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March 29, 2010

Assessing Your Risk Tolerance

Typically, before deciding how much to allocate to different investment categories, you answer several questions about your tolerance for risk. While it can be difficult to judge how you will react to different scenarios, the recent stock market fluctuations have provided a real-world test of theoretical answers. Many people have been surprised to find out that their tolerance for risk is not as high as they thought. That's not unusual. When the markets are performing well, it's easy to think you have a high tolerance for risk. But when the markets start to decline, our tolerance for losing money is not very high.

Thus, you should now have a better understanding of your comfort level with risk, making this a good time to reassess your risk tolerance. There are at least two components to your risk tolerance. One is the appropriate level of investment risk based on your personal situation. Factors such as your time horizon for investing, income level, total assets, debt levels, liquidity, and family responsibilities will affect that aspect.

The other element is your emotional tolerance for risk. Even if your personal situation indicates a high level of risk, that may not be prudent if you don't feel emotionally comfortable with that risk. How you have handled the recent stock market fluctuations should provide a good indication of your emotional comfort level with risk. How have you reacted during this volatile period? Have you taken the fluctuations in stride, or have you been anxious about your portfolio's value? Have you frequently calculated your portfolio's value or only occasionally checked? Have you been tempted to sell all your stock investments, or did you realize that this is a normal part of the investing process? What would you do if the market continued to decline? How long could you withstand a declining market before feeling compelled to sell?

One approach to develop an investment portfolio that reflects your individual risk tolerance is to consider your investment income needs and your attitude about the potential changes in investment values. If your standard of living is dependent on investment income, your portfolio should be concentrated in investments that provide stable and predictable income. However, if your living needs are covered through employment income, it makes more sense to take a little more risk with your investments, choosing investments with greater growth potential over the long run.

By knowing yourself and understanding your financial needs and goals, you will be better able to gauge how you may react to market fluctuations. In turn, this will help you determine what levels of risk to assume in your portfolio to help meet your financial goals.

March 24, 2010

Asset Allocation Revisited

No one enjoys the recent market fluctuations. But if these fluctuations have caused you extreme discomfort, then it's probably time to reassess your asset allocation. To do so, follow these four steps:

1. Review your desired asset allocation percentages. When designing your investment strategy, you probably decided what percentage of your portfolio to allocate to different investments. Review those percentages to see if they still make sense for your situation. How much you want to allocate to different asset classes will probably change over time, as your personal circumstances change. However, don't make significant changes as a result of discomfort over market fluctuations. First, reevaluate these factors:

Risk tolerance -- Carefully assess your tolerance for risk so that you invest in assets in which you are comfortable. While the recent stock market fluctuations have made many investors more risk averse, don't overreact to these fluctuations.

Return expectations -- You need to set realistic return expectations for various investments to help assure that you meet your investment goals. While past performance is not a guarantee of future results, reviewing historical rates of return can help you assess whether your return expectations are reasonable. Keep in mind that higher returns are generally accompanied by higher risk.

Time horizon -- The longer your investment period, the more risk you can typically tolerate. Investing for long periods through different market cycles generally reduces the risk of receiving a lower return than expected, especially with investments that can fluctuate significantly over the short term.

Investment preferences -- With such a wide variety of investments to choose from, you should understand the basics of each to decide which are appropriate for you.

In general, you should consider a more conservative allocation if you are older, have short-term needs for your funds, have low earnings, or are uncomfortable with investing. A more aggressive allocation may be appropriate if you have high earnings, are younger, do not need your funds for many years, or are an experienced investor.

2. Determine your portfolio's current allocation. You should consider all of your investments, including taxable accounts, individual retirement accounts, and retirement plans at work. Some investments may not fit totally in one category -- for instance, an investment may invest in both stocks and bonds or in both domestic and international stocks. In those cases, allocate a percentage of the market value to each of the categories in which it is invested. You don't have to be exact, since many investments' allocations will change over time.

3. Determine how much variation you are willing to tolerate in your asset allocation. It's unlikely that your actual asset allocation will equal your desired asset allocation, due to varying market values and rates of return. Since it is difficult to maintain precise asset allocation percentages, decide how much variation you will tolerate. For example, you may monitor your portfolio more closely if an asset class varies by 5% of your desired allocation and rebalance when it varies by 10%.

4. Decide how to move your portfolio closer to your desired asset allocation. If you have not reassessed your asset allocation for a while, you may find that significant changes are needed to get your allocation back in line. However, you may not want to make drastic changes all at once. Instead, you may want to take a more gradual approach to shifting your asset allocation. For instance, you can make new investments in assets that are underweighted in your portfolio. Periodic interest, dividends, or capital gains distributions can be redirected to other asset classes rather than reinvested in the same asset. Any withdrawals can come from overweighted asset classes.

March 17, 2010

Is 10% Enough for Retirement Savings?

A common rule of thumb when planning for retirement is to save 10% of your gross income during your working years. Since this rule of thumb has been around for a long time, it's logical to question whether it's still an appropriate guideline. Several trends suggest that it is probably on the low side:

Fewer individuals are covered by defined-benefit plans. The 10% guideline anticipated that a retiree would receive a defined-benefit pension as well as Social Security benefits. But a substantial portion of the work force is no longer covered by a defined-benefit pension.

The Social Security system will face increasing pressure in the future. Due to the unprecedented number of baby boomers that will be retiring in the near future, there will be fewer workers to pay the benefits for each retiree. By 2037, unless changes are made to the system, benefits will need to be reduced by approximately 25% to equal revenues collected (Source: Social Security Administration, 2009).

Life expectancies are continuing to increase. Average retirement ages have been decreasing, while life expectancies have been increasing. Currently, at age 65, the average life expectancy is 82 years for a man and 85 years for a woman, compared to 78 years for a man and 81 years for a woman in 1950 (Source: Journal of Financial Planning, August 2008).

Plans for retirement have changed. Another common retirement planning rule of thumb is that you'll need 70% of preretirement income during retirement. However, that guideline assumed a relatively inactive retirement lifestyle. Increasingly, retirees view retirement as a time to travel extensively or engage in expensive new hobbies. Thus, more and more retirees are finding little change in their income needs after retirement.

All these trends point to the fact that future retirees will be responsible for providing more of their income for a longer period of time. Thus, you should consider higher, not lower, savings rates. While 10% of income may sound like a lot of money, consider how many years you expect to work compared to how many years will be spent in retirement. Assume you start working at age 22, work until age 62, and then die at age 82. Thus, you work 40 years and are retired for 20 years -- for every two years you work, you need to support yourself for one year in retirement. If your retirement expenses don't go down and you don't have a defined-benefit pension, you'll need to save significant sums to support yourself for that length of time.

Contrast the current situation with a typical scenario in 1950. At that time, the average retiree worked 47 years before retiring for nine years. Thus, that person worked over five years to support one year of retirement.

For many people, then, the answer may be to extend their working years. In the above example, if you wait until age 70 instead of age 62 to retire, you will work for 48 years and be retired for 12 years. Thus, you will work four years for every year of retirement. While preretirees may not have the mathematics down, many realize that working longer, rather than retiring earlier, may be the only way to ensure that they don't run out of retirement funds. Almost all recent surveys of baby boomers indicate that the majority expect to work at least part-time during retirement.

These stark realities don't mean that you can't retire, just that you need to plan carefully. Thus, you should start saving as much as possible, as soon as possible, for your retirement. Waiting even a few years to start saving can substantially increase the annual amount you need to save.

Trying to gauge whether your retirement savings are on track? While there's nothing like going through a thorough analysis, you can take a quick look by adding up all your retirement assets and multiplying that balance by 3% or 4%. These withdrawal percentages should ensure that your retirement assets last for several decades.

March 11, 2010

Caught in the Financial Middle

At a time when baby boomer couples should be saving for their own retirements, many feel squeezed by competing financial needs. Having started families later than past generations, their children may just now be entering college or still living at home. At the same time, aging parents may need financial assistance. It is a dilemma that is likely to become more common in the years to come.

Caring for Parents

As life expectancies continue to rise, it becomes increasingly likely that you may need to help an aging parent. Some financial precautions you should consider now include:

• Investigate long-term-care insurance for your parents. If they can't afford the insurance, you may want to purchase it for them.

• Have your parents prepare a listing of their assets, liabilities, and income sources, including the location of important documents. This can save time if you need to take over their finances.

• Make sure your parents have legal documents in place so someone can take over their financial affairs if they become incapacitated. They may also want to delegate health care decisions.

• Understand the tax laws if you provide financial support to your parents. You may be able to claim them as dependents if you provide more than half their support. Additionally, you may be able to deduct medical expenses paid on their behalf.

• Find out if your employer offers a flexible spending account for elder care. This may allow you to set aside pretax dollars to pay for up to $5,000 of elder-care expenses for a dependent parent.

Assisting Your Children

For many families, college is a significant financial cost. While you may want to pay all college costs for your children, it may not be feasible. Some strategies to consider include:

• Shift some of the burden to your children, requiring them to work part-time during college or to take out student loans.

• Understand the financial aid system, investigating all financial aid sources. Search for scholarships that are not based on need. Apply to several different colleges, looking for the best financial aid package.

• Look for ways to reduce the costs of college. Your child can start at a community college, which is often cheaper than a four-year college. Or consider a public university in your state.

Once your child graduates from college, don't assume your financial responsibilities are over. Adult children may return home for a variety of reasons. If your child returns home, realize there are increased costs. Consider charging rent and imposing a deadline on how long he/she can stay.

Don't Forget Yourself

When faced with the needs of children and aging parents, it's easy to neglect your own need to save for retirement. But don't feel guilty about your retirement needs. One of the best gifts you can give your children is the knowledge that you will be financially independent during retirement. Consider these tips:

• Calculate how much you need for retirement and how much to save on an annual basis to reach that goal. Don't give up if that amount is beyond what you're able to save right now. Start out saving what you can, resolving to significantly increase your saving once your parents' or children's needs have passed. Also consider changing your retirement plans, perhaps delaying your retirement or reducing your financial needs.

• Take advantage of all retirement plans. Enroll in your company's 401(k), 403(b), or other defined-contribution plan as soon as you are eligible. Also consider investing in individual retirement accounts.

• Reconsider your views about retirement. Instead of a time of total leisure, consider working at a less stressful job, starting your own business, or turning hobbies into paying jobs.

March 4, 2010

The Problem with Using Average Returns

When setting up an investment program, the assumed rate of return is typically an average return for some historical period. While that is generally viewed as a conservative approach, there are some problems with using an average return:

• Average returns are an average of past returns and do not indicate what will happen in the future. Economic and market events may or may not replicate past events.

• The average annual return can vary substantially, depending on the historical period used. For instance, from 1926 to 2008, the Standard & Poor's 500 (S&P 500) had an average annual return of 9.6%. From 1984 to 2008 (25 years), the average return was 9.2% and 6.4% from 1999 to 2008 (10 years).* Those differences in average return would project a substantially different portfolio value over an extended time.

• The average return does not reveal the pattern of returns over that period. Some years will experience higher returns, while other years will experience lower or even negative returns. Even if you select an average return that is exactly right, your portfolio's ultimate balance will depend on the pattern of returns over that period. For instance, if you experience high returns in the early years when your portfolio's balance is low and then lower returns in the later years when your portfolio's balance is higher, you will have a lower value than if the opposite occurred.

• Most people don't just allow a lump sum to grow, but make deposits and withdrawals over the years. Since your actual return fluctuates from year to year, your pattern of additions and withdrawals can also significantly impact your portfolio's ultimate value.

While it is instructive to consider average returns when developing an investment program, you can't simply project that return into the future and hope for the best. Instead, consider these steps when deciding on an estimated rate of return:

Evaluate your expectations for future returns against historical averages. It may be prudent to assume lower returns in the future. It is easier to save less if you obtain higher returns than to try to save more over a short period of time if your actual return is lower.

Consider a range of possible returns for your portfolio. What would happen to your portfolio's balance if you earned your expected return, 1% less, 2% less, etc.? This analysis can help you determine what adjustments would need to be made to compensate for lower returns.

Review your progress every year. This will allow you to make adjustments along the way. If your return is lower than expected, you may need to increase savings or change investment allocations.

• Source: Stocks, Bonds, Bills, and Inflation 2009 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.


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