Financial Confidence through Personal Attention
April 2013
In This Issue
First Quarter 2013 Market Recap
The pursuit of records by the S&P 500 and Dow Jones Industrials was not mirrored at the United States' global trading and investment partners.
Bond Market Outlook: Points to Ponder
During the past decade, the returns of investment-grade bonds sometimes exceeded those of stocks.
Incentive Trusts: Setting Guidelines for Your Heirs
Incentive trusts can be an effective mechanism for influencing the future choices of your heirs.
Capitalization Strategy
Many experts recommend planning for worst-case, realistic, and best-case scenarios.
Strategies for Managing Volatility
Asset allocation, diversification, and the use of dividend-paying stocks are potential strategies for reducing volatility.
The pursuit of records by the S&P 500 and Dow Jones Industrials was not mirrored at the United States' global trading and
investment partners.
First Quarter 2013 Market Recap
(For the quarter ended March 31, 2013.)
2013's first quarter started with a relief rally and finished with major benchmarks pushing into record territory. In between, there were high points supported by good economic news. But there were also darker moments in the shadows of Europe's fiscal struggles, domestic political uncertainty, and individual company business struggles. What is more, the pursuit of records by the S&P 500 and Dow Jones Industrials was not mirrored at the United States' global trading and investment partners. Major global stock benchmarks show downward trends in Europe and Asia for the past two years, even as the U.S. unemployment rate edged lower and domestic inflation remained insignificant.
Through 3/31/13*
Quarter 1-Year 3-Year 5-Year Closing Value S&P 500 10.03% 11.4% 10.3% 3.5% 1,569.19 Dow Jones Industrials 11.25% 10.3% 10.3% 3.5% 14,578.54 NASDAQ Composite 8.21% 5.7% 10.9% 7.5% 3,267.52
Source: Standard & Poor's. The S&P 500, Dow Jones Industrials, and NASDAQ Composite are unmanaged indexes. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
*Price only. Does not include dividends.
Politics and Wall Street The federal budget compromise that ushered in the new year sparked a surge in stock trading that had not abated by quarter's end, even after it passed over the rough spots caused by the budget sequestration battle. The Federal Reserve continued its bond market interventions, policies which were still keeping interest rates at historic lows as the quarter closed.
Bond Market Update There was no net change in Treasury bond returns from the beginning of the quarter to the end. The benchmark 10-year bond yield started at 1.86% and finished at 1.87%, suggesting no meaningful change in the bond's value occurred during the period. A small increase in long-term corporate bond yields (an average of about one-fourth of a percentage point) suggested a small but meaningful decline in typical
corporate bond values.
It is helpful to weigh both the benefits and risks associated with bonds and other investments.
Bond Market Outlook: Points to Ponder
During the past decade, many long-term fundamentals of investing have been turned upside down, and one example is the performance of U.S. stocks compared with bonds. Over longer time periods, such as 20 or 30 years, stocks exhibited higher average annual returns along with greater volatility. Bonds, in contrast,1 presented lower long-term returns along with fewer ups and downs.
During the 10-year period ending December 31, 2012, the average annual return of stocks was 7.10%. For investment-grade bonds, it was 5.19% . But shifting the interval can alter the pattern. For example, the 10-year1 period ended December 31, 2011, showed the opposite, with the average annual return of investment-grade bonds exceeding stocks, earning 5.8%, compared with 2.9% for stocks. That particular period may have been a1 departure from the norm, but events currently present in the U.S. economy are causing observers to question the outlook in the years ahead.
Interest Rates The Federal Reserve has maintained the federal funds rate between 0.0% and 0.25% with the goal of stimulating the economy. Given how low short-term interest rates are, it is likely that they will turn upward at some point, which would present challenges for bondholders. Historically, higher interest rates have caused the prices of existing bonds to fall as investors have pursued newly issued bonds paying higher rates. This scenario presents the potential for losses for existing bondholders.
Inflation During 2012, inflation averaged 1.7%, well below the historical average of 3.0%. But if inflation2 were to increase even higher, an investor would lose money on a bond with a yield lower than the rate of inflation. Some observers believe that if the U.S. economy begins generating stronger growth, inflation could once again spike upward.
Federal Spending Sizeable federal deficits are almost old news as the government looks for ways to stimulate the country's economic engines. While economic growth is a laudable objective, outsized federal spending may impact the financial markets. If the federal government is forced to pay higher interest rates to entice investors to fund the debt, this action could lead to higher interest rates on other types of bonds as well in response to investor demand.
Bonds can help investors balance a portfolio weighted to stock funds or other assets. When making decisions about investments, it is important to weigh both the benefits and the risks associated with bonds and any other assets that you own.
Sources: Standard & Poor's; Barclays Capital. Stocks are represented by the Standard & Poor's 500 index, 1
bonds by the Barclays U.S. Aggregate Bond Index, volatility by standard deviation. You cannot invest directly in an index. Past performance does not guarantee future results. Investing in stocks involves risks, including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
Source: U.S. Bureau of Labor Statistics. Inflation is represented by the Consumer Price Index. Historical 2
Entrepreneurs can use trusts to provide incentives to those heirs who commit to helping carry on a family business.
Incentive Trusts: Setting Guidelines for Your Heirs
An incentive trust is an estate planning tool that allows the trust grantor to reward heirs for desired behavior. It also allows the grantor to impose appropriate penalties for undesirable activities.
Some common themes contained in incentive trusts:
Education: Incentive trusts have been used to provide extra support to those heirs who pursue advanced degrees, focus on designated fields of study, or attend specified institutions. Some trusts are designed to reward instances of outstanding scholarship and academic achievement. Some permit withholding support from those who fail to meet minimum levels of accomplishment.
Moral and family values: Some trusts are intended to promote family life by providing income support payments to heirs who choose to stay at home with children. Some trusts offer beneficiaries bonuses for childbearing, foster care, or adoption. Some withhold benefits from those heirs who might be convicted of a crime or fail a prescribed drug or alcohol screening test.
Business and vocational choices: Entrepreneurs can use trusts to provide incentives to those heirs who commit to helping carry on a family business. Trusts can be designed to encourage or discourage career choices specified by the trust creator. Trusts can also be used to offer focused financial support to those beneficiaries who opt to follow paths that are personally and socially rewarding yet generally less lucrative.
Charitable and religious opportunities: Some trusts are designed to encourage religious behavior by requiring specific observances. Some trusts provide funds for dues or other costs associated with religious participation. Some subsidize those heirs who choose missionary work or other religious vocations. Some provide matching funds for heirs' contributions to favored organizations.
Incentive trusts can provide many of the same benefits as other trust structures. For example, by placing assets in a properly designed trust, you can move them out of your estate in order to manage tax liabilities more efficiently. You can also ensure that assets will be managed professionally and held in safe custody through a stable financial institution.
Key Limitations
Just as you have broad discretion as a parent or guardian, you have great latitude when you create an incentive trust. But there are limits. The trust cannot, of course, require blatantly illegal activity; neither can it provide incentives for actions that might be deemed contrary to public policy -- violating the unwritten laws of the community. For example, a trust generally cannot provide incentives for a beneficiary to divorce an unpopular mate, nor can it be used to undercut existing voluntary separation, child support, or other domestic
arrangements generally permitted by law in your state.
Incentive trusts may be subject to what is called the rule of perpetuities, a legal concept that says trusts must be liquidated at some definite interval after their creation. This rule is enforced in many, but not all, states. It applies to trusts that are created in the state where the rule is enforced (you may generally create a trust in any state, not just the state in which you reside). As a consequence, you'll want to be sure that any trust you do create can last for as long as needed to achieve your goals.
Certain types of incentive trusts may also be subject to the generation skipping transfer (GST) tax. Where an incentive trust fits the complex definition of a GST, the rules limit the aggregate amounts that can be placed in the trust without incurring a tax of about half of the value in the trust. In some trust scenarios, life insurance can augment the amounts permitted under GST rules.
Creating an effective incentive trust involves complex legal, tax, and investment management choices. This article offers only an outline; it is not a definitive guide to all possible consequences and implications of any specific trust option. For this reason, be sure to seek advice from knowledgeable legal and financial
Many experts recommend planning for worst-case, realistic, and best-case scenarios.
Capitalization Strategy
Creating a capitalization strategy requires an understanding of many things, including the business activities your company plans to finance, estimates of how much these activities will cost, and knowledge of appropriate sources of financing. The state of the economy and your management skills also influence your company's need for capital. The prolonged economic downturn has reduced sales and profits for many entrepreneurs, often requiring business owners to scale back operations, cut their own salaries and extend payment cycles for customers who also are feeling the pinch.
Running the Numbers
Once you understand the business activity you need to finance, you can develop an annual budget and estimate your capital requirements one and two years hence. Your accountant can help with this exercise. Many experts recommend planning for worst-case, realistic, and best-case scenarios. This approach may decrease your likelihood of underestimating your capital requirements, running out of money, or passing up potential opportunities. After researching your capital needs, you are ready to consider potential sources of funding. The table below explains sources that entrepreneurs frequently use and the characteristics associated with each.
Source of Capital Advantages Disadvantages
Company profits Allows owner maximum control of business.
May be unpredictable for early-stage company. May be inadequate to finance long-term expansion.
Personal assets Owner maintains control. May require an increase in personal debt or jeopardize long-term goals such as a secure retirement.
Family and friends May provide flexible terms. May lack business expertise or be inadequate for long-term needs.
Loan from bank or commercial finance company
Frequent source of short-term financing. Loan officers may have business experience and provide assistance with financial issues.
May be reluctant to provide long-term loan or to finance a start-up company. Requires collateral to secure loan agreement.
Loan guaranteed by the U.S. Small Business Administration or a business development program sponsored by state government
May provide capital for businesses that would not qualify for loans through other economic channels.
Guaranty requirements may change in response to federal fiscal policy and current conditions.
If you are estimating capital needs for a start-up business, plan on maintaining sufficient funding to cover anticipated expenses for at least six months. Most start-up businesses are not profitable and typically operate six months or longer before generating capital internally. Also, the type of business you manage will influence your capital requirements. For example, a retail business requires inventory that must be financed before taking delivery. Many service businesses typically wait between 30 and 90 days before receiving payment from customers, which may require an infusion of capital to pay interim expenses.
A comprehensive financing strategy, including estimates of the capital required for short- and long-term needs, is a key element in growing your business. A long-term plan reinforces short-term spending discipline and reduces the likelihood your business will burn through capital too quickly. The time to create a capitalization strategy is before your business reaches a financing benchmark. You are more likely to impress potential lenders or investors if your financial affairs are in order and you have a firm grasp of your company's long-term needs.
When using
individual securities, 50 may be needed to diversify an equity portfolio.
Strategies for Managing Volatility
Investors are exposed to financial risk in two ways: company-specific risk or market risk. Long-term investors can reduce exposure to company-specific risk by diversifying among many different securities within the same asset class. Market risk is managed, but not eliminated, by holding investments in several different asset1 classes.
Low Correlation: The Key to Effective Asset Allocation
Longer term, the market risk associated with an individual asset class, such as stocks, may be reduced by allocating a portion of a portfolio's assets to other types of investments that historically have reacted differently to market and economic events. A statistic known as correlation measures the tendency of two investments to2 move together. A correlation close to zero indicates that two investments are largely independent of each other. The closer a correlation is to 1.00, the greater the tendency two investments have had to move in tandem. The table below lists four assets that have had relatively low correlations with U.S. stocks during the past decade. Past performance does not guarantee future results.
A Look at Correlation
Commodities Cash Investment-Grade
Bonds
Home Prices
Large-Cap Stocks
0.42 -0.09 0.04 0.17
Sources: S&P Capital IQ Financial Communications; Barclays Capital. Large-cap stocks are represented by the S&P 500 index, commodities by the Standard & Poor's GSCI , cash by the Barclays 3-Month Treasury Bill® Index, investment-grade bonds by the Barclays Aggregate Bond Index, home prices by the S&P/Case-Shiller 20-City Composite Home Price Index. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value. Exposure to the commodities markets may subject investors to greater volatility as commodity-linked investments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity. You cannot invest directly in an index. Past performance is not a guarantee of future results. Data is based on the 10-year period ending December 31, 2012.
Managing Single-Security Risk
Modern portfolio theory is founded on the assumption that investment markets do not reward investors for taking on risks that could be eliminated though diversification. A 2003 study found that at least 50 stocks may be required to provide adequate diversification for an equity portfolio.3
Fortunately, there are many strategies available for diversifying a stock portfolio. Investors can allocate portions of a portfolio to domestic and international stocks, which may take turns outperforming depending on circumstances in various global economies. An allocation to small-cap, midcap, and large-cap stocks also4 provides exposure to companies of various sizes. Although there are no guarantees, smaller companies may be nimble enough to exploit untapped market niches and capitalize on growth potential.5
Dividend Strategies
In addition, equity investors looking to limit volatility may want to consider dividend-paying stocks. Although a company can potentially eliminate or reduce dividends at any time, a dividend may provide something in the way of a return even when stock prices are volatile. When evaluating dividend-paying stocks, it may be worthwhile to review how long a company has paid a dividend and whether the dividend has increased over time. According to a study by Standard & Poor's, firms that had increased their dividends for the past 25 years outperformed the S&P 500 and also were less volatile during the 5-year, 10-year, and 15-year periods ending December 31, 2012. Past performance does not guarantee future results. While the top tax rate on qualified6 dividends increased in 2013, it is still much lower than the top rates on ordinary income for most taxpayers. For investors interested in managing volatility, asset allocation with low-correlation investments,
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a 1
nondiversified portfolio. Diversification does not ensure against market risk. Asset allocation does not assure a profit or protect against loss.
2
Source: H. Christine Hsu and H. Jeffrey Wei, "Stock Diversification in the U.S. Equity Market," 2003. 3
Foreign stocks involve greater risks than U.S. investments, including political and economic risks and the 4
risk of currency fluctuations, and may not be suitable for all investors.
Securities of smaller companies may be more volatile than those of larger companies. The illiquidity of the 5
small-cap market may adversely affect the value of these investments.
Source: Standard & Poor's. Returns are based on the Standard & Poor's Dividends Aristocrats portfolio. 6
Volatility is measured by a statistic known as standard deviation. Past performance does not guarantee future results.
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