2^nd Quarter 1998

Are You a Doomer or a Boomer?

There are two strong mindsets that heavily influence an investor’s success -- Doom and Boom. Recognizing where you fall on the spectrum between Doom and Boom can be the first step to building lasting wealth.

Doomers tend to be individuals raised in families affected by the 1929-1932 stock market crash and the Great Depression. The painful experiences of those days tended to foster highly cautious investors with a strongly pessimistic market view. For these investors, safety is often paramount and the fear of losing money has prevented them from benefiting from the phenomenal market returns of the last decade.

The Boomers, those born in the late 1940s and 1950s, have a different investing mindset. They tend to view the market as an easy game to play, with no significant downside. For these investors, there appears to be little reason to proactively protect their assets from declines.

The problem with being a Doomer is that you are passing up opportunities to build financial security by improving the return potential of your investments. In fact, you may even be losing buying power when inflation is calculated into your returns. Moving away from the Doomer mindset is a matter of weighing risk and reward. Over the past 25 years, the average mutual fund has returned nearly 12% annually. A $10,000 investment at that rate of return would be worth $169,782 in 25 years.

But what if you, the Doomer, opted instead for a conservative 10-year Treasury bond? At an average annual return of 8.65%, your investment would be worth $79,584 at the end of 25 years. That’s a difference of more than $90,000. In other words, caution can carry a pretty heavy price tag.

For the Boomer, the issue is more one of future consequences. Markets never go straight up forever. History tells us that a correction of 30% or more is not unrealistic in the next year or maybe even in the next few months. That can put a heavy setback in your retirement plans. Suddenly, instead of a nice nest egg of $500,000 generating $50,000 or more in returns each year, you could be looking at $350,000 that isn’t appreciating. If you still need to withdraw $50,000 annually to meet your expenses, your nest egg could erode very quickly. Some level of risk aversion only makes sense.

As an investment advisor we have two challenges. (1) Provide the Doomers with a level of risk management that helps them overcome their fear of losing money and (2) equip the Boomers with a safety net to protect them from their overly optimistic belief that the bear market is an element of the past.

Managing risk without unduly sacrificing return, as the Doomers tend to do, requires an active investment strategy that looks at market trends and strives to get out of the bear market’s way. Through analysis of the stock market’s historical trends, we have developed computerized models that look for indicators that the market trend is reversing itself.

While not every move will be profitable, and there may still be occasional losses, our objective is to miss 80% of the bear market slide and participate in at least 80% of the bull market’s rise. If we achieve these goals, our clients’ portfolios will equal the historical return of a buy-and-hold investor with significantly less risk. Exceeding the 80% goal will enable our clients to capture and hold on to even more of the market’s superior earning potential.

For the Doomer, the reduced risk offered by this investment strategy can mean greater mental comfort when investing in the market and greatly increased returns over more conservative investments. And for the Boomer, the jolt of a sharp market decline would not mean the end or postponement of a dream.

Conditioned by the last two bear markets of 1987 and 1990, many financial advice columnists are taking a bit cavalier attitude toward the risk of bear markets. After all, if you recover all your losses in a couple months, what does it matter?

The problem is the last two bear markets are not representative of the market’s history, even over just the last 50 years. To test your knowledge of bear markets, see if you can answer the two questions below.

Thanks to John Liscio, "Timing the Bear," Barrons, May 23, 1994. And yes, it’ still true today.

Answer 1: Someone with $10,000 in the DJIA back in February 1966 had to wait until June of 1986 to catch the guy with $10,000 in T-bills -- 20.4 years.

Answer 2: The Value Line investor is still trying to catch up.

As a result, according to CDA/Wiesenberger, investors have flocked to index funds in record numbers, with assets rising 177% to $152 billion in the two years ended in 1997. These investors may be in for a rude awakening by the very nature of the S&P 500.

The S&P 500 Index is diverse, although not in the way many people think. The index is weighted by market capitalization, so the influence of changing stock prices is not spread evenly among the 500 companies. Instead, the largest cap stocks have significantly greater impact on changes in the index.

A company’s market capitalization is calculated by multiplying the share price by the number of shares outstanding. Four companies, General Electric, Coca-Cola, Microsoft and Exxon, make up about 10% of the index. Just 52 companies, slightly more than 10% of the 500 companies represented in the index, account for half of the S&P 500 value.

These larger companies have been significantly outperforming their smaller counterparts in recent years. According to Gus Sauter, managing director of quantitative strategies at Vanguard Group, from 1995 to 1997, the largest 100 stocks in the S&P 500 rose 140%, the middle 100 rose 107% and the smallest 100 rose 92%.

Earlier in this cycle, the stock market’s upward movement was largely been propelled by declining interest rates. When the economy strengthened and interest rates leveled off, the market entered a "performance phase," with corporate earnings driving increased stock values. A steady influx of money into the market has added fuel to the advance, while a record number of corporate buy-backs and mergers have also helped keep prices high.

The trend change from an interest-rate driven phase to an earnings-driven phase in this bull market could prove troublesome to index fund investors. The key is that earnings must remain strong. The prospects for weaker earnings among the multi-national companies that make up the top quartile of the S&P 500 -- due to numerous factors, dominant of which is the Asian crisis -- could have a very negative impact on the indices and index-linked funds.

Because the index-linked funds have no active management, nothing can be done to limit the impact of a drop in value on investors. And, there’s another possible trap ahead for recent index fund investors. The market’s rise over the past 10 years has created enormous capital gains in the index funds, gains that don’t have be to recognized for tax purposes until investment positions are sold. If investors begin to liquidate their fund positions faster than new investors enter the funds, forcing the index funds to sell stocks, more recent investors will be saddled with capital gains taxes, without the earlier gains.

One ironic aspect of getting older is that you begin to read the obituary pages. It’s almost reassuring to see how many people are dying in their 80s and 90s. For someone to die in his or her 50s seems almost criminal. After all, they should have had so many productive years to come. We’ve begun to lose sight of the fact that Social Security was originally designed to begin paying out at 62 because most people died prior to that age.

Today, Americans as a whole are living longer than they ever have. A couple, now both aged 65, can expect that at least one of them will live another 25 years. For couples who are both 75 years of age, at least one could live another 17 years. Extra years can mean extra enjoyment - but they also require a more aggressive investment approach to make sure that retirement is adequately funded.

The traditional investment recommendation for retirees was to position their assets safely in income producing investments. With a limited time horizon, you didn't want to risk losses in volatile equities. But that strategy won't work today. Retirees must now consider stock funds for an increasing portion of their retirement portfolios. Long-term capital appreciation is necessary to fund longer-term retirement. After all, 25 years is a long time to get by every month on the same size interest checks from bond and money funds. Inflation and an over-emphasis on current income can virtually doom the retiree to a steadily declining standard of living.

(1) The difference between compounding the dividends and interest on $10,000 earning 10% annually and withdrawing your earnings each year is $73,347 over 25 years.

(2) Taxes paid annually at the 20% capital gains rate would reduce the $108,347 untaxed balance to $68,484. If the $10,000 were invested in $2,000 increments over five years in a Roth IRA (the individual contribution limit is $2,000 annually) in 25 years the account would total $90,358, tax free.

A relatively small investment can become a sizeable nest egg, given time and the magical impact of compounding.

Compounding is the process of earning interest on interest, or dividends on dividends, over time. Realizing the benefit of compounding is a simple matter of reinvesting your interest and dividends and putting your investment earnings back to work for you, preferably tax-deferred. Your money increases slowly at first, then with much more dramatic speed.

The sooner you put your savings and investment plan into action, the longer your money goes to work for you, compounding your investment returns into a substantial nest egg.

For example, $10,000 invested at 10% a year would return $1,000 per year. If you take that money out each year and spend it, at the end of 25 years you will still have your $10,000 principal and you would have spent $25,000 for a total of $35,000. If instead, you reinvest your earnings each year, at the end of 25 years, you would have $108,347.

To enhance the power of compounding, you want to minimize the impact of taxes. Assuming you paid capital gains taxes of 20% each year on your $10,000 plus interest and dividends earning 10% annually, you would have $68,484 at the end of 25 years. Taxes would eat away nearly $40,000 in earning power.

If the $10,000 is invested in a tax-deferred account, you would only pay taxes as the money is withdrawn at the end of 25 years at your personal income tax rate. If the full amount is withdrawn in a lump sum -- an unlikely scenario -- and you are in a 30% tax bracket, you would have $75,842 after taxes, a $7,358 improvement over the non-deferred account.

Invest that $10,000 in a Roth IRA, where earnings accumulate tax free, and your tax burden would be based only on the original $10,000 investment (assuming a 30% personal income tax rate, that would be $3,000) The catch is that you might need to invest the $10,000 over a five-year period to comply with the Roth IRA annual contributions limit of $2,000 per individual. But as the graph above shows, this would still produce significant benefits over a taxed account.

There are two approaches to saving for your children’s college education. The first is a bit simplistic. Just focus on getting wealthy and the odds are you will have the money to assure your children a first-rate education. The second is a bit more methodical, but much more likely to produce results. Plan and save now.

Remember the old saying, "The early bird gets the worm"? Well, that bird was able to get its breakfast for two simple reasons: he knew what he was looking for and he had time to achieve his goal. The same lessons translate to investing, and certainly apply when it comes to achieving one of life's most important goals - financing your child's college education.

A recent poll by Money magazine indicates that 87% of parents in the United States expect their children to attend college, but almost half have not saved enough money to cover the costs. And those costs are significant, with tuition, fees, and room and board at four-year public schools averaging $7,118 a year, and the price tag climbing to $18,184 at private universities, according to the College Board.

Smart investment strategies can help you be ready when the college years arrive. Keep these simple do's and don'ts in mind as you plan for your child's future:

Set family goals: Does your child want to go to an in-state school, or head to the Ivy League? It's important to know your destination - and make a commitment as a family to accumulate the resources to get there.

Start Saving Early and Don't Neglect Retirement Investing: Time is money, and more time can mean more money. As your investment principal grows, so will the earnings on your money. But don't forget about saving for your own future. You need to take advantage of the tax-deferred gains you can make on your 401(k), IRAs or similar tax-deferred retirement accounts. Retirement assets generally will not affect your child’s eligibility for federal need-based college financial aid.

Invest in Stock Mutual Funds: Again, according to the Money magazine poll, 53% of parents saving money for their children's higher education have invested in low-risk and low-interest certificates of deposit, while only 23% of the money is in stocks and stock funds. Stocks do carry more risk, but are your best bet for making money in the long term.

Who Owns the Assets Makes a Difference: Even though you have earmarked certain investments for your children’s education, it may not be the best idea to put those funds in your child’s name. For starters, if the account is in your child’s name, you cannot deny them access to the funds when they turn of age or dictate at that point how the monies are used. Second, by having assets in their names, your children may not be able to qualify for financial aid or loan programs, which could substantially pay for their education. The recent change in capital gains taxes also reduces the attractiveness of putting assets in a child’s name in terms of tax treatment.

Don’t Overlook Scholarships and Financial Aid Programs: There are actually scholarships that go unused because of a lack of applicants. Many philanthropic organizations offer specialized scholarships, as well a churches, businesses, non-profit organizations and even rural electric co-ops. In some instances, the financial aid office at your child’s college of choice may be able to help you find scholarship and financial aid money, but don’t stop there. Talk to local business groups and organizations to find out what else is available.

As in all investing, put time on your side. The earlier you begin, the greater the impact compounding will have on assuring your children the education they need to succeed in life as adults.

Sosnowy Investment Management Company. (SIMCO)
3883 Telegraph Road, Suite 100
Bloomfield Hills, MI 48302
Phone: 800-526-2152
Fax: 248-642-6741
Contact: info@lastingwealth.com

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