’s how to manage your assets wisely and effectively: Invest in a highly diversified manner, maintain a long-term focus and rebalance your portfolio as warranted.

An index is a portfolio of specific securities (common examples are the S&P, DJIA, NASDAQ), the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index. Past performance does not guarantee future results.
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There’s No Good Excuse for Neglecting This Financial Step

You don’t have to do it by yourself — just make sure it gets done.

Excuses, excuses. We all have them from time to time when we fail to do something we know we should do. Some excuses are legitimate, but most don’t stand up to scrutiny.

That’s especially true when it comes to one of the most important components of sound financial planning: acquiring enough life insurance to make sure your loved ones are protected if you die sooner than you expect.

You probably enjoy talking about investing, seeing your money grow, buying homes and cars, sending children to college, having enough to retire comfortably — but all of that is built on one basic assumption: that you will be alive to do and enjoy these things.

But what if you’re not? Will your spouse, partner or children be able to experience all that you hope for them? Making sure they can is what life insurance is all about.

Yet ownership of life insurance is at a 50-year low, according to the Life Insurance Marketing Association, which says that one in every four U.S. households has no life insurance, including 11 million households with children under age 18. And in 40% of households with children under age 18, the mother is the sole or primary wage earner. Women who own some life insurance have only 69% of the average coverage on men. Equally worrisome is the fact that the average amount of coverage for U.S. adults has dropped to $167,000, down from $300,000 a decade ago.

Lack of awareness isn’t the problem. According to the Life and Health Insurance Foundation for Education, 93% of Americans believe it’s important for people to own life insurance, and nearly 50% admit they need more coverage! That’s like saying, “I know I need it, but I’m not going to do anything about it!”

There are three reasons (excuses) people cite when explaining why they haven’t gotten the coverage they know they need, says LIMRA. Do any of these apply to you?

1. “It’s too expensive.”
2. “I just haven’t gotten around to it.” (procrastination)
3. “I don’t know enough about it to buy it.”

Are any of these excuses valid? Let’s see:

If you believe life insurance is too expensive, I ask you: compared to what? A big-screen television? Well, life insurance is a necessity, not a luxury. And it’s never been more affordable. Prices are at least 50% less than they were a decade ago. A 40-year-old, nonsmoking male in good health can buy a $1 million, 20-year, level-term policy for $73 per month. A healthy, nonsmoking female of the same age would pay even less.

If you have been procrastinating, consider this for your tombstone: “Here lies ________. His family is destitute because he was lazy.”

And if you think you don’t know enough about life insurance, well, that’s what independent financial advisors are for. You only need to know that you want the coverage for your family. They’ll help you do the rest — including figuring out how you’ll pay for it, if you’re not sure you can afford it. (See excuse #1.)

You need to protect your spouse, partner and children. September is Life Insurance Awareness Month — a good time to talk to a financial planner about your need for life insurance and how to get the coverage you need at the right price.

Originally published in Inside Personal Finance September 2015
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Should You Lend Money to a Family Member?

Don’t unless you are ready to sue

Like most people, you’d do just about anything for a family member. But what if a family member wanted to borrow money? Should you do it?

No — unless you are prepared to sue that family member.

Lending money to a family member is one of the quickest and surest ways to damage your relationship with that person. If the person can’t or won’t repay the loan, you’ll begin to resent him. If the person is a member of your side of the family, your spouse may begin to resent you. If you start to pressure the person for the money, he will avoid you. Other family members can become unwittingly caught in the middle, and before you know it, family gatherings become rife with tension.

And if the emotional implications aren’t enough, consider this: The only reason the person is asking you for money is because he couldn’t obtain a loan from a traditional source, such as a bank or credit card company. If these organizations don’t consider him worthy of getting a loan, why should you?

Get It in Writing

If you are still not deterred, then at least make sure you lend the money the proper way. This means you must handle the transaction as you would with a stranger. You must draft a loan agreement that will be signed by both parties. If the borrower is offended, or claims that your desire to put it in writing demonstrates that you don’t trust him, do not lend him the money. Any honest and reasonable borrower would be happy to sign a loan agreement. If they plan to pay you back, they will be happy to say so in writing. By the same token, anyone who is insulted over a request to commit to the transaction in writing never intends to pay you back at all.

In the agreement, state:

  1. The amount of money that is being lent. State this in numbers and letters, to avoid claims of miscommunication. Don’t just write $5,000. Print “five thousand dollars and no cents” on the document as well.
  2. The date the money is to be lent and returned. Be specific. “Sometime next year” or “after college graduation” doesn’t work. What if he never graduates?
  3. The interest rate you are charging for the loan. Yes, you must charge interest on the loan. Family members are allowed to charge rates below current market rates, but the IRS requires you to charge some rate of interest — and it must be reasonable. If you lend the money at no interest, the agency will consider the loan to be a gift — making you (the lender) liable for gift taxes.
  4. This gets even trickier if you lend a family member money to buy a house. Take John, for instance. He lent his son, Tim, money to buy a house, but he failed to charge interest. The IRS made John pay income taxes on the interest he didn’t get from Tim (but which he should have gotten), and because he should have paid interest, Tim was granted a tax deduction on the mortgage interest he never actually paid! To the IRS, it didn’t matter that Tim borrowed the money interest-free; he should have been paying interest, so he got the break anyway. Go figure.
  5. The payment schedule that the borrower must follow. State whether you will require periodic payments or a balloon payment, or some combination. Some examples:
    • Monthly payment of principal and interest. This is called an amortized loan, and works like your auto loan or home mortgage. In the early months, most of the payment is interest, with the bulk of the principal being repaid in the final months. Defaulting during the term of the loan means the borrower still owes most of the money he borrowed.
    • No monthly payments. The full loan and all interest are to be repaid at the maturity date. This is good when borrowers have little money or income now, but it’s a higher risk for the lender, since it requires the borrower to come up with a substantial amount of money at a later time.
    • Monthly payments of interest only. Known as a “balloon” loan, this is a hybrid of the above two. The monthly payments are smaller than the first example, but the final payment is smaller than the second example.
    • Or some other combination of the above. Just make sure it’s clearly spelled out in the document.
  6. Penalties for not meeting the above terms. You must state what the penalties are for missed payments and bounced checks. State the grace period, and then make sure you assess the penalty. Failure to abide by the rules of the agreement could cause the IRS to conclude that it is not a true loan agreement.

If the borrower doesn’t pay you back, you are entitled to take a tax deduction as a “bad debt” on your tax return. But in order to win this deduction, the IRS wants to know that you’ve tried everything to get the money back — which may include taking the borrower to court. Are you prepared to sue a family member? If not, then you are not likely to be able to take this deduction.

Clearly, lending money to family members can be treacherous. If you are willing to do it when approached by a family member, the first thing to say is, “If we are to proceed, this must be handled as an arms-length transaction, as though I were a bank and you were the customer. I’m going to charge you interest and demand timely repayment — and everything will be in writing. Are you willing to accept these terms?”

If the borrower is not, then let him go elsewhere for the loan.

This material was prepared for informational and/or educational purposes only. Neither Financial Engines Advisors L.L.C (also referred to as Edelman Financial Engines) nor its affiliates offer tax or legal advice. Be sure to consult with a qualified tax or legal professional regarding the best options for your particular circumstances.
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The Most Important Chart on Investing You’ll Ever See

Understanding the ups and downs of the stock market.

Here is a basic truth: stock prices rise and fall. Of course, literally speaking, this statement is true. But it’s misleading. That’s because the statement is incomplete; it’s not really accurate to say that stock prices ”rise and fall.”

Oh, sure, on any given day, prices might rise or fall. But over long periods, it’s more accurate to say that prices in the overall stock market rise a lot but fall a little, as shown in the image. This chart clearly shows that when  prices are rising, they rise a lot and for a long time. When prices fall, they fall a little and for a short period. This explains the real reason why the stock market is able to exist.

Think about it. If stock prices were to only rise and fall, there would never be growth in the economy. It would force investors to decide when to buy and when to sell.

Imagine playing with a yo-yo. It goes down, then it comes up. Down, up. Down, up. If that yo-yo were a stock’s price, the trick would be to catch it and release it at the right time. But as the chart shows, investing in the stock market is like playing with a yo-yo while climbing a hill. Even though the yo-yo is still going down, up, down, up, the height of the yo-yo is constantly climbing, thanks to the hill’s incline.

Here’s another way to put it: The market doesn’t simply go up one point and then down one point. Rather, it goes up two points, then down one point. Then it goes up four, down one, up three and down one. Sure, sometimes the down is larger than the previous up, but over long periods, the stock market has always produced net profits. That’s why it’s wrong to be upset when stock prices fall. Instead of lamenting the current decline, focus on what is about to happen next. This point is particularly important following 2008’s terrible performance.

But if you had the opportunity to invest at the moment of your choosing, where on the chart would you choose? And where are we on that chart right now? When you notice that stock prices are declining, don’t be upset. Instead become excited about what lies ahead.

An index is a portfolio of specific securities (common examples are the S&P, DJIA, NASDAQ), the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index. Past performance does not guarantee future results. Originally published in Rescue Your Money
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