November 2003

Top 10 Considerations for Prudent Financial Planning

By Mark A. Cirelli

Consider the big picture. First, determine the individual’s financial goals, time horizon, and individual risk tolerance. The investment strategy should then be based on an asset allocation that is appropriate for those parameters. Basic portfolio allocation models are: capital preservation; income; growth and income; long-term growth; and aggressive growth.

The next step, choosing appropriate investment vehicles and investment management (self-management or professional), requires deciding whether to use individual stocks and bonds, use mutual funds, or use a combination of both. Regardless of the investment vehicles, diversification is important. Professional advisors generally recommend using a “size and style” diversification strategy, which includes investing in companies of all sizes, international companies, and bonds. Different styles include growth or value investment approaches; professional advisors generally recommend using both.

Consider the risks. Generally, higher-risk investments should provide higher rates of return. Investors should consider how much principal risk they are willing to accept in an investment. Principal risk can be measured in relative terms based on historical volatility statistics. The investor should consider the volatility of each asset class as well as the aggregate portfolio risk. The investor should also consider the portfolio composition. Concentrations in individual stocks, bonds, styles, or sectors reduce diversification and can greatly increase the inherent risks and volatility in a portfolio.

Over long periods of time, stocks have generally generated the highest rates of return of any asset class, but when viewed over short periods of time they are highly volatile and risky. Given that growth is the objective of investing in stocks and income is the objective of investing in bonds, when viewed over the long term a portfolio that contains both will be less volatile or risky than one consisting only of stocks. A conservative investment approach may have only a 20% exposure to a diversified basket of stocks or stock mutual funds, whereas an aggressive growth investment approach may have 80% or even more. When investing in stocks, investors with less than $200,000 or $300,000 should seriously consider using mutual funds instead of individual stocks for the benefits of diversification and professional money management. Investors can get started in mutual funds with relatively small amounts of money and obtain high-quality investments and money management with modest costs.

Bond investors should pay attention to the credit quality of bond issuers when choosing individual bonds. Bonds that contain higher-interest yields generally carry more risks of default and consequently have lower credit ratings. Bond investors should carefully review independent credit ratings as provided by Standard & Poor’s, Moody’s, and Fitch, and choose only high-quality investment-grade bonds and bond funds for their portfolio.

Another risk associated with bonds is interest-rate risk, which has to do with the price volatility of the investor’s bond portfolio as a result of changes in the overall interest-rate environment. Another risk to consider is the opportunity cost of investing inappropriately or not investing at all, which can be high. Investors that systematically invest with relatively small amounts of money may benefit more by using high-quality bond mutual funds rather than individual bonds.

Understand investor psychology. When investment capital is at risk, human emotions can easily lead an investor down the path of financial ruin. The antidote is a well-thought-out investment plan. When proper attention has been given to the risk or volatility of a portfolio, the investor will have a good idea of what to expect on both the upside and downside, based on historical market performance. This knowledge can help the investor weather bad markets and keep a level head in good markets. Without investment discipline, the investor can easily get carried away in the fear and greed cycles of the market. When one asset or asset class is performing well, greed takes over and the investor might be reluctant to properly rebalance the investment portfolio. On the other hand, when an asset class is performing poorly, fear may take over and the investor may sell out and miss the opportunity to recover. There are, of course, valid reasons for holding or selling an asset or asset class, but these decisions should be based on an investment plan and sound financial advice, not emotion.

Understand market cycles and investment time horizon. Both stock and bond markets tend to move in complex and unpredictable cycles. While no investment plan can guarantee performance, impulsive decisions based on emotion and attempts to “time the market” tend to be counterproductive. In general, the longer the time horizon, the more aggressive an investor can be with portfolio allocation. When evaluating a portfolio, especially in bad market conditions, its performance should be put it into perspective against the time horizon and risk tolerance. Investors should be prepared to make appropriate modifications based upon these factors and wait for the market cycle to yield acceptable performance. In favorable markets, it should be easier to remain objective and rebalance a portfolio by taking money out of the better-performing asset class and reallocating it into the poorer-performing asset class. This seemingly counterintuitive approach is a time-tested method of asset management.

In light of the most recent market boom-and-bust cycle, investors should remember that stock market declines, even severe ones, are normal. In fact, in the last 102 years stock markets have weathered declines of more than 10% more than 100 times, declines of more than 15% 52 times, and declines of more than 20% 29 times.

Understand financial needs. In general, younger investors in the wealth-accumulation phase of life are primarily concerned with growth of their principal so that when they reach retirement they will have amassed a large sum of money that can be converted into an income stream to last throughout retirement. Most Americans are not covered by a defined benefit pension plan and must rely on their own retirement investments to fund perhaps 20 to 30 years of retirement. The lifestyle the investor wants should be used to calculate how much to systematically invest in a diversified portfolio at an assumed long-term rate of return, then how to implement and monitor that investment plan. At the other end of the spectrum, investors in the wealth-distribution phase of life (approaching or actually in retirement) should be primarily concerned with achieving relatively consistent rates of return for a secure retirement income, while balancing the need for current income with the need to keep the portfolio growing faster than inflation and spending.

Invest appropriately. The essence of appropriate investing is elusive because it is always subject to an individual’s personal financial situation, age, earnings potential, asset base, and other factors.

In general, stocks are for growth, and bonds are for income. An investment approach that involves both is called a balanced approach. An investor who buys both stocks and bonds in a given percentage and maintains that allocation regardless of near-term forecasts for the economic outlook would rebalance his portfolio on a periodic basis. Rebalancing a portfolio takes the emotion out of investing and may lead to better long-term portfolio returns. The key is to make sure that the portfolio allocation is suitable for one’s needs and risk tolerance. A balanced portfolio of 50% stocks and 50% bonds may be fine for a 55-year-old, but not for a 75-year-old whose sole source of income and stability is the portfolio.

Income objective. In general, very conservative investors and those near retirement should be investing primarily for income. A typical portfolio model geared toward income should contain 50% to 80% of investments in a diversified, high-quality bond portfolio that is managed for appropriate duration, average maturity, and credit quality. The portfolio should contain some exposure to the equity markets in order to provide a hedge against inflation and to boost the portfolio’s total return over long periods of time, and provide relative portfolio stability.

Growth objective. Investors seeking long-term capital appreciation would typically have an investment portfolio, with 60% to 80% of funds allocated to a diversified group of stocks. The portfolio should also have 10% to 30% of investment-grade bonds. Over the long term, the investor should expect portfolio returns to substantially outpace inflation.

Growth-and-income objective. The middle-of-the-road investor who is not living off the income or principal of her investments and is willing to accept a moderate level of risk in pursuit of above-average rates of return would tailor her portfolio accordingly. This strategy would include a mix of stocks and bonds in relatively equal proportions. The investment mix might include income-oriented stocks, preferred stocks, bonds, and high-yield fixed income and convertible securities. Investors should consider high-yield and convertible bonds to be as risky as stocks in general and allocate appropriately. This portfolio strategy should produce relatively stable performance in both good and challenging market conditions.

Special situations. At some point an investor’s focus may shift from wealth creation to wealth preservation. Investors that have amassed significant wealth in a concentrated stock position may be looking to hedge, diversify, or monetize their investment, depending on their needs. The investor should seek an experienced professional to assist with these types of strategies. Protective strategies involving the use of options include protective puts, covered calls, and zero-premium collars. One diversification strategy would be to use exchange funds. Monetization strategies involving options include prepaid forward agreements and contingent variable forward agreements. An additional monetization strategy would be a discount sale strategy.

Individuals that hold stock options must recognize the importance of financial and tax planning when it comes to incentive stock options and nonqualified stock options. Tax rules can be tricky for the average investor, who might inadvertently trigger ordinary income taxes or alternative minimum taxes. The investor should also recognize other traps like golden parachute excise taxes, holding-period requirements, and the tax implications of hedging. In general, unexercised stock options cannot be hedged. Investors should work closely with both tax and financial advisors to use the most appropriate strategy to fit their needs.

Tax considerations. A guiding principle should be to defer tax liabilities for as long as possible. Investors may use a variety of strategies, including contributions to employer retirement plans, IRAs, and variable annuities. Other possible strategies include investing in tax-free municipal bonds for income, tax-managed equity mutual funds, or simply harvesting and utilizing capital losses to offset capital gains in a timely manner. Additional strategies should be considered in light of the Jobs and Growth Tax Relief Reconciliation Act of 2003. Relevant provisions of this tax act include reduced dividend and capital gains tax rates and reduced marginal tax rates on ordinary income.

Asset management. In general, investors have to choose who will be responsible for developing and guiding a portfolio strategy and who will perform the day-to-day responsibilities of investment management. Several years ago, aided at least partly by the emergence of the Internet as a tool for research and investing, do-it-yourself management became a popular choice for the average investor. What an investment professional contributes is portfolio construction within the context of a well-thought-out financial plan, assistance in investment selection, and the choice of a competent portfolio manager. Investors that insist on managing their own portfolio should be very careful to construct a diversified portfolio using a size and style diversification technique and to not chase investment performance (i.e., buy yesterday’s winners).

Remain optimistic and objective. Investors that follow a sound strategy and use a disciplined approach have much to be optimistic about. Free markets are the basis of economic wealth; innovation and capitalism are the engines that drive personal wealth and freedom. If the investor believes this, it is easy to see how historically, despite the ups and downs of stock and bond markets over many economic and political cycles, it has paid off to be bullish.

The value of advice. History shows that investing is a discipline, not a hobby, and should be based on sound financial planning, not speculation. Individuals should always have someone to rely on as a trusted financial advisor. This advisor should have a solid financial background and the ability to prudently integrate financial planning with investment management. The merits of employing an advisor should be measured relative to both absolute and relative portfolio performance benchmarks, and relative to reasonable client expectations based on the simple risk-reward relationship, not the size of the advisory fees alone. Investors should anticipate bumps in the road, but a good advisor and a sound investment plan will ensure that they never stray far from the path.

Mark A. Cirelli, CPA, is a financial advisor with a global financial services company where he specializes in financial planning and investment management for high-net-worth individuals and institutional clientele. He can be reached at

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