What Can Investors Learn from Meteorologists?

What can economists and investors learn from meteorologists? Economics and finance professors in the Tippie College of Business at the University of Iowa are researching whether using multiple economic and financial models running concurrently can deliver more accurate economic forecasts than one model can. Of course, the concept of relying on a pool of models to predict the future has its roots in weather forecasting.

The researchers recently ran a series of “model pools” to see how they would predict returns on stock portfolios between 1932 and 2008. After comparing the prediction to actual market performance, they found that a two-model pool led to more accurate predictions than any one model. Better yet? The three-model pool.

Thus, the researchers concluded that model pooling can potentially produce more accurate predictions for a wide range of economic forecasts, whether it’s charting real estate values or tracking changes in unemployment.

Here’s my take: Modeling to control risk has its place, but when it comes to your portfolio, the best defense against market volatility is to maintain a diversified portfolio, stay true to your asset allocation, utilize low-cost investments, and periodically review and rebalance your portfolio.

Planning Amid Tax Uncertainty

Ben Franklin famously quipped that the only certainties in life were death and taxes. Of course, with the Bush tax cuts scheduled to sunset at the end of the year and the midterm elections capable of changing the balance of power on Capitol Hill, there is nothing certain about future tax policy. We can only surmise that taxes will, one way or another, likely increase at some point in the future.

If the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)--the official names for the “Bush tax cuts”--sunset as originally legislated at the end of 2010, tax rates on ordinary income, long-term capital gains, and qualified dividends will revert to the higher, pre-2001 levels.

This table illustrates the differences in marginal tax rates after the sunset:

      Marginal Tax Rates         Marginal Tax Rates
                 for 2010                    as of January 2011
                     10%                                 15% (indexed and expanded)
                     25%                                 28%
                     28%                                 31%
                     33%                                 36%
                     35%                                 39.6%

Investors will also face higher capital gains tax rates. On January 1, 2011, the capital gains rate is scheduled to revert from the current maximum rate of 15% back to the 20% capital gain tax rate that was in effect prior to 2003.

Also, dividends which under the Bush tax cuts were taxed for the first time at the same low 15% rate as capital gains, will be reclassified and grouped with interest to be taxed at the higher rates levied on wages. In fact, unless Congress acts before the end of 2010, next year the top dividend rate will revert to 39.6% from 15%. That’s quite a leap.

What’s an investor to do? In anticipation of higher tax rates, if your portfolio includes appreciated assets, this year might be a good time to realize some gains at the maximum capital gains rate of 15%, rather than the 20% capital gains rate currently slated for 2011.

Investors in the 15% tax bracket or lower have a greater opportunity to save. For these investors, no gains are due on appreciated assets sold in 2010 if their gains are below a specified threshold. They would, however, be taxed at the 10% capital gains rate in 2011.

You should not, however, embark on a selling spree just to avoid what you think may be higher taxes down the road. Generally, you would want to have a purpose for the cash a sale would generate. For example, it may make sense to sell investments at gains this year if you have college tuition due next year for a son or daughter.  It also makes sense to sell individual, concentrated stock positions to adopt a more diversified and properly allocated portfolio.

If you are a business owner nearing your planned exit date, you may want to accelerate the sale of your business to avoid higher tax rates in the future.

And lastly, it is important to realize that the "wash sale rules" do not apply when selling an investment at a gain.  In other words, you can sell an investment today, record your gain, and buy it back immediately without waiting 30 days like you would when you harvest losses in your portfolio.

Economic and Political Pressures Will Influence Tax Policy

It is an interesting time in our nation’s capital. The latest polls show that the Republican Party may gain more than the 39 seats necessary to tip the balance of power their way in the House. Noting in a recent blog post that control of the Senate is also up for grabs, Washington insider and CNBC commentator Greg Valliere, said the Democrats need a “pre-election Hail Mary pass.”

Valliere floats the possibility for the following scenario: What if, now that lawmakers have returned to D.C., President Obama brings together leaders of both parties and negotiates a deal to extend the Bush tax cuts indefinitely for 97% of Americans, and perhaps for two or three years for the wealthiest Americans whom he initially targeted for tax increases?

While Valliere says a tax cut deal should be a “no-brainer” given the struggling economy, he expects politics to get in the way – on both sides of the aisle. He questions whether there are enough moderates who “recognize that this is a terrible time to raise taxes on anybody” and sees little possibility that the Republican leadership that has refused to compromise thus far would do so on an issue that has great potential to help them win seats and gain Congressional control this fall.

Only time will tell. However, in the meantime tax planning is a challenge as we are still unsure how tax policy will change next year.

Yes, You Can Raise Prices in a Downturn

When was the last time you got a raise? Corporate America has been stingy with raises during the downturn, but pain has also been felt among the ranks of small business owners who have been hesitant to raise prices in a tough economy. In fact, the uncertain economy has promoted many companies to cut internal costs, and even lower prices. Over the last few months, your mailbox likely was full of flyers from local companies or restaurants offering you a deal. Late night infomercials take the marketing pitch to an extreme -- Order now, and you get two of whatever they are selling, and something tacked on for “free.” However, new research from Harvard Business School, “Performance Pricing in Tough Times,” suggests that businesses can, and should, charge more for delivering more -- even in a market downturn. Companies should compete “on the basis of initiatives for which their customers willingly pay higher prices,” says study co-author Frank V. Cespedes, a senior lecturer at Harvard Business School who spent 12 years running a professional services firm.

The key in selling your price increase, say the Harvard researchers, is that your customers understand the value represented in your pricing. To further explore the researchers’ assertion that “Pricing builds or destroys value faster than almost any business action,” check out the HBS interview where authors Frank Cespedes, Benson P. Shapiro, and Elliot Ross discuss pricing strategy and how to convince your customers that higher prices are worth the cost.

Would You Pay a Fund Manager to be Lucky?

How many of us would list luck as the key ingredient for a top performing mutual fund? That’s certainly not the message we receive from most mutual fund companies that stress the expertise and trading skill of their top managers. Interestingly, however, a new study by internationally renowned finance professors Eugene Fama and Kenneth French finds that luck plays a bigger role than skill in determining a fund’s success.

Although investors pay well over $10 billion annually in fees to managers of actively managed funds, Fama and French found that active funds’ returns actually trail their passive benchmarks by approximately the level of the funds’ expense ratios (around one percentage point per year). Furthermore, the professors found that even the small number of managers (just 3%) who cover their costs are unlikely to noticeably outperform a large, efficiently managed index fund in the future.

The current Fama and French study is another in a substantial body of academic research that clearly illustrates the folly of chasing past returns. It also underscores the wisdom of taking a passive approach to investing to secure the superior long-term results upon which your retirement depends.

Is a College Degree Worth the Cost?

If you are paying college tuition, watching your bills increase faster than the rate of inflation, you might be asking yourself this question. Over the course of a working life, it’s been estimated that college grads earn from $900,000 to $1.6 million more than workers without a degree. Yet, according to the a study conducted by PayScale for Bloomberg Businessweek, the dollar value of a college degree may be a lot closer to $400,000 over 30 years -- and varies wildly from school to school.

Of course, there’s the unquantifiable and undisputable personal value of a college degree, but if we seek to determine the true economic value, rather than simply factor in the extra earnings, we need to consider the debt many students take on in college. I recently read a compelling article by Randy Proto, the President of the American Institute, in the online publication The Huffington Post. His thoughtful analysis supports those who argue that a college degree is still worth the cost, even in today’s uncertain job market.

• The median debt owed by a Bachelor's degree graduate is about $20,000, according to a College Board study -- less for a public university, more for private schools. Proto compares that to the average debt level people assume when they buy a new car: $25,396, according to Experian Automotive. I agree with his conclusion that a college degree -- with its lasting economic, social, and personal value -- is worth far more indebtedness than a car, which begins to depreciate the day you drive it off the lot.
• While post-secondary education adds significantly to lifetime earnings, the economic argument makes even more sense once you examine who's been losing their jobs in the current downturn. According to data produced by Economic Modeling Specialists, eight out the top 10 occupations that lost the most jobs from 2007 to 2009 were ones that didn't require a degree.
• Finally, as Proto points out, according to UNESCO, post-secondary enrollment worldwide has increased by 53 million people from 2000 to 2007. In an increasingly global job market, that's a lot of competition for jobs.

For those saving for college in tax-advantaged 529 plans, your homework is about to get easier. Starting this fall, Morningstar will offer published reports on the 50 largest 529 plans. The reports will include a Morningstar qualitative rating, analyst commentary, and data on some of the largest options within the plan.

The “Giving Pledge” to Ignite Philanthropy

A few weeks ago, more than three dozen billionaires signed up for The Giving Pledge, an effort by Bill and Melinda Gates and Warren Buffett to encourage wealthy people to give at least half of their fortunes to charity.

According to Patrick Rooney, executive director and professor of Philanthropic Studies at the Center on Philanthropy at Indiana University, the idea has both potential and challenges. He estimates that if everyone on the Forbes 400 fulfilled the pledge, $600 billion would go to charity. That's about double the total amount of Americans' current annual charitable giving, meaning that some careful planning will need to accompany the generosity.

With such a massive increase of dollars into charitable organizations, it’s incumbent on donors to work with their advisors and charities to structure gifts effectively in ways that can make the greatest difference. Some of the smallest nonprofits, for example, simply may not have the administrative capacity to manage large gifts.

However you intend to express your philanthropic interests, I suggest sharing your thinking -- and your charitable volunteer work -- with your children. You will find this can both enhance your family relationships and lay the foundation for a rich legacy of giving.

If you are looking for more inspiration, you may want to read: The Ultimate Gift by Jim Stovall, The Giving Family: Raising Our Children to Help Others by Susan Crites Price or The Financially Intelligent Parent: 8 Steps To Raising Successful, Generous, Responsible Children by Eileen and Jon Gallo.

What’s Different About a Fiduciary Advisor?

I recently read a post by Kate McBride regarding the differences between an advisor held to a fiduciary standard and a broker held to a suitability standard.  It was short, accurate and to the point.  Therefore, I credit her entirely for the comments below:

What’s so different about a fiduciary advisor as compared to an advisor who meets the minimum requirements of the suitability standard?

It’s the legal duties to the client.

The suitability standard is a business standard, similar to the standard of a salesman, where you know you have to look out for yourself.

The fiduciary standard requires an advisor, like your family doctor, to be loyal and always put the client’s best interests first. This best interest requirement has practical consequences for investors. The fiduciary (best interest) standard means advisors must:

• Use the judgment of a professional to only select and recommend products in the investors’ best interest
• Either avoid or disclose and manage conflicts of interest
• Describe, before beginning work, all compensation, incentives, commissions, and expenses
• Ensure expenses are fair and reasonable
• And, of course, do only what’s best for investors.

An advisor only required to meet the suitability standard is not required to do any of these things.

In Fund Selection, Is It Wise to Reach for the Stars?

How often have you seen headlines on personal finance magazines touting Five Star Mutual Funds? You may figure that list generated by Morningstar constitutes great shopping ground. In fact, many professional financial advisors begin their analysis by evaluating those five-star funds.

It is human nature to be comforted by the idea that the investments you are buying are highly rated. The problem is that when we buy a “Five-Star” fund, we blindly extrapolate that the star rating translates into superior future performance. In fact, nothing could be further from truth. The Burns Advisory Group’s recent research paper, Star Gazing: Five Star Funds Revisited, went back to 1999 to study the subsequent 10-year performance of Morningstar’s five-star funds. The results were enlightening.

Burns found that of the 248 funds rated Five-Star by Morningstar on December 31, 1999, only four were still receiving that rating a decade later. Of the original sample, 87 had ceased to exist. And of those still existing, all had been downgraded to an average of just under three stars. And if this was not bad enough, the average performance for the five-star funds over this 10-year period was worse than the average for all funds in all categories except international stocks.

So what should you consider in making an investment decision? Clearly, a Five Star rating is nothing more than a starting point. You need a more broad-based evaluation, focusing on factors within your control. You might ask:

• Are the risks being taken related to return?
• Are those risks targeted in a reliable, consistent way?
• How diversified is the fund?
• What are the costs of the fund, i.e., expense ratio and turnover?
• Does it make promises it can't keep?
• What is more important - individual judgment or clear processes?
• Are the underlying strategies driven by forecasts?
• Does the fund take account of costs and taxes in its decisions?
• Does the fund manager communicate in a clear and consistent way?

While many of these attributes can lead to good outcomes, they cannot guarantee positive returns every year. However, the above characteristics can give you comfort that your money is being invested in a consistent, transparent way that ensures that when the targeted premiums kick in, you are positioned to receive them.

The bottom line is that we believe you should construct portfolios not around short-lived Five Star ratings, but based on the time-tested, enduring principles of asset allocation, broad diversification, passive management, and low costs.

Reaching for the stars today could mean you find yourself clutching at straws in the future.

Controlling Risk Mandates a Long-term Care Insurance Review

A note from a client thanking me for providing a complimentary long-term care (LTC) insurance policy review prompted me to think how a LTC review would be useful for many others.

Although you may have always figured your nest egg could cover your healthcare costs in retirement, the recession and continued volatility may require a re-evaluation of that assumption. With growth prospects low, LTC insurance may be an attractive risk-reduction strategy. Ironically, however, as consumers’ need for LTC insurance has increased, the recessionary environment has prompted insurance companies to re-assess their own risk levels, making the coverage more difficult and expensive to obtain.

Long-term care refers to the help you receive for a chronic illness, disability, or cognitive impairment that leaves you unable to care for yourself for an extended period of time. These services can be provided in a nursing home, assisted-living facility, or in your own home. Typically not covered by your health insurance, LTC can be expensive. In fact, a recent study by Genworth found average costs to be $74,208 a year, or $203 a day. Of course, these rates vary by region of the country.

So, should you buy LTC insurance and, if so, when? Cost has long been the reason for putting off purchasing LTC insurance until a decade or two before retirement. However, in this financial environment, the reasons for acquiring LTC coverage earlier in your adult life are compelling. In the midst of market uncertainty, adding a LTC policy can provide inflation-adjusted, guaranteed income for your healthcare needs later in life.

If you’re interested in determining if it’s still reasonable for you to self-insure or whether your existing LTC policy still meets your needs, please contact me. The LTC market is in constant flux and our consultant, Allen Hamm, is well-versed in everything from the newest riders to the financial stability of the insurance companies. In addition to ensuring you understand the coverage you are buying, Allen is also available to act as your advocate to protect your rights as a policyholder should you ever have a claim.