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.

EBRI’s 2011 Retirement Confidence Survey: Gender Comparisons Among Workers

Do men and women plan and save for retirement equally? The 21st annual Retirement Confidence Survey (RCS) provides some answers. The RCS found men and women are equally likely to save for retirement. Also, women are statistically as likely as men to report they are offered (43 percent vs. 49 percent) and contribute to (34 percent vs. 39 percent) a work place retirement savings plan. However, men (17%) are more likely than women (10%) to say they are very confident about several of the financial aspects of retirement.

Interestingly, although women tend to face higher health care expenses in retirement due to their greater longevity, women (35 percent) are more likely than men (26 percent) to think they will need to accumulate less than $250,000 for retirement. Another point of departure is that women are more likely than men to be very concerned about the possibility that Social Security payments will be reduced (68 percent vs. 52 percent) and the age at which they become eligible for Social Security retirement benefits will increase before they retire (54 percent vs.44 percent).

Apart from gender comparisons, the 2011 RCS reported some disconcerting news -- Americans’ confidence in their ability to afford a comfortable retirement has plunged to a new low. The percentage of workers not at all confident about having enough money for a comfortable retirement increased from 22 percent in 2010 to 27 percent this year, the highest level in the RCS’ 21 years. Also, instead of reducing spending and/or saving more to shore up retirement accounts, most workers are planning on delaying retirement and/or working part-time in retirement. My caution is always is that health concerns may not allow you to work as long as your figure to.

Decisions, Decisions

In Which Risks Are Worth Taking Jim Parker, a vice president at Dimensional Fund Advisors, writes, “Even the most self-declared risk-averse people take risks every day.” Parker notes that routine risks to our safety include crossing the road, exercising at the gym, choosing lunch and using electrical equipment. He adds, “There are the big decisions like selecting a degree course, choosing a career, finding a life partner, buying a house and having children. These are all risky decisions, all uncertain, all involving an element of fate.”

In making these decisions, Parker says we seek to “ameliorate risk by carefully weighing up alternatives, researching the market, judging possible consequences and balancing what feels right emotionally and intellectually, both in the short term and in the long.”

New research from Harvard Business School’s Michael Norton addresses how managers making decisions often err in one of two directions—either overanalyzing a situation or ignoring helpful information to go with their gut. More specifically, when deciding among potential products or employees, managers routinely take too much time considering all the attributes of their choices—even attributes that are irrelevant. Equally troublesome, their fear of the decision paralysis that can occur when evaluating too much information, often cause managers to decide to trust their instincts.

In an article discussing Norton’s finding, a sentence Dr. Seuss might have written caught my eye: “We know that sometimes people think too much, and sometimes they think too little. But we still don't know the right amount to think.”

I suggest that when it comes to financial decisions, it’s always wise to have a trusted financial advisor in your corner who understands the tradeoff between risk and return and how to build a portfolio that suits your risk tolerance level. A financial advisor can help you think and make solid decisions, giving you the best chance of achieving your goals.

Parker also believes investors need help making financial decisions about risk. “Advisors,” he writes, “help us take an objective assessment of the potential risks and rewards of various alternatives, by taking a holistic view of our circumstances and by keeping us free of distraction and focused on our original goals.”

I couldn’t agree more. Invest without the help of an advisor and you may be exposing yourself to unnecessary risks -- whether you’ve thought long and hard about your decision, or just gone with your gut.

Is Cash in the Pocket Better Than Waiting for More?

In a recent article, Why We're Not Wired for Successful Retirements, Philip Moeller explores the psychology behind the answers to that question as documented in new research by Justine Hastings of Yale University and Olivia Mitchell of the University of Pennsylvania. Their paper for the National Bureau of Economic Research reveals the results of two tests they conducted to ascertain why people often fail to make sound financial decisions.

Interestingly, the findings Moeller reports on were based on research with consumers in Chile, not the United States. The first test involved posing six relatively simple questions to gauge respondents’ financial literacy. (Nobody scored 100 percent.) In the second test, people were offered the option of receiving the equivalent of about $8 if they filled out a shopping questionnaire right away, or a larger amount of money if they took the questionnaire with them and mailed it back within four weeks. (Not surprisingly, more than half the people chose the immediate payment; 30 percent chose to wait for more money and 17 percent took the questionnaire with them, yet failed to return it.)

Said the researchers, "We find that the impatience measure strongly predicts respondents' self-reported retirement saving and health investments. Financial literacy is also associated with more retirement saving, but it is less closely associated with sensitivity to framing of investment information."

For me, the research’s real lesson for those saving for retirement comes from reviewing the question most people answered incorrectly. Addressing compound interest, the question asks: 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? Not too many people came up with $242. (You earn $20 the first year on 200, then $22 on $220 during the second year.) Understanding the long-term power of compound interest in tax-deferred savings accounts is crucial to motivating investors to sacrifice today for their benefit tomorrow.

The need for immediate gratification, a uniquely American characteristic, can be difficult to overcome, but doing the math may convince you.

Our Thoughts and Prayers are with the People of Japan

The massive March 11th earthquake and tsunami that devastated northeastern Japan left more than 18, 000 people dead and thousands more are still missing. Close to half a million people have been displaced and the nuclear crisis at the Fukushima Dai-ichi plant has the public’s fear mounting. While the overwhelming cost to human life is of paramount importance, many also worry about how Japan's economy will be impacted.

The World Bank recently estimated rebuilding from the worst earthquake and tsunami in 300 years may cost the world’s third largest economy upwards of $235 billion Other numbers, many noted in a recent story Economic Impact of Japan's Quake by Kimberly Amadeo, are staggering.

According to Carl Weinberg, High Frequency Economics, 11 of Japan's 50 nuclear reactors have been shut down. Given that Japan's nuclear industry supplies a third of the country's electricity, production will be limited to less than 80% of pre-quake/tsunami potential for a long time.

According to Kyohei Morita and Yuichiro Nagai of Barclays Capital, the quake hit the north-east section of the country, responsible for 6-8% of Japan's GDP. They figure damages could exceed 15 trillion yen, or 3% of GDP.

With a total of 22 manufacturing plants, including Sony, still closed, the global supply chain of semiconductor equipment and materials will clearly be impacted.

Here are two more numbers to consider: The American Red Cross now lists “Japan Earthquake and Pacific Tsunami” as one of the choices for online donations at the Red Cross. Alternatively, you can make a $10 donation by texting REDCROSS to 90999. Among countless other organizations, UNICEF is also coordinating efforts to help the children of Japan. You can use the form on UNICEF's website to donate 100 percent of your desired amount to their fund designated for victims of the earthquake. Or you can simply text JAPAN to 864233 to donate $10.

Dimensional Stories: People Putting Ideas Into Practice

Someone recently asked me for information about the story of Dimensional Fund Advisors.  I recalled this video and provided a link to it. I enjoyed watching the video again and decided I should share it on my blog.  I hope you find it informative.

If you have questions about Dimensional Fund Advisors, you should consult with your independent registered investment advisory firm.



If you want to see a bigger version of this video, click on this link.  Click Here>>

Disclaimer: This video contains the opinions of the participants but not necessarily Dimensional Fund Advisors, DFA Securities LLC, or Bernhardt Wealth Management, Inc., and do not represent a recommendation of any particular security, strategy or investment product. The participants' opinions are subject to change without notice. Information discussed in the videos has been obtained from sources believed to be reliable, but is not guaranteed. These videos are made available for educational purposes only and should not be considered investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.