Ten Fundamentals of Financial Planning

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1 Ten Fundamentals of Financial Planning The stock and bond markets are always uncertain. Investors with sound financial planning take into account the unexpected as well as the expected, and they have peace of mind from doing so. Here is a checklist of ten financial planning fundamentals with comments about each. They are the essential components of a framework for the management of your investment portfolio. 1. Include All Assets & Income in Your Financial Plan Consider every asset and income source including any financial investments, real estate, owned businesses, earned income from employment, Social Security, pensions, options, trust income, annuities, life insurance, future inheritance, etc. These assets and incomes should be analyzed to determine their ability to provide you with the funds you and your loved ones need over your lifetimes. 2. Determine Investment Time Horizon and Asset Allocation The time horizon for choosing investments is critically important. Funds required for expenditure within one to three years should not be exposed to the stock market. It s too volatile, and the risk of having to sell investments at disadvantaged prices to meet short term needs for cash is too great. At the same time, funds required for long term needs such as retirement expenses and childrens education should be invested with a significant portion in equities. Stocks may fluctuate in price, but they provide the best

2 returns in the long run. The long term compounded annual return of the stock market has been about 10% compared to 6% for the bond market, and time horizon is critical for the determination of asset allocation between equity and income investments. Asset allocation is a dynamic process which changes with circumstances as people age and portfolios grow. A general rule of thumb for those at retirement age is an asset allocation of 60% in equities and 40% in income investments. Generally speaking, the older the investor the greater the amount to be invested in income securities. For those who are younger with longer investment horizons a higher percentage in equities is more appropriate. 3. Diversify Investments to Reduce Risk Investment portfolios should be well diversified to avoid the risk of too much invested in any single investment, no matter how good it may seem to be. Too many eggs in one basket is never a good idea. 4. Manage Investments to Maximize After-Tax Returns It s what s left over after taxes that counts. For clients who have both retirement accounts and taxable accounts, high yielding interest and dividend income investments should be located in retirement accounts where taxes are deferred. Low dividend yielding stocks held for appreciation should be located in taxable accounts for low current taxable income and for low long term capital gains taxes when they are sold. Tax loss harvesting in taxable accounts should be used to offset capital gain income. Large 2

3 charitable contributions should be made with highly appreciated stocks whose full market value can be used for tax deductions without having to realize capital gain taxes. And changes in tax law should be followed closely. For example, laws enabling tax advantaged charitable contributions from IRAs usually expire every year but are then reinstated months later. 5. Assume Returns of 7% - 8% & Limit Withdrawals to 4% - 5% Savings and investment goals should be realistically set to provide investment portfolios that meet lifetime financial needs, with average expected returns on investments not to exceed 7% to 8% per annum and annual withdrawals from portfolios not to exceed 4% to 5% per annum. This will allow investments and withdrawals thereon to increase with inflation over the long term. While there may be unusual exceptions to these guidelines depending upon circumstances, they are good standards for sustaining the lifetime purchasing power of both principal and income. 6. Do Not Panic & Sell Good Investments at Distressed Prices When an investment decreases in market value, it should be re-examined for its future prospects, but not necessarily sold. Judging when to buy and when to sell based on market sentiment is impossible, and the vagaries of market timing are unfathomable. Do not panic and sell good investments at distressed prices. Consider the remorse of those who sold their stock portfolios at year-end 2008 and missed the subsequent stock market recovery. Underlying investment value is more important than current price. 3

4 7. Cover Catastrophic Risk with Appropriate Insurance Catastrophic risks should be covered by appropriate insurance, particularly risk exposures to loss of earned income, medical expenses and negligence liability claims. Life insurance and disability insurance to cover loss of employment earnings, comprehensive health insurance to cover medical expenses for all family members and personal liability umbrella insurance to cover potential exposure to negligence lawsuits are all essential. Long term care insurance may also be advisable, depending on affordability, capacity to self insure, concern about the adequacy of Medicare and other factors. 8. Keep Debt Manageable at Low Interest Rates Borrowing must be manageable, avoiding excessive servicing requirements and high interest rates, especially interest which is not tax deductible. An affordable home mortgage loan with low tax-deductible interest for the period you intend to own your home is generally a good idea. Home mortgage loan rates are still relatively low, and if you have not considered refinancing your home mortgage loan at an available lower rate, you should explore doing so now before rates go up. Be sure to consider the cost of loan arrangement and closing fees if you do. 9. Carefully Prepare Life-End & Estate Documents Everyone should have carefully and professionally prepared life-end and estate planning documents including a current Will, Advanced Medical Directive and Durable Power of Attorney. Don t burden your loved ones with difficult estate distribution, life support and financial management decisions which you can arrange for in advance. 4

5 10. Provide a List of Essential Estate Contacts Heirs and important family members should be provided a list of important contact information for estates including the following: Estate Lawyer Estate Executor Investment Advisor Accountant Insurance Agent Banks (including Safety Deposit Box) It may also be appropriate, depending upon circumstances, for heirs and family members to be informed about your will and estate so they can prepare for future decisions and be effective and responsible in the management of their own ongoing financial plans. Sounds simple, doesn t it? Well it is not as simple as it sounds, and it is surprising how many investors do not follow these fundamentals of financial planning, many to their ultimate regret. Don t be one of them! Timothy C. Coughlin, CFP February 27, 2015 The information provided in this brochure should not be considered investment advice or a recommendation to buy or sell a particular security. The opinions expressed herein are those of Edgemoor Investment Advisors, Inc. (Edgemoor) and are subject to change without notice. Edgemoor Investment Advisors, Inc. is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Edgemoor including our investment strategies, fees and objectives can be found in our ADV Part 2 which is available upon request. 5