Are We There Yet?

After just three up days in the market, some people are starting to check their account balances to see how much of their losses have been recovered. If only it were so easy!

Here's a depressing lesson in portfolio math that we'll all need to keep in mind as we (hopefully) dig out of the hole the market has fallen into since last summer. When the market drops by any percentage it always needs to rise by a greater percentage to get back to where it started. Take this simple example:

Say the market index you are using is at 100 and drops suddenly by 50%. Now the index is 50. If it rises 50%, the index will not be 100 again, it will be 75. It has to rise 100% to get back to your starting point of 100.

How does this translate to what's going on in the markets? Using the S&P 500 as a measure, the market lost over 56% of its value from the high in October 2007 to the low (to date) on March 9. To make it back to that 2007 starting point the market needs to gain 130%. The 10%+ gains we saw this week are a start, but we have far to go.

Annette Simon

Copyright 2009 Money Dames

Alternative Investments -- Money Dames-Style

Has the relentlessly falling market got you wondering what to do with money you would normally invest? Are you leaving extra cash in your checking or savings account rather than adding to your retirement or investment account?

We continue to believe that the market will turn around and that it could happen fairly quickly. By waiting for a sign that it's safe to get back in, you risk missing out on the biggest gains; and missing just a few of the highest return days can reduce your overall returns quite dramatically.

Our prescription: Think about how much of the money in your investment portfolio you will need to pay for expenditures in the next three to five years, then set that amount aside in a money market fund or CDs. What's left in your account should be long-term money -- funds you will not be drawing upon for five or more years. This money should be invested in a diversified portfolio incorporating a moderate level of risk that allows it to outpace inflation but still lets you to sleep at night. If you are not planning to draw upon your investments for five or more years and have the ability to contribute to your accounts, it makes sense to continue to do so and to buy securities at what will in the long run probably look like bargain prices.

We've been repeating this mantra since the downturn began and stand by it as the most sensible course of action. But, many people have reached the point where they don't want to hear it anymore. Adding to accounts that seem to shrink on a daily basis is more than they can stomach. They are accumulating cash -- building their checking, savings and money market funds rather than put any more money into the bottomless pit the market has become.

If you find yourself in that camp, here are some ways to make good use of your excess cash until you feel safe getting back into the market:

• Accelerate your mortgage payments. Paying extra principal will reduce the time it takes to retire your loan and yields a guaranteed rate of return -- the interest rate on your loan minus the value of tax deductions (for interest you will not pay in the future) you are forgoing. Reducing your debt increases your overall net worth just as much as increasing your assets -- and it's a sure thing.
• Prepay tuition. Check with your child's college or private school to see if they will allow you to prepay for one or two years of tuition. Tuition increases have outpaced general inflation for years, and if you believe the market will continue to drop it makes sense to pay future tuition bills now rather than waiting for your education fund to shrink further. Our caveat on this -- don't pay too far ahead -- especially if your child is starting at a new school or not entirely happy with the school she attends.
• If you definitely plan to purchase a house, remodel, buy a car or other big-ticket item in the near future, it might make sense to dive in now. You'll have great bargaining power in markets that are starved for buyers.
• Invest in yourself. If you've been thinking of going back to school to improve your job skills or train for a new career, use some of your cash-on-hand to cover the cost.
• Remember to look for opportunities to harvest lossses in your taxable accounts. Sell losing securities to capture the losses (up to $3,000 each year can be deducted from income, the remainder can offset realized gains this year or in years to come). Invest in another, similar fund if you want to be positioned to participate when the market rallies, or keep the proceeds in money market or other stable asset classes if you can't bear the risk. Just remember that you're locking in losses when you sell in a down market and don't reinvest in equities or stocks.

And a final reminder: you should always keep enough cash on hand to cover at least six months of living expenses, more if your income is at risk or irregular. These suggestions are only for investors who have a reliable income source that leaves you with excess cash you would normally be adding to your retirement or investment portfolio. We are not endorsing an irrational spending spree or depleting your cash reserves to pursue the ideas above.

Above all else, be sensible and plan to return to regular saving and investing as soon as possible.

Copyright 2009 Money Dames

How Much is Enough?

With the S & P 500 down more than 45% since October 2007, virtually every U. S. investor is holding a portfolio that has shrunk dramatically. Many boomers are asking themselves if they will ever recover their losses or be able to save enough to retire in their old age.

It all comes down to one question -- how much do you really need to maintain your desired lifestyle in retirement?

There has been a fair amount of academic research to determine how much you can continually withdraw from a portfolio over 30-35 years -- the length of the typical retirement these days. Based upon the range of historical returns in a diversified portfolio (pre-2008) a safe annual withdrawal rate is 4%-4 .5%, adjusted annually for inflation. In dollars that means that you can safely withdraw $40,000 - $45,000 from a $1 million portfolio in year one. In year two, if inflation is 3%, your withdrawl will increase to $41,200 - $46,350.

If you are spending $135,000 now and hoping to sustain the same lifestyle through 30 or more years of retirement you need to accumulate an investment portfolio of approximately $3 million unless you have a pension or other source of income in retirement.

Most people find this breakdown sobering, if not completely depressing -- and it doesn't even account for the likelihood that your savings are in pre-tax dollars (if they are in your 401(k), IRA or other retirement account). We'll deal with that gloomy aspect of the issue on another day.

The bottom line, for most of us in middle age, is that retirement, in the tradional, gold watch, puttering away your days in the garden or on the golf course model of the past is not in the future for us. But it's also true that it wasn't a realistic scenario even before the bottom fell out of the stock market in 2008!

Relatively few people had saved enough to achieve full retirement at age 60 or 65 . We have been a nation of spenders for years now -- almost no one, especially in the baby-boom generation-- has been able to pare back current consumption so that they are living a lifestyle they can reasonably sustain in retirement just by saving diligently. Most of the lucky few who are well-positioned for retirement received a windfall: an inheritance, stock options that paid off handsomely, or a cash settlement from a lawsuit or the sale of a business.

So don't beat yourself up. Retirement may not be a reality -- but work keeps us vibrant and engaged. You may not be golfing or fishing every day, but you can probably slow down and find work that feeds your soul and supplements your savings. That's the view we're taking.

Annette

Copyright 2009 The Money Dames

Are You Financially Literate?

We've been surprised by how little many otherwise sophisticated, successful people know about financial matters. The Madoff affair and the sub-prime credit crisis are both financial disasters that largely could have been averted if more Americans had a solid grasp of some basic financial concepts. Our hope is that the Obama adminstration recognizes this and will embrace the cause of increasing financial literacy.

Until they do so, here are a few questions to test your own financial literacy:

1. What is the difference between a stock and a bond?

2. How is investing in an IRA or 401(k) different from investing in a brokerage account or mutual fund?

3. What is the difference between term, universal and whole-life insurance?

4. Is $1 million enough to retire on?

5. How much income is too much to qualify for college financial aid?

6. Is real estate a better investment than "the market?"

7. How much can you reasonably expect to earn on a risk-free investment?

8. What is the average rate of inflation?

9. What are the basic estate planning documents everyone should have?

10. What types of insurance does everyone need to own?

11. What credentials, education and legal obligations are financial advisors required to meet?

12. How long will it take to repay your credit card balance making the required minimum payment each month?

13. Should avoiding taxes be your first priority in making financial decisions?

14. Which of these factors is the most significant determinant of portfolio performance: Security selection (which stocks and bonds you buy), asset class allocation (how much you have in stocks vs. bonds, large vs. small companies, etc.) or Market Timing (picking the right dates to move in and out of the market)?

15. How much cash do you need to keep in a checking/savings account for emergencies?

16. What is a mutual fund?

17. How much of current income do you need to save for a secure retirement?


If you can answer all of these questions accurately and confidently, good for you -- you have achieved an outstanding level of financial literacy.

The answers...? Oh you want the answers! We'll be addressing these questions and more in entries to come over the next several weeks. Stay tuned and submit your questions if we don't cover them.

Annette Simon

Copyright 2009 The Money Dames