Why I Chose Patience over Re-balancing

Investment-Rebalancing

Many financial advisors recommend re-balancing your portfolio no less often than annually to ensure the asset allocation is consistent with your risk tolerance, as illustrated in this post from Schwab.  In the past, I haven’t been one to re-balance my portfolio, so I spent some time thinking about why I haven’t followed this common advice.  Up until recently, almost all of my invested assets have been equities, equity-based mutual funds or exchange-traded funds (ETFs).  As such, I didn’t need to do any re-balancing across asset classes.

In this post, I’ll explain re-balancing, its specific purpose and examples of its benefits and drawbacks.  I’ll also explain my strategy (which may or may not be right for you).

What is Re-balancing?

Re-balancing is the process of buying and selling securities in your portfolio to meet certain targets.  In the case of asset classes, the primary purpose of re-balancing is to maintain your target risk/reward balance.

Some people have targets that define their desired allocation across asset classes.  One common rule of thumb is that the portion of your portfolio that should be in bonds is equal to your age with the rest in stocks.  In my case, that would mean roughly 60% of my portfolio in bonds and 40% in stocks.  The goal of this rule of thumb is to decrease the volatility of your investment returns as you get older and closer to that age at which you need to draw down your assets in retirement.

How Does Re-balancing Work?

The process of re-balancing is fairly simple.  Periodically, such as once or twice a year, you compare the market value of your investments with your targets.  If there is a significant difference between how much you own in an asset class and your target percentage, you sell the portion of your investments that is above the target and reinvest the proceeds in something different.

Let’s say your target is 75% stocks and 25% bonds.  You start the year with $10,000 of investments – $7,500 in stocks and $2,500 in bonds.  If stocks go up by 10% and bonds go up by 5%, your year-end balances will be $8,250 in stocks and $2,625 in bonds, for a total of $10,875.  Your targets though are $8,156 of stocks (75% of $10,875) and $2,719 of bonds.  To put your portfolio back in balance, you would need to sell $94 (= $8,250 – $8,156) of stocks and buy $94 of bonds.

You can avoid selling any assets if you have money to add to your investments at the end of the year.  Continuing the example, let’s say you have another $500 available to invest at the end of the year.  That brings your total available for investment to $11,375 (= $10,875 of investments plus $500 cash).  Your targets would be $8,531 (= 75% of $10,875) for stocks and $2,843 for bonds.  In this case, you would buy $281 of stocks and $219 of bonds to meet your targets, eliminating the need to sell any of your assets.

What Does Asset Allocation Do?

The chart below compares the average annual returns and risk profiles of several sample portfolios with different mixes between stocks and bonds.  In the middle four portfolios, the first number is the percentage of the portfolio invested in stocks and the second number is the percentage in bonds.

Annual Returns for Different Asset Allocations 1980-2019

Average Returns

In this chart, the average annual return is represented by the blue dash.  When the blue dash is higher on the chart, it means that the returns on the portfolio were higher, on average, over the historical time period.

Volatility

The green boxes correspond to the ranges between the 25th percentile and the 75th percentile.  The whiskers (lines sticking out of the boxes) correspond to the ranges from the 5th percentile to the 95th percentile.   When the box is tall and/or the whiskers are long, there is a lot of volatility.  In this case, it means that the annual return on the portfolio varied a lot from one year to the next.  At the opposite end of the spectrum, when the box and whiskers are all short, the range of returns observed historically was more consistent.

Comparison of Portfolios

I have arranged the portfolios so that the one with the most volatility – 100% in the S&P 500 – is on the left and the one with the least volatility – 100% in bonds as measured by the Fidelity Investment Grade Bond Fund (FBNDX) – is on the right.  You can see how adding bonds to the S&P 500 reduces volatility as the height of the boxes and whiskers gets smaller as you move from left to right.  At the same time, the average annual returns decrease as bonds are added to the portfolio.  Over the time period studied (1980 to 2019), the S&P 500 had an average annual return of 8.7% while the Bond Fund had an average annual return of 7.2%.  By comparison, returns on investment grade bonds are currently generally less than 4%.

Another Perspective

Because stocks and bonds are not 100% correlated, the volatility (spread between tops and bottoms of boxes and whiskers) of owning a combination of both is less than the volatility of owning just the riskier asset – stocks.  As I was preparing the chart above, I noticed, though, that the bottom whisker for the 100% bonds portfolio goes lower than the bottom whisker for the 80% bonds portfolio.

Specifically, there were more negative returns in the historical data (i.e., more years in which you would have lost money in a single year) if you owned just bonds than if you owned the portfolio with 80% bonds and 20% stocks.   The 80% bond portfolio had a negative return only 7.5% of the time while the 100% bonds portfolio had a negative return 10% of the time!  As more bonds are added to each portfolio, the blue bar/average moves down.  This downward shift actually moves the whole box and the whiskers down.

This relationship can be seen in the chart below.

The dots correspond to the portfolios in the previous chart with labels indicating the percentages of stocks in the portfolios.  The horizontal or x-axis on this chart represents the average annual return.  Values to the right correspond to higher average annual returns (which is good).  The vertical or y-axis represents the percentage of years with a negative return.  Values that are higher on the chart correspond to portfolios with more years with negative returns (which is bad).

Optimal Portfolios

“Optimal” portfolios are those that are to the right (higher return) and/or lower (fewer years with negative returns).  Any time a point is further to the right and at the same level or lower than another one, that portfolio better meets your objectives if probability of having a negative return is your risk metric.

More Stocks Can Be Less Risky

I have circled two pairs of dots.  The ones in the lower left corner are the two I’ve mentioned above.  The 20% stocks (80% bonds) point is lower than and to the right of the 0% stocks (100% bonds) point.  As you’ll recall, the average return on the 20% stocks portfolio is higher than the average return on the all-bond portfolio so the dot is to the right (better).  The percentage of the time that the annual return was less than zero was smaller for the 20% stocks portfolio so the dot is lower (also better).

There is a somewhat similar relationship between the 60% and 80% stocks portfolios (circled in green in the upper right).  The 80% stocks point is at the same level and to the right of the 60% stocks point.  As such, if average annual return and probability of a negative return are important metrics to you, moving from 80% to 60% stocks or 20% to 0% stocks would put you in a worse position as you would have less return for the same risk.

Re-balancing Can’t Be Done Blindly

Setting a target asset allocation, such as 80% stocks and 20% bonds, allows you to target a risk/reward mix that meets with your financial goals.  As I indicated, the purpose of re-balancing is to ensure that your portfolio is consistent with your goals.  However, it is important that you considering the then-current economic environment when re-balancing.

Interest Rates

For example, interest rates are lower than they were at any point in the historical period used in the analysis above.   Over the next several years, interest rates are unlikely to decrease much further, but could stay flat or increase.  If interest rates stay flat, the returns on bond funds will tend to approach the average coupon rate of bonds which is in the 1% to 3% range depending on the quality and time to maturity of the bonds held.  This range is much lower than the average annual return of 7.2% in the illustrations above.

If interest rates go up, the market price of bonds will go down, lowering returns even further.  As such, the risk-reward characteristics of bonds change over time.  I would characterize them as having lower returns and higher risk (the one-sided risk that prices will go down as interest rates go up) now than over the past 40 years.

Stock Prices

Similarly, the S&P 500 is currently close to or at its highest level ever in a period of significant economic and political uncertainty.  While I don’t have a strong opinion on the likely average annual returns on the S&P 500 in the next few years, I think it is likely to be more volatile in both directions than it has in the recent past.

If you re-balance your portfolio, you will want to form your own opinions about the average returns and volatility of the asset classes in which you invest.  With these opinions, you can decide whether the asset allocation you’ve held historically will still provide you with the risk/reward profile you are seeking.

Re-balancing and Income Taxes

Another consideration when you are deciding whether and how often to re-balance your portfolio is income taxes.  Every time you sell a security in a taxable account, you pay income taxes on any capital gains.  If you lose money on a security, the loss can offset other capital gains.  On the other hand, if you own the securities in a tax-free (Roth or TFSA) or tax-deferred (traditional or RRSP) account, re-balancing has no impact on your taxes.

Re-balancing Example

Let’s look at an example of the taxable account situation.  If you targeted a portfolio of 60% stocks (in an S&P 500 index fund) and 40% bonds (in FBNDX) from 1980 through 2019, you would have made the transactions shown in the chart below.

Rebalancing Stock Transactions

In this chart, the bars represent the amount of the transaction as a percentage of the amount of stocks held at the beginning of the year.  A bar that goes above zero indicates that you would have bought stocks in that year.  A bar that goes below zero indicates that you would have sold stocks in the year.  The proceeds from every sale would have been used to purchase the bond fund.  Similarly, the money used to purchase stocks would come from a corresponding sale of the bond fund.

In every year, you either sell some of the stock index fund or the bond fund.  The difference between the price at which you sell a security and the price at which you buy it is called a capital gain.  You pay income taxes on the amount of capital gains when they are positive.  In the US, many people pay a Federal tax rate of 15% on capital gains in addition to any state income taxes.  The Canadian tax rate on capital gains is of about the same order of magnitude.

Reduction in Return from Income Taxes

Income taxes, assuming a 15% tax rate, would have reduced your annual average return from 8.4% to 8.1% over the 1980-2019 time period.  Put in dollar terms, you would have had just under $250,000 at the end of 2019 if you started with $10,000 in 1980 and used this asset allocation strategy if you didn’t have to pay income taxes.  By comparison, you would have had about $220,000 if you had to pay income taxes on the capital gains, or 12% less.

As you consider whether re-balancing is an important component of your financial plan, you’ll want to make sure you understand the impact of any income taxes on your investments returns.

Why Only Equities?

You may have been wondering why I was invested almost solely in equities for all of my working life and not in a combination of asset classes, such as stocks and bonds.   My philosophy was that I preferred to use time to provide a diversification benefit rather than an array of asset classes.  By keeping my invested assets in stocks, I was able to take advantage of the higher expected returns from stocks as compared to bonds.

The chart below helps to illustrate this perspective.

Annual Returns - 1980-2019 - Time vs. Rebalance

It compares the volatility of the annual return on a portfolio of 100% stocks over a one-year time period with the same portfolio over five years and with a portfolio of 60% stocks and 40% bonds over one year.

The blue bars on the first and second bars (100% stocks for one year and five years, respectively) are at the same level, meaning they had the same average annual return.  Both the box and whiskers on the second bar are much more compact than the first bar, indicating that the annual returns fell in a much narrow range when considered on a five-year basis rather than a one-year basis.

Cost-Benefit Comparison

Comparison of the first and third bars highlights the cost and benefits of diversifying across asset classes.  The box and whiskers on the 60/40 portfolio are both shorter than the 100% stock portfolio.  That is, there was less variation from year-to-year in the annual return for the 60/40 portfolio than the 100% stock portfolio.   However, the average return (blue line) on the 60/40 portfolio is a bit lower because the 60/40 portfolio had an average annual return that was less than the 100% stock portfolio.

My Focus

The comparison on which I focused in selecting my investment strategy is the one between the second and third bars.  That is, I compared the volatility and average returns of a 100% stock portfolio over five years with the volatility and average returns of a 60/40 portfolio over one year.  As can be seen, there has been less volatility in annual stock returns when considered in five-year time periods.  Yet, the average return on stocks is higher than the average return on the blended portfolio.  Because I didn’t anticipate that I would need to draw down my investment portfolio, I was willing to look at risk over longer time periods and tolerate the year-to-year fluctuations in stock prices in order to expect higher investment returns.

Your time horizon until you might need the money in your investment portfolio and your willingness to wait out the ups and downs of the stock market are important considerations as you decide whether this strategy or a more traditional blended portfolio is a better fit for you.

What is Bitcoin: The Short and Long Answers

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The phrase “what is Bitcoin” is currently getting between ten and one hundred thousand search queries in Google per month. There is a broad spectrum of answers out there. In this exposition we’ll give an accessible answer that will help you decide if cryptocurrency is an investment that is right for you.

What is Bitcoin? … The Short Answer

Bitcoin as an investment, Man walking towards a city overlaid with bitcoin images
Time to Consider Bitcoin

The short answer is it is digital currency. Naturally, there is a long answer too. You should be aware that this is a complex subject because it touches many sophisticated topics like macroeconomics and centralized banking. Most people think of currency as what is used in their home country. In America they use US Dollars. Japan uses Yen. Other countries use Euros and Pounds. There is nothing wrong with thinking of Bitcoin as just another type of currency with the added nuance of it being purely digital.

Why is it Such a Hot Topic?

We have already briefly tackled the question of “what is Bitcoin.” At this point, it is worth mentioning why people are so fixated on it. There are a few reasons.

The most obvious reason is people have made lots of money with Bitcoin as an investment. Indeed, in 2017 the price shot from $5,600/coin to $19,000/coin. I owned lots of coin at this time and it was very exciting. However, what goes up, most come down. Over the year of 2018, the price of crashed to about $3,000. As of the time of writing, it has returned to about $10k, so don’t count it out yet.

Decentralization

It’s worth mentioning the other more innocuous reason why Bitcoin is such a controversial topic. That reason is decentralization. The impact that statement has on you depends on your level of knowledge with banking practices. Most countries have a central bank. In the Unites States, this is the Federal Reserve. Centralization means that the country’s currency has innate value based on the trust of the ruling government. When you give your money to a bank, it pays you interest because it invests that money to make more money. However, you are not privy to these investments and actually have no transparency as to how the bank is behaving. Historically, this has led to corruption.

The Blockchain

bitcoin blockchain
Blockchain is the Ledger of Bitcoin

Bitcoin is decentralized which means you have full transparency. Typical banks have a ledger detailing their customers’ transactions. Bitcoin has a similar concept called the Blockchain. This is the ledger of Bitcoin. Instead of it being centralized, it’s freely available to all its users. The users are given anonymous addresses and this is what creates decentralization. In the Blockchain, you can see every transaction, but you won’t know who is participating. Conceptually, this is very controversial because it takes all middlemen out of the equation. This includes the government. For this reason, some governments have made Bitcoin illegal. Denmark, Iran and Nepal have all banned it is some way.

The Controversy Continues …

The Blockchain is anonymous which makes tracing money almost impossible. This would make it very hard for litigious societies to cope with the existence of crytopcurrency. While you could theoretically hide all of your money in a wallet, you would be exposed to the fluctuations of the underlying price. The anonymity aspect of Bitcoin also makes it ideal for crime and lascivious pay outs. There are amazing upsides though. It’s free to participate and dramatically cuts down the possibility of corruption.

Why Does Bitcoin have Value?

The value is generated from simple supply and demand. People are willing to trade money for Bitcoin and this is where it derives its value. Critics claim this can be interpreted as fictitious and so it’s possible it could just vanish without a trace. The distributed nature of the Blockchain makes this very unlikely because so much actual money is tied up in it and the transparency is very high.

The Pros and Cons

Getting involved is synonymous with owning currency. Bitcoin is nothing more than a currency and its pros and cons can be compared to the US dollar. Participating doesn’t need to be an all or nothing consideration. You can buy a small amount as an investment and see how it performs. Similarly, I don’t think it’s justified to characterize Bitcoin as crazy nonsense either. In December 2018 The NYSE announced its launch of forwards and futures contracts on Bitcoin. This commitment likely signals that Bitcoin is here to stay. Let’s look at pros and cons.

Pros

  • Bitcoin is transparent. This is the nature of the distributed Blockchain.
  • Transactions are handled by computers and mathematics. This eliminates traditional labor and human emotions.
  • Bitcoin provides privacy that is currently eroding in countries like the US.

Cons

  • The exchange rate is volatile. We have seen wild swings in the value of Bitcoin in recent years, as can be seen in the chart below.  The chart compares the cumulative returns on four asset classes – bitcoin, the S&P 500 (stocks), a 20-year US Treasury mutual fund (TLT) and gold (GLD ETF). [1]  This chart highlights the high returns and extreme volatility of bitcoin compared to more familiar asset classes.

    [1] S&P 500, TLT and GLD prices from finance.yahoo.com.  Bitcoin prices from www.coindesk.com/price/bitcoin.  August 16, 2020

The line for Bitcoin fluctuates wildly while the other lines hover near the ottom of the chart

  • Bitcoin is not widely accepted.
  • Due to it’s lack of authority nobody can guarantee Bitcoin’s value. Different countries may even have a different current price for Bitcoin.

Should I get Involved ?

considering an investment
Thinking about Bitcoin

If you have read this far down you probably have a good idea as to whether you want to get involved with Bitcoin. The answer to this question hinges on how much effort you are willing to put into the learning the mechanics of it. Unless you are willing to learn more about Bitcoin wallets, exchanges, and mining efforts (all discussed below), I don’t think you should get involved. If you want to learn these fundamentals and have a dog in the fight then there is nothing wrong with that either.

Your participation is Bitcoin doesn’t need to be an all or nothing experience. There is a wide difference between liquidating your retirement account and putting it into Bitcoin and just buying and holding some Bitcoin. There are many ways that you can go deep into Bitcoin but you shouldn’t lose sight of what it is. It’s just another currency. It’s not a magic wand that pulls money out of thin air. In the following sections I’ll show you some Bitcoin basics so you can learn how to own some Bitcoin and manage your risk. Each of these topics is very dense and there is more to learn on all of them. This should demystify things a bit though.

Getting your Feet Wet

The easiest way to own Bitcoin is to just buy it. This is an investment and there is risk attached to it. There is risk both in the volatility of the Bitcoin currency and the security of your actual amount of Bitcoin. If you want to just buy Bitcoin, I recommend buying it on an exchange. There are many to choose from but I have the most experience with Coinbase. There, you can easily set up an account and buy a small amount of Bitcoin. Currently, one Bitcoin is worth about $10k. This doesn’t matter that much because you can own fractional amounts and $100 is probably the perfect amount to get started. Beyond this, the security of your coins is an issue too.

Wallets

wallet of crypto coins
You need a Bitcoin Wallet

I mentioned before that your Bitcoin security is an issue to be concerned with. This is where wallets come into play. A wallet stores your Bitcoin and its private key. This allows you to generate a Bitcoin address to participate in the Blockchain. Wallets are a dense subject and there are many types to choose from. The minimum that you need to know is that you should have one! Your Bitcoin is literally not safe without it.

It’s important to understand the wallet doesn’t actually hold coins. A better analogy is that it marks your place and value in the blockchain. It facilitates your participation in the blockchain by holding your private key and keeping it out of the possession of others.

An exchange can hold your Bitcoin but exchanges have been hacked before and  resulted in people completely losing their money. While it’s hard to recommend a Bitcoin wallet, it’s easier to recommend a type of wallet namely a cold storage wallet. This is the most secure type and that disconnects your private key from the internet. You can even have a paper wallet by printing out the private key.

Trading

No surprise here, trading is a complex topic. Like many assets, you can trade Bitcoin. This is risky, but here is what you should know. Trades are done by trying to predict the price. You can do this by following news about it or following the evolution of the technology supporting it. Historically, the price has been quite volatile, so you could potentially make a lot of money from it. The risk is high also.

Investing vs. Trading

It’s important to understand the subtle differences between investing and trading. You can do both simultaneously. The key difference is the amount of time you hold the asset. Trading is more speculative as you work to achieve a sequence of short term transactions that make you a profit. Vanilla investing just means you hold Bitcoin and wait for the value to go up and realize the profit in accordance to your own risk preferences.

You might hear Bitcoin investors declare they are “hodling”. This means they are holding Bitcoin long term. The misspelling is an acknowledgment of its early days where the misspelling “hodling” had widespread notoriety. 

Getting Started

To get started with trading, you can verify your identity on Coinbase and start trading immediately. Of course, this is an oversimplification. You need to develop a solid plan and strategy to be successful and realize that all traders have trades where they lose money. Here are some tips to get started trading.

  • Join an exchange like Coinbase
  • Have a wallet and never leave money on the exchange because your money could magically disappear.
  • Have a solid plan that you have researched and feel very confident with.
  • Realize that not all trades will be profitable.

Mining

mining
MMining is a way to Generate Bitcoin

Bitcoin Mining is a term you might hear thrown around quite a lot. To understand it in the most basic way you need to know that miners are participants in the Blockchain who work to synchronize the distributed nature of the Blockchain. Their reward for this is actual partial coin payout. This is a concrete way to make money. You might even hear comparisons to mining as printing money. In some ways this is true, but it’s short sighted.

Mining is a different way to profit from cryptocurrency and Bitcoin specifically. Mining is also a form of investment because you are investing capital to have a well preforming mining rig.

There is a lot of overhead to mining. The main overhead is elaborate hardware that will work to compete in the Blockchain. This is very competitive and successful mining rigs can cost thousands of dollars. It’s not uncommon for people to work in teams called “pools” where they split mining earnings. The upside to mining can be high but so is the price of entry. Here are some points to keep in mind.

  • Mining is a way you can immediately profit from cryptocurrency.
  • You will need expensive hardware to compete and be successful.
  • At this point of competition, you will likely need to work with others to be successful.

Transaction Complete

Remember cryptocurrency is a massive topic and what I have covered is only scratching the surface. The intent here is to expose you to Bitcoin and show you different risk levels at which you can participate. By now you should have a firm understanding of what it is and how you can invest.  Here are some walkaways from today:

  • Bitcoin is decentralized, digital currency.
  • The simplest way to invest is to buy it on an Exchange and hold it in a wallet.
  • There are more elaborate schemes to profit like trading and mining.
  • There are pros and cons to mining and trading. Either could lose money or make massive profits.
  • Bitcoin is not going away.
  • One way to invest is to not actually hold it, but to invest in its underlying technologies. It only stands to reason as Bitcoin grows so will these technologies.

Author

Adam Wilson is a Ph.D., professional software developer, and financial blogger. Check out more of his musings on his site: https://awesomepersonalfinance.com/

7 Must-Know Stock Market Sell Signals

7 Must-Know Stock Market Sell Signals: How to Avoid Selling a Stock Too Soon or Too Late

Before we talk about the specific indicators that would signify stock market sell signals, we must understand why we bought each stock in the first place. The simple theory of ‘buy low, sell high’ seems practically very easy, but the reality of the situation is much more complex. When investors look to spend their hard earned cash on stock market investments, it is absolutely necessary that they buy stocks when they are relatively undervalued in comparison to the company or market as a whole. What investors need to assume is the fact that you make money at the price you buy at, not the price you sell. It is imperative as an investor that you understand both sides of the coin when it comes to buying and selling stocks. A breadth of knowledge in technical, fundamental, and psychological factors that affect stock prices will give you an edge.

How You Buy a Stock

Many factors can be used to help look for and find buying opportunities. When buying stocks, look for low price-to-earnings or P/E ratios relative to the industry average or a P/E ratio that is near the low of its five-year range. Find companies with strong earnings and ones that have an economic moat that will protect said earnings. Use short-, medium-, and long-term charts to identify if the stock has a history of growth.  You’ll be surprised how many companies don’t make money or make less than before, and the stock chart usually reflects that. Finally look at the business you are interested in from afar. Is it growing? Does it change the world we live in positively? How does its competition look? Utilize everything you can when looking to buy stocks.  Trades should be based on calculated risk. Without that, you are gambling.

Stock Market Sell Signals

Now that we’ve discussed why we would buy a stock, let’s dive into why you should sell a stock. As the market moves, it’s important to keep an eye on how your company looks from a financial standpoint. Below we will discuss in detail some key fundamental metrics that could be used to signal that a stock is overvalued, also known as stock market sell signals.

Price-to-earnings (P/E)

The P/E ratio is used to show how expensive a stock is relative to the money it earns. The first check you can perform on any stock is to compare the stock in question’s P/E with the sector average. If the stock’s P/E is higher than the sector average, then the stock is relatively more expensive than the sector’s average and can be considered a sell signal. Some companies (typically tech companies) carry a high P/E due to the public pricing of future earnings. This is why the next step would be to compare the stocks P/E within a five-year range of its own P/E. If the stock is near the top of the five-year range, then it’s more overvalued than it has been in the last five years, which could be an indication to sell.

Next, with a word of caution we can look at the Forward P/E. I say with a word of caution because this is based on analysts’ expectations and guidance set by the company. Don’t forget these are educated guesses – they can be spot on or miss the mark completely. Typically, when the Forward P/E is higher next year than the current P/E, there is a projection of lower earnings. Most, if not all, investors should invest in companies projected to make more money quarter over quarter and year over year. This too could be used as a signal for when it’s time to sell a stock. With some simple yet advanced tactics, you can even project the stock price in a range for the next year. Want to learn how to do this? Click here: https://launchpadyourlife.com/learn-earn-retire-early-portfolio-builder/

Price-to-Book (P/B) Ratio

The price-to-book (P/B) ratio is a comparison between the market valuation and the book value of the company. A good buy point for any stock is a P/B under 1. But, when a stock’s P/B is higher than the sector average, then it’s relatively expensive. This comparison could be used to signal when to buy or sell depending on what the P/B is at, as well as how to compares to the industry average. Another word of caution – use this as a checkpoint and not a definitive buy/sell signal. Sometimes companies can window dress book value causing the P/B to appear lower than it really is, so again be cautious.

Earnings Per Share (EPS) Growth Next Year and Next 5 Years

Earnings per share (EPS) growth uses projected earnings to give us a glimpse into what may happen next year. This can also be used to understand trends. Is the company constantly growing its earnings? Is it stable, consistent growth? If the answer differs from its history, it could be one of our stock market sell signals. The importance of earnings growth is that the stock price inevitably follows earnings. Some newer companies could have growth based on expected future earnings, but the stock price generally reverts to the mean at some point – all based on the company’s actual earnings.

Debt Load Management

If a stock has a debt load, it is important to assess how management is handling it. Is management letting debt grow or paying it down faster than expected? The answer is important because a building debt load increases the interest expenses the company will have and therefore affect the bottom line.

We want to focus on year-over-year changes in the debt/equity ratio as well as the long-term debt/equity ratio. We want these ratios to either be a low stable number relative to the industry average or we want to see that management is actively paying it down. In doing so, shareholders equity or the value of the shares you currently own will increase. When the opposite is happening, such as erratic or increasing debt loads, we should be concerned and possibly ready to sell. If you want to look at a year-over-year trend of these statistics, Charles Schwab has some great tools that come with its account. Below we can see the five-year trend in graphical form to the left, a definition of the ratio in the middle area, and the current value of the ratio to the right for a sample company.

Debt to Capital Ratios

Do you want to open a Charles Schwab account to access these awesome features? Click this link to sign up, it only takes minutes! http://www.schwab.com/public/schwab/nn/refer-prospect.html?refrid={REFID}

The Big Picture

Sometimes the best way to tell if it is time to sell a stock is to see if the story has changed.

Changes in Business

Before you ever invest in a company, it is imperative that you look at the business from every angle. It is necessary as an investor to know what you are buying and why you are buying it. You would not buy a car without test driving it, would you? Typically, you look at Consumer Reports, talk to people who have owned that car model, and look at safety ratings and mechanical flaws or misnomers. The same can be said for stocks – look for changes in the income statement, balance sheet, and statement of cashflows. When these things begin to change from your initial thesis, it may be a stock market sell signal.

Changes in Management

When management changes, it may be time to sell. Typically, stock prices fall when new management is announced because a different mindset is at the helm of the company. People may have the same goal, but different paths to reach said goal. The story can change on a multitude of levels. Even if the financials are still intact, if the story about who it is as a company or what it does has changed, it may be one of our stock market sell signals.

An example of this is the Chinese company, Lukin Coffee, which, from its financials, was poised to be the next Starbucks. It was later realized that the earnings were not as they seemed and they were forging financial documents. The stock tanked and has since been delisted from the NASDAQ. Sometimes you can see the smoke before the fire and get out of a stock, and sometimes you will have to get out while down to prevent a total loss.  As a caution, though, a decrease in a stock price isn’t always a sell indicator.  In fact, in some cases it may be a chance to buy more of the company’s stock.  So, you’ll want to be sure to understand why the stock price has decreased.

Sector Rotation

The stock market moves in and out of sectors like the tides in the ocean based on the current point of the economic cycle. Understanding where money is moving in and out of could be used as a signal for when to sell a stock. The best way to grasp this concept is to take a step back and look at the overall economy. During times of fear, the best investments tend to be non-cyclical defensive positions like grocery stores and household goods.  In a depression or economic contraction, you may not buy a new iPhone, but you will still buy bread and toothpaste for your family.

Many graphics can be found by googling ‘sector rotation’ to give you a better idea as to what are the best sectors to invest in based on the economic picture at hand. Trying to time the market tends to not be a successful strategy. The old saying goes, ‘time in the market is better than trying to time the market.  Use sector rotation to either sell at right time or buy on the dips when the sectors rotate.

Portfolio Rebalancing/Profit taking

As you build your portfolio, if you invest in great companies, then eventually the underlying stock prices should rise. As those stock prices rise, the overall percentage that it takes up of your portfolio rises as well. For most passive investors, any one stock should not take up more than 3-5% of your overall portfolio to avoid company specific risk.

Closing Thoughts.

Now you have some stock market sell signals!  Remember that you should only invest in what you know.  When things start to change, do whatever you have to in order to protect your money and continue to grow your wealth. Good luck investing!

About the Author

Brandon Smith is the owner of Launchpad Finance – a financial education source for young adults and new investors. Brandon has been studying and trading in the stock market for over 6 years now, and has been interested in the markets since he was 12 years old. After graduating from The University of Houston with a BBA-Finance, he used his passion for the stock market to start Launchpad Finance to fuel others to have a passion for stock trading, as well as grasp of the value financial literacy in one’s own path to financial freedom.

Why I Don’t Hold the All Seasons Portfolio

All-Seasons Portfolio

The All Seasons Portfolio reports amazing statistics about its returns.  I’d never heard of the All Seasons Portfolio, so had to check it out.  As I’ll discuss in more detail, it is an asset allocation strategy with more than 50% of the portfolio allocated to US government bonds.  In this current environment of low interest rates, one of my followers asked my opinion of the portfolio as an investment strategy for the near future.  The answer is, as is almost always the case, it depends.  However, after studying the portfolio and relevant data, I won’t be aligning my portfolio with the All Seasons Portfolio.

In this post, I’ll define the All Season Portfolio, talk about when each of the components of the portfolio is expected to perform well and provide a wide variety of statistics regarding its historical performance.  I’ll also talk about the need to re-balance assets to stay aligned with the portfolio and the impact of income taxes on your investment returns.  I’ll close with how I’ve changed my portfolio based on this analysis.

All Seasons Portfolio

Ray Dalio is an extremely successful hedge fund manager.  If you have more than $5 billion in investable assets, he might consider accepting you as a client.  His fund is famous for the All Weather investment strategy.  According to Tony Robbins, in his book MONEY Master the Game, the annual returns on the All Weather portfolio exceed 21%![1]

Composition of Portfolio

In an interview with Robbins, Dalio described a much simpler version of the All Weather portfolio for the rest of us.  This asset allocation is called the All Seasons portfolio.  The allocation in the All Season portfolio[2] is:

  • 40% in Long-Term US Bonds (20+ years), using the iShares Barclays 20+ Year Treasury Bond fund (ticker symbol TLT)
  • 15% in Intermediate US Bonds (7-10 years), using the iShares Barclays 7-10 Year Treasury Bond fund (ticker symbol IEF)
  • 5% in Gold, using the SPDR Gold Trust (ticker symbol GLD)
  • 5% in Commodities, using the PowerShares DB Commodity Index Tracking fund (ticker symbol DBC)
  • 30% in the S&P 500

This allocation is illustrated in the pie chart below.

All Seasons portfolio Asset Allocation

Economic Indicators

The portfolio’s name, All Seasons, refers not to the four seasons of the calendar year but to four indicators of the economic cycle.  These four indicators are:

  1. Higher than expected growth (often measured using gross domestic product or GDP)
  2. Lower than expected growth
  3. Higher than expected inflation (often measured using the consumer price index or CPI)
  4. Lower than expected inflation

I note that there is overlap between the first pair of characteristics and the second pair.  That is, a period of higher than expected growth can have either higher or lower than expected inflation.

The chart below shows which of the five components of the portfolio are expected to perform well in each part of the economic cycle, according to Robbins.[3]

GrowthInflation
Rising

Stocks

Commodities

Gold

Commodities

Gold

FallingTreasury Bonds

Treasury Bonds

Stocks

Historical Performance

According to Robbins[4], the All Seasons portfolio had a compounded annual average return of 9.7%, net of fees, from 1984 to 2013.  By comparison, I calculate the corresponding value for the S&P 500 to be 8.4%.  In addition, the All Seasons portfolio had much lower volatility, with a standard deviation of 7.6%, as compared to the S&P 500 which had a standard deviation of 17%.  So, at first glance, the All Seasons portfolio seems to be a terrific option – higher return for lower risk.

My Estimate of Returns

There are many challenges to calculating the returns on the All Seasons portfolio.[5]  I made many assumptions to better understand the returns, so do not consider the statistics I’ve calculated as accurate, but I think they are close enough to be informative.

The chart below shows the annual returns on the S&P 500 and my approximation of the returns on the All Seasons portfolio from 1963 to 2019.

Annual returns on S&P 500 and All Seasons portfolio

From this graph, it appears that the biggest benefit of the All Seasons portfolio is that the non-S&P 500 asset classes diversify away a substantial portion of the significant negative returns on the S&P 500.  For example, in the three years in which the S&P 500 had returns worse than -20%, I approximated that the All Seasons portfolio lost an average of only 0.1%!

Returns by Asset Class

I wasn’t able to get a long enough history of Commodity price data, but was able to calculate the average return on the three other asset classes during those same years (1974, 2002 & 2008), as shown in the table below.

Asset ClassAverage Return in Years when S&P 500 Return was < -20%
S&P 500-30.5%
7-10 Year US Treasury Bonds8.0%
20 Year US Treasury Bonds15.2%
Gold33.5%

As can be seen, all three asset classes had positive returns in those three years, with Gold having the most significant increase.

My Investing Goals

I retired a little over two years ago, so have changed my investing goals to make sure I can meet my cash needs as I don’t have any earned income to cover my expenses.  Specifically, now that I’ve switched from the accumulation phase to the spending phase, I have less tolerance for volatility.

Goals While Accumulating

While I was accumulating assets, I wanted my invested asset portfolio to produce returns that were at least as high as the overall market.  I use the S&P 500 as my metric for market performance.  During that time, I was quite willing to tolerate the ups and downs of the market because I was diversifying my risk over time.  As a confirmation of my risk tolerance, I point out that I did not sell any assets during any of the market “crashes.”

My first market crash was October 19, 1987.  I can still remember being in the office that day.  The internet was not available to the general public, so our news came from TV and radio.  One of the senior people in the office had a TV in his office, though I suspect it had just the over-the-air channels as very few people had cable TV then either.  He told everyone what was happening in the market.  I asked him whether he was going to move his 401(k) money out of the market into a safer fund.  His advice was that it was already too late and that I should just hang on for the ride.  That was one of the best pieces of investing advice I’ve ever gotten.  I didn’t sell during that crash and haven’t sold during any of the crashes since.

Goals While Retired

Now that I’m retired, I am drawing down my assets.  I’ve made two changes to my asset mix to reflect the fact that I now need to spend my assets rather than add to them.

  1. Instead of having a six-month emergency fund in cash, I now have several years of expenses in cash.
  2. I’ve added a few individual corporate bonds (to be clear, not a bond fund) that mature in 3 to 5 years to my portfolio. When these bonds mature, they will add to my cash balance to cover my expenses in those years.

For the rest of my invested asset portfolio, I’ve maintained the same goal – meet or beat the S&P 500.

By having several years of expenses in cash, I know I won’t have to sell any assets during any market turmoil, such as we are experiencing now.  As discussed in my post on reacting to the most recent crash, the market has historically recovered in less than five years (excluding the crash of 1929) and has higher than average returns during the recovery phase.  As such, I don’t want to have to sell stocks when markets are down.

How I Evaluate the All Seasons Portfolio

As I said, my goal is to earn a return close to or higher than the return on the S&P 500.  I would be willing to take a small reduction in return for less risk, but not much given the other aspects of my strategy.  Therefore, I will look at the components of the All Seasons portfolio relative to what I can earn if I just invest in the S&P 500.

In particular, I am interested to see how these asset classes perform when interest rates are low, as they currently are.

Bonds

Returns on bonds (unless held to maturity) and bond funds have the following characteristics:

  • The total return is equal to the interest rate on the bond plus the change in market value from changes in interest rate levels.
  • Returns are higher when interest rates are high or are going down.
  • The total return is similar to the interest rate itself when interest rates stay fairly stable.
  • Returns are lower when interest rates are low or are increasing.

Bond Returns vs. Interest Rate Changes

This relationship can be seen in the chart below which compares the change in the 10-year US Treasury bond interest rate (yield) with the change in the market value of iShares Barclays 7-10 Year Treasury Bond fund (ticker symbol IEF) in each year from 2003 through 2019.

Change in Price goes down when yield on 10-Year Treasury goes up

What Can Happen from Here

We are currently in the last situation listed above.  Interest rates are currently quite low by historical standards.  The chart below which shows the yield on the 10-year US Treasury bond from 1962 to 2020.  The last point on the chart is the interest rate on July 8, 2020 of 0.65%.  It is lower than the interest rate at the end of any year since 1962.

10-Year Treasury Rate from 1962 to 2019 with single major peak in 1981

For all intents and purposes, interest rates can do one of two things from their current levels – stay about the same or go up.  If they stay the same, the return on bonds funds will be about the same as the interest rate on the bonds – currently less than 1% for 10-Year US Treasury bonds and less than 1.5% for 30-Year US Treasury bonds.  If interest rates go up, the market value of the bonds will go down and returns will be even lower.

As such, I don’t believe the returns on bonds or bond funds in the near term will be high enough to be consistent with my investing objectives.  I will continue to buy individual corporate bonds that mature in the next few years to ensure that I have cash available to meet my expenses.  But, I do not plan to add any bond funds to the investment portion of my portfolio.   If I were younger and the time until I needed to draw down my investments to cover my expenses was longer, I wouldn’t invest in bonds at all in the current environment.

Gold

I am particularly interested in how gold has behaved, as it isn’t something I’ve studied much.  For the current environment, I’m interested in how gold behaves when interest rates are flat or rising.  The chart below shows how I defined historical periods as having interest rates that are either flat or rising.

10-Year Treasury Interest Rate rose from 1962-1967 and 1977-1980 and was flat from 1968-1977, 2004-2007 and 2013-2018

The line is the same line shown in the 10-Year Treasury Interest Rate chart above.  I have shaded periods in which interest rates have been relatively stable in blue.  The time periods in which interest rates have increased are highlighted in green.

The chart below has the same time periods shaded as the previous chart, but the blue line shows the percentage change in the price of gold between 1971 (when the price of gold was no longer set by the US government) and today[6][7].

Gold prices increased in most years in which interest rates were flat or rising

Looking back to the 1970s, gold prices were generally up quite significantly when interest rates were either relatively flat and when they increased.  While the increases in price were not as large in the period from 2003 to 2006, another time period when interest rates were flat, as in the 1970s, annual price increases were still generally in the 10% to 30% range, much higher than would be expected on the S&P 500.  Only in the most recent flat period are changes in gold prices not as consistently high.

Gold Funds

Buying gold means that you have to find a way to take delivery of it or pay to have it stored.  One article about the All Seasons fund suggested investing in SPDR Gold Shares[8] (ticker symbol GLD) which is an exchange-traded fund (ETF) physically backed by gold.  I compared the changes in prices of this ETF with the changes in the price of gold.  Although they generally track each other, as shown in the chart below, they are not a perfect match.  Nonetheless, this ETF appears to be a much easier alternative for investing in gold than buying gold itself.

very close match between gold and GLD ETF price changes from 2005 to 2019

Commodities

I wasn’t able to get a long history of returns on commodities, but the table I provide earlier from Robbins’ book indicates that they are expected to behave in a manner similar to gold.

Overall Portfolio Evaluation

The chart below summarizes the annual average returns (on a compounded basis) for each of the asset classes for which I could approximate returns from 1963 to 2019[9].

Average returns from 1962-2019 on S&P 500 (7%), Gold (7%), 7-10 Year Treasuries (3%), 20-Year Treasuries (4%) and All Seasons Portfolio (6%)

Over this time period, it appears that Gold has had returns similar to that of the S&P 500, but the returns on US Treasuries have dragged down my estimate of the returns on the All Seasons portfolio.

I am particularly interested in how these asset classes perform when interest rates are either flat or increasing.  The chart below illustrates these returns using the same approximations as above.

Average annual returns when interest rates were rising and flat

In average in both rising and flat interest rate environments, gold has historical outperformed the S&P 500.  By comparison. both categories of bonds have underperformed and, in fact, have had average returns during those periods of roughly 0%.

Re-Balancing

The performance metrics reported by Robbins and others assume that you maintain the target mix in each asset class.  To accomplish that, you need re-balance regularly. That is, you need to to sell asset classes that have appreciated the most (or depreciated the least) and buy asset classes that have not performed as well.

What is Re-Balancing

Let’s look at an example.  At the beginning of a year, you invest $10,000 using the All Seasons portfolio.  Your portfolio looks like this:

Allocation of $10,000 using All Seasons portfolio

If your one-year returns were similar to those in 2019, your end of year asset allocation (light green) would not be the same as your target (dark green), as shown in the graph below.

End of year results compared to target for 2019 under the All Seasons portfolio

To reach the target allocation, you would need to make the following changes.

GoldSell $44
CommoditiesBuy $28
StocksSell $451
Medium Term BondsBuy $399
Long Term BondsBuy $67

To attain the high returns reported by Robbins, I suspect you need to re-balance the portfolio fairly often.  In my calculations, I assumed annual re-balancing on the first of each year.  How often you re-balance the portfolio depends on your personal preference, but should generally be more often when the prices of one or more of the asset classes is changing rapidly and no less often than annually.

Impact of Income Taxes

It is better to own portfolios you need to re-balance regularly in a tax-free or tax-deferred account.  Otherwise, you will need to pay income taxes on the net of your capital gains and capital losses.  401(k)s and IRAs are the most common tax-free and tax-deferred accounts in the US.  The Canadian counterparts are TFSAs and RRSPs.

Continuing the example above, you sell $44 of gold and $451 of stocks for a total of $495.  Without going into the details of the calculation, your cost basis for these two sales combined is $387, for a realized capital gain of $108.  Many Americans have a 10% tax rate on capital gains which corresponds to $11 on the capital gain of $108.  These taxes reduce your total return by 0.1 percentage point.  That might not sound like much, but it can add up.  If you make a $10,000 investment in this portfolio and taxes reduce your return from 10.0% to 9.9%, you will have $5,000 less after 30 years.  That’s half of the amount of your initial investment!

Changes I’ll Make to My Portfolio

The analysis presented in this post has refined my thinking about my portfolio in two ways.

First, I have confirmed my past thinking that I can maintain a substantial cash position, supplemented by some individual bonds held to maturity, as a hedge against the risk that the stock market will have a significant downturn.  Although holding several years of expenses in cash lowers the return on my total assets, I find it a much easier and less risky strategy than introducing bond funds into my portfolio.  That is, although the return on money market funds where I hold my cash is low, it isn’t much lower than the current returns on US treasury or even high-quality corporate bonds.  With the significant potential that the market price of bonds will go down, I am more comfortable with my cash position.

Second, I have invested in the SPDR Gold Trust (ticker symbol GLD).  I don’t plan to immediately move as much as the 7.5% of my portfolio into gold as suggested by the All Seasons portfolio (15% if I use gold as a substitute for commodities, too).   Rather, I plan to initially invest 1% to 2% of my portfolio in gold and add to that position as I gain more comfort and experience investing in it.

Footnotes

[1] Robbins, Tony, MONEY Master the Game, Simon & Schuster Paperbacks, 2014, p. 391-392.

[2] “Robbins’ All-Seasons Portfolio.” TuringTrader.com, https://www.turingtrader.com/robbins-all-seasons/.  Accessed July 5, 2020.

[3] Robbins, op. cit., p. 390

[4] Robbins, op. cit., p. 395.

[5] There are many components of the calculation of returns, including assumptions regarding frequency of reinvestment and fees and the choice sources of data used to calculate the returns of the components of the portfolio.  As such, I am not able to replicate his calculations.  In fact, I found another source for returns on the All Seasons portfolio that, in the single year for which details were provided both sources, shows a return that was 3 percentage points higher than reported by Robbins.

[6] “Historical Gold Prices.” CMI Gold & Silver, Inc, https://onlygold.com/gold-prices/historical-gold-prices/, Accessed July 7, 2020.

[7] “Gold Prices.” World Gold Council, https://www.gold.org/goldhub/data/gold-prices, Accessed July 8, 2020

[8] “Bringing the gold market to investors.” State Street Global Advisors, https://www.spdrgoldshares.com/.  Accessed July 8, 2020.

[9] As indicated above, the returns I calculated for the All Seasons portfolio are not as high as were calculated by Robbins.

Don’t Make these Financial Mistakes

Don't Make these Financial Mistakes

The world is going through a very difficult phase. Everywhere we are hearing that we need to get adjusted to the ‘new normal’. Nothing is normal as it used to be. Children are not able to go to schools.   Most people are working from home.  Healthcare professionals are working day and night for the recovery of people who get COVID-19.  In this situation, it’s quite natural that the economic situation is not good. Many people have lost jobs or are facing pay cuts and experts are predicting that an economic recession will set in.  We don’t have any control over this situation. But, what we can do is safeguard our finances, as much as we can, and avoid financial mistakes during this COVID-19 financial emergency.

Here are a few financial mistakes you should avoid.

Satisfying Wants to Avoid Boredom

Have you been browsing online shopping websites and ordering items? Is it because you need them or just to avoid boredom?

When the lockdown started, people were stockpiling grocery items. Now focus has shifted to buying items like clothes, books, entertainment things, and so on. So, in both situations, people are overspending.

But, now is not the time to do so. Rather, you should try to save as much as you can. We will discuss how to save more later in this article.

If you are getting bored at home, nurture a hobby (hopefully an inexpensive one). Do something which you’ve always wanted but didn’t get time to do so. If you wish, you can also do some online jobs as per your liking.

Following the Same Budget

Are you following your budget? You might say that you’re following it and saving. Good! But it’s a mistake. You’ll ask why? Because it’s necessary to re-assess your budget in light of the current situation and make modifications if required. If you’ve done that, well done!

If you still have income, it is time to save as much as possible. Doing so, you can be prepared for any future rainy days. If you save more, you won’t have to worry as much about losing your job. You know that you’ll be able to sustain yourself for a few months.

You can practice frugal budgeting to save more. Frugal budgeting doesn’t mean you’ll have to compromise with eating healthy or compromise with your life; it means to cut unnecessary expenses and increase your savings.

Overspending that Doesn’t Fit in your Budget

It is better to avoid buying big-ticket items during this time. Try to delay satisfying your wants for the time being.

To illustrate the previous point, let me highlight a survey conducted in January 2020 in Nebraska by First National Bank of Omaha.  It showed that about 50% of people in our country have a pay check to pay check lifestyle. So, it becomes quite tough to meet daily necessities when they face job loss, which has happened during this pandemic.

Therefore, you should try to have a good cash reserve. To do so, you need to save more and keep the amount in a high-yield savings account.

Check out how these ways to save more that you might be overlooking:

  • Stop eating out and have nutritious homemade food which is healthier too
  • Have a list when you go grocery shopping and don’t buy anything extra
  • Switch to debit cards if that can help you reduce your expenditures
  • Cancel your gym membership and work out in fresh air
  • Check out your magazine subscriptions and cancel if you rarely read them
  • Opt for bundling offers of television and internet
  • Opt for public schooling of kids instead of private schools
  • Start envelope budgeting to save more
  • Set temperature of water heater to 120 degrees to save electricity
  • Clip coupons and use them to save money

Using your Emergency Fund for Daily Necessities

Emergency funds are for rainy days. But, don’t touch it if you can manage without it.

Check how much you have in your emergency fund. Will you be able to sustain for about 6 months without a pay check? If not, try to have that amount in your emergency fund.

Do not touch your fund unless it’s an emergency. And, if you have to use it, try to save the required funds after the situation becomes normal and you start getting your usual pay check.

Every month, try to save a definite amount in your emergency fund. And, the account should be easily accessible so that you can withdraw funds whenever you need it.

Of course, if your emergency savings is the only thing between you and not paying your bills, you can start spending it.

Not using Available HSA funds

Instead of using your emergency fund for medical treatment, use your pre-tax HSA (Health Savings Account) funds. You can use the funds to get treated or tested for Coronavirus if required. You can even use the funds to consult a therapist if you’re anxious or depressed during this pandemic.

Delaying Filing your Taxes if You’re Eligible for a Refund

As per the CARES (Coronavirus Aid, Relief, and Economic Security) Act, the federal tax filing deadline has been extended to July 15, 2020, including any estimated tax payments for 2020. But, if you’re eligible for a refund, file your taxes.

As per IRS, the average refund is about $2,908 this year. It can help you to cover your living expenses or even make debt payments during this pandemic.

Not Paying the Entire Amount on your Credit Cards

It is a mistake to make only the minimum payments on your credit cards. If you do so, you’ll have to pay the interest on the outstanding balance every month. Therefore, it is always better to pay the entire balance on your cards every billing cycle if you possibly can. So, before swiping your cards, check out whether or not you’ll be able to make the entire payment in the billing cycle.

Also, use your reward points if you’re ordering things online; otherwise, your reward points may expire.

If required and if the creditors agree, you can take out a balance transfer card and transfer your existing balance to the new card. Usually, a balance transfer card comes with an introductory period of zero or low-interest rate. So, repay the transferred balance within that period.

However, after making the payment, do not cancel your existing cards especially if they have a long credit history.  If you cancel cards, the credit limit and the history of credit will reduce thereby affecting your credit score negatively.

Getting Panicked and Selling Stocks

Selling stocks after a stock market decline is one of the major financial mistakes that often people commit. They sell stocks when the market is down. But, have faith. The market will surely recover. Do not touch your investment portfolio at this time. The market recovered even after the economic crisis of 2009. However, it may take a bit more time. So, do not sell stocks right at this moment.

Another thing that the financial advisers always tell not to do is check your portfolio every day. It will make you stressed. Instead, if you have an additional amount after meeting your necessities, you can invest it in stocks as the prices are low.

Withdrawing from Retirement Accounts without Considering the Cons

The CARES Act has made it quite easy to withdraw funds from your retirement accounts, such as IRAs (Individual Retirement Account) and 401(k)s.

Here are a few advantages of withdrawing funds:

  • You can borrow up to $100,000 from your 401(k) plan.
  • You can withdraw $100,000 from any qualified retirement plan without having to pay an early withdrawal penalty.
  • You have 3 years to repay the amount without paying any income tax on the withdrawn amount.

The main advantage of starting to save early in such retirement accounts is to take advantage of compound interest. However, if you withdraw, you’ll lose the benefit to some extent. So, weigh the pros and cons before opting for this.

Not Reviewing your Financial Condition with your Financial Advisor

It is not a good idea to skip reviewing your financial situation with your financial advisor. It is rather more important at this time to have a clear view of your financial situation.

Discuss with your financial advisor how you need to maintain your investment portfolio and what moves you need to take. Talk about your financial goals and how you’ll implement them.

Taking on Debts without Thinking about How to Manage

Mortgage rates are comparatively low. You may feel the urge to take out a loan to meet your daily necessities if you’re facing financial problems. However, it is better not to take out additional debts that you can’t handle.

However, if you’re already having difficulty managing your existing debts, you can consolidate your debt. You don’t have to meet with a debt consolidator in person. You can just call a good consolidation company and seek help.

Sitting in Front of a Screen

At last, I would like to mention that it is quite important to stay physically and mentally healthy during this time. So, do not be stressed. Restrict your screen timing and have some me-time. Do something which you like. Nurture a hobby. Use this opportunity to spend time with kids and family members.

Enjoy quality time and take help from your family members to manage finances efficiently. Not committing these mistakes can help you have a better financial future.

About Good Nelly

Good Nelly is a financial writer who lives in Milwaukee, Wisconsin. She has started her financial journey long back. Good Nelly has been associated with Debt Consolidation Care for a long time. Through her writings, she has helped people overcome their debt problems and has solved personal finance related queries. She has also written for some other websites and blogs. You can follow her Twitter profile.

Selecting Stocks with a Score

Selecting Stocks with a Score

A friend of mine really likes selecting stocks with a score, the Piotroski score in particular.  Briefly, Professor Piotroski created a set of nine financial ratios that contribute to the score. If a company meets a certain criterion and has favorable results on 8 or 9 of the ratios, his analysis indicates that the company’s stock is likely to do well. My husband is primarily a value investor. The appeal of the Piotroski score to my husband is that it focuses on value stocks and, while it relies heavily on statistical analysis, it isn’t a black box.

In this post, I’ll identify the group of stocks to which the Piotroski score applies. I’ll then briefly explain the financial ratios that determine the score. I’ll close with a specific example of a stock I bought solely using the Piotroski score and provide some general guidance on applying the results of the score.

Book-to-Market Ratio

What is It?

The book-to-market (BM) ratio is a financial ratio. The numerator is the book value of the company. This value is shown on the balance sheet in the company’s financial statements and is usually reported as “Shareholders’ Equity.”

The denominator of the ratio is the total market value of the company on the evaluation date as the financial statements. The total market value is the stock price multiplied by the number of shares outstanding and is also called the market capitalization.

In mathematical terms,

BM Ratio = Book Value divided by Market Capitalization

Piotroski waits for the financial statements to be published for a particular year end to get the book value. He then looks up the market capitalization on the evaluation date of the financial statements for use in the ratio.

Piotroski’s Criterion

In his paper, Piotroski identifies value stocks as companies that have BM Ratios in the highest quintile (highest 20%) of traded stocks. These stocks have high book values relative to their market capitalization. Looked at from the other perspective, these stocks have low market capitalizations (and therefore low stock prices) relative to their book value.

Recall that the book value is the company’s assets minus its liabilities. In theory, if the company were liquidated on the evaluation date of the financials, shareholders would get their portion of the Shareholders’ Equity, based on the proportion of shares owned. Therefore, a BM ratio of 1.00 means that the market capitalization of the stock is equal to the Shareholders’ Equity.

By comparison, the cut-off for the highest quintile of BM ratios[1] across all stocks reported in the ValueLine Analyzer Plus on May 29, 2020 is 1.47. The book values per share of these companies are almost 50% higher than their stock prices!   You can see why Piotroski might consider these stocks to be potentially good values at their current prices.

Why Might It Be High?

There are at least two reasons that the BM ratio might be high.

First, the market may perceive that either assets are overvalued or liabilities are undervalued. Both of these situations would cause the reported book value to be higher than its true amount.

For example, some companies have not fully funded their pension plans. That means that the estimated present value of the future pension benefits is more than the liability on the balance sheet. Companies disclose these differences in the Notes to Financial Statements. If the liability for pension benefits is understated, it will cause the company’s book value to be overstated.

Second, financial theory tells us that the market value of a company’s stock is equal to its book value plus the present value of future profits. If the market perceives that the company is unlikely to make money in the future, the market capitalization will be less than the book value.

The Piotroski score focuses on companies in the second category. That is, it attempts to identify companies that will be profitable in the future from among all of the companies that the market thinks will have negative future profits.

Piotroski Score

The Piotroski score is calculated as the sum of a set of 9 values of 1 or 0. There are 9 criteria in the calculation, in addition to the BM ratio being in the highest quintile. The process assigns a 1 if a company’s financial statement values meet each criterion and a 0 if it does not. As such, companies that meet 8 or 9 of the criteria are considered more likely to have above market average performance.

The 9 criteria are listed below:

  1. Return on assets (ROA) = Net income / Total assets at beginning of year > 0
  2. ROA this year > ROA last year
  3. Cash flow from operations > 0
  4. Cash flow from operations > net income
  5. Long-term debt / Total assets this year < Long-term debt / Total assets last year
  6. Current ratio this year > current ratio last year
  7. Shares outstanding this year <= shares outstanding last year
  8. Gross margin this year > gross margin last year
  9. Total sales / Total assets this year > Total sales / Total assets last year

Piotroski performed his analysis using data from companies’ financial statements from 1976 to 1996. The average of the one-year returns for the companies with scores of 8 or 9 was 7.5 percentage points higher than the average for all companies with high BM ratios and 13.5 percentage points higher than the average for the market as a whole.

How to Calculate It

If you are familiar with reading financial statements, you can calculate the Piotroski score yourself using the formulas above. Or, you could extract the key ratios from a source, such as ValueLine, Tiingo or Bloomberg, all three of which require subscriptions. I use the latter approach as I have a subscription to ValueLine that I use for a variety of purposes.

An easier option is to use a Piotroski calculator or screener.   I’ve never used any of these tools, but I used Google to find a couple free options you might try.

  • Old School Value – This Excel spreadsheet will calculate and show you how a company does on each of the 9 tests and the total score.
  • ChartMill – This screener lets you identify stocks based on their Piotroski score. As such, it helps you find stocks with scores of 8 or 9, but does not show you the details of the underlying calculation.

I suggest being careful to check the documentation of any of these tools to make sure that the descriptions of the 9 tests are the same as I’ve included above (which I took directly from Piotroski’s paper). In poking around on-line, I found more than one site that did not correctly specify the nine tests.

My Experience Selecting Stocks with a Score

Although I’ve looked at stocks using the Piotroski score several times, I’ve made only one purchase using it as my primary buying criterion. I purchased FUJIFILMS (FUJIY) in March 2012. At the time, FUJIY had a BM Ratio of about 1.40, as compared to a market average BM ratio of about 0.5. It had a Piotroski score of 8, having failed the test for an increase in gross margin.

For many, many years, FUJIY’s biggest product was film for cameras. With the advent of the digital camera, its market shrank rapidly. In the year before I purchased the stock, its price decreased by 32%. As I was looking at the company, it was transitioning its business from camera film to other types of related products, including medical imaging and, more recently, office products with its purchase of Xerox. With a good story and a high Piotroski score, I decided to buy the stock.

It turns out I was a little early in buying the stock. In the 12 months after I bought the stock, it decreased by 19% while the S&P 500 increased by 13%. However, if I had bought it a year later, my total return would have been much better over both the short and long term, as shown in the table below.

Total Return starting in March 2013
1 Year2 YearsUntil June 2020
FUJIFILMS+51%+84%+171%
S&P 500+22%+36%+110%

 

So, even though my returns were lower than the market average because I bought the stock too early in the company’s turnaround, I correctly decided to keep it after its first year of poor performance. That is, if I had sold the stock one year after I purchased it and bought an S&P 500 index fund, I would have been worse off.

Caution

As with any investing strategy, it is important that you understand the assumptions underlying the Piotroski score. I also recommend that you understand the story behind the company you are considering for investment, as described in my post on buying stocks based on their financial fundamentals. There are companies that may have a Piotroski score of 8 or 9 that don’t have a good turn-around story, such as the one I described for FUJIY. In those cases, you may not want to rely solely on the Piotroski score.

 

[1] Calculated in this case as Book Value Per Share at most recent fiscal year end divided by Price on May 29, 2020, so not exactly equal to the ratio as calculated by Piotroski.

Picking Stocks Using Pictures

Picking Stocks Using Pictures

Technical analysts select companies for their portfolio based on patterns in stock prices.  That is, it allows them to enhance their process of picking stocks by using pictures. This approach is very different from some of the others I’ve discussed, as buy and sell decisions are based in large part on these patterns and less on the financial fundamentals of the company. Every technical analyst has a favorite set of graphs he or she likes to review and their own thresholds that determine when to buy or sell a particular stock.

I’ve done just a little trading based on technical analysis, so asked Rick Lage, a family friend who has much more experience with this approach, to help me out. In this post, I will provide some background on Rick and provide explanations of the graphs he uses. I’ll also provide some insights on who I think is best suited for this type of trading.

Rick’s Story

Rick’s Background

“I was first introduced to the stock market in a Junior High School math class. I made my first trade with a stockbroker about 6 years after graduating from High School.

My interest in the stock market never faded. I was always focused on this platform to make money. Unfortunately losing money was a regular occurrence for many years in the beginning, with not many gains to be proud of.

My interest peaked in 1999 when I attended my first stock trading event in Las Vegas, known as the TradersExpo[1]. TradersExpo provides a wealth of information available for the beginner to the pro, including hardware, trading software, classroom instruction and more.

I personally have never been a day trader. Swing trading is more my definition. I do touch base with my stock watch list daily. It’s always managed and checking my technical indicators is a must.”

Rick’s Goals

“I stock trade for the challenge; not so much for the fun or success. If there is success the fun will follow. There will be losses. No doubt. But you learn how to manage those losses. You have no choice. Technical trading is my science.”

Rick’s Advice to New Traders

Rick says, “I have tried hard to never complicate the trade. There are many technical indicators, so don’t get overwhelmed. I pick stocks that have the momentum. Pick your favorite few indicators and go with those.”

Rick’s Tools

Rick’s favorite indicators are

  • Simple Moving Averages using 9 and 180 days (SMA 9 and SMA 180)
  • Price and Volume Charts
  • Relative Strength Index (RSI)
  • Moving Average Convergence Divergence (MACD)
  • Heikin-Ashi bar chart

I will provide brief introductions to each of these indicators, illustrating each with two stocks – Apple and Shopify. A graph of Apple’s stock prices from January 1, 2018 through mid-May 2020 is shown below. It had some ups and downs in price in 2018 and 2019, followed by a significant decrease and recovery so far in 2020.

Apple stock price from 2018 to 2020, starts at about 150, goes to 200, back to 150 by early 2019, over 300 by early 2020, down below 250 in March 2020, back above 300

Shopify had a steadier increase in 2018 and 2019, but much more volatility so far in 2020, as illustrated in the graph below.

Shopify stock price from 2018 to 2020. Starts around 100, goes to 400 in mid-2019, down to 300 by end of 2019, above 500 in March 2020, down to almost 300 then above 700

Simple Moving Averages (SMA 180 and 9)

In this context, a simple moving average (SMA) is the average of the closing prices for the past n days, where n is specified by the person making the chart. In Rick’s case, he looks at the 180-day simple moving average and the 9-day simple moving average. For the former, he takes the average of the closing prices for the previous 180 days; for the latter, the average of the closing prices for the previous 9 days.

SMA Charts

Technical analysts add their favorite SMA lines to the chart of the stock’s price. For illustration, I’ve added the SMA 180 and SMA 9 lines to the Shopify and Apple stock price charts below.

Shopify stock prices from 2018 to 2020 with 9-day and 180-day moving averages. Apple stock price from 2018 to 2020 with 9-day and 180-day moving average lines.

SMA Indicators

Technical analysts then look at the crossing points on the chart to provide buy and sell indications. For example, a technical analyst might look at when the closing price line (black in these charts) goes up through the SMA 180 line (blue in these charts) and call it a buy signal or an indication of a time to buy a stock. You can see an example of a buy signal, using this method, for Shopify around May 1, 2019, as indicated by the green circle.  The buy signals for Apple are much more frequent using this criterion, two of which are indicated with green circles.

Similarly, a technical analyst might look at when the SMA 9 line (yellow/orange in these charts) goes down through the SMA 180 line and call it a sell signal. Using this criterion, there was a clear sell signal for Apple in early November 2018, as indicated by the red circle.

Every technical analyst has his or her favorite time periods for SMA lines. In addition, each technical analyst selects his or her own criteria for buy and sell signals based on those SMA lines. The shorter the time period associated with the SMA, the more often buy and sell transactions will be indicated. When I use SMA graphs to inform my buy and sell decisions, I use fairly long time periods as I am a long-term investor. By comparison, some people trade in and out of stocks several times a day, so use very short time periods, such as minutes or hours.

Price and Volume

A price and volume chart shows plots of both the price of a stock and its volume on a daily basis, color-coded to indicate whether the stock price went up or down each day. The graph below is a price and volume chart for Shopify.

Shopify Price with each day showing high, low, open and close. Days when price went down are in red (about 1/2 of the days), otherwise bars are green. Below price chart is a bar chart showing the daily trading volume.

The upper chart has rectangles (called boxes), sometimes with lines sticking out of them (called whiskers). The combination of the boxes and whiskers is often called a candle. There is one candle for each trading day.

Price & Volume Indicators

A red box indicates that the price was lower at the end of the day than at the end of the previous day; a green box, higher. Green boxes can be interpreted as follows:

  • The bottom of the box is the opening price.
  • The top of the box is the closing price.
  • The bottom of any whisker sticking down from the box is the lowest price on that day. If there is no downward whisker, the lowest daily price and the opening price were the same.
  • The top of any whisker sticking up from the box is the highest price on that day. If there is no upward whisker, the highest daily price and the closing price were the same.

Red boxes can be similarly interpreted, but the opening price is the top of the box and the closing price is the bottom of the box.

The lower section of the chart shows the number of shares traded each day. If the bar is green, the stock price went up that day, while red corresponds to down.

Technical analysts use these charts to identify trends. A really tall green bar in the lower section green is an indication that a lot of people think the stock will go up so are buying. Many technical analysts consider this a buy signal. Similarly, a really tall red bar is considered by some to be a sell signal. My sense is that you need to be very quick to respond using this type of strategy, as you don’t want to sell a stock after everyone has already sold it and the price has dropped or buy it after the price has increased.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is intended to measure whether a company’s stock is in an over-bought or over-sold position. If it is over-sold, it is a buy signal; if over-bought, a sell signal. The RSI is one of a broad class of measures called oscillators, all of which are intended to evaluate whether the market is over-bought or over-sold.

The RSI is determined based on a moving average of recent gains and the moving average of recent losses. The value of the RSI is scaled so it always falls between 0 and 100.

The RSI was developed by J. Welles Wilder. He considers the market over-bought when RSI is greater than 70 and oversold when it is below 30. There are many other ways in which the RSI chart can be used to identify trends and inform trading decisions that are outside the scope of this post.

The chart below shows the RSI for Apple (blue) and Shopify (orange).

Apple and Shopify Relative Strength Indices with red line at 70 (sell signal) and green line at 30 (buy signal).

The red horizontal line corresponds to RSI equal 70, Wilder’s over-bought signal. The green line is Wilder’s over-sold signal at RSI equals 30.

In this chart, there are several times when both stocks were over-bought. That is, the RSI for both stocks goes above the red line. Apple was considered slightly over-sold a few times, when the blue line crossed below the green line. By comparison, Shopify’s RSI came close to indicating that it was over-sold a few times, but never went below the green line.

Moving Average Convergence Divergence

The Moving Average Convergence Divergence indicator (MACD) is similar to the Simple Moving Average indicator discussed above. However, it uses an exponentially weighted moving average (EMA) instead of a simple moving average. A simple moving average gives the same weight to each observation. An exponentially weighted moving average gives more weight to more recent observations. MACD can use any period – minutes, hours, days, etc. For this illustration, I will set the period equal to a day. If you are trading more often, you’ll want to replace “day” in the explanation below with “hour” or “minute.”

The MACD was defined by its designer as the 12-day moving average (EMA 12) minus the 26-day moving average (EMA 26). MACD is compared to its own 9-day moving average to determine buy and sell signals. As with the simple moving average, the MACD crossing its 9-day moving average in the upward direction is a buy signal. When MACD falls below its 9-day moving average, it is a sell signal.

MACD Charts

The graph below shows Shopify’s daily closing prices along with the EMA 12 and EMA 26 lines in orange and green, respectively, starting on February 1, 2020.

Shopify price chart from Feb 1 2020 to May 11 2020 with EMA 12 and EMA 26.

This next chart shows the corresponding values of MACD (black) and its 9-day moving average (green).

Shopify MACD and 9-day simple moving average of MACD.

If you compare the two graphs, you can see that MACD goes below the 0 line on the second chart on April 1, 2020. This transition is consistent with the orange line crossing above the green line on the first chart on the same date.

MACD Indicators

When Shopify’s MACD is bullish, its MACD is greater than its 9-day moving average or the black line is above the green line in the second chart above. This situation has been seen several times in the past few months – for short periods starting on February 11, March 23 and May 4 and a longer period starting on April 9.

The Apple MACD chart, shown below, has gone back and forth between bullish and bearish (black line below the green line) much more often in the past few months. It sometimes changes from bearish to bullish and back again on almost a daily basis.

Apple MACD with 9-day moving average (sell signal).

The “convergence” and “divergence” part of MACD’s name refers to how the MACD behaves relative to the price. The relationship is somewhat complicated, so I suggest you refer to one of the sources I mention below if you are interested in this feature of MACD charts.

Heikin-Ashi bar chart

Also known as a Heikin-Ashi candlestick chart, the Heikin-Ashi bar chart is similar to the price part of the Price-Volume chart described above.   However, instead of using the actual high, low, open and close prices, all four of the points on the candle are calculated in a different manner. The purpose of the adjustments is to make a chart that makes identifying trends easier. I refer you to one of the resources below to learn the details of how these values are adjusted.

Heikin-Ashi Charts

The charts below show the Heikin-Ashi charts for Shopify and Apple for the past six months.

Shopify Heishen Ashi candles Apple Heikin Ashi Candles

As mentioned, they look a lot like Price charts, except the boxes corresponding to the adjusted open and close and the whiskers corresponding to the adjusted high and low. The boxes are colored green when the adjusted close is higher than the previous adjusted close and red otherwise.

Heikin-Ashi Indicators

Here are some of the indicators people review when using Heikin-Ashi charts:

  • Longer boxes are indicative of trends. In the charts above, you can see that the Apple chart tends to have longer boxes than the Shopify chart.
  • When there is no whisker on one end of the box, the trend is even stronger. For example, neither the Apple nor Shopify charts have upward whiskers on the red boxes from mid-February to mid-March 2020. This time period corresponds to the time period highlighted by the red arrow on the chart below when both stocks’ prices were going down.

Apple and Shopify closing prices from Nov 1 2019 to mid-May 2020. Red arrow showing downward trend in Shopify price from mid-Febrary 2020 to late-March 2020. Green line showing upward trend in Shopify price from early April 2020 to mid-May (end of chart)

Similarly, almost none of the green bars in the last month of the Heishen Ashi chart have downward whiskers, corresponding to the time period in the price chart indicated by the green arrow.

Time periods when the boxes are short, have both whiskers and change color often are indicators of changes. For example, the Apple Heikin-Ashi chart from mid-January to mid-February shows several bars of alternating colors. Apple’s price changed from an upward trend to a downward trend in this period, as shown in the purple circle in the chart below. Identifying turning points is very important in deciding when to buy and sell stocks.

Apple closing prices from Nov 1, 2019 to mid-May 2020. Circle around prices from late Jan 2020 to end of Feb 2020 where price bounces up and down

Who Can Use Technical Analysis

Technical analysis isn’t for everyone. It requires people who (a) have the ability to focus on markets fairly closely every day in the case of swing traders or all day in the case of day traders, (b) are happy with growing their portfolio with a large number of small “wins,” and (c) have a solid understanding of the charts being used.

Time Commitment

Unlike many other investment strategies, many day traders and swing traders do not consider a company’s financial fundamentals in their buy decisions. Instead, they monitor the patterns in their charts. Without the comfort of believing that the companies they own have sound fundamentals, it is important that they follow their charts consistently so they can quickly sell any positions that are not meeting expectations.

Lots of Small Wins

In my post on financial fundamentals, I talk about Peter Lynch’s concept of a 10-bagger – a stock whose value is at least 10 times what you paid for it. In that paradigm, the goal is to attain better-than-market-average returns by getting average returns on most of the positions in your portfolio and big gains on one or two positions.

By comparison, the goal of day traders and swing traders is to make a very small amount of money on every trade, but to make lots and lots of those trades. If you earn 0.1% on average on every trading day, it compounds to just over 20% a year!

For many of us, buying and selling with gains of less than 0.1% per security seems really small and might not seem worthwhile. As such, you need to be willing to be happy with lots of little wins rather than a 10-bagger if you want to be a day trader or swing trader.

Understand the Charts

One of the requirements of using technical analysis is to make sure you understand how to interpret the charts correctly. For example, Southwest Airlines (ticker: LUV) has done very poorly recently from the impact of COVID-19. The plot below shows its closing stock price from February 15, 2020 through May 20, 2020.

Southwest Airlines closing price from Feb 15 2020 to late May 2020.

As can be seen, the last stock price on the graph (about $29) is almost exactly half of the stock price in mid-February (peaked at $58.54). As such, while it has had a few days on which the price increased, the overall trend has been down.

The RSI chart is shown below. Remember that an RSI value of less than 30 is an indication that it might be time to buy the stock.

Southwest Airlines Relative Strength Index chart from Feb 15, 2020 to May 20, 2020.

In this example, there was a buy signal when the RSI crossed below the green line (30) on February 25. The closing stock price on that day was $49.66. If you had bought the stock on that date, you would have lost 41% in the subsequent three months as the stock was at $29 on May 20, 2020.

As you can see, interpreting charts takes time and expertise. If you are willing to invest the time to learn all of the nuances of each type of chart and monitor your positions, technical analysis might be the right investing strategy for you.

There’s a lot more to know about each of these indicators than I’ve provided in this post. Here are a few links to other sources of information to learn more.

  • Stock Charts
  • Technical Analysis for the Trading Professional by Constance Brown, McGraw-Hill Education, 2nd Edition, 2012.
  • Investopedia

How I Use Technical Analysis

I primarily rely on analysis of the underlying fundamentals of a company when I purchase individual stocks. Once I make the decision to buy a stock, I look at the charts to evaluate whether the timing is good for a purchase. If the consensus of the charts I review indicates that the position is over-bought (i.e., price is too high), I will wait to see if the price decreases before buying.

In addition, I use technical analysis in my Roth IRA, where there are no capital gains taxes on trades so more frequent trading isn’t adversely impacted. I follow a large handful of industry ETFs using technical analysis and buy and sell them as each one appears to be doing well. Because I am trading in industry exchange-traded funds (ETFs) and not individual stocks, I feel comfortable looking at my positions once a week. My thought is that industries aren’t likely to experience sudden weaknesses not seen throughout the market in shorter time frames.

When I pay sufficient attention to the positions in my Roth IRA, I tend to get about or slightly above market-average performance. However, when I don’t look at my positions and re-balance regularly, I find that my performance suffers which just confirms my first point in the previous section that using technical analysis requires time and diligence.

[1] There are now TradersExpo events held regularly in many cities (subject to change by the coronavirus).

Should I Buy Stocks Now?

Should I Buy Stocks Now?

Many, if not most, financial advisers recommend accumulating wealth from a diversified set of investments including stocks.  An investor can add stocks to her/his portfolio by purchasing stocks from an individual company or from buying mutual funds.  With the stock market down double digits since the beginning of 2020, some experts say stocks are “on sale” and now is a good time to buy, but just over half of Americans report they own stocks. This is down from 62% prior to the 2007/8 recession and it includes ownership of stocks that are contained within retirement funds and mutual funds, as well as individual stocks.  Common reasons to not buy stocks/mutual funds are (1) stocks are complicated and I don’t know how to get started, and (2) stocks are too risky.  Let’s review both of these drawbacks.

Stocks are Complicated

All too often, some of my friends and family are reluctant to purchase stocks because they do not understand the stock market.   Even some of my most intelligent friends shy away from financial conversations that involve the stock market because they do not want to appear ignorant.

If you did not learn about investing in school or from your parents, how can you figure this out?  How do you convert your dollars into stocks?  How do you learn which stocks are worthwhile?  Should you purchase individual stocks or mutual funds and, by the way, what exactly are mutual funds?

Investment Clubs Help You Buy Stocks

You can learn about many of these topics in a fun way by forming an investment club with like-minded friends and/or family.  Since 2004, I have been a member of Take Stock, a ladies’ investment club.  Our club is one of the 4,000 investment clubs of the National Association of Investors Corp. (NAIC).  The NAIC was formed in 1951 as a 501(c)(3) nonprofit organization with the aim of teaching individuals how to become successful long-term investors.  Originally, the NAIC’s focus was investing in common stocks, but, with the popularity of 401(k)s and other retirement plans, the NAIC has added education about stock and bond mutual funds.

The NAIC (also more recently known as Better Investing) stresses four principles for successful, long-term investing:

  1. Invest regularly, regardless of market conditions;
  2. Reinvest all earnings;
  3. Invest in growth companies (and growth mutual funds); and
  4. Diversify to reduce risk.

What Information Can I Get from NAIC/BI?

NAIC/Better Investing (NAIC/BI) provides many tools and resources to help individuals as well as investment clubs learn about investing.  There is a stock selection guide (SSG) that organizes companies’ performance information to allow you to determine for yourself whether a particular company is a stock you want to purchase and the price is reasonable.  Some of the free resources offered by NAIC/BI include:

  • Over 100 free stock investing videos;
  • An introduction to stock investing that explains the SSG;
  • How to start your own investment club;
  • Investor education articles;
  • Stories from members; and
  • 90-day free membership.

How My Club Works

My club was formed in 1999. It is comprised of nine women who meet monthly in each other’s homes.  Of the nine members, the one with the longest tenure is a charter member and the most recent arrival has been in our club for just over one year.   During our meetings, we review our club’s portfolio (currently stocks of twelve companies), discuss stocks to research for possible future purchase, and vote on any companies that we have already researched. It is not required that you meet in members’ homes—you could choose to meet at your local library, a restaurant, etc.  We typically meet in the evening on the second Tuesday of each month and the hostess for that month provides a light meal.  Every July, we meet at a local park for a summer concert and we bring our families/friends.

Monthly “dues” are used to invest in stocks and your ownership is based upon what percentage of the total portfolio you have invested through your paid dues.  The monthly dues are in multiples of $25 (i.e., $25, $50, $75 etc.) and there is a monthly minimum of $25.

I highly recommend forming or joining an investment club.  You’ll have the opportunity to learn more about the stock market, to learn more about individual companies that you and your club research, and you’ll get to know your friends and acquaintances better.  The best part is you’ll have fun while investing in your financial well-being and you will all become richer by enhancing your friendship.

One Final Caveat

If you are new to investing you will probably want to invest the portion of your money that you will not need in the near term, such as a down payment on a home you wish to  purchase three or more years from now, your children’s education fund, or your retirement fund.  Your rainy-day fund should be kept in more liquid investments that can be accessed quickly.

So now that you know you can have fun and learn about the stock market, you may still be reluctant to buy stocks due to the risk involved.  Let’s review this objection to increasing your wealth. . .

Stocks Are Too Risky

One of the primary concerns about owning stocks is the risk inherent in these investments.  What if I invest my money in the stock market and the stock market crashes as we have seen since Covid-19 or like we saw in 2008/2009?  While it is true that declines of 15+% in your investment portfolio are not desirable, it is also true that in every case where the stock market has had a large decrease, the stock market more than made up for the declines in the months and years following the drop.

As of this writing (April 30, 2020), since the beginning of 2020, the Dow Jones Industrial Average (Dow) is down about 18% and the S&P 500 is down about 11%.   While not good news, if you were invested in the market during 2019, you would still be ahead because the Dow rose more in 2019 than the current 2020 drop. (Dow added 22% and the S&P 500 added 28% during 2019).

We have likely heard the old adage:  risk is reward. That is, the more reward that is sought, the more risk that must be taken.  If you are desirous of the smallest risk possible, then you would probably choose to park your money in (for example) savings bonds or certificates of deposit which will guarantee you a reward albeit a small one.  If you prefer more reward, then you will likely choose to invest some of your portfolio into the stock market.  Let’s look at an example of how a specific risk tolerance manifests into investment growth.

Risk-Reward Comparison

Five years ago, assume you invested $1,000 with (1) small risk (investing in a certificate of deposit), (2) medium risk (investing in an S&P 500 mutual fund) or (3) high risk (investing in only one individual stock).  Here are the results:

 

CD:  “low” riskS&P 500: “medium” riskAmerican: “high” riskApple:   “high” risk

5/1/15

 $1,000 $1,000 $1,000

 $1,000

12/31/19 $ 1,073 $1,531 $633

 $2,376

4/30/20

 $1,077 $1,395 $298

 $2,209

5-year return

7.7%39.5%-70.2%

120.9%

4.75-year return (through 12/31/19, 0pre-Covid)

7.3%

53.1%-36.7%

137.6%

 

Takeaways from this Exercise

Here are the key takeaways from this table.

  • The lowest-risk investment provides a 7.7% return over five years. This is based on investing $1,000 over a period of five years at current CD rates of 1.5% per year.  Note that while the original investment of $1,000 grows over the five years, it is growing less than the rate of inflation over the five years so you have “lost ground” by investing in a CD.    Over this same five-year period, the Consumer Price Index rose by 8.9%, higher than the 7.7% earned in the CD; thus, your buying power is less since the cost of goods has risen by 8.9% while your investment grew at 7.7%.
  • The medium-risk investment provides a much better return than low risk. You would have earned nearly 40% over the five-year period.
  • The high-risk investment was defined as investing in only one single stock. As you can see, if you chose American Airlines for your one stock, you would have lost 70% of your investment.  However, if you had chosen Apple as your one stock, you would have more than doubled your money and earned a 121% return over five years.

Keep in mind that the results above include the effects of the drop in the stock market from COVID-19.  If we look instead at year end 2019 — before the effects of COVID-19 — we see returns of 7.3% (CD), 53% (S&P 500), -37% (AAL), and 138% (AAPL).

Your Risk Appetite

If your risk appetite is miniscule, then you would probably want to avoid the stock market altogether and put your money into certificates of deposit.   This will not bring wealth to you but it will give you peace of mind.  If you have more tolerance for risk, then investing in the stock market by diversifying your stocks is a much better way to accumulate wealth.   As shown in the example above, it is possible to earn more from investing in high-growth stocks, but it is also virtually impossible to pick which individual stocks will generate above average future growth.  The medium-risk option will usually provide much better returns over the long terms than will the low risk-option.

How I Built My Wealth

Stocks—primarily mutual funds with a variety of individual stocks—have contributed to my personal wealth accumulation.  I recommend including stocks in your assets and joining or forming an investment club with friends and family can be a fun way to further your wealth.  Good luck!

 

Kay Rahardjo, FCAS, MAAA is an actuary and risk management professional. She retired from The Hartford in 2014 from her role as Senior Vice President and Chief Operational Risk Officer. She developed and taught an operational risk management course at Columbia University.

How to Buy Life Insurance

How to buy life insurance

Choosing the right type of life insurance policy and its death benefit can be confusing. Not too long ago, I published a guest post from Baruch Silverman of The Smart Investor on the different types of life insurance. In this post, you’ll learn how to buy life insurance.  Specifically, I’ll help you evaluate which, if any, of those types of policies fit your situation and how to select your death benefit.

Why are You Buying It?

The first thing you want to consider is why you are buying life insurance. Three common purposes are:

  • the death benefit.
  • the investment returns.
  • sheltering gifts to your heirs from income taxes.

Death Benefit

If your primary purpose for purchasing life insurance is the death benefit, you’ll want to focus on term and whole life insurance.

Investment Portfolio

Some people use life insurance similar to other financial securities (such as stocks and bonds). Variable life and universal life have investment components to them. In simplified terms, the total amount you pay as premium for these types of life insurance is split between the amount to cover the cost of a whole life policy and the excess which can be invested. As such, the life insurer doesn’t invest the portion of premium related to the death benefit.  Further, the life insurer reduces the excess to cover its expenses, a risk charge and its profit margin before investing it.

Variable and universal life policies include the cost of whole life insurance.  Thus, only people who want the coverage provided by whole life insurance might consider using life insurance as part of their investment portfolio. Even then, the returns may not be as high as other investment vehicles with similar risk because of the additional costs charged by the life insurer.

Tax Shelter

Sheltering gifts to your heirs from income taxes only applies to the very wealthy (those who have more than $11 million in assets). I’m assuming that the vast majority of my readers aren’t in this situation, so won’t address it here.

Other Considerations

All types of life insurance can have an indirect impact on your investment portfolio. If you purchase life insurance in an amount that will cover your dependents’ basic living expenses, it allows you the option to invest your portfolio in riskier assets in anticipation of getting higher returns. That is, the death benefit itself could be considered a low-risk investment.  It reduces your overall portfolio risk when added to the other assets you own.

Do I Need Life Insurance?

Some people don’t need the death benefit from life insurance. In that case, it doesn’t make sense to buy life insurance as an investment security either. In the last section of this post, I provide the details of estimating your target death benefit. People whose target death benefit is zero are those who don’t need life insurance.   Briefly, characteristics of people who have a target death benefit of zero are:

  • Their available assets are more than their debts. Available assets exclude any illiquid assets (such as any real estate or personal property they own), savings for their dependents’ retirement (but not their retirement as they don’t need retirement savings after you die), emergency savings and any savings designated for large purchases.
  • They have enough money to cover their dependents’ education expenses.
  • Their dependents can support themselves on their existing income plus your available assets, including being able to make debt payments as they are due or after using available assets to pay off any debts.
  • They have enough money to pay any end-of-life expenses related to their death.

If you aren’t sure if you meet these criteria, keep reading!

Term vs. Whole

If  you’ve decided that you are buying life insurance for the death benefit, you need to decide whether term life or whole life insurance will better meet your needs. The primary differences between the two options are the length of time you need the insurance and the cost.

Term Life

If you think you will need life insurance for a limited period of time, term life insurance is likely better for you. For example, you might have dependents who aren’t currently able to cover their living expenses and the cost of any debt.  In that case, you might want to buy life insurance that will pay off your debts and support your dependents until they are independent.  If your needs change, many insurers will let you convert a term life insurance policy to a whole life policy without having to provide medical information or have a physical, one or both of which are often pre-requisites for purchasing whole life insurance.

Term life premiums are constant over the term of any policy you purchase. However, if you buy a policy when you are older, the premium will be higher than if you buy the same policy when you are younger.

Whole Life

If you think you will need life insurance for your entire life, whole life insurance is likely better for you. For example, if you have a spouse or disabled children who will never be able to support themselves, whole life insurance could supplement your savings to help make sure they are able to live more comfortably, regardless of when you die.

In addition to the death benefit, whole life insurance gives you the option to borrow money. As you pay premium, life insurers designate a portion of your premium as the cash value. The cash value is always owned by the insurance company, but you are able to borrow an amount up to the cash value at any time without prior approval, any collateral or impact on your credit score. The interest rates on cash-value loans are less than many other sources, particularly credit cards. If you die before the loan is re-paid, the amount of the loan will be deducted from your death benefit.

Cost Comparison

Whole life insurance is much more expensive than term life when you are young, but eventually becomes less expensive.

Probability of Dying

The graph below provides some initial insights into the difference in cost between whole life and term life, as it shows the probability that you will die at each age. I calculated the values based on 2016 data from the Social Security web site.

Probability of dying for each year of age

Not surprisingly, the probability you will die increases at each age. If you buy whole life insurance, it will cover the entire portion of the graph from your current age until you die. As such, there is a 100% probability that the life insurer will pay your death benefit (assuming you continue to pay your premiums). It is just a question of when.

If you buy a 20-year term policy and you are 30 years old, only the deaths that occur in the portion of the graph below highlighted in green would be covered. That is, you will receive the death benefit if you die between ages 30 and 50 and will get nothing if you die after age 50.

Same line graph with blue shading from ages 30-50

The probability you will die is much smaller in this narrow window than the 100% probability you will die at some point.

Present Value of the Death Benefit

There are many factors that determine the premium for term life and whole life insurance policies, but the most important component relates to the death benefit. Actuaries (who help price life insurance) usually base the portion of premium related to the death benefit as the present value of the death benefit expected to be paid, on average, in each year.

One-Year Term Policy

The chart below shows the present value for $1 of death benefit for several sample policies. For illustration only, I have calculated the present values using a 3% interest rate and the probabilities of dying from the charts above.

Present value of death benefit divided by death benefit at each of ages 25, 35, 50

The easiest way to see the impact of the increasing probability of dying is to look at the present value of the death benefit for a 1-Year Term Life policy. You can see it increases from almost zero (actually $0.0015 per dollar of death benefit) at age 25 to $0.042 per dollar of death benefit at age 70 which corresponds exactly to the increase in the probability of dying at each age.

Policies with Longer Terms

There are also increases in the present value of the death benefit for the Whole Life and 20-Year Term Life policies as the age you first start buying the policy increases.

You can also see that the present value of the death benefit at age 25 for the Whole Life policy is much, much larger than the present value for either of the two term life policies. This relationship corresponds to the graphs above which compared the probability of dying in a 20-year period as compared to the 100% probability that you will die at some point.

The difference between the Whole Life and 20-Year Term Life policies is fairly small at age 70, because there is a high probability that you will die between age 70 and 90 – the period covered by the 20-Year Term Life policy. In fact, almost 80% of people age 70 will die during the 20-Year Term Life policy period.  As such, the present value of the death benefit for a 20-Year Term Life policy at age 70 is very roughly 80% of the present value of the death benefit for a Whole Life policy.

Annual Premium

The insurance company collects premium over the full life of the insurance policy to cover the present value of the death benefit. That is, you don’t pay all of your premium to the insurance company in one lump sum, but rather on an annual or monthly basis.

Unless you die during the policy term of the Term Life policy, you will pay premium for more years under a Whole Life policy than under a Term Life policy. Therefore, the differences you see above are larger than the differences in premium payments.

Illustration

The chart below shows the annualized amount of the loss costs. That is, I divided the present values of the death benefits by the average number of years an insured is expected to pay their premium. For example, for the 20-Year Term Life policy, the denominator was calculated as the sum of the probabilities that the insured would be alive in each of the 20 years and therefore able to pay his or her premium.

Approximate loss cost per year per dollar of death benefit at ages 25, 35, 50 and 70

Although these relationships are not precise, they are roughly representative of the differences in annual premium you might pay for the different types of policies at different ages. At age 25, the annual cost of a Whole Life policy in this illustration is roughly three times the cost of either of the Term Life policies. By age 70, the annual cost of a Whole Life policy is less than the cost of 20-Year Term Life policy because, while the present value of the death benefit isn’t all that different between the two policies, people who buy Whole Life policies make more premium payments, on average.

Reality vs. Illustration

It is important to understand that I prepared these examples as illustrations to help you understand the differences between Whole Life and Term Life insurance premiums. In practice, life insurers use different tables showing the probability of dying and different interest rates than I used for illustration, as well as using more sophisticated methods for calculating the present value of the death benefit and including provisions for expenses, risk and profit.

In practice, I’ve seen estimates that Whole Life annual premiums are anywhere from three to fifteen times more than Term Life premium at young ages. As you are looking at your options, you’ll want to get several premium quotes, as they vary widely depending on your age, location, gender, health and many other factors.

How Much to Buy

As with any financial decision, there are two conflicting factors that will influence the amount of the death benefit you buy on a life insurance policy – your budget and your financial needs. In the section, I will talk about how to estimate the best (i.e., target) death benefit for your situation. Once you’ve selected an amount, you can get quotes from several insurers to see whether the premium for that death benefit will fit in your budget or whether you will need to find the best balance between premium affordability and death benefit for you.

Rules of Thumb

Not surprisingly, there are some rules of thumb for guiding your selection of a death benefit. Some of the ones I’ve heard are:

  • Three to five times your salary
  • Ten times your total earned income (i.e., salary, value of benefits and bonus)
  • Ten times your total earned income plus $100,000 per child for college

Rules of thumb like these can provide some insights, but they, by definition, can’t take into account your personal circumstances.

Tailored Approach

A better approach for selecting a death benefit is to analyze your own finances and goals for buying life insurance.   I suggest calculating your target death benefit as the total of the amounts needed to meet your goals, considering the following components.

Debt

If you have debt, you’ll want to consider whether your dependents will be able to continue to make the payments on the debt out of their own income. For example, if your spouse’s earned income is high enough to continue to make your mortgage payments, along with all of the other expenses he or she will need to cover if you die, then you might not need to include the remaining principal on your mortgage as a component of your target death benefit. On the other hand, if you are concerned about your dependents’ ability to continue payments on any debt, you’ll want to include the outstanding principal on those debts as a component of your target death benefit. I’ll define this amount as “Debt Principal to be Pre-Paid.”

Final Expenses

When you die, your dependents will incur some one-time expenses. These expenses can include your funeral or memorial costs and professional expenses to settle your estate. I’ll call the amount of these expenses, “Final Expenses.”

Net Future Living Expenses

The next component of your target death benefit calculation is the amount you need to cover your dependents’ future living expenses.

Current Expenses

Start with your household’s total expenses from your budget. This amount will include monthly expenses for everyone in your household, the amounts you are setting aside each month for your designated savings and any amounts you are setting aside for your spouse’s retirement. To be clear, it will exclude any amounts you are saving for your own retirement.

You can eliminate any monthly expenses or amounts for designated savings for things that are only for your benefit. For example, if you spend enough money on clothes for your job to include it in your budget, you can eliminate those expenses. Similarly, you can also eliminate any expenses related to a vehicle that only you drive or designated savings to replace it.

Earned Income

You then need to calculate your dependents’ monthly earned income. This amount may be calculated in two parts – current monthly earned income and future monthly earned income. For example, your spouse may currently work part time as you are relying primarily on your income for support. If you die, your spouse may be able to work full time to increase his or her earned income. Alternately, your spouse may need some education (discussed below) to get the qualifications needed for his or her desired profession.

Extra Expenses

Next, you’ll need to calculate the amount of any expenses that your household will have because of any changes in your spouse’s availability to provide household services. For example, your spouse may work part-time while your children are in school and provide childcare after school. If your spouse starts working full time after your death, you will need to add after-school care expenses to your budget.

Time Periods

The last factor that goes into this calculation is the length of time until you think your dependents will become self-sufficient. For children, you might assume that they will become independent after they turn 18 or graduate from college. The ability of your spouse to become self-sufficient will be a function of his or her skills, education and/or need for more education and household responsibilities (e.g., childcare or elder care).

I suggest splitting the calculation of this component of your death benefit into three time periods – short-term, medium-term and long-term. For each time period, you’ll calculate your net living expenses as expenses minus income. For any periods for which income is more than expenses, set the difference to zero.

  1. Short term – During this time period, you’ll use your current monthly expenses, excluding your personal expenses, and your dependents’ current monthly earned income.
  2. Medium term – During this time period, you’ll use your current monthly expenses with adjustments for extra expenses for services currently provided by your spouse and your dependents’ future monthly earned income.
  3. Long term – During this time period, you’ll assume that your children (other than those who will always be dependent on you for care) are self-sufficient, so can eliminate all expenses related to children and their care from your expenses. You’ll use your spouse’s future monthly earned income. In many households, income in this period will exceed expenses so there may not be a need for death benefits to cover expenses in this period.

You also need to estimate how many months each of these three time periods will last.

Net Future Living Expenses

Your Net Future Living Expense amount for each time period is calculated as the number of months it will last multiplied by monthly net living expense amount. You can then calculate your total Net Future Living Expenses as the sum of the three amounts you calculated for the three time periods.

For those of you who like to see formulas instead of words, you will calculate:

  1. Short-term Net Expenses = Greater of 0 and Current Expenses – Current Income
  2. Medium-term Net Expenses = Greater of 0 and Current Expenses + Extra Expenses – Future Income
  3. Long-term Net Expenses = Greater of 0 and Future Expenses – Future Income
  4. Net Future Living Expenses = (number of months in short-term period x Short-term Net Expenses) + (number of months in medium-term period x Medium-term Net Expenses) + (number of months in long-term period x Long-term Net Expenses)

You could refine this amount by considering inflation and investment returns. Depending on your investment strategy and the time until the funds are used, your investment returns, on average, can be more than inflation. As a conservative first approximation, I suggest using the total without adjustment for inflation and investment returns.

Education

There are two types of education expenses that you might want to include in your target death benefit calculation:

  1. The portion of the cost of education for your children that you want to provide. Some people suggest $100,000 per child for college. This amount may or may not be the right amount depending on how much you expect your children to contribute to their educations, how many years of college education you want to support and what type of school they attend. Prestigious colleges can cost as much as $75,000 to $80,000 a year currently (2020), while in-state tuition (assuming your children live at home while attending college) can cost as little as $15,000 a year in some states. Other children may not go to college or may attend a trade school.
  2. The cost of any education your spouse needs or wants to allow him or her to work in a profession he or she enjoys and allows him or her to earn enough money to increase his or her independence.

Target Death Benefit Calculation

You can now calculate your target death benefit as follows:

Debt Principal to be Pre-Paid

Plus        Final Expenses

Plus        Net Future Living Expenses

Minus   Savings in excess of your real estate and personal property assets, emergency fund, designated savings and spouse’s retirement savings

Plus        Education Expenses

Minus   Amounts in existing college funds

Minus   Any amounts included in your Net Future Living Expenses designated for college

If you are single with no debt, this amount could be zero indicating that you might not need to buy life insurance. If you are married with no children, don’t have a lot of debt and have a spouse who can increase income or decrease expenses to be self-sufficient fairly quickly, you may need only a small death benefit. At the other extreme, if you have several children and a spouse who won’t be able to be financially independent for many years or ever, your target death benefit could exceed $1 million.   As you can see, the specifics of your financial situation are very important to setting a target death benefit and a rule of thumb may not work for you.

Do I Need a Financial Planner?

Do I Need a Financial Planner?

Creating your own financial plan can be a daunting task. If you aren’t sure where to get started or have a plan but want to improve it, a financial planner might be able to help. I’ve never used a financial planner, so I interviewed two friends who use a planner and Graeme Hughes[1], The Money Geek, to get their insights and perspectives.

In this post, I’ll first distinguish financial planners from other types of financial advisors. The rest of the post provides responses to questions asked by a few of my readers to help you with the following:

  • Figure out whether and how a financial planner can help you.
  • Prepare for your first meeting with a financial planner.
  • Understand the process for developing a financial plan and the deliverables.
  • Select a financial planner who meets your needs.

Financial Planners vs Other Financial Advisors

There are many types of advisors who can help you with your finances. In this post, I’ll focus on professionals who provide financial planning services. These professionals can be independent advisors, work for firms that perform solely financial planning services or can be employed by mutual fund companies, stock brokerage firms (e.g., Schwab or Morgan Stanley), other financial institutions (e.g., Ameriprise) or other types of firms (e.g., accounting firms). Most of these financial planners provide a brand range of services intended to assist you in creating a sound financial plan and attaining your financial goals.

Types of Other Financial Advisors

There are many other types of financial advisors, some of whom may be called financial planners, who specialize in segments of your financial plan. Examples of these advisors include:

  • Insurance agents who can assist you in finding the best insurance policies to meet your needs. Some insurance agents specialize in just property & casualty lines (such as residences, cars or umbrella policies) or health or life insurance or annuities, while others can assist with several or all types of personal insurance.
  • Stock brokers who provide advice about specific companies or financial instruments in which you might want to invest.
  • Money managers who make decisions about what to buy and sell in your portfolio and execute the transactions.
  • Debt consultants or consolidators who can help you find the best strategy for paying off your debts.
  • Tax accountants and tax lawyers who can provide advice about your tax situation and how it might impact your financial decisions. Tax accountants can also prepare your tax returns.

What’s Best for You

You’ll want to choose an advisor who has the right expertise to address your questions. If you want help with your overall financial plan, a financial planner is best. If you go to an advisor with a narrower focus in that situation, you might not get the best information for your overall financial health. For example, an insurance agent who specializes in life insurance and annuities would be less likely to focus on non-insurance savings mechanisms, such as 401k’s or exchange-traded funds, than a financial planner with a broader area of expertise.

To be clear, all of these types of advisors can be very valuable in refining your financial plan, but you’ll want to make sure you have the right expectations about their expertise. In fact, your financial planner may refer you to one or more of these consultants on a specific aspect of your financial plan.

What Services do Financial Planners Provide?

The primary service provided by a financial planner is the development of a sound financial plan. This process can include assistance with setting financial goals, budgeting, estate planning, retirement planning, selection of insurance coverages and investment strategies.

The specific services provided will be tailored to your needs. If you are just getting started, the financial planner may focus on identifying goals and creating a budget. If you already have a financial plan and want increased comfort that you will meet your goals, these services could be as sophisticated as statistical (Monte Carlo) modeling of your future financial situations under a wide range of assumptions regarding future investment returns.

As part of or before your first meeting, a good financial planner will ask about the current status of your finances and what your goals are for deliverables to make sure the planner helps you in a way that makes sense for you.

Do I Need a Financial Planner?

Using a financial planner is a matter of personal preference. I’ve never used one, but my background as an actuary and working with the finance and risk management departments of insurance companies has given me the confidence to go it alone. However, most people can benefit from good advice. As Graeme says, though, “You only need to be careful not to pay for more than you need.” His thoughts about the services you might want to use by age are:

  • A young person starting out might get counseling on budgeting, savings strategies, how much to save, and which tax-advantaged accounts to use.
  • Middle-aged individuals with more substantial savings ($100K+) might want to get an assessment of where they stand for retirement and how much to save to meet their retirement income goals, considering all of the resources at their disposal.
  • Pre-retirees (5-10 years out) will want to have a comprehensive plan to ensure they have adequately covered all likely scenarios, so they can be confident in their retirement plans before pulling the plug on work.

If you have enough assets for it to matter and aren’t highly confident you are on track to meet your goals or you suspect there are gaps in your knowledge, a professional financial planner can help.

For a different perspective on using a financial planner, check out this article from Schwab that I happened to read as I was writing this post.

What Will I Get?

Primary Deliverable

The most important deliverable from a financial planner is a financial plan. Depending on where you are in the process of managing your finances, it will include some or all of the following items:

  • Your financial goals
  • A statement of your current financial position (assets and debt)
  • A budget
  • Your savings strategies and actions, including
    • Short-term savings
    • Designated savings
    • Retirement savings, sometimes including investment advice
  • A plan for re-paying your current debt
  • Guidance about the types and amounts of insurance to buy, along with descriptions of your current policies
  • A brief description of your income tax situation
  • Guidance on what needs to be done to ensure that the legal documents are in place in case you become incapacitated or die

Other Deliverables

In addition, financial planners can provide longer term projections that show estimates of the growth in your income, assets (from investment returns and additions to savings) and expenses. These types of projections can provide insights about your ability to retire when and in the style you want.

Another benefit of working with a financial planner is that you can get referrals to other advisors and can become aware of other financial resources to help with different aspects of your financial life. For example, most financial planners do not draft legal documents, such as wills, trust agreements or powers of attorney. Many financial planners, though, have worked with lawyers who have this expertise and can provide you with a referral.

How Should I Prepare?

All financial planners have their own unique processes. As such, you’ll want to ask your planner the format of the information he or she would like to see. Many planners will provide you with a questionnaire and/or an information request to guide you through the process of compiling your information. Nonetheless, there are a number of fundamental pieces of information that every financial planner will request. They are your:

  • Assets, including retirement accounts
  • Liabilities
  • Income
  • Monthly expenses
  • Current or future defined benefit pension benefits
  • Financial goals
  • Values

Graeme was quite clear that the numerical values above should be firm, accurate numbers, not guesses. It will take some time to compile all of this information, but will ensure that you get the best service from your financial planner. He also added that you should “run away” from any planner who makes recommendations before obtaining this information.

What is the Process?

You are likely to meet with your financial planner once or twice to create or refine your financial plan initially. Some planners prefer to learn about your finances by reviewing documents and answers you provide to their questionnaires. Other planners prefer to have an introductory meeting to learn about you and your finances. In either case, the financial planner wants to learn your objectives and concerns, along with your family structure.

The financial planner will then assess your situation and goals, identify gaps and challenges, and determine the most appropriate strategy for ensuring your goals will be met. The planner will prepare a financial plan and an investment plan, including an asset allocation assessment for investments, and provide them to you in writing.

Your financial planner will then meet with you in person to present the plan and make recommendations. You and your planner will then identify the action items that come out of the plan and assign them to either you or the planner, depending on their nature and your planner’s areas of expertise.

How Often Should I Check Back In?

Financial planning is not a “one and done” exercise. You’ll want to track your progress against your plan and adjust it as necessary. Adjustments might be needed as there are changes in the economy and investing markets or changes in your personal life, such as marriage, a death in the family, children, or a change in your goals.

If both your life and the economy are fairly stable, once a year may be often enough to meet with your financial planner. More typically, you’ll want to check in with your financial planner twice a year. Of course, if you have any life changes, it will also be a good time to check in with your financial planner to see if any tweaks or more significant changes to your financial plan are indicated.

How are Financial Planners Paid?

There are a number of different ways in which financial planners are paid. Here are some of the more common options.

No Charge

If you use a financial planner at a brokerage firm or mutual fund company, you can often get some financial planning services at no charge. The more money you hold at the brokerage firm, the more services you can get at no charge.

Fixed Fees Per Service

Many independent financial planners will provide services on a fixed-fee basis. That is, they will charge you a fixed cost for each of the different aspects of your financial plan with which they provide assistance. Financial planners at brokerage firms also can charge fixed fees for services that are beyond those that are provided at no cost.

Commissions

Financial planners who also sell products, such as insurance or mutual funds, are often paid based on the products you purchase through them. For example, sellers of insurance are often paid 5% to 15% of the premium on the policies you purchase.

Percentage of Assets

Although it is more common with people who manage your money than with advisors who help you with your financial plan, some financial planners are paid as a percentage of the market value of your assets that they manage. This type of compensation is also common for financial planners who work for mutual fund companies.

What’s Best for You

When you get advice from a financial planner, you’ll want to understand the possible biases introduced by the form of their compensation. The vast majority of financial planners are ethical and are focused on your best interests. Nonetheless, you’ll want to be aware of the possibility that the solution proposed by a financial planner is potentially influenced by their compensation. As such, I suggest seeking financial planning advice from people who provide their services either at no charge to you or for a fixed fee.

How Do I Find the Financial Planner that is Best for Me?

One of the best ways to identify possible financial planners is to get recommendations from other financial professionals with whom you already have a relationship, such as an accountant or attorney. If you have friends who are particularly financially savvy, you might ask them for a recommendation. However, you are probably at least as skilled at selecting a financial planner as any friends who are in the same boat as you. And, you are a better judge of a good fit for you than anyone else. Also, I strongly recommend against using a family member as a financial planner. There are almost always too many emotions tied up in family relationships for a family member to be able to advise you on a subject that often requires difficult conversations, such as your finances.

Check their Qualifications

Once you have identified one or more possible financial planners, you’ll want to check their qualifications and whether they have been disciplined. In the US, the most common designation attained by professional financial planners is a Certified Financial Planner, though there are many other designations that indicate expertise, such as a Certified Financial Analyst or a Certified Public Accountant (CPA).

Once you’ve identified the candidates’ professional designations, you’ll want to check to see if there has been any disciplinary action against them. Disciplinary actions are all available on-line. Graeme’s words of wisdom are, “I don’t care how minor the infraction. I wouldn’t go near anyone who has been disciplined. It’s not hard to be an honest advisor, and I wouldn’t trust anyone who has failed at that.”

Interview a Few Financial Planners

You then want to interview the remaining candidates. Again, I’ll provide Graeme’s advice, as I think it is right on target.

  • Are they generous with their time?
  • Do they listen to you?
  • Do they listen to your spouse?
  • Are they genuinely curious about your situation and your plans and goals?
  • Do they ask questions?
  • Or, are they too quick to sell you something?

Your Final Selection

Look for a combination of training and experience. A financial planning designation should be a minimum, along with several years in the industry. They should also be able to refer you to current clients who can recommend their services.”

I suggest that you also think about whether you feel you can develop a good, long-term relationship with the potential advisor.  Also, consider whether they garnered your respect during the interview. Starting the process of financial planning on a shaky foundation will be unproductive at best.

[1] Graeme Hughes is an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of his career he completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products.