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Posted: 7.27.17

Boost Your Credit Rating Now - and Make Your Money Work Harder for You

credit cards

 

How much are you worth?  Financially speaking, you can tally up all of your assets, subtract all of your debts, and get a number for your net worth - but does that really describe how much financial muscle you have?  Does that give a clear picture of your purchasing power or your financial health?

Imagine you need a car, so you go to the dealership, find a great new car and start talking financing.  It turns out that your monthly payments could be either $300 or $350 depending on the interest rate you get quoted.  That’s $50 more every month!  Over the life of a 5 year auto loan that adds up to paying an additional $3,000 - for the same car!  Why the difference? 

It is one of the most underrated aspects of personal finance, and one that you have the most control over.  Your credit score.  If you want to start gaining some serious financial power you need to make an effort to boost it.  Here are the three easiest ways to raise your credit score right now.

  1. Review your Credit Report

    • All the credit rating agencies will tell you - they are not perfect and credit reports can have errors in them.  Go to each of the credit rating agencies and make sure to get the report, and check it.  Getting erroneous accounts taken off can dramatically increase your score.  When I was living near Chicago, I found an unpaid bill from New Jersey on my report!  After a phone call and some verification was able to get that removed from my credit history, boosting my score.

  2. Have credit, but only use it sparingly.

    • If you do not have a credit card, get one.  If you currently run high balances on a credit card, pay them down.  According to Experian, one of the three major credit rating agencies, 30% of your credit limit is a good guideline to aim for.  So if you have a card with a $5,000 credit line, working to get the outstanding balance below$1,500 (that 30% level) can immediately increase your score.

  3. Pay all your bills on time, all the time.

    • Seriously.  Your reputation as a good borrower means a lot to the credit rating agencies and missed or late payments will cost you.  If you have been a little less than perfect in the past, there is nothing you can do now except to be perfect going forward.  Pay your bills early, set reminders, and make sure if you run into any financial trouble that could affect your ability to pay, you get on the phone and try to work something out.  Many companies will be willing to work with you (and count you as late) because they would rather get paid instead of sending your payment to a collection agency.

The biggest step you can take toward real financial freedom is to educate yourself about your personal situation and your credit score is going to be the biggest component of that.  It is also one thing that you have the power to change.  Taking positive steps to increase your score, thereby lowering your cost to borrow, will make your money work its hardest for you.

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Posted: 7.27.17

Preparing for the Next Market Crash

One Dollar Bills

 

"Risk Means More Things Can Happen Than Will Happen" – Elroy Dimson

The stock market is at all time highs, and valuations are at levels not seen since 2000.  Prudent investors will begin to ask (if they haven’t already),”When will the market turn?”

Here are a few statistics that give investors more than a little anxiety.

-        As of August 31st there have been 392 days since the last correction of 10% and 2,136 days since the last correction of 20%.  On average the market declines 10% every 167 days and 20% every 635 days.  These numbers suggest to many that we are “due” for a correction.

-        The volatility index (the VIX), which is believed to measure general anxiety levels in the market, is at historic lows and does not seem to react to much these days.  This is a cause for concern because long periods of low readings on the VIX are usually followed by sharp spikes, as some event needs to rock the market out of it’s complacency.

-        The Price-to-Earnings (PE) ratio on the S&P 500 is currently over 21 versus a long-term historical average of around 16.  Some of this overvaluation is justified by low interest rates, however those rates are slowly coming up which will slowly negate that rationale.

-        At a Price-to-Earnings multiple (PE) of 21 the market price (the P) would have to drop by 25% just to get back to the long-term average of 16.

So should investors sell everything and hide out in cash until this seemingly inevitable crash comes?  Absolutely not.  Now is the time to carefully reassess your risk tolerances and assess the possible consequences of a market crash happening - or not happening.

The crystal ball on my office desk (my PC monitor) is no better at divining the future than anyone else’s.  I gauge investment outcomes based on probability and constantly remind myself that if something has a 90% chance of occurring, there will still be 1 time out of 10 that it doesn’t.  There are no “slam-dunks” when it comes to the future.  The famous Yogi Berra quote captures it well “It’s tough to make predictions, especially about the future.”

So while we can’t predict what will happen, we can assess what is likely to happen, and invest accordingly.  Where risk-management comes into play is by constantly asking ourselves, “what if we are wrong?”  “What other outcomes could happen and how would that impact our clients?”  In other words we plan for what we expect, but prepare for what is possible.

That leads us to today.  The odds of the market correcting by 20% or more is rising, but what is it exactly?  Is it 5%, 30%, 70%.  We have no way to know for sure.  It has been over 2,000 days since the last 20% correction, but throughout the 90’s we went 3,000 days!  Another 1,000 days of bull market is over 3 years.  Nervous investors who go to cash expecting a correction would be just as hurt by missing out on 3 years of appreciation than by the correction itself.

Looking at the tables below, I outline two potential scenarios.  First, is a hypothetical market correction where the market goes down 22% in the first year, down modestly again the next year, before rebounding somewhat in the 3rd. The second scenario shows a potential return stream if the bull market continues to run like it did in the ‘90s (although much more conservatively).

For each scenario there are three investor responses.  The first, do nothing investor, is on the let it ride plan and takes whatever the market gives him.  As you can see, he is down quite a bit in the market correction scenario, but is a happy camper in the continuing bull case.

 

chart1

 

chart2

 

The nervous investor has decided to go to all cash and is secure in knowing that whether the market goes up or down, he will have his $100 secure and available for use.

Finally, a compromising investor does not want to risk losing too much, and is willing to give up some potential gains by going to half cash.  Therefore, she is getting half of whatever return the market offers.

Let’s say that each of these two outcomes has a 50% chance of occurring.  Which investor would you consider correct?  The do nothing investor, the nervous investor, or the compromising investor?

The answer is - it depends.

If our investor is a young person contributing to a retirement account, they are best off by aligning with the do nothing investor.  They will continue to contribute as the market goes down, thereby buying when prices are low and thus will recover more quickly.  This type of volatility is to be expected and simply treated as the price needed to be paid in order to get good long-term returns.

If, on the other hand, our investor is well into retirement and has significant cash flow needs, to the point where the portfolio is depleting, then they are better off joining the nervous investor and just moving to cash (in a practical reality it would likely be some combination of bonds, cash, and small amounts of stock).  Let’s say this investor needs $10 cash per year, meaning that if held in cash the portfolio can be expected to last for 10 years.  If it is fully invested in the market, the resulting hit in the market correction scenario would compound the negative results.

And finally, someone who has modest cash flow needs - to the point where they expect their portfolio to last a very long time, or even to continue to grow, may want to reduce their possible losses without giving up all of their potential returns.  This investor would side with the compromising investor.

The real world is obviously much more complex than this simple scenario analysis, but the following points can be instructive.

1)     As stock prices move higher, and valuations continue to increase, the odds of a market correction increases.

2)     Just because something may be more likely to happen, does not mean it will happen.

3)     Portfolios should be invested with keeping all possible scenarios in mind.

4)     Different investors should be in different portfolios based on time horizon, cash flow needs (contributing v. distributing), and personal risk preference.

5)     Times when investors fear a correction could happen are not times for knee-jerk risk avoidance, but rather, a time for careful risk analysis.  “Stay the course” is sometimes an appropriate action, and sometimes it is a dangerous one.

 

Bonus point – when listening to an advisor or television pundit talk about investing, certainty about future events is inversely related to the credibility of their advice.  In other words, the harder they pound the table, the more you should ignore them.

What should an investor do here?  They should very closely reexamine their risk/return profile with their financial advisor.  They should not ask, “is the market going to crash?” but rather “what will happen to my portfolio if the market crashes?”  If your financial goals are in jeopardy in that scenario, you should think about reducing your risk.  If you cannot get a straight answer on that question from your financial advisor, you should find another advisor.

The great investor David Swenson, Chief Investment Officer of the Yale Endowment, wrote in his seminal book “Pioneering Portfolio Management” – “Failure to achieve investment goals defines portfolio risk in the most fundamental way.”  Make sure that your goals are not at risk by looking at what can happen, not just what you think will happen.

Feel free to contact me if you have any questions.

 

Keith J. Akre, CFA, CFP®

Portfolio Manager – Midland States Bank

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Posted: 7.27.17

When Not to Save for Your Child's Education

child doing homework

 

One of the biggest challenges parents face is trying to afford the ever rising cost of their children’s college education.  Many planners will tell you that as soon as your child is born you should be putting money into a 529 plan to prepare for this expense.  While this is normally sound advice, there are a few exceptions.  So before you put money into any college savings plan, here are reasons you may want to wait.

If you have any credit card debt

Do not even think about putting money away for your children’s college education if you are running a balance on your credit card.  Get any expensive debt paid off first.  Credit cards can charge as much as 18% interest on balances.  Meanwhile, the return on your investments are uncertain, and have historically averaged in the 8-10% range. That means you could be paying 18% and only getting (possibly) 10% back, which is a losing proposition.  Put another way, by saving money for college while holding a credit card balance, you are actively losing money.  Pay off your credit cards and other high interest debt first.

You are behind on your retirement savings.

 If you are not currently maxing out on all of your available retirement vehicles, you should wait on contributing to your kids’ education.  This goes against many parents’ selfless instinct to provide for their kids at their own expense, however, it is necessary.  Think of it like the flight attendant’s speech on an airplane before take-off.  The instructions they give when the oxygen masks drop down is “Put the mask on yourself first before helping the person next to you.”  You should think of your money in the same way.

First of all, retirement assets will not count towards most financial aid calculations.  So the more money you put in the retirement bucket as opposed to a college savings plan, the more assistance your child may be able to receive in grants and loans.  Second, you can take money out of your IRA to pay for college without penalty so those funds can still be used as a funding source if necessary.

You have one child and intend to keep it that way

Let me be very clear: It is not that you should not save for an only child’s education.  It’s just that you should  consider all your available options.  One of the biggest advantages of the 529 plan is its portability.  Having an only child reduces that advantage.  What if you work very hard to fully fund a 529 plan and your child does not go to college?  Or what if they get college paid for with grants or scholarships?  Sure, you can pull that money back out, but it may face fees and penalties.

It may be beneficial to set up a Coverdell as opposed to a 529 plan because it has more flexibility in that it will pay for any qualified education expenses, even K-12.  For instance, by the time your child reaches high school you may have decided it would be in their best interest to go into private school.  The Coverdell can help cover the cost of those expenses right now.  Just remember that having an only child, along with many other special circumstances, requires a little more planning.  That’s why it is important to talk with a good financial advisor.

Conclusion

A college education is a requirement in most professions these days, and the cost of this education is continuing to rise.  It is a very important part of any financial plan to account for this large expense, but you have to remember to prioritize your savings dollars.

  1. Pay off expensive debt first
  2. Maximize retirement contributions to 401(k)s, 403(b)s, and traditional and Roth IRAs
  3. Remember that special circumstances (like having an only child) may alter your approach to saving.  Consult a financial advisor.

If you are getting close to college coming up and feel woefully short on your savings goal, just make sure you spend some time and effort with your child to research scholarships and grants; you may be surprised what you can find.  Attending a community college for two-years before university can also help make up a shortfall in savings. 

To teach our kids to be smart about money, we should again take the flight attendant’s advice and put that mask on ourselves first.

 

Keith J. Akre, CFA, CFP®

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