Till Money Do Us Part
As we think of the season of love, thoughts of candlelit dinners, romance and saying “I do” may pop into your head. When they do, it is wise to envision more than love, and mention a topic that often gets neglected: money. The topic of money may be an unromantic thought for some. But,but all things considered, it is what many couples fight about most often.
Big issues or small, money has an impact on all areas of a relationship. Examples range from balancing and overdrawing a checkbook, investments that have crashed, and out-of-control spending habits to overuse of credit and debit cards. These arguments are rarely about the money itself, but instead about power, control, security, beliefs, and communication.
So before you agree to “I do” and merge your finances, it is important to consider having The Money Talk.
My husband says, “This makes the hair on the back of my neck stand up.” And, in fact, many couples find it easier to discuss most all other topics, but delay covering their finances. Many people find it easier to talk about sex than money, regardless of their age. However, getting on the same page can prevent a lot of stress down the road; better to have “the talk” now rather than later.
Here are some questions which should open up the communication on finances whether you become a couple at 25 or 55.
- What is your credit score? It sounds rather unromantic, but a good place to start for an idea on how you handle your finances. Your credit score will indicate how well you handle borrowing (debt) from mortgage, credit cards, and car loans. The credit score will determine the financial building blocks and your access to credit and interest rates.
- Where are you going financially? As a couple you will map out what is important to you financially, and where you want to go. This could mean how much you save for a house, vacation, or retirement. Do you have other financial responsibilities, such as from a first marriage? For some, this question may revolve around how you handle debt or how much you are comfortable borrowing.
- What is your experience with money? What are your beliefs about money? Your family attitude towards money will shape how your attitudes are formed. Did your family hide money issues or “yell” about money? Were you taught to save or live day to day? Emotionally charged arguments about money arise because couples don’t always see money from the same perspective. Discussing this early on will help you understand each other’s financial habits and how you can find compromise on a middle ground further preventing arguments.
- Who handles which financial duty? Couples need to find a way to divide up these responsibilities and play to their strengths. One partner may balance the checkbook and pay the bills, while the other partner handles the investing and insurance. Unfortunately, what occurs with many couples is that one partner chooses to handle all the financial decisions and thus becomes a source of power and control over the other partner. You may also have a partner who completely ignores all the money matters. Neither situation is desirable. Both partners should be aware of what is happening with their finances, even if not involved with the daily activities. This will prevent surprises later on!
- How do you handle the checking accounts and credit cards? This question comes up a lot. Many couples find it easier to each have a checking account, with one being the household account. You may have a savings account for emergencies, vacations, and big purchases. Each partner can spend an agreed amount, say $250.00 without the approval of the other partner. Each of you should have a credit card in your own name to maintain a separate credit history.
When all is said and done, The Money Talk, like marriage, is about communication and compromise. You can live happily ever after, at least financially speaking.
The Stock-Bond Decision
Choosing a basic stock-bond mix is an important first step in portfolio design. Although the decision may appear simple, it can have a profound impact on your wealth.
Portfolio theory explains the value of making a deliberate, strategic decision about the proportion of stocks versus bonds to hold in a portfolio. This decision has roots in the “separation theorem,” which was proposed by Nobel laureate James Tobin in the late 1950s.1 The separation theorem proposes that all investors face two important decisions: (1) deciding how much risk to take, and then (2) forming a portfolio of “risky” assets (equities) and “less risky” assets (fixed income) to achieve this risk exposure.
Your stock-bond decision implements this risk position.
The Rationale
The theorem proposes that all investors who are willing to take stock risk should begin with a diversified market portfolio. Each investor then can dial down total risk in the portfolio by adding fixed income to the mix. The greater the bond allocation relative to stocks, the less risky the portfolio and the lower the total expected return; the greater the stock allocation relative to bonds, the higher the portfolio’s expected return and risk.
Investors who want to take even more risk than the market can increase exposure through borrowing on margin and/or tilting the stock portfolio toward asset groups that offer higher expected returns for higher risk.
So, how does one confidently allocate between stocks and bonds? A common method is to evaluate model portfolios along the risk-return spectrum. A riskier portfolio holds 100% stocks, and the least volatile portfolio holds 100% bonds. Between these extremes lie standard stock-bond allocations, such as 80%-20%, 60%-40%, 40%-60%, and 20%-80%.2 Then you compare the average annualized return and volatility (standard deviation) of each model portfolio for different periods, such as one, three, five, ten, and twenty years. Volatility is one of several risk measures investors may want to consider. With this in mind, the analysis should feature average returns, as well as best- and worst-case returns for the various periods.
While this technique relies on historical performance that may not repeat in the future, and does not consider various investment costs, it may help you think about the risk-return tradeoff and visualize the range of potential outcomes based on the aggressiveness of your strategy.
Refining Your Stock Allocation
After establishing the basic stock-bond mix, investors turn their attention to refining the stock allocation, which is where the best opportunities to refine the risk-return tradeoff are found. Investors who are comfortable with higher doses of equity risk can overweight or “tilt” their allocation toward riskier asset classes that have a history of offering average returns above the market. Research published by Eugene Fama and Kenneth French found that small cap stocks have had higher average returns than large cap stocks, and value stocks have had higher average returns than growth stocks. By holding a larger portion of small cap and value stocks in a portfolio, an investor increases the potential to earn higher returns for the additional risk taken.
The final step in refining the stock component is to diversify globally. By holding an array of equity asset classes across domestic and international markets, investors can reduce the impact of underperformance in a single market or region of the world. Although the markets may experience varying levels of return correlation, this diversification can further reduce volatility in a portfolio, which translates into higher compounded returns over time.
Fixed Income Strategies
Research shows that two risk factors—maturity and credit quality—account for most of the average return differences in diversified bond portfolios. Long-term bonds and lower-quality corporate bonds typically offer higher average yields to compensate investors for taking more risk. But keep in mind that these premiums are considerably lower than the market, size, and value premiums documented in the equity world.
Investors generally hold fixed income to either (1) reduce overall portfolio volatility, or (2) generate a reliable income stream. These objectives typically lead to different investment decisions. The first approach, volatility reduction, is an application of separation theorem (i.e., hold equities for higher return and use fixed income to temper portfolio volatility). Rather than increasing risk to maximize yield, these investors want to hold fixed income securities that are lower risk. Certain fixed income asset groups are better suited for this strategy.
With this in mind, some long-term investors may seek to earn higher expected returns by shifting risk to the equity side of their portfolio. With an eye to minimize maturity and credit risk, they hold short-term, high-quality debt instruments that have historically offered lower yields with much lower volatility.
The second purpose for holding bonds is to generate reliable cash flow. Income-oriented investors, including retirees, pension plans, and endowments, may not worry as much about short-term volatility in their bond portfolio. Their priority is to meet a specific funding obligation in the future. Consequently, they design a portfolio around bonds and accept more volatility in hope of earning higher yields, which they pursue by holding bonds with longer maturities and/or lower credit quality.
Whether investing for total long-term return or for income, a portfolio should be diversified across issues and global markets to avoid uncompensated risk from specific issuers and to capture differences in yield curves around the world.
Summary
The stock-bond decision drives a large part of your portfolio’s long-term performance. During portfolio design, evaluating different stock-bond combinations can help you visualize the risk-return tradeoff as you consider the range of potential outcomes over time. Once you determine a mix, it can guide more detailed choices of asset classes to hold in the portfolio. And as your appetite for risk shifts over time, you can revisit the mix to estimate how shifting your portfolio mix may impact your wealth accumulation goals in the future.
Endnotes- James Tobin, “Liquidity Preference as Behavior Towards Risk,” The Review of Economic Studies 25, no. 2 (February 1958): 65-86.
- The basic stock component may be reflected by the S&P 500 Index, or preferably, by a broader market proxy, such as the CRSP 1-10 Index. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca exchanges. The S&P 500 Index offers a proxy of the large cap US equities market. The fixed income component may be represented by an index of short-term US government securities or government and corporate bonds.
Disclosures
- Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. A bond is a loan that an investor makes to a corporation, government, federal agency, or other organization. Also known as debt or fixed income securities, most types of bonds pay interest based on a regular, predetermined coupon rate that is set when the bond is issued.
- Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.
- Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
- Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.
- Diversification neither assures a profit nor guarantees against loss in a declining market.
- A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.
Managing Inflation Risk
As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This article explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful.
As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.
Hedging vs. Total Return Strategies
Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return that outpaces inflation over time.
Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)
Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.
In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.
To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these:
Stocks
Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.1 To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.
Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.
Fixed Income (Bonds)
Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.
Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.
Treasury Inflation-Protected Securities (TIPS)
Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.
TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.
However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.
Commodities
Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.
Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.
Summary
While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.
As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:
- Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.
- Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.
- Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.
Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.
Endnotes 1 Real return calculation: (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago. The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Disclosures- Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.
- Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.
- CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.
- The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.
- Diversification neither assures a profit nor guarantees against loss in a declining market.
Freeze Your Credit File in 2010
From The Denver District Attorney’s Office:
Perhaps you intended to put a freeze on your credit files, but somehow the decade just got away from you. Start 2010 off right by freezing your file – its free!
A freeze prevents the 3 credit agencies from sharing your credit information with potential creditors which can help prevent ID theft. If your credit files are frozen, a crook or anyone else who has your Social Security number will be unable to get credit in your name. The freeze does not affect your current credit relationships – only new relationships.
Placing a security freeze:
- Requests must be in writing and sent by certified mail to each of the three major consumer credit reporting agencies:
- Equifax Security Freeze: P.O. Box 105788, Atlanta, GA 30348 – www.equifax.com
- Experian Security Freeze: P.O. Box 9554, Allen, TX 75013 – www.experian.com
- TransUnion Security Freeze: P.O. Box 6790, Fullerton, CA 92834-6790 – www.transunion.com
You must include:
- Full name
- Social Security number
- Date of birth
- Current address and previous addresses for the past two years
- Copy of a government issued ID
- Copy of a utility bill or recent billing statement that displays your name, current mailing address, and date of issue.
When you freeze your files, you will receive a unique PIN from each of the agencies as well as instructions on how to temporarily or permanently lift the freeze. Each agency will charge you $10.00 to lift the freeze.
Fraud Alert: Haitian Earthquake Relief
From the Office of Denver District Attorney Mitch Morrissey:
The situation in Haiti is tragic and will require tremendous resources from the Federal government as well as individuals. This is a good time to remind ourselves of important safety measures related to disaster relief donations. Internet users who receive appeals to donate money in the aftermath of the earthquake in Haiti or other disasters should be cautious and use due diligence before responding to requests.
- Do not respond to unsolicited incoming e-mails, and NEVER click links contained within those messages;
- Make contributions directly to disaster response organizations rather than to individuals representing themselves as victims or public officials asking for donations via e-mail or social networking sites;
- To make a contribution contact disaster relief organizations directly using information found via an independent source, such as a phone book or 411, rather than following a purported link to the site;
- Verify the legitimacy of nonprofit organizations by utilizing various Internet-based resources, such as www.give.org and www.charitynavigator.org;
- Make contributions directly to recognizable organizations rather than relying on others to make the donation on your behalf to ensure contributions are received and used for intended purposes;
- Be cautious of e-mails that claim to show pictures of the disaster areas in attached files – these files may contain viruses;
- Never give your personal or financial information to anyone who solicits contributions. Providing such information may compromise your identity and make you vulnerable to identity theft.
Denver DA’s Fraud Line: 720-913-9179
Fama and French on Inflationary Hedges
Professors Ken French and Eugene Fama posted a nice article on using TIPS as an inflation hedge
http://www.dimensional.com/famafrench/2010/01/qa-seeking-the-best-inflation-hedge.html#more
GoldMedalWaters.gooruze.com
Government Intervention and Stock Returns
There is a lot of talk out there right now that suggests that government intervention will impact the capital markets.
This video from a few months back addresses that topic pretty clearly:
http://www.dfaus.com/library/videos/governme/
Top 10 Scams and Rip-Offs of 2009
FRAUD ALERT!
From the Office of Denver District Attorney Mitch Morrissey
Top 10 Scams and Rip-Offs of 2009 from the BBB
…to be continued in 2010
- H1N1 Scams: Scams attempted to scare consumers into purchasing cures or providing essential information to prevent the H1N1 virus.
- Memorabilia: 2009 provided many opportunities for scammers to sell memorabilia and collectibles at inflated prices.
- Weight Loss Pills Free Trial Offers: Free trial offers for weight loss pills actually ended up costing unsuspecting consumers thousands of dollars.
- Phishing E-mails: Phishing e-mails appearing to be from government agencies popped up in in-boxes. These phishing emails attempted to trick victims into divulging sensitive financial information.
- Mystery Shopping: Consumers were told they would be paid to secretly shop in order to evaluate merchants’ customer service. In some instances, victims were asked to wire money back to scammers as a way to evaluate money wiring services such as MoneyGram and Western Union. Victims who participated were sent authentic looking checks which, when cashed left the victims “holding the bag”.
- Lottery Scams: Victims received bogus letters or phone calls informing them that they had won millions of dollars. Unfortunately, victims were also told they had to wire hundreds or thousands of dollars back to the scammers to cover taxes or other bogus fees.
- Friend/Family in Distress: Also known as the Grandma Scam, victims received messages from scammers claiming to be “friends” or “family members” needing immediate help. Victims were asked to wire money to pay for lawyer’s fees or to post bail.
- Mortgage Foreclosure Rescue/Debt Assistance: Victims paid upfront fees to avoid home foreclosures or to get help with credit card debt – with no results.
- Job Hunter Scams: Job seekers paid bogus upfront fees as part of an application process. Job applicants were also asked to provide personal financial information or social security numbers under the guise of evaluating their applications.
- Robocalls: Thousands of people received automated telephone calls related to auto warranties and lower credit card interest rates.
Questions or assistance related to fraud: Denver DA’s Fraud Line: 720-913-9179
Follow us on Twitter @DenverScamAlert
December 2009
Largest-Ever Hacking & ID Theft Case Bust
From The Denver District Attorney’s Office:
The U.S. Justice Department announced charges in what it said is its biggest ID Theft case ever. Hackers stole credit and debit card information from more than 130 million accounts. In most cases, the hackers either used personal credit card numbers to make fraudulent purchases or they used debit card numbers to drain individuals’ bank accounts.
The good news is that in Colorado, and 44 other states, the law requires that customers be notified when their identity has been compromised. In addition, almost every bank and credit card company takes responsibility when there are fraudulent charges on an account. If something goes wrong, consumers are protected by the Federal Fair Credit Billing Act. While it is virtually impossible for an individual to prevent this type of massive data breech, steps to minimize risk and mitigate losses are easy to take:
Monitor your credit card and bank accounts closely – reporting any charges or activity that you do not recognize.Request a free copy of your credit report once a year from each of the three major credit reporting agencies at www.annualcreditreport.com or 1-877-322-8228.Shop only on secure internet sites. For more information go to http://www.idtheftcenter.org.Don’t give any part of your Social Security, credit card or bank account numbers over the phone or Internet, unless you have made the contact to a company or financial institution with which you are familiar.
NAPFA Testifies before Congress
This video will add some clarity on why Fee Only advisors are so passionate about serving their clients as fiduciaries.
