Financial Planning Stuff You Need to Know

I saw an ad in today’s Wall Street Journal by Columbia/Bank of America Funds stating that they are #1 in Barron’s 5-Year Mutual Fund Family Ranking.  I immediately smelled a rat and began reading the fine print.  A different story emerged:

• They are #17 over a 10-year period (a better indicator of long-term performance)

• They excluded 12b-1 fees (pays for ads “like the one in the WSJ, and payments to brokers and others to sell their funds) and sales charges (commissions) from the calculations.

• They stated the following: Had 12b-1 fees or sales loads been included, rankings would have been lower.

The next time you want to buy a Columbia mutual fund sold by a broker make sure to tell him you want that without sales loads or 12b-1 fees, and see what the broker says.

Unfortunately for people who buy these loaded overpriced funds — this ain’t Burger King and you can’t have it your way.

The Wall Street Journal named the Bright Start Illinois 529 plan one of the top 529 plans in the country. The main reasons included:

• Low Expenses (Bright Start uses Vanguard Index Funds a favorite of mine)
• Diverse Investment choices

In addition Illinois residents receive a state tax deduction for contributions to a Bright Start 529 plan.  Note: The Bright Start Plan cannot be purchased through a financial adviser, although your adviser can certainly assist you in completing your application.

To find out more about the Illinois Bright Start plan go to https://www.brightstartsavings.com/

There has recently been a lot of press about many bond funds that have tanked recently due to investments in securities backed by subprime mortgages.

For example the Wall Street Journal reported today that the Schwab Yield Plus bond fund is down 24% so far this year, and the Fidelity Ultra-Short Bond Fund is down 7.3%.  Contrast that to the Vanguard Total Bond Market index fund which is up 2.1% this year.

Of course the Schwab fund was the darling of Wall Street and the fund manager was touted as one of the best by the firm according to the Journal article.

The collapse of many of the ultra-short funds that invested in securities backed by subprime mortgages proves the old adage that higher return=higher risk.  Of course no one cares about the higher risk until everything collapses.

So when you are thinking about investing in something new and exciting that is performing really well, understand the risk you are taking and don’t chase last year’s returns.

The Wall Street Journal published a front page article this morning entitled Stocks Tarnished By Lost Decade. The article stated that the S&P 500 index is where it was 10 years ago adjusted for inflation. Even including dividends they average return over the last 10 years (ending February, 2008) has only been 1.3%.

There are a few problems with this analysis:

1. The S&P 500 is not the Stock Market. It is made up primarily of large US companies it excludes most small and medium sized companies which make up 20-25% of the US stock market valuation
2. It only looks at US stocks and ignores international stocks
3. It assumes that you invested all of your money up front vs. investing a little over time as most investors in their pre-retirement years do.
4. The 10-year time horizon is too short for stock investments.
5. They only looked at one 10-year time period vs. multiple 10-year periods.

The Journal admits that other stock classes have significantly outperformed the S&P 500 over the last 10 years although they chose not to include them in their analysis. If they had they may have had to eat their words.

A more diversified stock portfolio made up of 55% S&P 500, 20% Small Cap US Stocks, and 20% International Stocks (90% Developed/ 10% Developing), and 5% Real Estate would have yielded an annual return of 6.12% over the 10-year period or more than double the S&P 500 return of 2.46% (neither return is adjusted for dividends or inflation).

The Wall Street Journal has a point that after a great run in the 90s large-cap US stocks have not done as well this decade. They have missed out on the fact that The Stock Market is a lot more than large-cap US Stocks. I hope you don’t make the same mistake.

There is a lot of talk that 2008 could be the year of an economic downturn and a stock market decline. I’m sure I will be getting some press requests to comment on what you should do to prepare your portfolio for a recession.

My Answer: Nothing more that you should be doing today.

1. Check your portfolio to see if it needs rebalancing on every six months or when there is a market change of more than 10%.

1. If your portfolio needs rebalancing, do it! Yes it will mean shifting more of your assets into downtrodden asset classes like real estate, but you will be buying more cheaply than those who did at the top of the market.

1. Continue to invest.  This is no time to stop investing for the long-run by trying to time the market.  Although market timers sometimes are right about when a downturn is coming, they are rarely right about when it is time to get back in and are often left waiting on the sidelines as stocks rise.  (If you think smart people can predict what will happen to stocks in the short run see my next blog on the latest installment of the Chicago Tribune’s stock picking contest.

1. Keep your focus on your long-term goals and things you have the most control over your own spending choices.

I hope that you make great progress towards your goals in 2008!

Many of my clients are interested in SRI. They would like to express their values through their investment strategy and are interested in an advisor who can assist them with developing a strategy based on their values.

If only it were that simple!  There are several levels of understanding involved with SRI:

Level 1 Advisor to Client

The first is from the advisor to the client. Are the advisor’s method of compensation and responsibility to the client in alignment with the clients’ ethics? Most clients prefer to work with a client who does not receive commissions or other third party payments  That way the advisor’s compensation is not influenced by the investment recommendations he or she makes.  This model of compensation is called Fee-Only. Unfortunately the vast majority of advisors do not operate this way.  They receive commissions and most clients do not fully realize how their advisor is compensated.  Even fee-based advisors receive commissions.  In order to advise a client on SRI the advisor’s business practices should also be ethical.

Level 2 Not all SRI Funds are the Same

Once the advisor is treating the client ethically, the next level involves the client’s values.  There are two major types of SRI funds:  Boycotters: those that do not invest in X-type of company and Influencers: those that do invest in X-type of company but try and influence its behavior through its ownership in the company.  The client needs to decide what causes they believe in, and which SRI philosophy they believe in, Boycotter or Influencer.

Level 3 Understanding the Costs/Effects of SRI Investing

This is an area that is not discussed often. Like actively managed funds most SRI funds charge substantially higher fees than index funds (an exception is the Vanguard FTSE Social Choice Index), and may reduce diversification somewhat because many of them do not invest in certain sectors of the economy.  The fee differential is about 1% per year.  For example if you invested $500,000 in SRI funds you would pay mutual fund fees of $6,250/year assuming an annual expense ratio of 1.25%.  If you invested in low cost mutual funds you would pay $1,250/year assuming an expense ratio of 0.25%

Often people also misunderstand the way the SRI funds influence company behavior.  The common misperception is that by not purchasing a company’s stock you have a direct effect on the company’s bottom line.(they strategy of Boycotters).  That is not correct in most cases.  Once a company has issued stock they have their money. Any subsequent stock trades have no direct effect on the company’s finances.  Investors are actually purchasing shares from each other, not the company.

There may be a secondary effect if (a big if) SRI fund actions can suppress the stock price since that will put pressure on the company’s management.  This is the strategy that Influencer SRI funds use.  Although they almost never control enough shares to dictate company policy they can shame or embarrass a company’s management by sponsoring resolutions.  These campaigns can be effective on an issue like Darfur.

Level 4 Are there Alternatives to SRI Funds?

I love for my clients to make their own decisions and not to accept anything uncritically even if it agrees with their overall world view. With that in mind, I have proposed to clients an alternative approach:  Invest in low-cost mutual funds and use the difference to directly fund causes that are important to you.  Although I have no evidence, my belief is that this approach may be more effective in causing the change the client wants to see, especially if desired change is on a local level.

Much of the high fees of SRI funds go to analyzing which companies meet the investment criteria of the fund.  I see this expense as a dead weight loss.  By having the client invest that dead weight loss directly into causes they believe in the money is used directly on the change they wish to see.

Although, only a very few clients have taken this approach, I put it out there as an alternative to think about for people that are interested in SRI.

PS.  If you really want to affect a company’s bottom line DON’T PURCHASE THEIR PRODUCTS or use less of them if the product is a necessity.  This is much more inconvenient, but if enough people do it, so much more effective than not purchasing that company’s stock.

Often the most worthwhile things we do require some sacrifice.

. . .when its earned in the Washington Mutual Savings for Success Account. This is another case of if it’s too good to be true it is.

I was walking by a Washington Mutual Branch (WAMU) today and I saw a sign for a 7.01% APY in BIG LETTERS. I went in and with a little prodding was able to get all of the rules for the account in writing.

Here’ the deal: You can open the account with anywhere between $1 and $500, and then you are required to deposit $25-$500 per month from a WAMU checking account (no interest there!). If you withdraw your funds early you get hit with a 6 month interest charge. This is beginning to sound like a convoluted CD.

Here’s where it gets really bad: I calculated two strategies to see what your actual interest rate would be assuming you kept any un-deposited money in a WAMU checking account earning no interest. If you put in $500 every month, the maximum allowed, your actual return would be only 3.9%. This is less than what ING (www.ingdirect.com) or Emigrant (www.emigrant-direct.com ) pay. The reason: You only earn the full 7% on the first months deposit, on the second month’s deposit you earn 6.43% (11/12ths of 7.01), on the third month 5.84% (10/12ths of 7.01), and on the last month’s deposit only a paltry 0.58% since it was sitting in the checking account earning no interest for 11 months.

You could earn a higher overall interest rate by making a $500 deposit for the first two months and then only $25 per month in months 3-12. This would yield an interest rate of 6.2% since your deposits are front loaded. If you really wanted to game the system, you could theoretically transfer money from a high-yield savings account to a WAMU checking account and then to the Savings for Success account on a just-in-time basis. However, that seems like a lot of hoops to jump through just to get a few extra dollars of interest. Plus if you goof up you get stung with that 6 months of lost interest.

WAMU does offer an online savings account but the terms and interest are not competitive with the best competitors. I don’t think that the current offering changes anything.

PS. You won’t find anything online about this account. I had to ask at the branch for information.