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Wealth
"Myth-Management": Debunking Popular Misconceptions about How to Invest Your
Wealth
By Vistage
speaker Peter Mallouk
Investing is a
complex, sophisticated activity. If it were simple, we would all be rich.
At the same time,
investing requires a personalized approach that doesn’t lend itself well to
cookie-cutter solutions. Time and again I see investors get into serious
trouble by trying to apply very broad rules of thumb to their individual
investing situations.
With that in mind,
here are some popular investing "rules of thumb" that can lead investors
astray:
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Rule of thumb:
To determine the appropriate asset allocation, subtract your age from 100.
For example, if you’re 60, 60 percent of your portfolio should be in bonds
and 40 percent in stocks.
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Reality:
Your asset allocation depends on the four building blocks of every
investment portfolio: what you have, what you need out of it, when you
need it, and the risk you’re willing to take. The starting point is to
work with a good wealth manager or financial planner, someone who
specializes in analyzing what you really need to get from here to
retirement and can help you put together the "big picture" portfolio that
will most likely get you there. Then you select the investment managers to
carry it out.
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Rule of thumb:
Everyone should have enough life insurance to cover at least five times
their annual salary.
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Reality:
The proper amount of life insurance depends on your survivor needs or
estate planning needs. If you die, how much do you need to pay off the
house, eliminate other debts, put the kids through college and have a lump
sum for your spouse to live on? To the extent your liquid available assets
are not enough to meet this need, make up the difference with inexpensive
term insurance. For those with estate tax issues that cannot be eliminated
with basic estate planning, permanent insurance held inside of an
Irrevocable Trust can provide the liquidity your estate needs. This
requires a sophisticated overlap of advanced estate planning and insurance
planning, so make sure you are dealing with experts.
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Rule of thumb:
Everyone should have at least three to six months’ pay as an emergency
reserve.
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Reality:
Many business owners don’t need a large personal reserve. Instead, put
your emergency reserve into your house, where you will get an immediate
five to seven percent guaranteed rate of return by paying down your
mortgage. In an emergency, you can always take out a home equity loan. In
the meantime, your money is working harder for you.
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Rule of thumb:
You will need 70 percent of your current income in retirement.
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Reality:
You may need more, you may need less; it all depends on your lifestyle.
For example, some people find they need more because they travel a lot,
have higher healthcare costs, and spend more in retirement, while others
cut back and can live on a smaller income.
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Rule of thumb:
All investment assets in your portfolio should be allocated in the same
manner, such as 70 percent stocks and 30 percent bonds.
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Reality:
Divvy up your portfolio so that the right investments are in the right
accounts. For example, you want to place some bond funds inside of IRAs
and retirement plans, where you won’t need to pay taxes on the income.
Place index funds in a taxable account since they don’t generate much
capital gains or dividends anyway. You can increase your portfolio’s real
rate of return simply by having the right investments in the right places.
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Rule of thumb:
Mutual funds are the most cost-effective way to diversify.
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Reality:
Mutual funds do provide diversification and active management, but most
are not tax-efficient. With mutual funds, you may pay taxes even if the
market goes down. Plus, they have high ongoing fees and carry a lot of
hidden charges.
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Rule of thumb:
Investing in
small amounts on a regular basis (dollar-cost averaging) is the safest way
to invest because it smoothes out the ups and downs of the market.
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Reality:
Dollar-cost averaging does reduce risk, but most investors
dollar-cost average the wrong way. Putting money into the market with
every paycheck is not the best strategy. If you have a retirement plan,
fund it all at the beginning of the year, as long as you can still retain
any company match. That way, your money has more time to compound and you
end up with more money down the road. If you invest $15,000 at the
beginning of each year for 25 years and it grows at 10 percent, you will
end up with $69,000 more than by investing the same amount over the same
period but with each paycheck.
The only real rule
of thumb is that for high net worth individuals there are no rules of thumb
in investing and estate planning. Every situation is different.
Managing Your
Wealth
How do you invest
wisely?
Start by creating
your own personalized wealth management plan, which consists of four basic
steps:
1.
Identify
where you are now (your current financial condition).
2.
Determine
where you want to go (establish your financial goals).
3.
Figure
out how much you will need to get there.
4.
Invest
your assets to generate maximum return with minimum risk.
When creating your
plan, set specific, measurable goals. "I want to retire with enough money to
live comfortably" isn’t specific enough. "I want to retire at age 65 with an
after-tax income of $150K a year" is a goal. Or, "I need to have $40K a year
per child to put all four kids through five years of college." These kinds
of goals give you targets to shoot for. Once you have completed the plan,
you can begin to build a successful investment portfolio.
The most important
part of investing is asset allocation, which involves the process of
determining how much to invest in each of the five different asset classes
-- stocks, bonds, commodities, cash and real estate. Diversification
determines how you distribute your assets within each asset class. Asset
allocation is critical because it determines 91 percent of the volatility of
your portfolio. An average investor with the right allocation and average
holdings (mutual funds, etc.) has a much better chance of reaching his or
her goals than a sophisticated investor with the wrong allocation but great
holdings.
Once you have your
investment portfolio in place, reset it and rebalance it once a year. This
demands discipline because it forces you to add money to the worst
performing sector, not the best. In the long run, however, it forces you to
buy low and sell high.
Put investments that
create a lot of taxes, like high-yield bonds and small-cap mutual funds,
into your retirement accounts so you can defer the taxes until a later date.
Put tax-efficient holdings, like municipal bonds and exchange-rated funds,
into your individual accounts.
Once a year, update
your net worth, financial projections, financial plan and risk tolerance and
adjust your wealth management plan accordingly.
Above all, stay away
from the aforementioned investing rules of thumb and remember that investing
is for the long term -- determine a plan and stick with it!
Vistage speaker
Peter Mallouk provides investment planning, estate planning and wealth
management services for high net-worth individuals and families.
Copyright © 2006
Vistage International, Inc. All rights reserved.
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