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July 28, 2010

How Much Life Insurance Should You Have?

While life insurance can serve a variety of purposes, one of the most common is to maintain your family's standard of living in case you die. Thus, you need to purchase an appropriate amount of insurance to ensure your family is adequately protected. Many rules of thumb exist, such as five to seven times your annual income, but don't rely on rules of thumb to determine your coverage. These rules don't take into account your individual circumstances, so they could leave you with an inadequate amount of insurance.

Your insurance needs will probably change over time. When you are a young, single adult, you may have little reason to purchase life insurance. As you start a family, your insurance needs will be greater, since other family members are depending on your income. As your children become independent, your insurance needs may decline. However, at that point, you may need life insurance for other purposes, such as to help fund estate taxes or for a business buy out.

To determine how much insurance you need, consider these questions:

What lifestyle do you want to provide for your spouse and dependents after your death? Review your needs in detail, taking a look at items such as:

• Do you want to provide the same standard of living, including things like vacations and club memberships? Will your spouse and children live in the same house?

• Will the family have to make different child care arrangements?

• Do you want to provide for college educations for your children?

• If your spouse doesn't work, do you want that to continue or do you expect him/her to work after your death? If you expect your spouse to work, what is a reasonable amount of income to expect him/her to earn?

• Do you need to consider the support of elderly parents or other relatives?

• How long must your family live off the insurance proceeds? Will your current retirement fund provide enough income for your spouse to live on after retirement or do you need to provide income until his/her death?

• Do you want to pay off a mortgage or other debt with insurance proceeds?

• Do you have estate tax considerations you want to address with life insurance?

How much will that lifestyle cost? Come up with an estimate of how much this lifestyle will cost. Include all of your current expenses that would remain the same as well as any new expenses you have identified, such as child care. Remember to factor in hidden costs, such as providing for health insurance that was paid for previously by your employer. For large debts, such as a mortgage, determine whether it makes sense to pay the loan off in full or to continue making monthly payments.

How much life insurance do you need? First, consider what other income sources your spouse and/or dependents will have. This could include your spouse's earnings, retirement plans, Social Security benefits, savings, and investments. Life insurance proceeds will be needed to provide the difference.

Your life insurance needs will change over time, so you should periodically go through this analysis.

July 26, 2010

Ally Bank Announces Rate Increase

Ally Bank announced a rate increase on their 12 month High Yield Certificate of Deposit effective 7/26/10. Ally Bank, originally part of the GMAC family of companies, is a subsidiary of Ally Financial Inc. Ally Financial Inc. is a FDIC-insured institution (NYSE:GJM). Click here to search and apply for online high-yielding, FDIC insured Certificates of Deposit, Savings & Money Market Accounts.

July 25, 2010

Why Asset Allocation Strategies Are Necessary

Your asset allocation strategy represents your personal decisions about how much of your portfolio to allocate to various investment categories, such as stocks, bonds, cash, and other alternatives. When stock market returns were above average for an extended period, investors did not have much interest in asset allocation. Then, the best strategy seemed to be to only own stocks. But with the stock market volatility of the past several years, investors are again focusing on asset allocation. Some of the advantages of an asset allocation strategy include:

Providing a disciplined approach to diversification. An asset allocation strategy is another name for diversification, an important strategy for reducing portfolio risk. Since different investments are affected differently by economic events and market factors, owning different types of investments helps reduce the chance that your portfolio will be adversely affected by a particular risk type.

Encouraging long-term investing. An asset allocation strategy is designed to control your portfolio's long-term makeup. It should not change based on economic conditions or market fluctuations.

Eliminating the need to time investment decisions. Market timing is a difficult concept to implement. Not only do investment professionals have a difficult time accurately predicting the market's movements, but waiting for the perfect time to invest keeps many investors on the sidelines. With an asset allocation strategy, you don't have to worry about timing the market, you just have to ensure your investments stay within the proper percentages.

Reducing the risk in your portfolio. Investments with higher returns typically have higher risk and more volatility in year-to-year returns. Asset allocation combines more aggressive investments with less aggressive ones. This combination can help reduce your portfolio's overall risk.

Adjusting your portfolio's risk over time. Your portfolio's risk can be adjusted by changing allocations for the different investments you hold. By anticipating changes in your personal situation, you can make those changes gradually.

Focusing on the big picture. Staying focused on your asset allocation strategy will help prevent you from investing in assets that won't help accomplish your goals. Rather than investing in a haphazard manner, it gives you a framework for making investment decisions.

Your asset allocation strategy will depend on a variety of factors unique to your situation, including your risk tolerance, return expectations, investment period, and investment preferences.

July 22, 2010

Investing in Municipal Bonds

Whether you're just investigating municipal bonds or are reviewing your current muni bond portfolio, consider the following guidelines:

Compare the returns from municipal bonds to other types of bonds. Since the interest income is exempt from federal, and sometimes state and local, income taxes, your marginal tax bracket is a significant factor in deciding whether municipal bonds are appropriate for you. (Any capital gains are subject to taxes. Interest income for some investors may be subject to the alternative minimum tax.) Make sure to determine how a muni bond's yield compares to the after-tax yield on a comparable taxable bond. To do that, calculate the tax-equivalent yield for the municipal bond. If you're not investing in a municipal bond issued within your resident state, which also exempts income from state and sometimes local income taxes, the calculation is fairly straightforward: the taxable equivalent yield equals the tax-exempt interest percentage divided by one minus your marginal tax bracket.

Don't simply select the bond maturity that offers the highest return. Since interest rate changes can significantly affect your bond's market value, it may make more sense to select a maturity that coincides with when you need the principal.

Look at a bond's call provisions. Most municipal bonds come with a call provision, which allows the issuer to redeem the bonds prior to their scheduled maturity. Calls are generally only exercised when market interest rates are lower than the interest rate being paid on the bond and are generally not good news for the bondholder. Purchase bonds with call provisions that are most favorable to you.

Review the bond's credit quality. While municipal bond defaults are rare, they do occur, so review carefully the credit quality of muni bonds. You may want to stick with investment-grade ratings, which means that the issuer is considered financially stable and unlikely to default.

Hold a diversified portfolio. You should plan to hold at least seven to nine different issues to ensure adequate diversification.

Consider bonds issued in your resident state. Purchasing muni bonds issued in the state in which you reside means that your interest income will also be exempt from state, and sometimes local, income taxes.

Review your holdings periodically. Review the credit ratings of all your municipal bonds at least annually. Check the call provisions so you aren't surprised by a call in the coming year. Also, review your holdings to see that they are still consistent with your overall investment objectives and asset allocation plan.

July 14, 2010

How to Evaluate P/E Ratios

Price/earnings (P/E) ratios are a common measure of stock value, both for individual stocks and the overall market. Calculating a P/E ratio is straightforward -- it is simply the price of a single share of stock divided by the company's per share earnings. For example, a stock selling at $50 per share with $2 per share of earnings would have a P/E ratio of 25. However, P/E ratios can be calculated using different earnings numbers. Trailing P/E ratios, which are typically reported in newspapers, use earnings per share for the most recent four quarters, while forward P/E ratios use forecasts of future earnings per share.

To understand what a P/E ratio represents, consider what it means in terms of how much you would pay for a business you want to purchase. The value of that business would be largely determined by how much income it generates and how long it would take to recover the purchase price with that income. You might be willing to pay four or five times earnings (for a P/E ratio of 4 or 5), realizing it would take that many years to recover the purchase price. However, if you felt earnings had the potential to increase significantly in future years, you might be willing to pay a higher multiple of current-year earnings.

When considering public companies, it seems reasonable that well-established businesses growing in a fairly predictable pattern would command a higher P/E ratio than a small private business. Since you don't have the risks or responsibilities that come with owning a business, you would probably pay a premium. Typically, companies with higher growth rates command higher P/E ratios.

The difficulty is deciding what a reasonable P/E ratio is for a particular company or for the overall stock market. For individual companies, investors' expectations about future earnings affect the P/E ratio. Confidence that a company will improve its profitability or remain profitable generally results in a higher P/E ratio. If profits are threatened or weak, the P/E ratio is likely to drop. P/E ratios for the overall market change based on broad market conditions and investors' views about how desirable stocks are compared to other investments.

There is no absolute measure of what P/E ratio should be paid for a given company with a given growth rate. P/E ratios can fluctuate significantly over time and among companies and industries. It generally helps to follow the P/E ratios of stocks that interest you, along with companies in similar industries, to develop a feel for how the P/E ratios fluctuate. Reviewing a company's P/E ratio for prior years can also be helpful. If a company's growth rate in the past is expected to continue in the future and market conditions are similar, you might not expect much change in P/E ratios. But you also must evaluate whether changes to the company, its industry, or the overall stock market would cause an increase or decrease in the company's P/E ratio.

One way to evaluate P/E ratios is to consider a company's current P/E ratio divided by its historical P/E ratio. If it is much lower than 1, you might want to investigate why. It could mean the business is in decline or having other problems. It may also imply that the stock is reasonably priced now. If the value is much higher than 1, carefully assess whether you want to invest at this time. You may want to wait until the P/E ratio returns to a more historical level.

You can also divide a company's current P/E ratio by the market's overall P/E ratio. If that figure is much higher than 1 (and thus higher than the overall market), you should evaluate whether the company's prospects justify that valuation.

July 7, 2010

Bond Strategies

The strategies used for bond investing will depend on the financial objectives you are pursuing. Consider these financial objectives and bond strategies:

Earning interest while preserving principal. This is the most typical role for bonds and is usually accomplished with a buy-and-hold strategy. With this strategy, you purchase a bond and hold it to maturity, looking for the highest return potential for a given time frame within a comfortable risk level. By holding the bond to maturity, you don't have to worry about interest rate changes impacting your bond's price.

Maximizing income. Since bonds with longer maturities typically have higher interest rates, this strategy typically involves investing in longer-term bonds. Interest rate changes will typically affect a longer-term bond's price more because long-term bonds have a longer stream of interest payments that don't match current interest rates. Someone looking to maximize income will also be more likely to sell a bond before maturity to lock in capital gains. Another strategy to help achieve this objective is to invest in high-yield bonds, which are bonds with lower credit ratings. Due to the lower credit rating, these bonds often have to offer higher interest rates to obtain investor interest.

Managing interest rate risk. One of the most significant bond risks is interest rate risk, or the risk that increases in interest rates will cause a decrease in your bond's price. Bond ladders can help manage this risk. A bond ladder is a portfolio of bonds of similar amounts maturing in several different years. When one of the bonds matures, the principal is reinvested in another bond at the bond ladder's longest maturity. By spreading out maturity dates, you lessen the impact of interest rate changes. Holding the bond to maturity prevents interest rate changes from resulting in a loss when you sell the bond. Since your bonds mature every year or so, your principal is reinvested over a period of time instead of in one lump sum. If interest rates rise, you have principal maturing every year or so to reinvest at higher rates. In a declining interest rate market, you have some funds in longer-term bonds with higher interest rates. But the main advantage is you don't continue to hold only short-term bonds while you wait for interest rates to peak, an event that is difficult to predict.

Help reduce the volatility of stock investments. The advantage of including both stocks and bonds in your portfolio is that when one category is declining, the other category will hopefully help offset this decline. For instance, in 2008, the Standard & Poor's 500 (S&P 500) returned -37%, while long-term government bonds returned 25.9%, and intermediate-term government bonds returned 13.1%.* One way to assess the percentage of bonds to include in your portfolio is to look at how holding varying percentages of stocks and bonds would have impacted your average return.

Investing for a specific future goal. Because bonds have a definite maturity date, you can select maturity dates to coincide with when you need your principal. You might want to consider zero-coupon bonds for this purpose. Zero-coupon bonds are issued with a deep discount from face value and do not pay interest during the bond's life. The return results from the bond's price increasing gradually from the discounted value to face value, which is reached at maturity. The longer a zero-coupon bond has until maturity, the greater its price discount will be. Like other fixed-income investments, a zero-coupon's price moves up when interest rates fall and down when rates rise. However, since zeros lock in a fixed reinvestment rate of return, they are affected more drastically by interest rate changes. One important fact to consider is taxation. Even though you do not receive any interest income until the zero-coupon bond matures, you are taxed on the yearly growth in the zero's value (called accretion).

Recognizing a loss for tax purposes. A bond swap, which is simply the sale of one bond and the purchase of another, can help achieve this objective without changing the basic composition of your bond portfolio. In essence, you sell a bond with a current market value less than your purchase price to realize a loss and deduct it on your tax return. You then use the proceeds to purchase similar bonds. The end result is that you still own a comparable bond, but you also have a tax loss. Review the cost of the swap before executing the transactions to ensure costs don't offset most of your expected tax savings. Make sure to comply with the wash sale rules or your loss won't be deductible. A wash sale occurs when an investor sells a security and within 30 days before or after, purchases a substantially similar security. Bonds purchased within the 30-day window must differ from the bonds sold in a material way, which includes different issuers, coupon rates, or maturity dates.

Reducing income taxes. One strategy would be to invest in municipal securities, since municipal bond interest is generally exempt from federal, and sometimes state and local, income taxes. Your marginal tax bracket is a major factor when deciding whether to include municipal bonds in your portfolio. Thus, you should compare a muni bond's yield to the after-tax yield of a comparable taxable bond. To do that, calculate the muni bond's taxable equivalent yield. If you're not investing in a municipal bond issued in your resident state, the calculation is: the taxable equivalent yield equals the tax-exempt interest rate divided by one minus your marginal tax bracket. For instance, if you are considering a municipal bond with a yield of 4.5% and you're in the 25% tax bracket, the taxable equivalent yield is 6.0% (4.5% divided by 1 minus 25%). Thus, you should compare 6.0% to any corporate bonds you are considering.

* Source: Stocks, Bonds, Bills, and Inflation 2010 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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