Category Archives: Retirement Planning

June 14, 2018

An Intriguing Exit Strategy for Today’s Business Owner

Written by Andrew Hunt

One of the more difficult challenges facing a business owner is the formulation of a viable and economically beneficial exit strategy at retirement. Typically, the main goals of such an exit strategy are: 1) to identify a qualified buyer; and 2) to receive fair compensation for the business, which would, in turn, translate into a desirable retirement income. One obstacle in realizing these goals is the substantial capital gain that is often attributable to the sale of company stock. For some owners, one method of finding a suitable buyer, and at least delaying payment of capital gains taxes, is to sell stock back to the company in the form of an employee stock ownership plan (ESOP). For others, the realization of a significant capital gain proves to be a major psychological stumbling block that delays action, and results in maintaining stock ownership much longer than desired or initially anticipated. In either case, the charitable remainder trust (CRT) can be a practical mechanism for eliminating the capital gains tax issue altogether, while assisting the business owner in meeting his or her goals.

The CRT is a highly effective financial planning tool that can: 1) remove assets from a donor’s estate; 2) avoid current capital gain on the transfer of appreciated assets; 3) provide the donor with a potentially significant charitable deduction; 4) benefit a donor’s charity of choice; and 5) provide the trust beneficiary (usually the donor) with a steady income stream for life or over a term of years (not to exceed 20 years). The minimum income payout from a CRT is 5%, while the maximum is 50% (the payout rate must also satisfy rules under the Taxpayer Relief Act of 1997). Typically, the payout rate is somewhere between 5% and 12%. In addition, the charitable deduction is based on the amount of time the charity must wait to receive payment, the percentage rate payable to non-charitable beneficiaries, and the current rate of return as determined by the applicable federal rate (i.e., a monthly rate based on the interest rate the federal government pays on borrowed funds).

An owner who has already sold stock to an ESOP, as well as an owner who has yet to do so, can equally benefit from using a CRT. However, an owner who has already sold all, or a portion, of his or her stock to an ESOP will face additional technical requirements that merit closer examination.

Understanding ESOPs

ESOPs are defined contribution retirement plans and are subject to the same guidelines imposed on 401(k) and profit-sharing plans. However, ESOPs are designed to invest primarily in the stock of the business in which the employees work. As such, an ESOP gives all employees a vested interest in the profitability of the company—as the company’s fortunes increase, so does the value of each employee-shareholder’s stock.

An ESOP basically functions as a private marketplace, enabling retiring employees to recognize a retirement benefit by selling their shares back to the ESOP. For example, an ESOP is then used to buy out the interest of a retiring owner, providing an alternative to selling the business (or an owner’s share of the business) to an outsider. Frequently, the ESOP borrows from a commercial lender and uses the funds to purchase the shares of the withdrawing shareholder. The corporation is entitled to an income tax deduction for contributions to the ESOP, which are then used to pay both principal and interest payment on the loan.

Another significant benefit is that gain on the sale can be deferred under Internal Revenue Code Section 1042 if the ESOP holds at least 30% of the retiring owner’s company stock after the sale and the seller reinvests the proceeds into qualified replacement property (generally defined as securities of U.S. domestic operating corporations). This so-called “Section 1042 rollover” must take place within a “qualified period” (beginning three months prior to the date of the sale and ending twelve months after the sale), and the ESOP must have no publicly-traded stock outstanding. However, nonrecognition of gain is only allowed if the owner-shareholder has held the shares for at least three years prior to the sale to the ESOP.

While a retiring owner can liquidate his or her interest in the business on a tax-advantaged basis using a Section 1042 transaction, he or she should be aware of some limitations. From an investment perspective, the definition of qualified replacement property is somewhat restrictive. —it does not include mutual funds, real estate investment trusts (REITs), or U.S. government and municipal bonds. In addition, the deferral of taxation ends once the qualified replacement property is sold. Thus, active management of a qualified replacement property portfolio is not possible without incurring capital gains taxes. When these factors are taken into consideration, some estate planners have come to view qualified replacement property assets as ideal for funding a CRT. (Note: There may be a 10% excise tax for the plan sponsor if the ESOP does not hold on to the newly acquired stock for at least three years.)

Timing of the Stock Transaction

While the ESOP does serve a critical purpose (by creating a marketplace for the owner’s company stock), it is not necessary to sell stock to an ESOP prior to funding a CRT. Thus, an owner who has yet to take action may be better served to transfer the stock directly to the CRT, and then allow the CRT to sell the stock to the ESOP (or other qualified buyer). By doing so, the tax reporting and technical requirements for qualified replacement property under Section 1042 become a nonissue. Nevertheless, an owner who has already sold all, or a portion, of his or her stock to an ESOP may enjoy the same benefits of a CRT—the only difference being the reporting and technical requirements under Section 1042.

Since the CRT is a tax-exempt entity, it can sell the funding assets with reduced capital gains consequences. The CRT can then reinvest the proceeds without restrictions—with the ultimate goal of the donor (in this case, the selling shareholder) being the recipient of a steady income stream from the trust assets (in actuality, a portion of the income payout may be a capital gain distribution).

Moreover, there may be additional flexibility if the CRT is designed as a unitrust, as opposed to an annuity trust, because a unitrust can accept additional contributions while an annuity trust cannot. Since there is often a desire to sell company stock to an ESOP (or other buyer) in stages, the opportunity exists for funding the unitrust in stages.

A Viable Combination

An owner planning for withdrawal from his or her business (such as retirement) faces a variety of challenges that can have an impact on both the business and the owner’s estate. While an ESOP assures ownership will remain within the company, the CRT/ESOP combination can be a powerful business liquidation/estate maximization strategy. However, it is important for a business owner to recognize that how assets are transferred to the CRT (either in the form of qualified replacement property or actual company stock), generally, will have little impact on the effectiveness of the CRT. Thus, individual circumstances often play a greater role in dictating the timing of the sale of stock to an ESOP. Regardless of the situation, as is the case with all advanced planning issues, a thorough review of a business owner’s long-term goals and objectives is essential to determine an appropriate course of action.

March 21, 2018

You, Your Financial Well-Being, and the Federal Reserve

Written by Andrew Hunt

After nearly a decade of leaving the federal funds rate at zero percent, the time finally came on December 16, 2015: The U.S. Federal Reserve (the Fed) raised the federal funds rate by 0.25 percent. Because it was the first rate increase since June 2006, it was reported as “a historic moment.” Since then, the Fed has made several modest increases. You can find the most recent rate changes reported here.

But what do these rate changes mean to your financial well-being? Is there anything you should “do” to your investment portfolio when they occur? As is nearly always the case for economic events over which we have no control, we typically recommend that you remain informed – but that you act only on factors you can expect to manage within your personal investing.

In that context, let’s take a moment to share some insights about the Federal Reserve funds rate.

What Is the Federal Reserve?

As described on its consumer education site, the Federal Reserve is the central bank of the U.S. It was created by Congress as an independent government agency in 1913 “to provide the nation with a safer, more flexible, and more stable monetary and financial system.” Jerome Powell is its current board of governors’ chair. Before Powell, the chairs were Janet Yellen, Ben Bernanke and Alan Greenspan.

Powell and his board of governors are based in Washington, DC. They also oversee 12 regional reserve branches across the country and are tasked with three main roles:

  1. Monetary Policy – Promoting “maximum employment, stable prices and moderate long-term interest rates”
  2. Supervision and Regulation – Overseeing U.S. banks and gathering information to understand financial industry trends
  3. Financial Services – Serving as a bank for U.S. banks as well as for the country’s monetary operations – issuing currency, managing the government’s bank accounts, borrowing money in the form of U.S. Savings bonds and more

What Is Going On?

While you wouldn’t want to run a country without all three of these roles in place, monetary policy is where much of the headline-grabbing action is often found. The Fed continuously grapples with when, by how much, and how often it should raise the federal funds rate.

The Federal Reserve sets monetary policy through its Federal Open Market Committee (FOMC), which includes the Fed’s board members and a rotating representation of Reserve Bank presidents.

The FOMC holds eight regularly scheduled annual meetings to consider what actions to take (if any). In the days before those meetings, the financial press often reports on expected outcomes as if they were a done deal, and markets often respond accordingly. In reality, until those meetings have taken place, nobody knows what their outcome will be.

Still, while the FOMC has a number of ways to seek balance among the competing demands of the economy, raising or lowering the federal funds rate has long been one of its more powerful management tools. So, it’s no wonder the question becomes the media’s central focus whenever the FOMC is set to meet. It’s also no wonder that investors are bombarded with the usual volume of conflicting coverage on what is and is not at stake, and what may or may not come to pass. Depending on who you heed, higher federal funds rates could be anything from a panacea, to a global scourge, to a non-event in the markets.

What Does All This Mean to You and Your Money?

First, it helps to understand that there is an intricate interplay between developed nations’ monetary policies, global interest rates and the markets in general. Anyone who claims to know exactly what will happen in one arena when we pull a lever in another had best be able to present a functioning crystal ball if he or she is to be believed.

To cite one example, consider this March 2018 column by Wall Street Journal columnist Jason Zweig, in which he chastises various brokers for their still-anemic sweep account yields despite rising interest rates: “The Federal Reserve has driven short-term interest rates up a full percentage point since late 2016; one-month Treasury bills were yielding 1.6% this week. But you’d never know any of that from looking at the returns on the cash in your brokerage account.”

This illustration also demonstrates that the only interest rate the Fed has direct control over is the U.S. federal funds rate, which is the rate at which depository institutions (mostly banks), lend and borrow overnight funds with one another.

The resulting cash flow is the grease that turns the wheels of the country’s federal banking system, so it’s an important factor. But as Zweig illustrates, that doesn’t mean that there is a consistent cause-and-effect relationship between federal funds rate movements and other yields-based financial instruments such as U.S. or international fixed income funds, interest-earning accounts, mortgages, credit cards and so on.

A separate Wall Street Journal article substantiates: “Think all rates would tick a little higher as the Fed tightens? That isn’t how it works. … The impacts will be uneven. Some borrowing costs are likely to rise closely in sync with short-term rates, but others won’t.”

Why is this so? It’s partly the result of those multiple global factors at play, with the Fed’s actions representing only one among many others. A post by “The Grumpy Economist” John Cochrane even suggests that the Fed’s actions may be one of the less-significant factors involved: “Lots of deposits (saving) and a dearth of demand for investment (borrowing) drives (real) interest rates down, and there is not a whole lot the Fed can do about that. Except to see the parade going by, grab a flag, jump in front and pretend to be in charge.”

What Should You Do?  

Whenever you’re wondering how best to respond to a shifting landscape such as that wrought by rising (or falling) interest rates and any related repercussions, begin by asking yourself: What can I do about it?

Unless you are Fed chair Jerome Powell, there is probably nothing you can do to personally influence what the Feds are going to decide about ongoing interest rates, or how the global markets are going to respond to the news. But there is plenty you can do to help or harm your own wealth interests.

First, if you already have a solid financial plan in place, we do not recommend abandoning it in rash reaction to unfolding news. If, on the other hand, you do not yet have a well-built plan and portfolio to guide the way, what are you waiting for? Personalized financial planning is a good idea in all environments.

Next, recognize that rising or falling interest rates can impact many facets of your wealth: saving, investing, spending and debt. A conversation with a wealth manager is one way you can position yourself to make the most of multi-factored influences in unfolding economic news.

Together and through varied interest rate climates, we can help put these and many other worldwide events into the context they deserve, so you can make informed judgments about what they mean to your own interests. The goal is to establish practical ways to manage your debt; wise ways to save and invest; and sensible ways to spend, before and in retirement.

These are the factors that matter the most in your life, and over which you can exercise the most control – for better or for worse. Give us a call today if we can help make things better for you.

January 31, 2018

The Vital Role of Rebalancing

Written by Andrew Hunt

If there is a universal investment ideal, it is this: Every investor wants to buy low and sell high. What if we told you there is a disciplined process for doing just that, and staying on track toward your personal goals while you’re at it? Guess what? There is. It’s called rebalancing.

Rebalancing: How It Works

Imagine it’s the first day of your investment experience. As you create your new portfolio, it’s best if you do so according to a personalized plan that prescribes how much weight you want to give to each asset class. So much to stocks, so much to bonds … and so on. Assigning these weights is called asset allocation.

Then time passes. As the markets shift around, your investments stray from their original allocations. That means you’re no longer invested according to plan, even if you’ve done nothing at all; you’re now taking on higher or lower market risks and expected rewards than you originally intended. Unless your plans have changed, your portfolio needs some attention.

This is what rebalancing is for: to shift your assets back to their intended, long-term allocations.

A Rebalancing Illustration

To illustrate, imagine you (or your advisor) has planned for your portfolio to be exposed to the stock and bond markets in a 50/50 mix. If stocks outperform bonds, you end up with too many stocks relative to bonds, until you’re no longer at your intended, balanced blend. To rebalance your portfolio, you can sell some of the now-overweight stocks, and use the proceeds to buy bonds that have become underrepresented, until you’re back at or near your desired mix. Another strategy is to use any new money you are adding to your portfolio anyway, to buy more of whatever is underweight at the time.

Either way, did you catch what just happened? Not only are you keeping your portfolio on track toward your goals, but you’re buying low (underweight holdings) and selling high (overweight holdings). Better yet, the trades are not a matter of random guesswork or emotional reactions. The feat is accomplished according to your carefully crafted, customized plan.

Portfolio Balancing: A Closer Look

In reality, rebalancing is more complicated, because asset allocation is completed on several levels. First, we suggest balancing your stocks versus bonds, reflecting your need to take on market risk in exchange for expected returns. Then we typically divide these assets among stock and bond subcategories, again according to your unique financial goals. For example, you can assign percentages of your stocks to small- vs. large-company and value vs. growth firms, and further divide these among international, U.S., and/or emerging markets.

One reason for these relatively precise allocations is to maximize your exposure to the right amount of expected market premiums for your personal goals, while minimizing the market risks involved by diversifying those risks around the globe and across sources of returns that don’t always move in tandem with one another. We are guided by these tenets of evidence-based investing.

Striking a Rebalancing Balance

Rebalancing using evidence-based investment strategies is integral to helping you succeed as an investor. But like any power tool, it should be used with care and understanding.

It’s scary to do in real time. Everyone understands the logic of buying low and selling high. But when it’s time to rebalance, your emotions make it easier said than done. To illustrate, consider these real-life scenarios.

  • When markets are down: Bad times in the market can represent good times for rebalancing. But that means you must sell some of your assets that have been doing okay and buy the unpopular ones. The Great Recession of 2007–2009 is a good example. To rebalance then, you had to sell some of your safe-harbor holdings and buy stocks, even as popular opinion was screaming that stocks were dead. Of course history has shown otherwise; those who did rebalance were best positioned to capture available returns during the subsequent recovery. But at the time, it represented a huge leap of faith in the academic evidence indicating that our capital markets would probably prevail.
  • When markets are up. An exuberant market can be another rebalancing opportunity – and another challenge – as you must sell some of your high flyers (selling high) and rebalance into the lonesome losers (buying low). At the time, this can feel counterintuitive. But disciplined rebalancing offers a rational approach to securing some of your past gains, managing your future risk exposure, and remaining invested as planned, for capturing future expected gains over the long-run.

Costs must be considered. Besides combatting your emotions, there are practical concerns. If trading were free, you could rebalance your portfolio daily with precision. In reality, trading incurs fees and potential tax liabilities. To achieve a reasonable middle ground, it’s best to have guidelines for when and how to cost-effectively rebalance. If you’d like to know more, we’re happy to discuss the guidelines we employ for our own rebalancing strategies.

The Rebalancing Take-Home

Rebalancing using evidence-based investment strategies makes a great deal of sense once you understand the basics. It offers objective guidelines and a clear process to help you remain on course toward your personal goals in rocky markets. It ensures you are buying low and selling high along the way. What’s not to like about that?

At the same time, rebalancing your globally diversified portfolio requires informed management, to ensure it’s being integrated consistently and cost effectively. An objective advisor also can help prevent your emotions from interfering with your reason as you implement a rebalancing plan. Helping clients periodically employ efficient portfolio rebalancing is another way we seek to add value to the investment experience.

January 24, 2018

Dimensional’s Advisor 2017 Market Review

Written by Jason Hiley

Happy New Year! With 2017 in the rearview mirror, we’re pleased to reflect on – and share with you – a newly released Dimensional Fund Advisors 2017 Market Review.

Overall, the view is quite pleasant for most global and domestic returns alike, even though few financial forecasters were predicting this sort of slam dunk at the outset of the year. If you think back to last January, there were plenty of reasons to wonder about the next 12 months – what with Brexit uncertainties, U.S. election upsets, continued terrorist threats hitting all too close to home, and the usual litany of other unknowns.

Digging deeper into the heady, mostly double-digit 2017 stock market returns, there’s another important theme found in this year’s data: While the profitability premium was positive across most markets, small-cap and value premia often underperformed their large-cap and growth counterparts.

These data points are relevant, because a typical evidence-based investment strategy calls for steadfast diversification across these expected sources of market premiums (as always, according to your unique financial goals and risk tolerance).

It’s especially pertinent to those who may be tilting their portfolio mix toward the very premia that happened to relatively underperform this year. If that’s you, and you’re in pursuit of these factors’ higher expected long-term returns, you may be wondering: “Should I alter my plans?

Unless your own goals or circumstances have changed, our short, evidence-based answer is, no, probably not. As described in Dimensional’s Year in Review, “Premiums can be difficult if not impossible to predict and relative performance can change quickly, reinforcing the need for discipline in pursuing these sources of higher expected returns.”

To use an analogy, think of your investment experience as a cross-continental trek. You get to define your desired destination – although, as in real life, you aren’t guaranteed to reach it. In pursuit of your journey’s end, you also get to choose between a low, slow, temperate trail (lower risk and lower expected returns), or a potentially swifter route with more peaks, valleys and weather extremes (higher risk and higher expected returns).

Whichever route you’ve chosen for your financial journey, don’t be too surprised when you encounter what you’ve signed up for. And remember, the most likely way to achieve your goals is almost always in the form of a steadfast, forward march.

Which brings us to our fundamental advice, this and every year. If you’ve not yet put your investment plans in place, consider that among your most important New Year’s resolutions. Balance your risk and expected return exposures according to what you want and need out of the markets. After that, enjoy the balmy returns where they exist and as they last. Be prepared to soldier through the storms when they periodically arise as well.

Last but never least, let us know how we can help.

 

September 25, 2017

Divorce Division of Assets: QDRO Part 1

Written by Jason Hiley

One of the toughest realities to prepare for after a divorce—and especially after a difficult one—is the division of financial assets. Wealth accumulated throughout a life’s hard work could be severely and negatively impacted in a matter of months, creating problems that could continue for years if the proper details are not attended to during the divorce proceedings. That is why today we will be discussing one of the most important acronyms to pay attention to during a divorce settlement: QDRO.

What Is a QDRO?

A qualified domestic relations order (QDRO) is a court order, judgment, or decree that allows a qualified retirement plan, such as a 401(k), 403(b), or pension, to pay benefits to the former spouse (or other dependent individual) in addition to the individual who controls and contributes to the plan. Without a QDRO, the alternate payee (the person assigned to share these types of benefits) is not entitled to receive any monies the plan will pay out. A QDRO agreement does not extend to include outside workplace retirement accounts such as savings/checking accounts, houses, etc.

Steps to Acquire a QDRO

Approval of a QDRO, which is finalized when the divorce itself is finalized, is generally granted before the divorce judgment is handed down. Any competent divorce attorney will know the steps needed to obtain a QDRO during the negotiation phase of a divorce.

But let’s say that a QDRO was not drafted for approval by your spouse, the retirement plan itself, or the judge during the proceedings for your divorce. This does not mean that you are out of luck. There is still a chance that you can obtain a QDRO and receive a fair portion of your now-ex-spouse’s retirement account. Here is what you need to do in order to make that happen:

  1. Sit down with an attorney who specializes in QDROs. Generally speaking, negotiating a QDRO during the divorce proceedings makes the division of assets easier. Once that time has passed, however, meeting with a lawyer to discuss how to obtain a QDRO will still ensure that you have the best chance to receive a post-decree settlement. The American Academy of Matrimonial Lawyers is one resource you could consider using to locate an attorney who specializes in family law which includes QDROs. It is important to lay out a clear legal plan before the proceedings.
  2. Send the resulting QDRO draft to the retirement/pension plan administrator. This is the most important step in the QDRO process. If the retirement/pension plan rejects your draft, you’ve wasted valuable time, which could prove costly. Oftentimes, the plan will return a copy of the draft with suggestions for changes based on the plan’s own rules and regulations. Consulting with an attorney with expertise in the QDRO process might enable you to circumvent some of these issues.
  3. Get the needed signatures from a judge and all affected parties. Once the retirement/pension plan has given its approval, it is important to obtain signatures from a divorce judge and all interested parties. The sooner this step is completed, the closer you will be to receiving your share of the benefits.
  4. Send a copy to the pension/retirement plan. Send the pension/retirement plan administrator a copy of the QDRO for approval. This will ensure that the benefits are paid out.

The steps listed above might take only a few months to complete, if everything happens quickly. Any delay, however, will mean more time before you receive the benefits, assuming all is in order. If your former spouse remarries or dies, it will become almost impossible to get any portion of the retirement account from the employer.

Divorce is one of the most difficult events a person may have to go through in life, and the aftermath of a divorce can be harder to handle if the marital assets were not divided well. A QDRO could be one of the most important financial documents obtained during this emotionally charged period of time. Seeking advice from a team of legal and financial experts will do wonders for your financial well-being and give you peace of mind.

June 29, 2017

A Checklist for Retirement Planning

Written by Jason Hiley

The time to begin planning for your financial future is now. So, when it comes to preparing for retirement, the earlier you start, the better. Here are some steps to help you achieve your overall objectives:

  1. Review your current financial situation by assessing your income and assets versus your expenses and liabilities.
  2. At first, determine a realistic amount to contribute regularly to your employer-sponsored qualified retirement plan, e.g., a 401(k) plan. Over time, try to maximize allowable contributions to your savings plan and take advantage of the company match, if offered.
  3. In 2017, you can contribute up to $5,500 into a traditional Individual Retirement Account (IRA) or Roth IRA. If you are age 50 or older, you can contribute an additional $1,000. Depending on your participation in other qualified plans, contributions to a traditional IRA may be tax deductible. Earnings for both traditional and Roth IRAs have the potential to grow on a tax-deferred basis.
  4. Work toward reducing your debt. Pay off large bills as soon as possible. Curb your spending to avoid taking on any new debt that could carry over into retirement.
  5. Consult with a qualified professional about your life, health, and disability income insurance policies to determine the amount of coverage for your current and future needs.
  6. Find out how much you can expect to receive in retirement from pension plans, veterans’ benefits, or Social Security. To get an estimate on your future Social Security benefits, visit www.socialsecurity.gov.
  7. Analyze which expenses are likely to decrease after you retire (clothing, commuting, etc.) and which are likely to increase (medical, travel, etc.), and plan accordingly.

If you adhere to your checklist, you may see your savings increase as you get closer to reaching your retirement income goals. Remember, it is never too early to start planning for your future.

March 24, 2017

An Index Overview Part IV: Index Investing – Opportunities and Obstacles

Written by Andrew Hunt

Legend has it, a pharmacist named John Pemberton was searching for a headache cure when he tried blending Coca leaves with Cola nuts. Who knew his recipe was destined to become such a smashing success, even if Coca-Cola® never did become the medicine Pemberton had in mind?

In similar vein, when Charles Dow launched the Dow Jones Industrial Average (the Dow), his aim was to better assess stock prices and market trends, hoping to determine when the market’s tides had turned by measuring the equivalent of its incoming and outgoing “waves.” He chose industrials (mostly railroads) because, as he proposed in 1882, “The industrial market is destined to be the great speculative market of the United States.”

While the actively minded Dow never did achieve market-timing clairvoyance (and neither has anyone else we’re aware of), he did devise the world’s first index. We’d like to think his creation turned into something even greater than what he’d intended – especially when Vanguard founder John Bogle and other pioneers leveraged Dow’s early work to create among the most passive ways to invest in today’s markets: the index fund.

Bogle launched the first publicly available index fund in 1976. Initially dismissed by many as “Bogle’s folly,” its modern-day rendition, the Vanguard 500 Index Fund, remains among the most familiar funds of any type.

Index Investing Is Born

In defense of Dow’s quest to forecast market movements, it’s worth remembering that his was a world in which electronic ticker tape was the latest technology, there were no open-ended mutual funds or fee-only financial advisors, and safeguards and regulations were few and far between. Essentially, speculating was the only way one could invest in late-nineteenth century markets.

Compared to actively managed funds that seek to “beat” the market by engaging in these now-outdated speculative strategies, passively managed index funds offer a more solid solution for sensibly capturing available market returns. As the name implies, an index fund buys and holds the securities tracked by a particular index, which is seeking to represent the performance of a particular slice of the market. For example, the Vanguard 500 Index Fund tracks the popular S&P 500 Index, which in turn approximately tracks the asset class of U.S. large-company stocks.

Compared to actively managed solutions, index funds lend themselves well to helping investors more efficiently and effectively target these three pillars of sensible investing:

  1. Asset allocation – How you allocate your portfolio across various market asset classes plays a far greater role in varying your long-term portfolio performance than does the individual securities you hold.
  2. Global diversification – Through broad and deep diversification, the sum of your whole risk can actually be lower than its individual parts.
  3. Cost control – The less you spend implementing a strategy, the more you get to keep.

Index Investing: Room for Improvement

As we’ve described throughout this series, indexes weren’t specifically devised to be invested in. There’s often a lot going on underneath their seemingly simple structures that can lead to inefficiencies by those trying to retrofit their investment products on top of popular indexes.

Index Dependence – Whenever an index “reconstitutes” by changing the underlying stocks it is following, any funds tracking that index must change its holdings as well – and relatively quickly if it’s to remain true to its stated goals. In a classic display of supply-and-demand pricing, this can generate a “buy high, sell low” environment as index fund managers hurry to sell stocks that have been removed from the index and buy stocks that have been added.

Compromised Composition – Asset allocation is based on the premise that particular market asset classes exhibit particular risk and return characteristics over time. That’s why your investment “pie” should be carefully managed to include the right asset class “slices” for your financial goals and risk tolerances. As we described in Part III of this series, if you’re invested in an index fund and you aren’t sure what its underlying index is precisely tracking, you may end up with off-sized pieces of pie. For example, the S&P 500 and the Russell 3000 are both positioned as U.S. stock market indexes, but both also track some real estate. If you don’t factor that into your plans, you can end up with a bigger helping of real estate than you had in mind.

Introducing Evidence-Based Investing

So, yes, index investing has its advantages … It also has inherent challenges. No wonder academically minded innovators from around the globe soon sought to improve on index investing’s best traits and minimize its weaknesses. In fact, many of these thought leaders were the same early adapters who introduced index fund investing to begin with. Building on index investing, they devised evidence-based investment funds, to offer several more advantages:

Index-independence – Instead of tracking an index that tracks an asset class … why not just directly capture the asset class itself as effectively as possible? Evidence-based fund managers have freed themselves from tracking popular indexes by establishing their own parameters for cost-effectively investing in most of the securities within the asset classes being targeted. This reduces the need to place unnecessary trades at inopportune times simply to track an index. It also allows more patient trading strategies and scales of economy to achieve better pricing.

Improved Concentration – Untethering themselves from popular indexes also enables evidence-based fund managers to more aggressively pursue targeted risk factors; for example, an evidence-based small-cap value fund often has more flexibility to hold smaller and more value-tilted holdings than a comparable index fund. This provides more refined control for building your personal investment portfolio according to your unique risk/return goals.

Focusing on Innovative Evidence – Evidence-based investing shifts the emphasis from tracking an index, to continually improving our understanding of the market factors that contribute to the returns we are seeking. By building portfolios using fund managers who apply this same evidence to their funds, you can make best use of existing academic insights, while efficiently incorporating credible new ones as they emerge.

An Index Overview, Revisited

From describing an index’s basic functions, to exploring some of the intricacies of their construction, we’ve covered a lot of ground in this four-part series on indexing. To recap, indexes can help us explore what is going on in particular slices of our capital markets. In the right context, they also can help you compare your own investment performance against a common benchmark. Last but not least, you can invest in funds that track particular indexes.

Equally important, remember that indexes do not help us forecast what to expect next in the markets, nor do high-water markets such as “Dow 20,000” foretell whether it’s a good or bad time to buy, hold or sell your own market holdings. And, while low-cost, well-managed index funds may still play a role in your overall investment portfolio, it’s worth ensuring that you select them when they are the best fit for your evidence-based investment strategy, not simply because they are a popular choice at the time.

What else can we tell you about indexes or index investing? Let’s take a look at your unique financial goals, and see how indexing fits into your globally diversified world of investments.

October 27, 2016

Wealth Management for Women: What Makes a Great Advisor? Part 2: Goal Focused Planning

Written by Jason Hiley

How often have you heard that “a penny saved is a penny earned”?

While I can’t claim credit for originating this succinct wisdom, it has served me well over the years — both personally and professionally — in helping my clients make smarter decisions about their money.

But at what point does a “penny saved” become an “experience missed”? When I was a child, my mother took us on wonderful vacations. We traveled to California; Hawaii; Florida; Washington, D.C.; and even Europe. Those were ever-lasting, life-altering experiences that I’m eternally grateful to my mother for. And now, as a parent of two children, I know all too well how expensive family travel can be!

But I often ask myself how much more money could my mom have set aside for her own retirement had we not taken those big trips? Could she have retired a couple of years earlier if that money had been invested instead of spent? The answers to those questions are probably “a lot” and “yes”; yet, I know my mom doesn’t regret a single dollar that she spent on those adventures with us.

The challenge for us all is to find a good balance between living life for today while also planning for tomorrow. That’s why Hiley Hunt Wealth Management advocates goals-based planning for our clients.

Goals-based planning puts the emphasis on what we think matters most: the achievement of your goals. How and where to invest are determined only after defining and then prioritizing your goals. Our goal-setting process is the foundation on which our clients’ financial plans are built.

This process affords a framework from which to make appropriate planning and investment decisions. During this exercise, you might find, as my own mother did, that spending money on creating memories is something that is very important to you. Although choosing to do something like this means that you are saving less money “in the present” for longer-term goals such as the creation of a retirement fund, it does not mean that you can’t successfully accomplish your short- and long-term goals. It simply means adjustments need to be made — you may need to plan to work a few years longer than you originally envisioned, commit to saving more after your children are on their own, or decrease the amount of money you plan to have available in retirement. Goals-based planning makes identifying these kinds of trade-offs possible.

Our financial planning and wealth management process is designed to lead our clients through a series of steps to help them identify goals and values, take stock of where they currently are, and develop a plan to get them where they want to go. The life path that each client travels is unique, so we map out personalized routes to enable each individual to reach his or her financial destination. If you are interested in working with a financial partner who is committed to helping you achieve your goals, contact us today for a complimentary consultation.

 

September 20, 2016

Wealth Management for Women: What Makes a Great Advisor? Part 1: Avoiding Confirmation Bias

Written by Andrew Hunt

Twice a week. Always twice a week.

Neither the oppressive heat nor the insufferable humidity hindered my mom from insisting that the lawn be mowed twice a week.

I had always assumed my mom had a good reason for wanting the lawn to be mowed that often. Perhaps it had something to do with the health of the grass. Maybe it was a strategy to ward off insects. Did it have something to do with water conservation? I was never brave enough to ask, but as I grew older, I figured that twice-weekly mowing made the grass healthy. After all, our yard always looked great!

Fast-forward to my mid 20’s, when I became a homeowner. I was so excited to begin my own twice-weekly mowing ritual for optimal lawn maintenance.

By this time, my parents lived in a villa-type neighborhood where lawn care was included in the monthly association fee. Apparently, the lawn wasn’t mowed twice a week there, because my father revealed to me that he still mowed. “You know how much Mom loves the lines in the grass,” he said.

All this time – all this time! – I had assumed that twice-weekly mowing was part of some larger program with some greater purpose, not something my father did just because my mom liked the lines in the grass! Indeed, I had been the victim of my own confirmation bias.

Confirmation bias is the natural tendency to use new information as confirmation of existing beliefs or theories. For more than 20 years, I thought I knew why lawns should be mowed twice a week. In fact, I had that idea only because I hadn’t asked the right questions and had never looked for information to the contrary.

Confirmation bias is at work in all our lives, and very often it colors the way we invest. We have a tendency to create a theory about an investment opportunity, and then we are drawn to content that confirms our theory.

In an article titled “A Behavioral View of How People Make Financial Decisions,” Keith Redhead explains that investors make financial decisions through a series of biases that shape our perceptions and motivations. Once we have a frame of reference for a decision – especially a decision that involves costs – we engage a part of our brain that encourages us to stay with the status quo. According to Redhead, even after we make a decision to move in a different direction – for example, to buy or sell an investment – we might not follow through with that decision because confirmation bias can lead our brains to overemphasize the case against change. This can be very costly for investors!

A great investment advisor will challenge your natural biases and present information that convinces you to consider the alternatives. But simply shedding light on a conflicting point of view is not enough. Once you have decided to make a change, the natural bias toward the status quo will fight against your motivation to implement the change. Your advisor should keep you accountable, ensuring that you carry out the change you decide to make. After all, a plan is only as good as its execution.

Hiley Hunt Wealth Management is a Registered Investment Advisor dedicated to serving women who are responsible for their household investment portfolio. We would love to connect with you to discuss how we can help you meet your financial goals. To learn more about how we work with our clients, please visit hileyhunt.com/what-to-expect.

May 17, 2016

Our Mixed Up, Messed Up Relationship with Investment Risk

Written by Jason Hiley

“What the imagination can’t conjure, reality delivers with a shrug.”

Trumbo (movie voice-over)

Whether it’s the recent destruction wrought by Canada’s Fort McMurray oil sands wildfire, a potential June “Brexit” from the European Union, or uncertainty surrounding this year’s US presidential election, there is plenty of risk to go around as we swing into another busy summer.

Is investing riskier than usual these days? In our experience, probably not. If there is such a thing as “normal” in this world of ours, risk is certainly built into the definition. Besides, investors often love and hate risk in a mixed up, messed up relationship. How so? Let us count the ways.

One: We Underestimate Risk.

It’s one thing when we imagine risk and its potential impact on our lives and our investments. It’s quite another when it really happens. That’s why it’s possible to live in a world where there are song lyrics romanticizing a horse named Wildfire. When the real inferno unfolds, we quickly realize how unromantic it is.

In investing, underestimating risk can trick you into believing that you can tolerate far more of it than you actually can. As financial columnist Chuck Jaffe has wryly observed: “[A] common mindset is ‘I can accept risks; I just don’t want to lose any money.’”

Unfortunately, we can’t have it both ways. When the risk comes home to roost, if you panic and sell, it’s usually at a substantial loss. If you manage to hold firm despite your doubts, you may be okay in the end, but it might inflict far more emotional distress than is necessary for achieving your financial goals. Who needs that?

Two: We Overestimate Risk.

On the flip side, we also see investors overestimate risk and its sibling, uncertainty. We humans tend to be loss-averse (as first described by Nobel Laureate Daniel Kahneman and his colleague Amos Tversky), which means we’ll exaggerate and go well out of our way to avoid financial risk – even when it means sacrificing a greater likelihood for potential reward.

This summer already is destined to deliver plenty of uncertain outcomes. On the political front, there are the especially stark contrasts found among the US presidential candidates. For better or worse, whichever candidate prevails is likely to set the tone for the country if not the world. The “stay or go” uncertainty surrounding the June 23 Brexit vote could also impact financial markets in significant ways. Then there are the usual suspects, such as oil prices, continued Middle Eastern unrest and so on and so forth.

We don’t mean to downplay the real influence world events can have on your personal and financial well-being. But the markets tend to price in the ebbs and flows of unfolding news far more quickly than you can trade on them with consistent profitability. So it’s a problem if you overestimate the lasting impact that this form of risk is expected to have on your individual investments.

Three: We Misunderstand Risk.

Especially when colored by our risk-averse, fight-or-flight instincts, it may seem important to react to current financial challenges by taking some sort of action – and fast.

Instead, once you’ve built a globally diversified, carefully allocated portfolio that reflects your personal goals and risk tolerances, you’re usually best off disregarding both the good and bad news that is unfolding in real time. This makes more sense when you understand the role that investment risks play in helping or hindering your overall investment experience. There are two, broadly different kinds of risks that investors face.

Avoidable Concentrated Risks – Concentrated risks are the kind we’ve been describing so far – the ones that wreak targeted havoc on particular stocks, bonds or sectors. In the science of investing, concentrated risks are considered avoidable. They still happen, but you can dramatically minimize their impact on your investments by diversifying your holdings widely and globally. That way, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with other, unaffected holdings.

Unavoidable Market Risks – At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (Its spending power may be eroded due to inflation, but that’s yet another kind of risk, for discussion on a different day.) Invest in the market and, presto, you’re exposed to market-wide risk that cannot be “diversified away.”

Four: We Mistreat Risk.

It’s a delicate balance – neither overestimating the impact of avoidable, concentrated risks nor underestimating the far-reaching market risks involved. Either miscalculation can cause you to panic and sell out or sit out of the market, thus missing out on its long-term growth.

In contrast, those who stay invested when market risks are on the rise are better positioned to be compensated for their loyalty with higher expected returns.

In many ways, managing your investments is about managing the risks involved. Properly employed, investment risk can be a powerful ally in your quest to build personal wealth. Position it as a foe, and it can become an equally powerful force against you. Friend or foe, don’t be surprised when it routinely challenges your investment resolve.

Respect and manage return-generating market risks. Avoid responding to toxic, concentrated risks. These are the steps toward a healthy relationship with financial risks and rewards.