March 2010 INTRODUCTION Recent years have been challenging for investors. Several of the articles in this Newsletter focus on some aspect of this subject with the hope that we have all learned some lessons that will help us going forward. We begin by looking back at what the media - and particularly the print media - was saying during the period beginning when the stock market headed down, and then 15 - 18 months later, as the market was about to turn around. That feature article is followed by pieces on what to look for in an "expert," a summary of an address by David Gergen, an alternative way to create a budget, a look at what goes into financial planning, a discussion of the pros and cons of rolling over an IRA into a Roth IRA, and a report of a price reduction at Schwab. As usual, we conclude with "Office Matters." WHAT HAVE WE LEARNED? As it became increasingly obvious late in 2007 and early 2008 that the stock market was sliding downhill, everyone hoped that someone would be able to provide an explanation that would eventually lead to some understanding of a chaotic situation and, ultimately, some control. Lots of people were asking the question, where (and when) will it all end? We thought it might be useful to review that two-and-a-half year period and pay particular attention to what some of the commentators were saying during that time. Memory plays tricks on us, so examining some of the actual data can be helpful if we now seek lessons from the past. In surveying the financial magazines and business sections of newspapers in the last few months of 2007, it is clear that no one, anywhere, predicted the kind of meltdown that occurred in the investment markets, nor did anyone forecast that the global economy might teeter on the edge of disaster. In fact, it is almost impossible to find even one prognosticator who realized that the US economy had already fallen into a recession by the end of 2007. The problems with several US corporations began in September of 2007, with the collapse of Lehman Brothers, the bailout of AIG, and the federal rescue of Fannie Mae and Freddie Mac. Various magazines published in early September just before the US stock market began a slide of more than 50% showed that nobody had a clue that a storm was brewing on the horizon. The Wall Street Journal wrote confidently about Lehman's efforts to secure a line of credit, and the consensus seemed to be that the damage from the burst housing bubble had been safely contained. Recent articles published about the crisis during that initial period show that Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson were caught flat-footed. This data now reminds our readers that while hindsight is 20-20, people at that time had no realistic vision of what was to come. We now move forward to January of 2009. For most of the period from October, 2007 - January, 2009, the stock market lost increasing amounts of money. In January, 2009, economists and pundits were talking about the likelihood of a sustained market drop. Some were predicting that we would experience the investment torture the Japanese had lived with for the past eleven years, when their stock market went nowhere and their fixed income returns were close to zero. Kiplinger's Personal Finance magazine identified the people who had been most correct in their predictions the previous January and asked them what they thought was going to happen in 2009. Not one of them predicted what actually occurred: a dramatic rise in stock prices. Early in 2009, prior to the dramatic stock market turnaround, the chief strategist at Federated Investors told Kiplinger's readers, "The dollar will decline, and it's very possible that inflation will pick up. The S&P 500 index could easily fall to 450 or so [i.e. more than 30%]. This will be a longer-term decline." He then gave readers very bad advice: "Investors should be selling equities and conserving cash." In the same issue of Kiplinger's, the strategists at First Pacific Advisors confidently predicted, "The upturn won't come until 2010, and when it does, it will look very sluggish." The president of Euro Pacific Capital seemed also to miss completely what would happen in 2009. "Interest rates [will] go up. We're going to be in a depressionary environment, but with rising prices and rising interest rates." Equally bad advice was being given right at the bottom, in March, 2009, just before prices were about to reward patient investors with an amazing rally. Consider this evaluation from the March 5 issue of Business Week: "We are looking at a 60% to 70% chance that this bear market is not over," said Robert Arnott, chairman of Research Affiliates, a firm that manages $25 billion. To review what occurred from that point on, we provide the following data: the S&P 500 reached the bottom on March 9, 2009, and rose 71%, as of February 28, 2010. During this time there has been a sharp rise in the value of the dollar, the economic recession - what economists are describing as a jobless recovery - has likely already ended, and both interest rates and inflation have remained low. Several distinct inferences can be drawn from the commentary of last two-and-a half years. The first is that we need to control the natural urge to sell when the market has cratered. Additionally, and more importantly, we must not assume that a man who heads an organization which manages $25 billion necessarily has any idea what the market is going to do in the next year. Said more generally, while experts are often particularly good in looking at the big picture, they often do poorly when they move to the near term, which is often their temptation. So what should an investor do? In previous Newsletters we have suggested that keeping a diary or journal of what you are reading and hearing, and recording your reactions to the same is useful. Such a strategy can help in keeping a cool head. Another suggestion is to contact us at O&A when it appears that the markets could go into a significant decline. We are happy to discuss the realities and emotions of such situations. We at O&A continue to believe that Modern Portfolio Theory (MPT) has a good deal to offer investors in today's economic environment. The major tenet of MPT is to diversify into investments that have historically not all moved together. Diversification across major asset classes is, in our opinion, the most solid and predictable investment strategy for both the short and long run. Our methodology includes buying no-load, managed funds rather than index funds -funds which we expect will enhance return and/or reduce risk. When things go well, they do both. Sometimes, of course, they do neither. But we cannot expect to be right all of the time. In addition, we use closed-end mutual funds in an opportunistic manner to enhance return when the price is right. Unfortunately, we cannot always predict when these opportunities will be available. And finally, we make certain limited judgment calls which we think will increase return in the near term. We often say we are not going to "bet the ranch" on what we perceive to be an investment that will increase returns. But we attempt to modify portfolios a bit by occasionally underweighting or overweighting an investment category and by judiciously using private placement investments for larger accounts. We do not normally make large moves in anticipation of some predicted future. These strategies seem to be the best way of climbing the investment mountain in order to provide reasonable returns. We try always to keep individual client goals as our primary focus so that people will have a minimum amount of anxiety around finances and will meet their long term goals. The wisdom of Warren Buffett provides a good conclusion: "We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now…I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children." GUIDED BY AN EXPERT Too often ordinary people who know a little about one thing or another - car maintenance, cooking, computer operations, finance, etc. - are sufficiently informed in the area that they somehow sense that if they can just "beam in" an expert, they will know what to do with their car, their meal planning, their computers, or their investment strategies. We at O&A urge caution in relying on experts. If this is a path you are likely to take, consider, particularly with financial matters - that your guru should be both broadly and deeply informed, should appeal to a diverse audience, and should have relevant credentials; that it is important for you to know and articulate why this person appeals to you and why this advice may be reasonable; that you know the other side of the position the expert is taking; that you keep your distance and your perspective, knowing not all so-called experts are what they seem, and also knowing that not all are right for you; and, perhaps most importantly, that s/he should be someone you know well - whose work you have read or whose advice you have considered over a period of time. Of course our primary concern is not how you go about maintaining your car or planning meals. We especially urge you to be cautious in selecting experts whose advice you use to make financial decisions. THE USA's FUTURE? David and the newest O&A employee, Susan Otto Goodell, attended the Regional NAPFA conference in Orlando, Florida, in November, 2009. Not surprisingly, they found the conference invigorating and enlightening. Among the keynote speakers was David Gergen, who served as an advisor to Presidents Nixon, Ford, Reagan, and Clinton. He currently works as a journalist and teaches at Harvard. His address demonstrated a comprehensive understanding of the current position of the United States in the world as he asked the question, "What is in store for the United States?" He made a number of interesting points: There is no way that the US can spend its way out of the recession. Nor can we tax our way out. The only way is innovation. The United States is 4% of the world's population but has 25% of GDP. That is a result of innovation. He gave a number of illustrations of how we innovate, among them a story from the late 1930s when we were building 6-7,000 large airplanes per year. President Roosevelt asked how many it would be possible for us to build. He was given the number of 25,000. FDR set a goal for the US to build 50,000 planes a year. At the end of the war we were building 75,000 per year. "That's American innovation." A question we should consider is, What, in twenty-five years, will the headline read regarding where we have come from? Will it be "The Rise of the West?" "The Rise of the Rest?" Another alternative, "The Rise and Fall of the West?" "Obama inherited the toughest job since FDR." "It is regrettable that the Congress has degenerated again into food fights." "We are not going to have hyper-inflation in the foreseeable future. The unemployment rate will keep a limit on that." There are rather straightforward guidelines that should be imposed on mega-banks, but Gergen was not optimistic this will ever happen. His suggestion is the larger the bank, the lower the allowed leverage should be. Many people are talking about the "new normal" (by which they mean that "normal" investment returns in the foreseeable future will be below average). Gergen is not at all convinced. He sees no reason to predict subpar returns in the next few years. We particularly liked the last point because we made the same assertion (along with reasons for our conclusions) in the Newsletter of March, 2009. DO YOU NEED A BUDGET? A budget can be a potentially helpful way to organize personal finances. It can allow us to manage our money, planning for all the discreet categories, including savings. We have often been told that in order to get control of spending, we need to first figure out where our money is going. Then we should be able to determine what spending can be eliminated. Not so, says Kenneth Robinson, a CFP from Ohio and author of the book Don't Make a Budget: Why it's So Hard to Save Money and What to Do About it. Robinson suggests that budgeting gets in the way of saving successfully. Budgeting is tedious and time-consuming, and as a result those who attempt to complete the process sometimes cut corners by simply estimating what is spent in various areas. This can easily leave people no better off in terms of accurately understanding their spending. In addition, what is usually discovered by the budgeting process is that too much money is spent on "desires" as opposed to "needs," and the budgeter is left feeling guilty for over-indulgence, confused about which desires to cut out, and frustrated by the tediousness of the process. It's no wonder that many people who attempt the budgeting process abandon it and retreat to the "spend what's in the checking account" method. Robinson suggests a better solution. First, figure out how much money must be saved. The savings can be for anything: college education, retirement, a trip, or even a rainy-day fund, but it should be savings that one is really committed to. The point is that by determining the amount of money that needs to be saved and then putting that money aside on a regular basis, a workable plan, with savings, can fall in place. By this process, the cutting back on items that fall into the "desires" category will take care of itself, because if you "pay yourself first," that is put savings aside at the beginning of the week or month, and do not allow yourself to use credit cards to buy what you cannot afford, the end result will be a more controlled set of expenditures. For some people, the time it takes to carefully keep a budget is invigorating, or at least is not so unpleasant that the effort is abandoned. But for many, the process outlined above is much more workable. FINANCIAL PLANNING: The When and the What It can be a challenge to explain clearly the work of Otto and Associates and other fee-only financial planners. Part of the problem is that unlike "psychiatrist" or "lawyer," "financial planner" is not a "protected" word. While Certified Financial Planner™, with the trademark symbol, is protected, anyone can call himself or herself a financial planner. Indeed, the work of Certified Financial Planners varies considerably. For instance, stockbrokers at the major wire houses are often encouraged to get their CFP®, which they may or may not use. At the other end of the spectrum are planners who focus on everything but investing, but then assist clients in finding investment managers who are trustworthy and talented. At Otto and Associates, Deborah, Susan, and David define themselves as full-service financial planners with some expertise in all areas. These areas encompass retirement planning, insurance analysis and evaluation (including homeowners, auto, life, and long-term care), estate planning, tax planning, college savings plans, and investing. While we have significant knowledge in all these fields, our expertise may be limited. One obvious example is that only attorneys draft wills, although we are normally involved in the process in an important way. And while we don't sell insurance, we normally have sufficient knowledge to help clients figure out the insurance policies that they need and we assist in buying appropriate policies. One area that is occasionally confusing when looking at the work of financial planners has to do with managing money. It is not a requirement for clients of O&A that we manage money. For some people, we may only help them figure out their life insurance needs or do a retirement plan for them. However, when clients opt for us to manage their funds, we manage all investment assets, including being involved in decisions regarding retirement plans [such as a 401(k) or 403(b) accounts], even when we do not have easy access to a particular company retirement plan. We do not manage only a part of the client's assets because we can help make good decisions only when we consistently have all the information. Another factor is that not all areas of financial planning are particularly relevant at every stage of a person's life. This is another reason clients sometimes don't think to consult with us when an issue comes up that has not been an issue previously, or perhaps not been an issue for a long time. To stimulate your thinking about financial planning areas that may be overlooked, here are some issues that clients have asked us about in the past: We have borrowed significantly on a home equity line and have a traditional mortgage. Is this a good time to consolidate both into a new mortgage? I have recently switched companies. Should I leave my old 401(k) with my previous employer? My daughter just graduated from high school. Should I continue to contribute to her 529 College Savings Plan? We are going to buy a new car but don't have the cash to do it. What alternatives are there to obtaining money to buy a car? My children are now out of the house and married. Do I need to change my will? My dad took out a $25,000 life insurance policy when I was born. The company sends me a dividend check every year. What should I do with this policy? The when and what of financial planning can only be addressed on an individual basis. While we strive to review all plans periodically, we also rely on you to ask the questions that occur to you. We look forward to the discussions that can follow from your inquiries and concerns. ROTH IRA CHANGES Roth IRAs have been in the news lately because for the first time ever, people can convert all or part of a regular IRA to a Roth IRA in 2010, regardless of income. There are pros and cons to consider and there are some tricky fine points that may apply in particular situations, so deciding whether a conversion or a partial conversion makes sense isn't always easy. The main advantage in making the change to a Roth is that no one will ever pay taxes again on this money, even on the growth of it. The main disadvantage of converting is that you have to pay income tax on any amount that you convert. However, it is particularly attractive to convert at this time since tax rates are relatively low and there is a general belief that tax rates will go up in the future. Additional advantages to converting exist for higher net worth people: 1) There are no annual required minimum distributions from Roth IRAs, a benefit if you don't need money from your IRA for living expenses. 2) If you have estate tax concerns, reducing your estate by prepaying taxes may be a good move. 3) If you convert money to a Roth and the investments then lose money, you can reverse the transfer, owe no tax, and then reconvert. 4) For 2010 only, a taxpayer has the option of deferring the income tax so that no additional tax is due in 2010 but is payable in the future, half in 2011 and half in 2012. There are, however, also some general risks to consider. Penalties are levied for early withdrawals, so you shouldn't convert if you expect to withdraw money in less than 5 years or before you are age 59½ (although it doesn't generally make sense to convert for only 5 years). Also, converting to a Roth can push you into a higher tax bracket, it might make more of your Social Security income taxable, and it can increase your Medicare premiums for one to two years. And, for those with college age children, financial aid might be less likely. We generally suggest that our clients have some tax diversification, as well as investment diversification, to allow maximum flexibility in retirement. So we expect to recommend that some people consider at least a partial IRA conversion this year. We look forward to discussing this with you. GO ELECTRONIC Charles Schwab recently announced that all clients of financial advisors who enroll in "eDelivery," meaning the client gets all statements and trade confirmations electronically, will be able to trade stocks (including closed end funds), for $8.95 per trade. Except for clients who previously had accounts in excess of $1 million and had eDelivery, the costs have been higher, in some cases as much as $19.95. If you are not yet signed up for eDelivery, we suggest doing so. We are happy to help facilitate that change. OFFICE HAPPENINGS Deborah has attended a number of local seminars and conferences in recent months. Topics have included regulation and compliance, the economy, investments, taxes, elder care, and estate planning. She volunteered for the United Way Financial Helpline and again at the "A Man is Not a Financial Plan" conference sponsored by Girls Inc. Judy recently attended a Schwab seminar where she learned about the latest computer technology applicable to the Schwab Advisor website. Schwab reportedly spends more than $1 million each year keeping the website current. Judy attended the seminar so she could teach the rest of us how to better utilize the latest improvements. David and Susan are offering workshops at both the Norwich Public Library and the Woodstock, VT, Center for Seniors and Community. They will do additional workshops in the coming months at the same two locations. The topics include: an overview of financial planning, investment considerations, retirement planning, and estate planning. As reported above, David and Susan attended the Northeast Regional Conference in Orlando last November. They will be attending the National NAPFA Conference in Chicago on May 19 - 21. The featured speakers this year are primarily from the investment arena. Christopher Davis and John Rogers may be the best known. Jean Chatzky, a journalist and author who has also appeared on The Oprah Winfrey Show's successful "Debt Diet" series, is another presenter.