Economic Indicators: News You Can’t Use

Whenever the latest economic indicators are announced, you’re apt to see the numbers make the evening news. As you ponder the latest on industrial production, retail sales, unemployment and other snapshots of economic activity, you may wonder how the information applies to your investment strategy. While the data can be helpful for your business planning, it’s important to recognize that regular announcements of economic indicators mean very little to your investments:

• Recent economic activity offers limited predictive value regarding future economic activity.
• The information already is priced into future market returns by the time you hear of it.
• Business decisions and investment decisions are two very different things.

You should not attach particular value to monitoring those indexes in relationship to your portfolios. Take for instance, the Chicago PMI (ISM-Chicago). The Institute for Supply Management compiles a survey/index of business conditions in the Chicago area, commonly referred to as the Chicago PMI. Many think that overall economic activity in the Chicago area is representative of the overall economy. Still, the Chicago PMI number encompasses the data for that specific dataset only. The same is true for a number like jobless claims, which quantify new unemployment claims that are compiled weekly to show the number of individuals who filed for unemployment insurance for the first time.

Financial news commentators may choose to analyze the data from economic indicators and attach additional meaning to it. But the data from any indicator is by its nature looking back at a period already passed. The financial markets are leading indicators, meaning that the collective wisdom of the financial markets has already “priced in” much of the economic data before it is even announced.

It is good to know what these indicators are, especially if you are an executive or business owner. But as an investor, your decisions are best made based on factors that are within your control, such as your own long-term financial goals and risk tolerances.

Seeking Second Opinions on Financial Services

If you’re a business owner or executive, you probably spent 2009 reviewing every part of your business, trying to squeeze costs while delivering as much or more service to your customers.  This activity was enlightening and heart wrenching, but it hopefully left you feeling like your company is now better positioned to move forward on stronger footing.

A big part of your business review may have included taking a closer look at your service providers, assessing which were the ones that were going to help you move forward in 2010. You may have sought second opinions to either verify that your existing relationships were built to last or to provide alternatives if they were not.

So, have you completed the same process for your personal income statement and balance sheet?

Toward the end of 2008, a study posted in The Wall Street Journal stated: “81% of investors with $1 million or more in investable assets plan to take money away from their current advisor. … The irritation is especially high at the ‘brand’ firms — large brokerages and banks.” (Robert Frank, “Wealthy Investors Stage Revolt Against Advisors,” The Wall Street Journal Online, September 30, 2008)

So, particularly if your wealth was managed by one of those brand firms, did you act on these kinds of plans?  If you went through the same process with your personal finances that you did at your business, you would have sought a second opinion on your financial advisor, CPA, estate and philanthropic plans, family wealth dynamics and more. 

Second opinions are not sales calls. They are the process of having someone look at your situation with fresh eyes to see any gaps in your planning. Top advisors only want new clients for whom they can add value, so this is a process they are willing to do for free. It’s in their best interest as well as your own to determine if the fit seems right. 

If you haven’t sought a second opinion on your wealth, what’s stopped you? Maybe it is time. In my experience, it usually takes about one hour upfront and one hour to review the findings. Let’s see. It’s free, it will probably help you feel more confident about future financial decisions, and it shouldn’t take more than two hours of your time. Tell me again what you’re waiting for?

Another hurdle can be selecting a good source for that second opinion. To help you with that, check out Larry Swedroe’s blog on the subject, to ensure that you screen for an advisor with whom you’d really want to work if a change is warranted.

Holidays, Families and …

Have you discussed your estate planning with your children lately? Have you ever, for that matter?

There are lots of reasons affluent parents avoid discussing family financial matters — time, discomfort, habit, mistrust, fear — but the results are more universal. If you don’t prepare your children for the privileges and responsibilities that come with wealth, who will? How will they be equipped to make satisfactory, independent decisions about their money?

This year, as the family gathers for the holidays, tear your kids away from their Beatles Rock Bands and Zhu Zhu hamsters. Set aside your own new iPod. Talk to each other for a while about what wealth means to each of you, and how your children can become an integral part of family wealth planning in 2010.

Pre-Teen and Teenagers — There are many affluent families like the Rockefellers, Forbes and Rothschilds, who have raised very productive children. How have they done it? First, they’ve let their children experience their own successes – and their own failures. Confidence and self esteem comes from doing it yourself; be it as a banker, teacher or carpenter. Perhaps this explains why Warren Buffet and Bill Gates are planning to limit their children’s inheritances.

But communication also is important, if daunting. The Financially Intelligent Parent by Eileen Gallo, Ph.D. and Jon Gallo, J.D. provides some great advice on that.[1] The Gallos offer examples of how to combine your values with projects or events that engage your children at various ages. They also emphasize the importance of identifying your financial perspective before you try to share it. Or, as they describe it, “Get your own money stories straight.”

Young Adults — As your children become adults, you may fret about how they are financing those new cars, new homes or grandkids’ upbringing. If you see or perceive that your children may be suffering from debt, it can be tempting to come to the rescue rather than let them fail. It’s a tough lesson to learn but, if we act too quickly to help solve adult children’s financial, educational or emotional problems, we risk extending the failure.

Spanning Generations — Estate planning is another area where communication remains critical. According to the estimates of The Williams Group Organization, “two-thirds of all wealth transfers fail after transition.”[2] It happens even after engaging high-powered estate attorneys and tax planners to set up complex partnerships or trust vehicles. It’s usually not the process that fails, it’s the lack of individual, emotional preparation. Preparing and include your heirs in the planning process – talking to them, that is – doesn’t have to be expensive or complicated, but failing to do so can be.

Doing the Math on Roth IRA Conversions

If you haven’t yet picked a good New Year’s resolution, congratulations, the revised rules for converting IRAs to Roth IRAs have provided a ready-made task for 2010. As of January 1, taxpayers at all wealth levels can convert traditional IRA assets to a Roth IRA.

As The Wall Street Journal commented, “The change – one of the biggest and most important on the IRA landscape in years – will widen the entryway to one of the best deals in retirement planning.”(1)

Like any “best deal,” I hope you will first review the fine print. Yes, the change may offer you important new wealth management opportunities, but it also has become a marketing feeding frenzy, as the many financial product pushers out there realize this may be the chance to attract easy new business by offering to help people with their Roth conversions.

Make no mistake. Opportunities may abound, but so do important caveats. As with any major shift in your strategy, you’ll want to “do the math,” as I like to say, to ensure that all consequences are carefully considered – both the ones that are obvious as well as the ones that require seasoned industry expertise and a deep understanding of your specific wealth profile. Only then can you figure out an equation that sums up well for you.

For an overview of the evolving conversion rules, you can refer to my Fall 2009 newsletter (page 3). The following provides an overview of some of the items I consider under the new rules, when analyzing IRA conversions for my clients. Most issues are covered under these questions:

• Do you have enough wealth to live on without your IRA?
• What are your estate planning needs?
• What are the tax consequences of early conversion?

Do you have enough wealth to live on without your IRA?
(Tax now or tax later?)
As a U.S. citizen obligated to pay income taxes, you are also allowed deductions and exemptions. If you require your IRA assets to support your lifestyle for the remainder of your life, then the distributions you take can or will be offset against these deductions when determining your future taxes. Why would you pay taxes now if, through these deductions, you won’t pay taxes when you take a distribution? That is the question your CPA is going to pose before he or she suggests a conversion. So before you go down this conversion road, you need to do the retirement planning you may have been avoiding since the market meltdown.

What is the appeal of a Roth? Well, for starters, there will be no taxes on any future growth or income and Roth IRAs do not have required minimum distributions. For those who can afford to leave their traditional IRAs to their heirs, they can convert them to Roth IRAs, pay the resulting tax bill, then leave the assets untouched to be passed on without any future taxes on distributions.

What are your estate planning needs?
Will the IRA be left to charity? Donating an IRA to charity is a tax-free event. In this case, it would be imprudent to convert to a Roth because this would create an unnecessary tax bill. This is only one critical example of how your overall estate-planning needs must be taken into consideration as you manage your wealth.

What are the tax consequences of early conversion?
For example, how does your current tax bracket compare with what’s expected in the future? If you expect your tax rate to be lower in the future, which is often the case for older individuals, you may end up paying higher taxes now through a conversion than simply paying taxes later when you receive distributions. On the other hand, if you expect your tax rates to increase which is typically the case for younger individuals, you may see a substantial benefit by paying a lower tax rate now and letting your assets grow tax-free.

I still don’t think any of us predict the future, but doing some math here can be particularly important. Also, an advisor who understands how to maximize allowable recharacterization techniques for structuring your conversion (such as converting into multiple accounts based on asset class exposure), may be able to better effect the most tax-advantaged conversion possible, or perform a timely “undo” if conversion ends up being ill-advised under evolving market conditions.

Have you looked before you leap?
For many, the new rules governing IRA income limits in 2010 represent a window of opportunity. But the conversion decision is not an easy one, as there are many factors to consider. You should work with your wealth advisor and tax experts to determine the tax, estate-planning and overall wealth implications of your decisions.

The “New Normal” Is Old Hat

We humans do love our catch phrases. Sometimes, that’s a good thing. A few words can often capture a whole lot of common understanding without as much boring repetition. Take, “the new normal,” for example. You’ve probably already heard all kinds of financial commentators leading with something like, “In this ‘new normal’ …”  They then explain things to us, assuming as a given that things have changed.

But have they?

Nobody would argue that the past year has been ho-hum. But take a step back from the trees and view the longer history of the financial forest. Dimensional Fund Advisors has provided the chart at right, which shows bull and bear markets, from January 1926 through June 2009. (Click  here, or on the image to view a larger version of it.)

First, I think this excellent visual shows that what is allegedly “new” seems far more likely to be another wave of old. As an added bonus, it shows that the good times generally have lasted longer than the bad, and resulted in more gains than losses.

But the economy is now different, some argue, and has changed the way we should think about investing. In reality, economic indicators such as employment are backward-looking indicators that the market already has incorporated into its forward-looking pricing faster than you can say “same old, same old.” If you ask me, the Rolling Stones had it right when they sang, “Meet the new boss, same as the old boss,” in “Won’t Be Fooled Again.”

Why are so many folks willing to buy into the far less likely scenario that the markets really are new and different? Look to behavioral psychology on that point, and a deeply embedded instinct of ours known as “recency,” or: “the human tendency to estimate probabilities not on the basis of long-term experience but rather on a handful of the latest outcomes” (as defined by Jason Zweig in his great book “Your Money & Your Brain.”1)

If there’s a silver lining in the recent cloudy markets, it’s that most of my clients now better recognize that I’m for real when I repeat over and over one of the unchanged principles of sound investing: risk and reward are related. They now have witnessed first hand — and recently — that risk is not just some mythical creature. It’s a living, breathing monster that periodically comes out to play. Yes, risk is very real. It should never be forgotten, even when it is no longer a recent memory. But so too are the expected returns for taking the risk to begin with. And that’s nothing new.

A Double-Take Worth Taking: The State of the U.S. Economy

Have you noticed how professional speakers often pause and repeat themselves when they’ve gotten to their key talking points? They want to make sure the most important things don’t get lost in the flow. If it’s good enough for President Obama to use repetition for emphasis, then it’s good enough for me.

That’s why I want to reiterate some recommended reading I mentioned a couple of blogs ago: “The U.S. Economic Crisis: Root Causes and the Road to Recovery” (Journal of Accountancy, October 2009). Authored by University of North Carolina at Chapel Hill business school professors Gregory W. Brown and Christian Lundblad, below is the executive summary they provided in their article. Whether or not you agree with every point, these seem like points worth exploring:

•  The root cause of the economic crisis is excessive consumption accompanied by record low savings rates and huge budget and current account deficits.
• Thawing credit markets alone will not mean a rapid economic recovery in output growth and employment.
• Unemployment will remain high in the near term and only decline slowly over many years as adjustments are made in the skills of the labor force.
• Expect inflation to remain low in the near term. Inflation risks will be present in the long run as the result of monetary stimulus provided by the Federal Reserve.
• The current fiscal stimulus package may not be the best approach since it ignores the need to reduce consumption relative to income.
• Higher tax rates and lower spending will be required once the economy has stabilized.

Digging for Gold With Silver Spoons

Family wealth planning is a tricky balancing act under the best of circumstances. No matter who the family is, it involves understanding fiduciary duty, recognizing the difference between beneficiaries and custodians, and accounting for complicated family dynamics. Add particularly large sums of money and public notoriety into the mix, and it’s little wonder that the media has a feeding frenzy whenever stories break involving the wealth of big-name dynasties.

This point was recently driven home for me when I read the fascinating book “Mrs. Astor Regrets: The Hidden Betrayals of a Family Beyond Approach,” by Meryl Gordon. In real life, Brooke Astor’s only son, 85-year-old Anthony Marshall-Astor, and his lawyer Francis Morrissey are on trial for charges of looting his mother’s $185 million estate during the final years of her life, while she suffered from Alzheimer’s. The jury is currently in final deliberations, with the outcome still unknown. You can Google the names if you’d like, to read the many twists and turns in the case.

Regardless of the court decision, the painful, public experiences of the Astor family can be used to help you avoid similar mistakes within your own family estate planning. Instead of the Marshall-Astor trial becoming the made-for-TV-movie that it will likely eventually become, it should instead be a documentary on what NOT do when creating your estate plan:

Avoid Dual Roles – Anthony Marshall-Astor held the dual roles of custodian and beneficiary – a red flag fraught with conflicts of interest. Now, we know that Mrs. Astor must have had the best estate lawyer money can buy. She should have chosen someone else to run her life if and when she couldn’t make those decisions herself. Mrs. Astor lived to 105 and had been diagnosed with Alzheimer’s. Even without the disease, most who manage to reach the triple digits in life tend to show some signs of decreased mental capacity.

Understand the Fiduciary Role – The definition of a fiduciary from “Black’s Law Dictionary” is as follows: “A fiduciary has a duty to act primarily for the client’s benefit in matters connected with the undertaking and not for the fiduciary’s own personal interest.” Had Anthony Marshall-Astor been fully familiar with this role, perhaps he would have better realized the need to establish an arm’s length relationship with respect to how he handled his mother’s estate. Just because it is your mother, grandmother, father, sister or brother doesn’t mean you don’t have a fiduciary duty to uphold their estate plans.

Clear Estate Planning – Mrs. Brooke Astor was known for making frequent changes to her will, muddying the waters of clear, consistent estate planning. According to a New York Times article, “The defense portrayed Mrs. Astor as obsessed with her will, making 38 revisions in the two decades before the two disputed changes at issue and sometimes taking a copy to her country estate on her weekend visits.”¹

Upfront Communications — Along with clear, consistent planning, families who communicate among all the key players stand a better chance of successfully transferring wealth from one generation to the next, or otherwise dispensing of the estate as truly desired. We don’t know what conversations did or did not take place among the family during Mrs. Astor’s final years, but surely they could have afforded to hire a wealth planner who specializes in fostering such critical communications.

Much of the “entertainment” found on TV these days is based on real-life situations. Celebrity personal follies are always great fodder. Luckily for Mrs. Astor, she was a grand lady and had some great friends who stepped up and petitioned the court to become legal guardians so they could manage her care in a manner befitting her legacy. When the results of the trail are announced, I will be tuning in to see if the immediate players have learned any lessons of their own.

Economic Uncluttering

Where will all our “stuff” go?

I recently had the pleasure of spending time on the Snake River in beautiful Swan Valley, Idaho. Lucky me, I stayed in a beautiful home and ate wonderful food, but I really wasn’t there for the amenities. I was there for the company of the 12 or more women with whom I was sharing time. Most of them slept on air mattresses on the floor and a few got beds, but no one complained. They too were there for the company.

One of my fellow guests was a businesswoman with artistic skills. As we talked about my role as a wealth manager and she wondered what her next project could be, I commented that one important thing she could do was “help us get rid of our stuff.”

She wanted to know what I meant by that, so I explained. As I work with maturing adults, the more I see — and the more my clients themselves see — that they really don’t want all their stuff. Don’t get me wrong. They have some pretty great stuff. But they have gotten to a place in their lives where having so much of it can become more of a hassle than an achievement.

There’s supporting data, too, that embracing a “less is more” lifestyle may have its upsides in both our personal and communal futures. A recent Journal of Accountancy article (yes I do read it!) provides a clear explanation on what has gotten us into our current financial instability, and an insightful prognostication of how we might successfully return ourselves closer to equilibrium. In short, the article describes how our U.S. economy grew on the back of easily financed consumer consumption and why it is not expected to readily recover if we go down that road again.

Fortunately, even if they haven’t analyzed the GDP charts or assessed the economic indicators, I think the baby boomers have always been intuitively ahead of their time. From many conversations I’ve been having lately, I think they are now too. Just listen and watch as they prioritize their lives for meaningful experiences and empty their shelves of stuff.

Five R’s to Financial Renewal: Part IV (final)

After RECALCULATING, you are now ready to implement your personal RECOVERY strategy — but not before. Afterward is when you are in a position to understand your personal required return and how the budget you prepared is a key component to your success. When the next person tells you how he or she is betting the farm on a certain stock that is going to go through the roof and make retirement dreams come true … you will just smile and know you are creating a strategy that has a healthier chance of success. It’s based on having done the math that you can believe in.

Your recovery strategy should realign your portfolio as needed to meet your return requirements and risk tolerance. Risk tolerance: another vague term. Let me help you with that. Remember back to what your asset allocation was in early 2009? Asset allocation is your proportion of riskier equities (those stocks that go bump in the night) versus safer fixed income (the can you sprayed under your bed to get rid of the bumps in the night).

If you are like most investors I’ve met before they’ve completed my mathematical gymnastics, you probably had close to 80 percent invested in equities and 20 percent in high-yield bonds (aka, junk bonds which are technically fixed income but, due to their own risky nature, not a great defense against equity risk).

Now remember the knees trembling, the dread and the sweaty palms you experienced when you were receiving statements proclaiming how low your portfolio could go. Did you want to throw up? Were you able to stay the course anyway and hang on to your existing investments even as you lost sleep worrying about them? Or did you succumb to fear and reverse course? That’s risk tolerance: how easily you can hold up when (not if) the down markets occur.

Even if you were able to stay the course, if you remember back to earlier in the year, you may have thought to yourself: “Self, I wouldn’t feel like hugging the porcelain god if only my statement were showing a less-severe loss. I could better tolerate it then.” That, my friend, is risk tolerance telling you to consider reducing your overall portfolio risk by allocating more to proper fixed income holdings such as high-quality bonds.

In other words, IF your portfolio requires adjustment, it’s important to adjust it according to your personal budget and goals, rather than in a blind panic. You didn’t do all this RESET, REGROUP and RECALCULATE work, only to keep or select an asset allocation that doesn’t meet both your personal need to take risk as well as your personal tolerance for taking it. Making sure your risk profile works for you will give you greater confidence in your personal RECOVERY strategy — no matter what “set for life” investment venture your next-door neighbor is touting.

Having determined your personal steps to recovery, I am delighted to pronounce your journey nearly complete, hopefully in six weeks or less. You can now exhale go on about living your life and enjoy your final “R” to its fullest.

RELAX.

Five R’s to Financial Renewal: Part III

So far, you pushed the RESET button on your financial mindset to REGROUP your personal financial realty. This steeled you to: (1) establish a budget, or maybe it was more just putting your expenses all on one page and actually looking at them, and (2) reunite with or select a qualified advisor to help you with your long-term goals.

What’s next? It’s time to RECALCULATE, or “do the math.” In my experience, there are usually two things that happen after I help new clients recalculate. First, I see them start to breathe again, after they’d been holding their breath for so long, hoping their financial choices were correct. Second, I find many people have been taking on more risk than they need to. They can often build a less risky portfolio and still feel good about their future. In my opinion, you have “arrived” when you can live comfortably off the safety found in a high-quality bond portfolio, NOT when you have been asked to invest in a potentially risk-filled hedge fund.

Usually, a good advisor focuses on the math (not intuition or market technical analysis, but the math!), using a Monte Carlo simulation. Yes, this is the same statistical modeling you learned back in college. Monte Carlo simulation looks at your projected spending and earning habits, chews through thousands of possible outcomes in these crazy markets of ours (translation: looks at returns and market volatility), and spits out your odds for retirement success. So, you do a few scenarios like you do at work: a worst case, best case and realistic case. You can then decide which odds you can live with as you plan for your future.

Now, if “retirement success” sounds like a vague term, it is. Only you can define what success means to you. Use your budget to gauge your living expenses during retirement. For example, do you think you’ll need to budget more or less to travel? (And if you are currently living on $250,000 a year, don’t say you’re going to live on $100,000, because you won’t.) The grand total of your future living expenses in relation to your current assets indicates how much (or little) return your investments are going to need to get there.

Ah ha, return, which is directly related to risk. The more you want of the one (return), the more you’ll have to tolerate the other (risk). Simple, in a way, but if you’ve designed your future such that loading up on the risky assets (equities) is the only way to achieve your goals … then it may take an enormous amount of bravado and a short memory about recent market ravages to be willing to stomach the risk that may be required.

Okay, what if you decide you’ve got that kind of stamina? What if you decide you’re going to go 100 percent equities and no fixed income, and see how much return you can achieve IF the market recovers?

This is why I sent you to a prudent advisor who will help you do the math, because that may or may not be the right decision for you. Even if you can tolerate the risk, you may not need the risk. More risk can actually reduce your probability of success. (I know, I know, why didn’t someone tell you this BEFORE October 2008? Sorry you’re not my client.)

Translation into success may mean a combination of taking on more risk, saving more, reducing your retirement budget or a variety of strategies. Or, if you’re already close to your goals, it may involve actually reducing your risk, to avoid destroying what has already been earned. A good advisor will help you assess your needs, consider the many possibilities for achieving them, help you come up with the combination that makes the most sense for you, and most importantly develop a plan that you think is believable and achievable.

If you’re one of my very affluent readers, you may be thinking, “I have plenty; I don’t need to budget.” Well, you may have plenty, but doing the math can still help you attach a dollar amount to your “plenty.” This can bring you increased peace of mind. It will make you address the risk you are taking and it can also give you a better sense of how much you may have left in your estate. Ah, that ugly estate tax, not to mention legacy plans you may have in mind. Yes, all things are connected.

So, regardless of your current wealth, get together with your advisor. Try a few different scenarios with him or her. Monte Carlo simulation can help you make better decisions. It’ll help make you more comfortable with your end decision. I personally hope that your current and future savings translates into a tweak here and a tweak there, with the satisfaction of understanding where you stand today as well as how you’re going to get to where you want to stand tomorrow.

Doesn’t it feel good to take charge? Congratulations, you are on the road to the next step: RECOVERY.