Is Your Portfolio Properly Seasoned?

The effect interest rates have on the performance of our economy cannot be overstated. Understanding how interest rates affect the business cycle will help you know how to structure your portfolio to achieve growth while minimizing risk. Read on to learn more.

Would you wear a winter parka on a Florida beach in the middle of summer? Of course not. I doubt any of us would... wear a bikini to go ice fishing in the middle of a Minnesota winter. I know I wouldn’t!

Clothes are a tool that is used to help regulate our body temperature. They protect us from the cold or keep us from over-heating. Their proper use determines our comfort from one season to the next. We don’t want our body temperature to wildly fluctuate up and down.

It’s the same when it comes to investing. Unfortunately, many don’t understand the changing of economic seasons and therefore fail to adjust the clothing used in their portfolio. As many saw in 1997-2000 and 2000-2002, the investment clothes that work in one season are close to useless in another.

There are economic business cycles. There are seasons when the economy is expanding, other’s when it is contracting. There are also times (called peaks and troughs) that are like spring and fall, times of transition from one major cycle to the other.

Interest rates are one key in determining where we are in that cycle. The Federal Reserve uses the rate it charges on over night loans to banks (the Fed Funds rate) as an accelerator or brake on the economy.

It may seem strange that small changes in the over night rate banks pay could have an impact on the overall economy. Banks lend more money then they receive in deposits. That ‘extra’ money comes from inter-bank loans and is referred to as the Fed Funds Market. It stands to reason that if a bank pays more on what it borrows, it will have to earn more on what it lends.

The Federal Reserve controls the Fed Funds rate by putting money into the inter-bank loan market or by taking it out. Just as supply and demand causes the price of a stock to go up or down, so is with the interest rate charged in the Fed Funds market. By putting money in or taking money out the Federal Reserve is able to artificially control the supply demand balance.

Interest rates affect every area of our economy. If you have to pay a higher interest rate on a mortgage your monthly payment is going to be higher. Since you can only afford to spend so much a month on that payment, the interest rate affects the how much home you can afford.

Likewise, most businesses borrow money to fund expansion, cover inventory and to smooth out cash-flow. Just like the homeowner, they have a limited amount they can afford in payments each month. The amount they borrow affects whether they can build bigger plants, buy more computers or hire additional employees.

Different industries do well in different parts of the economic cycle. The construction industry will perform best during periods of low interest rates because low interest rates are designed to spur growth. When people and businesses can borrow at low rates they will build new homes, skyscrapers and factories.

Similarly, we each tend to buy the same amount of toothpaste and toilet paper regardless of where interest rates are. The companies that make those essentials aren’t going to see the big change in demand for their product that a construction company might.

Equity investments can be categorized as cyclical or non-cyclical based on how they are affected by changes in the economic cycle. The proportion of each in a portfolio will greatly affect the overall volatility. I recommend having a portfolio of high-quality non-cyclical companies. You can then introduce cyclical companies as the seasons change to add additional growth. Make sure you adjust the cyclicals as the seasons change.

Economic cycles don’t just affect stocks. They determine whether it is a good time to own bonds, and what type of bonds to own, as well. The last several years, interest rates have been at historic lows. You don’t want to lock in low rates for 30 years. When interest rates are above the historic norms, that’s when you want to stretch out your maturities.

Think of your investment portfolio as a living, breathing entity. Recognize that the investments used in it will determine your comfort level as the economic seasons change. Doing so properly will allow you to increase your return while reducing your risk. Take advantage of economic cycles. Don’t let them take advantage of you.

Have a financial question? Send me an email and I’ll personally respond, free of charge. Go to www.guardingyourwealth.com and click on ‘Ask Jeff’.

In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.

The Tax Gifts Keep On Coming

Did you know that you can sell a stock at a profit and pay next to nothing in capital gains tax? Or that you may not owe any tax on dividends you receive? It's true. The Tax Increase Prevention and Reconciliation Act (TIPRA), which was signed into law in early 2006, reduces capital gains and dividend tax rates even further down to 0% in some cases. Read on to find out more and how you can save money through proper planning.

Capital gains tax must be paid when you sell an asset for a profit. For instance, if you buy a stock at $10 per share and sell it two years later for $15 per share, there is a $5 per share gain that is subject to tax. Most of us know that the maximum capital gains tax rate is 15%. But depending on your income, your capital gains rate might be 0%.

Your capital gains tax rate is based on your overall income tax bracket. If your overall tax bracket is greater than 15%, then your capital gains will be taxed at the maximum capital gains rate of 15%. Even if you are in the 35% tax bracket, you still only pay 15% on capital gains. But if you are in the 10% or 15% overall income tax bracket then your capital gains tax rate is only 5%!

There is also a big difference between the way that dividends and interest are taxed. Dividends are paid by preferred and common stocks. Interest is paid on bonds and Certificates of Deposit. Interest is taxed at your overall income tax rate, as are any gains from annuities. But dividends aren't. Just like capital gains, qualified dividends are taxed at a maximum rate of 15%. If you are in the 10% or 15% overall income tax bracket then your dividend tax rate is also only 5%!

TIPRA, passed in early 2006, changed this. Between 2008 and 2010, the maximum dividend and capital gains tax rate stays at 15%. But it drops to 0% for those in the 10% or 15% overall tax brackets. You can have capital gains and receive dividends and NOT pay any tax on them!

Assuming 2006 tax rates, you can have $61,300 in income (married filing jointly) and still be in the 15% overall tax bracket. You can have $60,000 in income and you will only pay 5% in tax on dividends and capital gains! Between 2008 and 2010 you wouldn't have to pay ANY tax on dividends and capital gains. It's the same for those who are single if they have $30,650 or less in income.

How should this affect your investments?

Regardless of your overall tax bracket, dividends and capital gains are more valuable than interest because of the tax savings. Let's say that you have the option of putting $10,000 into a Certificate of Deposit at 5% or a preferred stock that pays a 5% dividend. At the highest overall tax bracket, you will owe about $175 in taxes on the CD interest, leaving you $325 to spend.

You will only have to pay about $75 in taxes on the dividend from the preferred stock, giving you $425 to spend. That,s $100 more just off of a $10,000 investment. In percentage terms, you have 30% more to spend with the dividend-paying investment than with the Certificate of Deposit.

For those in the highest tax bracket, to produce the same spendable amount, a Certificate of Deposit would have to earn around 6.25%, or 5.75% for those in the 25% tax bracket.

It's possible to find dividend-paying investments that currently pay far more than Certificates of Deposit. For instance, I use several stocks for my clients that pay dividends of 7-10%. They may fluctuate in value whereas a Certificate of Deposit does not, but properly diversified and managed, they are a great way to receive a larger income stream from your investments. When taxes are taken into account, the amount of spendable income is close to double that provided by the CD.

The bottom line is this. If you pay any income taxes at all, you are better off (tax-wise) receiving dividends and capital gains than interest. That's even more true in 2008 when the minimum capital gains and dividend rate drops to 0%.

Nationally-syndicated financial columnist and Certified Financial Planner(R) Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He'll answer your financial question FREE at www.guardingyourwealth.com.

Income Investors Should Take Action

The Federal Reserve cut interest rates again yesterday and will be likely to do so again in six weeks. Yields on 5-year Certificates of Deposit are down to around 4.25% and falling. On top of that, the mortgage meltdown has hindered the performance of the entire stock market. If you are retired and need your investments to generate income you don't have to settle for these paltry rates and dismal returns. Read on to learn how you can get rates that are double that!

I have written several articles on various types of investments that can generate a dependable income stream that is far higher... than that paid by certificates of deposit. I've talked about income deposit securities, closed-end funds, regional telephone companies and Canadian income trusts in previous articles (you can find them at www.guardingyourwealth.com). Keep in mind that these types of investments aren't guaranteed by the government and their share value will fluctuate from day to day.

Closed-end funds make attractive income-oriented investments. Think of a closed-end fund as a pool of underlying investments. Those underlying investments can be U.S. corporate bonds, foreign bonds or even stocks. Something unique to closed-end funds is that they don't always trade at the same price as the underlying value of what they own.

For instance, a closed-end bond fund may own a pool of bonds that, if sold that day, would be worth $10 per share. Those shares don't always trade at $10. They can trade above or below that price at a premium or a discount to the fair market value of what it owns. Currently, high-quality closed-end funds that previously were trading at a premium are now trading at a discount. Some have discounts of 10% or more.

One reason why I particularly find select closed-end funds attractive is because the share price has been declining much faster than the value of the underlying securities. To me, this is an indication that the decline is a result of investor panic, not the underlying fundamentals of the fund. The yields on attractive closed-end funds have increased 2-3% with many yielding in the 9-10% range.

I also like the stocks of select regional telephone companies. Studies have been done that show how stocks paying dividends tend to out-perform those that don't over longer periods of time. That's because companies that pay dividends tend to be older and are in industries where their cash flow is more dependable.

These telephone companies have a steady, stable and growing cash flow. Think about it. Every month you pay your phone and cable bill. Things would have to get pretty bad before people allow their phone and cable to be shut off. Recent market fears have even caused the price of these stalwarts to decline. That means you can now get yields close to 10%--or even higher.

Canadian Trusts are popular among those seeking higher dividend yields. These investments are out of favor due to changes in Canadian tax laws. Those laws don't take effect until 2011 though, and even then will only have a limited impact on certain trusts. Yet the share prices of all of the trusts have declined as much as those trusts that are adversely affected. That means that high quality trusts with healthy and growing underlying businesses are paying unbelievable yields.

A company that prints telephone directories is now yielding over 7.5% and has already increased their dividend this year. There are trusts in the oil and gas sector that have shown they can weather the stress of low natural gas prices. Some are paying over 10%--some even 15%---and still they are only paying out 70-80% of the money they have available for dividends.

The key with all investments like these is to own several of them to reduce your risk. The prices will fluctuate. The prospects of individual companies can change. That's why I use groups of these in my clients, portfolios. For instance, my growth stock portfolio may utilize 10-15 different positions like those mentioned here.

So while everyone else is in a panic and rushing for the exits, I am using this opportunity to pick up investments that will give my clients a steady and growing source of income for years to come.

Nationally-syndicated financial columnist and Certified Financial Planner(R) Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He'll answer your financial question FREE at www.guardingyourwealth.com.

Are Variable Annuity Guaranteed Living Benefits Worth It?

If you have an IRA, sorting through all the investment options can be very confusing. Unfortunately, there is a lot of hype out there and, in my opinion, the financial services industry is great at selling the sizzle and delivering very little steak!

This is especially true in the area of annuities. Folks purchase variable annuities based on the belief that... the principal is protected and other guarantees. Often there is a wide gulf between what the investor thinks a product does and what it really ends up doing.

These are complex financial instruments that are sold using generalities. As with anything, the devil is in the details, and the more you know the details the less important some of these guarantees become.

Take a look at a principal guarantee on a variable annuity. The ones that I'm familiar with guarantee that you can withdraw so much a year for a certain number of years, thus getting back your principal even if the market goes to zero.

Think about that for a minute. Let's say they allow you to take 7% a year. It would take over 13 years for you to get back your principal. What are the probabilities of the market being worth less over a 13 year period? Very, very small.

Or there are the guaranteed income provisions--referred to as the guaranteed living benefit. Many investors think that these living benefits guarantee that they will earn 5-7% a year regardless of what the market does. They believe that if they leave their money in and 10 years later decide to take it out that they will have earned at least the 5-7% a year.

Nothing could be further from the truth.

These living benefit riders don't apply if you surrender the annuity. They ONLY apply if you take a lifetime income stream from the annuity. Even then, if you ever cash it in, what you get is based on the actual earnings of the annuity less any withdrawals. What you get when you cash it in isn't ever based on the 5-7% guarantee.

Let me explain it this way. Picture two columns on a piece of paper. The first column is the actual value of the annuity from year to year. So if the market goes up, so does that value. If the market goes down, so does that value. The second column is the 5-7% column. This column takes your initial investment and increases it by the 5-7% each year.

So 10 years down the road, you decide to cash in your annuity. You get the value in the first column; the value in the second column meant nothing.

In a different scenario, let's say that 10 years down the road you decide to start taking the income stream of 5%. That income stream is based on the second column. So if the second column was $200,000 your income stream would be $10,000 a year guaranteed for life.

So far so good.

Time has passed and you have been receiving the $10,000 a year. Your situation changes and you need (or want) what's left of the money in the variable annuity. Here's where the surprise happens. What you get isn't based on the value of the second column; what you get is based on the first column less any withdrawals you've made.

Actually, every time you get a payment, they reduce both columns. That payment affects the growth of the first column (as it should).

What if you die? Do your heirs get what's left in the second column? No. Your heirs get what's left in the first column.

That's why I don't place a lot of value on the guaranteed provisions associated with annuities. I expect that few people will ever use them or get the benefits that they expect.

That's why an annuity should first be evaluated based on its investment potential. These benefits are designed to take your eye off of the underlying investment. Investors can have a false sense of security thinking that changes in the market won't hurt them. They will.

When evaluated as an investment, I believe that there are many alternatives that are much more attractive and that allow the investor to retain the control, flexibility and access to their money.

Nationally-syndicated financial columnist and Certified Financial Planner(R) Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He'll answer your financial question - FREE at www.guardingyourwealth.com.