At Net Worth Advisory Group, we believe peoples ability to adequately pass this “chalkboard test” is crucial to their long-term success. Saving for retirement requires a different investment approach than does ensuring that resources are available and secure over a short period. How can investors be confident they are taking appropriate actions if they aren’t sure how they chose their investments?

Net Worth Advisory Group ensures that our clients are capable of passing the “chalkboard test.” This four-step process is how we recommend investors design their investment portfolios:

Step One: Asset Allocation – Stocks, Bonds, and Cash

This is the most important investment decision you’ll make because it has the largest impact on both risk and return. A simple approach to determine an appropriate mix of stocks vs. bonds is based on age (for example, take the number 110 and subtract the investor’s age; the answer equals the percentage of a portfolio to invest in stocks). An asset allocation based on age makes a portfolio more conservative at the appropriate time by reducing the allocation to stocks as retirement nears. Additionally, be sure to consider the risk associated with the asset allocation you choose. Examine how such an allocation performed during historical bear markets and be sure you can endure that degree of short-term loss.

The “bucket approach” is a more involved asset allocation strategy that considers spending needs. For more information on this strategy, view the second article in this month’s newsletter or click here.

Step Two: Diversification Across Different Asset Classes

A baseball team prepares by placing nine players across the field because they never know where the ball will be hit. Similarly, diversification of investments is important because we never know which asset classes will do well and which won’t.

Diversification lowers risk because it reduces the volatility of a portfolio. It creates ‘zig-zag’ relationships between asset classes so that when one investment is down, another will be up. These relationships are created by diversifying across asset category (stocks vs. bonds), size (large, mid and small cap), style (growth vs. value), and geography (U.S. vs. international).

The 2000’s are referred to as “the lost decade” for the S&P 500, but a diversified portfolio vastly outperformed the market as a whole. For instance, most stock categories lost nearly 40% in 2008, but government bonds gained 23%. Further, when the tech bubble burst in the early 2000’s, most growth stocks suffered but value stocks made huge profits. Clearly, diversification enables gains during bull markets while minimizing losses during market pullbacks.

Step Three: Selecting the Best Investments

If you decide to buy mutual funds, then you want to have criteria for how to select the best fund managers. Here are some of the standards Net Worth Advisory Group uses:

1. Determine the asset category, such as large cap growth or small cap value.
2. Find funds that outperform their peers.  Look for funds that performed in the top 25% of their asset category over one, three, five, and ten year time periods.
3. Choose managers that have at least ten years of experience.
4. Look for low expenses. Total fees, covering your financial advisor, investments, and transaction costs should be no more than 2%.
5. Make sure the fund outperforms its benchmark index (S&P 500 for large cap, Russell 2000 for small cap, etc.).

*Note: Net Worth Advisory Group often identifies the top mutual funds in each asset category and then purchases the individual stocks owned by those funds. This strategy is more cost effective and allows more control over the tax implications.

Step Four: Maintain, Review, Rebalance

Every six months you should tune-up your investment portfolio. Your allocation will get out of alignment over time because some assets will appreciate faster than others. When this happens you should rebalance to make sure you’re allocated properly and not taking extra risk. Always consider tax consequences and costs associated with rebalancing your accounts.   

You should also review the performance of your investments to see if they’re still meeting the criteria you set. If a fund isn’t keeping up with its peers, then flag it and give it a chance to redeem itself. If flagged funds continue to underperform, then replace them with funds that meet your criteria.

As you conduct your routine checkups, make sure you maintain sound investment behavior. Don’t panic when you see the market experiencing a pullback. Remember, when you built your portfolio you accepted a certain amount of risk. If you used the bucket approach to determine your allocation then the money invested in stocks is for the long-term, so expect some short-term uncertainty. Stay the course and make minor adjustments when necessary.

Summary

This four-step strategy is the foundation of the static portion of client portfolios at Net Worth Advisory Group. This strategy can be supplemented by various tactical strategies, which you can learn more about by speaking with our advisors.

Our clients understand the investment strategies they are utilizing and can be confident they are appropriately pursing their retirement goals. If you or your financial advisor isn’t following a clearly defined strategy that you could express on a chalkboard, contact Net Worth Advisory Group for a portfolio upgrade to ensure your approach matches your goals.

Proper asset allocation ensures the portfolio represents the investor’s risk tolerance. If too much of the nest egg is held in stocks and the market tanks, the investor is more likely to panic and sell. In doing this, the investor buys high and sells low.

Picture three buckets. The first bucket should contain money that will be withdrawn from the portfolio within three years. The second bucket contains funds that will be used in four to ten years. And finally, the third bucket holds money that will not be needed during the next ten years.

The money in the first bucket should be invested in liquid, cash-type investments such as money market or savings accounts. This is short-term money which should not be exposed to market fluctuations.

The second bucket, holding intermediate-term money, should be invested in bonds. Although bonds fluctuate in value, they are not as volatile as stocks. However, bond returns are usually a significant improvement on cash-type investments. Constructing a bond ladder by purchasing bonds that mature each year will refill the cash bucket once a year.

The long-term money in bucket three is invested in stocks. This ten-year money is the growth portion of a portfolio and will fluctuate with the market. An investor doesn’t need to worry about a down year in the market because these stocks will not be sold for at least seven years, which is plenty of time for the market to recover. In fact, it took the U.S. stock market seven years to recover from the Great Depression. Thus, an investor utilizing this strategy would have survived the worst investment climate in history without selling assets at a loss.

This strategy provides a consistent source of income when it is needed. Money from the cash bucket can be used to meet living expenses, a bond will mature each year to replenish the cash bucket, and stock positions can occasionally be sold to replenish the bond portfolio. If the market has a poor year, stocks can be held for an extended period to avoid selling during a down market. This strategy will increase the probability that funds will be available to meet any planned expenses ranging from retirement, to business expenditures, to college tuition.

The market pullback of 2008 forced many investors to sell investments at an undesirable time. Speak to your financial professional about developing an asset allocation that represents your risk tolerance and provides sufficient liquidity to prevent having to sell your nest egg at a loss.

Research indicates that investment decisions can be affected by a variety of issues, including “herd mentality,” overconfidence, pride and regret. There is also a tendency to respond much more strongly to losses than to gains, a tendency that drives many investors out of the markets during acute declines. Thus, this difference in returns is largely attributable to investors getting in when times are good — essentially buying high and selling low.

Additionally, the following standard deduction levels and personal exemption will apply to all 2012 tax filings:

Finally, the following chart details the changes in tax law that are scheduled to occur in 2013. Notice the increase in the capital gains tax, that dividends will be taxed as ordinary income, and that the top tax rates are scheduled to rise:

Consequently, it may make sense for some investors to recognize certain long-term capital gains or ordinary income in 2012 while rates are low.

However, your ability to make deductible IRA contributions and to qualify to make Roth IRA contributions fades out after you exceed certain income levels:

Using exchange-traded funds, here’s a chart showing how various market sectors performed from 12/31/2010 through 12/31/2011:

As you can see, the S&P 500 was flat for the year. The chart includes six other equity sectors that had losses. Finally, four sectors had gains: real estate, gold, corporate bonds, and U.S. Treasurys. What happened?

The third year of a U.S. presidential term has historically been the best performing year for stocks within the four-year presidential cycle. Incumbent presidents have used the third year of their terms to push through economic stimuli in hopes of getting the votes necessary to be re-elected. The gridlock in Washington this year prevented that from happening. Other negative factors included slow domestic economic growth, Europe’s sovereign debt problems, the earthquake in Japan, and a potential decline in China’s economy.

The performance numbers in the above chart point out the importance of a fundamental investment concept: the need for allocating your investments among various market sectors. If you had some exposure to the asset categories that did well such as real estate, bonds, and gold, it helped your portfolio. However, even with exposure to these asset classes, most portfolios holding a majority proportion of stocks experienced an overall loss in 2011.

Another thing to note is that diversification worked quite well in 2011. Perhaps it didn’t work the way we wanted, but there was a definite variance in asset class performance. After the gruesome bear market in 2008 when virtually all asset classes declined in tandem, many investors claimed that diversification didn’t work anymore. The good news is that 2011 confirmed diversification does work and that when certain asset categories decline others are likely to increase in value.

The Callan Periodic Table of Investment Returns lists nine asset categories (or sectors) and their annual returns over a period of twenty years, ranked in order from the best-performing to the worst. This table is instructive in several ways.

1. Every year the best-performing asset category has been positive.
2. The nine categories’ rankings often change dramatically from year-to-year.
3. There is no identifiable pattern that can predict the best-performing sector going forward.

Because we investors don’t have crystal balls to predict the future, the best action we can take is to have exposure to each of the major sectors and maintain our asset allocation percentages.

It can be tempting to abandon target allocation percentages that were established when a thoughtful diversification strategy was originally established. Investors are naturally drawn to higher-performing sectors. For example, from 1995 through 1999 large cap growth stocks led the pack by a substantial margin. Consequently, investors threw their money into this asset class with reckless abandon. Then this trend abruptly reversed as small cap value stocks were the #1 performers in 2000 and 2001.

Finally, we should keep in mind the importance of exercising discipline. As W. Scott O’Neil, President of MarketSmith, recently stated, “The trait most common among successful investors is not intelligence, experience or intuition. It’s discipline.”

At Net Worth Advisory Group, we don’t believe any investors who maintained their appropriate investment allocations failed in 2011. We believe that maintaining proper diversification has paid off over time and will continue to do so.

Avoiding Capital Gains Taxes

First, you need to take a look at the investments in your non-retirement accounts to see if you have any capital gains that will add to your 2011 tax-burden.  For example, let’s assume you bought a stock for $10,000 in 2009 and sold it in 2011 for $20,000; a gain of $10,000.  You will have to pay a capital gains tax of $1,500 (15%) on your $10,000 profit. Even worse, if you owned the investment for less than one year the income will be counted as ordinary income, which can be taxed as high as 35% (creating a tax bill of $3,500!). However, you can avoid the tax by finding another stock/bond/mutual fund in your portfolio trading at a $10,000 loss.  By selling the stock and incurring the loss it will cancel out the gain for tax purposes.  In this example the strategy will save you $1,500 in taxes (or $3,500 if the profit is counted as short-term capital gains!).  If you like the stock or fund you sold you can simply buy it back 31 days later. By reviewing your taxable account(s) your advisor can check your capital gains and look for ways to offset those gains.  If this isn’t happening your advisor is not doing his/her job.

Avoid a 50% Penalty

Second, if you are over 70 ½ you are required to withdraw some money from your IRA.  If you don’t take the required distribution you’ll have to pay a 50% penalty.  For example, if you are a 72 year old with a $500,000 IRA you are required to withdraw $19,531 and pay income taxes on the distribution.  If the distribution is not taken the penalty is 50% of the amount you were expected to withdraw.  In the case of our example the penalty would equal $9,465!  If you are over 70 ½ make sure you take your distribution.  Again, if your advisor isn’t doing his/her job and overlooks required distributions it could cost you.

Convert to a Roth IRA

Finally, if you are in a low tax bracket in 2011, which may occur if you lost your job or recently retired, you should consider converting some of your traditional IRA money to a Roth IRA.  Be aware that there are pros and a cons when you convert. The “pros” of converting is that once the money is in a Roth it will grow tax-free throughout retirement, and annual minimum distributions are not required.  The “con” is that you will have to pay income taxes on the money you convert.  However, if you are in a low tax bracket your tax bill will be small.

It may makes sense to convert to a Roth and pay the taxes now if you are in a lower tax bracket so you can avoid paying the taxes later when you may be in a higher tax bracket.  This strategy could save you a lot of money over time.  For those in a lower income tax bracket, you could very well benefit from a Roth conversion.

Now that we are closing in on the end of the year you can see how much income you’ve earned and determine at what rate you’ll be taxed.  Your advisor should be aware of your annual income to help you determine whether a Roth conversion might be a good option. If your advisor isn’t aware of your annual income amount, you may want to look for an advisor who is a little more on top of things.

The Bottom Line

At Net Worth Advisory Group, we review all of our client’s accounts to see if there are capital gains issues, monitor distributions for our clients who are over age 70 ½, and make sure we are familiar with our clients income so we can help them decide if a Roth conversion makes sense.  This is routine for us in November each year.

If your advisor is not talking to you about these cost saving strategies I’d recommend you contact them, have a frank discussion about why he/she hasn’t contacted you to discuss these three strategies, and consider hiring an advisor who won’t let things fall through the cracks.

There is an old myth that 401(k) plans are “free.” In fact, in a 2011 survey conducted by AARP, 71% of plan participants thought they paid no 401(k) fees. For this reason, expect to hear a collective gasp when investors open their quarterly 401(k) statements in April.

In reality, the fees charged by poorly-managed 401(k) plans can be quite extensive – recordkeeping, fiduciary services, direct or indirect compensation for service providers (not to mention the cost of the actual investments) just to name a few. Sharebuilder, a nationwide manager of 401(k) plans, estimates that total annual costs for the average 401(k) plan is approximately 2.25%. Further, many registered investment advisors estimate that some 401(k) plans, especially those of smaller firms, could be as high as 3.5% to 4.8% per year.

This certainly doesn’t suggest that 401(k) plans are poor retirement vehicles. The tax-deferral, automatic contributions, and employer-matching benefits are paramount and should be utilized by nearly everyone with access to a plan. Fortunately, the benefit of the new disclosure laws coming into effect in April is that it forces employers to take more responsibility in ensuring their 401(k) plans offer high-quality investments at a reasonable cost.

Although these new laws have not yet taken effect, they are already beginning to serve their purpose. In preparation for complying with disclosure requirements, many employers are already doing additional due diligence and have discovered that their employees have been paying unjustified and unreasonable fees. Consequently, many employers are already making modifications to their 401k plans, or even changing their 401(k) provider.

Look forward to April 2012. Minimizing investment fees is just as important as obtaining a satisfactory rate of return. Be sure to speak to a fee-only financial planner when you receive your first quarter statement to determine whether your 401(k) plan’s fees are appropriate and to identify responsible actions to be taken.

Suddenly, October brought the eighth-largest monthly gain in the S&P 500 during the past 54 years, rising 11%. Unfortunately, some investors were better positioned to take advantage of this advance than others as many individuals sold investments after tiring of watching their portfolio values decline. Why were some investors more capable of sticking to their investment strategies during volatile times than others?

I decided to look at my previous articles to find a way to reflect on recent events; I didn’t have to look long. Here is an excerpt from a newsletter I published back in March of 2009:

How volatile is this investment environment? As measured by the S&P 500, the market moved more than 3% in either direction during a single day only once between 2004 and 2007. By comparison, the market moved at least 3% in one day 40 times in 2008. Further, moves of 2% to 3% occurred 28 times during the year.

For those who see no end in sight for this volatile market, remember — we have been here before! Between 2001 and 2003, the market moved between 2% and 3% an average of 20 times per year, and that was over a three year period! We then moved on to enjoy a relatively stable and profitable period between 2004 and 2007. Thus, history indicates that the increased volatility we are currently seeing in the market is not the “new norm” and we should expect volatility to subside at some point, creating a more reasonable investment environment for all.

I researched the performance of the S&P 500 during 2011 and found that through the end of October the market has moved 3% or more in either direction only 10 times this year, and 5 of those times the moves were positive. Additionally, moves of 2% to 3% have occurred only 17 times during the calendar year. Again, I can look back and say “we’ve been here before” and point to another historical example of moving on to more calm and profitable times — 2009 and 2010. In addition, by comparison, the volatility we’ve recently experienced is actually quite tame compared to market fluctuations we’ve experienced even recently.

The human mind has a unique way of interpreting events relating to investing hard-earned money. We always convince ourselves that current times are unlike anything that’s been experienced before and that today’s problems are more difficult and numerous than yesterday’s. The present never seems like a good time to invest and save – we always want things to settle down and be more stable before investing. Unfortunately, these are the feelings that are present in the marketplace 75% of the time. Even worse, if you wait for the 25% of the time when investors feel comfortable you have likely already missed the boat and are likely to invest immediately after the market has experienced a profitable run (October has proved to be a perfect example).

This is the reason having a well thought out investment strategy teamed with a long term approach is so critical to investment success. The mind of an investor will never make things easy. There will always be a reason for heightened fear or concern, a reason to sell or not invest. Fortunately, investment advisors can add tremendous value in overcoming these obstacles. Do you have an investment strategy? Can you write down exactly the logic used to determine why you hold the investments you currently own? Have you documented which elements of your portfolio are designated to provide income during various periods of your life? Have you established safe measures that will prevent you from selling in the middle of a panic and ensure you don’t end up buying high and selling low?  Net Worth Advisory Group can help you with these tasks.

Too often we wait until the market has had an impressive run to feel confident putting our money to work. This is why having a sound investment plan can help you avoid making investment decisions with only a short-term focus. It is also why having a financial planner on your side to ensure you stick to a well-defined strategy during both good and bad times will ultimately maximize your chance of achieving your investment goals.