Mr. Nocera also stands out for his willingness to discuss the sorry state of his personal finances, a startling admission for a world-class financial journalist. With his sixtieth birthday approaching, he recently revealed to readers that his 401(k) is “in tatters.” Some of the culprits are familiar: A concentrated strategy during the technology boom put a big dent in his portfolio, and a divorce several years later inflicted similar damage. A third source of difficulty is harder to fathom—the decision to raid his 401(k) to fund a home remodeling project. Such behavior strikes us as the sort of short-term thinking journalists are so quick to condemn in the executive suite. Mr. Nocera acknowledges that good financial advisors provide sound advice regarding discipline and diversification, but he doesn’t appear to have consulted one.

Mr. Nocera found a sympathetic ear in Teresa Ghilarducci, a behavioral economist at The New School. She was not the least bit surprised by his experience—most humans, in her view, have neither the skill nor the emotional stability to be successful investors. She finds the entire concept of a participant-driven 401(k) a “failed experiment.”

Prompted by this tale of woe, I dug out twenty-three years’ worth of 401(k) statements and surveyed the results for the first time. As a thirty-nine-year-old research director at LPL Financial, I was late to the starting line for the retirement race. I filled out the enrollment forms and devoted about three minutes to the task of selecting my retirement plan vehicles. When I opened my first 401(k) statement in March 1990, it showed a whopping balance of $195.26 from investments in three Putnam Equity mutual funds—two US and one global. (Mr. Nocera says he began putting retirement money away in the late 1970s, so he had at least a ten-year head start.)

After joining Dimensional in early 1995, I liquidated the Putnam funds and placed the rollover balance in Dimensional’s 401(k). I don’t recall what my thinking was at the time, but with seven equity funds in my account rather than three, it seems plausible that I devoted more than three minutes to the portfolio construction decision. Maybe six.

Over the last twenty-three years I have occasionally been tempted to fiddle with the allocation scheme, usually after some big move in the markets up or down. But I am skeptical of my capacity for self-discipline. What if a tactical decision to underweight small stocks or overweight emerging markets turned out to be right? Would I be tempted to make an even bigger bet the next time? I could find myself on a slippery slope leading to a one-fund portfolio. My preferred strategy, as a result, is to do nothing. Some might argue I have taken this slothful approach to an extreme, having never added a new fund to the lineup (no Emerging Markets Value?!), never tweaked the portfolio weights, and never rebalanced. Call it the Rip Van Winkle strategy—when you get the urge to do something, take a nap.

From a humble beginning, my account has grown to a generous sum over the past twenty-three years, although it hasn’t always been smooth sailing. Using quarterly data, the overall value fell 12.8% during the technology stock meltdown (March 31, 2000–September 30, 2002) and suffered a thumping loss of 46.8% during the financial crisis (September 30, 2007–March 31, 2009), despite a stream of fresh contributions. But the recovery was dramatic as well—up 77.5% for the twelve months ending March 2010 and up another 23.5% for the subsequent year. The current balance exceeds the 2007 high water mark by a comfortable margin. This is not an exercise in self-congratulation, just an example of what anyone could have done by harnessing the forces of competitive markets.

Perhaps the 401(k), in its current form, is indeed a “failed experiment” for a substantial fraction of the workforce. Another interpretation is that the 401(k) was never intended as a centerpiece for retirement funding, and the enrollment process cries out for improvement. Participant outcomes might be greatly enhanced if choices were presented in a way that acknowledges persistent behavioral traits leading to poor decisions.

And when it comes to charting one’s financial future, it appears even journalists skillful enough to unravel complicated financial puzzles can benefit from an objective second opinion.

References

Joe Nocera, “My Faith-Based Retirement,” New York Times, April 28, 2012.

Weston Wellington

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

The exclusivity trap – Congratulations, your higher net worth “earns” you the right to invest in limited access hedge funds, private equity funds, IPOs, or other not-for-everyone investment vehicles. The lure of exclusivity may be a plus for marketing purposes, but it’s no guarantee of less risk or higher return. In fact, getting past the velvet rope line may come at the cost of big minimum investments or higher fees that significantly erode returns. Limited access investments may also have smaller, less liquid markets or lock-up periods that make them harder or impossible to sell.

The glossy brochure trap – When you have more money, you will likely also get more attention. You’ll get more phone calls, more emails, and more glossy brochures, many of them promoting specific investment products, from annuities to commodities to currency trading systems.  These marketing materials can be highly persuasive, but you should be cautious about any sales pitch that begins with the product instead of your goals, risk tolerance, and income needs. BMW may send you a beautiful marketing piece for its latest high performance motorcycle, but that doesn’t make it the right ride for you.

The expertise trap – More investable income means more choice in general, including the choice to act on the expert advice of market commentators, subscribe to pundit newsletters, or take the can’t-miss advice of a wealthy friend. Experts can be convincing, but that doesn’t make them right. And even when they are right on a stock pick or market timing call, it may still not be the right investment for you or your goals.

The pre-fee, pre-tax trap – No matter how many times you hear the phrase “Past results are no guarantee of future performance,” it’s only human to look at historical returns when making investment decisions (along with Morningstar ratings, price/volume charts, and other data with no predictive value.)  What gets less attention but deserves much more is the impact of sales charges, transaction fees, management expenses, and taxes. Because what matters most is not what you earn, but what you keep, fees and tax management are important considerations.

The sacred cow trap – Personal wealth is often concentrated in a single stock, thanks to a long career with one company, the sale or merger of a business, or inheritance. When you treat any big holdings as unsellable based on how you acquired them, the holdings can unnecessarily boost the risk level of your portfolio as a whole.  Because any single stock can crater based on a scandal, lawsuit, product failure, accident, or rumor, deliberate diversification is a smart, easy safeguard, even when it seems like treason to sell “special” stocks.

The by-the-slice trap – Potentially the biggest trap of all is the purchase of any investment without an understanding of how it fits into your total portfolio. Overall investing performance – and the ability to meet important financial goals like a comfortable retirement – hinge less on the individual securities in a portfolio than on the overall asset allocation pie. How assets are distributed among stocks and bonds, and among different types of stocks, is the real key to risk and return. Any decisions that don’t take overall asset allocation into account pose a real danger, regardless of your level of wealth.

The peril of emotion

These are just a few of the traps that await you in the investment arena, especially as your net worth rises. What’s the common thread among them? Well, most have a distinct emotional element, a strong influence on decision-making that’s driven by sentiment rather than science. Whether it’s envy, loyalty, regret or impatience, emotion just doesn’t add much value in investing, and often subtracts plenty.

As hard as it may be to vanquish emotions from the investment equation, it’s one of the most important steps you can take as you negotiate through and around the traps of modern investing.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2012 Bright Sky Group, LLC. All rights reserved.

Long-Term Capital Gains Rates Increase – Taxpayers have enjoyed reduced long-term capital gains rates for several years as a result of the Bush era tax cuts.  However, without Congressional action, which is not expected, those reduced rates will return to the higher rates in effect prior to 2003.  The table below compares the current long-term capital gains rates to the anticipated rates for 2013 and subsequent years.

Taxpayers with unrealized long-term capital gains may wish to review their holdings and consider whether it is appropriate to sell during 2012 at the lower rates or whether to continue to hold for additional increases in value.  Where future increases in value are anticipated, a taxpayer could sell and realize existing gains in 2012 and then repurchase the investment for future anticipated increases.  Investment strategies depend on a variety of issues, including existing capital loss carryovers, growth potential of individual investments, and other factors related to each individual, and should be carefully analyzed before taking action.

Regular Tax Rates – In addition to lower long-term capital gains rates, the regular marginal tax rates have been declining since 2001. However, without Congressional action, those reduced rates will return to higher rates in effect prior to 2001.  The table below compares the current marginal individual tax rates to the anticipated rates for 2013 and subsequent years.

These increased rates will apply to all varieties of ordinary income including interest, dividends, short-term capital gains, employment income, etc.   Marginal tax rates increase as a taxpayer’s overall income increases, taxing the first block of income received at the lowest rate and each subsequent block at ever-increasing rates until the maximum rate is reached. As with assets eligible for the long-term capital gains rates, it may be appropriate for some taxpayers to accelerate ordinary income into 2012 to take advantage of the lower rates.

Surtax on Investment Income – Depending upon what the Supreme Court ultimately decides about the Health Care Law, starting in 2013 a new surtax, called the Unearned Income Medicare Contribution Tax, will be imposed on individuals, estates, and trusts. For individuals, the surtax is 3.8% of the lesser of:

1. The taxpayer’s net investment income or
2. The excess of modified adjusted gross income over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others).

Thus, this surtax will only impact higher income individuals.

“Net” investment income is investment income reduced by allowable investment expenses. Investment income includes:

• Income from interest, dividends, annuities, and royalties,
• Rents (other than derived from a trade or business), 
• Capital gains (other than derived from a trade or business),
• Trade or business income that is a passive activity with respect to the taxpayer, and
• Trade or business income with respect to trading financial instruments or commodities.     

For surtax purposes, the net investment income does not include excluded items, such as interest on tax-exempt bonds, veterans’ benefits, and excluded gain from the sale of a principal residence.

For planning purposes, existing law favors tax-exempt bond interest, which avoids both the surtax and the regular income tax.  However, you should be aware that President Obama’s tax plan would also tax the income from “tax-exempt” bonds for higher-income individuals at generally the same threshold as this surtax kicks in.

It is not too early to start planning for the 2013 tax increases. Prudent planning can significantly reduce the tax bite.  At the same time, keep a watchful eye on Congress. Since this is an election year, tax changes are most likely to come after the November elections.  Please call our office if we can be of assistance in your investment tax planning.

It was a bad year for forecasters of markets and economic data, but not an unusual one. While forecasts – from GNP and interest rates to earnings growth and individual stocks prices – gain lots of media attention, few provide much real direction or value for investors. And many are just plain wrong:

• At the end of 2010, USA Today compiled a list of predictions for the 2011 performance of the S&P 500 index. The forecasts – from eight top investment firms and banks with extensive research departments – ranged from +5 percent (Citigroup) to +15 percent (Barclays Capital). None of the firms correctly predicted the index’s actual performance: flat for the year. ¹ Goldman Sachs predicted a gain of 25 percent, even farther afield. ²
• Blackstone Vice Chairman Byron Wien bravely makes public predictions each year, ten in all. For 2011 he was about half right overall. He correctly guessed where gold would finish the year. But on stocks and bonds he missed wildly. He pegged the S&P 500 up 20 percent and predicted the 10-year treasury yield would jump from 3.3 percent to 5 percent.3  The S&P was flat and the 10-year went the other way – down, not up.
• For 30 years The Wall Street Journal has surveyed economists twice each year on the future direction of interest rates. In 38 of 59 semi-annual periods from 1982 to 2011 the consensus of economists was for a move in the opposite direction of actual results. That’s 36 percent accuracy – considerably worse than one would expect by flipping a coin. ⁴

Active management is prediction
Okay, so predictions by economists and pundits often miss the mark. But do predictions by industry pros really matter to individual investors? The answer is yes. Even if investors ignore analyst forecasts, their portfolios and results can be strongly influenced by predictions. Here’s how.

Any individual with a portfolio that contains actively managed mutual funds is essentially buying into the predictions made by those funds’ managers.

The bread and butter tools of active management – stock picking and market timing – are simply predictions expressed through transactions. Buying Bank of America is a prediction that it will perform positively. Overweighting tech stocks is a prediction. Shifting from bonds to stocks is a prediction. Selling Apple is a prediction. Timing the bottom of a bear market or the top of a bull is a prediction.

More predictions, more trades
Active managers make predictions every day through their buy and sell decisions. More trades means more predictions. According to William Harding, an analyst with Morningstar, the average turnover ratio for managed domestic stock funds is 130 percent.⁵ That means that, on average, all holdings are replaced 1.3 times each year. For a fund with hundreds of stocks, that’s hundreds of predictions each year.

In 2011 many of those predictions were wrong. Standard and Poors reported that 84 percent of actively managed funds underperformed their relevant S&P benchmarks for the year. ⁶ Despite professional experience, sophisticated research tools and elaborate pricing models, far more than half of the active managers fell short of unmanaged benchmarks.

Over the longer term it’s the same story. In six of the last ten years, more than half of active funds have underperformed their S&P benchmarks.⁷ Further, a 2008 study of 2100 active funds over 30 years found only about 14 percent of managers showed a sustained statistical ability (beyond luck) to beat the market. Those results were before expenses; only 0.6 percent outperformed after expenses, essentially zero. ⁸

Investors predict too
Despite the discouraging statistics above, some active managers and their funds can and do beat the market, especially over short timeframes. However, can investors find the winners in advance? To do so, an investor must go to the crystal ball too.

If stock picking by managers is dicey, then fund picking by investors is equally chancy. Past performance, seemingly the most obvious place to look for manager skill, is definitely no guarantee of future results.

Consider the case of Bill Gross of PIMCO. His Total Return Fund grew to the world’s largest mutual fund based on a strong track record of past performance. Until 2011. Early in the year Gross predicted a surge in interest rates and sold off US Treasuries. His prediction was off by 180 degrees – rates fell, not rose – and the fund slid to the bottom end of peer bond funds.⁹ Investors attracted by Gross’s past performance would have seen better results with almost any other bond fund in 2011.

Managers do have good years, but extended winning streaks are rare. According to an analysis in The Fortune Sellers by William Sherden, of the large funds that finished in the top half of returns in 1991, only half repeated in 1992; half of those repeated again in 1993; and so on through five years, the same ratios random coin flipping would yield. ¹⁰ Identifying the few managers capable of a hot multiyear run – in advance – appears to be largely a matter of luck.

Portfolios without predictions
Basing any investment decisions on prediction of future events is essentially a guessing game. The alternative for investors is to ignore all forecasts, reject all predictions and create a buy-hold-rebalance portfolio of asset class holdings.

Unlike actively managed funds, asset class funds seek to deliver the market returns of their specific asset classes (such as large cap domestic stocks, emerging market stocks, or short-term bonds), while controlling expenses and tax exposure. It is no coincidence that asset class funds typically have far lower turnover rates than actively managed funds; their managers are not making daily judgments and predictions about what is going to happen next.

A diversified portfolio of asset class funds is a patient investment in capitalism, not a speculative attempt to beat the market. Asset class investing allows individuals to attain the rates of return offered by the market and move on with life.

Suggested reading: William A. Sherden, The Fortune Sellers, John Wiley & Sons, 1998.

¹ “Stock forecasters predict market gains in 2011,” http://www.usatoday.com/money/markets/2010-12-10-targets10_ST_N.htm

² “Goldman Sachs 2011 Forecast: Stocks, Gold, Oil Higher,” http://www.cnbc.com/id/40530212/Goldman_Sachs_2011_Forecast_Stocks_Gold_Oil_Higher

³ “Blackstone’s Byron Wien Presents His 10 Big Surprises For 2011,” http://www.businessinsider.com/blackstones-byron-wien-10-surprises-2011-2011-1#1-gdp-surges-to-5-growth-and-unemployment-falls-below-9-1

⁴ Sources: Legg Mason, The Wall Street Journal Survey of Economists and Davis Funds.

⁵ “Mutual fund turnover and taxes,” http://www.bankrate.com/brm/news/investing/20020306a.asp

⁶ “S&P study finds 84 percent of stock funds underperformed market benchmarks last year,” http://www.washingtonpost.com/business/industries/sandp-study-finds-84-percent-of-stock-funds-underperformed-market-benchmarks-last-year/2012/03/12/gIQAnEx57R_story.html

⁷ Ibid

⁸ “The Prescient Are Few,” http://www.nytimes.com/2008/07/13/business/13stra.html?_r=2

⁹ “Pimco’s bad bond bet,” http://money.cnn.com/2011/08/30/markets/bondcenter/bonds_pimco_bill_gross/index.htm

¹⁰ William A Sherden, The Fortune Sellers, John Wiley & Sons, 1998, p.108.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2012 Bright Sky Group, LLC. All rights reserved.

Talking About Money With Children Under 18

Q: At what age should children begin to be educated about money?

A: You talk about it as soon as they can start understanding those concepts. When children are in elementary school, you can introduce the concepts of planning and saving, long-term gratification and short-term gratification, and “giving back.” You gear the conversation to where a child is developmentally and what he or she can cognitively understand at that point.

Q: How can we help the next generation learn to manage what they have and adapt when they encounter challenges (financial and otherwise)?

A: In an effort to give children everything and at the same time protect them from hardship, we are robbing them of having the experiences that ultimately create a sense of well-being for us as adults.

For example, let’s use the analogy of the increasing rates of children with allergies. There is much speculation that we are now seeing higher levels of allergies because children have less exposure to dirt, dust, pollen and the outdoors. Children raised in this type of “hermetically-sealed” environment do not develop resistance to allergens. We can make the same statement with regard to children and self-sufficiency. In our culture, we are seeing college students fall apart emotionally because they have not yet developed any of their own internal resources. Their resilience is still based on external factors — what mom and dad do for them.

Instead, by allowing a child to feel the impact and consequences of his or her behavior, or by letting a child feel disappointment, we empower children to think independently and develop their emotional muscle.

Q: What negative messages do children learn about money from society?

A: Two big messages are: 1) it is shameful to talk about money and 2) if you have money, you’re better than somebody who doesn’t have money.

As a society, we send out these messages of “Shhh, we don’t talk about money.” This silence can suggest to a child that there must be something bad about it. Otherwise, why would we be secretive?

Society also sends the message that money equals power: If I have money, I can expect you to treat me as if I am special. Society gives very mixed messages about money: That it is really important to have money, and it makes you special but that it also sets you apart. Do people like you or really want to be with you only because you have money, or do they like you for who you are? If your sense of self is tied up in net worth, you are dependent on things outside of yourself instead of feeling good because of who you are and what you have accomplished.

If children grow up feeling that their power is because of money, what happens if they no longer have that money? Do they have any power? Do they have any presence? Do they have any real sense of self-worth? Too often, people confuse their self-worth with their net worth.

It is important for children to understand that wealth is a result of our hard work, or because of the hard work of our ancestors, and we have been the beneficiaries of that work. So, we don’t squander what we have because we respect the amount of work that goes into gaining it. As a parent, you want to convey the respect you have for what you do and for your hard work. And you want your children to value what they have and treat their things responsibly. As parents, we want our children to understand that we have what we have because we work hard for it. And that knowledge comes by talking.

Q: How can you teach children the value of items that the family may view as precious and important (for example, family heirlooms) that children may consider just another household item that can be easily replaced?

A: I would start with stories. Very early on, you can talk with a child about how important it is for the family to have these cherished items from grandparents or other family members. So, the theme I would keep coming back to is one in which you begin to invocate value and what it means for the family to have these special items. For children to understand that something is special, not just because it might be worth a lot of money, but because of the item’s family history. Children benefit from learning that everything does not have equal value. If everything were deemed equally important, then children have no way of assessing what really matters and why. We need to teach children that not everything is disposable.

When you have something tangible, for example, grandma’s ring or grandfather’s sword, you can have the conversation about its significance and how it is not replaceable. You can also introduce the idea that, one day, the item will become theirs, but not right now. Starting these conversations early on also helps children deal with the current culture that sends the message that things are replaceable.

Q: How do you begin to tell a child that he or she will be an heir?

A: You talk about it at different levels depending on the age of the child. For young children, you could start by introducing the idea of how fortunate your family is, that not everyone is so fortunate, and that they will be in a position to have a wider range of choices about what they would like to do when they grow up.

When children are old enough to begin making career choices, you might discuss how they will not have to choose a career based on its earning potential. Instead, they will have enough money to choose a career based on its heart potential. They can pursue something they feel passionate about without worrying whether it will also be highly paid.

Allowances and Budgets for Children Under 18

Q: What are some ways to teach children good money management skills?

A: I’m a big believer in allowances and clothing budgets. Allowances give children the opportunity to prioritize and make decisions about how to spend what’s available to them. Parents with young children (because I do think this should start at an early age) can introduce the concept of allocating money. For example, X percentage of allowance goes to savings, X percentage of allowance goes to philanthropy and X percentage of allowance goes to spending.

When it’s their money and they budget it, they can choose to spend what and how they want. They start to get some experience with being responsible for their financial decisions. This becomes the same issue with a clothing budget. I think the glory of clothing budgets is this: When you give children a clothing allowance, you move away from a scenario of conflict in which you have to say “No, you can’t have that,” or “That’s too expensive” or “You have too many of those already.”

Instead, you give a certain amount of money, and they have to learn how to allocate that money. If they want to blow their whole allowance on one pair of jeans, that’s their choice. But they can’t come back and say, “But I don’t have enough money for new shoes.” This way, they have to learn about the relative value of things as it relates to their spending habits.

Q: How does this process work?

Amounts of allowances or clothing budgets vary from one family to the next. It can be useful for a parent to sit down and look at what’s been spent. Then come up with an initial amount that seems reasonable. Not as fixed in stone, but as a trial period for 3–6 months and see how it works.

Allowances should be a base. If children want to earn extra money, they could do chores around the house or mow the lawn every week. That way, if they want more than what seems reasonable to you as an allowance, they have other options to earn money. It also teaches them about motivation, incentive and agency.

Q: Should an allowance be based on work/chores?

A: No, the allowance I’m suggesting is based on the idea that they are part of a family. It is associated with being a productive and functioning member of a family, and how a parent defines that is important. Parents encounter problems when chores are connected to allowances. What portion of an allowance should parents withhold if their children do not complete all their chores? How do parents respond if a child empties the dishwasher only five days one week and seven days the next week? I think parents can get into trouble with that system — and it is a lot of extra work for them!

Q: What happens when children become teenagers and their parents have never talked to them about money?

A: It may be more difficult because a parent may have to focus on undoing learned behaviors. But even with 30-year-old children, it’s not too late to start. It’s never too late to start to ask people to be accountable. And it’s never too early.

About Marilyn Wechter, MSW, BCD

Marilyn Wechter, MSW, BCD is a psychotherapist and wealth counselor. She has been in private practice in St. Louis for more than 30 years working with adolescents, adults, families and couples. In addition, she works with estate lawyers, investment advisors and executive coaches. She has taught courses on normal and abnormal development at Washington University in St. Louis, and courses on images of women in film from a cultural and psychological perspective at Webster University in St. Louis. The opinions and comments expressed in this article are her own and may not accurately reflect those of Green Wealth Management.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2012, Green Wealth Management, LLC, used with permission.

Successful investing and financial planning also require balancing tradeoffs. For example, a common investment tradeoff is that of risk and return. One of the competing demands is preservation of capital versus preservation of purchasing power. The former may allow for a better night’s sleep during periods of heightened uncertainty and corresponding volatility, but the latter helps ensure you’ll have a comfortable bed in the future when accounting for rising prices from inflation. Once again, there is no right answer, no “optimal” solution. Understanding the tradeoffs between preserving capital and preserving purchasing power will help investors find the balance that is right for them. This balance will depend on their definition of risk and attitude towards it.

Some investors may consider risk to be volatility. They have difficulty stomaching the daily ups and downs associated with investing in asset classes that experience significant price fluctuations, such as equities, because declining prices are often accompanied by predominantly negative headlines. Although information will be reflected in prices before one can react to it, this is little solace to investors who extrapolate the recent past into the future and see the bad news as an indicator of what’s to come rather than a commentary on what has already happened. These investors yearn for short-term preservation of capital.

Other investors may define risk as a diminishing standard of living. They have long-term financial obligations, such as spending during their retirement years, and their primary goal is building wealth to meet those future expenses. They recognize that, while the cumulative effects of inflation are sometimes glacially slow or even undetectable in real time, inflation can be the silent killer of a financial plan. These investors desire long-term preservation of purchasing power.

Investing is relatively straightforward when the definition of risk and attitude toward it are so black and white. For example, you can virtually guarantee the preservation of capital by investing in the equivalent of Treasury bills as long as you accept the corresponding potential for the loss of purchasing power. On the other hand, you can preserve purchasing power by investing in asset classes with expected returns exceeding inflation, providing you accept price fluctuations that can temporarily impair your capital.

Unfortunately, in practice, investing isn’t that simple. Individual investors rarely have black and white objectives or well-defined definitions of and attitudes towards risk. Some expect long-term preservation of purchasing power and short-term preservation of capital. Making matters worse is the tendency for the priority and relative importance of their competing demands to change through time, often in response to what’s happened in the recent past.

Investors who succumb to the cycle of fear and greed end up chasing a moving target. Advisors can try to mitigate this destructive behavior by focusing investors on the tradeoffs that were made at the outset when determining their balance between assets that are expected to grow faster than inflation and those that stabilize the portfolio and reduce its fluctuations. So if an investor is now fearful and therefore more focused on capital preservation, it is time to reframe the tradeoffs by emphasizing why growth assets were in the portfolio to begin with and how the so-called “riskless” asset (i.e., bills) can actually be extremely risky in the long run.

For example, Table 1 contains annualized returns from Australia, Canada, the US, and the UK for more than a century. Bills only slightly beat inflation before tax, but this small return advantage can easily disappear on an after-tax basis.¹ Nonetheless, the table clearly demonstrates that equities have delivered returns exceeding both bills and inflation by a wide margin, even when accounting for taxes.²

Table 1: Annualized Nominal Returns (1900–2010)³

However, the tradeoff for pursuing higher expected returns of equities is accepting the risk of substantial declines compared to the relative stability of bills. Table 2 shows that equity values in the four markets have dropped from 50–69% over a two- to six-year period, whereas bills have always been flat or better (if you consider minus 2 basis points a rounding error).

Table 2: Worst Performing Periods for Equities and Bills, Nominal Returns (1900–2010)³

The risk and return relationship from a preservation of capital perspective is apparent in these nominal returns, but the picture is a bit different after considering the impact of inflation. In terms of preserving purchasing power, now the “riskless” asset looks far from risk free.

Table 3 contains the biggest peak-to-trough declines, in real terms, for equities in these four countries over the same time period. It likely comes as no surprise that the magnitude of the real declines is substantial, with stock prices dropping anywhere from 55–71% after inflation. However, the duration of the declines is still relatively short, ranging from two to five years, and it took equity investors in these countries anywhere from three to eleven years to break even.

Table 3: Worst Performing Periods for Equities, Real Returns (1900–2010)³

In contrast, the data in Table 4 for bills, or the “riskless” asset, in these four countries is revealing. The biggest peak-to-trough declines after inflation now remarkably range from 44–61%, a similar order of magnitude to equities. Furthermore, the duration of the declines extends to a range of seven to forty-one years with investors in bills waiting an astounding seven to forty-eight years to recover!

Table 4: Worst Performing Periods for Bills, Real Returns (1900–2010)³

More than ever, comparisons like these are needed when discussing the tradeoff of preserving capital versus preserving purchasing power. Investors feel the risk of equities in real time. Volatility is immediate and apparent as their portfolio value shows up in the mail every month or on their computer screen every day. Conversely, the risk of investing in bills and other low-volatility assets is less discernible and may take time to detect as it shows up when investors open their wallet at the grocery store or gas station many years later.

Investors may still want to revisit the tradeoffs they made and alter course if appropriate. However, changes to a long-term plan should reflect an informed decision rather than an emotional one. Fear and greed are powerful forces, but we should resist letting them dictate the tradeoffs we make in our lives or in our portfolios.

As the Most Interesting Man in the World would say, “stay invested, my friends!”

Many thanks to Marlena Lee for compiling this data from the Dimson Marsh Staunton (DMS) Global Returns Database.

2. The difference in the real return of equities versus bills would increase after taxes in countries where the tax rate on income exceeds the tax rate on dividends and capital gains.

3. In local currency. Dimson Marsh Staunton (DMS) Global Returns Database. Past performance is no guarantee of future results.

Brad Steiman

Copyright 2012 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

• Focusing solely on how much of an investment gain could be lost to taxes
• Worrying so much about taxes that it adversely affects decision making

Eating Up Gains
Many (if not most) investors focus on the pretax value of their investments, even though they can only spend after-tax dollars. To see why this is so important, consider the 1993 study done by two Stanford University economics professors. They examined 62 stock mutual funds before and after taxes for the period 1963–1992. They found that each dollar invested would have grown to $21.89 in a tax-deferred account, but only $9.87 in a taxable account (for high-income investors).

Many fund companies offer tax-managed counterparts, which strive both to minimize fund distributions and to maximize the percentage of distributions that will be in the form of long-term capital gains (which are currently taxed at lower rates than short-term gains or ordinary income).

Avoiding Taxes, Creating Other Problems
Such tax issues may leave some investors saying, “I’ll just avoid paying taxes at all costs.” However, avoiding tax bills could end up being a bad decision. For this, let’s look at a hypothetical example.

In August 2004, an investor bought 200 shares of Google at $100 per share. This $20,000 investment was 5 percent of his total portfolio of $400,000, which was split evenly between stocks and bonds (meaning $200,000 in each). The stock skyrocketed, as Google crossed $700 about three years later. His stake in Google, now worth $140,000, represented about 25 percent of his portfolio, which had grown to $600,000. This also meant his stock allocation had jumped from 50 percent to 70 percent.

While seeing such an increase in the portfolio was a welcome sight, it also meant the investor’s allocation had drifted far from where he started, meaning he was now taking on much more risk than before. However, rebalancing the portfolio would mean paying the tax bill on his appreciated shares. Assuming a federal and state tax rate of 20 percent, there would be $24,000 in taxes on the $120,000 gain. That bill was too much for the investor to swallow, so he decided against rebalancing.

By January 2009, Google fell to $300, leaving his investment sitting at $60,000. Had he sold at the peak, the investor would have had net cash of $116,000 (the stock’s $140,000 minus the $24,000 tax bill). Selling at $300 meant his tax bill dropped to just $8,000, leaving him with $52,000 net cash. He still saw a solid profit from his investment, but avoiding $16,000 of that $24,000 tax bill cost him $64,000.

Summary
Taxes are possibly the largest single expense that investors incur, even greater than management fees or commissions. Therefore, ignoring the impact of taxes is one of the biggest mistakes you can make.

However, it is also possible to become so concerned with taxes that you deviate from a prudent investment strategy to avoid the pain of paying them. You would be wise to remember that the only thing worse than having to pay taxes is not having to pay them.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2012, Green Wealth Management, LLC, used with permission.

Probate protection
In addition to ensuring your assets pass to the individual(s) of your choice, assigning a beneficiary can exempt some assets from probate. Probate is typically a lengthy multi-step process where your assets are inventoried, creditors are paid, and remaining assets are distributed according to your estate plan. Probate is also costly; costs vary by state but may total as much as 3-7% of estate value. By designating a beneficiary, your loved ones will typically have access to funds more quickly, and with less legal expense.

Here are some beneficiary strategies that will help to ensure your estate plan follows your intentions. Of course, consult your legal and investment advisors on these matters.

• Check all your accounts. Beneficiary designations can be made on a wide range of assets, from 401(k) plans and ESOPs to insurance policies, annuities, and stock options. Verify that you have made your wishes known on all eligible accounts.
• Stay current.  Births, deaths, marriages, divorces, graduations, changes in the financial status of loved ones, and philanthropic interests may affect your intentions for passing on your assets. Be sure to review all beneficiary designations on a regular basis. Failing to do so may mean, for example, that an ex-spouse receives funds you would prefer someone else to have.
• Divide when appropriate. When you make designations, you can split assets among loved ones in the exact percentages you desire. This ability can be particularly helpful in preventing family disputes after your death.  Intentionally splitting assets within accounts may also be preferable to naming different family members as beneficiaries on different accounts that may appreciate at different rates.
• Designate a back-up. If your primary beneficiary predeceases you and no secondary designation has been made, the asset may end up in probate. Assign a secondary beneficiary on all eligible accounts.
• Remember causes. In many cases, your beneficiaries will be liable for income tax on some or all of the assets received. However, the tax bill may not apply to a qualified charity. If you intend to support a philanthropic cause, naming it as a beneficiary may be an efficient way to do it.
• Think beyond your estate. It is generally not advisable to name your estate as beneficiary as it will pull non-probate assets into probate. It may also have adverse income tax consequences.
• Carefully consider trusts. It may make sense to name a trust as beneficiary in some cases, especially if the trust will oversee funds for minor children or disabled individuals. However, other things being equal, naming a trust may require accelerated distributions to recipients – possibly creating greater tax liability sooner than if the individuals were named as beneficiaries directly. Consult your attorney or CPA for the specifics of your situation.

Stay in synch
Above all else, make sure your beneficiary designations are aligned with your will, living trust, and overall estate plan. Consult with you attorney and CPA as you make beneficiary designations to ensure that all elements of your plan work together toward the same goals.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2012 Bright Sky Group, LLC. All rights reserved.

In regard to gold and its investment merits, however, Buffett has had little to say—at least in the pages of his annual shareholder letter. We searched through 34 years’ worth of Berkshire Hathaway annual reports and were hard-pressed to find any mention of the subject whatsoever. The closest we came was a rueful acknowledgement from Buffett in early 1980 that Berkshire’s book value, when expressed in gold bullion terms, had shown no increase from year-end 1964 to year-end 1979.

Buffett appeared vexed that his diligent efforts to grow Berkshire’s business value over a fifteen-year period had been matched stride for stride by a lump of shiny metal requiring no business acumen at all. He promised his shareholders he would continue to do his best but warned, “You should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.”

As it turned out, the ink was barely dry on this gloomy assessment when gold began a lengthy period of decline that tested the conviction of even its most fervent devotees. Fifteen years later, gold prices were 25% lower, and even after thirty-one years (1980–2010), had failed to keep pace with rising consumer prices. By year-end 2011, gold’s appreciation over thirty-two years finally exceeded the rate of inflation (205% vs. 195%) but still trailed well behind the total return on one-month Treasury bills (398%).

Perhaps to compensate for his past reticence on the subject, Buffett has devoted a considerable portion of his forthcoming shareholder letter (usually released in mid-March) to the merits of gold.

With his customary gift for explaining complex issues in the simplest manner, Buffett deftly presents a two-pronged argument. Like a sympathetic talk show host, he quickly acknowledges the darkest fears among gold enthusiasts—the prospect of currency manipulation and persistent inflation. He points out that the US dollar has lost 86% of its value since he took control of Berkshire Hathaway in 1965 and states unequivocally, “I do not like currency-based investments.”

But where gold advocates see a safe harbor, Buffett sees just a different set of rocks to crash into. Since gold generates no return, the only source of appreciation for today’s anxious purchaser is the buyer of tomorrow who is even more fearful.

Buffett completes the argument by asking the reader to compare the long-run potential of two portfolios. The first holds all the gold in the world (worth roughly $9.6 trillion) while the second owns all the cropland in America plus the equivalent of sixteen ExxonMobils plus $1 trillion for “walking around money.” Brushing aside the squabbles over monetary theory, Buffett calmly points out that the first portfolio will produce absolutely nothing over the next century while the second will generate a river of corn, cotton, and petroleum products. People will exchange their labor for these goods regardless of whether the currency is “gold, seashells, or shark’s teeth.” (Nobel laureate Milton Friedman has pointed out that Yap Islanders got along very well with a currency consisting of enormous stone wheels that were rarely moved.)

When Buffett assumed control of Berkshire Hathaway in 1965, the book value was $19 per share, or roughly half an ounce of gold. Using the cash flow from existing businesses and reinvesting in new ones, Berkshire has grown into a substantial enterprise with a book value at year-end 2010 of $95,453 per share. The half-ounce of gold is still a half-ounce and has never generated a dime that could have been invested in more gold.

Few of us can hope to duplicate Buffett’s record of business success, but the underlying principles of reinvestment and compound interest require no special knowledge. Every financial professional can point to individuals who have accumulated substantial real wealth from investment in farms, businesses, or real estate, and sometimes the success stories turn up in unlikely places. (See “The Millionaire Next Door.”)

Where are the fortunes created from gold?

Warren Buffett, “Warren Buffett: Why Stocks Beat Gold and Bonds,” Fortune, February 27, 2012. Available at: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/.

Milton Friedman, Money Mischief (Boston: Houghton Mifflin Harcourt, February 1992).

Stocks, Bonds, Bills and Inflation, March 2011.

Bloomberg.

Berkshire Hathaway Inc. Available at: www.berkshirehathawy.com (accessed February 21, 2012).

Weston Wellington

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

This month, twenty-four out of twenty-seven market economists polled by Bloomberg forecast that the Reserve Bank of Australia would cut its benchmark official cash rate by one-quarter of a percentage point to 4.0%, the third such move since November last year.¹

The rationale seemed clear enough. The global economy was moderating, local activity was slowing, household spending had eased, employment growth was weakening, inflation pressures had receded, and the strength of the local currency was making life tough for non-commodity exporters and import-competing businesses.

A Bloomberg journalist wrote: “The Reserve Bank of Australia is poised to respond to the nation’s weakest job market in almost 20 years by lowering interest rates for a third time tomorrow, the most aggressive rate cuts since the global financial crisis.”

In its own preview, the Sydney Morning Herald‘s reporter was even more emphatic: “A betting plunge on financial markets puts an interest rate cut today as good as certain with weak retail sales figures indicating the worst growth on record.”²

Yet, the central bank confounded market expectations and kept rates on hold. The market reaction was dramatic. The Australian dollar took off like a rocket, hitting its highest levels in six months against the US dollar and rising on the cross rates. Shares eased and bond yields rose.

At this point, the very same economists who had carefully parsed the bank’s language going into its decision proceeded to analyze in great detail the wording of the statement announcing that rates would stay where they were for another month.

Actually, there really wasn’t that much remarkable about what the RBA said. Essentially, it had decided that, with economic growth close to its long-term trend and inflation on target, the RBA could afford to wait another month to see how events in Europe and elsewhere panned out.

Local bank economists immediately pushed out their expectations for the next policy easing to March. Some had second thoughts altogether and decided the central bank might be done on interest rates for the foreseeable future.

For everyday investors, there are a few lessons out of this episode. The first is that there is very little evidence market professionals—including the ones closest to policymakers—are any better than anyone else in forecasting the prices of securities, commodities, interest rates, or currencies.

Last August, for instance, a global bond fund manager admitted he felt like “crying in his beer” over his call in March 2011 to dump almost all of his flagship fund’s US government bond holdings because interest rates were unsustainably low.³

The second lesson is that trying to time markets—picking the turn in performance of bonds versus equities or government bonds versus corporate bonds or value stocks versus growth stocks—is a pretty tough job. In fact, few (if any) people seem to get it consistently right.

The third takeout is that it really doesn’t matter how strong you think the fundamental case is for an interest rate change or a lower currency or a higher stock price; events have a distinctive and unerring way of messing up your impeccable logic.

An example: In the US in February this year, strategists at some of the world’s biggest investment banks capitulated on their bearish forecasts after global stocks registered their best start to a year since 1994. In a summary of recent research, Bloomberg quoted strategists at several banks as admitting they had gotten their timing badly wrong.⁴

The final message is that you don’t really need any of this fundamental analysis to build long-term wealth. Markets are unpredictable because news is unpredictable.

This means the best approach is to structure a diversified portfolio that is built according to your own investment goals and risk appetite, both across and within asset classes. Occasional rebalancing of the portfolio ensures you maintain an asset allocation consistent with your risk profile. The rest is all about discipline.

This may not be a particularly exciting investment story. But it’s one that works. And it doesn’t require you to make forecasts about interest rates, currencies, stock prices, or economies. As we have seen, there are some serious cracks in the crystal ball.

1. Michael Heath, “RBA Poised to Cut Rate on Worst Jobs Since ’92,” Bloomberg, February 6, 2012.

2. Peter Martin, “Markets Bet on Rates Cut,” Sydney Morning Herald, February 7, 2012.

3. David Magee, “PIMCO’s Bill Gross: Betting Against US Debt a Mistake,” International Business Times, August 30, 2011.

4. “Global Strategists are Abandoning Bearish Views,” Bloomberg, February 3, 2012.

Jim Parker

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.