Investment Risks:
Lessons From the Subprime Ooze

As the subprime crisis continues to take its toll on the world’s financial institutions – and those they were meant to serve – it’s worth pausing to see if there are any lessons to be learned.

Lax lending requirements, ineffective regulations and unrealistic expectations all played important roles in the making of the credit crunch. While the first two are beyond the individual investor’s control, the third is not. It does, however, require the ability to recognize and assess risk in all its forms.

Although some investments are riskier than others, none are without risk. Sometimes they are masked, for example, by an “investment-grade” ranking or mitigated by, say, the Federal Reserve’s efforts to stabilize the economy. But risks are always present, and must be recognized and assessed.

Risk includes interest-rate risk, market risk, idiosyncratic risk, credit risk, inflation risk, liquidity risk and, most importantly, the “bottom-line” risk that your investment results ultimately will not be adequate to allow you to do what you had planned.

Any time you overlook, forget or ignore these risks, you do so at your peril.

Yet risks are impossible not to take. Stash your cash in the strongest, most secure bank vault on earth? You run the very real risk of losing to inflation, meaning that your dollars will erode in value over time.

Put your nest egg into real estate, assuming your property will appreciate? That, of course, was one of the mistakes that fueled the subprime debacle.

And while the worst of the credit crisis may be over, it probably isn’t finished. Nor is it likely to be the last financial crisis that many of us will see. If risk and your tolerance for it raises questions about your own portfolio, please give me a call.

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Risky Location

While it’s not on most lists of likely risks to your portfolio, where you

stash your retirement savings matters, too, because you risk ending up with a smaller nest egg if you don’t locate your investments wisely. Consider bonds.

You may not bother with bonds or bond funds when you’re young. As you get closer to retirement, however, you may want the relative stability of fixed income products in your portfolio. You’ll find it to your advantage to hold them in your IRA or 401(k) rather than in a taxable account because bond income is regarded as regular interest and taxed at your full income rate.

Bonds are recommended to balance the risks of equities in the other sections of your portfolio. It would be a shame to undercut their value by paying full-rate taxes on their returns.

There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.

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The Many Flavors of Risk

Interest rate risk – The possibility that a bond’s or bond mutual fund’s value will decrease if interest rates rise.

Market risk – The possibility that an investment’s value will fall because of a general decline in the financial markets.

Idiosyncratic risk – The risk of price change due to the circumstances of a specific security, as opposed to the overall market.

Credit risk – The risk that the issuer of a security, such as a bond, may default on interest and/or principal payments or go bankrupt.

Inflation or purchasing power risk – The risk that increasing inflation will diminish or eliminate returns from an investment.

Liquidity risk – The ability or inability to sell and collect the proceeds for a specific asset in a timely manner.

Reinvestment risk – The possibility that you will reinvest investment proceeds at lower prevailing rates.

Selection risk – The risk that the selected security underperforms the market for reasons that cannot be anticipated.

Timing risk – The risk that an investment performs poorly after its purchase or better after its sale.

Legislative risk – The possibility that a tax law change could affect a security’s value.

Call risk – The possibility that an issuer may redeem or “call” a bond before it matures.

There are other, more specific, risks, such as duration risk, event risk, prepayment risk, negative convexity risk, contraction risk, extension risk and early amortization risk.

Fortunately, these risks are encountered far less frequently.

High Deductible? Explore the Health Savings Accounts

As healthcare costs continue to rise, employers are increasingly seeking options such as high-deductible policies to help them control costs.

While doing that may curb the company’s costs, the policies offered typically present employees with thou-sands of dollars of out-of-pocket ex-penses before their coverage kicks in.

Health savings accounts (HSAs) offer a tax-advantaged way to cope with those soaring expenses. But before you open an HSA, make sure your plan qualifies. Not all plans with high deductibles do, and you must be covered by a qualified high-deductible health plan (HDHP) obtained either through your employer or purchased on your own.

IRA With a Health Twist

HSAs are similar to individual retirement accounts (IRAs), but are designed specifically for medical care. For 2008, individuals can contribute up to $2,900, while families can contribute up to $5,800. If you are 55 or older, you can also make additional “catch-up” contributions.

You decide how to invest your HSA, and as long as the funds are ultimately spent on eligible medical expenses, both your contributions and any earnings are tax-free. Your entire annual contribution is deductible from federal income taxes.

You can use your HSA to pay for current medical expenses or to save for future ones without incurring any penalty for carrying funds over.

To be eligible, you cannot be claimed as a dependent on someone else's tax return, may not be enrolled in Medicare or have other “first-dollar” medical coverage. However, some types of insurance, including disability, dental and vision care, and long-term care insurance, are permitted.

Keep in mind that an HSA may not be right for you if funding it is a struggle or if you're dealing with a chronic illness that would regularly require you to spend up to or more than your annual deductible. You can learn more about HSAs at treas.gov/offices/public-affairs/hsa, and if you have questions about whether an HSA fits into your financial plan, please don’t hesitate to call me.

In Retirement Planning, Divide-and-Conquer Couples Fare Best

“And even though we ain’t got money
I’m so in love with ya honey
And everything will bring a chain of love
And in the mornin’ when I rise
You bring a tear of joy to my eyes
And tell me everything’s gonna be all right”

—“Danny’s Song”
by Kenny Loggins and Jim Messina

Couples throughout history have courted each other to lyrics like those in the ’70s “Danny’s Song,” extolling the power of love over money to create happiness. The lyrics of romantic songs generally evoke the power of love as the prerequisite for a lifetime of bliss. As love matures, however, successful couples recognize the importance of financial planning for their general well-being.

In a new research study,^* couples were found to have three different approaches to financial planning. The study found that 36% of couples fall into the “driver/passenger” category. These couples have one partner – typically the male – entirely responsible for managing the family finances. A second model found is the “joined at the hip” arrangement, which describes 53% of couples surveyed. They share equally in all major money decisions.

Divide and Conquer

That leaves only 11% of couples practicing the most successful of the three approaches: the “divide and conquer” strategy. For many reasons, researchers found, couples employing this form of money management enjoyed significantly higher savings rates and better returns on their investments than the other 89%, no matter which model they followed.

The “divide and conquer” method presumes that each partner takes responsibility for some aspect of the financial wellness of the partnership. Couples practicing this style are more likely to have taken a practical approach to planning a wide variety of life events.

Of all the couples, they are most likely to have in place a safety net for the surviving spouse should one partner become incapacitated or deceased. The individual partners were best equipped to become the sole money manager should it become necessary.

Of particular interest, at a time when investment options are multifaceted, these couples are more likely than others to establish relationships with professional money managers. The “divide and conquer” style gives couples a significant advantage in their ability to respond flexibly and efficiently to complex and changing economic conditions.

While every couple is different, there’s much to be learned from the “divide and conquer” couples who apparently will enjoy a better quality of life thanks to their shared approach to money management.

^*Source: The Hartford Financial Services Group, Inc. and the MIT AgeLab. February 2008.

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Double the Success
– The “Divide and Conquer” Couple

Accept that each partner will take an active role in managing finances.

Agree to divide tasks into categories (investing, saving, cash flow and monthly budgeting).

Pick money management categories that fit individual interests and skills.

Educate themselves by reading books and magazines, joining an investment group or taking courses.

Establish relationships with financial professionals who help keep them informed about changing economic conditions.

Maintain clear records and update partners so that either can take over, if necessary.

Definitions Matter:
Income and Cash Flow Are Different Concepts

All too often, investors confuse cash flow and income, as if they were the same thing. They’re not, however, and it may be useful to keep the concepts distinct in your mind.

Cash flow, simply put, is the money you need to pay your mortgage, your general living expenses and your daily cash needs.

Income is dividends and interest earned by your portfolio on which you will pay income taxes if the underlying assets are not held in a tax-advantaged account. Currently, for example, you’ll pay 15% tax on your income from qualified dividends while paying your ordinary income rate on interest. Adding to the confusion is the crossover terminology sometimes used. A taxable money market fund, for example, may call the periodic payments it makes to you a

“dividend,” but it is essentially interest and taxed at your ordinary rate, as is most dividend income received from real estate investment trust stocks or mutual funds.

Remember the definitions when meeting retirement expenses. Cash flow generated from qualified dividends and the sale of stock held more than a year will be taxed at 15% maximum, while cash generated by other sources may attract your ordinary rate.

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Investmentmyth

“No Need To Update IRA Beneficiaries.” — Your will won’t prevail over your named primary and secondary beneficiaries of your individual retirement accounts, which is why it is essential to keep such designations updated. There are many documented instances of IRA funds going to beneficiaries who are no longer part of the deceased’s life or family.