Category Archives: Financial education

Wealth – a place for art and wine in your portfolio?

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Not long ago I was asked by a client about purchasing a valuable musical treasure. What did I think about taking money from her budget to make such a purchase? What role could it play, she wondered, in her investment portfolio? And just last week I was asked by another client how he could include his valuable wine inventory in his portfolio? Interesting questions, indeed, and not just because they have to do with investing, but because they are a reflection of the deep seated desire in all of us to find some way to make our passions work for us.

As an intelligent investor we must first create a base or foundation on which to build wealth before investing current cash flow into such possibilities. If you think of your wealth as forming three tiers, the first tier, or foundation, consists of good credit sources together with a robust combination of liquid assets and emergency funds. With this tier in place, an investor can withstand market volatility, support ongoing needs and endure any unforeseen emergencies for a period of time. The first tier provides the conditions necessary for building the second tier—a diversified equity and bond portfolio.

The purpose of the second tier is to extract as much growth as possible from the market, while providing a safety-net that respects your risk tolerance. The second tier is intended for your future financial security and must therefore not be exposed to excessive risk (at Aikapa, we believe that the best way to counter market risk is through a diversified global portfolio). Once your finances cover these two tiers, then, and only then, can we seriously consider a third (speculative) investment tier that could potentially offer higher returns in exchange for accepting higher risks. These speculative investments could include art,
musical instruments, wine, coins, jewelry, antique firearms or other collectibles for which you may have a passion and an expertise (though not pertinent to this article, this tier can also include other non-collectible investments).

The beauty of this third tier is that it often feeds your creativity and passion, and so should never be discouraged or dismissed, so long as it comes from a position of knowledge and experience. With time and talent it is possible to build a collection that can grow in value over the years. We have a client that has collected stamps since childhood and has therefore a very valuable asset. These investments can be very lucrative when the market is favorable, but a heavy burden when not.

The risk and expense of collectible investing goes beyond the volatility that we’ve seen with wine and the recent upsurge in artworks, with high-profile purchases like the Gaugin that sold for around $300 million.

Collectibles require storage, insurance and maintenance regardless of whether there is even a market to buy them (at times they can be highly illiquid). Accurate valuation is also a challenge, since you must actually attempt to sell any given item to determine its fair market value. The market for collectibles is fickle and historic value is no guarantee. What once sold for a good price, may no longer be in vogue.

If we’re to consider a collectible as part of a portfolio, it must be evaluated for
potential future return. What is often overlooked is the cost of bringing an item to market. In addition to the usual insurance, there can be maintenance costs, special storage facility fees to retain value, and fees associated with proving authenticity. There may also be costs for shipping, installations and appraisals. Selling a collectible often incurs a commission. For artworks, auction house fees can range from 10-25%. Finally, don’t forget that tax liability exists on any gain. For collectibles, the federal tax rate is 28%. There is also state tax and, potentially, a 3.8% net investment income tax for those in
higher tax brackets. We estimate that for most of our California clients they would pay 35-43% of their gain in taxes on collectibles, which often comes as a great shock to the uninitiated.

In a nutshell, speculative investments should never be depended upon to achieve critical goals, such as retirement. While many of our clients include collectibles as part of their wealth (and are generally very passionate and knowledgeable about them), it is only as a component of the third tier of their investment strategy. These collectibles, while often extremely valuable, are never an essential part of a core investment portfolio or retirement plan.

If you’re interested in developing a third tier for your investment portfolio let us know and we’ll work together to provide a financial perspective on your plan. We do not recommend developing this tier from a budget unless tier 1 and 2 are already fully funded.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Retirement Portfolio Distribution – vital considerations

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Not sure when and how to start dipping into your hard-earned retirement funds? It’s a BIG consideration with BIG implications. How might you withdraw your money without worry that you’ll outlive your portfolio?

You could use a generic retirement distribution model that targets a 4% withdrawal from your portfolio (if portfolio is allocated at 60/40 equities/bonds). This generic model focuses on not outliving your assets and often leaves much to be desired in terms of maximizing how you distribute your portfolio efficiently. This is where a retirement distribution plan is absolutely vital since it will outline the amount that you need to meet your specific needs each year, the impact on taxes and on your ability to not outlive your portfolio (particularly important 5-10 years to retirement).

Many studies demonstrate that creating a portfolio withdrawal plan that more closely fits your needs in early retirement while providing for your wishes later in retirement leads to a successful retirement. Of course, retirement planning first requires that you’ve accumulated enough assets to support your lifestyle for the length of your potential retirement. It should also allow for unexpected obstacles and other goals.

You may find after discussions that your retirement of choice might be much different than a standard generic model. In some cases, it is in your best interests to keep working even part-time into your “retirement.” This is becoming more and more the case (so don’t feel alone if it comes to that) even if you have enough assets to support full retirement.

A recent study by T. Rowe Price revealed that 22% of recent retirees have rejoined the workforce at least part-time and of these 18% are earning as much as they were earning prior to retirement. Of course others have chosen to adjust their budgets to extend the life of their portfolio and are living on 67% of pre-retirement incomes rather than returning to employment. The study found that retirees are covering their early retirement expenses from the following sources: 18% from pension plans, 42% from social security and 17% from tax-advantaged accounts.

The latest methods for funding retirement are much more specific to your individual situation than a flat 4% withdrawal. When working together (5-6 years to retirement) we’ll formulate your distribution plan through retirement. This would include how your portfolio will be allowed to recover from any potential market decline and how it provides for your wishes during the 30-40 years in retirement. As retirement approaches (or whenever you make the request) we will outline the latest successful approaches to asset distribution for your situation – we want to be sure that you don’t unnecessarily skimp through early retirement or outlive your portfolio later in life.

A formal retirement distribution plan should include a review of alternative income streams, a financial breakdown of at least the first 3 years of retirement, an overall budget for those years, including expected distribution and social security. This is when the value of having different cash flow streams becomes obvious. Taxable accounts, tax free, pension/social security, annuities, and tax-deferred are the usual assets considered in all retirement distribution plans.

By setting the finances for the first years in retirement, you can plan for the potential of a market downturn and also the possibility of allocating more during the first 10 years of retirement if you so wish. Most often, families want to spend their first 10 years traveling or hosting family events as a way of enjoying their most active phase of retirement.

The most obvious danger of ad-hoc or unplanned withdrawals from a portfolio is that the account balance dwindles faster than any return can support. By funding non-budget needs, the portfolio may no longer be able to fund the necessary budget items that are important in that client’s lifetime. To succeed, this requires open communication with our clients, their trust in our work, and their discipline to rein-in non-budget expenses.

Retirement can last 30-40 years and can exhaust any portfolio without a distribution plan. Outside of retirement, your other goals may or may not need a separate distribution plan (we do one for college plans and home purchase too). Speak to your advisor if you are in any way uncertain about how or when to tap into any of your portfolio savings.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Cost Basis: How not knowing can hurt you

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Knowing the cost basis on your house or your investment portfolio is critical to building your wealth in a tax efficient manner. Without managing the cost basis in your portfolio you may inadvertently increase your tax liability. These last six months we’ve encountered a large number of cost basis issues so I’d like to enhance your understanding of how cost basis can impact your wealth.

What is cost basis? When you look at your investment statements you’ll see a column that states the cost basis for that investment. Simply stated, cost basis is the cost you incurred for that security. In reality, cost basis is more than the original cost. In fact, many securities change their cost basis annually and in other specific situations.

First let’s make sure that we’re clear on the types of accounts that we’re talking about. If your investment portfolio only consists of tax-advantaged accounts (401K, pension or any IRA) you can safely ignore cost basis. In such accounts your tax liability is governed by Federal and State tax rules and not impacted by the cost basis rules discussed here. If, on the other hand, you have a taxable account (a trust, individual, or transfer on death (TOD)), every year your personal tax liability will be dependent on what is in that account and how it is managed.

Just about everyone knows that gain from the sales of a security is taxed (short-term rates if held less than 12 months and long-term rates if held longer). This taxable gain, as you can imagine, is the difference between the sale price and the cost basis. It is to our tax advantage to keep this difference low but it is a better investment when it grows far higher than the basis.

What you may not realize is that without buying/selling you may still incur 1099 dividend and capital gain distributions that are taxable. These are distributions that flow to the shareholders from funds when they earn and “realize” gain. For high earners these distributions can add an unreasonable annual tax burden because the current tax code not only taxes the gain but adds the gain to inflate the Adjusted Gross Income (AGI). After all, it is the level of the AGI that will determine the phase out deductions and if higher taxes apply. If possible high earners need to reduce funds that yield large distributions from their taxable portfolio.

Up until 2012 we were each responsible for tracking cost basis on our taxable accounts and reporting cost basis and gains for our investments. If you have no actual evidence of the cost basis then your basis is considered to be zero – maximizing your gain and therefore your taxes. Not something any tax payer would want. In 2012 funds were required to report basis relieving us of this task by creating what are known as “covered shares” (those purchased after 2012 and for which the brokerage firm has records) and non-covered shares (those for which the brokerage firm has no record or were purchased prior to 2012). We help you track, recreate and manage cost basis for portfolios under our management.

If you were diligent enough to read this far, I want to alert you to one very important role of cost basis. On the death of the original owner of a security current rules allow for the basis to be elevated to the market value on the day of death. This is called a step-up in basis. Why is this important? If those securities have appreciated in value, the advantage is substantial. The gain in the securities is wiped out so that inherited assets are received at current value without paying capital gain tax. This process of step-up must follow required steps and careful monitoring of cost basis information.

When managing a portfolio whose goal is to be inherited there is little advantage to reducing any gains to the portfolio, particularly if the current owner already is subject to high taxes. The opposite might be true if the owner has low taxable earnings and is still young since they would benefit from keeping the gain of the portfolio low and therefore available for near term purchases (with minimal tax implications in any one year).

Considering the effort in managing cost basis, why do I consider a taxable account essential to your portfolio? A taxable account has at least two practical advantages that other types of accounts can’t provide. One is that it is available for short-term goals (for withdrawals prior to age 59½). The other is that in a retirement portfolio it often provides a means to reduce taxes during retirement. For example, most retirees have social security and tax deferred accounts to fund retirement. Withdrawals from such tax-deferred accounts are treated as having a zero cost basis and taxed as regular income. Whereas assets withdrawn from a taxable account with the cost basis carefully managed should see a lower tax liability. A taxable account is a key part in planning how the portfolio will support your needs.

The real lesson here is that growth in a taxable account is a double edge sword. To avoid paying unnecessary taxes and take full advantage of the account, it needs to be managed and, moreover, requires that you provide your advisor with updates on your past taxes and current year tax plan. The key is to choose the right investments and to manage the cost basis based on your specific goals and tax situation.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Fostering Financial Peace of Mind

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According to a study (conducted by the Research Intelligence Group) we struggle with regret over financial decisions, argue over spending, feel pressure to keep up with friends or colleagues, and bend the truth to friends and family about our financial situation in order to save face. In many cases, the primary response of stress is denial. Unfortunately, putting off these financial conversations can affect mental and physical well-being and the quality of our lives. The longer we stay silent about challenging financial situations, the bigger the problem is likely to become. Often this leads to regret for not having created a financial plan (and good financial habits) early in our lives – but is it ever too late?

Without a financial plan in place it is difficult to know if you’re making the most of the resources you have. It is also difficult to establish financial habits that will support you regardless of what life throws your way. Moreover, it is difficult to annually monitor and adjust the various competing demands for your finances in a way that allows you to sleep well at night.

According to many studies women are significantly more likely than men to lose sleep over financial worries. Fifty percent of women admit losing sleep over financial worries and forty percent of men. It is these issues that bring out some of the differences in how women handle financial adversity. For women, financial planning is inclusive, focused on building and maintaining the family, community and even beyond, well into the future. For men (on average) it seems that the focus is less on the relationship and more on the short-term transaction. According to financial author Kelley Keehn, in the face of considerable stress, men release higher doses of adrenaline, activating a “flight or flight” response, while women produce higher levels of oxytocin, activating a “tend and befriend” response.

Keeping in mind how we tend to react to financial stress, a clear well-defined financial path and a trusted financial professional with whom you can maintain a sincere collaborative and communicative relationship can go a long way toward building confidence, and hence, peace of mind.

Here are a few things you can do to ensure that you’re not the one losing sleep over finances:

  1. Do your due diligence. Demand that those giving you advice have your best interest at heart and have the qualifications and experience to provide this advice (especially if you have very specific needs). Moreover, find out if your advisor has any real or potential conflicts of interest.
  2. Understand what fees you pay and what value they add to your ongoing and future financial needs.
  3. Be prepared when you meet with your advisor. Do your part, keeping track of your finances and letting your advisor know in advance of your meeting of any items that you would like clarified as part of the agenda.
  4. Get to know your financial and personal goals intimately and be sure that they are reflected in all your financial decisions.
  5. Seek opportunities to enhance your financial education. Keeping abreast of valuable (not hyped) financial news. Stay away from pundits and financial hype.
  6. Include your partner and your adviser in your process. Don’t try to “go it alone.”

At Aikapa, we choose our clients carefully to be sure that we have the greatest chance to add value to their financial lives and their portfolio. Our clients tend to be high achieving professionals/business owners with an interest in building solid financial habits that will lead them to a life they will enjoy.

Sleeping well is essential to good solid decisions and enjoying life. If you find yourself losing sleep over your finances or getting overly anxious, give us a call or drop us an email. It is our mission to educate and help you build a stress reduced financial life while maximizing your wealth. Let’s continue to remain in touch and let us know if we can help you with any financial issue.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Empowering yourself through financial education

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After six years of annual editions, we have decided to retire the Aikapa Financial Planning Calendar. Once this decision was made, it became clear that I needed to find some new way to address financial education since it is a fundamental aspect of our (AIKAPA’s) mission.

But what was it to be?

I explored tools that help build healthier financial habits. I listened to several clients describe how difficult it is to evaluate media stories about the market and investments. This led me to recognize that the financial media and the internet tend to hype products and encourage quick (‘easy’) financial decisions without providing any fundamentals. What was needed, I realized, was a tool to help you educate yourself and build your confidence regarding investments.

In the coming week I’ll be sending our clients a well written book that I feel best describes the fundamental behavior and considerations of a successful long term investor (let me know if you wish me to send it to a different address). To encourage you to read the book and truly absorb the most important principles of investing I’ve taken the liberty of personalizing it–tabbing and annotating the sections that I think will be of most value.

Whether you choose to read the entire book or just the highlighted sections, it is my hope that you will understand why your portfolio is made up of low cost, quality investment funds, why they are diversified, and why we don’t buy the latest gimmick or sell only based on a poor annual performance. I think you will see that the role of a long term investor is to preserve purchasing power while holding on to a margin of safety so that we can build our wealth. Each component in your portfolio has a role. If we want to change them we can, but never as an emotional response (or as the book states – never in response to the bipolar reactions of “Mr Market”). If you do buy and sell based on Mr Market’s reaction then you’ve entered in the realm of speculation.

As markets go up and down there will be times when a diversified portfolio will not perform as well as those focused in one sector. Unlike a single sector portfolio, it is a diversified portfolio that provides a long term margin of safety while allowing for growth opportunities. If you fully understand where you are going and how your portfolio will get you there then you’ll embrace market gyrations.

I hope this book and future discussions will help you filter out the investment media and help you better understand your own portfolio.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Uncloaking Investment Sales Pitches – Dig beyond the pitch

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Two weeks ago a client brought promotional material from a stock-picking service and asked if it was “too good to be true”. In October we had a client bring in a booklet titled “Banned in America” providing an opportunity to obtain a “Death of Cash Survival Kit”. These types of sales pitches, along with the advertising practices of some firms, increase anxiety and misunderstanding, contributing little if anything to consumer education. I thought I’d share some of the sales tactics we’ve encountered this year.

Example 1: The Stock Picking Service

Consider this claim “84% of our stock picks are winners … gained more than 300% in less than eight years’ time … An investment of $100,000 in our portfolio recommendations would be worth $389,414 today. In comparison, the same investment in the S&P 500 index would be worth only $149,970 … outperformed the S&P by 165%”.

Sounds fabulous, doesn’t it?! So, what’s wrong? There is no portfolio. There are only stock picks at the beginning of the 8 year period and no indication of how you would buy the next picks. Since there is no portfolio, they don’t address buy/sell timing, costs, or performance. Usually they have a large number of purchases (beyond the $100K) that must be made before there is a sell order. If you sold any of the original stocks (to make the recommended buys) you would not have the gains quoted. What about the recommendations that didn’t perform? Any picks that do not work may disappear in future reports. In some cases, they might even be “pump and dump” schemes to raise the price of particular stocks before the owners sell them.

But how can they be allowed to make these claims? Most of these offerings are made through “educational subscriptions” that fall short of the definition of investment advice. In fact, they are not required or accountable to any investment regulatory agency.

Example 2: Selection of “hand-picked” Managers

This year we had a new experience with a prospective client who compared our real portfolio performance with a portfolio of investment managers selected specifically for them by another advisory firm. I found it difficult to explain (without appearing self-serving) that the portfolio of ‘hand-picked’ managers with an impressive portfolio return (well above all averages) was a new creation not a proven selection. There was no evidence to indicate that the advisory firm had any talent for selecting managers in the past or that this outstanding performance was not the result of survivorship bias (that is, ignoring under performers and only reporting returns for well performing advisors).

Sometimes it can be difficult to understand or explain the problem of survivorship bias in a ‘hand-picked’ portfolio. At Aikapa, all positions in our portfolio are publicly reported and there is no survivorship bias.

Example 3: Modeled Mutual Fund Portfolio

Some large investment firms love to create model portfolios that have little relevance to a client’s actual (real) portfolio. By model portfolios we mean portfolios in which the securities aren’t specifically identified. Since the securities included in the portfolio are unidentified, there is no way for an independent evaluator to verify if the calculated return provided by the model has any relevance to attainable returns or past history. There is the potential in model portfolios for survivorship bias (any under performing fund can be eliminated and no one the wiser). In addition, the models do not include front, back and ongoing fees. A model portfolio that doesn’t include real large costs obfuscates the performance that the client can expect from their portfolio now and in retirement.

Example 4: Cumulative Return

Although cumulative return presentations are ubiquitous I have been spared seeing client portfolio reports with only cumulative returns – until this year. Cumulative returns are calculated using total earnings without regard for time. Cumulative returns (on their own) are intrinsically deceptive. For example, a 20% return is a good return over two years but a dismal return over 20. If two cumulative returns start at different times then the returns can’t be compared. It is much more useful to report rolling annualized compounded returns for each year than to show only the cumulative return.

Example 5: Purchase of illiquid assets as core investments

Many investment advertisements show private real estate investments as an excellent way for a small investor to quickly grow their entire retirement asset. The presentations illustrate the very high upside potential but often fail to point out the significant change in liquidity and risks compared to a publicly traded diversified portfolio. Unfortunately, several of our new clients experienced the real impact of the downside when the market took a downturn and their real estate projects couldn’t obtain necessary financing. It is during such a crises that a client learns the real meaning of downside risk and how lack of liquidity prevents them from recovering any of their investment. In addition, these sales pitches often forget to outline the increased costs and administration associated with managing such investments.

In short, a sales pitch should never be the sole basis for evaluating how to invest your hard earned money particularly assets already earmarked for your retirement. Do your homework and explore the strategies behind the sales pitches. In all investment decisions let your goals (not the sales pitch) define your target return.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Net Worth “Accredited Investor” – much ado about nothing

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Is this something or nothing?

Today the SEC adopted the new Net Worth Standard that excludes the value of someone’s home from a calculation that allows individuals to be categorized as accredited investors.  Is this much to do about nothing? Should we want to be labelled an accredit investor?  (see http://www.sec.gov/news/press/2011/2011-274.htm for details on the new standard announced today December 21st, 2011).

What is an ‘accredited investor’?  Someone who no longer needs the protections provided by the SEC as provided through the process of registration and regulation.  It implies that you will take all necessary steps to evaluate these investments and do not need the basic protection provided through the registration process.

The real question is not if a home value should be included but whether having a $1M in assets (with or without a home) truly qualifies you as able to evaluate unregistered/unregulated investments.  In my experience, many full time advisers and investors with several million are not qualified to evaluate and invest in unregulated/unregistered investments.

The changes were made to conform the SEC’s definition of an “accredited investor” to the requirements of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (final rule No. 33-9287).  See below for pertinent details:

Under the amended rule, the value of an individual’s primary residence will not count as an asset when calculating net worth to determine “accredited investor” status. The amendments also clarify the treatment of borrowing secured by a primary residence for purposes of the net worth calculation. Under certain circumstances, they also permit individuals who qualified as accredited investors under the pre-Dodd-Frank Act definition of net worth to use that prior net worth standard for certain follow-on investments.

SEC rules permit certain private and limited offerings to be made without registration, and without requiring specified disclosures, if sales are made only to “accredited investors.”

The amended net worth standard will take effect 60 days after publication in the Federal Register. Beginning in 2014, and every four years thereafter, the Dodd-Frank Act requires the Commission to review the “accredited investor” definition in its entirety and to engage in further rulemaking to the extent it deems appropriate.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Habits and ruts encourage old age – Edith Wharton

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… the deathly process of doing the same thing in the same way at the same hour day after day, first from carelessness, then from inclination, at last from cowardice or inertia. Luckily the inconsequent life is not the only alternative; for caprice is as ruinous as routine. Habit is necessary; it is the habit of having habits, of turning a trail into a rut, that must be incessantly fought against if one is to remain alive.

                                         — Edith Wharton

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com