Time to Re-assess Market Risks/Rewards?

According to Jim Parker, Vice President, DFA Australia Limited, understanding investment risk begins with accepting that “the market itself has already done a lot of the worrying for you.” As Parker notes, “Markets are highly competitive, which means that new information is quickly built into prices. Instead of trying to second guess the market, you work with it and take the rewards that are on offer.”

To put yourself in the best position to “take the rewards,” it’s wise to work with an advisor to build a diversified portfolio designed to meet your long-term goals – and meet periodically to review your progress and make necessary changes to ensure you are still on course.

If the Great Recession has altered your perception of risk, now may be a good time to meet to re-assess your risk tolerance. Remember, how much risk you decide to take involves assessing three inter-related factors: your future goals; your age and investment time horizon; and additional personal factors such as your current net worth and natural temperament.

As you consider where you fit in the risk spectrum, remind yourself of the Catch 22 inherent in the risk and return equation. That is, while Merriam-Webster’s Collegiate Dictionary defines risk as “possible loss or injury,” risk also is present in opportunities that will be lost if you totally avoid risk. The simple truth, according to Parker, is: “If there were no risk, there would be no return.” Your chances of getting the balance just right are much greater if you work with a financial advisor who combines what Parker refers to as the “accumulated knowledge of financial science” with in-depth knowledge about you.

Ready for a Challenge?

Last month I wrote about a recent article, Why We're Not Wired for Successful Retirements by Philip Moeller, that was based on a financial literacy test given to consumers in Chile. I noted how many of those surveyed misunderstood the power of compound interest. Since then, blog readers have asked about the other questions. So, here they are, reprinted directly from the article. Only 68 out of nearly 14,250 tested answered all six correctly. See how you do. (The correct answers follow, but no peeking!)

1. Chance of Disease: If the chance of catching an illness is 10 percent, how many people out of 1,000 would get the illness?
2. Lottery Division: If five people share winning lottery tickets and the total prize is two million Chilean pesos, how much would each receive?
3. Numeracy in Investment Context: Assume that you have $100 in a savings account and the interest rate you earn on this money is 2 percent a year. If you keep this money in the account for five years, how much would you have after five years? Choose one: more than $102, exactly $102 or less than $102.
4. Compound Interest: Assume that you have $200 in a savings account, and the interest rate that you earn on these savings is 10 percent a year. How much would you have in the account after two years?
5. Inflation: Assume that you have $100 in a savings account and the interest rate that you earn on these savings is 1 percent a year. Inflation is 2 percent a year. After one year, if you withdraw the money from the savings account, you could buy more/less/the same?
6. Risk Diversification: Buying shares in one company is less risky than buying shares from many different companies with the same money. True/False

Answers:

1.  100
2. 400,000 pesos
3. More than $102
4. $242
5. Less
6. False

How did you do?

Do You Have a Lead Advisor?

A new report from State Street Global Advisors and the Wharton School Taking on the Role of Lead Advisor: A Model for Driving Assets, Growth and Retention offers some insights into how investors’ loss of confidence in markets during the recession prompted many to begin managing their money themselves or to engage multiple advisors to diversify the risk they perceived of working with just one advisor.

However, because multiple advisors rarely share information about the clients, the report found that investors working with multiple advisors can easily and mistakenly take on too much or too little risk relative to their financial goals. Specifically, the report notes, “Using multiple advisors to work out portfolio strategies independently often can lead to overlapping exposures or to divergent allocations that result in neutral market positions.”

To guard against this risk, the report suggests that investors may want to consider appointing a lead advisor to oversee the entire investment portfolio. That’s how I think of myself – as my clients’ personal chief financial officer – working to identify and prioritize goals and develop a clear plan for how they will reach them.

As the State Street/Wharton report points out, this “lead advisor model” is one successfully used by advisors to the ultra high net worth. Especially because, more than ever, investors desire unbiased, personalized financial advice they can trust, it makes good sense to working with a fiduciary who oversees all your investments, across all accounts and among other professionals and coordinates with other professionals, such as CPAs and estate planning attorneys.

What’s the Future of Social Security?

Do American workers have confidence that they will receive future benefits from Social Security? Results from the Employee Benefit Research Institute’s 2011 Retirement Confidence Survey (RCS) show most American workers are skeptical about the program. Here are some statistics from the report:

• Seventy percent of workers are not too or not at all confident that Social Security will continue to provide benefits of at least equal value to the benefits retirees receive today.
• Three-quarters of workers express concern that the age at which they become eligible for Social Security retirement benefits will increase before they retire.
• Today’s workers are less likely to expect Social Security income in retirement (77 percent total major and minor source of income, down from 88 percent in 1991) than today’s retirees are to report having Social Security income (91 percent total).
• Workers are half as likely to expect Social Security to provide a major share of their income in retirement (33 percent) as retirees are to say Social Security makes up a major share of their income (68 percent). However, EBRI research found in 2009 that 60 percent of those age 65 or older received at least 75 percent of their income from Social Security.
• Workers who are closer to retirement are more likely to expect Social Security to be a source of income in retirement than are younger workers (92 percent of workers age 55 and older vs. 63 percent ages 25–34).

The message here is clear: The unsure long-term status of Social Security coupled with the significant decline of defined benefit plans mean that working Americans must shoulder an increased responsibility to fund a financially secure retirement.

Mother Knows Best: Don’t Put All Your Eggs in One Basket

We probably all can recall hearing our mother say, “Don’t put all your eggs in one basket.”  That solid advice to diversify is often misapplied to the investing front. Some investors think that buying 50 blue chip stocks complies with that adage. Others figure that buying ten mutual funds properly diversifies their portfolio, only to find that those ten mutual funds invest in many of the same stocks. Still others think hiring multiple advisors will ensure a truly diversified portfolio, but soon discover that those advisors use similar funds and that the management fees are higher than they would be with just one advisor.  So what does not putting all of your eggs in one basket mean?

True diversification means owning all of the stocks that make up the market, and it is the only true way to ensure you get market returns.  Further, spreading your money between stocks, bonds, and cash--asset classes that historically have responded differently to market conditions--is your best defense against being hurt by poor performance in any one asset class. History teaches us that, like a seesaw, as some investments decline, others rise to offset those losses. Additionally, you should diversify within asset categories by sub-asset class, even by investment style. Note, too, that diversification in any asset category is achieved more effectively through asset class mutual funds rather than with individual stocks. Building a diversified portfolio requires identifying your asset allocation strategy, diversifying within each asset class, and then periodically rebalancing your portfolio.

In honor of Mother’s Day, think back to what your mother told you about life: Be patient. Do your best. Look before you leap. Remarkably, her words of wisdom have a direct application in today’s markets.