Image credit: David Shankbone, Wikipedia Creative Commons
By Kelly Greene, Liam Pleven, Laura Saunders, Dawn Wotapka and Jason Zweig
Sept. 13, 2013 4:41 p.m. ET
There is nothing quite like living through a financial cataclysm to teach you what really is important when it comes to your finances.
Or is there?
It has been five years since the collapse of investment bank Lehman Brothers Holdings, a shock point in an era that saw the takeover or shutdown of many household-name financial institutions and the meltdown of the stock and housing markets. Despite a government bailout of financial firms costing hundreds of billions of dollars, 8.8 million jobs and $19.2 trillion in household wealth were lost, according to a U.S. Treasury report on the crisis.
But many investors remain confused about what they should take away from those tumultuous years. People still are wrestling with fundamental questions about how to manage their finances.
On the one hand, the rebounding stock market has made some investors comfortable again with taking risk.
“People’s memory has been completely erased,” says Mark Cortazzo, a certified financial planner in Parsippany, N.J. “They want to dial up risk, even though they’re five years older and five years closer to retirement.”
At the same time, many remain wary of stocks and worried that the markets could face more upheaval in the future.
A Gallup poll conducted for Wells Fargo and released Friday found that respondents were more worried about another crisis occurring during their retirement than they were about running out of money or working in retirement.
Some investors are ramping up savings, assuming they can’t rely on market returns to fund future needs. Others are seeking alternative sources of income, potentially exposing themselves to unfamiliar risks.
The financial crisis taught some basic lessons that could help investors navigate the postcrisis landscape and put themselves in a stronger position if the fears of a repeat are justified, experts say.
Among those lessons: sticking with a strategy and avoiding panic. Sally Evans, a 61-year-old pharmaceutical-industry sales analyst in the Chicago area, recalls her friends “bailing from the market,” even as she increased her retirement-account contributions and invested more aggressively in stocks.
Ms. Evans says she was following the example of her 89-year-old father, who “taught me that you haven’t lost it until you’ve sold it.” Now, as she gets ready to retire next year, she is pulling back on her more aggressive investments, focusing on stocks that pay dividends and diversifying her portfolio.
Other important lessons, according to experts, include building in flexibility in the timing of retirement withdrawals, avoiding too much housing debt, keeping tabs on your broker and investments, harvesting tax losses, scaling back on risk in college investments for teenagers and avoiding unnecessarily complex investments.
Here is what investors need to know.
Retirement timing matters.
Before 2008, few financial planners focused on what is called “sequence risk”—the danger that big losses early in retirement can upset your plan to live off your investments.
For example, say you had retired on Jan. 1, 2000, with a 4% withdrawal rate—meaning you withdrew $40,000 from a $1 million portfolio that year, then increased that amount the following year to $41,200 to include a 3% raise for inflation, and so on.
If you had a portfolio of 55% stocks and 45% bonds, using a model created by investment firm T. Rowe Price Group, you would have lost a third of your savings by the end of 2010. That would have left you with a 33% chance of it lasting 30 years.
Second, get ready to adjust your withdrawal rate. With the huge market swings of recent years, retirees no longer can set their withdrawals at a certain rate and leave them there, says Christine Fahlund, a senior financial planner at T. Rowe Price.
She now encourages retirees to evaluate their withdrawal rates at least once a year and lower them if necessary to avoid permanent damage to their nest egg. That could mean postponing discretionary purchases, such as a cruise or new kitchen cabinets.
The most common strategy for adjusting a withdrawal after you take a hit: forgoing a cost-of-living raise. In the example above, you could quit giving yourself the 3% cost-of-living raise for three years.
Doing so after each bear market in the past decade would have given you a 69% chance of your savings lasting 30 years, says T. Rowe Price.
It also is a bad idea to accelerate your retirement date following a market run-up. “People subject themselves to sequence risk if they alter their plans and retire early because the markets have done well,” says David Blanchett, Morningstar’s head of retirement research. “You don’t have the same ability to recover losses as you would have if you had stayed on the job,” because you no longer are making new contributions to your retirement accounts.
Getting out of stocks on March 9, 2009—the day the S&P 500 closed 57% below its peak—might have seemed smart. There was no way to know the index was about to begin a rebound that has continued more or less to the present.
But the forgone gains could have been profound. If an investor had moved $100,000 into bonds that day, it would be worth $124,033, based on the total return of the Barclays U.S. Aggregate Bond Index through Thursday, according to investment researcher Morningstar.
By contrast, an investor who put $100,000 into a portfolio comprised of 60% stocks and 40% bonds and left it alone would now have $214,080, based on the total returns of the S&P 500 and the Barclays bond index, over the same period.
The next time there is a crisis, it probably won’t be any easier to figure out which investment decision reflects wisdom or panic. But the differing outcomes for the two hypothetical investors amid the 2009 meltdown highlight the risk of being wrong.
One way to hedge that risk is by rebalancing. Richard Sylla, a professor of economics at New York University, says investors should choose what percentage of their portfolios they are normally comfortable allotting to stocks and bonds, and return to that balance on a regular basis, perhaps every year or six months. “A certain amount of discipline is needed to do that,” he says.
The payoff is that such investors regularly push themselves toward a profitable goal: buying low and selling high.
If stocks have shot up and bond prices have fallen, for instance, an investor’s 60% stocks/40% bonds portfolio might have moved closer to 70% stocks and 30% bonds. Rebalancing back to 60% and 40% could mean scooping up relatively cheap bonds while locking in stock-market gains.
Keep tabs on your broker.
Global stock markets fell roughly 50% between summer 2007 and spring 2009. Even though stocks have since more than doubled, the shock of losing half your money in a year and a half might well have taken away some of your appetite for seeking risk. But your investment adviser might not have changed along with you.
Reviewing your investment objectives and risk tolerance at least once a year is critical to ensure that your strategy remains appropriate, says Lance Gunkel, chief operating officer at Sherpa Investment Management in West Des Moines, Iowa.
If the past five years have taught you that your tolerance for risk has gone down, meet with your adviser and tell him so. Ask how he will take that into account. He should recommend gradual, tax-efficient steps, such as incrementally reducing your exposure to stocks, allocating new money into lower-risk investments and building up your cash reserves—not a sudden, sharp overhaul of your account.
If your adviser suggests drastic action, or seems evasive or defensive, then get a second opinion. Seek out a fee-only financial adviser in your area. (You can start your search at www.napfa.org.) A good second opinion, advisers say, will help you determine the level of risk you are comfortable with, set realistic expectations for future returns and find ways to lower your fees.
It generally shouldn’t cost more than $500, says Gary Karz, an investment adviser in Los Angeles. Many advisers will offer a second opinion gratis—but be on your guard lest they use the free assessment as a marketing come-on for their own services.
Look under the hood of your college-savings plan.
So-called 529 college-savings plans—those state-sponsored accounts for college savers in which earnings are tax-free as long as they are used to pay for qualified higher-education expenses—typically let account holders select once a year from a number of investment options.
They include “age-based” tracks that move money from stocks into bonds and cash as the child grows up. By the time the student starts college, less than 20% should be in stocks in order to limit potential damage in a bear market.
That wasn’t the case in 2008. A number of states offered age-based portfolios with a higher portion of stocks to college enrollees. Others invested their fixed-income portions in funds heavily weighted in mortgage-backed securities that tanked. Assets in 529s fell 21% in 2008 to $88.5 billion at the end of the year.
Since then, a number of plans have scaled back the risk in their age-based plans, realizing belatedly that “a lot of parents assumed their accounts really could not lose money,” says Joseph Hurley, founder of information website Savingforcollege.com in Pittsford, N.Y.
College-savings plans also have added federally insured certificates of deposit, bank savings accounts and age-based options that scale back stock investments for older children. The trade-off is often low interest rates, Mr. Hurley says.
Still, the income-tax break on any earnings used to pay legitimate college expenses, coupled with the ability to avoid borrowing costs for tuition later, could make even lower returns in a 529 plan equivalent to higher returns outside of one—and better than not saving at all.
Harvest your losses—but be realistic about their value.
There is a bright side for investors who suffered losses in their taxable accounts: Losses on the sale of a holding can offset other capital gains, or they can shelter ordinary income up to $3,000 a year, or both. Losses larger than that amount roll forward for future use—with no time limit.
The strategy known as “loss harvesting” refers to selling an investment that has dropped in value, realizing a loss and repurchasing the holding soon after. Tax rules require sellers to wait 31 days to repurchase the same investment, but it is OK to swap two holdings that aren’t the same—such as a large-company index fund and a total-market index fund.
The 2008 market drop provided an excellent opportunity for loss harvesting, given the near 40% decline for the year.
But the economic benefit of loss harvesting is often modest, says Kent Smetters, a tax expert and professor at the University of Pennsylvania’s Wharton School. He estimates the tax savings from taking a $100,000 loss at the end of 2008 that was used before 2013 to be less than $200.
“Too often, strategies promising ‘tax alpha’ count the upfront tax savings from harvesting but not the higher taxes later,” he says. That is because the repurchase lowers the holding’s “cost basis,” or the starting point for measuring future taxable gain. When the position is ultimately sold, the tax bill will be higher than it would have been on the original investment, unless the investor dies holding the position or donates it to charity.
The benefit of loss harvesting can shrink further from many factors, including high transaction costs or increases in capital-gains taxes, which hit many this year, says Paul Robertson, a senior portfolio manager at Bernstein Global Wealth Management.
The biggest benefit of loss harvesting is often psychological, says Mr. Smetters: “It gives investors who are facing losses a feeling of control.”
Home prices don’t always go up.
Before the housing crash, many buyers didn’t think twice about paying inflated prices or taking out second mortgages to fund everything from home improvements to lavish vacations.
Then home values tumbled by one-third or more, leaving millions of Americans “underwater,” or owing more on their homes than they were worth. Some homeowners, feeling they could never recover, walked away. Others sold their homes for less than they owed on their mortgages.
Five years after the crisis, 5.3 million U.S. households—11% of mortgage holders—remain in homes worth less than their loans, according to Lender Processing Services, a mortgage-data provider. Being underwater can make it tougher to move for a new job or refinance to get a lower interest rate.
Still, it is an improvement from early 2011, when a third of mortgage holders owed more than their homes were worth.
Now, home buyers are sticking largely to plain-vanilla, 30-year fixed-rate loans and borrowing less than lenders say they can afford. In July, 83% of home buyers selected such loans, compared with 60% in July 2005, according to the Mortgage Bankers Association.
Adjustable-rate loans fell to 7% of July’s mortgage applications from 31% in 2005, according to Freddie Mac. Lenders have tightened requirements as well, making borrowers document income and retirement savings.
Americans will never stop counting on rising home prices. But the crash made them realize that housing should be purchased for shelter—and while values might increase, there are no guarantees.
Don’t invest in what you don’t understand.
Credit default swaps. Option adjustable-rate mortgages. Collateralized debt obligations. The products that did the most damage to investors during the financial crisis were often the most complex ones. Even the financial wizards who sold them were at times caught off guard by the fallout.
Over the past five years, regulators have ramped up scrutiny. But there still are many financial instruments that are difficult to understand and companies whose balance sheets could contain hidden traps.
Investors should have a simple response when a product or company seems too complex, says Janet Tavakoli, who runs Tavakoli Structured Finance, a consulting firm in Chicago. “They should run far and run fast,” she says.
There is evidence some investors are doing the opposite. They have plowed billions of dollars into funds that track investments such as master limited partnerships and floating-rate loans, which can contain risks that average investors might not fully comprehend.
Warren Buffett famously says he invests only in businesses he understands. John Bogle, the founder of Vanguard Group, outlined his philosophy in a speech he gave just before the Internet bubble burst.
“To earn the highest returns that are realistically possible, you should invest with simplicity,” he said in 1999. “Rely on the ordinary virtues that intelligent human beings have relied on for centuries: common sense, thrift, realistic expectations, patience and perseverance. Call them ‘character.’ And in investing, over the long run, character will be rewarded.”
Source: The Wall Street Journal