Category: Financial Articles

15 Jun

6 Risks Mutual Fund Investors Need to Know

Investopedia defines a mutual fund as an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers who invest in the fund’s capital and attempt to produce capital gains and income for the fund’s investors.

One of the main allures to investing in mutual funds is that they are essentially pre-diversified. Rather than needing to be an expert on a particular stock or bond, an investor can utilize a mutual fund due to the broad amount of underlying investments held in the fund. This diversified nature causes mutual funds to often be considered more secure than stocks, but it’s always important to remember past performance is not an indicator of future results and investing in mutual funds involves risk. Mutual funds are also flexible in regards to their investment amounts, which opens up a wide swath of prospective investors. This provides accessibility to investors at all income levels.

While there are plenty of reasons an investor might consider a mutual fund, it’s absolutely crucial that a prospective investor knows the risks as well. While there are endless possibilities in terms of pros and cons, I’ve identified 6 risks mutual fund investors need to know.

Fund Performance

No one wants to talk about the enormous sums of money mutual fund companies make, but let’s face it, they are in this to generate a profit. Many companies are stuck in the conundrum of providing performance for investors while also generating a profit for themselves. Mutual fund companies spend a lot of money on advertising in an effort to acquire assets. While I’ll dive into fund expenses later, you’ll notice a correlation between performance and expenses. There’s an old adage that you get what you pay for, but that’s not always true. All of the fees and expenses directly conflict with investor returns.

If you do some research, you’ll notice a lot of mutual funds struggle to provide above-average returns. Most fund managers have a goal to beat the overall market, which can be extremely difficult to do. The individual fund managers are benchmarked against a particular index, which becomes difficult to beat when saddled with high costs. This can lead to what’s known as chasing returns, which can sometimes exacerbate potential losses. Mutual fund companies focus a lot of effort on promoting their flagship funds, such as ones that receive high ratings from a firm like Morningstar. Many investors pour a lot of money into funds simply based on their star rating thinking that they stand a better chance at capital appreciation.

Bond Mutual Funds

I’ve heard many times that an investor has purchased a bond mutual fund for the purpose of safety and income. It’s very important to understand that a bond mutual fund is NOT a bond. If you purchase a 30-year bond, the price sensitivity to interest rate changes declines as the bond gets closer to maturity. If you invest in a bond mutual fund with an average maturity of 30 years, you’re involved in a completely different situation. Bond mutual funds do not have a maturity date, but rather often utilize a fixed average maturity that doesn’t decline. A conservative investor seeking interest income payments might be better suited to utilize an individual bond, but it’s important to investigate the risks you’re willing to take.

Another key aspect that is overlooked in regards to a bond mutual fund is that the fund manager can use leverage to increase its yield. Anytime leverage is involved, this can always increase the investor’s overall risk to their principal. Ratings can only identify funds that have performed well in the past, which absolutely does not predict future results. In fact, this type of behavior is one of the most common mistakes investors make and that is buying high and selling low.

Fees and Expenses

As I noted earlier, fees and expenses directly affect a mutual fund’s performance. According to the Investment Company Institute, the average expense ratio of equity mutual funds was 1.28% in 2016. While this figure has declined over the years, the expense ratio still has a direct impact on overall returns. These expenses are required to be disclosed in the mutual fund’s prospectus.

What can sometimes go overlooked in regards to fees and expenses are some lesser known items such as trading costs, commissions, market impacts and taxes (another risk to discuss later).

Trading costs are associated with all securities transactions and they can increase overall expenses in active mutual funds. The industry sometimes refers to trading costs as the bid/offer spread,  which is simply the difference between the price a buyer is willing to pay and the price at which a seller is willing to sell. Mutual fund managers buy and sell securities within a mutual fund and each time they do, they incur trading costs, which are passed along to the mutual fund owner. A telling report in 2013 by Roger Edelen, an associate professor of finance at the University of California, Davis, found that mutual funds’ trading costs were 1.44%. These trading costs are “invisible”, yet can have a significant impact on the return investors ultimately realize.

While commissions to brokers are typically disclosed (yet another risk to discuss), transaction commissions can often go overlooked. While large trade sizes can cause a fund to operate in a low commission structure, the cost is still worth noting as it all adds up as a potential risk to the investor.

Market impacts are likely the most overlooked, yet they could have the potential for the biggest risk in terms of fees and expenses. All institutional investors are afforded concessions in price when they execute large trades. By a fund simply executing a trade of this type, they could move the cost due to the sheer size of shares being sold. If an individual investor were to sell 100 shares of Google stock in the open market, the price won’t move much. However, if a large fund sells 1000 times that (100,000 shares), it could have an impact on the overall share price. This leaves investors vulnerable to a market phenomenon that is 100% out of their control, yet they are fully exposed to.

Confusing or Limited Disclosures

In 2001, the Securities and Exchange Commission (SEC) adopted a rule that prohibited misleading mutual fund names. This rule required that “a fund with a name suggesting that the fund focuses on a particular type of investment (e.g., “stocks” or “bonds”) to invest at least 80% of its assets accordingly.” With that in mind, let’s examine a common mutual fund.

The Income Fund of America is a mutual fund that has an emphasis on income, hence the name. There’s one key point that needs to be addressed right away. There’s absolutely nothing wrong in terms of the above SEC rule. However, the average investor might see a name like that and assume that the fund invests primarily in fixed income instruments. One need not look very far to see that up to 25% of assets can be invested in stocks of companies based outside of the United States and up to 20% of assets in bonds rated below investment grade (BB and below). Again, there’s nothing wrong here and this fund is listed under “equity-income funds”, but many consumers fixate on the name of the fund itself. This underscores the importance of truly knowing what’s held within the mutual fund and not just focusing on the fund name.

Taxes

Any investment comes with tax implications and mutual funds are no different. As always, please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation. Mutual funds can be inefficient at times in regards to taxation. Remember, a mutual fund is a basket of different shares that the fund manager deems fit given the fund’s objective. This means you are buying a share of an existing company that owns many individual investments and they each have their own tax liabilities.

To avoid paying corporate income taxes on their profits, mutual funds are required to distribute all their net gains to shareholders at least once per year. This income the investor receives is either distributed as a capital gain or dividend distribution. Capital gains distributions are generated when the fund manager sells fund assets for more than they were purchased. Dividend distributions are generated when your fund includes dividend stocks and interest-bearing bonds.

The overlooked aspect of this is that depending on how long your fund has held the assets, the income you receive may be taxed as ordinary income or capital gains. Investors overlook this quite often and it’s a very important risk to understand. Remember that not all capital gains distributions are taxed at the capital gains rates. Unlike when you invest in individual stocks, the applicability of capital gains has nothing to do with how long you have held the mutual fund shares, but rather how long the fund itself has held the underlying assets. Only gains from assets in the fund that have been held for more than a year are taxed at capital gains rate. This is important to know because the difference between your ordinary income tax rate and your capital gains tax rate could be large. The inability to control your individual tax situation can be a headwind for your overall performance.

Share Classes

In the first risk, I noted that the old adage “you get what you pay for” is not always true and this final risk will magnify that statement. There’s zero evidence that if you pay more in fees that you’ll get a better rate of return. It’s crucial to understand mutual fund share classes, as this will tell you the upfront cost of doing business when you invest. There are more than three types of mutual fund share classes, but I’ll focus on the three most common share classes.

Class A shares charge an upfront sales fee that is taken off of your initial investment. If a Class A sales charge is 5% and you invest $5,000 in the mutual fund, you will start with $4,750. This leaves you needing to hold the mutual fund for a long enough time to burn off that sales charge. What if the fund returned 3% the first year and you need to liquidate the shares? You’ve taken a loss. It’s also important to remember that you don’t need to achieve a 5% return to get back to even, as any potential gains are figured on your account value of $4,750 NOT $5,000. This leaves you needing to achieve gains of more than 5% to just get back to even. What happens when the market is not favorable for this happening? These are all things you need to consider when purchasing Class A shares.

Class B shares charge on the backend, which is typically referred to as contingent deferred sales charges (a fee is charged when you sell shares a specified period after original purchase). These can be appealing to investors with little investment dollars and a long time horizon. This fee structure causes higher than normal expense ratios. Class B shares are slowly disappearing from the mutual fund world.

Class C shares are known as a level load sales charge that charge an annual fee. If an investor has a shorter time horizon, these might be appealing. Class C shares tend to have higher expense ratios than Class A shares. This ultimately causes a drag on your investment over the long haul.

There are pros and cons to all mutual fund share classes and the system itself exists simply as a way to provide compensation for the intermediaries (your broker).

All too often, investors are passive and too accepting of poor fund management. When investors should question things, they rarely do, even when things go horribly wrong (2000 and 2008 are prime examples). There are risks involved with any type of investment and as I’ve pointed out, mutual funds are not exempt from this notion. Their perceived simplicity has made mutual funds very popular, but as with everything else in the investing world, do your homework before jumping in. A financial planner can help you get on the path towards greater confidence in your financial future. It’s crucial to always have a clear strategy and prepare for all possibilities in retirement such as longevity and other life-altering events.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

29 May

529Day! National 529 College Savings Plan Day

May 29th is “529Day” and it is used as a day to promote saving for education via a 529 Savings Plan. What exactly is a 529 Savings Plan?

Very few Americans know that 529 Savings Plans are an education savings tool. 529 Savings Plans were established to help parents and grandparents save money for post-secondary or higher education. Their unique features make them one of the more popular ways to save for college.

Account owners can receive a tax deduction or credit for contributions (check your specific plan in your state) and earnings grow on a tax-advantaged basis. Furthermore, when you withdraw the money, it is tax-free if the funds are used for qualified education expenses such as tuition, fees, books and room and board.

Investing in a 529 Savings Plan has little effect on your child’s ability to qualify for financial aid under FAFSA. If your child is a dependent and you are the account owner, the 529 Savings Plan is considered your asset. This means only 3-6% of the 529 Savings Plan’s total account value will be counted towards your Estimated Family Contribution (EFC), as determined from FAFSA.

529 Savings Plan Highlights

  • Tax-deferred investment growth
  • Tax-free withdrawals for qualified expenses
  • Gift and estate tax benefits
  • Control by you over how assets are used
  • Flexibility to use at eligible colleges, universities and vocational schools worldwide

 

For more information about financial aid eligibility, you should consult with a financial aid professional and/or the state or educational institution offering a financial aid program.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

21 Mar

Pros & Cons of Health Savings Accounts (HSA)

A health savings account (HSA) is something like a personal savings account, but the money is only intended for qualified health care expenses. Established in 2003 as part of the Medicare Prescription Drug, Improvement and Modernization Act, HSAs allow people with high-deductible health insurance plans to pay for current health care expenses and save for future expenses in a tax favorable manner. The IRS defines an HSA as a “tax-exempt trust or custodial account you set up with a qualified HSA trustee to pay or reimburse certain medical expenses you incur.”  The IRS establishes guidelines each year, based on individual and family coverage. For the calendar year 2018, the IRS set the minimum deductible amounts at $1,350 for self-only plans and $2,700 for family plans. The maximum out-of-pocket costs for individuals is $6,650 while the figure is $13,300 for family pans. Consumers can contribute $3,450 for self only HSA plans in 2018 and $6,900 for families. With the eligibility guidelines out of the way, let’s take a look at some pros and cons about health savings accounts that need to be considered.

PROS

Health Savings Accounts (HSAs) offer a way to save and pay for healthcare expenses.

  • Others can contribute to your HSA. Contributions can come from not only you but your employer or anyone else who wants to add to your account.
  • Contributions are commonly made on a pre-tax basis, which means that they are not subject to federal incomes taxes. Your employer can also make contributions on your behalf, which are then not included in your gross income.
  • Contributions made with after-tax dollars can be deducted from your gross income when filing your tax return.
  • Withdrawals from your HSA are not subject to federal income taxes provided they are used for qualified medical expenses. The IRS sets guidelines as to what is deemed a qualified medical expense here.
  • Any interest or earnings on the assets in the HSA are tax-free.
  • Funds within an HSA rollover on an annual basis, which means they do not expire or have to be used within a certain timeframe.
  • The money within your HSA remains available for future medical expenses even if you change health insurance plans, change employers or retire.
  • Many HSAs now issue a convenient debit card to facilitate easy access to your funds when paying for qualified expenses.

CONS

While there are many advantages to health savings accounts (HSAs), consumers need to be aware of the disadvantages as well.

  • Even though you are likely paying less in monthly premiums with a high-deductible health plan, it can be difficult even with an HSA to come up with the funds to meet a high deductible.
  • Unexpected health care costs can exceed what you had planned for and you may not have enough in your HSA to cover these expenses.
  • There might be pressure to continue to save in your HSA that could cause you to be reluctant to seek healthcare when you need it.
  • Recordkeeping can be very daunting as you will need to keep your receipts to prove withdrawals were used for qualified healthcare expenses.
  • Some HSAs charge a maintenance fee and while these fees are typically not very high, they do eat into your bottom line. Sometimes these fees can be avoided if you maintain a minimum balance.
  • One of the biggest cons of HSAs is taxes and penalties. If you withdraw funds for non-qualified expenses before age 65, you’ll owe not only taxes on the money but also a 20% penalty. After age 65, you will avoid the penalty for a non-qualified withdrawal, but you still owe taxes on any growth.

A health savings account (HSA) can be a great choice for people who are looking to limit their upfront health care costs while saving for future expenses. HSAs are ideal for high-deductible health plans as monthly premiums are usually much lower than a low-deductible health plan. Favorable tax treatment could also factor into why a consumer might be compelled to utilize an HSA. With that in mind, HSAs aren’t ideal for everyone and you should analyze your unique situation before blindly jumping into an account that might not suit your needs. As always, take a close look at everything before making any final decisions.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

2 Nov

Buckets on Buckets: 3 Risks to Avoid in Any Economy

Investopedia defines diversification as “a risk management technique that mixes a wide variety of investments within a portfolio”. In simpler terms, don’t put all of your eggs in one bucket, right? We’ve heard the old adage countless times not only in regards to investing but also in life. It makes perfect sense. By going all in on a particular strategy, you’ve essentially pinned whatever your end goal is solely on that coming fruition. What happens when your strategy isn’t maximized, or even worse, fails altogether? In some aspects of life, we simply pick things up and start over. But when it comes to financial planning, you aren’t always afforded that luxury. That’s where a bucket approach comes in to play. It’s no longer enough to simply diversify and keep your fingers crossed. It’s time to diversify within diversification.

Correlation

As I noted in a previous article, The New Normal: Thinking About the Future Through a Different Lens, several factors have become prevalent in today’s financial environment that make traditional diversification dicey at best. Correlations are on the rise, which makes it incredibly difficult to find ways to truly diversify. The point of mixing a wide variety of investments within a portfolio is to find investments that behave differently, as an attempt to reduce risk. However, globalization and central bank intervention across the globe have resulted in growing correlations among even the most traditional investments, especially during times of stress within the markets.

Volatility

If rising correlations weren’t enough to ponder a new way to diversify, take a look at volatility that exists in today’s markets. Between 1996 and 2015, there were 422 days when the S&P 500 Index had a move of 2% or more. Rewind even further back, and look at the time period from 1956 to 1996. During that 40 year span, there were just 254 days of 2% or more price movements in the index. So in a span of just nine years, this even occurred 1.67 times more than it did over a 40-year time frame.

Low Yields

For the most part, interest rates have been declining for nearly 30 years. Low inflation and monetary policies that are accommodating have pushed yields on the 10-year U.S. Treasury Note to a low of 1.61% in 2012. Consider that in 1981, the yield was over 15%! Although the U.S. Federal Reserve has slowly begun to emerge from a zero interest rate environment, central banks throughout the rest of the world remain extremely accommodating, which could lead to global rates that stay low. As you look back at the historical yield of the 10-year U.S. Treasury note, bonds may not be able to provide adequate income in the low-interest rate environment that we face for the foreseeable future. Here’s another piece to consider. What happens when interest rates actually start to rise? Traditional fixed income investments may suffer losses as rates rise, which diminishes the short-term value of fixed holdings.

Diversify Within Diversification

So how do we avoid some of the risks outlined above? It’s an answer that some may not want to hear, but as I’ve stated many times, there is no “one-size-fits-all” answer. However, I can state that employing a bucket approach can prove to be very effective in diversification. This may mean that you have a totally different plan than the next person in terms of underlying components, but the overall strategy itself is simple. The more buckets you are able to employ, the better chance you have at staving off some of the headwinds that are inevitable in life.

Tax Buckets

To diversify within diversification, you not only avoid putting all of your eggs in one bucket, but you also create buckets on buckets. In simpler terms, let’s say you have a well-diversified mix of holdings within your 401(k), and after maxing out your contributions, you open a Traditional IRA that holds a well-diversified mix of mutual funds. While the exercise itself is great, you’ve not created another bucket, as both are taxed in the same manner (deferred taxation). Instead of setting up another bucket of funds that will be taxed upon withdrawal in retirement, consider the value of a Roth IRA. Just by setting up a Roth IRA, you’ve created another bucket, as you now have a choice of where you go to withdraw funds in terms of potential tax ramifications, instead of only having a bucket that holds all tax-deferred fund.

Investment Buckets

While setting up different buckets in terms of the taxation can prove to be extremely beneficial in retirement, you can take this strategy even further. Let’s say you’ve established a Traditional IRA and a Roth IRA, but both hold the same type of underlying investment. You’ve managed to give yourself flexibility in terms of withdrawals, but you’ve not removed any of the potential pitfalls above. This is where it is prudent to have buckets of not only different tax qualifications but also entirely different investments.

The Modern Portfolio Theory was created in an environment that had a limited range of choices, where expected return and risk were based on a mix of stocks and bonds. In those times, an investor seeking to lower risk in their portfolio would simply tilt their portfolio weighting towards more bonds, whereas investors looking for maximum returns would seek out more stock allocations. But as I’ve laid out above, today’s environment forces us to look at the investment landscape differently.

There are ways to create a more diverse portfolio through the addition of alternative investments, which tend to not be correlated with stocks or bonds. A common mistake that I see or hear is when others treat alternative investments as a single asset class. Alternatives cover a wide spectrum of assets and strategies, and should not be looked at as a replacement for a class in your portfolio, but rather a complement to your portfolio.

Investors should always consider alternatives while keeping in mind their goals, objectives, risk tolerance, liquidity needs, and time horizon. Only then can an investor begin to review how alternatives might serve as a complement to their traditional portfolio. Although alternative investments have varying degrees of risk and return, they may be able to contribute to improved overall returns on a portfolio due to their lower correlation to traditional investments.

Buckets on Buckets

As you can see, there are many ways you can prepare for the road ahead. Simply having a Traditional IRA bucket that holds a 60/40 mix of stocks and bonds may not be as prudent of a strategy as it once was. By creating buckets on buckets, you can give yourself the freedom and flexibility to determine when and where you withdraw, as opposed to the financial landscape dictating how you live out your retirement.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

***Alternative Investment Disclosure: Diversification does not assure a profit or protect against loss in a declining market. Portfolios that have a greater percentage of alternatives may have greater risks, and this additional risk can offset the benefit of diversification. Alternative investment strategies such as leveraging, arbitrage and commodities investing are subject to greater risks and volatility than more traditional investment offerings. Although asset allocation among different asset categories generally limits risk and exposure to any one category, the risk remains that an asset category could perform poorly relative to the other asset categories. Some of those risks include general economic risk, geopolitical risk, commodity-price volatility, counterparty and settlement risk, currency risk, industry concentration risk, leveraging risk, market risk, liquidity risk, real estate investment risk, and sector risk.***

19 Oct

Supercharge Your Retirement

Investors have had the old adage of socking away everything possible into their 401(k) and/or Traditional IRA pounded into their minds for years. While the general notion makes complete sense, there are ways to strive towards the same end goal, while eliminating some potential pitfalls down the road. A little bit of planning today can make all of the difference in an effort to supercharge your retirement.

401(k)

Many people refer to their retirement savings plans as 401(k)s even when they aren’t actually a 401(k), as the majority of financial advice centers around utilizing these accounts. While 401(k)s are a solid tool for contributing on an ongoing basis towards your retirement, these can sometimes be complicated and expensive, which oftentimes is passed on to the unaware consumer. You generally fund a 401(k) for the long-term, as the dollars are all contributed on a pre-tax basis, which means every dollar that is withdrawn is taxable. These dollars are also often subject to early withdrawal penalties, which can restrict when you access the funds. Generally, most 401(k) plans are very limited in the scope of which they can be invested, meaning you have very little choice in how the dollars are working for you. Simply put, 401(k)s were designed to help workers save for retirement in a relatively easy way. Go to work, fill out the investment allocations, be sure they add up to 100% and watch your contributions get deducted from your gross wages each pay period.

Traditional IRA

A Traditional IRA is a type of account in which the investor contributes dollars on a pre-tax basis much like a 401(k), but there are much lower contribution limits. Also like a 401(k), earnings grow tax-free, but every withdrawal is taxable. A Traditional IRA can be ideal for investors if you exceed the income limits for contributing to a Roth IRA, or if you anticipate being in a lower tax bracket in retirement. Keep in mind that there are penalties involved for early withdrawals (currently age 59 1/2), and you are required to being distributions at age 70 1/2.

Roth IRA

While 401(k)s and Traditional IRAs are fine ways to accumulate retirement assets, there are more efficient ways to approach your retirement goals. One way to supercharge your retirement is by utilizing a Roth IRA. A Roth IRA is funded with after-tax dollars, while the growth and subsequent withdrawals are not subject to tax. This can be especially helpful for investors who might be in a low tax bracket now, but anticipate being in a higher bracket in retirement.

Roth IRA Basic Rules

  • You can contribute to a Roth IRA if you make less than $133,00 for single filers and $196,000 for married couples (click here to see full IRS breakdown)
  • The maximum contribution to a Roth IRA is $5,500 per year, unless you are 50 or older, in which case it jumps to $6,500 per year
  • You have 15 months to contribute for the current tax year (January 1 until tax filing deadline of the following year)
  • Roth IRA account owners are subject to a penalty if they withdraw earnings or interest before age 59 1/2 and at least five years have not elapsed since your initial contributions have been made

Supercharge Your Retirement – While Maximizing Today

Now that the basics have been covered (be sure to consult with a tax professional for advice), let’s look at some ways that an investor can not only supercharge retirement, but also maximize today. While earnings or interest have restrictions in regards to withdrawals, your contributions can be accessed tax and penalty fee at any time for any reason. Additionally, there are some exceptions that allow you to access funds:

  • College Planning

    • Most think of 529 Plans when saving for education expenses, and that’s a solid choice for many because you can save above and beyond what you can in a Roth IRA. However, a Roth IRA can provide more flexibility as you can simply leave the funds for retirement if you don’t end up using it for college costs.
    • Unlike 529 Plans, money in a Roth IRA isn’t counted towards estimated family contributions for college. This could possible help lead towards a more generous financial aid package.
  • Buying a Home

    • You can withdraw up to $10,000 of your earnings (in addition to any amount of contributions) without being subject to taxes or penalties if you’re a first-time home buyer. If you’re married, your spouse can withdraw the same. This money can be extremely useful for applying towards a down payment or closing costs.
  • A Backup to Your Backup

    • If you’re faced with a difficult situation that has erased your emergency savings, your Roth IRA can provide additional funds to help out in a tough time. This should not be thought of as a cash reserve, but rather a tool to help out with major unexpected issues (major medical bills, etc.). Again, make your Roth IRA a last resort, but it can help you to avoid racking up expensive credit card debt.
  • Leaving a Legacy for the Next Generation

    • As noted earlier, 401(k)s and Traditional IRAs are subject to Required Minimum Distributions (RMDs) at age 70 1/2. Roth IRAs are not subject to this requirement, which means you are never forced to withdraw from this account. Oftentimes we forget that while passing on a generous amount of money in a Traditional IRA is a nice gift, it can be very troublesome for the recipient in terms of taxes. This makes a Roth IRA a fantastic way to pass along money to your heirs, as there won’t be an potential tax issues to worry about.
    • Be sure to have your beneficiary designations set and reviewed often, because it prevents assets in this account from passing through probate before being distributed. Non-spousal beneficiaries will have to make a withdrawal from that money each year, but they will not be subject to taxes.

Plan for Tomorrow, But Don’t Ignore Today

In summary, there are many ways to utilize your Roth IRA as it is a very flexible vehicle to save for major financial goals. As always, be sure to plan and review that plan before making a withdrawal as using your Roth IRA contributions today means there’s less money to have the potential to grow between now and retirement.

 

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

29 Aug

Is Your Financial Advisor Right for You? Salsa Might Have Your Answer

I’ve had the great opportunity to attend an event where I was able to listen to Dr. Craig Israelsen speak, a professor who developed a multi-asset balanced portfolio in 2008. Dr. Israelsen has written a book about this concept, which he describes with a spot on metaphor. When you make great salsa, it’s all about diversification according to Dr. Israelsen. Only by adding diverse ingredients together can we achieve the desired outcome. However, he correctly states that there are some ingredients in salsa that most would never eat individually, such as hot peppers or Tabasco sauce. But without the hot ingredients, the salsa would be flat. That accurately describes how to approach a truly diversified investment portfolio. I’ve written about this topic, specifically in regards to thinking about the future through a different lens.  This topic couldn’t be more important given today’s overall financial landscape, and I’d like to dive in a bit further in addressing whether or not your current advisor is right for you.

The rationale behind Dr. Israelsen’s approach is simple. Raw performance should not be the primary issue, but it shouldn’t be ignored. This general concept should be embraced by investors of all walks, whether you’re just getting started, or you’re nearing the distribution phase of retirement. Every advisor wants to help their clients in the accumulation phase (working years), but the most crucial part is the phase that often goes overlooked, and that’s the distribution phase. This phase makes the accumulation stage look like child’s play, and I am sincere about that statement. Too many advisors use the “herd approach”, which essentially lumps all of the clients into one management style. Take this for instance. Let’s say your advisor just called you and stated that he feels the market is overvalued, and he recommends shifting 20% of your portfolio into cash. Your first response will likely be “sure, that sounds like a prudent move.” But in fact, he could very well have called his entire book of business and gave the exact same advice. Ask yourself if that’s truly the best advice you could have received. Now, ask yourself if that advisor is truly the right one to help you prepare for later in life, when you begin the distribution phase of retirement.

Why is the distribution phase so important? When you’re still working, it’s your income that allows you to withstand the natural ebbs and flows of the markets, but what happens when you cannot afford a portfolio or advisor who asks you to remain patient when you need to live in retirement? This is the difference between a financial advisor who is solely focused on total return, rather than retirement income planning, and that difference is as big as an ocean. The former describes the majority of today’s financial advisors, but the latter is the one who is focused on multiple facets all at once (think different ingredients in salsa). These include, but are not limited to, producing income, tax efficiency, estate planning, charitable desires, income protection and more. Here’s the crucial component to a financial advisor who is truly a retirement income planner – they are doing all of this regardless of the market conditions. So why aren’t more advisors doing this for clients? Quite simply, it’s hard work. Don’t take this as a suggestion to dump your advisor tomorrow, or as a slam against other advisors. There are plenty of other good advisors who are trying to do their best for their clients. But if you are asking a question like “how will income be created in retirement?” and the blanket response is utilizing a 4% withdrawal strategy that is adjusted for inflation, you need to seriously consider if this strategy will outlive you, because at the end of the day that’s the end goal.

As I noted in a previous article titled “Risk versus Risk“, retirees are living longer, so don’t think you’ll simply die before you run out of money. In today’s environment, where the entire globe is seemingly on edge about various geopolitical or social issues, the markets no longer allow for the old way of thinking when it comes to investing. This new era has only amplified what happens in the markets, good or bad, which introduces the next question you should ask your advisor: “Have you put my portfolio through a stress test?” This important issue is described at length in “Risk versus Risk“, as a nest egg can look pretty on paper without subjecting it to any outside factors. In the example from my previous article, I utilized three portfolios, all with the same starting amount and the same 5% annualized rate of return. However, all three performed much differently simply by focusing on the sequence of returns. Take that example a step further, by implementing inflationary risks or different taxation levels, and you’ve made it even more important to stress test your portfolio BEFORE you reach the distribution phase.

Whether you realize it or not, you’ve almost certainly dealt with this scenario in life. Whether it’s moving from a pediatrician to a family doctor, or a high school coach to a higher level specialist, the concept is the same. Once you move beyond the early years (think accumulation), it might be time to lean on someone with more sophisticated skills and abilities, who looks at the entire picture and not just accumulating assets. Accumulation is the fun part, but distribution is the more challenging phase of retirement, and there’s no blanket way to address it. Sounds a bit like making salsa, right? You need some very similar ingredients, but only by adding diverse elements can we truly achieve the desired outcome, and I’m guessing there are countless ways to arrive at the same end result, which is what makes this journey called retirement so exciting!

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

24 Aug

Risk Versus Risk

The average investor is probably familiar with the term investment risk. What the average investor is probably not familiar with is the types of investment risks that exist. Risks faced in retirement are markedly different than those faced during accumulation years. The types of investment risks are: interest rate risk, business risk, credit risk, tax-ability risk, call risk, inflationary risk, liquidity risk, market risk, reinvestment risk, political or social risk and currency risk. Most of those terms may not mean much to the average investor, but they are very important to be cognizant of not only during the accumulation phase, but also during the distribution phase (retirement). So we’ve identified the general basic risks that the average investor will face, but there’s another frontier of risk to explore that many rarely consider. The investment risks stated above do not go away during the distribution phase (retirement), but a few other risks come into play. One of the risks is withdrawal rate risk, which I wrote about in this post. Withdrawal rate risk works hand in hand with the other two risks, which are longevity risk and sequence of return risk. As stated in the article regarding withdrawal rates in retirement, the old 4% rule may not be a viable strategy going forward, unless you can mitigate the risks of longevity and/or sequence of returns.

As the calendar turned to January of 2011, the oldest batch of the Baby Boom generation turned 65. That day, and every day since, approximately 10,000 boomers have turned 65. The Pew Research Center states that this trend until 2030, which is when 18% of the nation will be at least 65. Why is this important? Well not only has life expectancy risen, but it’s rising while a massive generation reaches retirement age and puts an unprecedented strain on the government for Social Security and Medicare. This isn’t to start a debate about those programs, it’s simply a fact. As we live longer and a large group of individuals turns 65 in a small time frame, our focus needs to shift towards thinking about retirement through a new lens. As I wrote in that article, fundamentals alone are shifting, which doesn’t even account for longevity risk. Read that article and then introduce potentially living longer to the equation. Simply put, your retirement savings not only need to support a likely higher withdrawal rate, but they also need to last longer.

Sequence of return risk is simply the risk of receiving lower or negative returns early in a period when withdrawals are being made from an individual’s investments. The order, or sequence, of investment returns is the most overlooked of the three risks. Most investors focus on the average rate of return needed to sustain their lifestyle in retirement, but that can be devastating once you’re out of the accumulation phase. I’ve inserted a basic chart that I created to illustrate the impact, with the following criteria: 5% annual return, positive sequence of 15%, 7%, 3% -5%, negative sequence of -5%, 3%, 7%, 15%. The portfolio starts with $1,000,000 and assumes a 5% annual withdrawal, with a 3% increase each year for inflation.

The blue line represents a portfolio with a 5% rate of return each year. The orange line depicts a positive sequence of returns and the gray line represents a negative sequence. All three scenarios are an average return of 5%, but look at the impact of the sequence. This is how it’s easy for investors to not worry about sequence when in the accumulation phase, as three basic scenarios listed above all wind up with a 5% average rate of return, yet the picture is so much different based on how you arrived at that 5% average. This basic exercise underscores the importance of having a well thought out financial plan BEFORE  you reach the distribution phase of your life. When you factor in withdrawal rate risk as well as longevity risk, you can see how important mitigating sequence of returns risk as well.

Some 50% of the population in the U.S. are likely to live past their average mortality rate, and if you don’t properly address all three of these risks, one can run the risk of outliving their retirement funds. There are many ways to mitigate these risks, and the time is now to address these issues.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

12 Jul

Irrational Exuberance? I Have No Idea

Let me get this out of the way now, by thanking Alan Greenspan (and professor Robert Shiller), for allowing me to utilize the headline phrase ‘Irrational Exuberance’. As you’ll see in that link, irrational exuberance is “unsustainable investor enthusiasm that drives asset prices up to levels that aren’t supported by fundamentals.” In layman’s terms, there’s no real basis for sentiment. Due to the nature of my profession I have the benefit of watching the financial markets closely and I must admit, I’m reminded quite often that despite being glued to this on a daily basis, I have no idea what’s going on. If you’re reading this, that statement might be a cause for concern, but let’s be frank with each other. Who really does? The problem is that someone will always be right, and someone will always be wrong. Rather than try to hit a moving target, read the rest of this article, and then decide if anyone truly knows what might happen going forward.

Take a look at this chart, courtesy of Big Charts:

That chart illustrates the last 10 years of returns from the S&P 500 Index. That index has experienced gains in eight straight years, and it’s been nearly six years since a 20% decline has happened. Speaking of professor Robert Shiller, the Shiller PE Ratio for the S&P 500 currently sits at 29.91. A  P/E ratio is simply price-to-earnings, which can be calculated as Market Value per Share/Earnings per Share. Shiller’s ratio is calculated a bit differently, in that it is cyclically adjusted, which removes any bias prone to wild swings. Looking at that link, you’ll notice that the mean for this ratio over the last 136 years is 16.76. Using those simple data points, one could argue that the overall market is rather expensive.

Coming into 2017 after an election with such magnitude, I don’t think many would have predicted below-average volatility in the financial markets, but alas here we are with incredibly low levels in the VIX Index (the unofficial market fear gauge). Despite all of the noise surrounding the financial markets, whether it be political or across the entire globe, the resiliency shown by markets has been nothing short of amazing. Once coined the most hated rally, it’s hard not to wonder just how complacent investors have become during what is now the third longest economic expansion on record.

The problem with identifying bubbles is that it’s the bubble itself that makes it very difficult to discern between a healthy rise in prices and full blown euphoria. While formulas and ratios much like the Shiller PE ratio above are nice, they aren’t bullet proof in predicting the future, as nothing can understand or account for the human element. Economic indicators are extremely important and, but you have to look at sociological areas as well. There are no metrics for capturing whether or not everyone is talking about stocks or real estate, and their ability to “get rich” from those assets. You can’t quantify in an efficient way how many people are quitting their jobs to get involved in day trading or becoming a real estate broker. I have yet to find an index that can capture how often someone is getting ridiculed in an ardent manner for not being “all in” on stocks or some other foolproof asset. What I do know is that the sociological and economic elements need to be accounted for together, with neither being the sole manner to evaluate the current environment. Is the recent financial crisis of 2008 and 2009 still fresh enough in people’s minds to keep a bubble from inflating too much? It’s possible, and while I think the terms ‘bubble’ or ‘crash’ can be used far too much, I can’t help but wonder if complacency is the film the bubble is wrapped in this time.

In some ways, it feels like the financial crisis that unfolded nine years ago has completely changed the way investors approach the financial markets, but in other ways it feels like too many have already forgotten the lessons that should have been learned as a result of that crisis. Am I predicting a continuation in the current rally, or conversely, a market crash? Absolutely not, and that’s why I mentioned at the beginning of this article that no one should be making such bold claims, regardless if they are a financial professional or not. The truth is that we don’t know what will happen going forward, especially on a day-to-day basis, but we can be equipped with knowledge and an understanding of how to approach investing, regardless of the environment. We learn from what has happened, not what might happen in the future. So the burning question after all of this;  how do we identify whether or not exuberance is irrational or not? That’s precisely my point, because until it actually happens, I have no idea.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

3 Jul

Don’t Leave A Change to Chance

The fear of change grips most, if not all, of us at some point in life. Sometimes it can be irrational in nature, but other times it can be well warranted. Regardless of how you approach this notion, one thing is clear: change can and will happen in our lives, but how we adapt or handle a transition is crucial. In managing life’s transitions, dealing with the concept of change can be overwhelming and in some instances, it can create serious challenges. Whether it be starting your a new career, buying a new home, getting married, having a child or owning a business, these life changes require planning to various degrees.

When you start a new job, you may have addressed the obvious items on your checklist, but have you dug a bit deeper on the financial planning end of things? We’ve all done it before; sign on these lines, make the allocations add up to 100% and turn the form in. But just because it’s what mom or dad did, doesn’t mean it’s right for you. A career change is not only a chance for you to forge ahead towards your goals, but you can also begin laying the foundation for a better tomorrow, with slight tweaks to common schools of thought.

Purchasing a new home can cover just about every aspect of the emotional spectrum, but as we saw in 2008, homes aren’t viewed the same anymore in the financial world (at least they shouldn’t be). We all have our opinions as to what may or may not have caused the housing crisis, but the truth is many homeowners treated their home as an asset, and some were punished for continuing that old thought process that the housing market is infallible. Not only should you consider your mortgage and how you might protect others should you pass (ie. life insurance), but you also need to examine the way you manage this instrument while you’re alive. There can be appealing benefits to utilizing your home as an asset, but as we saw nearly 10 years ago, downside risks do come as well.

Getting married is likely one of the biggest decisions you’ll ever have to make in life, but the ramifications from a financial aspect can be just as big. Not only do you need to consider each person’s individual goals, but you always have to be open and forthright. This isn’t an attempt to be a marriage counselor, because I’m not here for that, but I am stressing the importance of financial planning after deciding to tie the knot.

Having a child ties right into marriage, in that you’re introducing a new person into your life that previously wasn’t there. We know all of the challenges this can create, but this is yet another prime example of not letting a change in your life go to chance. When used properly, life insurance can be a vital tool of protection not only for debts (mortgage, car loan, student loan, etc), but also for income replacement. What happens if a spouse that was earning an income dies unexpectedly? Even if both spouses work, that can still be a huge void to fill, even if there is no debt. This is called replacing a paycheck, and while it’s something no one wants to ever think about, the truth is the unexpected does happen. There’s a saying that there is no better time than yesterday to plan, and this is especially true when considering if life insurance might be right for you.

Small business is an integral part of our economy, and if you’re a small business owner, you should never leave anything to chance. Of all the important items to focus on in the day to day operations of a small business, business succession planning is often the most overlooked. According to Robert Frank of CNBC, nearly two-thirds of small businesses do not have a succession plan in place. That’s a staggering number when you take into account how important small businesses are. We don’t want to think about the unexpected, but how would your business deal with an unexpected disability or death? Without a succession plan, the loss of a partner can leave a business at risk for closure or takeover. A properly designed business succession plan can help your business to beat the odds and handle an unexpected event in a much smoother fashion. Whether it’s funding a buy-sell agreement, paying estate taxes and business debt obligations, protecting a surviving spouse from the financial impact of a disability or death, or treating heirs in an equitable fashion to reduce potential family tensions, there are solutions available to help achieve a sound plan.

Many of us rely on family or friends for advice and support in all matters, whether it’s a shift in markets or a lifestyle change similar to those mentioned above. This can create challenges not only emotionally, but also financially. The path towards retirement is not a straight one. Life changes, for good or bad, but it doesn’t have to derail your future. We can help navigate through these transitions in life, while sticking to a plan that was established. Experience and understanding in dealing with these matters helps to focus on the big picture, while not leaving these changes to chance.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

15 Jun

The New Normal: Thinking About the Future Through a Different Lens

It’s been exactly 3,020 days since the financial markets bottomed out in the wake of the financial crisis that literally wiped away trillions of dollars in assets. Panic struck everyday investors, who ran for the hills thinking that the unrest would never end. We learned in hindsight that the best thing to do was batten down the hatches and ride out the storm, but unfortunately we as humans can’t live that way. Sure, the traditional scientific method is always 20-20 hindsight at its best, which allows you to see where you’ve been. It allows us to formulate a certainty of what we think we know, a validation of sorts. But unfortunately, hindsight doesn’t tell us where we should go moving forward, so we need to ask ourselves if it’s time to break the mold.

March 9, 2009 is the date that I was referring to in the above paragraph, and since then the S&P 500 Index has grown a whopping 260.36% (note: the S&P 500 Index is an unmanaged index and cannot be directly invested in). While that certainly sounds great, the fact of the matter is a lot of investors were left behind, still stricken by fear of another crisis. With the current economic expansion at 96 months and counting, what factors should you be thinking about as you ponder the “new normal”?

First of all, correlations are on the rise. What is correlation? According to Investopedia, “Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management. Correlation is computed into what is known as the correlation coefficient, which has value that must fall between -1 and 1.” In today’s post-crisis environment, emerging markets, U.S. Treasuries, emerging market bonds, government bonds and U.S. high yield bonds have all moved in lockstep with equities. Pre-crisis, many investors subscribed to the Modern Portfolio Theory (MPT), which essentially states that it’s not enough to look at the risk and return of one individual stock, but rather one should diversify by having a mix of stocks and bonds, thus reducing overall risk. When stocks and bonds weren’t positively correlated, that theory was sound financial advice. However, it has become challenging to build a diversified portfolio that contains assets that behave differently. Globalization and central bank intervention across the globe have resulted in growing correlations among even the most traditional investments, especially during times of stress within the markets.

Drastic increases in volatility is another factor to consider when evaluating how to approach a “new normal”. Financial markets are more volatile than ever, and looking at the last 60 years proves it. Between 1996 and 2015, there were 422 days when the S&P 500 Index moved 2% or more. Consider that from 1956 to 1996 there were just 254 days of 2% or more price movements in the index. So in a span of just nine years, this event occurred 1.67 times more than it did over a 40 year time frame. It’s not just stocks that have experienced magnified volatility, as bonds have seen some huge price movements as well. Typically known as safe havens and instruments of low volatility, government bonds experienced volatility that rose over 40% in 2013, and 40% in early 2015 (data from Merrill Lynch’s MOVE Index, which measures bond market volatility). Central banks have flooded the financial markets with easy monetary policies, while the U.S. Federal Reserve has embarked on a tightening policy, which could cause volatility to persist as markets adjust to a rate tightening cycle.

The final component to consider that has been a direct byproduct of the financial crisis is low yields. For the most part, interest rates have been declining for the better part of 30 years. Low inflation and monetary policies that are accommodating have pushed yields on the 10-year U.S. Treasury note to a low of 1.61% in 2012, down from a rate of over 15% in 1981. Although the U.S. Federal Reserve has slowly begun to emerge from a zero interest rate policy, central banks throughout the rest of the world remain ultra accommodating, which could lead to interest rates around the globe that stay low. As you look back at the historical yield of the 10-year U.S. Treasure note, bonds may not be able to provide adequate income in the low interest rate environment that we face for the foreseeable future. Here’s the double whammy. What happens when interest rates actually start to rise? Traditional fixed income investments may suffer losses as rates rise, which diminishes the short term value of fixed holdings.

The Modern Portfolio Theory was created in an environment that had a limited range pf choices, where expected return and risk was based on a mix of stocks and bonds. In those times, an investor seeking to lower risk in their portfolio would simply tilt their portfolio weighting towards more bonds, whereas investors looking for maximum returns would seek out more stock allocations. But as I’ve laid out above, today’s environment forces us to look at the investment landscape through a different lens. There are ways to create a more diverse portfolio through the addition of alternative investments, which tend to not be correlated with stocks or bonds. A common mistake that I see or hear is when others treat alternative investments as a single asset class. Alternatives cover a wide spectrum of assets and strategies, and should not be looked at as a replacement for a class in your portfolio, but rather a complement to your portfolio. Investors should always consider alternatives while keeping in mind their goals, objectives, risk tolerance, liquidity needs and time horizon. Only then can an investor begin to review how alternatives might serve as a complement to their traditional portfolio. Although alternative investments have varying degrees of risk and return, they may be able to contribute to improved overall returns on a portfolio due to their lower correlation to traditional investments.

Investing in the “new normal” requires investors to rethink their approach to portfolio construction. Now more than ever, individuals need to develop tailor-made solutions that address today’s financial challenges. There is no one-size-fits-all approach solution to investing and how it relates to alternatives. If you’re worried about how the future looks in regards to the overall financial landscape, maybe it’s time to look at the “new normal” with a new lens.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.

***Alternative Investment Disclosure: Diversification does not assure a profit or protect against loss in a declining market. Portfolios that have a greater percentage of alternatives may have greater risks, and this additional risk can offset the benefit of diversification. Alternative investment strategies such as leveraging, arbitrage and commodities investing are subject to greater risks and volatility than more traditional investment offerings. Although asset allocation among different asset categories generally limits risk and exposure to any one category, the risk remains that an asset category could perform poorly relative to the other asset categories. Some of those risks include general economic risk, geopolitical risk, commodity-price volatility, counter party and settlement risk, currency risk, industry concentration risk, leveraging risk, market risk, liquidity risk, real estate investment risk, and sector risk.***