Last Updated: October 27, 2008
Forget interesting. It now seems as if we are cursed to live in turbulent times. Down, up, up, down goes the Dow Jones industrial average, seemingly with one new record rise or fall after the other. So what's the average American to do? Countless publications, Web sites and pundits are stepping into the breach with advice of one sort or another. So who should you believe? What should you do?
Anxious Is the New Normal
Well, first things first. It's normal to be anxious during times like these, said FPA member Mike Busch, CFP®, president of Vogel Financial Advisors in Dallas. But rather than fret the nights and days away, Busch suggests taking advantage of all that anxiety. "The anxiousness can serve as a wake-up call for those who were complacent or haphazard in structuring their investments and were taking inappropriate risk in their portfolio."
For those who have failed to create a financial plan and an investment plan, now would be a good time to do so, says Busch. (Numerous studies have shown the benefits of having a financial plan and a financial planner, including the FPA and Ameriprise Value of Financial Planning Study (PDF | 2.4MB)). And for those who do have a financial plan and an investment plan, now would be a good time to give it a once over, to make sure it performed according to expectations and perhaps to tweak it given current circumstances.
Some experts view the current turbulence as the best thing that could have ever happened to America in an odd way. It gets people focused on their finances. It reminds them about the concept of not just reward, but risk. Indeed, it reminds them about the need to insure against or mitigate risks. It reminds them to put or keep their financial house in order. In short, it's a good time to take stock of every element of your financial plan, especially your net worth and cash flow:
Assets, Including Your Job, Your Investments, Social Security and Your Traditional Pension, the Value of Your Home and Income, Including Earned and Unearned Income
Economists who study what's called "life-cycle saving and investing" suggest that your job — just like your 401(k) or IRA — is an asset as much as it is a source of income. Many Americans tend to overlook or fail to consider this fact when adding up their assets, but economists regard your human capital just as important as your financial capital, your IRA, 401(k), and bank accounts. Why? Well, let's say you are in the early stages of your working life, it's likely that your human capital (the value of all the money you will make working over your lifetime) is actually larger than your financial capital, the amount of money you have set aside in taxable or tax-deferred accounts. As you age, you typically convert your human capital (through saving and investing in your 401(k) plan, for instance) into financial capital. And by the time you are in the later stages of your career, your financial capital will likely be greater than your human capital.
So why is this important given what's happening in the global markets? Well, economists suggest that if you are in the early part of your career and your job is safe, it's important to view your financial assets — even if they have fallen in value over the past couple months — in context. If you have a long time horizon, decades for instance, there's every reason to keep saving and investing, to buy — as experts are fond of suggesting — low, to dollar-cost average (to buy a fixed dollar amount of investments on a regular basis). In some cases experts are even suggesting that you increase — assuming your job is safe and that you have discretionary income — the amount you save in your taxable and tax-deferred accounts. "Investors with a long investment horizon should welcome the discounted prices available in the market," said Busch. "For example, those who are dollar cost averaging into their 401(k) plans should not only continue to do so, buy may want to consider increasing their deferrals. With the depressed market, they are accumulating more shares with each dollar invested. That will pay off when they reach retirement."
For those who are in the middle of or late in their career, now would be a good time to review the value of your human capital relative to your financial capital. It's a tricky balance, but experts often suggest building a portfolio with your financial capital such that it will provide a steady and sufficient enough stream of income to last a lifetime, as well as the need to build a portfolio that will keep pace with inflation. To be sure, it's not easy to square up the two main investment objectives that people have late in life — the need for safety and the need for growth. But examining your financial, human, social (the value of your future Social Security benefits) capital in context — can create a clearer picture of your situation and perhaps reduce the need to fret or panic. (Of note, one way to increase the value of your human capital is to work longer. And one way to increase the value of your Social Security is to delay taking benefits till full retirement age, if not later.)
For his part, Moshe Milevsky, author of Are You a Stock or a Bond? has coined a new term called "product allocation" in which he advances the notion of allocating assets across not just traditional investments (stocks and bonds) , but certain types of insurance products that mitigate the risks of retirement (specifically longevity) and guarantee income. This theory will likely become more accepted as Americans adjust or re-evaluate their tolerance for risk in light of current events.
As for your house, economists tend to view home sweet home as what's called a "use" asset rather than an economic asset; it's something that you live in. Yes, many Americans want to and plan to tap the equity in their home as a way to create income in retirement. But experts generally suggest that you view the equity in your home as one potential stream of income in retirement, not the principal source of income.
Other assets that need to be toted might include the cash value in life insurance policies, any potential inheritance and other assets including your business or rental property.
As for income, it's well worth evaluating the security of any earned and unearned income. For those whose jobs aren't safe, now would be a good time to make sure you have at least three to six months of living expenses set aside. For those who are retired and who may be taking money from their retirement accounts, now would be a good time to re-evaluate not just your asset mix, but the amount you're withdrawing. In some cases, experts suggest that you reduce the amount you take out when the value of those assets decline. In other cases, experts suggest that you return to work, if possible, if only part time to make up for any loss in income. Some suggest, for instance, that $10,000 in earned income is the near equivalent of drawing down 4 percent from a $250,000 portfolio.
The upshot of looking at all your assets and income in light of current conditions is this: Taken together, it's quite possible that losses in one area — your 401(k) or IRA — though substantial, are not nearly as bad when viewed in the larger scheme of things. At a minimum, Busch says investors should use this as an opportunity to take stock of their portfolio and determine if they need to be positioned differently for the next crisis.
Liabilities, Including Your Credit Card Balances, Automobile Loans, Mortgages, Home Equity Loans, Insurance, Student Loans, Personal Loans and Expenses, Including Fixed and Discretionary
According to a Center for Retirement Research at Boston College report, household debt totaled $10 trillion in 2004, double that in 1992. What's your share of that number? What do liabilities and expenses represent as a percent of your assets? According to the Pew Research Center, the median debt-to-asset ratio for all families in the U.S. in 2004 was 34 percent. That means for every $100 in assets, the median family had $34 in debt. But that percent changes dramatically based on your household income. For upper-income families, the debt-to-asset ratio is 27 percent while for lower income families it's 40 percent. Not surprisingly, households with a higher debt-to-asset (and higher debt-to-income) ratios are more likely to default on their obligations when they suffer adversity, such as job loss or illness. How can you reduce the risk of defaulting?
Experts generally suggest that you create a budget and search for places to trim any unnecessary expenses. Expenses are typically categorized as fixed or discretionary. Fixed expenses are those over which you have no control while discretionary expenses are those of which you have some control. Fixed expenses typically include housing (mortgage payments or rent, property insurance), savings (your 401(k)), taxes, and health care (insurance premiums). Discretionary expenses might include transportation (fuel) and entertainment (dining out), for instance.
Part of the fat-trimming also includes searching for and eliminating high-interest credit cards and switching, if possible, from adjustable-rate loans to fixed-rate loans. Indeed, reducing the interest expense associated with a credit card could free hundreds of dollars each month.
To be sure, not all debt is bad. But during turbulent times, when the value of homes and 401(k) plans are declining, when the possibility of job loss is great, it's better to weather the storm with as little debt and as little discretionary expenses as possible.
Whatever You Do, Don't Panic
"We don't want to seem as though we are simply offering the same platitudes and neglecting to recognize the challenging times we're seeing in the economy," said Marc Freedman, CFP®, president of Freedman Financial. "As the market sorts through its emotions and rises and falls with each change, we know how difficult this will be for many of you. It is frightening when you envision your plans and your safety net possibly being eroded. While no one has a crystal ball, we believe that reacting out of panic now is not likely to get you to where you need to be."
