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May 1, 2003

Evaluate Your Company 40l(k) Plan

Don't leave your 401(k) account on autopilot. As with all investments, you should review your 401(k) account at least annually. If you haven't done so in a while, use the arrival of your 401(k) statement as a trigger for a review. Be sure to consider the following items:
  • Evaluate your investments compared to all investment alternatives offered by the plan. Your investments should be appropriate for your goals. As you age, you might want to shift some of your investments. Or, based on recent market fluctuations, you may want a more diversified portfolio. Selling investments within your 401(k) plan typically doesn't generate tax liabilities, so you can make these kinds of changes without worrying about the tax effects.

  • Make sure no single company's stock comprises more than 10-20% of your 401(k) balance. Especially as you near retirement and don't have as much time to recover from market declines, you don't want too much of your balance allocated to one investment. This is especially important if that investment is stock in the company you work for.

  • Review how much you are contributing to the plan. Over time, you should strive to increase the percentage of your income that is set aside for retirement. One way to do that is to immediately allocate any salary increases to your 401(k) plan. At a minimum, make sure to contribute enough to take full advantage of any employer matching contributions.

  • Check your statement for errors. Always check your statement to make sure all payroll deductions and employer matching contributions went to your account and that the proper investments were purchased with those funds. If you have a loan, verify that the balance is accurate and that loan repayments have been properly applied.

Follow These Three Principles to Reach Your Financial Goals

Be honest. How much progress are you making toward your financial goals? Are you getting somewhere or does it seem like you fall a bit further behind every year? If you can't seem to make any financial progress, resolve to follow these three fundamental principles:
  1. Live within your means. The amount of money left over for saving is a direct result of your chosen lifestyle. Your lifestyle impacts you now and in the future, since you'll probably want a similar lifestyle after retirement. Bite the bullet now and ruthlessly cut your expenses. Forget about designer clothes, morning stops for coffee, dinners out every evening, and expensive vacations. Reprioritize your life and learn to live with less. Keep cutting until you can save at least 10% of your gross income.

  2. Invest those savings. Your portfolio's ultimate value is a function of two factors -- how much you save and how much you earn on those savings. Become comfortable with various investment alternatives, so you'll feel comfortable investing in more aggressive alternatives with higher return potential. Even small differences in your long-term rate of return can significantly impact the ultimate size of your savings.

  3. Avoid debt. You'll probably need debt to purchase large items like a house, but don't let debt sabotage your financial goals. Resolve not to purchase anything on credit this year. Any income going to pay interest can't be used for saving. Strive to eliminate all debt except your mortgage. Start by paying down the debt with the highest interest rate. Once that is paid in full, start paying down the debt with the next highest interest rate, continuing until all your debt is paid in full.

For many, these three principles will represent a significant change in their way of life. While it may be difficult at first, faithfully following these principles can make a major difference in your financial progress.

When Did You Last Rebalance Your Portfolio?

These days, many people don't even want to look at their portfolio, let alone think about rebalancing it. But you developed an asset allocation strategy for a reason -- you wanted to control the risk in your portfolio by deciding how to allocate among different asset classes. Your portfolio won't stay within that allocation by itself. Since different investments earn different rates of return, over time your allocation will get out of line. To keep your allocation in line, you need to review your portfolio periodically and make adjustments to rebalance it.

While the theory of rebalancing is easy enough to understand, rebalancing is often a difficult concept for investors to implement. The problem is rebalancing goes against your basic instincts. With rebalancing, you are basically selling those investments performing well to purchase those that are underperforming. It might help to remember that, by rebalancing, you are following a basic investment principle -- you are buying low (those investments that are underperforming) and selling high (those investments that are performing well).

Decide how you want to rebalance and then follow through. There are three basic approaches to rebalancing:

  1. Rebalance annually. You can choose a date to rebalance, perhaps the beginning of the year, when you receive your annual statements, or at the end of a quarter. On that date every year, you compare your current allocation to your target allocation. Any allocations off by more than 5-10% would require rebalancing. Once you have rebalanced, don't be tempted to make other rebalancing changes during the year. Wait for your next rebalancing date.

  2. Rebalance whenever your allocation moves away from your target allocation by a designated percentage. With this type of rebalancing, you monitor your portfolio more frequently, perhaps monthly. Once your allocation moves from your target allocation by a certain predetermined percentage, perhaps 5-10%, you rebalance your portfolio.

  3. Rebalance based on your views about current market conditions. With this approach, rather than one specific percentage for each asset class, you might have a target range. For instance, you might allocate from 30% to 50% of your portfolio to large-cap stocks. Depending on your views of the market, you might want to allocate near the low or high end of that range. Thus, your allocations will change as your views about the market change.

Once you've decided what needs to be rebalanced, you need to implement those changes. If the change is within a tax-deferred account, such as a 401(k) plan or Individual Retirement Account(IRA), you can typically make these changes without tax ramifications. With taxable accounts, you'll want to consider the tax ramifications before implementing the changes. If selling an asset will result in a tax liability, consider other methods to implement the change. For instance, new investments can be made in the underweighted portion of your portfolio, or you can redirect periodic interest, dividends, or capital gains to the underweighted portion. If you will be making withdrawals, take them from the overweighted portion of your portfolio. However, if you can't implement the changes in a relatively short period, you might want to actually sell some investments. If the sale generates a gain, you might be able to sell other investments at a loss to offset that gain.

Should You Invest Globally?

For much of the 1990s, the U.S. stock market significantly outperformed international stock markets. Never a particularly large percentage of U.S. investment portfolios, international investments drew even less attention during this time. But the U.S. stock market has experienced its third consecutive year of negative returns, with many expecting U.S. stocks to encounter below-average returns in the future. Is now the time to take another look at international investments? Before deciding, consider the following:
  • Return potential. During the 1990s, the U.S. stock market clearly outperformed international stocks. But that was not always the case -- international markets outperformed U.S. stocks during the 1980s. A study of 10-year annualized returns for the Standard & Poor's 500 (S&P 500) and the Europe, Australasia, and Far East (EAFE) index from 1970 to 2000 found that the EAFE outperformed the S&P 500 in 15 of those 21 periods (Source: AAII Journal, October 2001).* After U.S. markets dominated in the 1990s, are international investments set to start outperforming? While no one knows for sure, there may now be opportunities to find investments in other parts of the world that are more attractively priced than those in the U.S.

  • Diversification. One of the primary advantages cited for international investing is to reduce the volatility in a portfolio through diversification. The theory is that when the U.S. stock market is declining, investments in other parts of the world may counter that trend. Recently, however, it appears that during periods of crisis, stock markets throughout the world have moved in the same general direction. How accurate is this assessment?

    One way to measure the benefits of diversification is to look at the correlation of two asset classes. A positive correlation means that the prices of the two assets move in the same direction. A correlation of +1 indicates that the assets move together very closely in the same direction. A correlation of -1 indicates that the assets move in opposite directions. A correlation close to 0 means that there is no relationship in the price movements of the two assets. The lower the positive correlation or the higher the negative correlation, the more risk that will potentially be eliminated. Typically, asset classes are considered to have good diversification benefits if they have correlations of 0.6 or less. Until recently, the correlation between the U.S. stock market and the EAFE was 0.5 or less (Source: AAII Journal, October 2001). As of early 2001, however, that correlation had increased to 0.75 (Source: Money, September 2001). While that reduces the diversification benefits, it remains to be seen whether the correlation stays at these higher levels or comes down to more historical levels.

    Also keep in mind that the correlations listed above relate to foreign stock markets overall. The correlation between the U.S. stock market and specific foreign stock markets can be significantly different. For instance, historical correlations between the U.S. and Canadian stock markets are higher than 0.7, while the U.S. and Japanese correlation is 0.3. Emerging markets typically have a low correlation with the U.S. stock market (Source: AAII Journal, October 2001).

  • Currency fluctuations. When considering international investing, make sure you understand the significant role of currency fluctuations. Your return from an international investment is comprised of two components: the investment's return in local dollars and the impact of any currency fluctuations. Part of the reason U.S. investments dominated in the 1990s was due to the strong U.S. dollar. Now, the U.S. dollar is starting to show some weakness against other currencies, which could bolster the returns of foreign investments.

  • Investment opportunities. The U.S. stock market now represents only slightly more than 50% of the total market capitalization of the world (Source: Reuters Business Report, February 20, 2002). Limiting yourself to U.S. stock investments means eliminating nearly half of the world's investments from consideration. In a number of industries, the world's leading companies are not U.S.-based companies. International investing is increasingly moving from a methodology of selecting regions of the world to invest in to selecting stocks of leading companies, no matter where they are based.

    For all these reasons, now may be a good time to take another look at international investing. Keep in mind, however, that international investments may not be suitable for everyone. In addition to the risks associated with domestic investing, foreign investing has unique risks, such as currency fluctuations, political and social changes, and greater share price volatility.

    * The S&P 500 is an unmanaged, weighted index generally considered representative of the U.S. stock market. The EAFE is an unmanaged index of 1,000 foreign stocks generally considered representative of stock markets outside the U.S. Investors cannot directly purchase an index. Past performance is not a guarantee of future results. This information is presented for illustrative purposes only.


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