The following post was written by Thomas King, a CPA and financial planner based in Kansas City.  The following letter was sent to his clients last week, and he allowed us to repost it in its entirety. These views are not necessarily reflective of his firm, CBIZ.

As you are probably aware, the stock market has taken it on the chin for the last 3 or 4 days.  I usually don’t like to use the term “correction”, as I believe the stock markets are efficient for the most part and there needs to be a buyer for every seller, i.e. there is essentially a winner and a loser for each trade that is made, making it a zero sum game.

This downturn in the markets has been expected for some time now, and it is my opinion that the economic troubles of Greece had very little to do with this recent downturn.  I guess I also need to include Spain and Portugal as part of the problems in the EEU.

For the US during 2010, our markets have continued to outperform the economy by the proverbial mile.  Much of this market performance was fueled by institutional buying, where manager compensation is primarily tied to performance.  For the most part, individual investors remained on the sidelines.

If there is any good economic news, you need to be able to sort through all of the confusing pro and con media stories.  It is my belief that…

• there has been a small amount of job (employment) improvement, which is somewhat contrary to what we hear from our government.  I’m not faulting the government for the lack of meaningful employment improvement. Heck, I can’t remember a time, other than during the presidency of FDR and his “New Deal” WPA program, where the government was actually able to produce a significant number of jobs.  Unfortunately, after the end of the WPA, unemployment retreated to its previously high levels.

• Although there have been a number of articles suggesting that business has used up all of the excess productivity from its slimmed-down workforce, business still needs to believe that there will be economic stability moving forward.  I do fault the government here for creating a very confusing and unstable economic picture for the next few years.
• Although the consumer has appeared to shed his or her dour view of the economy, and started shopping again, there is a good chance that this spending spurt may be short-lived without any significant improvement in the economy.

• The rather new “anti-spending” position of the government will also be short-lived, as incumbent politicians struggle to be reelected at a time when the voting public has started to figure out that many of these folk stink at what they do.

What should an investor do at this time?  I don’t believe that selling out at this point in time is the right answer.  I do believe that we will find some market stability in the near term.  Traders, and not long-term investors, are the main cause of our current volatility.  At some point these traders will determine that they can make more money in an improving market than they can make in a market that is trending downward.

If I had additional investment funds, I would wait for this upward trend or “momentum” to start back and I would be buying at the then existing lower prices.  If you were previously buying equities based on their dividend yield, the new yield will be that much higher.  Buying equities for their long-term growth potential will still be a favorable move.

I would tend to favor US equities over non-US equities, primarily Europe.  The inherent problems with the EEU aren’t going away overnight.  Greece will probably need to be saved again, as well as some of the other smaller, less stabile countries.  ( Do I smell socialism in these problems?)

In the fixed income markets, you will most likely find that the yield spread between the lower credit quality bonds and the better credit quality bonds will have increased over what it was a week ago.  You will be getting paid more for the additional risk you are taking by owning these high risk, high yield investments.  If you are somewhat risk adverse with your fixed income holdings, owning shorter-term bonds will help when the coming inflation storm begins.  For those in the middle of the risk scale, don’t forget the U.S government TIPs (longer-term inflation protected bonds).

Those of you that currently invest with us in our fully-diversified portfolios are well aware that we significantly favor US equities over their international counterparts.  In addition, we favor smaller companies over larger companies and value companies over growth companies.  Our research in general tells us that smaller companies have outperformed larger companies over longer periods of time.  The same is true for value companies versus growth companies.  The simple answer to the question of “Why?” is the concept of risk.

Thanks again for your business and the trust you have shown in us.  We wish you a most enjoyable summer season.

Investment Advisory Services Offered Through CBIZ Financial Solutions, Inc.

An SEC Registered Investment Adviser

44 Baltimore St.  Cumberland, MD 21502  (800) 445-7447

For the last few months, I’ve been hard at work on a comprehensive system for determining what to do with your money. I’ve spoken with financial advisors, friends and family, working to establish the easiest and most effective way to give you a personalized financial report.

And now, it’s ready for an alpha release. As such, I present to you, HapiMoney.

How it’s set up

There are 4 main sections: Basic Info, Budgeting, Balance Sheet, and the Risk Questionaire.

Basic Info: The shortest section, but still very important; just fill in your email, age and when you want to retire. The longer you’ve got until retirement, the better off you are.

Budgeting: Your monthly income and monthly expenses. Using these variables, we can determine the amount you’ll need to retire, how much free cash you’ll generate (for investing purposes), and how much cash you should keep on hand for an emergency fund.

Balance Sheet: This tells us what you own and what you owe. From this information, we can determine which of your debts to pay off and the required rate of return for you to reach your goals.

Risk Questionaire: How risk averse are you? By taking this academically developed survey, we can determine how much of your investable income should be allocated towards risky investments like stocks or towards less risky assets like fixed income.

Your Personalized Report

Given your responses to the 4 main sections, we can give you a step by step analysis of what to do with your money: how much cash to keep on hand and where to put it, give you recommendations on a brokerage account along with some ETFs to buy (and how much), and finally tell you whether you can achieve your retirement goals.

So give it a try, and let me know if you found it helpful. Email me at alex@hapimoney.com. I’d love to hear what you like and what you dislike (and if you find any bugs)!

Image via Wikipedia

Most of us who work for large corporations get granted stock options as part of the compensation package. As a result, many also hold onto stakes which make up huge portions of their net worth.  Make no mistake, Stock is a great incentive mechanism, especially for smaller companies where each individual has more effect on the bottom line.  Company stock is, however, incredibly risky to hold on to in any large amounts.

Aside from the fact that having large amounts of your net worth tied up in any one asset is a mistake, owning your own companies stock compounds this immensely. Why? Because your job security and the value of the stock are incredibly correlated. If the company’s stock tanks, chances are going to lose your job.  If you lose your job AND your retirement fund disappears, you are straight up screwed.  Look at what happened to the employees of Enron? Or the employees of WorldCom? These employees l0st their livelihood and retirement funds and will now have to work for the rest of their lives.

Be smart, and while you should definitely keep some stock, make sure its not an outrageously high amount.

Image via Wikipedia

Once you’ve determined how much cash to keep on hand the next step is to figure out what to do with the rest of your assets.  It seems confusing, especially if you’ve never done it before, but it’s not.

These assets should be divided into two categories, fixed income (or assets whose value is derived from a fixed series of interest payments – things like CD’s, bonds, ) and what I will call capital appreciation assets (or assets whose value is derived from increase in asset price – things like stocks, real estate, currencies, etc).

How you determine this is based on 2 things:  1) How risk averse you are and 2) What your financial goals are (when do you want to retire?  how old are you now?). The younger you are and more risk seeking you are, the more you should put into equities. The older you get, or the more risk averse you are, the more you should put into bonds.

Here’s how you do that:

1) Establish how risk averse you are:

• Go take this quiz. Come back after it tells you how willing you are to take risks.  Remember what your score is (it’s out of 47).

2) Go to this site, and input how old you are, when you want to retire, and the score you got on the risk site. This will give you the answers to where you should put your money.

Lastly, you’ll need to figure out if this asset allocation will allow you to reach your goals, especially for you risk averse 55 year olds who have no savings, and no income… but that’s for another post.

How do you decide what stocks to purchase? Which index funds are the best? The problem with finance isn’t the lack of information but rather that there is too much of it. The paradox of choice overwhelms us and in the end, we do nothing, and stick with the status quo.

Information is everywhere, but education is limited, and we find ourselves constantly saying “I’ll do this later”.

I’m going to recommend two index funds for you and then explain why I like them:

1. For your stocks/equities I recommend VTSMX: This is the Vanguard Total Market Index. It is comprised of over 3,000 individual stock holdings and aims to track the returns of the US stock market as a whole. It’s got low annual expenses (.18% at the time of writing) and is run by the folks over at Vanguard whom are highly respected individuals.
2. For your fixed income assets I recommend VBMFX: This is the Vanguard Total Bond Market Index. Like it’s sibling VTSMX, this fixed income portfolio is comprised of 3,000 different bond holdings. The goal, per usual, is to track the returns of the US bond market as a whole.

Great, so what do you do with this? First, research these index funds to make sure you are comfortable with buying them. Next, decide how much to put in – you’ll need a minimum of $3k per fund. I keep promising to tell you how to divide your assets between equities and fixed income (and why) and I keep pushing it off, but I promise I will eventually get around to it. For simplicity’s sake, the most common splits are 60% Equities/ 40% Bonds or 50% Equities / 50% Bonds. The younger and more risk seeking you are, the more equities you should own.

Lastly, REINVEST ALL DIVIDENDS. These things are supposed to compound over time, but how are they going to do that if you keep taking away the interest?

Disclaimer: I do not own either Vanguard Fund. Instead, I split my assets between DGEIX (a total equity portfolio) and DFGFX (a total bond portfolio). The reason I recommend neither here is that they are run by the DFA and are not available to the general public.

Those real estate agents are tricky, prone to all sorts of chicanery. They will tell you things like “oh, this home is a great investment!” and fill your head with dreams of your home doubling, or even tripling in value.  Certainly, you will live here and raise a family here, but you are also putting your money to work.

Unfortunately, this type of thinking is wrong…murderously wrong.  Oh, fine, not murderously wrong, but I’m prone to hyperbole.

So why isn’t your home an investment? After all, it can appreciate in value, often significantly.  To answer this, I’m going to ask a question in return: provided your house has increased in value, how do you capture that value? Do you sell your house? Okay, so where do you go?

The problem is that property values do not rise or fall in a vaccuum – rather, they all tend to rise together and fall together (a major part of the problem with the current recession). So when your home has tripled in price, so has your neighbors house, and probably every house in your area. And, this is a major assumption, but I’m assuming that if you were to sell your house to capture the rise in price you would want to live somewhere else, which means you’ll have to buy again – but you’ll be buying at increased prices.

In fact, there are only two ways to “profit” from your home:

1. Significantly decrease your standard of living by selling your home and moving into a worse house in a poorer area
2. Make significant capital improvements to your home (new kitchens, bathrooms, etc) and hope that the value of the home rises far more than the money you spent.

Now, don’t misunderstand, as real estate can be a valuable investment, but your home (or primary residence) should not be considered part of those investments.

MarketWatch just came out with an interesting article analyzing twelve different retirement calculators (courtesy of the Society of Actuaries) and came to the conclusion that they all, in short, sucked. Here are the reasons they listed as the short comings:

Longevity- In other words, how long will you live. Average age is now about 78 years, but most calculators expect you to live shorter- which kind of blows if you run out of money by the time you are 75. This is why you should plan to be living off the interest from Fixed Income- the amount you will need to save will be greater, but you nearly eliminate longevity risk.

Unexpected events and risks- or the odds that someone nearing retirement might lose their job in a huge recession at the same time the market crashes, wiping out their investment value. In summary, this is an asset allocation problem, and there is absolutely no reason that someone about to retire should have a majority of their assets in high risk assets like stocks.  Truth be told though, nobody can forecast unexpected events…hence the name.

Housing: From the article, “There is inconsistent treatment of housing as an asset for use in financing retirement. Some programs allow users to specify whether they are willing to sell their home to meet retirement expenses.” Here’s a golden rule of thumb, and never violate this: Never ever ever ever ever treat your home as an investment. It’s not. If your home sky rockets in value, and you decide to sell it, you still have to live somewhere, so unless you seriously downgrade, you are going to be paying a similar amount for a similar home. I can’t think of many people who will willingly downgrade their standard of living.

Social Security: “Software programs inadequately estimated the level of Social Security benefits users are entitled to, and did not direct consumers to the Social Security Administration Web site to obtain an accurate benefit estimate at no charge.” If you are age 55 or above, this might be a true statement. If you are below this age, you should under no circumstance expect Social Security to be around by the time you retire. Hope for it, but don’t plan for it. In my book, the retirement calculators are doing the right thing.

Annuities: “Software programs usually did not evaluate the possibility of annuitization — converting assets into lifetime income annuities — as an option to reduce risk. There was also a lack of consideration of different options for timing of payouts.” In other words, this is an asset allocation problem – similar to the problems covered by Longevity Risk and Unexpected Risks. Calculators don’t expect you to have saved enough in order to put all of your money into fixed income.

I’ll get into asset allocation in a future article- it’s part science, part rule of thumb. Basically be aggressive when you are young and pull back the reigns when you are older.

Everyone knows that you should invest your money in the stock market, but not a lot of newbies understand a lot of the rationale.  Thus, here’s a little investing 101 seminar.

Risk/Reward

To simplify, the riskier something is, the better the payout should be. For instance, winning the lottery is such a low probability event that the payout has to be huge in order for people to play. If the payout were only a few dollars but the chance of winning was still a million to one, nobody would play (or rather, nobody should play).

In terms of investing, this is also a true. The cash you have in your bank account is basically as risk free as you can get…which is also why it pays so little in interest. CD’s are a little riskier, so they pay better, bond’s are even riskier, and stocks are the riskiest (non-publicly traded stock being the most risky of all).

You can actually see this represented in what’s called a “yield curve“. Click here to see the latest rates on bonds of different maturities (or in other words, how long they take to pay off).

Returns

If you clicked on that link, you would see that if you were to invest all of your money into 30 year government bonds, then you would earn about 5% in interest every year.  That’s not too shabby. So what about stocks?

Well, it’s a little bit more complicated because stocks don’t all pay interest like bonds do (though many pay dividends). Rather, we have to calculate how much the price of the stock goes up in order to see what the equivalent “yield” is.  If you look back historically, from 1900 through 2008,  the S&P returned about 9.5% annually (this is compounded, not a simple average).  Thus, stocks over the last century performed about twice as well per year than long term bonds. To play around with this yourself, click here.

So why wouldn’t everyone invest everything into stocks? Because of the enormous swings. In 2008, the market lost almost 40% of it’s value – so you’re $10,000 investment would be worth $6,000 in the course of a few months. In 2002,  it lost about 20%. And in the years 1929, 1930, 1931 and 1932 it lost 10%, 23%, 44% and 6% respectively. Over the short term, bad bad things can happen.

So what do I do?

When investing, plan for the long term. Understand that if you are in the game long enough, eventually stocks will rebound and provide you with solid returns, but it will take time. If you need money in the short term, invest in things that are safer like bonds.  And ideally, construct a combination of stocks and bonds that will provide for large enough returns while also providing relative safety.

In our last post, we covered exactly how much cash you should keep on hand. 6 months worth of expenses plus any additional known large cash outlays should do just the trick. One thing that wasn’t mentioned is that this assumes that your income is greater than your expenses.  If you are unemployed, or are spending more than you make, step one is to hoard as much cash as possible and step two is to rectify the situation.

Now, for those of you who are not in dire straits, its time to talk interest rates.

As of right now, interest rates on checking accounts, money markets and other short term accounts are hovering right around 0%. This means you’d almost be better off with a cash stuffed mattress.  That also means we should keep a bare minimum in these types of accounts.  Personally,  I have a checking account through Bank of America earning zilch and a Schwab Account which sweeps my free cash into a money market earning 0.1%.  The only reason I have any cash at all in Bank of America is because they’ve got ATM’s all over where I can deposit checks.   Thus, the money market functions as my true checking account, and I have 2 months worth of expenses there.

The remainder of your cash should be in a high interest bearing savings account. Your money will be less liquid than a checking account, but it will be maximizing your return in respect to risk.  As of right now, Ally Bank, American Express and HSBC Direct offer 1.5%, 1.5%, and 1.35% respectively.  Personally, I’ve gone with American Express, but make sure to investigate current rates whenever you decide to invest.

To summarize: 1/3 of your cash in low interest checking, and 2/3 of your cash in high yield savings.

The next step after establishing your emergency cash fund is to figure out where to put the rest of your money (stocks, bonds, CD’s, etc). We’ll get into that next.