Wealth Clarity Blog

Hot off the press is the latest edition of the Highland Investment Snapshot; our best thinking on 2012 investment and economic themes and outlook.  As most investors are aware, this time in history is fraught with a tremendous amount of conflicting data and unique risks. In our opinion, this environment is creating some interesting investment opportunities for those willing to put the broad range of global economic and political concerns in perspective.  I hope you find our reading of the tea leaves to be insightful and helpful.

This link will take you there:  Highland Investment Snapshot 2012

Not everyone needs to withdraw money from their portfolios right now, but for many, it will happen sooner or later. 

With uncertainties high and appetites for risk as low as government bond yields, it’s more important than ever to stretch your portfolio dollar longevity.  Becoming a miser and living in fear isn’t the outcome that most of our clients want to pursue to avoid running out of money.   

Instead, consider these five keys to thinking about your portfolio that involve being a bit creative and adapting your strategy to the circumstances.  If done correctly, the hope is you can live life more fully, and make your money last longer, regardless of the economic environment. 

1)      Withdraw less from your portfolio when you have negative returns.  This can range from simply not increasing your withdrawal for inflation after a negative year to reducing spending by 10% after a severe bear market (like 2008).  While not pleasant, these adjustments are not materially life changing and can provide more future security, leaving room to increase withdrawals when the economic environment improves. 

2)      Sell bonds, not stocks to fund withdrawals when stocks are down.  By following this strategy, your portfolio’s risk profile increases slightly during a down period, but it helps avoid the permanent damage caused by selling equities when they are low. 

3)      Bank profits in good times.  When investments exceed their target allocations due to appreciation, take gains and place in cash; then use this cash to fund future withdrawals.  This builds a war chest to fund your needs during bad times.  

4)      Bet on the probable – not the possible.  Position your portfolio on the highest probability event and stay away from trying to pick either extreme.  Portfolios designed with extreme events in mind can dramatically impact your ability to live fully if your thinking or timing is wrong.  Avoid making big changes based on fear, greed, or what everyone else is doing.  Rather, make adjustments centered on empirical evidence. 

5)      Broad global diversification, while boring, is still the crown jewel of making your money last.  Having meaningful exposures to asset classes that don’t correlate well to one another helps smooth portfolio returns, in both expansionary and recessionary periods.  It also reduces the risk that you’ll make an emotional decision amidst a severe downdraft that could sabotage your long term returns.   

These strategies allow you to focus on things you can control and should let you concentrate on your life rather than the economy.  By making minor adjustments along the way, you ought to be able to withdraw more over your lifetime than if you have a static plan.   

Guyton and Klinger, pioneers in the study of sustainable withdrawal rates, illustrated this concept (and some of the strategies listed above) in their Journal of Financial Planning paper titled “Decision Rules and Maximum Initial Withdrawal Rates.” 

Guest post by Colleen Kroeger, Director of Client Care

Looking for a way to be smart and stay positive (at least from an attitude perspective) in the current market situation?  

Now may be a good time to consider both sides of the Roth IRA conversion coin:  if you did a full or partial conversion in 2010 and lost substantial market value afterward, you may want to recharacterize your conversion back to a traditional IRA; likewise, if you’ve delayed converting your IRA to Roth, you may want to consider converting for the 2011 tax year.  

Recharacterization

Recharacterization – “undoing” your Roth conversion – is an option to consider if the amount converted declined in value during the year.  The deadline for recharacterizing a 2010 Roth conversion is October 17, 2011. 

A unique tax planning option was offered to individuals who converted to Roth IRAs in 2010: taxpayers could spread the associated tax over 2011 and 2012.  However, the decision to recharacterize gets tricky if you elect this option and only plan to recharacterize a portion of your original conversion.  If you intended to spread the tax from your 2010 conversion over 2011 and 2012, the only way to do so if you recharacterize is to re-convert half in 2011 and half in 2012.  There is some risk of re-converting at higher values with market volatility so high, potentially undoing the value of recharacterizing in the first place. Keep in mind if you recharacterize, you need to wait 30 days to re-convert. 

Some of our clients converted to Roth IRAs during 2010.  In response to the market’s volatility we recently compared the conversion amounts to the current values. The change in values since conversion ranged from approximately -6% to +5%.  Because of continued market volatility, we found that it may not be valuable to consider recharacterization unless the converted amount dropped more than 10%.  Although our ultimate recommendation for those clients was to not recharacterize their conversions, the exercise sparked meaningful and valuable conversations with our clients, allowing them to understand the strategic relationship between this tax “tail” and the investment “dog.” 

Conversion

With many accounts posting negative returns year to date, now may be a good time for a partial or full conversion. Taxes due from a conversion are dependent on a number of things including investment earnings and deductible contributions. Just make sure you have adequate cash on the sidelines for the tax bill due in April 2012. 

We suggest you consult with your wealth and tax advisors if you are considering either of these strategies. For additional ideas, take a look at this interesting article.

Employee stock options can be a great way to achieve substantial wealth.  The difficulty is it can disappear quickly if not addressed properly. 

Something that has really dawned on me after helping executives with these decisions over many market cycles, is that option wealth is usually a once in a lifetime event.  Not realizing this, many executives place more emphasis on where they think the stock will go than on their long term goals.  This is further complicated by the general excitement they can have for a company they founded or helped build to be very successful.

Recently, I was helping an executive that had the majority of their net worth in options think through the issues.   I thought it might be helpful to list some key questions we reviewed that would be relevant to anyone in this fortunate, yet complex situation.

1)      Does the current after tax value of the options allow you to be financially independent today?  If so, it may mean it’s time to take risk off the table to secure the future.  If not, you may want to let run since you are still in wealth accumulation mode.

2)      What are the tax implications?  With some stock options, you can pay less tax if you exercise and hold the stock for at least a year.  With others, there’s no tax benefit to waiting.

3)      What are the risks of exercising and holding?  The risks are often higher than the benefits.  Upon exercise, there may be taxes.   If the stock declines, you’ll still be on the hook for the taxes.  Also, the expected return of the stock would need to be sufficiently high to offset the concentrated holding risk.

4)      Who is affected by this decision and how are they impacted?  When you explore this question, you might realize it’s more than just your family.  For example, if you have philanthropic goals, there may be many people beyond your family that will be impacted.

5)      Has your lifestyle expenses increased ahead of exercising the options?  It’s important to realize option wealth isn’t real until the options have been exercised and sold.  Up until that point, the wealth is on paper and subject to considerable concentrated holding risk.  If your current lifestyle is dependant on the current option value, it’s crucial to take some risk off.

The decision points around stock options can be complex, but they are surmountable.  Since future option values are so unpredictable, finding the time to formulate a strategy around realizing the option wealth is essential. 

If you would like me to address other issues about employee stock options, feel free to drop me a line.

With stocks coming off their worst decade ever and the risk of recession rising, I’ve had many people ask me if it’s time to abandon stocks.  While this feels like the right thing to do, don’t do it!  Why? The greatest risk most people face is outliving their assets, and stocks combat this better than any other asset class.  I’ve found in times like these, it’s easy for investors to forget about purchasing power risk and focus entirely on today’s headline, as if they had the time horizon of a fruit fly.

Taking inflation into account, the real return on “safe” assets like bonds and cash is negative at today’s rates.  Since bond yields can’t go much lower, the only major move from here is up.   This means that in addition to earning a negative real rate (including inflation), you also risk losing principal on the “safe” part of your portfolio.   Alternatively, stocks are achieving an earnings yield over 8%, which is about 6% more than 10-Year Treasuries.  This, combined with strong balance sheets, high cash positions, and low valuations makes stocks fairly appealing despite all the economic uncertainties. 

Unfortunately, the price to be paid for this level of earnings yield is gut-wrenching volatility.  Hard as this is to stomach, this isn’t as bad as it seems.  If you are allocated properly for your goals and time horizon, you shouldn’t have to sell much at the bottom.  For example, a balanced portfolio would likely yield 2.5% today.   Sustainable portfolio withdrawal rates range from 3% to 5%, depending on an individual’s age.  As long as annual withdrawals are in this range, the most that would need to be sold in a given year is 2.5% of the starting portfolio value.  

I think another reason stocks are important is our changing world.  With the rise of the emerging markets, millions of consumers are entering the middle class each year.  As they earn more, they buy cars, houses, furnishings, appliances, and expand their diet.  This increases the demand on natural resources, which will likely push prices ever higher.  Companies adapt and take advantage of these changes in ways the consumer cannot.  For example, they sell to all these new customers to get increasing revenues and profits, and can raise prices if necessary.  If you own their stocks, this benefit flows through to you.

Over the years, I’ve seen many people make the mistake of thinking they can move to the sidelines until there’s more certainty.  For sure, this is sometimes a good idea.  Unfortunately, I usually see people make emotional decisions to sell stocks after they have already fallen.  Then, they sit out until all is well with the world only to pay much higher prices when they buy back in.  This is why studies by Dalbar Inc. continually show that the average investor vastly underperforms the market due to bad timing.

In the end, balance is essential.  Approaches suggesting “all stocks” or “all bonds” are too extreme for most situations.  Wealth preservation certainly calls for a healthy amount of bonds no matter how low yields go.  Investors should also hold other asset classes such as cash, natural resources, real estate, and hedge funds.   Further, valuations and the economic environment should be monitored to determine if adjustments are prudent.

I think the Wall Street adage “the hard trade is the right trade” is worth keeping in mind especially when emotions are high.  At the moment, holding stocks amidst all the uncertainty is the “hard trade.”  With earnings yields high and fixed income yielding so little, and long-term inflation risks stemming from a changing world, maintaining a meaningful allocation to stocks is the “right trade” today.

Our recent investment snapshot posed this question: “Is the current economic crisis a ‘soft patch’ or the beginning of a double-dip recession?”  I’m starting to wonder if we aren’t instead in a mud puddle.  I recently heard this term used to describe the space between soft patch and recession, and it resonated with me.

In short, our economic outlook is messy – muddy, in fact.  Yesterday’s stock market response showed some of the pent-up concern and frustration with our political circus, our persistently stuck unemployment, and the slow (or absent) economic growth that is lingering like a fog over any sense of confidence.

Is this “Groundhog Day” as it relates to the recessionary period starting in 2008?  Are we heading back towards a repeat of that time frame?  I really don’t think so, primarily because the backdrop is different this time around.  The consumer has taken steps to deleverage and in fact is saving more; businesses have gotten leaner and are generating decent levels of cash flow; and economic indicators including auto sales, home starts, and unemployment are already hovering near their lows.  It doesn’t mean they won’t move lower, but our economic dashboard is already anemic and that isn’t news.  (One important caveat: the European debt crisis could continue to have material global effects.)

Objectively, equity valuations are below historical averages on a price to earnings basis, and the earnings yield (inverse of the P/E ratio) is trending well above 10-year Treasury rates.  This is something even Warren Buffett likes to see!  When compared to other investment alternatives, including negative real rates of return on money market funds, growth assets should not be arbitrarily put in the dog house.

I have found that one healthy way to look at your portfolio is to use the following exercise:  assume that your portfolio is sitting in cash today instead of the current positions you may hold.  Then, look at all of your possible investment alternatives from a risk and return standpoint and ask yourself how you would you allocate the money if you had to right now.  Many times investors can get anchored to their existing holdings too strongly, especially when viewed through the lens of trading costs, unrealized gains/losses, and taxes.  If you try to position your portfolio using the approach above, you can minimize the emotional challenges of making investment decisions.

So, here are a few investment keys for working through this financial mud puddle while keeping you moving towards your goals:

1.  Focus on fundamentals more than you focus on the news—now is the time to hone in on the facts and not get blown around by the ever increasing list of “experts” espousing fear (in most cases.)

2.  Stay agnostic about the investment choices you have—remember that interest rates are at historically low levels, and cash is paying virtually nothing.  This isn’t the case in equities, nor in a few other spaces.  I’m not suggesting increasing your risk posture without great consideration – instead, focus on objectively seeking value where it exists.

3.  Don’t change your investment philosophy or strategy now—my experience has shown that successful investors hold tighter to their investment approach during times of uncertainty.  Better to have an approach and philosophy that you believe in (even if it’s not perfect) than to not have one at all, because the damage caused can be material.

4.  Be nimble—the world changes quickly, and the pace of change continues to increase. Make sure that your investment approach has the ability to make tactical shifts as new information emerges.

5.  Favor quality and cash flow in this potentially low growth environment—going forward, as noted in previous posts about the “New Normal,” adjusting your return expectations downward and looking at cash flow as an important part of return will be critical.  Don’t get seduced into reaching for yield or outsized returns.

How can you work through these types of world stress points?  Be resilient.  Be a survivor, and not a hero. Feel free to contact me if there is a specific question you would like me to address.

Young wealth creators (Gen X and Y), many in the social media industry, are opting for more self-directed financial advice than previous generations did.

A recent survey done by Spectrem Group, the Chicago based research firm that focuses on the affluent and retirement markets, found that millionaires ages 45 and less were not as interested in seeking the advice of financial advisors, and felt it was too expensive; the younger the age (especially the group under 35) the stronger the belief.

While this is concerning for the investment business as a whole, I believe it’s equally as dangerous for the young wealth creators and here’s why: Continue Reading »

As the memory of the 2008 global financial wake-up call starts to recede ever so slightly and we are starting to see signs of normalcy again, I wanted to make sure that you have taken the steps to adjust your investment discipline and strategy that takes into account the new investing world (new normal) and the new rules that will be required going forward.  If you hit the proverbial snooze button on the first alarm several years ago, consider this the equivalent of your second wake up call.  Don’t fall back asleep and continue dreaming that you don’t have to do anything different.  In my opinion, that would be a huge mistake.

This month is roughly the two year anniversary of when the financial world was starting to unwind in a way that we haven’t seen in my or many wealth creators lifetimes.  The financial shocks that really started hitting about that time including Lehman Brothers bankruptcy, and Merrill Lynch sale, caused us at Highland to make a bold change in our investment strategy:  We raised a significant amount of cash.  This was the beginning of investment process changes that have continued and been refined over the past couple of years and will be a material part of our decision making going forward.

Continue Reading »

If you missed our webinar earlier this month, you’re in luck!  Click this link for playback of the Preserving, Protecting, and Enhancing Wealth in the New Normal webinar. Slides, audio, and tips.

Sorry you missed the ‘live’ webinar, we’ll let you know when our next one will be.  In the meantime, do you have any questions or feedback for us?

It’s the third Friday, which means it’s our third and last guest sports blog!

Guest post by Daniel McGilvray, vice president of investments, Highland Capital Management

During the U.S. Open at Pebble Beach a month or so ago, Dustin Johnson lost a three shot lead going into the final round on Sunday and actually ended up outside of the top 10. Justin Rose followed the week after at the Travelers Championship by blowing a three shot lead over the rest of the field and did not end up even coming in the top five. Both of them seemed to lose the strategy that got them to the top of the leader board in the first place. They went from making great shots to getting cautious to making horrible shots to try to make up for the cautious shots and losing the lead. Contrast that with what happened this past weekend with a virtual no name in golf: Louis Oosthuizen. He went into the final day of the British Open at St. Andrews leading by four strokes and actually EXTENDED his lead by a few strokes on the final day. While he adjusted his strategy to be slightly less risky, he stuck with his overall game and did not get too cautious.

It can be the same way at times in investing…we stray from our originally intended strategy because things get “too bad” or there’s a new “normal” or new “paradigm”.  At Highland, while we make tactical over weights or under weights at certain times, we work hard to come up with the right strategic targets for clients as the anchor to ensure that the underlying investments do not stray too far from target (high or low) and get too far away from the originally intended strategy. Without those “anchors” to make sure you don’t stray too far from the original strategy, you could easily end up losing all the gains you’ve made and possibly even going below what you originally had if there is no process to assure some money is taken off the table and gains are harvested (or that funds are added to those areas that underperform over an extended period of time).

In this manner, an investor can ensure that they do not lose the lead (or are unable to ever get back losses). An obvious example of this is the advisor/investor who gets conservative near the bottom of the markets or aggressive near the top of the markets. Bad timing in either account can cause losses to persist. So remember, stay anchored to your long-term strategy.