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Investment Articles

 

 

Finding a Financial Advisor Who Is Right For You

Financial advisors deserve to get paid just like any other service. However, if you want an adviser whose interests are aligned with yours, it's important that you not only know how much your adviser will be compensated, but also the method in which he/she is paid. In general, financial advisors are paid in three ways: commissions, fee-only, and fee-based.

Commissions
Commission based advisors make money when they sell a product. This compensation is paid in the form of a commission. Commission rates typically range from 3 to as much as 10 percent, depending on the type of product they are selling. For investment products such as mutual funds, the commission is known as a load, which is paid by the client. For example, if you invest $10,000 into a mutual fund with a 5 percent load (sales commission), the actual dollar amount invested in your account would be $95,000. The $5,000 commission is automatically deducted to pay the adviser and or his firm.

Fee-Based
A fee-based financial advisor can receive fees paid by the client, and commissions paid to them by a brokerage firm, mutual fund company, or insurance company. They are also not required to inform their clients in detail how their compensation is accrued.

Fee-Only
Unlike fee based and commission based financial advisors, a fee only advisor is compensated solely by their clients. They cannot accept commissions or compensation from any other source. Fees are calculated as a percentage of assets under management or on an hourly basis.

Conflict of Interest
The method of compensation should not create a conflict of interest between the advisor and the client. Unfortunately, any compensation in the form of a commission cannot help but present a conflict of interest. If a commission or fee-based advisor can convince a client with $250,000 to invest into a annuity paying an 8% commission, he or she would earn $20,000 in just one day. If the client invested the same $250,000 into a significantly lower expense, no-load annuity, the advisor would earn nothing. Which annuity do you think they would recommend to their client?

Fiduciary versus Suitability
According to Cerulli Associates, approximately 95 percent of financial advisers are compensated in commissions, or a combination of commissions and fees. Only five percent of all financial advisors are fee-only registered investment advisors, and a fee-only registered investment adviser (such as Capital Wealth Management) has a sworn fiduciary duty to put their client’s interest first. The ninety-five percent of commission and fee-based advisors at firms such as; Merrill Lynch, Smith Barney, UBS, Raymond James, Wells Fargo, Morgan Stanley, Ameriprise, and UBS (just to name a few) are held to a lower standard of recommending investments that are only considered as “suitable” to their clients needs.

5 Questions to Ask
When you first meet with a financial advisor, it’s important to ask not only how much his or her fees are, but who actually pays. An advisor’s compensation method can affect the type of advice you get, so you should understand the differences before you choose who to hire. Below are five questions I think people should ask every prospective financial advisor.

1. Will you provide a list of the fees and commissions you receive either directly from me or from other sources in writing?

2. Are you a Registered Investment Adviser (RIA)?

3. Are you willing to accept fiduciary responsibility to manage my investment account?

4. Are you willing to disclose any conflicts of interest that may interfere with your acting solely on my behalf?

5. Are you willing to provide this information in writing?

If they answer no to even one of the five questions, you may want to consider looking elsewhere.  

 

Why Investors Shouldn’t Bail on Bonds 

I received quite a few phone calls and emails from investors who are still nervous about the bond market. After reading the headlines in financial publications, web sites, and listening to the talking heads in the financial media – who can blame them. The following are examples of four actual recent headlines.

“Get out of bonds now before the bubble bursts”

“There is going to be a meltdown,"

"It's time to get out of bonds."

“The bond implosion has officially begun”

“The worst of the bond-market bust is yet to come”

A bond bear market is different than a bear market in stocks Contrary to what the financial media would like you to believe, there has been no comparison between bear markets for stocks and bonds. Since 1929, stocks lost money in 24 of the last 83 years, with a worst calendar year loss of 43.8 percent in 1931. During this same period, the bond market experienced five losing years. The worst year was an 8.9 percent loss in 1969. The Benefits of Bonds Even though bonds may not provide the steady returns investors have been used to, bonds are an important component of a well-diversified portfolio. The reason is that stocks and bonds are not highly correlated; that is, they tend to move independently of each other. Sometimes stock returns may be up while bond returns are down. When stock prices are falling, investors looking for a safer place to move their money often buy bonds. This has historically caused bond prices to rise. The accompanying chart shows that during the thirteen investment periods since the Great Depression in which stocks suffered double-digit losses, bonds provided double-digit gains.

 

Investment Period

Stock Lost

Bonds Gained

Sep 1929 - Jul 1932

-86%

+14%

Mar 1937 - Apr 1942

-60%

+6%

May 1946 - Jun 1949

-30%

+7%

Dec 1961 - Jun 1962

-28%

+8%

Feb 1966 - Oct 1966

-22%

+5%

Jan 1973 - Oct 1974

-48%

+9%

Nov 1980 - Aug 1982

-17%

+5%

Jul   1990 - Oct 1990

-19%

+15%

Apr  2000 - Mar 2003

-43%

+37%

Oct  2007 - Mar 2009

-57%

+9%

Apr  2011 - Aug 2011

-12%

+7%

Average Return

-35%

+11%

 

 

 

 

 

 

 

 

 

 

 

 

Stocks: Dow Jones Index from 1929 to 1972; S&P 500 Index from 1973 – 2012.

Bonds: Intermediate Term U.S. Corporate / Treasury Bonds

The importance of bonds, to any portfolio for any age investor, is about reducing portfolio volatility and minimizing the damage that bear markets inflict on retirement portfolios. While bonds may provide a lower return than in recent past, they still offer diversification benefits.




The Hidden Cost of Mutual Funds

In selecting mutual funds, the expense ratio is frequently the only cost that many investors believe they pay when owning a mutual fund. The expense ratio is the annual fee that all funds charge their shareholders. It expresses the percentage of assets shareholders pay each year for fund expenses including; 12b-1 fees, management fees, administrative fees, and other operating costs incurred by the fund. The problem is that there are other costs not reported in the expense ratio, and those expenses can make a fund two or three times as costly as advertised. Two such expenses are sales charges and transaction costs.

Sales Charges
Many mutual funds charge a front-end sales charge upon purchase. This fee essentially serves as a commission to the broker who sold the fund to the investor. In addition, many mutual funds charge a back-end sales charge when a fund is sold.

Transactions Costs
Far and away the potential biggest cost not included in a funds expense ratio are, transaction costs. Every time a fund manager places a buy or sell order on a stock within the portfolio, he or she must pay brokerage commissions. The cost for these transactions aren’t actually paid by the fund manager, they are passed along to each of the funds shareholders. Transaction costs can be difficult to determine, as they are not found in most prospectuses. They can however be determined based on information found in the “Statement of Additional Information”, a document mutual fund companies don't generally distribute to investors, but must make available upon request.

Studies conducted by researchers at Virginia Tech and the University of Virginia found that actively managed stock mutual fund incur average trading costs of 1.4% per year. This is in addition to their 1.3% average expense ratio. By comparison, the average index funds transaction costs are only 0.20% per year. As a result, index funds have significantly lower overall expenses. Do you know how much your mutual funds are costing you each year? It’s probably a lot more than you think. The accompanying chart shows that the average mutual funds actual expense ratio, after factoring in sales charges and transactions costs is approximately six times higher than a low cost index fund.

 

 

Average Mutual
Fund

Average Index
Fund

Expense Ratio

1.3%

0.30

Transaction costs

1.4%

0.20

Sales Charges

0.5%

None

Actual Expense Ratio

3.2%

0.50

 

 

 

 

 

How much of a difference can this make? Consider the following three examples.

  1. The average actively managed stock fund incurs annual expenses of about 3.2%, or $3,200 for every $100,000 an investor has in the fund. An investor with $100,000 in an index fund with annual expenses of .50 would pay only $500.
  2. If the stock market earned 10 percent, an index fund would return 9.5% (after expenses). The actively managed fund would return 6.8 percent. A $100,000 investment in the actively managed fund after 20 years would be worth $372,000. The same $100,000 investment in the index fund after twenty years would be worth $615,000. The additional $243,000 (65 percent) of savings in the index fund is due entirely to its lower expenses.
  3. A fund manager in the actively managed fund would need a return of 12.8 percent (before expenses) to outperform the 9.5 return of the index fund.

The success of indexing has been well documented over the years. Due to their significantly lower overall expenses, index funds outperform approximately two out of every three actively-managed funds each year. Increase the holding period to 10 years, and index funds outperform approximately 80 percent of all actively managed funds.

 

Managing Risk with Asset Allocation

Numerous studies and Nobel Prize-winning research over the last fifty years shows that over the long term that 95 percent of a portfolios performance will be determined by its asset allocation. Only 5 percent is determined by the return of the individual investments. In other words, asset allocation will have more to do with the success or failure of your portfolio than finding the best-performing investments. How can that be? That makes absolutely no sense. After all, what matters more than having the best investments? Consider the following example. It’s 2008, and you have $100,000 to invest. You decide to invest $70,000 in the Fidelity Contrafund (4 star fund) and $30,000 in the Vanguard Total Bond Market Index Fund (3 star fund). Your asset allocation is 70 percent stocks and 30 percent bonds. For the year, the Contrafund lost 37 percent, and the Vanguard Bond Market Index Fund gained five percent. As a result, you end up with $75,600 - a loss of almost 25%. If instead you invested $70,000 in the Vanguard Total Bond Market Index Fund, and $30,000 in the Fidelity Contrafund your portfolio with an asset allocation of 70 percent bonds and 30 percent stocks would be worth $93,000, - a loss of only 7 percent. In both instances the funds in each portfolio were the same however the ending values were not. The $17,400 difference between the two portfolios was due to the difference in the asset allocation.

When it comes to investing, the goal is to increase your savings, but not at the risk of jeopardizing your lifestyle or your financial security. During my 15 years as a registered investment advisor I have always been amazed how many individuals in their fifties and sixties invest so much of their retirement savings in stocks. The statistics also back this up. According to the Employee Benefit Research Institute, over forty-percent of investors between the ages of 56 and 65 had more than 70 percent of their retirement savings in stocks into 2008. At Capital Wealth Management we believe a more prudent asset allocation should be closer to the opposite end of the risk spectrum. As a result, the majority of our client’s assets who are close to, or in retirement, are invested in a diversified multi-asset class portfolio comprised of 30 percent stocks and 70 percent bonds.

A portfolio with an asset allocation heavily weighted in stocks can expose an investor to the risk of a significant financial loss during down markets The accompany chart shows how a portfolio with an asset allocation of 70 percent stocks and 30 percent bonds, and a portfolio of 30 percent stocks and 70 percent bonds performed during each of the stock markets seven worst bear markets. The top line shows that during the Great Depression (from Sept. 1929 to July of 1932), the U.S stock market lost 86 percent. During this time, the 70/30 portfolio lost a whopping 56%, while the 30/70 portfolio lost only 16 percent. The bottom line shows that the 30/70 portfolios average loss in ten bear markets were “significantly smaller” than the U.S. stock market and 70/30 portfolio. 

Investment Period

Stock Market

70/30
Portfolio

30/70
Portfolio

Sep 1929 - Jul 1932

-86%

-56%

-16%

Mar 1937 - Apr 1942

-60%

-40%

-13%

May 1946 - Jun 1949

-30%

-19%

-4%

Dec 1961 - Jun 1962

-28%

-17%

-2%

Feb 1966 - Oct 1966

-22%

-14%

-3%

Jan 1973 - Oct 1974

-48%

-31%

-8%

Nov 1980 - Aug 1982

-17%

-5%

+11%

Jul   1990 - Oct 1990

-19%

-12%

-2%

Apr  2000 - Mar 2003

-43%

-19%

+13%

Oct  2007 - Mar 2009

-57%

-37%

-11%

Average Loss

-41%

-25%

-4%

 

 

 

 

 

 

 

 

 

 

 

 

Stocks: Dow Jones Index from 1929 to 1966; S&P 500 Index from

1973 – 2010. Bonds: Intermediate Term U.S. Treasury Bonds

Investors who use effective risk management strategies increase their odds of earning acceptable returns in both up and down markets. From 1926-2011 the 70/30 portfolio earned an average return of 8.4 percent. The 30/70 portfolio achieved an average return of 7.0 percent. Put another way, the 30/70 portfolio earned nearly 85 percent of the return of the 70/30 portfolio return while taking significantly less risk.

 

Protecting Your 401(k) Savings

"If a 401K plan has been abandoned, it is extremely difficult for an individual participant to actually get access to his account." Virginia Smith, Director of Employee Benefits U.S. Department of Labor

When you are working for a company, participating in its 401(k) plan with high contribution limits, tax deferred growth, upfront tax deductions, and a company match is a great way to save for retirement. But what do you do with your 401(k) when you move to your next job? Most individuals often make one of two mistakes; they cash it out, or they leave it in their former employers plan.

Mistake #1 - Cash it out
Cashing out a 401k is never a good idea. When you take money out you have to pay federal income taxes; and a 10 percent penalty if you are under the age of fifty-nine and a half. For example; A 50 year old in the 28 percent tax bracket, chooses to cash out his 401(k) worth $500,000. After paying $140,000 in taxes, and $50,000 in penalties, he is left with $310,000. Taking this cash distribution has reduced his retirement savings by 39%.

Mistake #2 – Leave it behind
At first blush, there is little reason to not leave a 401(k) plan with an old employer. Leaving money in a former employers plan is easy to do. There are no forms to fill out, and no additional investment decisions to make. You won’t be assessed any taxes or penalties, and your money can continue to grow tax deferred. There are however, two disadvantages of leaving money in a former employers plan. One is high fees. Every year thousands of people leave money sitting in their former employers plan without having any idea how much it costs them. According to a study by Deloitte Consulting, the average cost for a company 401k plan is 1.25%. An individual with $500,000 in 401k plan with a cost 1.25% would pay more than $140,000 in fees over 20 years.

The second and potentially bigger disadvantage is the risk of losing track of your 401k. If a former employer gets bought out, shuts it doors, or declares bankruptcy, the 401k plan for that company can become “orphaned”. An orphaned plan is one where the sponsor and fiduciary have abandoned the plan. The money in an orphaned plan is not actually lost; it is still there, but without a fiduciary and sponsor any longer overseeing the plan, the money cannot be distributed to its employees. The Department of Labor estimates there are at least 15,000 orphaned company plans each year. Since 2007, the number of businesses filing for bankruptcy has risen 46 percent.

The most effective way to avoid the risk of this ever happening is to roll a 401k into an IRA.  Once you roll your 401k savings into an IRA, your former employers problems are no longer your problems. A rollover IRA allows you to have complete control of your retirement savings. A rollover IRA also provides additional advantages over a 401k:

Penalty Free Withdrawals
The IRS allows for penalty-free withdrawals from an IRA to pay college tuition for yourself, a spouse, children or grandchildren, or to pay health insurance premiums if you are unemployed, including COBRA premiums. You can also withdraw up to $10,000 penalty-free to put toward the purchase of a home.

More Investment choices
Rather than being limited to the number of funds within an employers plan, rolling your 401k into an IRA gives you access to more than 15,000 mutual funds to choose from.

Simpler Distribution Rules
There is one set of IRS rules governing required minimum distributions at age 701/2 for rollover IRA’s and another set of rules for 401k plans. If you have multiple IRA accounts, you can add up the value of all your IRAs and take the required distribution amount from any one of the accounts. If you have multiple 401(k) accounts, you must calculate the required distribution amount for each 401(k) separately and then withdraw the required amount from each account. The failure to take a distribution from a rollover IRA or 401k will result in a 50 percent penalty of the difference between the required minimum distribution and the amount you actually withdrew.


Peace of Mind
The odds of your 401k becoming lost or abandoned may be small, but it is a possibility. Imagine what it would be like if you couldn't access your 401(k) savings when it comes time to retire? Rolling your 401k into an IRA will make sure that the retirement savings you need, will be there when you need it in retirement.

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Capital Wealth Management is a Massachusetts fee only financial advisory firm that offers free financial portfolio reviews to analyze and recommend investment management strategies. Capital Wealth Management President, Martin Krikorian of Tyngsborough is a fee-only financial advisor and Lowell Sun financial columnist.