Cornerstone

Wrong Kind of Diversification

What is “diworsification”? The aforementioned word and its definition cannot be found in the Webster’s dictionary. Still, many investors may be “diworsifying” their portfolio by adding investments and/or advisors that ultimately result in increasing the risk of their portfolio.

Probably the most common diversification error made by individual investors is purchasing several different mutual funds that invest in the same asset class. Owning five different U.S. large-cap growth funds provides only minimal diversification benefit. In this case, all the funds would be invested in the same basket and exposed to the same types of risks.

Investors may make a similar error when deciding who will manage the assets in their portfolio. Not wanting to have all their eggs in one basket, some investors hire several investment advisor firms. This is a mistake on two fronts. First, academic research indicates that almost all of a portfolio’s risk is determined by asset allocation and not by the number of advisors.

Second, hiring multiple advisors can create several problems:
 Most people want to simplify their life, not complicate it. Working with multiple advisors complicates the portfolio’s management.
 Economies of scale can be lost. Advisors who charge by the amount of assets under management typically charge lower fees on larger portfolios. Investors who split their assets among several different managers may miss out on such a benefit.
 Holdings may be duplicated, both in terms of individual stocks and asset class exposure. Thus, the portfolio may not be effectively diversified and may be more risky.
 If each advisor operates independently, there is the potential for inefficient tax management.
 If each advisor operates independently, the portfolio’s desired asset allocation may not be maintained.
 
Having several advisors not only creates difficulties on the investment front, but could create other problems as well. Consider that it is not enough to have a well-developed investment plan. For example, it is also necessary to have the discipline to adhere to the plan, including regularly rebalancing the portfolio.

Therefore, a prudent approach would be to integrate an investment plan into a carefully constructed estate, tax and risk management plan because investment decisions and performance can impact other areas of the plan and vice versa.

You should have a qualified financial wealth manager serve as the quarterback of your financial services team to ensure you have the greatest chance of achieving your financial goals. That person should be responsible for coordinating asset allocation and estate, tax management and risk management plans. And he or she should make the appropriate adjustments as your personal circumstances change.

You should seek a relationship in which you are comfortable disclosing all of your investment accounts (such as IRAs and 401(k) accounts), all of your financial assets (such as stock options and life insurance) and all of your financial and estate planning decisions to your financial quarterback. That is the only way you can be sure that your plan is a well-integrated one. It will also allow you to avoid duplicating holdings, minimize asset allocation drift and ensure that the asset location decisions are correct.

Summary

While diversification is part of a prudent investment strategy, some kinds of diversification are more effective than others. Hiring multiple investment advisors creates the potential for inefficient portfolio management, and it may add unwanted complexity to your life while increasing costs.

There are simple steps you can take to eliminate the need for multiple advisors, including hiring an advisor that:
 Adopts a passive investment strategy
 Operates an open platform (doesn’t sell proprietary products)
 Provides both investment management and wealth management services
 Provides a fiduciary (not suitability) standard of care

Hiring a qualified and trusted financial quarterback will not only provide you the best chance of achieving your financial goals, but it will also simplify your life — two worthy objectives.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2007, Cornerstone Wealth Advisors, LLC.

Confusing the Familiar with the Safe

Peter Lynch, a legendary investor, authored the book One Up on Wall Street: How to Use What You Already Know to Make Money in the Market. However, too many investors follow Lynch’s advice to buy what they know. Doing so causes them to make the investment mistake of confusing the familiar with the safe.

An example of “familiarity breeding investment” comes from a working paper by Gur Huberman, who cited Georgia residents and their ownership of Coca-Cola stock. At one point, residents of the Peach State owned 16% of all Coca-Cola stock, despite making up less than 3% of the U.S. population. Since it is no safer to own Coca-Cola stock if you live in Georgia than it is if you live in Missouri, the only logical explanation is that Coke’s headquarters are in Atlanta. And why did people in Rochester, NY tend to own a disproportionate share of stock in Kodak and Xerox? Both have large operations in Rochester.

It’s likely that many St. Louisans are following similar patterns. Some might own disproportionate shares of local companies, such as Anheuser-Busch, Ralston and Monsanto. Despite the outstanding returns generated by the market in 2006, we were provided with many reminders of the dangers of confusing the familiar with the safe.

According to the St. Louis Post-Dispatch, of the 54 companies included in a list of St. Louis major-index stocks, 21 (or 39%) generated negative returns. Of those 21 companies, 13 produced double-digit losses. Four produced losses of between 20% and 30%, two had losses of between 30% and 40%, one had a loss of 41% and one with a whopping loss of 77%.

Compensated Versus Uncompensated Risk

There are two types of financial risk: those that can be diversified away and those that cannot. Among the risks that can be diversified away are those that come from attempts to pick winning stocks. Investors are not compensated for taking these individual-stock risks that can be diversified away. In other words, although the expected returns from a stock-picking approach are no greater than broadly investing in equities, the risk is significantly greater when one’s holdings are concentrated in fewer securities. And that’s before one considers the expenses of implementing the approach.

In 2006, employees of the following companies learned that just because you work for a company and are familiar with it, doesn’t mean it is a safe investment.

COMPANY                             CHANGE
Revlon                                  –57%
Vonage                                 –53%
Whole Foods                         –39%
Yahoo                                   –35%
Cheesecake Factory               –34%
Six Flags                               –32%
eBay                                     –30%
Boston Scientific                   –30%
Red Robin                             –30%
Williams-Sonoma                   –27%
Arch Coal                              -25%
Intel*                                    –19%
*Worst performing stock in the Dow Jones Industrial Average Summary

Gary Belsky and Thomas Gilovich, authors of Why Smart People Make Big Money Mistakes — And How to Correct Them, warned investors to avoid confusing familiarity with knowledge: “For every example of a person who made money on an investment because she used a company’s product or understood its strategy, we can give you five instances where such knowledge was insufficient to justify the investment.”

Prudent investors take only risks for which they are compensated. The prudent strategy, therefore, is to use low-cost, passively managed funds because they are efficient ways to build a globally diversified portfolio, and help to eliminate uncompensated risk.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2007, Buckingham Family of Financial Services.

Where Should You Hold Your Equities?

One common investment mistake some investors make has to do with the asset location decision — dividing assets between taxable and tax-advantaged accounts.

The conventional investment wisdom is to locate equities (those expected to have higher returns) in tax-advantaged accounts and bonds in taxable accounts. Thus, many investors hold their equities in tax-advantaged accounts — such as IRAs, Roth IRAs and annuities — and then hold municipal bonds or other fixed-income investments in taxable accounts. However, the current tax structure should encourage investors to consider reversing that strategy.

Only those investors who are very active traders (whose trading activity is so frequent they don’t qualify for the preferential capital gains treatment, thus losing an important advantage of equity investing) might be advised to follow the conventional wisdom. Note that the evidence is compelling that active traders, on average, have underperformed their appropriate benchmarks, even before taxes.
 
There are five reasons one might prefer holding equities in taxable accounts. First, holding equities in tax-deferred accounts converts what would otherwise be long-term capital gains into ordinary income, subjecting the gains to the higher income tax rates. In addition, in most cases, withdrawals from tax-deferred accounts prior to age 59½ are subject to a 10% early withdrawal penalty. And required minimum distributions must begin no later than April 1 of the year after which you turn age 70½. Investors also have the ability to time gains within their taxable accounts to take them in low-tax years (years when their marginal tax rate might be lower) and to potentially take losses in high-tax years.
 
Second, holding equities in taxable accounts creates the potential for a step-up in basis upon death, thus avoiding all income taxes.

Third, holding equities in taxable accounts creates the potential for tax-loss harvesting, which can allow investors to reduce their tax bill.

Fourth, holding equities in taxable accounts allows investors to donate appreciated shares to charities, avoiding taxes altogether.

Fifth, holding international equities in taxable accounts allows an investor to take advantage of the foreign tax credit (FTC). The FTC has no value in tax-advantaged accounts.   
Keep in mind that the location decision is a preference. Investors typically should choose to first fund tax-advantaged accounts. Thus, if you don’t have sufficient room in your taxable account to accommodate all of your equity holdings, you might still want to hold them in a tax-advantaged account.

Another bit of conventional investment wisdom that is typically wrong is that investors who don’t have enough room for their equities in tax-advantaged accounts should own them inside of variable annuities (VAs). For all the reasons that investors should prefer to hold equities in taxable accounts versus tax-advantaged ones, they should also prefer to hold them in taxable accounts and not VAs.

Holding equities in a VA causes the loss of the potential for a step-up in basis for the estate of the investor, the inability to harvest losses, the inability to donate appreciated shares to charity and the loss of the foreign tax credit. And should the buyer need liquidity prior to age 59½, unless the distribution takes the form of a life annuity, an additional 10% penalty would apply.

Besides all that, there is another reason to avoid VAs: their high costs. The only equity asset class that is likely to make sense for holding in a VA is REITs — because their dividends don’t qualify for preferential tax treatment.   

Summarizing, the tax advantages and the availability of tax-efficient funds such as index funds, ETFs and tax-managed funds should typically lead investors to prefer to hold equities in taxable accounts. Additional discussion with your tax consultant is warranted.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2007, Buckingham Family of Financial Services.

Tax Law Changes to Charitable Contribution Rules

As a result of the enactment of this year's Pension Protection Act, the
IRS will be cracking down on contributions you plan to deduct on
your tax return.  Here are two important changes from this new law
that could affect you:

NEW RECORDKEEPING AND SUBSTANTIATION REQUIREMENTS:

The Pension Protection Act now requires taxpayers to maintain
documented written records of ALL contributions of money and
property regardless of the amount.  Substantiation may consist of
bank records, receipts, or written communications from donors.
Documentation must include the following elements:

1) Date of the contribution
2) Name of the donee
3) Amount of the contribution.

Record-keeping requirements can no longer be satisfied by keeping a
journal of contributions.  For example, this would seem to
eliminate deductions for currency contributions made to church
collection plates.

The provision is effective for tax years beginning after August 17,
2006 (for most calendar year individuals and companies, this would
mean 2007.

CONTRIBUTIONS OF CLOTHING AND HOUSEHOLD ITEMS:

The donor is now required to maintain written records of the
donation, regardless of the donated property's value.  If the
deduction for the donated property is $250 or more, the taxpayer
must have a contemporaneous written acknowledgement from the donee.
We recommend that you keep a detailed listing of each item of
clothing and the value you assigned with the receipt from the donee.

The Pension Protection Act of 2006 now prohibits deductions for
charitable contributions of clothing or household goods unless the
items are in good or better used condition. The IRS has the
authority to deny deductions for items with minimal value, such as
socks and underwear.

This provision is effective for donations made after August 17,
2006.

Many of our clients have found the following resources helpful:

· www.deductionpro.com—For $19.95 per year, this product will help you track and determine the value of non-cash donations, as well as generate detailed reports to provide your tax preparer.

· www.itsdeductible.com—Much the same as the above, for $19.95 per year.

· www.charitydeductions.com—This website is $19.95 per year.  This product lets you store your information online.  You then have the choice to either print out reports or let your accountant access the information directly.

Pursuant to federal regulations imposed on practitioners who render
tax advice (IRS Circular 230), we are required to advise you that
any tax advice contained herein is not intended or written to be
used for the purpose of avoiding tax penalties that may be imposed
by the IRS.

New Tax Law Changes to the "Kiddie Tax"

In our second in a series outlining some new tax law changes, we
outline some changes to the "kiddie tax."  This change comes from
the Tax Increase Prevention and Reconciliation Act of 2005 or TIPRA.

Many parents reduce their income tax liability by shifting income
to their minor children to take advantage of their children's lower
tax rates.  Congress implemented the "kiddie tax" to circumvent
this practice by taxing the unearned income of children under age
14 at their parent's tax rate.  TIPRA retroactively extends this
kiddie tax to children who are under age 18 as of December 31, 2006
whose 2006 unearned income exceeds $1,700.

For example, Michelle, who is age 17 at the end of 2006, has her
own brokerage account with $150,000 of funds invested in corporate
bonds.  Michelle's 2006 interest income from that brokerage account
was $8,000.  She has no earned income in 2006.

Due to the TIPRA provisions, Michelle's 2006 total tax liability is
$3,055, computed as follows:

Adjusted Gross Income (her interest income)  $8,000
Less: the standard deduction                             (850)
                                                                   _______
Taxable Income                                             $7,150

Tax on the first $850 of interest due to
standard deduction                                              $0

Tax on the next $850 of interest using
Michelle's tax rate   ($850 x10%)                           85

Tax on the $6,300 balance of interest using
parent's top tax rate($6,300 x 35%)                  2,205
                                                                   _______
Michelle's total 2006 tax on her $8,000
of interest income                                         $2,290

Under prior law, Michelle's total 2006 tax on her would have been
only $715 ($8,000 - $850 standard deduction = $7,150 x 10% = $715).

Due to the TIPRA provision, Michelle's 2006 tax liability is $1,575
greater than under prior law.  This example shows that this TIPRA
provision is a significant revenue raiser for the government.

Parents who planned to sell stocks or bonds in a child's portfolio
because the child attained the age of 14 in 2006 must now wait or
face higher taxes.  Under the old law, if the stock was sold in
2008, any gains may have escaped tax since the child would
presumably be in a tax bracket low enough to be exempt from the
capital gains tax.  However, if the child is under age 18 in 2008,
the gain is subject to tax at the parent's rate, which is
presumably high enough to trigger a capital gains tax.

Pursuant to federal regulations imposed on practitioners who
render tax advice (IRS Circular 230), we are required to advise you
that any tax advice contained herein is not intended or written to
be used for the purpose of avoiding tax penalties that may be
imposed by the IRS.

Tax Free Distributions from IRAs

This year, the new Pension Protection Act provides an exclusion
from gross income for taxable IRA distributions contributed directly
to qualified charities by taxpayers age 70½ or over.  The exclusion
only applies to contributions up to $100,000 per year.  This means that,
if you are age 70½ or over, you can take a distribution from your
IRA (up to $100,000) tax free, if you give it directly to a qualified
charitable organization.

These distributions are taken into account when calculating a taxpayer's
required minimum distribution (RMD) but do not count against a
taxpayer's charitable contribution limitation.  Trustees must distribute
contributions directly to charities.

For example, Sally directs the trustee of her traditional IRA to make
$100,000 distribution directly to her church.  Sally is 75 years old. 
Consequently, the distribution is not included in her gross income
and does not affect her charitable contribution deduction on her return. 
However, the distribution does count toward her required minimum distribution.

This provision is effective for charitable distributions made after
December 31, 2005 and before January 1, 2008.

Pursuant to federal regulations imposed on practitioners who render
tax advice (IRS Circular 230), we are required to advise you that any tax
advice contained herein is not intended or written to be used for
the purpose of avoiding tax penalties that may be imposed by the IRS.

Taxes are Often the Largest Expense Investors Incur

The following is from Larry Swedrow, investment guru and author of The Only Winning Investment Strategy You'll Ever Need. 

Most individuals will be surprised to learn that taxes can be the largest expense mutual fund investors may face — often greater than either management fees or trading costs. When a mutual fund realizes gains, it must distribute them to investors. Because dividend and realized capital-gains distributions are subject to state, local and federal taxation, after-tax returns are the only returns that matter for taxable accounts.

The impact of taxes on returns can be devastating. When the investment horizon is long enough (25–30 years), an academic study found that taxes could reduce pretax returns by almost 60%. That same study found that the average annual turnover of actively managed funds was close to 100%. Yet research has found that to materially reduce the negative impact of taxes on returns, turnover should be reduced to 20%–25% or less. The typically greater turnover of actively managed funds compared to passively managed funds makes the active approach relatively tax inefficient. Instead of active investing, relying upon attempts to time the market or pick future winning stocks, the passive investor builds and adheres to a disciplined portfolio of diversified asset class components.

Investor Focus
Although the effect of paying taxes may be minimal in any one year, it becomes substantial over protracted periods. A Schwab study measured the performance of equity funds for the period 1963–1992 and found that while each dollar invested would have grown to $21.89 in a tax-deferred account, a taxable account would have produced only $9.87 for an investor in a high tax bracket. Taxes cut returns by 55%. 

Another study covering the period 1979–1998, found that on an after-tax basis only 14% of the actively managed funds managed to beat their benchmark. The average outperformance was 1.3% per annum while the average underperformance was 3.2% per annum. Since there were many more losers than winners, and the average loss was much greater than the gain, the risk-adjusted odds of outperformance were almost 20:1. 

In an interview with Barron’s, active manager Ted Aronson stated: “Once you introduce taxes active management probably has an insurmountable hurdle. We have been asked to run taxable money — and declined. The costs of our active strategies are high enough without paying Uncle Sam.” He added: “Capital gains taxes, when combined with transactions costs and fees, make indexing profoundly advantaged, I’m sorry to say.” He concluded with: “If you crunch the numbers, turnover has to come down, not low, but to super-low, like 15%–20%, or taxes kill you. That’s the real dirty little secret in our business. Because mutual funds are bought and sold with virtually no attention attached to tax efficiency.”

Ignoring the impact of taxes on the returns of taxable accounts is one of the biggest mistakes investors make. After examining the evidence, one study concluded that: “The preponderance of evidence is so convincing. We conclude that the typical approach of managing taxable portfolios as if they were tax-exempt is inherently irresponsible, even though doing so is the industry standard.”

The Winning Strategy
Wall Street Journal columnist Jonathan Clements concluded: “If index funds look great before taxes, their performance is almost unbeatable after taxes, thanks to their low turnover and thus slow realization of capital gains.” The logical conclusion is that, for taxable accounts the already low probability of actively managed funds outperforming a passive alternative are dramatically reduced. Thus, passively managed funds that are also tax-managed should be the investment vehicles of choice for taxable accounts.

Rules for the Prudent Investor, Part IV

This post final part of a four part article from our friends at Buckingham Asset Management on Rules for the Prudent Investor.

Part IV: Observations on Life and Investing
This section includes some observations that apply generally in life and specifically to investing.

1. Don’t treat the highly improbable as impossible or the highly likely as certain
Stocks have provided higher returns than bonds over almost all periods of 20 years or longer, at least in the U.S. So investors assume that, if their horizon is long enough, this will certainly continue to be the case. The result is they take more risk than they should. Stocks, like any risky asset, are risky no matter what the length of the investment horizon.   

2. The only thing worse than having to pay taxes is not having to pay them
Investors who hold a large amount of stock with a low cost basis often refuse to sell because of the tax bill. Unfortunately, large fortunes have been lost because of this error.

Instead, the dominant decision-making factor should be the present asset allocation of the current holdings versus the desired asset allocation that the investor has defined for his or her portfolio within a carefully designed investment policy.

Other considerations, such as tax implications within taxable accounts, have less impact but should be included in the decision-making process.

3. The four most dangerous words are as follows: “This time it’s different.”
Placing faith in the phrase, “this time it’s different,” has caused the investment plans of many individuals to end up in the proverbial trash heap. Getting caught up in the mania of the “new thing” is one reason why the following phrase has become a cliché: “The surest way to create a small fortune is to start out with a large one.”

4. Good advice does not have to be expensive; but bad advice often costs dearly
Most people wouldn’t choose the cheapest doctor, the cheapest attorney or the cheapest CPA. Costs do matter; but it is the value added relative to the cost of the advice that ultimately matters.

Conclusion
These principles can provide investors with resolve to stay the course regardless of market events. For investors, designing and adhering to an investment strategy that addresses their long-term financial goals and their overall ability, need and willingness to take risk is a prudent approach that can serve them well through good times and bad.

Rules for the Prudent Investor, Part III

This post is the third in a four part article from our friends at Buckingham Asset Management on Rules for the Prudent Investor.

Part III: On Diversification
In this section, we address the subject of diversification and the essential role it plays in portfolio construction.

1. The safest port in a sea of uncertainty is diversification across many asset classes
A well-diversified portfolio would typically include allocations to the asset classes of large-cap and small-cap, value and growth, real estate, international developed markets, emerging markets, commodities, and the appropriate amount of fixed income (bonds).

For example, it is not possible to diversify properly using only the S&P 500 Index. Although there would be a large number of holdings, there would not be enough diversification by asset class. Although an investor would receive ownership in 500 companies by investing in the S&P 500, many of them belong to the same asset class. Therefore, investors need to look further than a single index to achieve appropriate diversification.

2. Diversification is always working
Sometimes, investors like the results of diversification in their portfolios, and sometimes they don’t. Most investors are familiar with the benefits of diversification. Done properly, diversification reduces risk without reducing expected returns.

However, once investors diversify beyond popular indices (such as the S&P 500), they must accept the fact that they can expect to be faced with periods, even long ones, when a popular benchmark index, reported by the media on a daily basis, outperforms their portfolio.

The noise of the media may then test their ability to adhere to their investment strategy. Nothing will have changed (diversification will still be the right strategy), yet many investors will make the mistake of confusing strategy with outcome (a strategy is either right or wrong before we know the outcome) and abandon their plan.

Stay tuned for more on Rules for the Prudent Investor.

Rules for the Prudent Investor, Part II

This post is the second in a four part article from our friends at Buckingham Asset Management on Rules for the Prudent Investor.

Part II: On Individual Stocks
In this section, we touch on why investors are advised to avoid trying to “beat the market” by investing in individual stocks.

1. Owning individual stocks and sector funds is more akin to speculating than investing
The market only compensates investors for risks that cannot be diversified away — like the risk of investing in stocks versus bonds, or corporate bonds versus Treasury bonds. Investors should not expect the market to compensate them for risk that can easily be diversified away (the unique risks related to owning just one stock or one sector fund). Thus, owning one large-cap growth stock has the same expected return as owning an index fund of large-cap growth stocks, but it obviously entails far greater risk. Prudent investors only accept risk for which they are compensated in the form of higher expected returns.

2. Costs accompany each strategy
To outperform the market, an investor has to first identify a mispriced security and then be able to exploit any mispricing after the expenses of the effort. Strategies have no costs, but implementing them does. Countless investors have tried to exploit what they believed were mispricings (and perhaps even were), but found that the trading and other costs of implementing their strategies exceeded the potential benefits.

3. It is wise to avoid investment products with “club” appeal
We feel that hedge funds and private equity (including venture capital) fall into the same category, one that appeals to investors by offering them the possibility of achieving superior returns while appearing to extend invitations to an elite group of investors. Recently, however, both the hedge fund and private equity industries have lowered their minimums significantly. In addition, many of these vehicles turn out to be more expensive than they are expansive for an investor’s portfolio.

Generally, investors should not invest in a security without fully understanding the nature of all of its risks. In addition, they should avoid investing in an investment product purely for the sake of its inherent complexity or exclusive nature. Such products are designed to be sold, not bought; the complexity is likely to be designed in favor of the issuer/seller, not the buyer.

Check back for more on Rules for the Prudent Investor in the coming weeks.