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Most financial advisors are preparing to add more financial planning services to their practices as a result of the recent recession, according to a report on practice management by Cerulli Associates.

In addition, financial advisors are looking into adding alternative investments to client portfolios as a way to help them recover lost ground.

A majority of those advisors surveyed or 57%, say they will add more financial planning services to their practices. They are broadening the focus of their practices beyond investment performance.
However, investment performance is still vital. Most advisors, 51%, said they would adopt more conservative portfolio allocations, and 43% of advisors said they are turning to alternative investments as a result of the recent market downturn. Some products under consideration are hedge funds, venture capital funds and managed futures, Bing Waldert, a director at Boston-based Cerulli Associates, said. “Financial advisors are using them as a way to diversify portfolios,” he said.

Although alternative investments haven’t all lived up to their marketing, they have beaten broader equity benchmarks, the study found. There has been a lot of discussion among advisors about how to use them in their own practices, Waldert said. “Broker-dealers should be thinking about this,” as a way to educate and serve advisors, he said.

The Cerulli report, which was recently released surveyed 1,900 financial advisors from February 2009 through September.

And you know what?  Over the last 70 years, the market has averaged a 10% return per year.  But here’s my question.  We have market data going back to 1896, so why are we using just part of the data and not all of it?

Once we start looking at all the data, the answer becomes very clear.  All the data doesn’t support a 10% average return, and that is a message that big brokerage firms would prefer not to get out.

I like to get right answers, so here’s what I did.  I downloaded the history of the Dow Jones Industrial Average since it started (or at least since we have data on it) in 1896.  I got the data from Dow Jones itself at www.djindexes.com.

Then, to keep it simple, I started calculating year-by-year returns and grouped them by decades.  I started with 1900 – 1909, then went to 1910 – 1919, and so on.  I started in 1900, because the data only went back to 1896, and I didn’t want to do 1896 – 1905, 1906 – 1915, etc.  So my analysis does leave out the first few years.

What I Learned

Here’s what I learned about how the market performed over the decades, starting in 1900:

Decade Return Return + 3% Dividend

1900 – 1909                          +4.19%                                   +7.19%

1910 – 1919                          +0.80%                                   +3.80%

1920 – 1929                          +8.77%                                   +11.77%

1930 – 1939                          -4.92%                                    -1.92%

1940 – 1949                          +2.95%                                   +5.95%

1950 – 1959                          +12.98%                                 +15.98%

1960 – 1969                          +1.65%                                   +4.65%

1970 – 1979                          +0.47%                                   +3.47%

1980 – 1989                          +12.62%                                 +15.62%

1990 – 1999                          +15.37%                                 +18.37%

2000 – 2008                          -2.96%                                    +0.04%

Average Return                   +4.72%                                 +7.72%

Now, please be aware of two items.  First, dividends are NOT included.  In the far right column, I plugged in the effect of a 3% dividend.  But you need to recognize that this is only an estimate.  Dividends vary throughout the years.  They were a bit higher in the early years and lower in the more recent years.  If you don’t like my 3% dividend rate, please feel free to plug in your own.

Second, the returns calculated are compound annual returns.  That means that if at the beginning of each decade, you purchased a 10-year CD at the return rate of that decade, you would have exactly the same amount of money in your account.  For example, let’s say that on January 1, 1900, you went to a bank and bought a 10-year CD paying you 7.19% per year of interest.  You then took an equal amount of money and placed it into the Dow Jones Industrial Average and let’s assume that those companies were paying a 3% dividend for each of the next 10 years, and you reinvested those dividends.  On December 31, 1909, you would have exactly the same amount of money in each account.

Analyzing The Data

If you take a look at the returns by decade, you start to notice some interesting results.  Let’s use the “3% dividend” column for our discussion.

First, you’ll see that out of the eleven (11) decades represented (with 2000 – 2008 being one year short), only four (4) of them broke the classic 10% per year return.  And when they did better, boy oh boy did they do better!  For the most part, the good decades crushed the 10% average number.

But what about the other seven (7) decades?  After all, aren’t they the majority?  If you look at those decades, you find that you will normally fall far short of the 10% per year average.  So what does this tell us?

The majority of the time (64%), the market returns far less than the touted “10%” average rate of return.  Only 36% of the decades beat the 10% number (unless, of course, 2009 pulls off a 240% return).  So over a 10 year period, you have roughly a 1/3 chance at beating a 10% return in the market, and a 2/3 chance of falling far short of your target.

Further, you’ll notice that long-term, the market actually averaged closer to 8% than 10% when you use all the data (minus the first few years, of course).

Finding Patterns

Do you see a pattern in the data?  How about this?  The market seems to have a tendency of low returns, or pretty flat returns, over a 20-year period.  And then it takes off for a decade.  What do I mean?

Look at 1900 – 1919.  You see 20 years of lower returns.  Then suddenly, the decade of the 1920’s goes crazy.  Next, 1930 – 1949.  20 more years of lower returns.  Then the 1950’s hit, and it’s boom time.  Following is 1960 – 1979, more blah years.  But then the pattern broke, and we had two good decades in a row, the 1980’s and the 1990’s.  This was unprecedented growth.  But what’s happened in the 2000’s?  Back to more blah.

What Does The Future Bring?

The big question here is what will we see going forward?  Will we see a return to big returns, or will we revert to the mean, and are we in the middle of a 20-year low return cycle?  Nobody knows that answer, of course, but it’s also true that history has a way of repeating itself.

Of course, when it comes to your investments, where the markets are going is a huge deal.  You need to have some kind of feel of market direction to position your holdings.  Buy and hold works great when times are good, and the 1980’s and 1990’s were a good example of that.  It doesn’t work so well, though, in the lower return years.  During those time periods, your account balances look like a roller coaster.  Basically, you see a bunch of ups and downs, but overall, you’re not really going anywhere.

Investment Options

When it comes down to it, you really only have three basic types of investments to choose from:  fixed, market, and hybrid.  Let’s describe each of them and discuss when they are most attractive.

Fixed investments are those that provide you a guaranteed rate of return and no market risk.  Generally speaking you have three to choose from:

1. CD’s
2. Government Bonds
3. Fixed Annuities

Each of these provide you a guaranteed rate of return, while protecting your principal at the same time.  The disadvantage, of course, is that the returns are often relatively low.

Market investments are those that are linked to the stock market in some form.  You may hold individual stocks, mutual funds, unit investment trusts, etc.  With these investments, you are trading security for a potentially higher rate of return.  You might hold these accounts at mutual fund companies, brokerage houses, or insurance companies.

Hybrid investments are a creation of insurance companies, and they pay you an interest rate equal to some calculation of what a market index does.  For example, you might receive interest for the year equal to 50% of what the Dow Jones Industrial Average does.  If the index goes down for the year, you simply receive 0% interest.  You do not lose anything.

So with hybrid investments, your annual return might vary from 0% to 20% depending on what the index your interest is linked to does.  So these accounts are a way for you to participate in market returns in years that the market does well without the risk.

What Investment To Use When

Now, when does each investment option perform well, and when should they be avoided?  A simple matrix below tells the story.

*Note:  in decades when the market is going up & down, when all is said and done, the fixed and market positions might flip, depending on the final market results.  However, even if the market ekes out a bit better return than fixed for the period, very few people find the additional return worth the risk they had to take to get it.  In other words, over a 10-year period, market investments might have earned 1% per year more, but you had significant up & down movements along the way.

I’m often asked why hybrids do better in up & down market conditions than the other options.  The reason is pretty simple – hybrids are credited with significant interest when the market is up, yet they lose nothing when the market is down.

Comparing Market Investments vs. Hybrid Investments

Here’s an example of a 10-year up & down period, 1970 – 1979.

Since some people understand better with pictures (I’m one of them), I’ve graphed out on the next page what the portfolio values would be if one invested in the market directly during this time period vs. investing in a hybrid approach that credits interest at an amount equal to 50% of the Dow Return, not including dividends.

Market vs Hypbrid 1970-1979

From the chart, you see the value of avoiding the negative market years.  When it comes to investing, the good years help, but the bad years kill you.  When faced with a constantly rising market, like we saw in the 1950’s, 1980’s, and 1990’s, being in the market directly is a sure winner.  The problem is that only helps you about 1/3 of the decades.  The majority of the decades, you get something very similar to the above chart.

Here’s another chart that’s a bit more recent.

Market vs Hypbrid 2000-2008

Summary

When you invest in the stock market, you are told that it is reasonable to expect a 10% average return, because “that’s what the market averages over time”.  The problem is that 10 years is clearly not enough time to have any reasonable expectation of hitting that average.  In fact, 20 years is also not long enough.  As a result, millions of Americans may end up going through their entire retirement years, never reaching their investment expectations.

The culprit in the underperforming decades is that they have a few negative years.  It’s not that the markets are down every year during those decades, just a few.  And it only takes one or two down years to kill the return of an entire decade.

Fortunately, other avenues are available, including fixed and hybrid investments, to assist an investor in protecting against those very downturns that kill you.  Since you can anticipate these types of downturns every 2 out of 3 decades, you would be wise to consider other options to immunize your retirement portfolio against significant risk.

Steve Sexton is the President of the Sexton Advisory Group in Temecula, California. The mission of the firm is to assist our client in achieving the goals and objectives that are most important to them by integrating all areas of planning including financial, insurance, tax and legal strategies. We assist them in gaining clarity in a world of increasing complexity by serving as our client’s “Personal CFO.”

As a result of Mr. Sexton’s planning strategies, his clients enjoy Total Wealth Optimization. Because they are freed from the chains of financial worry, they are able to spend time doing the activities that bring them the most internal satisfaction. They are clear about what is important to them in life and understand that money is nothing more than a tool for them to use to support their value system.

Each year, Mr. Sexton educates area investors by holding educational seminars open to the public. Topics include: taking money out of IRA’s tax-free, stopping the unfair tax on your Social Security Income, how to get long-term care protection without paying annual premiums, safe investment alternatives, protecting yourself from market losses, and much more.

Mr. Sexton has over 16 years experience in the financial services industry and holds multiple licenses and designations. He continues improving his knowledge base by attending several advanced planning industry meetings held throughout the year.

Steve is a resident of Temecula and is happily married to his wife, Lora of 12 years. He enjoys spending time with his 2 children, Connor (10), and Paige (9).

Borman818 Via Flickr

The Financial Stability Plan – Progress So Far: Over the past six weeks, the Treasury Department has implemented a series of initiatives as part of its Financial Stability Plan that – alongside the American Recovery and Reinvestment Act – lay the foundations for economic recovery:

·    Efforts to Improve Affordability for Responsible Homeowners: Treasury has implemented programs to allow families to save on their mortgage payments by refinancing, assist responsible homeowners in avoiding foreclosure through a loan modification plan, and, alongside the Federal Reserve, help bring mortgage interest rates down to near historic lows. This past month, the 30% increase in mortgage refinancing demonstrated that working families are benefiting from the savings due to these lower rates.

·    Consumer and Business Lending Initiative to Unlock Frozen Credit Markets: Treasury and the Federal Reserve are expanding the TALF in conjunction with the Federal Reserve to jumpstart the secondary markets that support consumer and business lending. Last week, Treasury announced its plans to purchase up to $15 billion in securities backed by Small Business Administration loans.

·    Capital Assistance Program: Treasury has also launched a new capital program, including a forward-looking capital assessment undertaken by bank supervisors to ensure that banks have the capital they need in the event of a worse-than-expected recession. If banks are confident that they will have sufficient capital to weather a severe economic storm, they are more likely to lend now – making it less likely that a more serious downturn will occur.
The Challenge of Legacy Assets: Despite these efforts, the financial system is still working against economic recovery. One major reason is the problem of “legacy assets” – both real estate loans held directly on the books of banks (”legacy loans”) and securities backed by loan portfolios (”legacy securities”). These assets create uncertainty around the balance sheets of these financial institutions, compromising their ability to raise capital and their willingness to increase lending.

·    Origins of the Problem:The challenge posed by these legacy assets began with an initial shock due to the bursting of the housing bubble in 2007, which generated losses for investors and banks. Losses were compounded by the lax underwriting standards that had been used by some lenders and by the proliferation of complex securitization products, some of whose risks were not fully understood. The resulting need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity.

·    Creation of a Negative Economic Cycle: As a result, a negative cycle has developed where declining asset prices have triggered further deleveraging, which has in turn led to further price declines. The excessive discounts embedded in some legacy asset prices are now straining the capital of U.S. financial institutions, limiting their ability to lend and increasing the cost of credit throughout the financial system. The lack of clarity about the value of these legacy assets has also made it difficult for some financial institutions to raise new private capital on their own.

The Public-Private Investment Program for Legacy Assets
To address the challenge of legacy assets, Treasury – in conjunction with the Federal Deposit Insurance Corporation and the Federal Reserve – is announcing the Public-Private Investment Program as part of its efforts to repair balance sheets throughout our financial system and ensure that credit is available to the households and businesses, large and small, that will help drive us toward recovery.

Three Basic Principles: Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time. The Public-Private Investment Program will be designed around three basic principles:

·    Maximizing the Impact of Each Taxpayer Dollar: First, by using government financing in partnership with the FDIC and Federal Reserve and co-investment with private sector investors, substantial purchasing power will be created, making the most of taxpayer resources.

·    Shared Risk and Profits With Private Sector Participants: Second, the Public-Private Investment Program ensures that private sector participants invest alongside the taxpayer, with the private sector investors standing to lose their entire investment in a downside scenario and the taxpayer sharing in profitable returns.

·    Private Sector Price Discovery: Third, to reduce the likelihood that the government will overpay for these assets, private sector investors competing with one another will establish the price of the loans and securities purchased under the program.

The Merits of This Approach: This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases – along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets.

Two Components for Two Types of Assets: The Public-Private Investment Program has two parts, addressing both the legacy loans and legacy securities clogging the balance sheets of financial firms:

·    Legacy Loans:The overhang of troubled legacy loans stuck on bank balance sheets has made it difficult for banks to access private markets for new capital and limited their ability to lend.

·    Legacy Securities: Secondary markets have become highly illiquid, and are trading at prices below where they would be in normally functioning markets. These securities are held by banks as well as insurance companies, pension funds, mutual funds, and funds held in individual retirement accounts.

The Legacy Loans Program: To cleanse bank balance sheets of troubled legacy loans and reduce the overhang of uncertainty associated with these assets, the Federal Deposit Insurance Corporation and Treasury are launching a program to attract private capital to purchase eligible legacy loans from participating banks through the provision of FDIC debt guarantees and Treasury equity co-investment. Treasury currently anticipates that approximately half of the TARP resources for legacy assets will be devoted to the Legacy Loans Program, but our approach will allow for flexibility to allocate resources where we see the greatest impact.

·    Involving Private Investors to Set Prices: A broad array of investors are expected to participate in the Legacy Loans Program. The participation of individual investors, pension plans, insurance companies and other long-term investors is particularly encouraged. The Legacy Loans Program will facilitate the creation of individual Public-Private Investment Funds which will purchase asset pools on a discrete basis. The program will boost private demand for distressed assets that are currently held by banks and facilitate market-priced sales of troubled assets.

·    Using FDIC Expertise to Provide Oversight: The FDIC will provide oversight for the formation, funding, and operation of these new funds that will purchase assets from banks.

·    Joint Financing from Treasury, Private Capital and FDIC: Treasury and private capital will provide equity financing and the FDIC will provide a guarantee for debt financing issued by the Public-Private Investment Funds to fund asset purchases. The Treasury will manage its investment on behalf of taxpayers to ensure the public interest is protected. The Treasury intends to provide 50 percent of the equity capital for each fund, but private managers will retain control of asset management subject to rigorous oversight from the FDIC.

·    The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing assets in the Legacy Loans Program will occur through the following process:

·    Banks Identify the Assets They Wish to Sell: To start the process, banks will decide which assets – usually a pool of loans – they would like to sell. The FDIC will conduct an analysis to determine the amount of funding it is willing to guarantee. Leverage will not exceed a 6-to-1 debt-to-equity ratio. Assets eligible for purchase will be determined by the participating banks, their primary regulators, the FDIC and Treasury. Financial institutions of all sizes will be eligible to sell assets.

·    Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.

·    Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.

·    Private Sector Partners Manage the Assets:Once the assets have been sold, private fund managers will control and manage the assets until final liquidation, subject to strict FDIC oversight.