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Why Is Financial Advice Critical?

Frankly, financial advice is everywhere. It’s on television, the Internet, in hundreds of publications and newspapers, and just as far away as your Uncle Morty who’s always bragging about his stock picks. But what would happen if you had one person working for you who had access to all the information out there and edited out all the investment noise that doesn’t fit you? What would happen if you had someone who created a savings, debt management, and .investment plan that conformed to your financial circumstances, your risk tolerance, and your specific goals? It would probably make life a lot easier. That’s what a financial planner does. A financial planner doesn’t take control of your assets (unless you specify that role and they are specifically trained and licensed to take it on); they work with you over the course of a lifetime to review, set and execute goals for your money. They don’t set a plan and then. say, “Okay, you’re set for the next 25 years.” These are individuals who sit down with you, set a plan, and review that strategy on a regular basis, whether quarterly or every two to three years, but especially when a major life change occurs.

There are no official surveys or studies that say that working with a financial planner ensures a stronger financial future than not working with one. But as you read this book, it might make sense to consider one.

The most common financial mistakes made by those who fail to plan

Financial planning goes far beyond picking places to put your money. First, you have to understand your past behaviors and why they have to change. Failure to budget. Planning is all about realistic use of resources and making accommodations for the unexpected. Many people never think about classifying or ordering what they spend. financial planning is a process that forces individuals to really think about what they’re spending their money on and whether that expense is genuinely worthwhile. Losing control of debt. The ease of getting a credit card in this country has long been a fact, but the number of people who are borrowing against home equity is staggering.

According to the Federal Reserve, in early 2006, household debt climbed at twice the pace of household income from the beginning of 2000 through 2003, and because of low interest rates, Americans took on $2.3 trillion in new mortgage debt during that period-an increase of nearly 50 percent. Consumer credit, from zero-interest auto loans to the much more expensive debt on credit cards, climbed 33 percent, rising to $2 trillion in 2003 from $1.5 trillion in 2000. This rise in mortgage-related debt is frightening because if home owners can’t pay their debt, they risk losing their homes. Borrowing from retirement funds. Money in 40.l(k) and 403(b) accounts is tax-free until you withdraw it, and then it will have to be paid back, usually over a shorter period of time than a traditional mortgage. Even though some people use retirement funds to finance their first home purchase, it’s still a bad idea. Credit scores affect virtually everything we do in our financial life-they’re checked not only for approvals of home loans and other forms of credit, but for stuff you almost never hear about, like insurance premiums, unpaid parking tickets, and overdue library books. Make sure you’re whole and on time with all your bills.

Failure to Plan: A Case Study

The 2001 recession lasted only eight months, but it has had a lasting effect to the date of this book’s publication. One of the big reasons is how much was lost by investors who thought the sky was the limit right up until April 2000, when the NASDAQ would begin a decline which at its worst point would shave nearly 80 percent off its all-time high. While recessions have come and gone since the early 1980s, never in recent memory have so many individual investors suffered critical losses due to their own poor assumptions. Why? Since the early 1980s, Americans have been put in charge of money once managed by corporations and other employers. First there was the creation of the 401(k) retirement savings plan provision in 1978-which benefits adviser Ted Benna lifted out of the arcane language to create today’s widespread 40l(k) plan. And in the early 1980s, the Reagan administration’s bellwether step to popularize the individual retirement account (IRA) gave individual investors the idea that they would potentially see greater results once  they became responsible for investing their own retirement nest eggs. Figure 1.1 illustrates the dramatic shift in workers subject to defined contribution plans, like 401(k)s.

What happened? The post 9/11 economic shock and the 2000-2002 recession that followed proved that most investors weren’t ready to fly solo. The move over the last 25 years from defined benefit plans (traditional company-sponsored pension plans) to defined contribution plans ( 401(k) and 403(b) plans, primarily) has changed everything in the structure of how we save for retirement. A defined benefit plan provides employees with a guaranteed level of retirement income typically based on the employee’s years of service with vesting-or qualification for minimum benefits-at an assigned time in their seniority with the company. Defined contribution plans offer employees an opportunity to contribute a share of their income to an individual account. Employers generally contribute directly to such plans or match the contributions of employees with all investment choices left up to the employee.

The shift to defined contribution plans has been dramatic. According to the Federal Reserve, the share of households that had a defined contribution plan rose by 70 percent from 1979 to 1998, while the share of households covered by a traditional defined benefit plan declined simultaneously by 22 percent. In the early 1980s, it all sounded like a good idea. Companies could save money by offsetting the heavy costs for their traditional plans, and employees, empowered by the reality that they would determine their retirement future and tailor their plans to their specific risk tolerance, would be able to do a much better job than the boss.

Yet today, the retirement outlook for many is shockingly poor. In a 2005 MetLife study, 64 percent of full-time U.S. workers reported they were either behind in their retirement savings goals, or haven’t yet started saving. The financial services giant said women were particularly at risk. Twenty-three percent of women said they haven’t yet started to save for retirement (compared ‘With 15 percent of men). Among widows, 26 percent said they had no retirement savings goals-70 percent of them said they live paycheck to paycheck.

What Types of People Hire Professional Advice?

It’s a fact that people with more substantial assets tend to rely more on advisory services because they have more disposable income to pay for them. Yet those who have less are the ones who really need the help. ln a 2003 study, the Economic Policy Institute, a Washington, DC, economic think tank, pointed out how severely various constituencies need financial advice and assistance with their overall financial planning:

a. 1988 federal data showed that more than 19 percent of all near-retiree households (households in which the earner is between the ages of 47 and 64) could expect to retire in poverty. Only 57 percent of these older households can expect to replace half their income in retirement, down from 70 percent in 1989.
The late 1990s stock market did not raise all boats for workers in 401(k) plans. The boom primarily helped those with accumulated wealth of $1 million or more.
Women generally have less retirement security than men do. In 2000, 43.2 percent of men over 65 received annuity or pension income compared with 28.S percent of women. The mean annuity in 2000 was $14,232 for men, and $8,734 for women. (See Figure 1.2.) Fron11976 to 1996, pension income levels for women remained stagnant, while men experienced a 13 percent increase.
African American and Hispanic workers have significantly less retirement security than their white counterparts. The percentage of workers aged 47-64 with expected retirement income below the poverty line-based on 1998 retirement wealth-was 43.1 percent for African American.

Keeping Emotion Out of Your Decisions  

Do-it-yourself financial planning has worked for people with ‘the right temperament, ability to learn, and time to focus on their financial life. Timing’s also a big factor. It’s not for everyone, though, as the American Association for Individual Investors points out in an educational piece entitled, “The Psychology Behind Common Investor Mistakes.” It’s an interesting view of how the human mind works in decision-making. Most of us can’t separate our emotions from our decision-making.

There are six key mistakes the AAII points to in the go-it-alone approach:

Overconfidence: Overconfidence in our own abilities can lower returns. The article points out that in a study of trading at a national discount brokerage, returns averaged 16.4 percent over the period of study, though those accounts that traded the most averaged 11.4 percent in annual returns, significantly less than for an account with average turnover. Over the same period, the S&P 500 returned 17.9 percent on average. H also points out that men tend to trade more aggressive­ly than women do when left to their own devices.
Fear of regret: When it comes to money, humans ten~ to obsess about whether they’ve made the right decision. In stock transactions, as the article points out, individuals who want to avoid the pain of regret often hold losing stocks too long and sell winners too soon.
Cognitive dissonance: We like to believe fully in our decisions, even to the point of shutting out good information from other sources. Call it “investment noise,” if you want. The idea is that, at a certain point, an individual with certain preparation or skills will make a decision and then act to screen out all the new or conflicting information. It’s why people dump stocks when they hear a frightening news report or hang on to them after a significant run-up, even when the news has started to turn bad.
Anchoring: According to the piece, “The brain uses mental shortcuts to simplify the very complex tasks of information processing and decision-making. Anchoring is the psychologists’ term for one shortcut the brain uses:’ Yet, when you’re working full-time, watching the kids, trying to relax, etc., such shortcuts mean you’re not developing new ways to think about important things like your investments. This is why it’s particularly important to get a second set of eyes on the investment strategy you’ve chosen.
5· Representativeness: This is a psychological term that reflects another key danger to our financial life-we assume things with the same qualities are quite alike. “If poor earnings and share price performance has a stock branded as ‘bad,’ representativeness will tend to delay the reclassification of the stock as ones investors would like to own. On the other hand, ‘good’ stocks may continue to be classified as such by investors well after the firm’s prospects for either earnings or price appreciation have diminished significantly:’
6· Myopic risk aversion: If you were to judge an investment in the stock based on its performance between 2000-2002, you’d never want to buy a single share. This characteristic refers to a human tendency to fixate on a single “good” quality or “bad” quality of an investment. It’s shortsightedness, pure and simple.

What’s the point of all this? That it’s virtually impossible, given the way most of us have to get through the day, for us to do the best job of research, study, and decision-making in our financial planning. Most of us need an expert second opinion to overcome our own biases and timing issues.
The next chapter will focus on what financial planning is and what financial planners do.

Why Is Financial Advice Critical? by