Frequently Asked Questions
Why Should We Focus on Setting Goals?
Many business coaches and books tell the story of a famous
study of 1979 Harvard graduates (or 1953 Yale graduates). Ten years after graduation,
the 3% who had written goals were earning ten times the average income of their
peers who had no goals. The story is an urban myth, but verifiable research at Dominican
University has confirmed the power of putting your goals into writing. You have
now joined the fabled 3%. You have SMART Goals in writing. SMART stands for Specific
Measurable Achievable Results in Time.
Believe It, You Can Do It. Does It Really Work?
Your beliefs determine your behavior. Therefore it is extremely
important that you believe this plan is achievable. Achievable is the “A” in SMART
goals. What you achieve is primarily mental. “Whether you think you can or can’t,
you’re right.”(Henry Ford). Only human beings have the ability to create the future
in their minds first. Remember the building illustration. Every human accomplishment,
from the invention of the plow to smashing the atom and putting a man on the moon,
was first a thought in the human brain before it became a reality.
Every one of us has this amazing ability. We just may not be aware of its potential
power in all areas of life. If you can plan a vacation, build a home or plan your
day, you can plan and achieve financial independence. It’s 99% mental. The levers
above give you choices. You can change your beliefs about what is possible for you
or you can change the levers until the goals match your current beliefs.
What's The Difference Between Achievement And Fulfillment When It Comes To Financial
What is the difference between achievement and fulfillment?
Nigerians (#1) rank much higher than Americans in global studies measuring happiness.
Surveys indicate one-half to two-thirds of those currently retired and not working
are unhappy. Actuaries have discovered an incredible spike in the mortality rate
in the first three years after retiring. Emerging research suggests that not working
may be related to loss of meaning and significance.
Most Americans know what they want to have, but they have no idea of what they want
to be. There are two types of life values: ends and means. Money,
family and things are means values. Happiness, love, freedom and growth are examples
of ends values. The only way we can ever feel happy and fulfilled in the long term
is to understand our deepest ends values and live them. If we don’t, we will experience
pain. What do you value most in life?
What Should I Take Into Consideration When Creating A Savings Plan Strategy?
- Percentage savings is the simplest and easiest of all budgets. If you are saving
10% of your income, by definition you are living within your means.
- Saving 10% of your income is evidence of your ability to defer gratification. According
to psychologists the ability to defer gratification is an indicator of emotional
intelligence and perhaps the most powerful predictor of success for young toddlers.
- Nobel Laureate, Robert William Fogel, has calculated that if the average couple
with one spouse working part time, saved 14.7% of their income from the day both
spouses entered the work force, the couple could retire at age 55 with a retirement
income that placed them among the top 20% of all US households.1 (Fogel, The Fourth
Great Awakening, p. 196.)
- The higher your income, the lower the replacement ratio of your social security
benefit. Social Security was meant to be a safety net for the elderly poor, not
a universal retirement plan. When Social Security started there were 40 workers
contributing for every single beneficiary. Today the ratio of workers to beneficiaries
is 3/1 and soon it will be 2/1. There is no doubt that social security benefits
will have to be reduced even more for the program to remain solvent.
- Saving 10% of your income provides a cash flow cushion which allows you to take
more risk in your portfolio. During an emergency, you can reduce your savings rate
instead of tapping your investments.
- Saving 10% of your income even after you retire provides some inflation protection
during the withdrawal years. In practice this means that when you retire, your taxes
and living expenses should be about 90% of your total income.
- Saving 10% of your income even during retirement reduces the impact of portfolio
losses during the withdrawal years. The key to retirement is spending.
By never spending more than 90% of your gross income, you continue to fund your
future first and greatly reduce the odds that you will outlive your money.
What Are Some Creative Ways To Save For A Child’s Education?
No one knows what methods of paying for college will be available
years from now. We have only to look at the recent changes to understand the challenges
of financial planning for college. Twenty years ago Education IRA’s and state-run
Section 529 plans did not exist. Twenty years ago there were no provisions to borrow
from your 401(k) plan or to make penalty free withdrawals from your IRA to pay for
children’s college. There were no education tax credits. The concept of using home
equity to pay for college was not an accepted practice. Liquidation rules for US
Savings bonds did not allow an exemption from federal and state taxes if the bonds
were used for qualified college expenses. Many of the federally subsidized loan
programs were not available twenty years ago.
The best way to save for college is to put money in the most effective place to
build wealth. The best way to pay for college expenses is to take money from the
most effective place to conserve wealth. Planning under uncertainty requires planning
with flexibility. Saving for retirement is the best way to save for children’s college.
Money saved inside an IRA or QRP does not reduce eligibility for financial aid because
it is an “exempt asset” when calculating the Expected Family Contribution (EFC)
on the federal FAFSA form. You can borrow from your 401k to pay for children’s college.
Money inside an IRA can be used to pay for college without penalty. Saving for college
inside a 401k or IRA is planning with flexibility.
Paying for your children’s college is a great act of love. But building your wealth
so you don’t become a financial burden to your children in your old age may be an
even greater act of love. The “sandwich generation” refers to the growing number
of families who find themselves ”squeezed” by the need to care for children and
aging parents at the same time. Funding your own retirement and long term care in
old age has higher priority than funding a child’s college education. Saving for
your own retirement is an act of love for both your child and your fellow citizens.
Social Security, Medicare and Medicaid are going broke because people are not saving
enough for their own retirement and long term care. You can get loans for college
education, but you cannot get loans for retirement or long term care.
What Are Some Helpful Budgeting Resources?
If you want to manage your spending with a budget we recommend
one of the FREE online services which help you track your cash flows, account balances
and net worth automatically. The most comprehensive is Yodlee Money Center at www.yodlee.com. The easiest
to use is Mint at www.mint.com.
A relatively new service is Quizzle at
What Are Some Of The Top Tax Planning Tips?
We want to balance your present needs with your future needs,
between saving too little or too much. If you are on track we generally recommend
saving no less than 10% and no more than 20% from your income. You may have to save
more than 20% if you are behind or want to retire before your Social Security full
Why does Fundamental #3 (Tax Planning) encourage you to MAXIMIZE your contributions
to QRPs (Qualified Retirement Plans) and IRAs (Individual Retirement Accounts)?
Whenever the IRS puts a limit on something that means it’s probably “too good” for
the taxpayer. You should usually get as close as you can to the IRS limit. The benefits
from an employer plan are so great, that you cannot deposit money directly as you
can to a bank checking or savings account. You can only put money into an employer
plan by deferring some of your income. While you cannot just write out a check for
$16,500 and put it into your QRP, if you have some cash or assets that can be converted
to cash, we will show you a strategy for moving it into your QRP “indirectly”.
As a minimum, everyone should put 10% savings into an employer plan or IRA. After
the minimum 10% savings rate, people differ in the benefits they will receive from
maximizing their contributions to their qualified tax shelters. They will also differ
in their ability to “harvest” those benefits. Let’s talk about the benefits first.
Are There Any Sources Of “Free Money” When Planning For Retirement?
People also differ in their ability to harvest this free money
from the government. A family which earns $20,000/year and needs all that income
to pay for food and shelter has limited ability to defer income into their QRP or
IRA. On the other hand, a couple making $31,000/year with $20,000 in CDs and a piece
of vacant land in Arizona worth $30,000 can “harvest” a big return by deferring
most, if not all, of their income into their QRP or IRA. If each spouse earns $15,500
or ½ of their $31,000/year income, they could each defer their entire income of
$15,500 into their respective 401(k) plan for a total deferral of $31,000. But what
would they use to pay living expenses? They could live off the cash in their CDs.
And when the cash is used up they could sell the land for another $30,000. It’s
an “indirect” method for getting your cash or the value of your vacant land into
Why is it so important to maximize your qualified tax shelters? There’s even more
free money than you might think. By maximizing contributions to your QRPs and tax-deductible
IRAs, you can sometimes reduce your taxable income to the 0% tax bracket. This creates
an extraordinary and rare opportunity to convert a tax deferred IRA to a tax-free
ROTH IRA at a 0-15% federal marginal tax rate, depending on how much you convert.
The Roth IRA does not give you a tax deduction now, but it gives you the opportunity
for tax free growth if you wait until age 59 and ½ before taking the money out!
And you can take some money out before age 59 and ½ because your contribution cost
basis can be withdrawn anytime. Conversion cost basis can be withdrawn without penalty
5 years after the conversion. The value of tax free growth is so great, that people
with an Adjusted Gross Income of more than $160,000 cannot contribute to a ROTH
IRA. The ability to convert a tax-deferred IRA to a tax-free Roth IRA had even stricter
limits. Normally people with an Adjusted Gross Income of more than $100,000 have
not been eligible. That law has been changed in 2010.
There’s another reason for Fundamental #3. If you ever get in debt or someone sues
you, the Employee Retirement Income Security Act of 1974 (ERISA) protects money
in your QRP and money rolled from an employer plan into IRA against creditors. Even
though OJ Simpson was convicted of murder in civil court, the victims’ families
were not able to collect much of the damage award because most of OJ’s money was
in his NFL retirement plan protected by ERISA. Many states have laws which protect
IRA contributions against bankruptcy creditors. You should learn the limits of the
asset protection (bankruptcy) laws in your state. One popular resource is http://www.assetprotectionbook.com
Are There Other Creative Uses For An IRA?
Money in an IRA can be used to pay for college education,
to purchase a new home and pay health insurance premiums during unemployment. Money
in 401(k) plans can be used for loans, certain emergencies and early retirement
at age 55. The cost basis or after-tax contributions to a Roth IRA can be withdrawn
anytime without penalty because you have already paid the taxes. A traditional IRA
can be converted to a Roth IRA. The best way to save for a child’s college or down
payment for a new home is to save for your own retirement. These are just a few
of the MANY reasons to maximize your contributions to QRPs and IRAs. See Internal
Revenue Code 72(t) for details about the exceptions to the 10% penalty for early
Why Is The “First 10%” Important When It Comes To Saving For Retirement?
The first level of deferrals and contributions should always
come from your income and be true savings of 10% of income. Everything above the
first 10% of income can be either savings from income or repositioning of assets
(tax efficient liquidation of capital assets or pulling equity out of home). It
is important to calculate how much of this “maximization activity” is simple repositioning
of assets, and how much is actual savings from income. The free money can be viewed
as “payment” from the government for both saving of income and for changing the
location of your money.
Should You Use Insurance For Retirement Planning?
In most states it’s illegal to sell cash value life insurance
as a retirement vehicle or savings plan. Unfortunately the laws are not enforced.
Because of the high expenses and commissions to the agent, it’s usually a terrible
investment. It’s also an expensive tax shelter that usually does more harm than
good for middle income Americans. There is no additional tax benefit from using
an annuity inside an IRA. There are additional expenses. The SEC has posted two
consumer publications with useful warnings and questions that should be asked before
purchasing variable insurance products for the benefit of the tax shelter:
Most people should not be putting money into cash value life insurance or annuities
until they are maximizing their contributions to the QRPs and IRAs and are in a
very high tax bracket. Premiums paid into cash value life insurance or annuities
are NOT tax deductible. Investments in cash value life insurance and annuities are
not protected from creditors by ERISA. Investment gains in cash value life insurance
and annuities are subject to higher income tax rates instead of lower capital gains
Some agents believe that term insurance is too risky because your health may change
and you may need the insurance longer than expected. For example, you may be diagnosed
with terminal cancer one month before your term insurance policy expires.
We do not accept that argument because most good term insurance includes the legal
right to convert to a permanent policy anytime before the lapse date. In other words,
if you are diagnosed with cancer one month before the policy terminates, the insurance
company is legally obligated to let you convert to a permanent policy at healthy
rates for someone your age. We ask, “if you’re uninsurable but the insurance company
has to sell you a permanent insurance at healthy rates for your age, isn’t that
a good deal? If you have a choice between a $100,000 permanent cash value policy
or a $500,000 10-year year level term policy with the right to convert to up to
permanent insurance at any time, which would you prefer assuming they both cost
Government uses the same rules for Social Security survivor benefits. Social Security
survivor benefits for spouse raising a dependent child end when child turns 16.
Social Security survivor benefits for the dependent child end when child turns 19
or is no longer in high school.
In most cases, life insurance above 60-80% of income replacement ratio or for a
longer period of time than beneficiary dependency is a discretionary expenditure
to be balanced against other important and competing needs such as disability insurance
and saving for retirement.
Low cost term insurance can be purchased online at www.insure.com or
What Is The Importance Of Diversification And Investment Strategy?
Until the 1960’s the term asset allocation did not exist in
our vocabulary. Diversification was achieved by owning more than one stock. But
all that changed as the world became familiar with the 1956 doctoral thesis of Harry
Markowitz. Markowitz’s paper eventually won a Nobel Prize in 1990 and he became
the “Father of Modern Portfolio Theory” by demonstrating how risk and return could
be more precisely managed by what is known today as “asset allocation.”
Harry Markowitz won the Nobel Prize because he gave investors a mathematical formula
to measure and manage risk. He is called the father of Modern Portfolio Theory because
he was the first to quantify both the probability and the degree of a loss by measuring
the variability in returns.
Assume both Stock A and Stock B return 10%.
- Which stock is “riskier”?
- Is the assumption of 10% return for both realistic?
In his paper Markowitz showed us how we can both reduce risk
and increase return at the same time by selecting non-correlated asset
Portfolio #1 is very volatile because the two investments are 100% positively correlated.
Portfolio #1 illustrates why you do not want to have a portfolio where everything
goes up at the same time. Portfolio #2 has ZERO volatility, because the two investments
are 100% non-correlated. Portfolio #2 illustrates why you want a portfolio with
one investment going down while another goes up at the same time. Since there are
very few perfectly non-correlated investments, Portfolio #3 is a picture of how
diversification reduces volatility in most actual portfolios.
Asset allocation models seek to control the means variance characteristics of a
portfolio to improve their investment results in two ways.
First, investors can improve the efficiency of their portfolio by
changing their asset allocation. Having an efficient portfolio means you get the
most return for the least risk. The curved line represents “the efficient frontier”
of all possible portfolios underneath the line.
The graph below illustrates how a standard 40/60 portfolio can be made more efficient
by simply changing the asset allocation. Each successive portfolio is slightly more
efficient than the previous version. Version #1 reduces risk by 100 basis points.
Version #2 increases both return and risk. Version #3 increases the return some
more. The final version gets the most return for the least amount of risk. The original
and final portfolios are both 40/60, but the final portfolio is clearly more efficient.
Second, investors can improve the suitability of their portfolio by changing their
asset allocation and moving it along the efficient frontier. Having a suitable portfolio
means that the risk/reward characteristics of your portfolio match your financial
needs and goals. Many efficient portfolios are possible. You want the one that matches
your needs and goals.
Test your understanding of Modern Portfolio Theory and Asset Allocation. Which efficient
portfolio is most suitable for a young investor in the accumulation stage and with
a high risk tolerance? Which efficient portfolio is the most suitable for a 50-year
old employee getting ready to retire? And which efficient portfolio is the most
suitable for a 70-year old investor who can’t afford any losses?
Stocks, Bonds And Modern Portfolio Theory. What’s It Really Mean?
What is the difference between a “stock” and a “bond”? A stock
is a title or deed of ownership. A bond is an I.O.U or promise to repay with a specified
rate of interest.
Entrepreneurs like Sam Walton need money or capital to build stores. Suppose you
are an investor with $10,000 looking for an opportunity. You and Sam Walton can
meet in one of the two capital markets where he is shopping for money and you are
shopping for investment opportunities. You can do business in either:
1. The bond market, or
2. The stock market
Mr. Walton can borrow your money in the bond market or he can sell shares of his
company in the stock market.
A mutual fund is a basket of stocks or bonds or both.
Modern Portfolio Theory, on which most asset allocation theories are based, focuses
on diversification across asset classes to reduce the volatility (risk) of the portfolio.
Usually asset managers identify six to twelve different asset classes, and then
use computer models to ascertain the "efficient frontier". The efficient frontier
is presumably the exact mix of investments in each asset class which has historically
provided the highest return for a given amount of risk. While this approach may
be suitable for managing large pension funds, most middle income people don't have
enough zeros in their portfolio for this approach to be practical.
We call our strategy "Functional Asset Allocation" because, when working with families
and individuals, each category serves an important function, or purpose, beyond
simple diversification. For example, while Real Estate is recognized as a separate
asset class by most money managers, the value of your personal residence is more
than a financial calculation. A great deal of your home's value is in your own enjoyment.
Likewise, Functional Asset Allocation takes into account the reality that taxes
are a driving force in Middle America.
While Modern Portfolio Theory seeks to optimize statistical returns on a passive,
static investment portfolio relative to risk based on historical performance, Functional
Asset Allocation uses a different paradigm. It is based on optimizing value in the
utilization of assets in a household, and on the psychological needs and life goals
of real people in a dynamic society. Interestingly, our experience and comparative
analysis have demonstrated that Functional Asset Allocation not only provides most
of the diversification benefits of Modern Portfolio Theory, but also yields a better
after-tax return with less risk for Middle America.
The analogy of the farmer is useful for understanding the separate functions of
the three major asset classes. The interest earning asset class is what the farmer
puts in the root cellar to feed the family during a bad winter or reseed his fields
after a drought. The real estate asset class which is primarily your home is the
equivalent of the farmer’s garden. The garden provides food to eat and flowers for
enjoyment. The equity asset class is the equivalent of the farmer’s fields. The
fields are the farmer’s engine for growing wealth. The larger the fields and the
more productive the crops, the faster his wealth grows.
What Does It Mean To “Properly Balance” Your Investments?
If you have too much in cash reserves you incur the “opportunity
cost” of what that money could be earning if invested elsewhere. If you have too
little in cash reserves you incur the “cost of financial distress”. One example
of the cost of financial distress is when you have to pay 18% interest on a credit
card because you did not have enough cash to pay your electric bill.
Most people just don’t seem to comprehend the risk they are taking. The average
life expectancy of a company is 12.5 years. A full one-third of the companies listed
in the 1970 Fortune 500 had vanished by 1983. The life expectancy of small companies
is even shorter. Do you remember the media stories of employees of Enron, MCI, Worldcom
and small hi-tech companies who were devastated by the tech crash of 2000 because
they had everything in employer stock? Did the warning make a difference? Apparently
not. The same thing happened in 2008. Employees of Lehman Brothers, Countrywide,
AIG, etc lost both their jobs and retirement portfolios heavily invested in company
stock. If you think it is foolish for others to invest so much of their portfolio
in one stock shouldn’t you apply the same standard to yourself?
Everyone agrees with “Don’t put all your eggs in one basket”. Even more hazardous
is to put both your present and future financial well-being into one egg.
Having too much wealth in employer stock is a very common problem. Selling and diversifying
is usually the best solution. But that’s not always possible. There are many other
ways to hedge this risk, such as the use of collars, puts, short selling, risk exchange
pools, etc. You should talk to a qualified advisor who specializes in hedging employee
stock ownership for your particular company.
Why Do People Think Real Estate Is A Better Investment Than Stocks?
Real estate has created more millionaires than any other investment
and it has caused more bankruptcies than any other investment. The explanation for
the two extremes is LEVERAGE. The ability to borrow large sums of money with a small
down payment creates leverage. Without the ability to leverage most Americans would
never be able to own a home. A $20,000 down payment enables the investor to purchase
a $100,000 asset. If the home appreciates 4%/year (the historical average) it will
increase $4,000 in the first year. That $4,000 gain is a 20% Return On Investment
(ROI). How is that possible? While the asset is worth $100,000, your investment
in the home is only $20,000. The ability to borrow money “leveraged” the 4% gain
on your investment into a $20% gain by a factor of five (5x). A smaller 10% down
payment on a $100,000 home would have created greater leverage of 10x. In that case,
a 4% gain would have been leveraged into a 40% return on investment (ROI).
But leverage can also work against you. A 4% decline in the home value becomes a
20% or 40% loss, depending on the degree of leverage, 5x or 10x. It’s the leverage,
not the real estate that creates the millionaires and the bankruptcies.
Because leverage can work both ways, it’s important to not have too much or too
little. Calculating the right amount of leverage and then hedging the downside are
two factors in being a “savvy” real estate investor.
What Is The Fallacy Of Traditional “Asset Allocation Models”?
Below are three reasons traditional asset allocation models
do not work well for individuals:
- The models do not differentiate between risk tolerance, risk capacity, and risk
- Risk Tolerance (Psychological) – How much risk you prefer to take
- Risk Capacity (Financial) – How much risk you can afford to take
- Risk Required (Financial) – How much risk you need to take
- The models ignore human biases and irrational decision making processes recently
identified by behavioral economists.
- The models ignore the economic concepts of consumption smoothing and diminishing
marginal utility. In plain English, most models ignore the human capacity to adjust
So Many Stocks – So Many Options. What Are My Investing Options?
There are about 8,500 publicly traded companies in the United
States. Over 2,300 of them cannot be purchased by either the individual or institutional
investor for various reasons.
Of the remaining 6,200, the largest 3,000 represent 98% of the total value of all
publicly traded companies. In other words, the remaining 3,200 are so small that
they represent only 2% of the total market value of US publicly traded companies.
These smallest 3,200 are called micro caps. For all practical purposes they are
not available to the investing public either. The companies are so small that a
mutual fund would have to purchase the entire company to have even minimal impact
on the portfolio return. This is unfortunate because the long term average return
of the micro cap asset class/category has been about 15%/year which is about 5%
more than the large cap average of 10%/year.
Since there are only about 3,000 companies available to the investing public, and
500 of them make up 85% of the market value, most mutual funds are trading the same
large cap stocks. The manager of one of your mutual funds is selling the “overpriced”
stock to a manager who is buying it for his fund because he believes it is “underpriced”.
For every seller, there is a buyer and vice versa.