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Damage Control

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Illustration by Brian HubbleSo stocks crashed and portfolios went up in flames. That can’t be changed unless you borrow a page from the Book of Bernie (as in Madoff) and dream up your own figures. The question now is how to fire up the future.

We’ve asked four area financial mavens for their counsel in these times of tattered nest eggs. In their view, the sky is neither falling nor endlessly blue. To weather storms, investors need perspective and patience.

“The long-term concept changed with the dot-com era. People were seeking more instant gratification,” says Irv Rosenzweig, president of Rosenzweig & Associates Wealth Management Group in Media. “The new paradigm was [bidding up] companies with nonexistent earnings. We can see where that ended.”

But endings lead to new beginnings. Hank Smith, chief investment officer at Haverford Trust, cites a study showing that every 10-year period since 1926 in which stocks returned less than an average of 3 percent per year has been followed by an average annual gain of 12 percent (price appreciation and dividends combined) over the next 10 years. The longer the period, the better stocks generally tend to look.

This decade, however, has given investors two exploding bubbles—dot-com in 2000-01, and real-estate/banking in ’08—and they’ve prompted some unnerving comparisons. Last November, the S&P 500 index fell to its lowest level since early 1997. Not exactly the path to a comfortable retirement.

So now the question is whether stocks will bounce back, as history shows they always have. Smith, for one, is betting they will. “Our macro theme for 2009 is ‘reversion to the mean,’” he says. “They revert to their historical averages—across all asset classes.”

Eventually. The long-term average annual return for stocks has been about 10.5 percent. Will they get there this year?

The true measure will involve a longer period of time. That brings up the very notion of “long term.” What exactly does it mean? In the long term, a wise philosopher once said, we’re all dead. No argument there.

But many of us will be drawing breath for some time to come. And with longevity in a bull market, there’s an increasing likelihood that individuals will be parted from their money before they die. In that scenario, cash won’t cut it—unless you happen to have a vault’s worth.

“If you stop working, your money has to work harder,” says Joel Goodhart, managing partner with BIRE Financial Services in Plymouth Meeting. “The stock market is still the only place to be in the long term.”

Goodhart identifies long-term funds as money you won’t need for at least 14 years. That money is best invested in equities (stocks in one form or another). Keep short-term money—enough to meet your needs for the next seven years—in bank accounts, CDs, money markets and U.S. treasury obligations of short duration. Personal circumstances determine whether the seven-year gap between the two is short term or long term.

As for the money that’s invested in equities, Goodhart makes a strong case for sitting tight. One study reveals that the S&P has been up an average annualized 9.6 percent in the past 25 years. But if you take out the best 25 days, the gain is only 3.8 percent.

Other advisors put one’s staying power to an even sterner test. “Getting out and getting back in is a recipe for disaster,” says Scott Donaldson, a senior analyst with Vanguard. “You need to be in there the whole 40 years.”

To jump ahead to “Don Lancer’s Airtight Recession-Survival Tips,” click here.
 

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That’s right, Donaldson’s recommended long-term time horizon for most investors is 40 years. “Equities are a risky asset class,” he says. “It may take many years to capture that risk premium.”

Donaldson says “bonds have beaten stocks” for a number of multiyear periods, but stocks prevail “by four or five percentage points annually” over most 10- and 20-year periods. One way to rein in risk, he suggests, is to invest in both, setting an allocation ratio based on needs and expectations, and routinely rebalancing. Some mutual funds and professionally managed accounts automatically rebalance per a set timetable.

Consistent with his “reversion to the mean” thesis, Haverford Trust’s Smith also emphasizes the value of rebalancing. “It’s not intended to be a market timing tool,” he says. “But if the equity percentage [in a portfolio] is lower, you’ll be dedicating more to equities. It’s difficult to do because of the pain of the losses, but the [equity] markets will turn north well before the bad news has subsided.”

While some financial prognosticators shriek that buying gold or moving to Nova Scotia are the only safe bets, most subscribe to the long-term way of thinking. Beyond the technical analysis, metaphors abound in financial speak. More than one TV analyst recently has insisted that “when the pendulum swings back,” you have to be invested.

“That’s all well and good,” say many investors caught in the downdraft. “But when it swings the other way again, how do I avoid being decapitated?” Trying to time market trends is often a fruitless pursuit for professionals and the uninitiated alike.

“I never bought into the idea of ‘smart money’ being ahead of the curve,” says Smith.

“Good luck with that [market timing],” says Donaldson, who adds that straight index investing actually beat (lost less than) active management last year.

Rosenzweig contends that investors and money managers need to be wise to various investment options (e.g., shorting, hedging) that can mitigate risk. “Classical investing using strictly traditional products is not a good idea,” he says.
 

The FIA Safety Net

BIRE’s Goodhart likes investors to mix a little insurance with their risk, and says that the fixed index annuity is the perfect vehicle. An FIA investment mirrors the performance of selected indexes like the S&P 500 or Dow Jones, returning a percentage of the gains but sustaining none of the losses in each 12-month period, starting with your contract date. If the indexes have advanced, your increased bottom line becomes your new “floor,” below which the balance in your account will never drop.

“It should be part of any portfolio,” says Goodhart. “Because of the ‘up’ years, [FIAs] made a substantial profit during the long period when the market was slightly lower (1997-2008).”

Since an annuity entails penalties for early withdrawal, it becomes doubly important for an investor to commit only funds that won’t be needed for years. And if your long term is long enough, buying equity mutual funds or stocks directly should give you the greater return. Goodhart concurs, but says the annuity helps many people “avoid major doses of agita when they open their statement.”

Investor, know thy nerves.

“You should be able to stomach a little more volatility [in the market] when you’ll be working for many years ahead—you can be heavily equity oriented,” says Donaldson. “The closer to retirement you are, the more money you should have in bonds and cash.”

Indeed, timing can be everything. If the period when you need or desire your invested money coincides with a big downturn, you’ll likely have to adjust your lifestyle. Many recent retirees—and those on the brink of retirement—are facing that right now. That’s why attention should be paid to cash, bonds and annuities.

But if your future has a healthy run yet, now is probably the time to put some money to work in a smart, patient fashion. Smith sees cyclical companies—their stock prices more than cut in half—as compelling investment opportunities.

“When the headlines say throw out the buy-and-hold playbook,” he says, “it’s the time to buy and hold.”
 
To jump ahead to “Don Lancer’s Airtight Recession-Survival Tips,” click here.
 

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Retire Wiser (and Richer)

Joslyn Ewart recalls a couple who’d become quite concerned that the income they were drawing from their investment portfolio was creating a serious drain on the principal.

“The couple had sufficient investments to comfortably provide the income they needed,” says Ewart, president of Wayne’s Entrust Financial. “But the sources being drawn from had heavy tax implications.”

Ewart was able to reconfigure the clients’ portfolio disbursements in such a way to save the pair about $25,000 in annual tax payments, reducing their annual income needs accordingly. Principal preserved; case closed.

As important as it is to have enough resources to fund your retirement goals, it’s equally important to determine where you’ll be drawing that income from those sources. “Taxation greatly affects the value of your nest egg,” Ewart says.

Before you can tackle the taxation issue, though, you have to account for all those sources of income from your entire spectrum of investments. And that spectrum includes—believe it or not—the value of your future Social Security payout. Yet many investors overlook Social Security when evaluating their retirement nest eggs. “Most people tend to look at their tangible assets,” says Malvern’s David Duncan, a financial planner with Independent Wealth Services.

Duncan runs a model for his clients that shows the total capitalized value of what they’re entitled to from their Social Security. “They’re aware of that eventual payout, but they don’t feel that money actually belongs to them,” he says.

According to a recent Wall Street Journal article, “Social Security is equivalent to holding a bond.” That bond even has a name: an inflation-adjusted immediate annuity. It has special value—especially when considering the risk levels you want to maintain (stocks and commercial bonds) other than that handy Social Security bond.

“Knowing what the capitalized value of your Social Security is reveals how much risk you’re willing to absorb with your variable assets and still remain within the overall risk parameters you’re comfortable with,” notes Duncan.

Duncan underscores the importance of considering all of your other assets—salary, house, pension, along with Social Security—before even thinking about your portfolio. This is most critical in a declining market.

“Say your stock portfolio suffers a 30-percent loss in the marketplace,” he poses. “Considered by itself, that percentage drop may be outside your comfort zone for risk tolerance. But when you add in all those other assets, your stock may represent only a 15-percent decline in your portfolio—something likely to be well within your comfort level.”

Keeping oneself within that psychological comfort level of risk can make all the difference when it comes to riding out a bear market and then regaining—and even exceeding—your original investment level when the market becomes bullish again. According to Duncan, the historic average for market recovery is 22 months.

“The question is, if you pull out of the market when it’s in decline, can you still recover to reach your original financial goals?” says Duncan. “Most of the time, the answer is no.”
 

Timing Is Everything

Deciding when and if to get out—then return to—the market isn’t easy. “Most don’t make both decisions correctly,” says Jim Wright of Paoli-based Harvest Financial Partners.

John Fattibene, Wright’s partner at Harvest, says a better alternative to simply cashing in poor-performing investments is to upgrade their quality. “Look for stocks with companies with the best balance sheets—those that show less debt and more cash available,” Fattibene says.

Wright suggests that removing one market risk—equity value—may merely open you up to other risks previously unforeseen. “Changes like deflationary or inflationary pressures, tax policy and regulatory risk all impact the value of a portfolio and can be more important considerations than merely looking at a decline in equity value,” he says.
 

See page 4 for “Don Lancer’s Airtight Recession-Survival Tips”
 

Among all those changes, Entrust’s Ewart focuses on tax policy—especially when it comes to evaluating that Social Security component. “Taxation can greatly impact your Social Security payout,” Ewart says. “For most people, up to 85 percent of their Social Security benefit will be taxed as a result of their other investments.”

Even the capitalized Social Security component may not be worth all the calculation says it is. “Medicare premiums are rising, and are deducted from Social Security benefits,” Ewart points out.

When more income is necessary from your investments, Ewart advises to start with those that have the least tax bite—like a Roth IRA rather than a fully taxed one.

If all this leaves you more confused and risk averse than before, take heart. There is a strategy that can guide you and your planner through the thicket. “We look at both a client’s income stream and need,” says Fattibene. “Most people invest for a reason, and that reason is to not run out of money. So we start with income and then look at what level the portfolio has to reach in order to produce that income. Then it becomes an issue of appropriate asset allocation.”

And in financial planning, sticking to the basics can often prove both prosperous and reassuring.
 

Don Lancer’s Airtight Recession-Survival Tips

Recently retired, Don Lancer was the dean of KYW-AM 1060. For almost four decades, his unmatched professionalism defined the delivery of business and financial news in our region. A true Philadelphia broadcast pioneer, the King of Prussia resident offers his tips on weathering the economic downturn.

1. Don’t sell out of stocks if the companies are “quality.” Then again, what’s quality? If they’re integral to the country’s economic machine, then Washington probably won’t let them fail. Look at Citigroup, GM, Ford, Chrysler—the list goes on and on. All of them have world market involvement, which is important for the future. The point is, if you own them and they’ve dropped precipitously, don’t dump them now. Hold on.

2. Have someone advise you in how to handle your money. It should be someone you trust. Forget tips, Internet sales pitches and those in the mail. Get an expert in building toward retirement to advise you—even if you’re still young. You want to minimize risk right now and maximize return. Use smaller local (FDIC-insured) banks you know are not locked into the mortgage mess. Also, go back to the old-fashioned savings account as an emergency cash reserve. Stop using credit cards as your emergency reserve.

3. This mess is going to take a long time to get out of, so if you get a tax return, save it.
If you get another stimulus payment from the government, save it. Build up that cash reserve; invest in money market funds—anything that’s insured. But for now, stay away from stocks. There will be plenty of time to get back in when this thing turns around.

4. Diversification is still the key. If you’re getting older, invest more conservatively. With the unemployment rate rising, update your resume and rework your financial plans. If you have an IRA, put the maximum into it. More and more companies are dumping their 401(k) match, so be aware of that trend. Continuing to put money into a 401(k) can still be a good idea—even without the match—because it’s tax-deferred savings. Again, always ask your advisor.

5. Don’t close your eyes and hope the clouds will go away. They probably won’t.

—J.F. Pirro
 

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