The Vote on the Debt Ceiling Doesn't Matter: 5 Thoughts

As we have watched the slow slog towards August 2nd and the expiration of the debt ceiling, there are a few things we should consider in advance of that date and a couple of additional thoughts in the days immediately following. Like most things, the debt ceiling expiration date is mostly arbitrary, much like the turning of a new year or the end of a quarter. In other words, 08.02.11 means little to the average person and in the days following, should not be of much concern. Here's why.

Borrowing: We have been in one of the most favorable borrowing environments since records began being kept. If you qualify for a loan, be it a home mortgage or other big ticket purchase, the date will not change your ability to borrow. It may cost you more but prudent borrowers should have already considered this eventuality prior to beginning their purchase. Interest rates may and probably should go up if an agreement isn't reached. The phrase "lock-it-in" will be considered sage advice as it should be. On the flip side, there is little likelihood the seller of whatever big ticket item you are purchasing may just offer additional financial incentives to offset any increased borrowing cost.

Selling: An increase in interest rates would not benefit those who believe their homes are worth a certain amount. It would stymy the housing market, slow the sale of automobiles and create a situation that most retailers have been dealing with already: more saving than spending. While less spending will not get the economy moving and certainly won't create more jobs, despite the argument in Congress that less spending has the opposite effect. We'll just be stuck in neutral for longer than we had hoped. But not as long as many suggest we will.

Markets, Bonds: If you are a conservative investor with money in bonds, you are much smarter than the media gives you credit. Savvy bond investors ladder their holdings for just such an event and will probably fair well. Yes, the foreign investor might become a little more cautious and the next Treasury auction will be weaker than most hope it will be. But over the long-term, the real reason folks hold bonds, the effect will be offset as time moves on. Yet, if you are in bond mutual funds, you should have little to worry about as long as your holdings aren't too much of your portfolio. If you're older, cash might be a better place in the interim.

Markets, Stocks: More than one person has suggested getting into much safer investments before the 08.02.11 deadline. Cash is okay but if history tells us anything, this might be amongst the worst long-term decisions you could make. Most companies could borrow if they needed to no matter what happens. But why bother. Most of the corporate debt has been refinanced to historically low levels. And most companies in the S&P 500, an index of the largest companies in the country, are flush with cash reserves. That has been the most worrisome part of the recovery: businesses could have hired, they could have afforded to hire but they didn't. Selling stocks even if they dip somewhat should provide an opportunity to buy shares that are worth more for less. If you are buying steadily, this should prove an advantage for those with time.

You: Turn off the television or change the channel. None of what you are hearing, none of the talking heads everyone is trotting out means anything. The politicians involved in the debate are saying little or nothing and in many respects, act like this is the first time such an event has ever happened. Personally, the President should simply invoke his right in the 14th amendment and raise it without Congress. Yes, it will cause an uproar and yes, it would be the right thing to do. But creating tension among the American people is not a solution to solving some of the nation's biggest concerns.

In the three years since the Great Recession began, you should have put all of your plan in place: reduced your personal debt, created a modicum of savings and in the process, increased your contributions to your retirement plans. If you haven't, this will probably send the message again that your wealth is not what Washington thinks it is. You should be much more pliable and hopefully, just a tad smarter - or jaded.

Paul Petillo is the managing editor of BlueCollarDollar.com/Target2025.com

Understanding Risk - The Risk of Too Little Risk

Last week, on the radio show I appear on as a regular guest, I suggested that instead of trying to determine what your risk tolerance was, you should instead think about what makes you anxious. This anxiety tolerance takes a more introspective view of who you are rather than what your investments might be doing. It requires, among other things, that you turn off the media.

Streaming into your living room is an after-the-fact representation of what the markets are doing. Even real time reports are not so much real time as a tool for edgy traders to plot their next move. If you really care about what your retirement accounts are doing, in terms of what they will provide ten, twenty or even thirty years down the road, looking at this type of data will force to re-examine what you may have previously thought was a good idea.

Although there is a science to investing, it is far less competent at coaxing the truth or any sort of conclusion fro the available data. The markets, pushed by human emotion (even if it is pre-programmed into a computer via modeling) fail to give you a true perspective, something that you would consider concrete, undeniable and/or truthful. This sort of representation is enough to make even the most savvy investor squeamish.

The knee-jerk reaction, the one a vast majority of investors are considering or have already begun is a move back to less risk. As banks fail, as markets gyrate, and as the recovery, albeit jobless, begins, some basic things should be kept, not in the back of your mind, but in the forefront.

No risk means saving. This is the traditional approach to keeping your money close at hand, for emergencies. It comes with risk as well. There is the inflation risk. Currently at or around zero, inflation strips the value of your dollar by making it worth less in the future. Without the interest that savings provides, each dollar saved will have less buying power. In an inflationary environment, that interest paid to you must beat inflation (even if you use the historic reference point of 3.5%).

And it must beat taxes. These will always rise, if not right up front, the increases will be felt through the products we buy, the business we conduct or the income we earn. No risk, in other words, has some risk and it is mostly on the downside. (That doesn't mean should abandon the emergency funds you are currently funding or stop you from getting one started.)

Your anxiety (or risk) tolerance may be forcing you to look for investments in your retirement accounts that take more risk than is desirable. Before we look at those types of investments, it is important to note that the reason you invest in your 401(k) is to provide income for a time when you no longer want to work (or work doing what you are doing).

For many of you, this has meant turning to the ever-present and often innocuous retirement calculator online. You enter into these tools, your current balance, which according to the latest Employee Benefits Research Institute report, is about $74,148 for the average 40 year-old. (The study reports data as of the year ending 2008.) While this down over 25% from the close of 2007, that figure represents a 35% increase for the investor in this age group since 2003.

The report also indicates that this was in-line with the stock markets performance over the same period. If you suffered less, it was due to diversification and the ability of the 401(k) to supply ongoing and consistent investment. This diversification was found using equity investments as the primary driver for the growth in these portfolios. In terms of asset allocation, 40% of this group allocated 80% or more of their assets to the equity markets, down only slightly from their years as a twenty-year old. (This group also owned about 11% of the remaining portion of their portfolios in their own company's stock.

These contributions are, as one might expect, greater in your investment youth. Or they should be. Investment returns (and sometimes losses) are the result of many of the changes in portfolio valuations. Even after the losses experienced in this age group's portfolios (28.5% in 2007-2008 and 5.8% in 2001-2002) the average account over a ten year period had increased 94%.

I have suggested that you should contribute at least 5%, company match or not. If you begin with that average balance of $74k, in 25 years you will have breached the $250,000 mark using a conservative approach which has about 50% of your portfolio invested in equities. Reduce your exposure to bonds in that portfolio to 15% or less, and the same time span could leave you with a balance of four times as much.

In terms of risk, 2008 was a game-changer. While 64.5% of those with plans in 1998 found equities the most desirable of investments, by 2008 this sentiment had shifted to 41.9% with the shift to a more balanced approach such as lifecycle funds (an increase of over 300% and to bond funds, which posted a 100% increase from a decade ago. Although we are looking at the forty year-olds, the sixty year olds made essentially the same moves as their counterparts twenty years their junior.

Using a retirement calculator, based on a generous 5% withdrawal when you retire, at age 40 or younger, will not produce the retirement income (based on a growth rate of 8% after you retire, beginning with zero and ending with a balance of $250,000 and an inflation rate of a modest 3.5%) you might imagine. If you can live on $14,446 in the first year (excluding Social Security and if you are fortunate enough, pension payments) then you are on track. This will however, draw your balance to zero in thirty years or less, if your investments fail to meet the 8% mark, year over year.

2008 also brought a dramatic increase in the number of loans on these plans (90% offer some sort of loan available). Eighteen percent of you tapped these provisions with, the report cites, an average outstanding balance of $7100. This may have been money you thought you needed at the time. But what it represents has a far greater impact in the future.

So why are so many individuals shifting to a less riskier (less anxiety inducing) form of investment? Perhaps they simply do not know what they are setting themselves up for in twenty or more years.

There is the argument that these more conservative investments utilized by retirement investors are not as risk free as previously imagined. This could put an additional drag on perceived outcomes you and your calculator have projected.

All bonds, essentially an extension of credit are compared to what the US Treasury issues. The difference between what a bond yields against this measure suggests the creditworthiness of the bond. In other words, the closer the bond to the US Treasury, the safer it is.

And as we say safe, we also remind you what we have previously discussed about safety. Without some risk, the chances that your money will grow are greatly diminished.

While this complicates the purchase of a bond individually, it makes bond funds much more attractive and some respects, slightly more risky. And in lifecycle funds, the employment of bonds lowers the risk of too much equity while possibly increasing risk where safety is sought.

What if, as Eric Fry of the Daily Reckoning suggests, the creditworthiness of the US Treasury comes under pressure? It is extremely important to bonds that it have a good benchmark to use. He writes: "Are foreign sovereign issuers becoming MORE credit-worthy or is the US government becoming LESS credit-worthy? Or is it a little bit of both?"

This type of risk may undermine the best intentions of the retirement investor and those who invest for them from a direction they will be mostly unprepared to handle. Not only will the return they are seeking be less than than they need to get to where they are going, there is a possible risk that they will receive far less than they anticipated. Fixed income may not be so fixed.

There is a risk to the equity markets because of this possibility. Yet it is still one worth taking. Even if your anxiety tolerance will not let you go beyond the simplicity of an index fund, you will fair better over the long run that those who shift gradually to a more balanced approach with an increasing amount of bond type investments. I'm not adverse to adding to your portfolio a fund that offers even more diversity (even a conservative choice) but in many instances, investors simply reallocate existing contributions when they should, for the best possible balance, increase their contribution and direct these increases to the more conservative product.

There is a distinct possibility that too little risk will not perform as planned.

The Beginning Investor's Dilemma

Where to begin? This question has stymied beginning investors since the time the market began. These days though, the question is twofold: why should I begin and where will I get the money?

Time remains the single best attribute to investing early and equally important, often. The powers of the equity markets are confusing unless you remember two basic rules:

There is risk;

And if you take no risk, there will be no reward.

That risk demands you put money somewhere. For the beginning investor, the best place is in a mutual fund. Your 401(k) at work is often a healthy list of choices. (Keep in mind, the number of choices available don't always signify the quality of the plan.) Among the most common types of funds in these defined contribution plans (so called because you define how much you will contribute) are index funds, growth funds, bond funds, balanced funds, and some combination of the lot.

Index funds track a broad index of companies in almost every instance, due to size. Growth funds may also be a type of index fund or one aimed at a particular group of companies. Bond funds invest in debt, which makes you a sort of lender (but in a mutual fund, without many of the problems associated with the transaction). Balanced funds look to provide some stocks and some bonds and usually tell you right up front how they allocate their investments.

The combination of the lot is represented by a growing sector called lifestyle funds or target-dated funds. These fund reallocate their holdings over the course of an investors career. The employee picks the date they would like to retire, say 2040 and the fund manager does the rest. As your holdings grow in tandem with your years in the plan, the fund gets more and more conservative.

Beginning investors are attracted to these because they are advertised as buy and forget. But they should be aware of the problems that may be associated with this type of investment. First, they don't have much of a track record. Even in the recent downturn, some very conservative funds (with short retirement dates targeted) did not beat the S&P500. Secondly, I worry that some fund families are using these new funds to prop up laggard funds that have done extremely poorly and lost many of its core investors.

While you are educating yourself on the subject, choose an index fund.

Now, where to get the money? If you set aside 5% of your income in a pre-tax situation (and 401(k) plans are just that), you will not feel a change in your take home pay. Do this even if your company doesn't match your contributions. (Some used to, some companies still do but to a much lesser degree and some never have added a contribution, usually dollar for dollar up to a certain percentage.)

If you have no defined contribution plan, use your tax refund (you know the one you plan on getting in about five months) to open an IRA.

No matter when you begin, waiting is no longer an excuse.

Retirement Planning: Close but Not Quite Close Enough

More folks are looking at the past year with notable regret. They are looking at the fate of their investment strategy and wishing they had listened to the few who were warning of the coming investment storm or, promising to change their thinking in favor of a once-bitten-twice-shy approach moving forward.

Those closer to retirement are concerned that their current portfolio balance may not be enough to get them to retirement or, they feel comfortable with the current balance and want to protect whats left just in case. To those who have suffered losses, moving the whole of what you previously owned can be fraught with perils.

Your old portfolio was probably more open to risk and was not forward looking as much as it was now looking. You would check your portfolio and congratulate yourself for your investment savvy, even if the gains were due to market forces you knew little about as long as they trickled into your portfolio. But now we realize that this was not a very prudent approach. And as human nature dictates, we recoil from doing the same harmful thing again. (Although that same human nature is also responsible for our short-term memory, a hindsight look at risk that argues it was probably worth it; I'll try again.)

Leaving well-enough alone, even if it is not as well as you would have liked it to be, is actually the most prudent method for recovering those losses. Selling at the bottom, especially in a mutual fund, does not allow you the time to recoup and, if you you still have a long-term approach, shuns the idea that any recovery will take place. (In a previous post, I suggested that this could take as little as four to six years.)

But what do you do to change the habit of chasing market fads? First, leave the funds you currently own right where they are. This doesn't mean that you should ignore them completely. What it does suggest is no longer funding them if you are within five years of retirement.

Instead, use new money to take a new approach. Fixed income has become much more attractive post-meltdown and for good reason. There are some guarantees that your money will still be there when you retire. Building on your stock allocation with bond funds is not only wise, it has been highly suggested by many planners. (What those planners will also suggest is moving from one fund to another. Not wise.)

Municipal bond funds have become increasingly attractive. The reason I suggest buying munis through a bond fund is the relative inability of the average investor at determining the risk in these bonds. (Yes, there is risk. Some municipalities may be facing dire straights as a result of the current economy and will offer too high a return to attract investors.) But right now, munis have a sizable spread over Treasury offerings of similar duration meaning that, to attract investors, the yield is higher over the same period of time.

To fully appreciate what a bond can do for your portfolio, but a total bond fund that encompasses a broad swath of fixed income debt. Because there is risk and fees, don't think you can simply buy in and forget about it.

Inflation could create problems in the future diminishing the expected returns and making your invested dollar worth less even as the face value of it remains the same. Interest rates could fall as well and investors who purchase bonds outside of a bond fund are more vulnerable - provided they are aware of these two key elements: If you hold a security until maturity, interest rate risk is not a factor. You’ll get back the entire principal upon maturity. But if you buy a bond that is considered a zero-coupon investment, you might face some interest rate concerns. Zero-coupon bonds make all their interest payments when the bond matures and because of that, they are the most vulnerable to interest rate swings.

Credit agencies rate bonds based on numerous factors. The higher the rating, the lesser the chance you will face a default risk. In other words, the higher the rating on the bond, the greater the likelihood you will get your principal back in tact. But on the flip side, the yield for this degree of safety is much lower than on a riskier bond.

Another good reason for using a bond fund is liquidity. Suppose you had one to sell and no one wanted it? And the last big risk factor is reinvestment. A bond you may be holding may be called back, a move that essentially allows the issuer to pay off the bond, return your principal and leave you looking for a similar bond with comparable yield.

Even those these risks persist, a bond fund helps alleviate them. I'm not so sure a Target-dated fund could do as well. In my mind, it would be like fighting a war on two fronts.