Your Portfolio Allocation and Emotional Reactions: The Coronavirus and Portfolio Discipline

Here we go again – we’ve been down a similar road before, so none of this is news to those who have been with us through prior overreactions by market participants.

Volatility is part and parcel of participating in the market. When fear grips the market, selloffs by those who react to that fear provide portfolio opportunities for those who understand and adhere to a strategy. It is AIKAPA’s strategy to maintain your risk allocation and either ride out the volatile times or rebalance into them. Meaning that if you don’t need cash in the short-term, we buy when everyone else is selling.

As news of the Coronavirus (or other events outside of our control) stokes fear and uncertainty on a variety of fronts, it is only natural to wonder if we should make adjustments to your portfolio. If you are reacting to fear, then the answer is a resounding NO. On the other hand, if you are applying our strategy in combination with an understanding of the impact on business, then the answer is likely YES. When an adjustment is indicated we look for value and BUY while selling positions that are relatively over-valued. If the market continues to respond fearfully (without a change in value) then we will likely continue to buy equities and may sell bonds to fund those purchases. The only caveats to this strategy are that we must know that you don’t have short-term cash flow needs, that we stay within your risk tolerance, and that we are buying based on current value (keep in mind that value is based on facts not fear).

If you feel compelled to do something, then consider the following:

  1. Contact your mortgage broker and see if it makes sense to refinance (likely rates will drop soon after a significant market decline).
  2. Seriously examine the impact this has on your life today and let’s talk about changing your allocation once markets recover.
  3. Review the money you’ve set aside for emergencies and prepare for potential disruptions if these are likely.
  4. Business owners should consider the impact (if any) on their business, vendors and employees. Particularly important will be to maintain communication with all stake holders and retain a good cash flow to sustain the business if there is a possibility of disruptions.
  5. Regarding your portfolio, if you have cash/savings that you want to invest, this is a good time to transfer it to your account and have us buy into the market decline.

Market changes are a normal part of investing. Risk and return are linked. To earn the higher returns offered by investing in stocks, it is necessary to accept investment risk, which manifests itself through stock price volatility. Large downturns are a common feature of the stock market. Despite these downturns the stock market does tend to trend upwards over the long-term, driven by economics, inflation, and corporate profit growth. To earn the attractive long-term returns offered by stock market investing, one must stay invested for the long-term and resist the urge to jump in and out of the market. It has been proven many times that we can’t time stock market behavior consistently and must instead maintain portfolio discipline (if you want a historical overview of markets, see the “Market Uncertainty and You” video on our website www.aikapa.com/education.htm).

It is your long-term goals and risk tolerance that provide us with our guide to rebalancing and adjusting your portfolio, not short-term political, economic or market emotional reactions. In your globally diversified portfolio, we will take every opportunity to rebalance and capture value during portfolio gyrations. This IS the benefit of diversification and working with AIKAPA.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Cyber-crime, Phishing, Robocalls, and Wanting to do Good

Almost every day there is an article in the news about financial fraud. Much of it impacts seniors, like the telephone scam now doing the rounds that has fraudsters posing as Social Security representatives. However, we are all at risk, especially if we believe we are too young, too smart and too vigilant to fall for a scam. Sadly, scam artists are very sophisticated, intelligent, and focused so that they’ve become experts at separating people from their money. Only last month, “Shark Tank” magnate, Barbara Corcoran, was tricked out of nearly $400,000 through an email phishing scam in which fraudsters convincingly posed as her assistant.

A lot of financial fraud targets seniors or those in high pressure situations because cognitive agility decreases as we age or when we are stressed. Furthermore, seniors who live alone are particularly vulnerable.

Here are several things you can do to protect yourself and loved ones from financial fraud:

  1. Simplify your financial life. One of the best things you can do to reduce the chances you’ll be taken advantage of is to reduce the number of accounts you have and the number of financial institutions you work with. Fraudsters are experts at catching people off guard, posing as others and making their prying questions sound both reasonable and plausible. Make it a habit not to respond to phone calls regarding finances unless you know the person at the other end and never trust emails involving finances without first verifying the source.
  2. Limit access to and block large transactions. The first step in preventing fraud is to limit the money that can be easily accessed by not keeping large sums in checking accounts. Keep large accounts with a separate institution so that it takes a day or two to make a transfer. Next, if your bank allows it, set alerts for large transactions or block transactions over a certain size. Always use a credit card for online purchases since they give you the ability to reject a charge, while your debit card will automatically pay from your account.
  3. Always use maximum security on email accounts that you use for financial communications. We’ve seen most cyber fraud through yahoo.com and gmail.com accounts prior to the additional security currently available.
  4. For large transfers, particularly during hectic times, involve a trusted financial partner and NEVER accept changes to the receiving account and contact over email (or a call from someone you don’t know). It is better to halt the process entirely or at least confirm with a known financial entity than to change course midstream during a cash transfer. Most of the successful fraudulent transfers have been during escrow for a new house purchase or sale. The methods used are creative and ever improving.
  5. Families should plan their spending ahead and NOT respond to charitable requests on the fly. It is not unusual for seniors to receive many robocalls and mail requests from real charitable organizations because they know that seniors want to do good. It is not unusual for seniors to spend more on charitable donations made ad hoc than was planned. Make a point never to donate based on a phone call or last-minute request at a checkout unless that is part of your charitable plan for the year. I recommend families sit together and come up with an annual plan for charitable donations. When charitable opportunities present themselves defer them for review at your next family charitable giving gathering.
  6. For seniors or those facing high stress situations, you may want a backup notification sent to your spouse, financial caretaker, or a trusted person for high value transfers. If your bank does not provide for such alerts, then make it a standard practice never to make high value transfers without extensive planning and verification.
  7. For seniors, it’s important to have a potential financial surrogate in place long in advance of cognitive decline. Identify a trusted family member or friend or trusted professional to be your financial caretaker and start conversations long before you feel you need to turn over your finances. Consider providing view-only access to a trusted person so that they can help you monitor your account activity and be notified of large transactions and suspicious activity. It is a good idea to involve them with your tax preparation and filings as well.
  8. Due to the number of data breaches in recent years (that have exposed thousands of people’s Social Security numbers and other sensitive data), it has become increasingly possible for fraudsters to open accounts in another person’s name. On a regular basis, personally monitor your credit history with all three major credit agencies for new activity that you didn’t initiate.
  9. I’m personally uncomfortable with ongoing Credit Freezes unless you can monitor and implement them yourself at minimal cost and without involving a third party. Using a credit monitoring service is not recommended since you are involving an unregulated third party and, in any case, will only alert you after you’ve been victimized. The recommended approach when this happens is to freeze your credit at all 3 major credit agencies. Keep in mind that though this is often recommended by cybersecurity experts it can become a major hassle for you. Freezing your credit can be an issue for you if a company needs to legitimately verify a transaction with your credit history (this is the case for some insurance and bank transactions). Unfortunately, freezing your credit is sometimes the only way to prevent attempts to open a new account in your name, and maybe the preferred or only option for seniors.

Financial fraud is rampant. However, with a bit of preparation, a support system, and communication, you can significantly reduce the odds that it happens to you and your love ones.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Death and sepulcher – facing the inevitable

Benjamin Franklin famously wrote, “in this world nothing can be said to be certain, except death and taxes.” In all the years that I’ve worked with clients to create a financial path for their long-term wishes in life and after they are gone, I’ve covered a huge spectrum of topics. Until now, I’ve never asked clients about their “right of sepulcher” (the right of sepulcher means the right to choose and control the burial, cremation, or other final disposition of a deceased person). I recognize that, for some, this topic may seem a tad morbid. The cautionary tales of contentious and messy celebrity funerals that follow (suggested by Amy F. Altman, an associate at Meltzer, Lippe, Goldstein and Breitstone) may provide you with some perspective and may help you consider how you and your loved ones feel about your right of sepulcher.

  • Litigation surrounding the 2007 death of actor, model and TV personality Anna Nicole Smith made headline news for weeks as her mother and the guardian of her infant daughter battled for the right of sepulcher. Ultimately, the daughter’s guardian prevailed and Anna was buried in the Bahamas next to her late (and recently deceased) son.
  • Boston Red Sox Hall of Famer Ted Williams’ death in 2002 resulted in a spectacular rift between his children over the disposition of his remains. His eldest daughter argued that Williams’ will clearly stipulated cremation, BUT his son had been given power of attorney and his father’s health proxy and he wanted his father cryogenically preserved. Eventually, the son won out, largely because the daughter could not afford the cost of litigation.
  • Legendary actor Mickey Rooney died in 2014. His estranged wife wanted him buried in a shared plot purchased before they had separated. Rooney’s conservator (court appointed guardian) had other ideas and a costly tug-of-war ensued. In the end, his wife capitulated, recognizing that burial in a Hollywood cemetery befitting Rooney’s status was appropriate.

These cases, regardless of age, underscore the importance and value of discussing with loved ones your preferences for disposition. The laws regarding rights of sepulcher vary widely by state. If permitted under state law, completing a “disposition of remains form” together with advanced directives seems an appropriate start. This will create clarity with respect to the sensitive issues surrounding burial.

As with all legal documents you need to first understand what it is that you really want, which can take a long time to fully grasp and may require delicate discussions with loved ones and personal introspection. Leaving aside what I consider the more important question regarding life support for now, you can first deal with the question, do you want to be cremated, or perhaps cryogenically preserved? Do you want to be an organ donor? Would you like your funeral to take place at home or at a funeral parlor? Do you want a formal service or commemorative event? Though you’ll be gone, these are all options that may well prove to be important (and costly if mishandled) to those you leave behind.

At times, I think that there is so much to do while we are alive that taking time to consider what will happen after we’re gone seems inconsequential and entirely unimportant, but this may not be the case for loved ones. Let me offer an example.

Recently, a client shared that over the course of a dinner conversation with his parents they casually revealed their preference to be cremated. This came as an enormous shock. “Never in a million years,” he said, “would I have predicted that this was my parents actual wish.” This is a man who has made every effort to ensure he is in touch with the real wishes of his aging parents. “I would have got it wrong,” he said, adding “a split second’s worth of conversation set me straight.” He felt like a huge weight was lifted from his shoulders.

The person to whom you give the right of sepulcher may gain much by having even a short conversation about your wishes, regardless of your age.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Understanding Longevity Risk and Your Retirement

The oldest person alive today is Emma Morano of Vercelli, Italy who turned 117 this November. She was born in 1899! Queen Victoria was still on the throne of England and William McKinley was president of the United States. If you’d asked Emma in 1917 if she could imagine living long enough to see 2017, would she have imagined such a long life? Most Americans do not live as long as Emma, but in general we are living longer and healthier lives. The number of centenarians is on the rise. Longevity – long life – can have obvious perks, but also poses a conundrum in terms of finances. To help us plan for longevity we use “longevity risk” to measure the likelihood that you’ll run out of wealth before you’ll run out of life. In our planning we like to ensure that we mindfully set longevity at the right level for each person.

Few, if any of us, have advance knowledge of precisely when our time will come, so questions like this often boil down to statistics. You’ll sometimes hear that the average life expectancy for females is age 83 and age 81 for males, BUT are these appropriate target-end dates for your retirement plan? The truly important challenge is coming up with the best end-dates for retirement that will allow you to enjoy your wealth early while leaving enough assets to comfortably support you later in life.

In retirement planning, the variation in life expectancy can range quite dramatically and yet we find that client expectations generally fall into two categories, (1) those who want to make absolutely sure they don’t outlive their wealth, and (2) those who have a definite expiration date in mind, say 80 years of age, and believe that planning for life beyond that age is simply not relevant or realistic. The latter are often operating on some assumption based on, for example, both parents dying in their late 70s or not long after retirement.

At the risk of sounding morbid, but with the goal of having your retirement plan more fully represent your expected end of life target date, I want you to consider three facts that most often cause people to underestimate their longevity (in turn, this may help you understand why we sometimes encourage you to increase your target-end date):

Life expectancies that are often quoted may not be relevant since they are often calculated at birth. Life expectancy on reaching age 60 or 65 should be much higher than those quoted at birth since some will die before they reach this age. In fact, life expectancy for a 65-year-old, non-smoker is much higher. As an example, a 65-year-old female of average health has a 50% chance of reaching age 88 (see the table below) but once she reaches age 88 she has a much higher chance of reaching age 95.

longetvity_table

  1. Life expectancy is often calculated using mortality rates from a fixed year instead of projected to future expected mortality rates. Social Security Administration (SSA)’s period life tables are based on real mortalities in any given year. Though valuable, since they are real, they underestimate the observed trend for increased survival. As mentioned above, we perceive our survival based on our own anecdotal experiences. The question to ask ourselves, is this correct or is this an underestimation?
  2. Finally, we find that the population on which longevity risk calculations are based may not be appropriate. If we work with an aggregate US population life expectancy (as does the SSA period life tables) we must include a correction for socioeconomic and other factors that are known to impact mortality rates and could underestimate our lifespans. To-date there is evidence to indicate a positive link between income, education, long-term planning, and health. Yes, someone who plans and prepares appears (statistically) to live longer.

In case it is still not clear – let me explain. When planning retirement projections, the length of retirement greatly impacts planning choices (planning for 20 versus 45 years may require different strategies given the same wealth). Considering your specific longevity risk necessitates that we prepare for the contingencies that apply to you. There may be good reasons to target a lower longevity, but for most we will likely need to include, at the very least, a reasonable adjustment for expected increased longevity. This often means distribution of existing assets and thinking about end-of-life questions (a topic most prefer not to address too closely). If you are expecting a longer life, consider accumulating a pool of longevity assets (like some are doing to cover for potential Long-Term Care contingency) or purchasing a longevity annuity (this asset would only be used if you live past a certain age and, therefore, accumulate what are called mortality credits that can provide a good income late in life, but would be lost if you wind up passing sooner).

Obviously, estimations are just that, estimations. Still, a thoughtful scientific approach ought to be the foundation for retirement projections, never speculation or conjecture. Like Emma, some of us will be blessed with a long life, even inadvertently. One way or the other, I want all of us to feel that we’ve had a life well spent, and that will depend largely on how well we’ve planned for possible contingencies in your life.

This educational piece was drawn from my work with clients, www.longevityillustrator.org, the Social Security Administration period life tables, and a recent academic publication by Wade D. Pfau, Ph.D., published in The Journal of Financial Planning, November 2016, vol 29, issue 11, pp 40.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

What makes a portfolio “good”

What are the ingredients of a good portfolio?

If you do a little research, you will likely discover the three characteristics or criteria of a ‘good’ portfolio: (1) it should be diversified, (2) uses indexes, and (3) keeps costs low. All valid characteristics, to a point. In reality, this amounts to an over simplification that tells only part of the story. Applied to a poorly constructed portfolio, these characteristics will not help you create a good portfolio and you will not feel the confidence you need to see you through a market downturn. So, what is the best recipe for a ‘good’ portfolio—one that doesn’t cause you anxiety and keeps you up at night while generating long-term reasonable returns?

Here is my list of five ingredients for an effective long-term portfolio:

1.      HAS A STRATEGY. First and foremost, your portfolio should follow a strategy that you believe will be effective. You need to understand and believe in it enough that you can allow it to capture value over time (while others are off chasing the latest trend). At AIKAPA we use a global investment strategy that leans towards value (rather than growth) allocations.

2.      IS DIVERSIFIED. Select a diversification that represents your strategy and provides exposure to asset classes that behave significantly different from each other. In AIKAPA’s portfolio we are diversified across equities (that include large and small US and non-US equities) and across bonds, each global asset class providing opportunities to capture value. Using the chart below, you can compare global asset classes and how their volatility and returns differ from each other.

august_nibbles_asset-class-return-risk-for-2000-2005

3.      IS LOW-COST/HIGH-QUALITY (i.e., often an index fund). Implementing your diversified strategy needs to be completed using low cost, high quality securities. Use of baskets of securities (such as proven index funds) to represent chosen asset classes in your portfolio will permit the needed diversification while eliminating the risk associated with the failure of any one company (mutual funds or exchange traded funds are the baskets we use for your portfolio).

4.      IS LOCATION SENSITIVE and TAX MINDFUL.  Being mindful and “tax sensitive” when purchasing securities and locating them in the appropriate type of account can result in higher NET gains. Tax free, tax deferred, and taxable accounts should hold securities that will provide needed diversification, but will also yield the best AFTER tax returns. This approach is termed asset LOCATION selection. Taxable accounts are particularly valuable in the short and long-term but should hold assets that will not dramatically increase personal tax liability (particularly for those already in the higher tax brackets). As an example, two similar US Small capitalization funds can create very different tax liability simply by the level of “turnover” inside the fund. This turnover is often caused by frequent trading by the fund managers and can significantly reduce after tax net returns.

5.      IS REGULARLY REBALANCED. Finally, we have rebalancing of a portfolio. Rebalancing by conventional wisdom is what enhances your long-term returns by periodically selling what is overpriced (over-valued) and buying those that are underpriced (under-valued). The reality is not quite that simple. Automatic rebalancing software, for example, is tempting owing to its simplicity, BUT can lead to high turnover and reduced gains. Keep in mind, rebalancing has at least two different purposes. Rebalancing across unlike return assets (for example between equities and bonds) will result in a decrease in long-term returns, while reducing volatility (or risk). Yes, you trade some upside to reduce the downside. On the other hand, rebalancing between similar return assets (such as, between equity funds of large and small capitalized companies) will capture gains and lead to enhanced long-term returns as long as you don’t trade too often.

Assuming you’ve got all the correct characteristics in place, a ‘good’ portfolio ensures you’ve got adequate exposure to the market while assuming a measured level of risk, tax sensitivity, and an appropriate degree of rebalancing.

At the end of the day, a good portfolio can only succeed if you believe in the strategy and, most importantly, allow it to perform as designed over the long-term. To do this you, you must be certain that it is a good portfolio for you.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Money Battles and the pitfalls of financial infidelity

Let’s face it, making important financial decisions can be stressful at the best of times. When life partners fail to see eye-to-eye on finances it can lead to discord if they don’t have a way of working through their differences. It’s no secret, when compared to other types of marital disagreements, arguments over finance are the strongest predictors of divorce.  Financial decisions get even harder to make as we grow older—the habits of the past increasingly difficult to break. Add a touch of procrastination to the mix and you’ve got the potential for real trouble. It’s no wonder then, how easily decisions affecting retirement can turn into a battle over money, when so much is at stake. The best way to avoid unpleasant (and generally unnecessary) confrontations over money is to have a process in place. Let me explain . . .

Ideally, couples will create a money decision-making process early enough in their relationship that it becomes almost second nature—ensuring financial discussions are honest, frank, frequent and cordial. Both partners must be kept up-to-date on the family’s financial dealings and how those dealings align with understood and accepted goals. From our experience, monthly or at least quarterly meetings to discuss/review finances are invaluable.

This isn’t to say, every penny must be accounted for. Each partner must feel that they have reasonable autonomy and freedom to act within an allotted budget, BUT both must be clear that there are boundaries. Some couples set a specific dollar amount above which they must check with their partner and/or reach out to their financial advisor when especially tough financial decisions arise. For example, couples are well advised to discuss in detail funding a child’s college education, their retirement budget, or when to cease working.

Fights over money can be avoided if both partners have a handle on household finances, and moreover, feel their voice is included in all financial decisions.

If one partner pays all the bills and takes care of all the investments, the other partner over the long-term will begin to feel they are not a full participant in the relationship (or at least, they ought to feel that way). To counter this possibility, some choose to exchange roles for part of the year. Others have a regular monthly meeting to be sure that both are indeed aware of the family’s finances. AT A MINIMUM, all couples should go over how to access the family’s financial information (bank accounts, retirement plans, insurance, and investment accounts, etc.) AT LEAST ONCE PER YEAR.

When one partner takes on the financial responsibility for the family the inequity can (unintendedly or not) lead to “financial infidelity.” Financial infidelity occurs when one partner hides their spending on things they feel strongly about despite a clear agreement to the contrary by the couple. As an example, one partner might secretly fund their child’s business venture. I’m aware of one case where this actually happened. The situation was not revealed until the death of the offending life partner. The surviving partner’s betrayal was made all the worse by the fact that their retirement assets were depleted without his/her knowledge. The child that benefited from the covert funding, moreover, was not in a position to repay the surviving parent.

To avoid or at least reduce the likelihood of conflict over money, here are a few helpful guidelines:

  1. Communicate on expenses early, frankly, openly and honestly
  2. Meet regularly to review finances
  3. Update goals and ensure all parties are on the same page

When speaking of goals, articulate them out loud (i.e., verbally or in writing) and be sure to include your goals for both the present and the future.

The decision-making process itself should be reviewed as part of your conversation. For example, how do you determine your life-style budget, your savings goals, and what happens when you encounter expenses that fall outside of your budget for some reason?

As large financial decisions approach (such as retirement funding), the reality will undoubtedly generate much needed discussion. This conversation can turn into conflict if one side of a partnership is not in touch with family finances and family goals. Those who opt to avoid financial conversations will invariably find themselves in “money battles” that can seriously erode trust and faith in the relationship.

Facing major financial decisions, such as when, how and where to retire, needn’t be a source of discomfort or conflict. Far from it. If there is a reasonable process in place, the experience can be part of a shared life experience, an opportunity for optimism and mutual support.

I should add, in closing, that being single and unattached, doesn’t make you less susceptible to the stress imposed by major financial decisions like those discussed above. In fact, the “internal conflict” may be worse without someone to bounce things off of. If you are on your own, the same guidelines apply, but your “partner” in this is your trusted financial advisor.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Caregiving for a Parent or Elder Can be Rewarding

As I read the latest survey which found Americans unprepared for the complex and unpredictable realities of longevity and caregiving, I thought about my own experience. In my case, planning with parents for their wishes has allowed for open and frank conversations that helped to develop trust and understanding. It provided a chance to resolve and express unspoken sentiments and a time to see parents/in-laws as peers. It was also a time for them to share life enriching experiences. In the process of helping them plan for their lifestyle choices and care, I learned something more about them, myself and my family. In my situation it allowed me to recognize how much value I place on having intellectual and meaningful activities.

It was interesting to read, in the survey of caregivers, (called C.A.R.E.—Costs, Accountabilities, Realities, and Expectations) that 60% said caring for two aging parents can be more demanding than caring for two children (ages 3-5). It also found that 66% said that the extra costs involved would have a large financial impact on them, and, perhaps more significantly, 38% said they had not planned for these costs. Most respondents believe the shortfall would be offset from cuts to discretionary living expenses, retirement savings, or from another source of income.

This survey is particularly worthwhile because it reveals a disconnect between the perception and the reality of caring for an elder. The perception is that caregiving is mostly about grocery shopping, cooking and laundry. Whereas, experienced caregivers know that although chores and emotional support play a large part, it is financial support and personal hygiene that are the most stressful and anxiety building aspects of caregiving. The lesson here is that you can best assist your parent or elder by pointing out this disconnect—help with chores is fine and may be necessary, but thinking through how caregiving will be financed and how their physical needs will be met is paramount to avoiding serious challenges.

As they plan their caregiving you should encourage them to agree on the signs that will be used to indicate it is time to seek further assistance with their finances and physical care. It is during these caring conversations about their wishes that you can volunteer ways in which you are willing and able to be of help (but only after you’ve examined your own retirement plan).

As the off-spring of a parent that raised a family, that may have managed a firm and made countless complicated decisions during their careers, it can be difficult to envision your mother or father sometime down the road when logging onto the Internet or even frying an egg seem onerous tasks. A key ingredient to helping them along is to examine honestly what lies ahead and plan accordingly. Encourage them to remain connected to family (they will benefit from increased meaningful contact with a loved one) and to build a fiduciary team for their physical, mental and financial wellbeing. With the right type of built-in support along the way, their retirement can truly be the “golden years,” an immensely satisfying and productive time.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Building Wealth: Your Real Estate Asset

Real estate is often purchased as a lifestyle asset (to live in) or as a commercial investment (to generate rental income). It’s also quite common for people to think of their home as both lifestyle and an investment. Certainly, the most common near-term goal for families is home ownership – many think it amounts to a “no brainer” investment (meaning they think their home is a great investment) when it actually costs them much more than they realize.

In our examination of annual return rates on residential and commercial real estate we find that real estate is by no means a no brainer investment. Real estate assets can indeed contribute to wealth creation if the purchaser buys for value, carefully manages maintenance/renovation costs, and the sale is handled with an eye to minimizing taxes on gain from the sale.

Your residence has the potential to be a large part of your wealth, particularly in the Bay Area, but it can also be your largest liability.

Lending institutions have different requirements when lending for an owner occupied residence than for commercial real estate. A primary residence can often be purchased with lower down payments and lower mortgage rates than non-owner occupied real estate. In addition, on the sale of the owner occupied residence the gain will often fall under the capital gain exclusion rules which allow couples to exclude $500K from their income, tax free. This is one of the few opportunities to realize gain completely tax free. Couples who want their residence to be an investment rather than a lifestyle asset should consider selling their home once the gain (market value above basis) in their home approaches the $500K cap gain exclusion. This doesn’t mean you have to buy bigger or smaller or move away from your neighborhood but it does mean that you must sell a property to capture this tax free gain.

If a couple bought a home for $600K, made no renovations and 5-10 years later it is worth $1M they could choose to sell their home and retain the $400K gain tax free. They could repeat this process several times in a couple’s lives and each time a sale is completed the gain can be retained tax free. At the end of 3 rounds (there are residence requirements for each exclusion to be allowed) this couple could have managed to clear (net) well over $1M tax free. Despite this unparalleled opportunity to build tax free wealth, most home owners will buy one home and live in it until retirement. A well purchased property will still yield gain but much of it will be taxed. A home purchased at $600K that sells for $1.8M in retirement will have $500K of the gain tax free but $700K will be taxed at capital gain rates federally and at regular income rates by the state.

A residence can turn into a large liability when the debt burden is too high, when the home renovations do not yield increased value for resale, when the home requires a lot of maintenance, and when the location is no longer appealing (loss of home value appreciation).

Unlike residential home purchases, real estate purchased for investment is first valued on its ability to generate sufficient income and not as much on its appreciation. Before buying an investment property the property is thoroughly analyzed from various perspectives. An APOD (Annual Property Operating Data) is the principal tool to understand the cash flow, return rate, and profitability that can be expected from a prospective property. Once a property passes the APOD test (primarily for risk assessment) then the tax shelter provided by such an investment and the impact of the time value can be used to determine if this is an appropriate investment. Not surprisingly, much of the success of these investments stem from proper usage of tax rules. The value of the annual depreciation (using Schedule E) is well known. An equally important tax tool is a 1031 exchange. In a 1031 exchange the value of the investment property you own can be used to buy a second investment property of the same or greater market value while deferring tax payments on the gain.

In short, both residential and non-owner occupied real estate can be part of your investment plan. Unlike market investments it is more difficult to identify and protect against unexpected events and the illiquid nature of ‘real’ assets. Managing real estate to attain investment value requires thoughtful deliberate actions that may not always be aligned with your personal wishes (far from being a “no brainer”). Investing in real estate can reap big rewards, but entails doing a lot of meticulous research, taking only risks that are necessary, covering for contingencies, working with an experienced team, and then allowing time to do the work.

If you need help deciding whether a real estate purchase fits with your long term goals, give Aikapa a call.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Financial Decisions: Taming unhealthy habits

I’ve always been fascinated by how and why we continue with habits (behaviors) we know to be intrinsically out of line with what we want. There’s plenty of literature to explain the biology, particularly related to marketing and Artificial Intelligence (AI), that illustrate how our brains make decisions. I wrote an article some years ago on the science behind financial decision making (“Taming Our Irrational Brain,” Association for Women in Science Magazine, Summer 2009, Vol 39, No 3). If you’re interested in the science you may find it a good place to start. In summary, I think understanding how to change our decision making process begins with a deeper understanding of ourselves.

Choosing among competing options is a fundamental part of life. Historically cognitive processes or reflexive stimulus-driven automatic reactions. To deal with the massive and complex number of choices we face on an ongoing basis, individuals use multiple “systems” that offer tradeoffs in terms of speed and accuracy, but can optimize behavior and decisions under different situations. We shift quickly from “use your head” to “go with your gut” making daily decisions heart wrenching. This clutters the brain and adds uncertainty to decisions – making decisions stress-filled.

Ideally we would have automatic behaviors that keep us aligned with our planned (cognitive) objectives. I believe that sustainable change has to be linked to a simple consistent and believable process that can support you during stress-filled times. Though there are different approaches to creating these behaviors I will focus on Charles Duhigg’s three-step process for changing habits (he refers to them as CUE-REWARD-ROUTINE) and add my own thoughts as we go along. Obviously, my focus is on developing healthy financial habits.

  1. First, we need to acknowledge what it is that we want to change and what it is that we wish to attain. What financial behavior are we interested in changing? We need to visualize what we’d like to see instead of our current behavior.
  2. We must then identify the triggers for this behavior (or “CUEs”). Duhigg suggests that we ask ourselves what we were doing right at the time, who were we with, where we were, and, what we were doing just before the behavior. One of his best examples is when you get up to get a snack in the middle of your work – what were you doing just before you got up? What was your trigger? Some people have similar triggers for spending beyond their budget and, yes, even for making buy/sell decisions on their portfolio.
  3. Next, we must understand what “reward” we obtain from this particular behavior (habit). This step is essential because we need to find something equally rewarding to successfully implement a change in our reaction when we next experience the same trigger. The new reward must be one that is both doable and strong enough to replace the current reward but also in line with our plan. Was the reward for getting a snack really to satisfy hunger, or were we bored, or in need of social interaction or just anxious? For example, consider the person who checks their portfolio every time they feel the trigger. Their reward may be to talk to people about it (social interaction) or it may be boredom (interacting with a different software) or it may be something else. This individual will first need to identify the trigger that prompts them to check their portfolio often and determine what reward they receive for doing this action.To change a reaction to a particular trigger, the goal is always to identify a substitute reward that is aligned with your well-being and your plan. For example, going for a walk alone or with friends, taking up a mental or physical activity that is positive–anything that will actually yield the change you are hoping to make.
  4. Then lock it in, so to speak, by establishing a “routine” around both the triggers and reactions that will make the new habit permanent. If the reward is strong enough, over time it will seem less and less routine, even enjoyable. In our fast moving world more and more decisions are made quickly, even without thought. It doesn’t help that marketers are out to manipulate our choices at every turn even if it means deviating us from our personal wishes (after all that is their job). This imposes a degree of stress if not countered by healthy habits. Ultimately, a well-lived life is all about making daily choices that enhance our chances of achieving the goals we set for ourselves.

It is evident that establishing any new behavior (habit) needs a belief system and a support system that you can reach out to during stressful times to ensure that you don’t revert to the original behavior. I find that for some clients Aikapa has become this support system as they strive to adjust financial habits and align them with their financial plan. It’s our job to help clients remember the reason(s) why these behaviors are important and to help them visualize their financial rewards on an annual basis. We do this through client meetings and by examining savings, investment portfolio and retirement plans.

In short, attaining financial wealth and peace of mind are indeed possible when you can develop habits that work for you. It is our mission to educate and help you build a stress reduced financial life while maximizing your wealth. If you are working on building a new financial habit to support your dreams, don’t forget to include Aikapa as part of your support team.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Wealth – a place for art and wine in your portfolio?

Not long ago I was asked by a client about purchasing a valuable musical treasure. What did I think about taking money from her budget to make such a purchase? What role could it play, she wondered, in her investment portfolio? And just last week I was asked by another client how he could include his valuable wine inventory in his portfolio? Interesting questions, indeed, and not just because they have to do with investing, but because they are a reflection of the deep seated desire in all of us to find some way to make our passions work for us.

As an intelligent investor we must first create a base or foundation on which to build wealth before investing current cash flow into such possibilities. If you think of your wealth as forming three tiers, the first tier, or foundation, consists of good credit sources together with a robust combination of liquid assets and emergency funds. With this tier in place, an investor can withstand market volatility, support ongoing needs and endure any unforeseen emergencies for a period of time. The first tier provides the conditions necessary for building the second tier—a diversified equity and bond portfolio.

The purpose of the second tier is to extract as much growth as possible from the market, while providing a safety-net that respects your risk tolerance. The second tier is intended for your future financial security and must therefore not be exposed to excessive risk (at Aikapa, we believe that the best way to counter market risk is through a diversified global portfolio). Once your finances cover these two tiers, then, and only then, can we seriously consider a third (speculative) investment tier that could potentially offer higher returns in exchange for accepting higher risks. These speculative investments could include art,
musical instruments, wine, coins, jewelry, antique firearms or other collectibles for which you may have a passion and an expertise (though not pertinent to this article, this tier can also include other non-collectible investments).

The beauty of this third tier is that it often feeds your creativity and passion, and so should never be discouraged or dismissed, so long as it comes from a position of knowledge and experience. With time and talent it is possible to build a collection that can grow in value over the years. We have a client that has collected stamps since childhood and has therefore a very valuable asset. These investments can be very lucrative when the market is favorable, but a heavy burden when not.

The risk and expense of collectible investing goes beyond the volatility that we’ve seen with wine and the recent upsurge in artworks, with high-profile purchases like the Gaugin that sold for around $300 million.

Collectibles require storage, insurance and maintenance regardless of whether there is even a market to buy them (at times they can be highly illiquid). Accurate valuation is also a challenge, since you must actually attempt to sell any given item to determine its fair market value. The market for collectibles is fickle and historic value is no guarantee. What once sold for a good price, may no longer be in vogue.

If we’re to consider a collectible as part of a portfolio, it must be evaluated for
potential future return. What is often overlooked is the cost of bringing an item to market. In addition to the usual insurance, there can be maintenance costs, special storage facility fees to retain value, and fees associated with proving authenticity. There may also be costs for shipping, installations and appraisals. Selling a collectible often incurs a commission. For artworks, auction house fees can range from 10-25%. Finally, don’t forget that tax liability exists on any gain. For collectibles, the federal tax rate is 28%. There is also state tax and, potentially, a 3.8% net investment income tax for those in
higher tax brackets. We estimate that for most of our California clients they would pay 35-43% of their gain in taxes on collectibles, which often comes as a great shock to the uninitiated.

In a nutshell, speculative investments should never be depended upon to achieve critical goals, such as retirement. While many of our clients include collectibles as part of their wealth (and are generally very passionate and knowledgeable about them), it is only as a component of the third tier of their investment strategy. These collectibles, while often extremely valuable, are never an essential part of a core investment portfolio or retirement plan.

If you’re interested in developing a third tier for your investment portfolio let us know and we’ll work together to provide a financial perspective on your plan. We do not recommend developing this tier from a budget unless tier 1 and 2 are already fully funded.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com