The Power of the Human Mind
Is Opportunity Knocking?
Is Asset Allocation Enough?
Finding the Right Balance with Asset Class Investing
Even Market Declines Have A Silver Lining
Eight Costly Investment Mistakes
Rediscovering the Power of Stock Dividends
The Fed: Serving in the Economic Interest
Pension Plans Are Changing
Getting the Most from a Dollar
Making Healthy Choices
Betting on a Longer Life
Social Security’s Role in Your Retirement
The Power of the Human Mind
Investors are often portrayed as rational thinkers who, driven by financial self-interest, consider all the information available to them before making a decision. But are they? Do they evaluate their options with clear-eyed objectivity and then make sensible financial choices? According to the relatively new field of behavioral finance, they do not. In fact, the way your brain works often plays a critical role in your investment decision-making.
A growing number of researchers have found that people’s idiosyncrasies and psychological biases can lead them to act in ways that don’t make financial sense. Investors would do well to keep these discoveries in mind as they make decisions, especially in today’s volatile investment environment.
The psychology of investing
Until recently, most financial models were based on the assumption that ordinary people made decisions about their investments the way a mathematician or economist would – logically and rationally. But in the late 1970s, psychologists Daniel Kahneman and Amos Tversky embarked on research that led to an entirely a new field of study called “behavioral finance.”
In 1979, they proposed “prospect theory,” which was based on research showing that human beings put “different weights on gains and losses and on different ranges of probability.”1 In other words, people tend to get more distressed by the prospect of a loss than happy about the possibility of an equivalent gain.
A contributing factor to this behavior may be “loss aversion.” Studies have shown that people are willing to take on additional risk simply to avoid losses. They are less inclined to take on the same risk for a potential gain. This tendency may be one reason why investors are twice as likely to sell a winner as they are a loser.2
Furthermore, investors don’t want to admit when they’ve lost money. “Regret theory” suggests that an individual may resist selling a losing investment simply to avoid feeling sad or anguished about the loss.
But what if an investment is successful? Enter “overconfidence.” When people have good results, they are liable to interpret it as skill. In reality, it may only be luck. Researchers found this to be true when they analyzed the sports phenomenon of “hot hands.” They studied basketball players who had made their last few shots to determine how likely it was that they would make their next one and found that success didn’t depend at all on the previous shots.3
Human beings also seem to put too much faith in recent experience, believing that they can extrapolate future events from current trends – a tendency called “anchoring.” When a stock price falls, for example, they tend believe the decline will continue and might therefore sell a position prematurely. As more and more people follow suit, this “herding” behavior has been known to result in panics and crashes. Conversely, overly enthusiastic buying may cause bubbles.
Gaining the upper hand
So what can investors do to mitigate the impact of their psychological biases on their long-term investment results? The first step is an investment plan. It can help you keep your head when all around you are losing theirs. Other strategies include:
- An asset allocation strategy based on your goals, time horizon and risk tolerance to keep you focused on what’s most important to you.
- Diversification to help minimize swings in the value of your portfolio, which may reduce the temptation to act out of fear or exhilaration.
- Dollar cost averaging by which you invest a designated amount on a regular basis and according to your plan, thereby removing some of the potential emotion from decision-making.
Human psychology may be powerful, but you can make wise investment decisions despite its influence. For an objective viewpoint, call your financial advisor and ask for assistance.
Eve B. Rose is a business writer specializing in finance and investments. A Certified Investment Management Analyst (CIMA®), she has been writing articles, white papers and shareholder reports for more than 20 years. She is not affiliated with Aston Asset Management LLC and her views do not necessarily reflect those of Aston.
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1 “The Ultimate Investor: The People and Ideas that Make Modern Investment” by Dean LeBaron and Romesh Vaitilingam, 1999. (http://www.investorhome.com/psych.htm)
2“Are Investors Reluctant to Realize Their Losses?” by Terrance Odean, The Journal of Finance, October 1998. (http://faculty.haas.berkeley.edu/odean/papers/disposition/disposit.pdf )
3“Hot Hands Phenomenon: A Myth?” The New York Times, April 19, 1988.
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Is Opportunity Knocking?
The Resurgence in Large Cap Growth
Between 2000 and 2006, value stocks dominated the large cap universe. During that time, large cap growth stocks – which have historically provided strong returns – lagged significantly. From all indications, however, large cap growth appears to be staging a comeback, outperforming large cap value in 2007 by a considerable margin.
Why? What has brought investors flocking back to this asset class? The answer is far from simple. Subprime lending troubles, slower earnings growth, fluctuating consumer spending, as well as higher interest rates and inflationary pressures have all combined to raise the level of anxiety among investors. In this environment, they have shown an increased interest in companies that historically perform well in a weak economy – large cap growth names.
What’s more, growth stocks have been trading at attractive levels. During the years that value outperformed, many growth companies began to look cheap relative to their earnings. The opposite was true of value stocks; as they appreciated in value they started to appear expensive. For investors, perhaps, it may have been a signal that opportunity was knocking.
Large Cap Growth Explained
Large cap is an abbreviation for the term “large market capitalization,” which is a way to measure a company’s size. (Market capitalization is calculated by multiplying the number of a company’s outstanding shares by the stock price.) Large cap companies tend to have market capitalizations of between $10 and $200 billion.
Growth companies are those with earnings that are expected to grow at an above-average rate. Many do not pay dividends, choosing instead to reinvest earnings in the business by making acquisitions, building new facilities, and/or funding research and development. As a result, investors usually expect most of their return to come from capital appreciation.
Large cap growth stocks combine both these characteristics. Examples include Microsoft, FedEx, and Goldman Sachs.
The Resurgence Examined
According to MarketWatch, the revival of large cap stocks “reflects growing investor concern about the U.S. economy even as the global picture appears healthy.”1 And in fact, the state of the U.S. economy has contributed to the stock market upheavals of 2007 and the resurgence of large cap growth.
During periods of volatility and uncertainty, investors tend to prefer large, well-known businesses with a variety of products and services as well as significant market share. Companies with larger capitalizations often enjoy economies of scale, which can help them weather an economic slowdown. Furthermore, large cap companies are frequently global multinational firms, positioned to benefit from the expansion of the international economy.
Here are some of the other reasons large cap growth performed well in 2007 and may continue to do so.
• The decline of financial stocks, many of which were considered mainstays by value investors. The financial sector was hampered by the crisis in the credit markets, problems in the subprime lending sector, and the possibility that large numbers of homeowners could default on their mortgages.
• A slowdown in corporate profits. The cumulative effects of rate hikes by the Federal Reserve Board combined with a weak housing market and rising energy prices began to take a toll on corporate earnings in 2007. If they continue to slow, investors are likely to focus more attention on large cap growth companies, which tend to be cash rich and therefore able to fund operations with their existing capital.
• A weaker U.S. dollar, which makes American exports more attractive to overseas buyers. And since many large cap growth companies have significant international operations, some of their earnings will be in other currencies. Revenue converted into U.S. dollars will be worth more, boosting the company’s profits and benefiting its bottom line.
• Potential reversal in favorable dividend tax treatment. With a changing political climate, the current tax rate on dividend income could be at risk, which might make value stocks even less attractive to investors.
• Valuations may have compressed too far. At the end of 2006, the relative price to earnings multiple of the largest 25 companies in the S&P 500 was at one of its lowest points in 20 years. Meanwhile, the Russell 1000 Growth Index’s price to sales ratio relative to the Russell 1000 Value’s ratio was at a historic low. Historically, when there are unusual periods of valuation dispersion and compression, conditions will ultimately reverse.2 From the numbers, the outlook for large cap growth is promising.
An Investment Opportunity?
The resurgence of large cap growth stocks appears to be underway, but there is still time to take advantage of the investment opportunity. A portfolio rebalancing or a change in asset allocation may be all that is necessary. To find out how to incorporate large cap growth into your investment plan, contact your financial advisor.
2 Aston's Spotlight publication "Large Cap Growth: Is It Time?" featuring the Aston/Montag & Caldwell Growth Fund, June 2007.
Eve B. Rose is a business writer specializing in finance and investments. A Certified Investment Management Analyst (CIMA®), she has been writing articles, white papers and shareholder reports for more than 20 years. She is not affiliated with Aston Asset Management LLC and her views do not necessarily reflect those of Aston.
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Is Asset Allocation Enough?
Selecting an appropriate asset allocation can be one of the most important decisions you make as an investor. Asset allocation is the process by which you divide your investment portfolio among different asset classes, such as stocks, bonds, and cash. The mix that works best for you may depend on the stage you are in life as well as your time horizon and your ability to tolerate risk.1
But is asset allocation enough?
Studies and mathematical models have shown that a well-diversified portfolio can reduce risk and potentially increase returns. And while many individuals use an asset allocation strategy to diversify their investments, they often draw the line at U.S. stocks and bonds.
In such cases, a better question might be: Does your asset allocation go far enough?
Using a technique called “low-correlation investing,” you can draw on a richer universe of investment alternatives. Harry Markowitz won a Nobel Prize in Economics in 1990 for proving that it was possible to reduce the overall volatility (or risk) of a portfolio by combining investments that were negatively correlated. Investors now use his discoveries to lessen the effect of market swings and potentially improve their returns. This is commonly called “low-correlation” investing.
Correlation and its Role in Investing
Correlation is a statistical measure that can help you determine how differently one asset behaves from another. For example, if two asset classes are correlated, it means that they tend to move in lockstep. A negative or low correlation indicates that they usually move in opposite directions. (A zero correlation means that there is no relationship between their returns.)
According to an article in The CPA Journal, “No one can predict market performance over any time period, short or long, but the study of correlations shows that, over time, different asset types have not performed in sync with the stock market. An investor who holds a portfolio diversified with low-correlating assets has the
opportunity to benefit from returns with less risk.”2
To maximize the opportunity, minimize the number of asset classes with strong correlations. If you are invested entirely in equity funds, for instance, you may not want to hold both a growth fund and a blended fund (one comprised of value and growth stocks) because they are closely correlated.
Then find asset classes that have consistently lower correlations to the rest of your portfolio. You should also determine if they have the potential to meet your return objectives. Remember, low-
correlation investing is not undertaken for its own sake but as a means of improving your chances of investment success.
Here are a few tactics for low-correlation investing:
• Mix stocks and bonds – if you’re not already. The high volatility of stocks is tempered by less volatile bonds. That’s because bonds tend to go up when stocks go down (and vice versa).
• Take a multi-cap approach to stock investing to help you capture opportunities across the spectrum – from large, dividend paying stocks to mid cap and small cap companies.
• Split your equity investments among value and growth options as well as different size companies.
• Go beyond U.S. stocks and bonds. International investments, for example. Foreign securities do not always move in sync with domestic investments.
• Consider non-traditional asset classes, such as real estate. Real estate securities have a low correlation with stocks and therefore can rise in value at a time with stocks decline.
• Make the most of mutual funds. They can make the process of mixing and matching securities and asset classes more
convenient and relatively less expensive.
To evaluate whether your investments are too closely correlated and to find out what you can do about it, speak to your financial advisor.
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1“Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing,” U.S. Securities and Exchange Commission. (http://www.sec.gov/investor/pubs/assetallocation.htm)
2 “The Power of Low-Correlation Investing,” by Marc D. Stern, The CPA Journal, November 2003. (http://www.nysscpa.org/cpajournal/2003/1103/features/f114203.htm)
Eve B. Rose is a business writer specializing in finance and investments. A Certified Investment Management Analyst (CIMA®), she has been writing articles, white papers and shareholder reports for more than 20 years. She is not affiliated with Aston Asset Management LLC and her views do not necessarily reflect those of Aston.
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Finding the Right Balance with Asset Class Investing
Investors are not created equal. Your needs and goals are important factors to consider when you make investment decisions. So is your stage in life. Asset class investing – better known as diversification – can help you find the right balance between risk and reward. It is much easier to keep your portfolio on an even keel if you spread your investments among different asset classes. Studies and mathematical models have shown that maintaining a well-diversified portfolio can reduce risk and increase reward. That’s because all asset classes do not move up and down in value at the same time or at the same rate. When you diversify, you can counterbalance a downturn in one asset class with an upswing in another. The resulting portfolio is likely to provide more consistent performance with less volatility.
The greatest benefits of diversification are realized when asset classes are “uncorrelated” or “negatively” correlated. When two investments are uncorrelated, movements in the value of one may have no effect on the value of the other. And if they are "negatively” correlated, one investment will move up or down in the opposite direction of the other.
For example, bonds tend to be negatively correlated with stocks. They are apt to rise in price when stocks fall – and vice versa. For this reason, investors who own both stocks and bonds may find that their portfolio continues to grow as declines in one asset class are offset by increases in the other. To diversify further, they can invest in real estate or international securities. Foreign stocks and bonds are relatively uncorrelated with U.S. stocks and bonds. After all, an economic downturn in the United States generally does not impact the securities markets of Europe and the Far East to the degree as those in the U.S.
Diversification Adds Value at Any Stage in Life
A diversification plan can help investors manage their assets throughout their lives. If you are just starting out, your plan might focus mostly on stocks because they offer long-term growth prospects. You could also choose to include bond investments to help you protect money you have earmarked for your first house or for graduate school. Once you start a family, you may want to diversify further and spread your risk. After all, you are probably saving for yourself, your family’s needs, and your children’s education. Then, as you approach retirement, you might decide to re-allocate your investments in order to preserve the assets you have and generate a steady cash flow in the future.
Whatever you do, here are a few options worth considering:
- Use mutual funds. By purchasing shares in a mutual fund, you can diversify cost effectively.
- Look beyond U.S. stocks and bonds. Other investment styles can potentially reduce the overall risk of your portfolio and help it be a steadier performer.
- Establish an automatic investment plan. By adding to your portfolio on a regular basis, you can put more of your money to work for you.
- Extend your diversification plan to all your investments, such as employer-sponsored plans (e.g., 401k, 403b, etc.).
To create a diversification plan that makes sense for you and your stage in life, speak to your financial advisor. A skilled professional can help you find the right balance between risk and reward.
Eve B. Rose is a business writer specializing in finance and investments. A Certified Investment Management Analyst (CIMA®), she has been writing articles, white papers and shareholder reports for more than 20 years. She is not affiliated with Aston Asset Management LLC and her views do not necessarily reflect those of Aston.
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Even Market Declines Have A Silver Lining
A decline of between 3% and 4% doesn’t even qualify as a “market correction” although some observers thought that the February slump might be the beginning of one. A market correction is usually defined as a drop of at least 10% and is considered healthy. It demonstrates that the market is capable of readjusting itself when investor enthusiasm pushes prices beyond rational measures of their worth (such as company earnings).
Furthermore, market corrections often give way to solid gains. From January 1926 through December 2006 the annualized total return for the S&P 500 was 10.50% per year.
Nonetheless, it can be disturbing to watch stock prices fall. Some investors – fearful of losing money – may overreact and make poor decisions about their money. With the right preparation, however, they could weather a correction and even take advantage of it.
Here are a few strategies to consider:
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Revisit your asset allocation plan. Do you have an asset allocation that minimizes swings in your portfolio? Are you properly diversified? Consider investing in multiple equity mutual funds, each with different investment objectives. Evaluate your bond investments and determine if you need to broaden your exposure.
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Resist the urge to flee into Treasury bonds. Because they are backed by the full faith and credit of the U.S. government, Treasuries can be appealing when you want total safety. But you can reduce your exposure to equities without giving up the higher-yield potential of other fixed-income investments, such as corporate, mortgage-backed or municipal bonds.
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Bide your time. During periods of volatility, it can be tempting to leap out of stock funds and into another type of investment. All the more reason to revisit your investment plan to determine if your risk tolerance and time horizon match. Historically, equities offer the most growth potential. Longer-term investors may find that they have the time to wait out a short-term decline.
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Look for bargains. When investors panic and sell, equity prices can fall. As a result, you may be able to find attractive stocks and buy them “on the cheap.” The cost per share of some equity mutual funds may also drop, allowing you to buy more shares for less money.
Market declines are inevitable, but you can minimize the risk to your portfolio by preparing for them now. Talk to your financial advisor to find out what you can do to be ready for the next one.
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Eight Costly Investment Mistakes
(And How You Can Avoid Them)
In investing, the only certainty is uncertainty. No one really knows what will happen from one day to the next. So smart investors do their utmost to control whatever they can by establishing a disciplined approach to their investment decision-making. They know, sometimes from painful experience, that even the smallest missteps can undermine their investment returns.
But other investors make the same mistakes over and over again, becoming their own worst enemies. Fortunately, there are ways to sidestep the most common investment pitfalls. Here are eight classic investment mistakes and how you can avoid them.
- Not investing in the first place. Sometimes it is procrastination, sometimes anxiety about what to do – but not investing can be the biggest investment mistake of all. The AARP Bulletin recently reported that if you had deposited $50 in a savings account in 1957, you would have a total of $284 by 2007. However, if you had invested $50 in the stock market instead, you would have seen your money grow to $1,952 by 2007.
- Having no long-term strategy. When you have somewhere to go, a map can keep you from getting lost. Likewise, an investment strategy, based on your needs and objectives, can help you get where you want to go. It can also help you stay focused during periods of market fluctuation – either up or down. Your strategy should take into account your time horizon, tolerance for risk, amount of investable assets, and planned future contributions.
- Buying willy-nilly. Your financial future should not be left to chance. Construct a diversified portfolio with a personalized asset allocation that includes a range of asset classes and investment styles. Be careful not to spread yourself too thin. Over-diversification carries risk, just as concentrated positions do.
- Buying what’s in vogue. When everyone seems to be enthusiastic about an investment, the temptation to buy it can become irresistible. Regrettably, the greater a “hot” investment grows in value, the less room it has to appreciate. You could purchase it just as it starts to cool off. An old Wall Street adage says that when an investment is hot, the smart money gets out.
- Exaggerating your abilities. It can be tempting to “do it yourself,” especially in sharply rising markets. Professionals, however, manage money for a living. Many spend years in college and on the job, learning their craft. They also have access to information most individuals do not.
- Reacting to short-term performance. Act in haste, repent at leisure. If you make investment decisions in response to quarter-to-quarter performance or even day-to-day events, you may sell a position prematurely. Instead, you should evaluate your progress based on the asset allocation you put in place. It is a more accurate measure of whether you are on track to meeting your long-term investment goals.
- Missing opportunities. Make the most of your employer-sponsored pension plans by fully funding them and taking advantage of any employer match. Consider putting additional money into an IRA. Even if your IRA contributions aren’t tax-deductible, they will grow on a tax-deferred basis.
- Spending your profits. Put all your money to work by reinvesting your interest and dividends. Your portfolio benefits when you leverage the power of compounding – the growth of earnings on earnings.
Our emotions may be part of what makes us human, but we don’t have to let them lead us into error. Contact your financial advisor if you want help avoiding some of the most costly investment mistakes.
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Rediscovering the Power of Stock Dividends
What a difference a decade makes. Ten years ago, investors were exuberant as the U.S. equity markets - led by technology stocks - hit one record high after another. Even after the Internet bubble burst and that bull market ended, a real estate boom sent home prices skyward.
But lately, the financial news has been confusing and contradictory. The hot housing market has cooled. The direction of inflation is uncertain. Energy prices spiked higher, then fell back to lower levels. Job growth and consumer spending are in flux. Meanwhile, the stock market, has reached new highs during 2006, while reacting - sometimes up and sometimes down - to almost every piece of economic and geopolitical news. What are investors to make of these mixed signals? The pundits have not been of much help. Some predict a recession while others foresee renewed economic growth.
Given this climate of uncertainty and increased market volatility, some investors have been looking for new ideas. In the process, many have rediscovered dividend-paying stocks - companies that choose to return some of their profits to the owners (shareholders) rather than reinvesting the profits in the business. During turbulent times, dividend paying stocks have a special appeal because they offer an attractive combination: the long-term capital appreciation potential of equities and quarterly income payments in the form of dividends.
Dividend Stocks Offer Unique Advantages
Because dividend stocks tend to pay income every three months, they can provide a higher total return (change in share price plus dividend payments). In 2005, for example, dividend stocks in the S&P 500 had a total return of 9.3% as compared to the 8.2% return of non-dividend stocks.1 2006 looks even better. Through August 24th, the total return of dividend stocks was 5.1% while non-dividend payers showed a 0.9% return.2
Dividend stocks can also help provide added stability to an investment portfolio but it is important to remember that there are still risks involved. Historically, dividend stocks do not gain as much in rising markets as non-dividend stocks but they typically do not fall as far in declining markets.
They may also offer special advantages in weak or falling markets. If the share price of a dividend payer stalls, investors can continue to collect their dividends while they wait for the price to rise. If the price drops, investors may find more willing buyers because the stock's dividend yield will be higher for new investors. The dividend yield is amount of dividends paid per share over the next year, divided by stock's price. For example, if a stock pays $10 annually in dividends and trades at $80 a share, its dividend yield is 12.5%. If the share price falls to $50, the yield increases to 20% ($10 divided by $50).
Investing in a Good Reputation
Dividend-paying companies are often household names. Many regularly increase their dividend payments, earning a reputation for being well-managed because they share their profits or cash reserves with shareholders. To learn which companies have raised their dividends for 10 years in a row, visit www.dividendachievers.com. For those that have increased dividends for 25 years in a row, go to www.standardandpoors.com. Keep in mind that any of these companies could choose to reduce their dividends or cease paying them altogether.
Here are a Few Other Benefits:
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With dividend reinvestment, you may see dramatic increases in your returns. For the last 25 years, the S&P 500 Index has gained 914%. Investors who reinvested their dividends enjoyed an increase of 2,008%.3 Please keep in mind however that past performance is no guarantee of future performance. The S&P 500 index is unmanaged and is used as a benchmark. It is not possible to invest in an index.
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You can help lower your tax bill. Interest from a bank certificate of deposit is taxed at the maximum rate, which was 35% in 2005. But qualified dividends on stocks are taxed at the long-term capital gains rate, which is 15% for most individuals and as low as 5% people in the lowest tax brackets.4
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When increased regularly, dividends can help you keep pace with inflation. Most bonds offer fixed interest payments. For example, a $1,000 10-year Treasury note with a 4.88% yield will pay $48.88 a year until 2016. If inflation averages 3% a year, the buying power of that yield will be cut to $36.04 - 26% less. 5
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Mutual funds offer an effective way to invest in a large number of dividend-paying stocks. Equity income funds, for example, usually include many of these securities. So do large value funds, balanced funds, as well as real estate funds. Keep in mind that an investment in a mutual fund is subject to risk including the possibility that the fund's income and the value of its portfolio holdings may fluctuate in response to events specific to the companies in which the fund invests as well as other market conditions. The dividend amount passed on to an investor and tax treatment of mutual fund dividends may be different than that of a dividend paying stock company. To find out more, talk to your financial advisor.
1 "Making Money the Slow-Fashioned Way," by Scott Patterson, The Wall Street Journal, August 27, 2006. (http://online.wsj.com/article/SB115663197848246567-search.html?KEYWORDS=dividend+stocks&COLLECTION=wsjie/6month )
2 "Making Money the Slow-Fashioned Way," by Scott Patterson, The Wall Street Journal, August 27, 2006. (http://online.wsj.com/article/SB115663197848246567-search.html?KEYWORDS=dividend+stocks&COLLECTION=wsjie/6month )
3 "Dividend-paying stocks work so you don't have to," by John Waggoner, USA Today, August 11, 2005. (http://www.usatoday.com/money/perfi/columnist/waggon/2005-08-11-dividends_x.htm )
4"Dividend-paying stocks work so you don't have to," by John Waggoner, USA Today, August11, 2005. (http://www.usatoday.com/money/perfi/columnist/waggon/2005-08-11-dividends_x.htm )
5 "You can temper scary times with dividend-paying stocks," by John Waggoner, USA Today, August 10, 2006.
(http://www.usatoday.com/money/perfi/columnist/waggon/2006-08-10-dividend-stocks_x.htm )
Treasury notes are guaranteed by the full faith and credit of the U.S. Government. There is no guarantee that a stock company will pay or continue to increase dividend payments. An investor can lose money in an investment.
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The Fed: Serving in the Economic Interest
Can a Folded Newspaper Foretell the Actions of the Federal Reserve Board?
Some members of the financial media - tongue firmly in cheek - would once have had us believe so. Until he retired early this year, former Fed chairman Alan Greenspan was continuously scrutinized for clues about his state of mind. These "leading indicators" ranged from the way he carried his newspaper to the type of fruit juice he ordered at breakfast. The new chairman, Ben Bernanke, is not yet the subject of such amateur psychoanalysis, but the investment community actively speculates about his point of view.
Why the Intense Interest?
The answer lies in the Federal Reserve itself and its power to regulate the nation's money supply. The word "Fed" is generally used to refer to the Federal Open Market Committee (FOMC), a 12-member group that meets eight times a year to review U.S. economic conditions and set monetary policy. The FOMC is one part of the Federal Reserve System, which was established in 1913 as the central bank of the United States.
The Fed uses two tools to manage monetary policy. First, it determines the amount of money banks cannot loan and must hold in reserve in the 12 Federal Reserve Banks. Second, it controls certain interest rates - the discount rate (the interest rate banks pay on loans from a Federal Reserve Bank) and the federal fund rate. The public is most familiar with the federal funds rate, which is the interest rate banks pay each other for overnight loans.
When the Fed raises or lowers interest rates, it becomes more or less expensive for banks to borrow money. Banks, in turn, pass any changes along to customers. If rates go up, businesses and consumers must pay more in interest on their new or adjustable-rate loans. If rates go down, their interest payments usually fall.
How do Changes in Interest Rates Affect Investors?
The Fed's interest-rate policies have a significant impact on the financial markets. When the FOMC cuts rates, stock prices tend to rise in anticipation of strong corporate growth. Investors expect companies to take advantage of lower interest rates to fund their expansions. And because a lower fed funds rate gradually translates into reduced interest payments on credit cards and mortgages, consumers often begin to spend more, driving up corporate profits. Meanwhile, the yields on money market and bond investments fall. The price of bonds, however, climbs. (Interest rates and bond prices move in opposite directions of each other.)
Everything happens in reverse when the Fed boosts interest rates - as it has 17 times between June 2004 and July 2006. When the FOMC raises rates, it is trying to "cool" economic growth and keep inflation under control. Interest rate increases ultimately drive down bond prices, the value of bond funds can decline, which may result in the loss of principal. On the bright side, bond and money market investors, especially those who need an income stream, benefit from rising yields. Stock prices typically decline as investors fret about the impact of higher debt loads on corporate earnings.
But raising interest rates is a delicate business. Increase them too much or too fast and it can choke off economic growth. During the spring, equity investors were worried about just such a scenario. However, when the FOMC suggested it might stop raising rates sooner rather than later, the stock market rallied in relief.
So What Will the Fed Do Next?
No one really knows. But we do know that the financial markets will react to whatever the Fed does - even if it chooses not to act. One thing is certain: a long-term investment strategy with a diversified asset allocation continues to be one of the best ways to seek growth and help protect one's assets. Talk to your financial advisor about designing a plan that makes sense for you.
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Pension Plans Are Changing
Pensions aren't what they used to be. Twenty years ago, more than 170,000 companies offered traditional pension plans1 - "defined benefit" programs that promised to pay a specific benefit to an employee at retirement. However, some of these plans have gone bankrupt. Others have been phased out as companies shift to "defined contribution" plans, such as 401k and 403b programs, that require employees to save for their own retirement. By 1998, the total number of defined benefit plans had fallen to 56,405, according to the U.S. Department of Labor.2
Some American workers - approximately 48 million full-time employees - have no pension benefits at all. Their companies do not even offer a retirement-savings program.3
Are You Sure You will Receive a Pension?
Over the last five years, American companies have terminated more than 640 under-funded retirement plans, affecting about three-quarters of a million people.4 Even companies with healthy pension plans have made changes. Between 2001 and 2004, 23 percent of Fortune 1000 companies announced that they would freeze or consider freezing their defined benefit pension plans.5 In January, IBM - once famous for its generous benefits - said it would freeze its U.S. pension plans in 2008 and shift employees to its 401(k) programs.
According to The Wall Street Journal, workers most at risk are:
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in companies with a large percentage of older, longtime employees.
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those not covered by a collective-bargaining agreement.
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in companies that have a history of cutting retiree benefits.6
Creating Your Own Pension Plan
As the number of traditional pension programs decline, Americans are forced to take on more responsibility for their financial future. To give yourself the best chance of maintaining your standard of living during retirement, you may want to establish your own pension plan.
Your financial future does not have to be dependent on the benefit policies of your employer. A plan will help you save and invest. Here are some strategies for you to consider:
A pension may be uncertain, but you don't have to rely on having one. Talk to your financial advisor to find out what you can do about your specific situation.
1 Private Pension Plan Bulletin, Abstract of 1998 Form 5500 Annual Reports, U.S. Department of Labor, Number 11, Winter 2001-2002, Table E1.
2 Private Pension Plan Bulletin, Abstract of 1998 Form 5500 Annual Reports, U.S. Department of Labor, Number 11, Winter 2001-2002, Table E1.
3 "Congress May Focus on Retirement Funds," The Wall Street Journal, January 4, 2006.
4 "The Best Retirement Tools," The Wall Street Journal, January 7, 2006.
5 http://www.americanbenefitscouncil.org/documents/definedbenefits_paper.pdf (seepage 6 of white paper)
6 "How Safe Is Your Pension?" The Wall Street Journal, January 12, 2006.
7 "Goodbye, Holiday Splurges. Hello, Saving." The Wall Street Journal, January 1, 2006.
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Getting the Most from a Dollar
Fifty cents - that's what a 16-ounce loaf of bread cost in January 1980. But by the end of 2005, the price had more than doubled to $1.05. Over the same period, the price of a pound of ground beef rose from $1.82 to $2.61.1
Behold the corrosive effects of inflation. As inflation increases, every dollar buys less and less of a product or service. The U.S. Bureau of Labor Statistics defines inflation as "the overall upward price movement of goods and services in an economy." However, to most Americans, it means that they have to spend more money to buy the same things. In 2005, for example, they would have needed $237.01 to buy the identical goods and services for which they paid $100 in 1980.2
Will You Have Enough Money to Pay Your Living Expenses?
Even a low rate of inflation can have a dramatic impact on your "purchasing power." For example, if you retire on living expenses of $75,000 and the annual inflation rate holds steady at 3%, you would need more than $145,000 to pay the same bills 25 years later.3 And some costs, like health care, rise faster than the cost of other goods and services. The monthly government Medicare insurance premium was $5.30 in 1970. In January 2006, it was $88.50 - 1,664% inflation.4
Because inflation forces you to pay more for what you need or give up some items in order to buy others, it can undermine your standard of living. Not surprisingly, it can exact a heavy price on retirees, many of whom live on fixed incomes.
Protecting Your Retirement Lifestyle
Inflation can also erode the value of your nest-egg. Interest and dividend payments are sometimes said to "offset" the impact, but they are subject to income tax and often do not exceed the inflation rate.
A plan can help you minimize inflation's effect on your cash flow and your retirement standard of living. Here are a few strategies to consider:
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Create a retirement income plan. Determine how much money you need to fund your retirement lifestyle and pay your day-to-day bills. Consider your potential lifespan and the health care expenses you may incur.
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Save as much as possible. According to CNNMoney.com, you need a portfolio about 25 times the amount you withdraw in your first year of retirement to support your inflation-adjusted withdrawals over a period of 30 to 40 years.5 While automatic investment plans won't assure a profit or protect against a loss, they will help you save on a regular basis by investing a fixed dollar amount at regular intervals.
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Balance safety and growth. Many retirees invest in bonds and bank certificates of deposit (CDs) because of their safety - relative to stocks - and the income they pay. But these so-called "safe investments are highly vulnerable to inflation because they frequently offer returns lower than the rate of inflation and their real value can erode over time.
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Maximize the potential of your self-directed retirement accounts. Fully fund your employer-sponsored pension plans, taking advantage of any employer match. Keep in mind that even when IRA contributions aren't tax-deductible, they grow on a tax-deferred basis.
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Build on your gains. By reinvesting all interest and dividends, you can leverage the power of compounding - the growth of earnings on earnings.
Inflation has become a fact of life. To learn more about how you can minimize its impact on your standard of living, speak to your financial advisor.
1 Average price data provided by the U.S. Bureau of Labor Statistics. To calculate the change in price for other goods, visit www.bls.gov/cpi/home.htm and click on "Average Price Data."
2 The U.S. Bureau of Labor Statistics inflation calculator can be found at www.bls.gov/cpi/home.htm. Click on "Inflation Calculator."
3 A retiree with $75,000 in 2005, would need $146,391.18 by 2031 if inflation rose at 3% a year. See http://www.halfhill.com/inflation.html
4 "Inflation - Who Says It's Dead?", by Michael W. Hodges, Grandfather Economic Report, January 2006. (http://www.financialsense.com/editorials/hodges/2006/0106.html)
5 "Can I retire early?" by Walter Updegrave, May 9, 2005. (http://money.cnn.com/2005/05/03/pf/expert/ask_expert/)
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Making Healthy Choices
Rising healthcare costs continue to grab headlines. Garnering significant attention: the impact of higher health expenditures on America's retired population. Some observers predict that a large number of retirees may not be able to obtain the level of healthcare they desire.
Many do not even know they are at risk. According to a study by the Employee Benefits Research Institute (EBRI)1, adults between the ages of 55 and 64 expect employers to pick up their expenses. The balance, they anticipate, will be covered by Medicare.
Will You Have the Healthcare You Want?
In reality, retirees use a substantial amount of their own money for medical care and prescription medicines. In 2003, Medicare beneficiaries age 65 and older spent an average of $3,455 - with 45 percent of it going to premiums, private Medicare plans, and private supplemental insurance.2
The EBRI study found:
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Actual healthcare costs are five times higher than retirees anticipate. Despite the 2004 Medicare drug benefit, they will need between $80,000 and $700,000 to pay out-of-pocket healthcare costs.
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Employers are providing less coverage for retired former employees. Some plans have cut medical benefits entirely or have asked retired employees to accept lower pension payouts in return for full medical coverage. The level of benefits is expected to drop to 10% of total medical expenses by the year 2031.
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Only 71% of employers are increasing retiree premium contributions.3
Meanwhile, some pundits say that Medicare is in deeper financial trouble than Social Security.
In this climate, retirees will face potentially devastating financial challenges - nursing-home expenses, for example. At some point in their lives, most Americans will need nursing-home care to recover from an illness or for extended treatment. The average cost of nursing-home care is more than $50,000 a year and rising - and costs can vary widely, depending on where one lives. About one-third of nursing-home residents pay all of their nursing home costs themselves, and many deplete their personal resources in just six months.4
Preparing for Your Health Care Needs
Even under the best of circumstances, you are likely to pay more for your healthcare benefits in the years ahead. You may also be required to meet higher deductibles, and will probably have to reach into your own pocket for cutting-edge treatments.
To fund the level of healthcare you want, you must have adequate financial resources. A plan can help you prepare for your healthcare needs while safeguarding your retirement quality of life. Here are some of the issues that you should consider:
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Save for your future medical benefits and healthcare expenses. Allocate part of your investment plan to accumulating assets for your medical expenses during retirement. Remember, healthcare costs can rise faster than the general inflation rate, so you may want to include investments that can minimize the corrosive effects of inflation.
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Fund employee healthcare accounts. Leverage the tax advantages of flexible healthcare spending programs so you can put more of your principal to work in your savings and investment accounts.
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Purchase long-term care insurance. Long-term care insurance can help you pay for assistance with activities of daily living, home healthcare, respite care, adult day care, care in a nursing home, and care in an assisted living facility. Visit www.naic.org (National Association of Insurance Commissioners) for A Shopper's Guide to Long-Term Care Insurance.
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Sign up for Medicare on time. Applying late may result in delayed benefits and higher premiums. Keep in mind that the application process, timeline, and premiums may vary.
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Buy supplemental Medicare coverage. "Medigap" insurance can help you pay for specialized medical care by covering some of the services that Medicare does not.
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Set aside emergency funds. Invest the money in a liquid, interest-bearing account, such as a money market fund. Your assets will earn income and be easily available to pay unexpected healthcare expenses.
With proper planning, you can be ready to manage your future healthcare needs. Speak with your financial advisor to find out how to address your unique situation.
1"Health Insurance Coverage of Individuals Ages 55-64, 1994-2002," Notes, Employee Benefit Research Institute, March 2004.
2"Out of Pocket Spending on Health Care By Medicare Beneficiaries Age 65 and Older in 2003," Data Digest, AARP's Public Policy Institute, September 2004.
3As reported in "Retirees Vastly Underestimate Their Healthcare Costs," The Caregiver's Hotline, May 24, 2004. (See http://www.caregivershome.com/news/article.cfm?UID=180)
4"Starting the Nursing Home Search," American Association of Retired Persons (see http://www.aarp.org/families/housing_choices/nursing_homes/a2004-02-26-homesearch.html)
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Betting on a Longer Life
Americans are living longer. Driven by advances in medical treatment and increased access to health care services, the average life expectancy in the United States has risen from 47.3 years in 1900 to more than 77.3 years in 2002.1
A longer life means you can look forward to more years of retirement. According to the American Association of Retired Persons (AARP), the number of Americans 65 years of age and older increased by a factor of 11 during the 20th century; by 2030, about one out of every five people will be a senior citizen.2 You may even reach the century mark. After reporting 37,306 centenarians in 1990, the U.S. Census Bureau projected that 834,000 Americans would be 100 years or older by 2050.3
Can Your Money Take You the Distance?
Since the odds favor a long retirement, you should be prepared to cover your living expenses for 20, 30, even 40 more years. The Congressional Budget Office projects that median-income couples, retiring at age 66, need at least $298,000 in net assets to maintain their pre-retirement standard of living.4 But with the personal saving rate in the United States at a record low of approximately 0.5% of post-tax disposable income, 5 Americans may not be saving enough.
In fact, many pre-retirees - those between the ages of 55 and 64 - are worried that their nest egg is not large enough to last through their retirements.6 Your savings should be adequate to pay for your day-to-day expenses, without forcing you to give anything up, while plentiful enough to fund your retirement plans and dreams. You may also want to make sure that some of your money remains at the end of your life as a legacy for your children and grandchildren.
Planning for Your Retirement Needs
A plan can help you lay the groundwork for financial independence. It may also give you peace of mind - the knowledge that you have a strategy for accumulating the money you need to manage daily cash flow, the cost of your retirement activities, and future healthcare expenses. Focus first on the following issues:
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Estimate your financial needs. Assess how much money you may require and when you may need it. A good rule of thumb: Overestimate your lifespan to minimize the chance you will outlive your money.
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Review your savings and retirement options. Determine how much you might receive from Social Security. In addition to offering annual estimates, the Social Security Administration provides online benefit calculators. Ask your employer to explain your pension benefits to you. Determine the distributions you can expect from employer-sponsored retirement plans (i.e., 401k and 403b plans) and your own IRA(s).
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Create an investment plan with stated goals and a customized asset allocation. If possible, you should factor all your retirement savings vehicles into your asset allocation plan.
Build on each year's gains. You can leverage the power of compounding - the growth of earnings on earnings - by reinvesting all interest and dividends.
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Maximize the potential of your self-directed retirement accounts. Fully fund your employer-sponsored pension plans, taking advantage of any employer match. Keep in mind that even when IRA contributions aren't tax-deductible, they grow on a tax-deferred basis.
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Don't rely on Social Security. According to Social Security Administration, the average monthly benefit in January 2005 - after the cost of living adjustment - was $955 for a total of $11,460 per year.7 Your benefits, however, may be lower; the normal retirement age (used to calculate your primary benefit) varies by your date of birth. Furthermore, the government may one day overhaul the Social Security system.
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Manage inflation risk. Even an annual inflation rate of 3% can have a significant impact on your purchasing power. Furthermore, costs like health care can rise even faster than the general inflation rate.
Advance planning can help you secure your golden years. To design a retirement strategy that can last your lifetime, seek the advice of your financial advisor.
1 National Vital Statistics Reports, Vol. 53, No. 6, November 10, 2004.
2 Source: The American Geriatrics Society (AGS) Foundation for Health in Aging. "Trends in the Elderly Population," Topics At a Glance (http://www.healthinaging.org/agingintheknow/)
3 "Centenarians in the United States," U.S. Census Bureau, July 1990.
4 "Retirement Age and the Need for Saving," Economic and Budget Issue Brief, Congressional Budget Office, May 24, 2004. Data does not address the potential for significant healthcare expenses and difficulties obtaining health insurance comparable to what could be obtained during working years. (http://www.cbo.gov/showdoc.cfm?index=5419&sequence=0#F5)
5 The Economist, May 14, 2005.
6 "America's Long-Term Nest Egg Crisis," The Wall Street Journal, May 5, 2005.
7 Social Security Administration, http://ssa-custhelp.ssa.gov. Click on "What are the tax, benefit and earning amounts for 2005?"
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Social Security’s Role in Your Retirement
It has been said that a comfortable retirement rests on a three-legged stool of pensions, Social Security and savings. If so, the stool looks a bit wobbly these days. Employer pensions are becoming rarer and the future of Social Security is now under debate, leaving personal savings to bear much of the weight of retirement.
No matter what reforms the government may have in store, Social Security is unlikely to pay for all or most of your retirement dreams. Even with the system solvent today, the Social Security Administration expects the average retired worker to receive just $11,460 in benefits this year.
How Does Social Security Work?
Social Security follows a "pay-as-you-go" process, which means the taxes you pay into the system aren't held in your name for retirement. Instead, those dollars are used to fund the benefits of current retirees, just as contributions from younger workers will someday subsidize your benefits.
This approach works well as long as Social Security collects more in taxes than it pays in benefits, as is the case today. However, as current retirees live longer and 79 million baby boomers join the ranks of the retired, fewer workers will be left to fund the system. Social Security data indicates that there were nearly 42 employed Americans for every retiree back in 1945. Today, that figure has dropped to 3.3 and is expected to decline even further in coming years.
As a result, Social Security will be forced to tap into its reserves starting in 2018, when system outflows are first projected to exceed inflows. By 2042, those reserves will be exhausted unless changes are made in the meantime.
What Does It Mean to You?
The good news is that a secure retirement is still within your reach. All it takes is a little careful planning and disciplined investing on your part. Start by asking yourself a few essential questions:
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How much will I need each year in retirement? One rule of thumb suggests that it takes 75% of your working salary to maintain the same lifestyle in retirement. Keep in mind, however, that inflation is constantly increasing the cost of living. The younger you are, the more you can expect to pay for food, travel, health care and most other expenses during retirement.
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How much will come out of my pocket? To figure your share, subtract any pension payments, Social Security benefits and other income sources from your annual retirement goal. The Social Security statement mailed to most U.S. workers each year includes the latest estimate of expected benefits.
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How will I generate my "retirement paycheck?” Do you plan to save enough to live off your investment earnings and interest? Or will you dip into your principal each year? If so, remember that longer life expectancies increase the likelihood of outliving your money.
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Where should I invest? Start by contributing to tax-advantaged accounts, such as an employer's retirement plan or Individual Retirement Account (IRA). Because investment earnings in these accounts aren't eroded by taxes each year, they have the potential to grow faster than assets subject to current taxes.
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When should I begin investing? The sooner you start, the less you may need to invest to reach your goal. Even small, regular investments can grow into large amounts if given enough time. If you're getting a late start, IRAs and 401(k)s now offer special "catch-up" contributions to investors age 50 and older.
Of course, your retirement plans may involve different questions or answers. Consult your financial advisor for strategies specific to your situation.
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Investors should consider the investment objectives, risks, charges and expenses of the Aston Funds carefully before investing. Please call for a prospectus, which contains this and other information about the Funds. Read it carefully before you invest or send money.