Where to Turn When Your Adviser Does You Wrong

While I’m not a big fan of how many people quickly jump on the litigation bandwagon for almost anything these days, there are legitimate situations where you may have a case against a bad broker or advisor. Even so, keep in mind that you can’t sue just because you lose money on an investment they have recommended. Certainly, losses may be a part of some underlying illegal activity, but the fact that you lost money is not enough to seek legal action.

It’s also important to note that just because the finance professional you’re working with may have put you into an investment that didn’t do as well as expected it doesn’t mean they are doing anything wrong. Especially after the latest market meltdown where it was nearly impossible to find a safe place for money it should be clear that the likelihood of losing money out there is real. That being said, there are times when your broker or financial advisor are not exactly working with your best interest at heart which may give you some legal recourse.

Omission and Misrepresentation

If you sit down with someone and they explain to you that a particular investment guarantees a certain return and then fails to perform as such, the broker may be misleading you. In fact, any time someone tells you that an investment is guaranteed and they aren’t talking about something like a certificate of deposit or other guaranteed fixed income instrument, be very cautious. Even if there are guarantees for the investment it probably comes with significant fees and/or long holding periods which are not in your best interest.

There is also the case where a broker may simply omit information completely. A common example of this is when they advise you to purchase a mutual fund that has a front-load, yet they fail to mention it prior to the sale. Any time they don’t properly disclose the fees or commissions associated with a product you may have a case of omission.

Account Churning

This isn’t as common unless you have an account where the broker or advisor has authorization to place trades within your account on your behalf or if they are managing it on their own. For most people, these types of accounts aren’t something to be concerned with, but a lot of people want a completely hands-off approach and give their advisor the ability to make trades as needed. Generally speaking, the broker or advisor then makes a commission on each sale, which can lead to excessive trading within your account so that they can generate higher commissions. Even if the returns are good, this excessive trading is prohibited.

Unsuitable Investments

This is where it can become a bit subjective, but that is what makes it an area that is easily abused. Unless you specifically tell your broker or advisor to buy X number of shares of ABC stock, any recommendations that they make must be within your suitability. There are a few different criteria that can be used to determine investment suitability:

• Time horizon
• Risk tolerance
• Investment objective
• Liquidity

For example, let’s consider a 65 year old retired person that seeks investment advice regarding a way to generate a relatively steady stream of income with the ability to access their principal at any time. Just by looking at the client’s age, investment objective (to generate income), and need for a liquid investment, it is pretty clear what type of investment vehicles would be suitable. Even so, the advisor may make an argument for adding stocks or mutual funds to their portfolio, or even worse, lock the person into an annuity which generates fixed income, but lacks liquidity for a number of years. In cases like this, the advisor is probably not following suitability requirements.

Most brokers and financial advisors will do a basic suitability test and gather information about your financial situation and goals before making any recommendations. If you meet with someone and they hardly ask you any questions about your income, investment objectives, risk tolerance, or anything of that nature, be extremely cautious. How can someone honestly make a suitable recommendation if they know little or nothing about you?

Of course, good advisors will keep meticulous notes during your meetings and will keep risk tolerance and other suitability information in your file. So, if they have gone through the suitability process and you find yourself with an investment that just isn’t performing as well as you’d like, you may be out of luck. Legal recourse is only for when they completely disregard or don’t even consider your situation before making a recommendation.

What to do if You Experience One of These Offenses

There are two ways you can go about it–through the legal process with a securities lawyer or through arbitration. Attorneys who specialize in securities law can certainly help determine whether or not you have a case, but they can be expensive. Most attorneys will require an up-front, or contingency fee, before taking your case. In addition, they will likely seek somewhere between 20 and 40 percent of the damages collected.

What you may not know is that when you open an investment account with a broker or advisor, you probably entered an agreement to go to arbitration in the event something goes wrong. Arbitration is a dispute resolution process which is an alternative to the traditional lawsuit in court. Rather than have a matter decided by a judge and jury, participants to an arbitration proceeding have their dispute resolved by impartial persons who are knowledgeable in the areas in controversy. Those persons are called arbitrators.

Arbitration is generally a much cheaper and quicker process than the traditional legal process. Not only that, but you can generally represent yourself during arbitration, which can save a lot of money on legal fees. Once both sides present their case, the arbitrators make a final decision. Neither side can rebuke or appeal. For more information, visit the American Arbitration Association.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

What to do When You Have a Bad Financial Advisor, Planner, or Broker That Isn’t Working in Your Best Interest

Diversification is the foundation of an investment portfolio. While simply being diversified can’t eliminate risk, it can help minimize your overall risk and protect you from catastrophic losses. But what does it mean to be diversified? Everyone tells us about how we need to diversify our investments, own stocks, bonds, real estate, cash, commodities, and everything else. That makes sense, but not many people explain how to go about it. Do you just buy an index fund or ETF that covers each type of asset? What percentage of each should you hold? And when do you rebalance your portfolio, if at all?

One thing is certain, and it’s that there’s no silver bullet allocation that will work for everyone. We all have different investment goals, risk tolerance, and time frames. We also know that just buying a bunch of funds does not always equal instant diversification due to fund overlap. So, before you begin picking a bunch of funds to add to your portfolio in order to become more diversified we first need to understand the basic types of asset allocation: strategic, tactical, and core-satellite.

Strategic Asset Allocation

The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon. If you aren’t implementing a specific strategy to your current portfolio, chances are you’re holding a strategic asset allocation and don’t even realize it. With this type of allocation the investor simply picks and chooses different funds and asset classes that will hopefully minimize risk with offsetting investments that generate a return within a specific range.

This is the most common type of allocation where investors typically pick a few stock funds and then offset it with a certain percentage of bond funds that’s suitable for their age or risk tolerance. The idea is that you can strategically offset some of the risk from stocks by adding some safer investments such as bonds or cash equivalents. With that mix and the known expected historical returns of each type of asset you have a defined range in which you deem your portfolio successful.

Strategic asset allocation is also the allocation that can benefit from regular rebalancing. Since you are primarily concerned with keeping your overall stock/bond mix in-check and therefore keeping your risk at a suitable level you’ll want to rebalance at least once a year as those ratios begin to skew from your target. Over time, either stocks or bonds will outperform the other and make you overweight in one area and underweight in another. By rebalancing back to your target you’re effectively taking some of your profit by selling high and reinvesting it in the asset that is lagging, therefore buying low.

Tactical Asset Allocation

Think you have what it takes to beat the market? If so, tactical asset allocation is for you. With this method an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains. Tactical investors aren’t concerned about owning the whole market or just sitting on a few index funds for years at a time. Instead, they try to ride the tide and buy into asset classes that are on the move. If you’re someone who jumps out of stocks when things head south and move into bonds, or dump your money into gold because that’s the current hot commodity, you’re a tactical investor.

But tactical asset allocation doesn’t simply have to do with trying to find the current hot sector. You can also be a contrarian investor. A contrarian usually goes against the grain and instead of buying into the current hot investment they buy into something that’s been beaten down in hopes that it is undervalued because nobody is paying attention to it. This will hopefully result in investors coming back to that asset and driving the price up so the contrarian and eventually sell for a significant gain.

Keep in mind that this type of asset allocation is riskier than others because it does take an active approach. Anyone can get on a hot streak or get lucky, but don’t forget that even the best money managers in the world can’t consistently outperform the market forever. This strategy is usually not well-suited for your long-term assets such as those used for retirement, but if you have an investment account on the side or simply limit this type of strategy to a small portion of your overall portfolio you can still try to take advantage of moves in the market without putting everything on the line.

Core-Satellite Asset Allocation

Finally, we come to the core-satellite asset allocation strategy. This strategy is more or less a hybrid of both the strategic and tactical allocations mentioned above. Here, your portfolio is essentially made up of two components:

1. First, a core holding of stocks, bonds, or index funds make up the bulk of your portfolio. This is the strategic component that uses the offsetting risk strategies mentioned above. The core of your portfolio may consist of anywhere from 50-80% of your total portfolio.
2. The remaining portion of your portfolio is your satellite allocation which may implement more of a tactical approach. While your core holdings make up the bulk of your portfolio and won’t change much over time, your tactical component allows you to still scope out opportunities in the market. This is where you would take a more active approach and try to take advantage trends without risking your entire portfolio.

This strategy is great for those who want to be more involved with their investments without relying entirely on their investment selection success. With the bulk of your holdings following a more passive approach you will still generally follow the market with relative ease, but you also have the potential to enhance your gains (and possibly losses) by managing some of the money on your own.

Which Strategy is Right For You?

There’s no right or wrong answer because it really depends on what you’re comfortable with and how active a role you want to play in your portfolio. That being said, most people will probably benefit the most from taking a traditional strategic approach that consists of creating a tried and true mix of stocks and bonds suitable for their age and risk tolerance, but the recession and stock market performance has a lot of investors thinking twice about this strategy. Some have abandoned the strategic model completely and are now pure tactical investors, but I’d caution anyone about making that drastic of a move. At least with your entire nest egg.

Personally, I use the core-satellite approach. About 80% of my total portfolio consists of long-term and low-cost funds that give me about a 75% stock and 25% bond position. Then, I do have about 20% of my assets that I have more control over and use these funds to buy ETFs, funds, or individual stocks that I think will provide above average returns in a year or two. It has proven to be a decent strategy for the past four or five years. As a whole I typically perform on par with, or slightly outperform the market from year to year. In fact, 2009 was a great year for this strategy as I picked up a number of individual stocks at near record low prices such as GE, Abbott Labrotories, and Intel only to see them surge in price, boosting my returns on the year.

So, what kind of asset allocation approach do you use? If you are thinking about adding some tactical investing to your portfolio it’s important to keep trading costs down as frequent trading and commissions can have a negative impact on your total return. So, stick with a low-cost or free broker such as Zecco.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Three Types of Asset Allocation: Strategic, Tactical, and Core-Satellite – Which is Right for You?

Using Roth Assets to Pay Tax Liability May Eliminate Conversion Benefits

Everyone loves the Roth IRA. If you read any personal finance blog, website, or listen to any financial guru they will rave about how the Roth IRA is the best thing since sliced bread. What makes this investment vehicle even better is that starting in 2010 anyone can convert their Traditional IRA (therefore pre-taxed) accounts to a Roth IRA regardless of their income. Wow, the government is really doing investors a a favor, aren’t they? Now even those who were not eligible for a Roth IRA in the past can now convert all of their money so that it’s tax free in retirement!

Not so fast. While it’s generally accepted that the Roth is going to be a better option for a lot of people in retirement you can’t discount the true cost of the conversion. In most cases, the argument is that many people will be in a lower tax bracket right now and at the time of the conversion compared to in retirement. This has to do with the fact that the government has a nasty habit of increasing taxes and that you may have accumulated a significant nest egg that generates even more income in retirement than you had before you retired. So, in this scenario it would make sense to have tax-free income in retirement rather than getting less of at tax break while you’re working.

Unfortunately, it’s not that simple.

Using Roth IRA Assets to Pay Conversion Taxes

There are two different ways you can handle the taxes when you do a Roth conversion. Ideally, you would have funds already set aside outside the IRA that you can use to pay the taxes. This means your account value remains intact and you only have to pay the prevailing tax rate on the conversion amount. There’s also another way, and that’s to use the funds inside your IRA to cover the tax bill. Sadly, this is what a lot of people are choosing to do simply because they don’t have the money available to pay the taxes on the conversion. Big mistake.

First of all, if you choose to do this you’re actually taking a distribution from your IRA. Now, if you’re under 59 1/2 when you do this you’ll be subject to the 10% early withdrawal penalty. So, not only are you owing the regular taxes, but you are getting hit with an additional 10% penalty. If you use outside funds to pay the taxes this penalty wouldn’t apply. Second, using IRA proceeds to cover the taxes just reduces your account value. You could easily be faced with the fact that your account will be cut by about 40% just to do the conversion. How long would it take to recover from that?

Running a Few Different Scenarios

One of the tools I have through work is Blackrock’s Roth IRA conversion calculator. With this tool you get to plug in a bunch of numbers to create different scenarios to tell you whether or not a Roth conversion is the best choice. For this exercise I wanted to focus on the impact that paying the taxes from the IRA assets has on the conversion. Obviously, there were many scenarios where having a very low tax rate now versus a very high tax rate in retirement showed the Roth was the big winner, but I wanted to focus on a few more realistic scenarios.

For these scenarios all of the data is the same except for the tax rates before and during retirement:

• 35 years old at the time of the conversion
• Begin taking retirement distributions at 62
• Planning for 30 years worth distributions
• 8% returns pre-retirement
• 5% returns in retirement
• $100,000 account value

Assumptions:

The results assume that the taxes due when converting your current account to a Roth IRA are taken from the assets being transferred. It also accounts for the early withdrawal penalty on assets used to meet that tax liability. You do have the option of paying the tax liability out-of-pocket, which would affect the results. It further assumes that taxpayers at any income level may convert to a Roth IRA and that any tax liability arising from the conversion is paid in equal installments over two years, beginning with the 2011 tax year, at the same tax rate. These rules apply to conversions made during 2010. It also assumes that no distributions are taken before age 59½ and that you take even annual distributions during the retirement period you specified.

Roth Conversion at 28% Tax Rate Before and During Retirement

For the first example I wanted to see what would happen if tax rates didn’t change between the date of the conversion through retirement. I stuck with a middle of the road tax rate of 28%. As you can see, when you take money out of the IRA to cover the taxes and penalty you are left with a much smaller nest egg upon retirement when compared to leaving it in a pre-tax account. In this case, it’s nearly a $300,000 difference. Of course, when you break it out into annual withdrawals the impact is minimized, but you’d still be better off in this case to not do a Roth IRA conversion.

Roth Conversion at 25% Tax Rate Before and 28% During Retirement

What happens when your tax rate is higher in retirement? This is the classic example of when a Roth is the perfect retirement vehicle. Well, again we can see that because taxes were paid out from the IRA the damage done is hard to recover from. Even in this scenario there is a case that can be made to show that the conversion might not be the best idea.

Roth Conversion at 28% Tax Rate Before and 33% During Retirement

As tax rates increase both before and after, the gap narrows. Sticking with the pre-tax account virtually identical with the Roth just slightly losing out. But in reality and with variations that can’t be planned for I’d call this scenario as virtually equal.

Roth Conversion at 33% Tax Rate Before and 25% During Retirement

What happens when you bet wrong completely? All of the previous examples were showing tax rates the same or higher in retirement. But we simply don’t know what will happen decades from now. So what happens if tax rates end up being lower, or you make less in retirement therefore have a lower tax rate? Ouch! Making the wrong bet and using IRA assets to pay the conversion taxes cost you almost 20% overall.

Some Final Considerations

First of all, there are a lot of assumptions being made when it comes to long-term financial planning. Even though these examples kept everything constant across the board except for tax rates the real world will throw things in that can’t be predicted here or anywhere. You may retire earlier, or later. You may not be able to get the returns you expected leading up to retirement. You may not get the returns you expect in retirement. Your tax rates may change numerous times between now and retirement. Laws regarding retirement plan distributions may change entirely. There are many things we simply can’t plan for, so you need to keep that in mind when trying to weigh your options. Even what appears to be the best decision on paper today may come back to bite you in 30 years. The best you can do is make an informed decision.

This exercise wasn’t to make an argument against a Roth IRA conversion. Not at all. It was simply done to show the significant impact that using your account proceeds to pay the tax bill can have on the end result. Paying the taxes with outside funds is a completely different situation and the results are very different. Instead, this just throws a little information out there for those who were thinking about doing the conversion after hearing all the hype in the news and maybe didn’t think about where the money for taxes was going to come from.

Finally, keep in mind that even if you do have outside funds to cover the tax bill you want to make sure you’re not putting yourself into financial harm. If it’s going to take every penny of your emergency fund to pay the taxes on a conversion you’re putting yourself in a risky short-term situation only to try and maximize something in the future. In addition, even if you do spread out your tax bill across two years it may still end up bumping you into a higher tax rate, could end up subjecting you to AMT, or any number of tax complications.

My recommendation is to simply not take the decision to convert to a Roth IRA lightly. Unless your account is very small or you’re only converting a portion of your total retirement portfolio you should seriously consider getting some professional advice. Either from an accountant who handles your taxes or a fee-only financial planner you trust. They can help you navigate the waters of this important decision.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Think Twice Before Doing a Roth IRA Conversion if You Are Using Account Assets to Pay the Taxes Due

Identify and Eliminate Overlap for Real Diversification

So, you’ve got a nice portfolio with a handful of index funds that include a good mix of growth, value, and various market caps. You’re diversified quite well, right? Not so fast. If you’re like most investors, even though you have a number of funds that you’re invested in, chances are there’s a lot of overlap going on.

What is fund overlap? To put it simply it just means that two different funds or ETFs share some of the same underlying holdings. The more overlap the funds have, the less diversified your overall portfolio. For example, if you own three large-cap stock funds and 85% of the holdings are found in each fund, what’s the point of owning three funds just to diversify 15% of your total portfolio? Ideally, you want to create an efficient portfolio where each fund or investment does a specific job and overlaps as little as possible with your other holdings. Otherwise you might find yourself holding a bunch of funds while only providing very little true diversification.

How to Find Overlap

How do you actually find out if your funds overlap? Thankfully, there is a easy and free tool provided by Morningstar called Instant X-Ray. To use it, all you’ll have to do is create a free account. Even better, is there are a bunch of additional tools you’ll then be able to use, but that’s a topic for another day. So, once you get logged in you’ll first be presented with a screen that looks like this:

You can see how simple it is. You just have to enter the ticker symbols and either the percentage or dollar amount of each holding. For this example I created a simple Vanguard large-cap stock portfolio:

• 50% Vanguard 500 Index (VFINX)
• 25% Vanguard Value Index (VIVAX)
• 25% Vanguard Growth Equity (VGEQX)

This is something many people would do with their portfolio, although the percentages would differ since you’d also have some other asset classes mixed in. But many people take the approach of putting the bulk of their investment into an S&P 500 index fund and then complement that with a few funds that focus specifically on growth and/or value. On the surface it seems like this would be a pretty broad portfolio encompassing virtually the entire large-cap equity universe, but is that really the case?

Getting the Results of the X-Ray

Once you enter your holdings and proceed to the next page you’ll be taken to the overall x-ray overview page, which looks like this:

X-Ray Results

As you can see, there is a lot of good information here. It analyzes your portfolio and gives you a detailed breakdown as to how the investments are spread out. While this is all useful, we can go one step further to specifically target fund overlap.

But before we do that I wanted to take a moment to highlight something. You’ll see I have highlighted some of the data in yellow on this image. The two columns represent your portfolio and the S&P 500. Without even moving on to the stock intersection tool we can see that even though you have three different funds, your portfolio is virtually identical to the S&P 500. Most categories vary by only a fraction of a percent! Think about that for a second. What’s the point of having three different funds just so it can look identical to what a single index fund looks like?

Detailed Stock Intersection Report

Going one step further, click on the “Intersection” tab at the top of the X-Ray report. This will take you to a detailed breakdown of the individual stock holdings inside each fund. For this example you’ll get this:

Stock Intersection Report

This image is just showing the top few holdings, but the list will go on and on detailing everything. But this one is sorted by the top holdings by percentage of your current portfolio. To understand what we’re seeing, let’s look at the top holding overall, which is ExxonMobil. Looking to the right you’ll see that it makes up 3.35% of your overall portfolio. Under that heading you’ll see that Exxon is held in two of your funds–the 500 index and the value fund. The numbers on the left represent what percentage of the fund is invested in Exxon. But what is of more interest is the numbers on the right which tell you the percentage in each fund as it stands in your portfolio.

Glancing at the list of the top 14 or so holdings you can quickly see that each stock is in at least two, and in many cases, all three of your funds. This seems like quite a bit of overlap, but what does the rest of the list look like? Well, you have to move down to the 29th largest holding to finally find a stock that is only in one of the three funds and doesn’t overlap at all. And guess what? That stock makes up just 0.81% of your portfolio. As you go down the list it takes another 10 holdings or so before you find another non-overlapping stock and they slowly begin to become more common as you reach the bottom of the list. But in most cases the stocks that don’t overlap make up just 0.10% to 0.65% of your total portfolio each. As a whole, less than 15% of your portfolio is made up of stocks that don’t overlap with your other holdings. That probably isn’t the kind of diversification you had in mind.

Eliminating Overlap

Fund overlap is just a fact of life when it comes to investing. There are only so many viable stocks out there to invest in and there will always be certain funds of different types that invest in some of the same stocks. Unless you’re crafting a custom portfolio of individual stocks by hand, don’t expect to eliminate all of the overlap. But having excessive overlap isn’t helping you create a diversified portfolio and it’s just complicating things with additional fund holdings that you may not need.

As you can see from the example we used above, even having three different large-cap funds with different investment styles, the end result was that nearly 90% of the stocks within the funds were found in the other funds and your overall portfolio looked nearly identical to the S&P 500. That was a slightly exaggerated example to make a point, but chances are you will have a few funds that overlap quite a bit and really aren’t helping you diversify.

So, keep things simple. Stick to just holding one or maybe two funds of each major asset class at the most. The most common and accessible classes are:

• Large-cap Domestic Stocks
• Mid-cap Domestic Stocks
• Small-cap Domestic Stocks
• International Stocks
• Aggressive Bonds
• Conservative Bonds
• Real Estate

Now, each of these asset classes are then broken down into things like value, growth, individual sectors, and international stocks may have specific regions and market caps, and there are all sorts of types of bonds. But as you saw from the example above, investing in various types of funds within the same broad category really didn’t do much good. To keep things simple, consider just an S&P 500 index fund to cover your large-cap, pick a small/mid-cap index to cover that category, and so on.

Sure, you may want to find some additional funds within a specific category to further diversify, but start with the basis and create your core portfolio with just one fund out of the major categories that gives you the proper overall allocation in line with your investment objectives and risk tolerance. Once you’ve created your core holdings you can then explore some specialty funds that can further diversify your portfolio. And the best part is you now have a tool at your disposal that can help you determine whether or not those funds make sense in meeting your diversification goals.

Remember, it isn’t the end of the world if you have a lot of overlap in your portfolio, but it can give you a false sense of diversification and expose you to more risk than you anticipated. It’s also just easier to manage a streamlined portfolio. You can own just 5 index funds and be more diversified than a portfolio with 20 funds. Guess which one will be easier to keep track of and monitor?

Go ahead and sign up for a free account at Morningstar and plug your holdings into the X-Ray tool to see where you stand. You might be surprised.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Avoid Fund Overlap to Achieve True Diversification in Your Portfolio

Investing can be as simple or complex as you want to make it. With literally thousands of funds to choose from and countless individual stocks it’s easy to see how choosing the investments for your portfolio can be a daunting task. On the other end of the spectrum it can be incredibly easy. With the creation of target date funds and other asset allocation funds you can achieve a diversified portfolio by just choosing one investment.

Unfortunately, there’s more to it than that. Think of all the different rules of thumb you’ve heard over the years. You have the 100 minus your age to determine what percentage you should have in stocks. Then there was the 110 minus your age and so on. Then you have some people that suggest you should have just 10% of your portfolio in international stocks and others telling you to put up to 50%. Who is right? Well, there is no right or wrong answer because creating the right investment mix isn’t as simple as looking at your age and risk tolerance and slapping a model portfolio together. There are plenty of other factors to consider.

Thinking About Risk

Everyone has their own risk tolerance and this tolerance generally changes as a person ages or as different life events occur. Typically the younger you are, the more risk you should be comfortable in taking and as you age you generally become more conservative. While this may may often be true, nobody fits into a perfect mold based on age alone.

The main problem people have is not understanding risk and this leads them to  invest in a way that is either leaving money on the table or causing them to lose money when they can’t afford to. Most people simply categorize risk as the chance they will lose money but there are many other forms of risk to consider with all investment vehicles:

1. Market Risk: The most commonly thought of type of risk. Stocks in the market go up and down so investments in these securities can fluctuate and possibly even drop to zero in extreme situations. This type of risk is easy to see and understand.
2. Credit Risk: Fixed income securities like bonds also carry risk. Just because they pay a fixed interest doesn’t mean they are safe. Just like people, companies carry the risk of being unable to repay the lender which could lead to the loss of your principal.
3. Interest Rate Risk: Going along with credit risk and fixed securities is interest rate risk. Since many of these investing vehicles require money to be locked in for a certain period of time, interest rate changes up or down can have an effect on your underlying holding and/or mean you are leaving money on the table when higher rates become available.
4. Inflation Risk: This is the big one that most people don’t think about. Even if you have a 100% guaranteed investment either through an FDIC insured product or a government issued bond you are still subject to inflation risk. On average, the annual rate of inflation is roughly 3%. This means even if you are earning a guaranteed 4% return on your money you are in reality only earning 1% before taxes. If inflation rises even slightly you are at the risk of actually losing money on a “guaranteed” investment.

Age is Only Part of the Equation

There are many different asset allocation models out there that tell you how you should invest based on your age. Unfortunately, like much of the financial advice out there this is very general and should only be used as a guideline as everyone’s individual situation is unique. Just because a portfolio that is right for most people your age doesn’t mean it’s right for you.

Some people have basic formulas that say 120 minus your age equals the percentage of money you should have in stocks, others say 100 minus your age, and there are even many other fancy calculations you can find on the internet to tell you what you should do. While this general rule of thumb is a good start, it is far from the only thing you should be considering.

For example, these calculations don’t take into account what type of stocks you are holding. You can adhere to the 90% stock and 10% bond rule yet find your allocation either extremely conservative or extremely aggressive. Not all stocks and bonds are created equal and these guidelines do not tell you how to further allocate those investments.

Your Specific Needs Matter Most

Even if you take the time to create the optimal portfolio based on the breakdown of stocks and bonds as well as ensuring it is diversified among those investments it still may be misaligned from your actual needs. Beyond age you need to take a look at your individual situation. Are you single or married? Do you own a home or plan to buy one? Do you have children? Do you have a stable job? What do you plan on doing in retirement?

These are the questions you need to ask yourself. A single 30 year old renting an apartment in a big city with no intentions of getting married, having kids, or buying a house has very different financial needs than a married 30 year old with one child and another on the way while looking to buy their first house. The single person might be in a position to dump every last penny they have in the stock market looking to grow their portfolio as fast as possible while the married couple needs to focus more on safety and security as they try to save up for a house and have to worry about providing for a family and children. As you can see, age plays only a very small role in determining how these people might invest their money.

You Must Adapt as Things Change

The other thing that’s certain is that your needs and goals change over time. In fact, even if your needs don’t change the economy and market climate will and this can also force you to make some changes. A big problem a lot of people have is that they set it and forget it. They create what seems to be a good portfolio and they never touch it for ten or twenty years. While you shouldn’t be fooling around with your investments too frequently you also don’t want to just let it ride forever.

This can be seen in many of the stories you’ve read over the past few years about new retirees who lost a good chunk of their invested money because they were still invested as if they were 10 years away from retirement and the market was on a roll. Now the market reverses and they just retired and realize they were far too aggressive. That’s not a situation you want to be in.

So, it’s up to you to regularly monitor your investments and analyze your situation to see if anything has happened that could force you to rethink your strategy. Getting married, having kids, changing careers, or even external factors in the market and overall economy are all triggers to get you to look over your investment strategy. Don’t be caught by surprise and adapt as changes take place.

What Should You Do?

At the very least you should look at the various allocation models for a starting point. Generally speaking, the younger you are the more you should have in stocks. Just remember that it doesn’t stop there. Take a look at what your actual holdings are to determine the real risk. Then take a look at other aspects of your situation that could affect your underlying investments. Maybe you plan on moving, you could be getting a new job, maybe a child is on the way, a home purchase is in your future or maybe you are shooting for an early retirement to start a business. All of these things are important to consider when creating your portfolio so that you can invest appropriately in order to reach your goals, not just reaching a rule of thumb.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Asset Allocation is Important But There Are More Things to Consider When Investing

Zecco is Offering 20 Free Trades

You may know that I tend to focus on long-term investing through index funds and ETFs, but I also like to do a little trading on the side. For obvious reasons, any trading is done with non-essential assets and won’t negatively impact my retirement if I make a few trades. With that being said, one of the biggest problems with trading individual stocks are the commissions. The more you trade, usually the more you pay.

One way I’ve found to keep my trading costs low was to use Zecco for my stock trading. Zecco already offers 10 free stock trades a month and otherwise very low trading costs, but for a limited time they are offering new customers 20 free stock trades in addition to the rest of their account features!

This has been a great tool for me this year because I’ve been buying a lot of quality stocks in the past few months and have made some nice money on the recovery. I’ve had good luck with a few companies such as GE, INTC, and ABT. In fact, some of those proceeds will be covering some of the down payment on our new house. We didn’t plan on that, but I’ll happily take my profits and run while I can. But thanks to Zecco there is even more money in my pocket since I’m not handing it over for trading fees.

Promo Details

Zecco Trading is offering 20 free stock trades — a $90 value — to all new brokerage customers who sign up by Sunday, September 13th 2009! Use promo code “bonus1” to qualify.

These free stock trades are special, because you have a whole 90 days to use them. Some other brokerages give you free equity trades to use within 30 days of signing up, so by the time you transfer money into your account, the free stock trades might have expired! With Zecco Trading, you have more time to use your free stock trades when it makes sense to trade.

Plus, these trades are completely additional to the 10 free stock trades Zecco Trading customers can earn every month when they keep a balance of $25,000 or make 25 free trades per month. And stock trading commissions at Zecco Trading are a low $4.50 each.

Be sure to use the promotion code “bonus1” when signing up. Be sure to use all lowercase or the code won’t work.

Special terms and conditions:

• New Zecco Trading accounts must be opened and approved by Sunday, September 13th, 2009.
• The 20 free stock trades will be granted on or before September 16th, 2009. The free trades will expire 90 days after the date they are granted.
• Offer not eligible to existing Zecco Trading customers.
• Limit one bonus per household.

Join Zecco Trading and get 20 free trades with bonus code “bonus1“

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Get 20 Free Stock Trades With Zecco – Special Promotion Ends September 13

Most of us didn’t get much of a formal education when it comes to investing. We may have learned some basic concepts in an economics class, but when we’re talking about stocks, bonds, mutual funds and investment strategies, most of us have to learn on our own. But, there is an option out there that can give you a basic investing education that works similar to how a typical course in school is used.  Morningstar has put together a terrific resource to help investors sharpen their skills in various aspects of investing called the Investing Classroom.

The classroom is put together like college courses with 100 level courses being introductory and 400+ level courses being relatively advanced. This allows individuals at all knowledge levels to partake in the courses and work through the material in a progressive manner. The classroom covers four main areas:

1. Stocks
2. Mutual Funds
3. Bonds
4. Portfolio Allocations

You’ll learn about the difference between stocks, bonds, and funds. In addition, you’ll learn more about portfolio construction and different investment strategies, and even gain some tidbits about how to research investments on Morningstar.

Each course is structured with plenty of reading material and examples about the underlying topic and then you are presented with a quiz at the end of each course which are graded. The best part of the courses are that with each correct answer you accumulate points that can be used to obtain many great rewards. There are books, Morningstar fund and stock catalogs and even a free premium membership.

The course is 100% free and you can start taking some of the courses right now. But, if you want to keep track of your accumulated points so you can eventually apply them to the rewards, you will need to create a basic free Morningstar account.  So what are you waiting for, start learning today: Morningstar Investing Classroom

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Take Free Investing Classes at Morningstar and Even Earn Rewards

Morningstar is great, and it is one of my favorite investing research sites out there. They have a ton of tools available for researching stocks, mutual funds, and now options. While some of these tools do require a premium membership, there are plenty of great tools that are free and available to everyone. You may need to create a free account to login with, but one of the best tools is the Mutual Fund Compare tool. This tool allows you to compare one fund against another, or many other funds and display the results in an easy to read format.

If you’d like to walk through this post by using the tool yourself I encourage you to set up your free Morningstar account. It takes just a few seconds and not only will you get the mutual fund comparison tool, but you can access even more tools and save your portfolios to be used again in the future.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Using Morningstar’s Mutual Fund Comparison Tool to Compare Funds

Mutual funds are one of the most common investment tools for the average investor. You’ll find them in your 401(k) plan, in your IRA, and everywhere in-between. Mutual funds are popular for good reason. They provide instant diversification without a lot of money. Instead of having to pick all of the individual stocks you want to own and buy them yourself, you can simply purchase a share of a mutual or index fund and automatically get pieces of all the underlying companies.

Like anything, this convenience comes at a cost. Whether you’re investing in an actively managed mutual fund or an index fund, it costs money to run these investments. Some funds charge up-front fees and recurring expenses, others charge a back-end fee, and some just charge a regular recurring fee. It can get confusing for a new investor but with a little help you can learn how to spot what type of fees you’ll be paying and how to minimize those fees. After all, the less you pay in fees the greater your overall returns will be.

Load vs. No-Load

A load is one of the most important fees to watch out for. A load just means it’s an expense in addition to the underlying fund expenses. Typically these come in the form of front-end loads. You pay the load up-front when you purchase the shares. Loads can vary greatly between fund companies, how much money you’re investing, and more. But it isn’t uncommon to see equity funds with a front load as high as 5.75%. To put that into perspective, if you wanted to invest $10,000 in ABC fund with a 5.75% load, you’d immediately lose $575 to the front-load fee. Ouch!

The good news is that you don’t have to use loaded funds. While nobody will stop you from purchasing shares in a fund with a front-load, you’re typically going to be presented these funds by someone in the financial industry who works on commission. That’s because most of that load is a salesperson’s commission. So if you think about it, it’s no wonder they might try to steer you to a fund with a high load since they are going to instantly put a few hundred bucks in their own pocket. So you have to ask yourself whether the advice they gave you was worth that fee. In most cases, probably not. A fee-only financial planner won’t steer you into loaded funds since they aren’t earning a commission based on how much money you invest and where.

What about if you’re investing on your own? Obviously, you want to stay far away from front-load funds if you’re investing on your own. There’s no need to throw money away to a one-time fee just for purchasing the fund. So, how do you spot funds with fees? Morningstar is my favorite tool for this task. It packages all of the important information on an easy to use page that highlights everything from return, fees, yield, and more. Here is an example of using Morningstar to pull a quote on the Franklin Income Fund (FKINX):

You can easily see the front load listed on the first page. This fund has a 4.25% front load. If you had typed in a no-load fund it would show 0.00%.

Stick to No-Load Funds

It’s probably quite obvious, but you should stick to no-load funds. There’s almost never a situation where it’s worth losing a few percentage points off each investment just by investing in a load fund. Not sure where to start with no-load funds? While there are many options available you’ll probably end up with one of the four main no-load fund providers: Vanguard, T. Rowe Price, Fidelity, and Schwab.

If you’re looking for a more comprehensive search, I’ll again have to refer you to Morningstar and their Fund Screener. Here, you can easily select to only search no-load funds and then further narrow down your search by other criteria. You’ll probably be amazed at how many no-load funds there actually are to choose from.

Expense Ratios

You’ve found a no-load fund so that means you’re all set, right? Not so fast. Loads are only one of the fees to look out for. While not all funds have loads, all funds do have expenses. These expenses are expressed in the form of an expense ratio. This makes it easy to compare apples to apples when looking at multiple funds since the fee is shown as a percentage. Looking at the example above with the Franklin Income Fund you’ll see the expense ratio is 0.62%. That means if you had $10,000 invested in this fund for a year it would basically cost you $62.

Unlike a front load you don’t see this expense deducted directly from your account. Instead, the expenses are built into the fund’s overall return. So if you pull up your account statement and it shows that your fund had a 4.3% return, that is your net return after expenses already. You won’t have a quarterly or annual fee deducted from your account. That’s why these expenses can be tricky because they are almost hidden and people don’t really consider the effect they have on returns.

So, make sure you’re also looking at a fund’s expense ratio before making an investment. The lower the expense the better. If you’re looking for the absolute lowest fees you should probably stick to index funds. Since these aren’t actively managed and simply track an index they can keep costs down. This means you’re looking at usually only 0.10-0.25% expense ratios on index funds. Once you get into actively managed funds it’s a different story. You might find one fund charging 0.3% and another charging 1.3%.

Share Classes

While this won’t apply to most of you simply investing in no-load funds, it is important to be aware of the different fund classes in the event you find yourself talking to a financial advisor or otherwise who might bring them up. While not as common today as they were, there are three main types of share classes. Each share class invests in the same assets, but the difference lies in how the load is applied.

• Class A – Your standard front-end load funds as discussed above.
• Class B – Deferred sales load. No up-front load, but if you sell prior a predetermined holding period you’re charged a back-end load.
• Class C – A fixed load applied every year.

Thankfully, class B and C shares are heading the way of the dinosaurs, but that doesn’t mean they aren’t still used by some financial salesmen. They are often used to encourage an investment where they can still earn a commission by putting you into something that doesn’t appear to have a big front load like A shares. While none of these share classes are good, you most certainly want to stay away from B and C.

In addition to these primary share classes you may also stumble across other odd share classes in your research. You might see something like R shares or Z shares. These are typically special share classes offered by a fund company to be used in employer-sponsored retirement plans, sold by advisors, or to institutions. You may not be eligible to invest in these classes, so make sure you check the details and investment requirements.

Recap

As you can see, understanding the fees associated with your funds isn’t all that difficult, but you can probably also see how it’s easy to underestimate the impact the fees can actually have on your returns. An expense ratio of 0.6% might not sound like much, but when you’re talking about tens or hundreds of thousands of dollars over 30+ years that can significantly eat away at your return. And with the different share classes, loads, and no-load funds available you can see how some people, namely commission brokers, will steer you into a fund that could end up costing you.

Hopefully now that you’re armed with the basics you can make sure you’re getting the most out of your funds, both with new purchases and existing holdings. Now would be a good time to dig into the details of your current investments and see how much they are costing you. If it seems high, you can always use something like Morningstar to explore your other options.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Mutual Fund Fees for Beginners – Loads, Expense Ratios, and Share Classes

Does Lending Club Work?

Peer-to-peer lending has been around for a few years now, and two of the biggest players are Prosper and Lending Club. I’m going to talk a little bit about Lending Club since that’s the service I’ve been using and have the most experience with.

To give you a quick primer on peer-to-peer lending, it’s a relatively simple concept. Individuals use the power of the internet to get matched with others for their lending and borrowing needs. For example, instead of going to the bank and asking for a loan, I could hop on Lending Club and ask for a loan. My request goes up on the site and people who are looking to lend money could personally fund my loan. So instead of relying on a bank, I rely on individuals to provide the financing I need.

The benefits are two-fold. People looking to borrow money can often do so with better interest rates than what a bank would offer or the interest rate on a credit card. People looking to lend money have an opportunity to help people while earning an attractive interest rate.

Becoming a Lender

I’m going to focus on lending money since that’s what I do, and I suspect what most people reading this are looking to do. So, just how easy is it to lend money and start earning interest? To put it simply — very easy.

The sign up process is pretty straightforward and its the same process you’d go through if you were to open any sort of bank or brokerage account. It will ask for your personal information and some basic questions to get started. The main thing you will need to do as a lender is link your Lending Club account to a bank account so you can transfer funds back and forth. I’m not going to walk you through that process as it’s pretty self-explanatory.

Once your account is open and funded you can begin funding loans and there are two ways to accomplish this. You can select a pre-allocated portfolio of loans based on risk level, or you can create your own custom portfolio by picking and choosing the notes you want to fund. There isn’t a right or wrong way to do this, it just depends on how much work you want to put into it.

Finally, Lending Club takes care of the rest. They handle getting the money from the borrowers, calculating interest, collecting late fees, and everything else. Then they go ahead and funnel the money to your account where you’re free to reinvest it in new loans or send it to your linked bank account. It really couldn’t be easier once you’ve created your portfolio.

My Lending Club Account and Experience

Now that you understand the basic process, I wanted to give you an idea of what you can expect once you’re up and running and share some of the things I’ve picked up from it.

My Portfolio

I went ahead and customized my own portfolio by picking and choosing who I lent money to. Loans are graded from A to G with A being those with the highest credit scores and G being those with the lowest. Even so, you need at least a credit score of 660 in order to use Lending Club, so there is some assurance that you aren’t going to have many total deadbeats. That being said, I still didn’t want to get too crazy with my first set of loans so I kept the bulk of my money in A through D which put the average interest rate between 8-14%.

Return So Far

Here you can see my performance thus far. I’m pretty happy with around a 12% annualized return and the fact that all of my loans are still current. It’s still pretty early in my 3-year term for these loans so that could always change, but so far so good.

My Individual Notes

I wanted to give you an idea of how you can track each individual note. As you can see, I invested just the minimum $25 in some, and up to $100 in others. The notes that I put a little more money into were generally funding causes I believed in and wanted to help out with, or for borrowers who I thought were more likely to pay off their loan. The credit grade is helpful, but I know that a credit score doesn’t paint the whole picture and you can learn a lot about the borrower by reading their borrowing statement. As you can see, even someone I invested in with a relatively low grade of D actually paid off their loan in full early.

Trading Notes in the Secondary Market

One of the main drawbacks people have found with peer-to-peer lending is that the loan terms are typically three years. So, what happens if you decide you want out early? You used to be stuck. Now, you can actually trade your notes on an open exchange. This would work pretty much the same as if you were to buy or sell bonds in the market. Here’s what a screen from the trading platform looks like when searching current loans being offered:

You’ll see a lot of good information here. You’ll see the current interest rate, loan status, credit score changes, outstanding payments, and most importantly, the yield to maturity. The YTM basically tells you what you’d earn in total on that note if you bought it for the asking price and if they borrower made the remaining payments. You want to be careful as there are people who put a significant markup on their asking price and it could leave you earning very little or even nothing over the remainder of the loan term. But it’s nice to know that there is an active market out there available if you find that you would rather unload your investment early.

Who Should Invest With Lending Club

The most common question I hear is asking who should invest with Lending Club. First, you need to understand where this type of investment fits in your overall portfolio. It’s important to realize that this is not a place to park emergency savings. Remember, this isn’t an FDIC insured bank account and there are liquidity issues to take into account. So you should go into it thinking about only using money you won’t need for 3 years.

In addition, you should think of Lending Club the same as you would corporate and high-yield bonds. After all, you are lending money just as you would if you were to buy individual bonds. That being said, you can earn decent interest, but there’s also the possibility that your borrower won’t hold up to their end of the agreement and default. While it doesn’t happen all that often, you need to plan for that. You can help minimize default risk by diversifying your investment across dozens of loans or only choosing the highest quality notes.

So, if you have money that isn’t needed for emergency savings but you’re looking for a possible investment where you can earn more than a few percent, Lending Club might be a good fit. At the very least, it’s kind of nice to know that you’re helping real people instead of helping some big corporation somewhere. It is rewarding to know that you helped play a part in helping someone get out of debt or fund their new business. If this sounds like something you’d like to do, I encourage you to give it a shot.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Making Money With Lending Club and a Review of Peer-to-Peer Lending