Ask Lynn - This Week’s Column

In life, there are certain things that are beyond indispensable. Like brake lights, hot showers, birthday candles and second chances. And if you’re saving for retirement, the Roth Individual Retirement Account, belongs on that list.

Among all the competing IRAs, the Roth is the alpha dog. That’s because the Roth is more effective than a homicidal pit bull at protecting your cash against one of Americans’ most feared predators — the Internal Revenue Service. When you invest in a Roth and keep the money there until retirement, taxes become somebody else’s problem.

Tax concerns melt away because what’s inside a Roth grows tax free for your lifetime and beyond. If there is money left in your Roth when you die, your heirs, if they are smart enough to know what a fabulous gift they’ve inherited, will prevent this tax-free bubble from bursting. What’s more, the tax protection doesn’t disintegrate if a retiree pulls the cash out. As long as somebody is at least 59 1/2 and has kept cash in at least five years, all withdrawals are tax free.

Of course, the Roth isn’t the only IRA you’ve got. In this beauty contest, the bucktoothed runner up is the deductible IRA. Unlike the Roth, the deductible IRA provides instant gratification. You’re awarded a tax deduction on your income tax return for any contributions you make. How much will depend on the amount you kicked in, as well as your tax bracket. If you invest $4,000 in a deductible IRA this year and you’re in the 15% tax bracket, you’d shave $600 off your federal income taxes. This year, by the way, you can put up to $4,000 into a traditional or Roth IRA and if you’re at least 50, you can toss in another $1,000.

If that tax break caught your eye, you may be wondering why you’d want to walk away from free money. Here’s your answer: When you start draining your deductible IRA during retirement, you’ll be stuck paying income taxes on every withdrawal. Suppose one saver contributed $3,000 a year for 30 year in a Roth and somebody else did the same thing with a deductible. With the hypothetical accounts each earning 8% a year, both investors would end up with more than $359,000. Okay class, you won’t need a calculator for this next question. If our Roth investor cashed in the account, what’s the tax bill? That’s right, it would be zilch.

The IRS, however, would attack the deductible IRA account like it was an all-you-can-eat, steak-and-lobster buffet. If our deductible IRA investor had remained in the 15% bracket, $150 out of every $1,000 withdrawal would belong to the IRS. And in California, there’d be state tax to pay too. The pain would be worse for the more affluent. A guy in the 35% tax bracket, who cashed out that $359,000 would owe $125,650 in federal taxes. Imagine writing that check! And here’s more bad news: the owner of a deductible IRA must begin withdrawals not long after reaching the age of 70 1/2. In contrast, a Roth owner never has to touch his stash.

While the case for the Roth is overwhelming, you wouldn’t necessarily reach that conclusion if you poured over IRA material that is mass produced by financial institutions. Reading the literature, you may assume that picking between a Roth and a deductible IRA is as tortuous as deciding which of your children you love the most. But if you examine how these guys compare the two IRAS, you’ll see that their conclusions about Americans’ spending and investing habits are borderline delusional.

Here’s the scenario that’s often presented in literature. Someone invests $3,000 a year in either a Roth or a deductible IRA. Okay, so far. But then those financial brochures make this huge assumption: The person contributing to the deductible IRA puts the tax savings (Remember that hypothetical $450 tax break?) in a taxable account and lets it ferment like a French Bordeaux until retirement. Now, excuse me, but wouldn’t people choose a deductible IRA so they could get their grubby hands on the tax break right now? If someone receives a refund, isn’t he or she more likely to use this mad money to pay off a credit card, blow it on a weekend trip to San Francisco or buy a PlayStation 2 to shut up a whining kid? If you eliminate the industry’s preposterous scenario, the argument for considering a deductible IRA blows up like a cactus on a weapons testing range.

Now that I’ve hyped the Roth, you should know that not everybody can contribute to one. If you’re a member of the top 1% of Americans that we keep hearing are hogging the recent tax breaks, you can stop reading. This is one cushy tax break that you can’t exploit. Actually, you can’t take full advantage of a Roth IRA if your adjusted gross income exceeds $150,000 (married taxpayers filing jointly) and $95,000 (single taxpayers.) You are eligible for a partial contribution if your income is slightly higher. If you can’t qualify for a Roth, the deductible IRA won’t work either since the income limitations are lower. For those who’ve been shut out, the consolation prize is a nondeductible IRA. With a nondeductible IRA, you don’t get a front-end tax break and you’ll owe taxes on your investment gains when the money’s withdrawn. But the cash remains sheltered from taxes as long as it stays inside the account. Hey, it’s something.

When people start talking to me about IRAs, too often it becomes clear that their knowledge of IRAs could easily fit inside a peach pit. The tip off comes when I ask investors how they’ve invested their IRA. Here’s what I’ve heard many times: “It’s in an IRA investment.” An IRA, however, is only a shell. The account is like an empty Easter basket or a church collection plate that hasn’t been passed around yet. Once you put money into an IRA account, which you can open at just about any financial institution, you then have to decide how to invest it. And what you choose is just as important as deciding which IRA to select.

Imagine how many excuses a cop has heard from speeding motorists and you’ll get some idea of how many investing choices you face. You are free to invest in mutual funds, stocks, bonds, certificates of deposit, money markets and more. It’s usually best to choose mutual funds and, of course, my favorite choices are low-cost index funds.
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Is there anybody out there who’d rather not be sitting on top of the world? When you let your mind wander, perhaps you live in a house so large you get lost trying to find the laundry room. You don’t need no stinking Atkins diet because you’ve got the flattest abs on the beach and your kids are smarter than their teachers. In this fantasy world, even your dog or cat is better behaved than the trained pooches on TV commercials.

But with investing, being No. 1 isn’t what it’s all about. The wisest investors aren’t shooting for the most spectacular returns. Instead, they diversify their portfolios to maximize their returns and protect themselves from a potential financial tsunami.

Asset allocation, as you may have figured out from last week’s column, isn’t about hitting home runs. As an investor, what should keep you from swinging for the upper deck of the Western Metals Building is fear. You can’t chase the highest returns unless you are willing to lose your sleep and possibly a big chunk of your 401(k), Individual Retirement Account and the kids’ college money. When you diversify across different types of assets, you are more likely to hit single and doubles, but your investment risk is much lower.

In contrast, when you aim for the biggest, showiest returns, you essentially drench your portfolio in lighter fluid. With an undiversified portfolio, you may bet on a narrow market niche. Remember, when people threw all their money at dot coms? The profits were stupendous until they incinerated.

If you’d love to have a diversified portfolio, here are some steps to follow:

Examine your latest investment account statements. Do you know why you’ve been holding onto this stuff? Would you buy the same investments if you could strap your portfolio into a time machine and jettison back 10 or 20 years? Probably not.

Just because you own lots of investments doesn’t mean that you’re practicing asset allocation. A stock jockey might think he’s safely diversified because he owns Microsoft, Pfizer and two dozen other blue chip stocks. This type of portfolio is horribly risky because all the cash is sunk into just one asset class, large-cap growth stocks.

Identify your portfolio’s asset classes. Not sure what they are? Here are the major equity categories: large-cap stocks, small-cap stocks and foreign stocks. It’s not as simple to describe the big fixed-income groups. One way to classify bonds is by their maturities. There’s short, intermediate and long-term bonds. (It’s generally best to avoid long-term bonds, because investors aren’t rewarded for the extra volatility.) Bonds are also grouped according to the borrower. There’s federal Treasuries, state and local municipals bonds, corporate bonds and overseas bonds.

Learn more about asset-class returns. Many aggressive investors, who don’t blanche when the market drops like a manhole cover, bulk up on growth stocks. If they knew their history, they’d probably spend more time shopping in the dog pound. Historically, beaten-down value stocks have performed better than growth. And small companies have performed better than large ones. According to Ibbotson Associates, if someone had invested $1,000 in small-cap value stocks in 1927, the cash would have mushroomed to $38 million recently. If that same cash was sunk into large-cap growth stocks, the ending balance would have reached a mere $1 million. Does this mean you should ditch growth and embrace value? Absolutely not. You want a mix, but how much growth versus value will depend upon your own circumstances, including your stomach for risk and your time horizon. Aggressive investors, who know what they are doing, tend to weight their portfolios more heavily towards small-cap value and foreign-stock funds.

Check your portfolio’s volatility. One common way to determine if an investment has a short fuse is to know its standard deviation. Standard deviation is one popular measurement of risk. The greater the standard deviation, the higher the investment’s risk. You can find the standard deviation of any mutual fund that Morningstar tracks by clicking on “risk measures.” If you have a financial advisor, he or she should be able to tell you the standard deviation of each of your stock and bond holdings. If the advisor can’t, that’s a problem.

Get help. Understandably, many people have a better chance of hitting the high notes during the National Anthem than assembling a model portfolio. A good financial planner can help.

But what about the do-it-yourselfers? Here’s a short cut: Visit the web site of IndexFunds.com. Once there, you can find 20 model portfolios that you can look at to get ideas. You’ll see historic returns and standard deviations for each portfolio. The most timid portfolio invests 85% of its cash in short-to-intermediate government and global bonds. The riskiest portfolio is heavily weighted towards small and small-cap value funds (40%) and foreign equity funds (31%) with no fixed-income exposure.

Start reading. You won’t learn the backstroke by watching the swimmers at the Summer Olympics and you sure can’t become a diversification whiz by reading this column. If you’re serious about a portfolio spring cleaning, you’ve got to hit the books. Pick up a copy of The Intelligent Asset Allocator, by William Bernstein and if you slog through that, try his companion title, The Four Pillars of Investing. You might find The Smartest Investment Book You’ll Ever Read by Daniel R. Solin and The Only Guide to a Winning Investment Strategy You’ll Ever Need, tad lighter reads.

Start diversifying. The perfect portfolio for you may not look anything like the best portfolio for your mother-in-law or the cable guy. If you prefer a super-simple solution, here’s a possible bare-bones asset mix: large-cap stock mutual fund, small-cap stock fund, foreign stock fund and short-term bond fund. If you want to get fancier, divide these asset classes into growth and value. You could invest, for example, in a small-cap value and small-cap growth fund. Of course, the simplest and best way to invest in any asset classes is through index funds.

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When my son dumped out the contents of his backpack on the last day of school, here’s a sampling of what hit the floor: An unfinished timeline of the Roman Empire, standardized testing tips (unread), parent notes (undelivered), ripped folders, a moldy Valencia orange, a No. 2 pencil denuded of its yellow paint and lots of wadded-up paper.

Here’s why I’m sharing his motley inventory: If many of the investors reading this column tipped their portfolios upside down and shook out their investments, the contents wouldn’t look any better than the stuff that was jammed inside my son’s scruffy Jansport backpack.

Mishmashed portfolios that are bulging with odd assortments of stocks, bonds, mutual funds, annuities and other flotsam happen because many of us look at the world of investment opportunities from the perspective of a beetle. When you’re less than an inch tall, everything looks big and impressive. Back in 1999, tech fund appeared larger than life. When the market melted tech stocks into a puddle, bond and small-cap stock funds looked like sure bets. Lately people have been slobbering over foreign stock funds.

The problem isn’t with any of these particular asset classes. It’s how you assemble them in your portfolio. Picture what happens when a piñata bursts and frantic kids are stepping on fingers and toes as they grab for Hershey kisses, Skittles, and Nerds. Sure some good stuff gets tossed in the kids’ bags during the commotion, but so does grass and dirt. We get so excited about packing our portfolio with goodies that we wind up with portfolios that are as healthy as a buffet of Krispie Kremes.

What can save us from owning a portfolio stuffed with empty calories? The only way to build and maintain a model portfolio is by diversifying through asset allocation. Here’s a quick lesson on what the heck that is and how to pull it off:

Rule No. 1: When you diversify, you should forget about the tantalizing mutual funds or stocks that you are dying to buy or the mutts you’re itching to sell. In this process, that comes dead last. You should first focus on the asset classes you want to include in your portfolio and then the percentages. By asset classes, I mean major investment categories such as large corporations, small companies, foreign stocks, intermediate bonds and short-term bonds.

At the very start, you’ll have to determine how much of your portfolio should be devoted to the three broadest categories: stocks, bonds and cash. After that, you’ll choose what are essentially subgroups within that trio. For a cash allocation, for instance, someone might use U.S. Treasury bills and a money-market fund. The same investor could spread his or her fixed-income allocation between TIPS and a mutual fund that invests in short-term bonds.

Depending upon how much money you’ve got, your investing smarts and your time horizon, you can invest in more than a dozen asset classes or just a handful.

I can already hear the whining. Focusing on these faceless investment categories makes time spent watching a CSPAN rebroadcast look thrilling. Perhaps this will get you motivated: Back in the 1980s, some famous researchers concluded that asset allocation explains more than 90% of the variation in returns among different investment portfolios. Picking specific investments, they insisted, accounted for only a small amount of the difference between returns. In other words, scouring the likes of Value Line and Morningstar’s data fields to uncover brilliant stock picks is a waste of time. The same researchers concluded that market timing also does little to impact investment results. What counts big time is the asset classes you pick for your portfolio’s foundation.

Rule No.2: Risk is the four-letter word that should be burnt into the frontal lobe of every investor’s brain. The reason why asset allocation is so important is that it helps you to control risk and squeeze out the highest returns possible for the amount of volatility you’re willing to accept. When you spread your bets among different investment categories, you reduce your risk. That way, if your bond fund slips or a foreign fund disintegrates, the blow is softened by your other asset classes that could be levitating above the carnage.

It’s important to understand the potential risks and rewards of different asset classes before pulling any off the shelf. The greater the risk, the higher the potential returns. Let’s look, for example, at Treasury bills. Imagine that one day every American stopped watching TV. Well the chances of that happening are probably greater than the possibility of you losing money on Treasury bills. It ain’t gonna happen. Because the risk is nil, the reward is underwhelming. Since 1925, Treasury bills have generated an annualized return of 3.7%, which barely squeaks past the historic inflation rate. Now let’s contrast that with small company stocks, which, in comparison, can be as scary as a 16-year-old driver let loose on the Merge at rush hour. During the same time period, small-company stocks produced an awesome return of 12.7%. Obviously, the market rewards investors for betting on fledgling companies that may only survive as long as a Chargers’ winning streak.

Lesson No. 3: You might assume that if you accumulate a lot of white-knuckle assets, like small-company stocks, emerging market-debt and junk bonds that your portfolio’s risk level will blow a hole through the roof. Ironically, however, this won’t necessarily happen. That’s because a rainbow-coalition portfolio, which contains assets that look and behave quite different, will actually reduce the risk. For instance, a simple portfolio of blue chip stocks (60%) and run-of-the-mill bonds (40%) actually is considered riskier than a portfolio that keeps the same percentage of bonds, but adds small companies and foreign stocks to the blue-chip equity mix. Strange, but true.

Stay tuned next week for more summertime fun with diversification.

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Since this is my debut column on my new web site, I don’t want to waste my 900 words on chitchat. Here’s what’s been gnawing at me for years: Most investors are stupid.

Actually, the financial industry thinks many of you are stupid. So do academics at places like the University of California, the University of Chicago and the Wharton School of Business, who have generated exhaustively footnoted research papers that dispassionately conclude that lots of investors are dumber than dumb.

Editors at money magazines also believe your investing IQ is borderline Forrest Gump. Why else would they keep shamelessly publishing lists of the best stocks, bonds and funds to BUY RIGHT NOW? Why indeed, when they know that their chances of pinpointing the exact mutual funds that are going to break the year’s speed records (if any do) are as remote as guessing what year the Chicago Cubs are going to win the World Series.

For obvious reasons, all the sniggering by these insiders is done privately. You can, however, catch a glimpse of what the financial world really thinks about average Joe investor if you flip through its trade publications. Within the glossy pages, industry types, who feel free to talk candidly among peers, complain about any number of reforms that would benefit people just like you. Requiring mutual fund companies to disclose just how much each investor is paying in yearly fees is just one of many issues that have insiders riled. William J. Bernstein, one of the smartest investors that I know, jokes that these industry rags are the financial industry’s equivalent of a trade magazine for concentration camp guards. (Sophisticated investors or those who aspire to be should visit Bernstein’s Web site at www.efficientfrontier.com.)

There’s a big problem with the financial world thinking investors are dim. They treat you that way. And when they treat you with contempt, your portfolio can end up looking as jumbled as a carry-on bag after airport security has rifled through it. Ever hear of a variable annuity? If you’ve ever exchanged business cards with a stockbroker, you may have one. Most people would enjoy a better chance of winning American Idol than explaining why a variable annuity is burrowed inside their retirement portfolio. The short answer is usually this: a broker wanted to make money off of you. If you don’t understand why a variable annuity is a terrible idea for all, but an infinitesimal number of people, chances are you’ve got other Tar Babies stuck to your portfolio too.

It’s not just financial predators that you have to protect yourself from. Even if you invested in a hermetically sealed room, chances are you’d still have to worry about y-o-u. People tend to be irrational investors–that’s what those tenured finance professors keep telling us. Consequently, when people invest money, too many of them abandon common sense.

Consider this: People will push super-sized shopping carts through the Saturday afternoon throngs at Costco or Sam’s Club to save a few bucks on 1,000 rolls toilet paper, but they freak at investing in the stock market when prices are hovering at Costco levels. Remember back in 2000, 2001 and 2002, when stocks were pummeled and left for dead? If you were a true discount shopper, you’d have continued stuffing money–perhaps even more than before–into the market for your retirement or other long-term goals. Millions of otherwise smart consumers, however, waited until stocks prices soared in 2003 before they jumped back into the market. How is this behavior different from patronizing the highest-priced gas station up until the day it lowers its prices?

Okay, enough of the downer messages. Here’s a far easier one to digest: Contrary to what the financial industry would have you believe, being a smart investor needn’t be difficult. You don’t have to subscribe to The Wall Street Journal or pour over Smart Money Magazine with a yellow highlighter. Neither do you need a business degree to figure this stuff out. Even if math beyond the fifth grade scares you, you can manage just fine.

To become an intelligent and wealthier investor, you need to be able to distinguish Wall Street hype from reliable, if dull, common sense. This is where I hope to help. Once a week, I’ll be sharing a new column to help you become a more successful investor. Why me?

I could make the case that I’m a poster child for the average investor. When I left my reporting job at the Los Angeles Times 16 years ago to move to San Diego, I had to figure out what to do with my 401(k) and pension money. Most of you reading this column probably know more about investing than I did back then. I ended up teaching myself how to invest, in large part, by becoming a financial journalist. One of the true perks of being a journalist is that you are paid to research and interview people far smarter than yourself and arguably learn as much as someone shelling out $700 a credit hour for an Ivy League education.

Having spent many years as a financial journalist, here’s one of the favorite lessons that I’ve learned: Managing money successfully doesn’t require a lot of time. If you sat through the latest Pirates of the Caribbean movie, you spent more time eating popcorn (almost three hours) than many of the most brilliant investors spend on their own finances during an entire year. Once you learn the simple basics and discover the short cuts, you can devote more time to the important things in life.

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