So What's Your HATE Of Return?

I know this may sound strange coming from an investment professional, but I have come to HATE rate of return discussions.  The way that most companies present investment "rate of return" to their prospective clients is generally so over-simplified and remote in time as to border on the ridiculous, if not in fact fraudulent.

These are bold claims, but allow me just one example to demonstrate its veracity.  I will set out the advice that you might receive from a fictional financial planner, Ed Jones, then you decide if the “rate of return” that he projects for you has any basis in reality. 

To start, we have to imagine where Ed’s advice is going to lead you.  In other words, what would your portfolio look like following Ed’s advice?  I have a pretty good sense of this because I see these portfolios every day.  More than likely your portfolio would consist of mutual funds (or stocks & bonds) in a qualified account (IRA, Roth IRA, 401(k), SEP, SIMPLE, etc).  If Ed is a good guy, he will also have you set up a cash emergency fund in some sort of bank account (savings, money market, CD, etc).  If you have any money left, Ed will make sure that all of your risks are managed through insurance.  And that usually covers it. 

Is there a benefit to this arrangement?  Yes, of course.  You get tax-deferral in your investments and, most often, tax deductibility.  You have cash for any bumps in the road and your insurance will kick in if any major calamity (health or property) happens to you.  So where’s the rub? 

First, the client buys off on the proposal based upon very speculative projections of their investments growing at 6, 8 or 10% rates.  Second, the client is never shown the COST of the decision to arrange their finances this way, which is akin to claiming that gross profit is the same as net profit.  It is this second problem that I will focus on for the remainder of this article. 

What Ed has failed to account for is where you will get the money to make your regular, major purchases (cars, home repairs, vacations, educational expenses for children, etc).  In other words, since he has your cash flow allocated into locked boxes (especially the qualified accounts where you get penalties and taxes for early withdrawal), you have no capital for making major purchases.  So that leaves you with one choice—borrowing—and that is exactly what Ed recommends. 

In other words, when Ed was convincing you to invest in the market for better returns and locking your money into qualified accounts to avoid taxes, he never considered the COST OF FINANCING in his overall economic plan. And therein lies the mistake: Ed takes a micro-economic approach, looking strictly at rates of return and ignoring costs.  But surely these costs are going to be a DRAG on your overall return. 

Ed does this because he knows of no other way and assumes debt to be part of life.  And truly debt is a part of life, which is precisely why he should try to MITIGATE its effects on your financial plan.  He just doesn’t know how. 

But to be fair and to make an accurate assessment of the REAL value of his plan, he ought to DEDUCT the amount of interest that you paid as a result of his advice.  That would be the true NET return and a fairer estimate of the future value of your account.  This would then allow a client to make apple-to-apple comparisons with other investment strategies. 

And truly the STRATEGY is more important than the rate of return.  When a prospective client comes to me and professes to be able to earn 10-12% long-term in the market, I know that I will have the near impossible task of convincing him to consider earning less but COSTING less and doing so on a GUARANTEED basis rather than in the very risky manner he proposes…and have people just forgotten the old adage that “what goes up, must come down?"

What I suggest will just be dismissed as “kooky” talk.  I mean, who wants a 4% return, when they can get “12% long-term with stocks.”  The demonstrable FACT that my real return will be significantly higher (and certain) and their market return significantly less (and at terrible risk) never crosses these people’s mind. 

And that is just ONE reason (there are more) I hate the rates of return being bandied about these days.  But perhaps now you can see why I HATE rate of return discussions.  

How To Choose A Financial Advisor

What does financial planning mean to you? For most it is a periodic visit from a pushy life insurance salesman who never knows when to leave or an occasional visit from a relative, friend or classmate who seems to get out of the business as quickly as he got in. How has that worked out for you?

Well here are three things you should expect from a good financial advisor. And if you don't get these things, you could be making the most expensive mistakes of your life!

1. System of Financial Planning

Your advisor should have a system of financial planning, a philosophy that he uses to direct his actions and guide yours. How else are you going to gauge your success or his?Now this system should be explicit, researched, supportable by data and make sense to you. It is NOT the sales training that a financial representative gets from his company. If that is all your advisor knows, then you will certainly be sold a lot of products, but will rarely know why.

Some ways to find out if your advisor has a financial planning system are:

A. Ask: "What system or process do you use to assess my financial health?" Or more to the point: "What is your financial planning philosophy?" If it sounds like he's making it up as he goes along, he probably is!

B. Ask what books he's read in the past year related to economics or financial planning. Or what books he recommends that comport with his vision. If he stammers, look out.

C. Look for a systematic evaluation process. We call ours a "Financial Report Card".

2. Macro-economic Outlook

What impact does one financial decision have on another? How does each financial choice you make effect your entire plan?These are macro-economic questions and they are critical to your success. Each time you make a money decision, the BIG PICTURE should be discussed and addressed. While it is not possible to avoid every negative potentiality in every decision, you need to be aware of the competing interests to make the best decision for you.

If your advisor fails at #1 above, it is very unlikely that he will succeed here. In truth, if you have a sound system of financial planning, most financial decisions will become pretty clear. On the other hand, trying to solve your financial problems by buying products is akin to trying to shoot a lower golf score by getting a new set of clubs. It's possible, but highly unlikely.

3. Paying Yourself First

A rule for financial success that appears repeatedly in the good literature is: Pay Yourself First. Another way to say the same thing is SAVE, SAVE, SAVE.

Saving (and spending less than you make) is the surest way to economic freedom. If you want to do away with advisors altogether then follow this rule assiduously and you will do fine. However, my experience has been that most people need an advisor to constantly remind them of this rule, encourage them to follow it and insist on saving for savings sake.

Following the rules set out above, the best advisors seek out a system that will account for the macro-economic issues while forcing you to save, save, save. The rest is really up to you. After all, you earn the money so how do you want to use it?

The Best Place To Store Money

Blogger's Note: This article was originally written in September 2009 as an email to clients.

Here are a few excerpts from an article in this month's Financial Planning magazine entitled: Better Than Nothing:

• Clients are piling up cash for both anticipated spending needs and future opportunities. But where do you put it? In the country of the 0% money fund, the 1% payer is king.
• Financial planners are scrambling to find safe places for cash holdings, along with yields that actually enter single-digit territory.
• "I've been using an account that pays 1.05%," says Rich Chambers...."That may not be great but, as I tell clients, that's 105 times better than a money market fund paying 0.01%."
• ....FDIC-insured bank accounts are increasingly appealing. Even so, bank deposits are not fool-proof. Through August, 83 banks failed in the U.S. this year.
• For cash equivalents today, yields above 3% are truly king size. However, investors who don this type of crown may have real reason to feel uneasy. [My note: This last statement refers to the level of risk people are taking with their cash in non-FDIC insured investments.]

Throughout the article, the author quotes "experts" who are heralding 1, 2 and 3% taxable returns, many with market, interest rate and other risks. One more quote:

"An ultra-short fund can lose principal, so these funds are suitable only for clients willing to take a loss."

Now who wants to LOSE money on their cash savings? Imagine if your traditional savings account went down one month and your bank said, "Well yes, but you did earn 1% on the balance."

Incredibly, the safest (at least, historically) and higher yielding option of cash value life insurance was NEVER mentioned in the article. While these experts are willing to put your cash at various risks to squeeze out an extra 2% of TAXABLE yield, there is a very low-risk option that contractually guarantees you a TAX-DEFERRED yield of 3-4% (and it can go higher!). In essence, you could follow their advice OR you could store your cash in a lower-risk "investment" with a return 1.8 times better (and that's 1.8 times better in the lowest tax bracket). Which one do you want?

In bad times you discover good investments. Why? Because you can see what really works versus what was promised in the "good times". Everyone that I know that has adopted the "insurance bank" concept, especially those that apply the "be your own banker principles", has now discovered why I consider this to be the "best place to store money."

If you haven't shared this concept with everyone in your family, now is the time to do so. Let's save them from the advice of planners and magazine reporters who still just don't get it!