The enactment of the new health-care reform legislation contains some provisions that directly affect our nation's older population. If you're a senior, you may be concerned about how these reforms may affect your access to health care and the benefits you are currently receiving.
Medicare spending cuts
Not surprisingly, the concerns of retirees and seniors generally center on potential cuts in Medicare benefits. At the outset, the new legislation does not affect Medicare's guaranteed benefits. However, a goal of the new health-care legislation is to slow the increasing cost of Medicare premiums paid by beneficiaries, and to ensure that Medicare will not run out of funds. To help achieve these goals, cuts in Medicare spending will occur over a ten-year period, beginning in 2011, particularly targeting Medicare Advantage programs––Medicare programs provided through private insurers but subsidized by the federal government. These cuts could reduce or eliminate some of the extra benefits Medicare Advantage plans may offer, such as dental or vision care, and some insurers may choose to increase premiums. But Medicare Advantage plans cannot reduce primary Medicare benefits, nor can they impose deductibles and co-payments that are greater than what is allowed under the traditional Medicare program for comparable benefits. And, some of the federal funds previously earmarked for Medicare will be reallocated to doctors and surgeons as an incentive to treat Medicare patients.
Medicare Part D drug program changes
Some Medicare Part D beneficiaries are surprised to find that they have to pay for the entire cost of prescription drugs out-of-pocket after reaching a gap in their annual coverage, referred to as the "donut hole." Currently, if you're a Medicare Part D beneficiary, you may pay up to an additional $3,610, out-of-pocket, for medicines after reaching an initial threshold of $2,830 in total prescription drug costs (including Part D payments, beneficiary co-pays, and deductibles). But, beginning in 2010, beneficiaries who fall in the donut hole will receive a $250 rebate, and, in 2011, they will receive a 50% discount on brand-name drugs. By 2020, a combination of federal subsidies and a reduction in co-payments will completely eliminate the donut hole. However, individuals with annual incomes greater than $85,000, and couples with incomes exceeding $170,000, will see their Part D premiums increase as the federal subsidy offsetting some of the cost of Medicare Part D premiums is reduced.
Benefits added to Medicare
The leglislation also improves some traditional Medicare benefits. For example, Medicare beneficiaries will receive free wellness and preventive care beginning in 2011.
Increased access to home-based care
Often, people with disabilities or illnesses would rather receive care at home instead of at a hospital or nursing home. The new health-care reform law provides for programs and incentives for greater access to in-home care. The Community Living Assistance Services and Support program (CLASS) will be established sometime after 2011 (depending on when final regulations are published) as a voluntary insurance program, financed through payroll deductions and available to all working adults who choose to participate. This national program allows participants with functional limitations to maintain their personal and financial independence and live in the community by providing a cash benefit of at least $50 per day (after a five-year vesting period) for nonmedical services, such as home-care services, family caregiver support, and adult day-care or residential-care services. In order to qualify, a participant must need help with at least two activities of daily living, such as eating, toileting, transferring, bathing, dressing, or continence.
Also in 2011, the Community First Choice Option will be available to states to add to their Medicaid programs. This option will provide benefits to Medicaid-eligible individuals for community-based care instead of placement in a nursing home. In addition, the State Balancing Incentive Program, to be established in 2011, will provide increased federal funds to qualifying states that offer Medicaid benefits to disabled individuals seeking long-term care services at home, or in the community, instead of in a nursing home. The Independence at Home demonstration program, available in 2012, will be a test program that provides Medicare beneficiaries with chronic conditions the opportunity to receive primary care services at home. That is intended to reduce costs associated with emergency room visits and hospital readmissions, and generally improve the efficiency of care.
Thursday, April 22, 2010
Wednesday, April 7, 2010
Rebalancing Act
Global diversification gives investors a valuable tool for managing risk and volatility in a portfolio. But smart diversification has an important side effect. It requires maintenance.
In a given period, asset classes experience divergent performance. This is inevitable and, in fact, desirable. A portfolio that holds assets that do not perform similarly (i.e., with low return correlation) will experience less overall volatility. That results in a smoother ride over time. However, dissimilar performance also changes the integrity of your asset mix, or allocation—a condition known as “asset drift.” As some assets appreciate in value and others lose value, your portfolio’s allocation changes, which affects its risk and return qualities. If you let the allocation drift far enough away from your original target, you end up with a different portfolio.
Once you form a portfolio to match your current investment goals and risk tolerance, you should preserve its structural integrity since asset allocation accounts for most of a portfolio’s return.1 This is a strategic priority, like portfolio design or investment manager selection. To efficiently pursue investment goals, you must manage asset drift.
Rebalancing is the remedy. To rebalance, you sell assets that have risen in value and buy more assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.
Why rebalance?
At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future—and there’s no reliable way to predict future returns.
Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making—an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.
Challenges and decision factors
In the real world, portfolio allocations are usually complex, incorporating not only fixed income and equity, but also the multiple asset groups within equity investing. The more complex a portfolio’s allocation, the greater is the need for maintenance.
Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance. Rebalancing also incurs transaction fees and potential capital gains in taxable accounts. Thus, while there are good reasons to rebalance, the benefits must outweigh the costs.
Given these challenges, a practical rebalancing approach will establish asset drift triggering points while leaving enough flexibility to manage costs effectively.
Defining triggering points helps investors decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations. This may be widely defined according to stock-bond mix, or more appropriately, according to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.
While rebalancing costs are unavoidable, several strategies can help minimize the impact:
• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.
• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
• Incorporate tax management within taxable accounts, such as cost basis management, strategic loss harvesting, dividend management, gain/loss matching, and similar considerations.
• Implement an integrated portfolio strategy. Rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.
Rebalancing incurs real costs that can detract from returns. We can help investors define ranges within which investment components can acceptably drift, and adopt cost-saving strategies during rebalancing, paying particular attention to tax-sensitive transactions. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.
No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.
Endnotes
1 Gilbert L. Beebower , Gary P. Brinson, and L. Randolph Hood, “Determinants of Portfolio Performance ,” Financial Analysts Journal 42, no. 4 (July/August 1986): 15-29. Gilbert L. Beebower, Gary P. Brinson, and Brian D. Singer, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47, no. 3 (May/June 1991): 40.
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.
Disclosures
Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.
Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty, and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.
Diversification neither assures a profit nor guarantees against loss in a declining market.
A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.
In a given period, asset classes experience divergent performance. This is inevitable and, in fact, desirable. A portfolio that holds assets that do not perform similarly (i.e., with low return correlation) will experience less overall volatility. That results in a smoother ride over time. However, dissimilar performance also changes the integrity of your asset mix, or allocation—a condition known as “asset drift.” As some assets appreciate in value and others lose value, your portfolio’s allocation changes, which affects its risk and return qualities. If you let the allocation drift far enough away from your original target, you end up with a different portfolio.
Once you form a portfolio to match your current investment goals and risk tolerance, you should preserve its structural integrity since asset allocation accounts for most of a portfolio’s return.1 This is a strategic priority, like portfolio design or investment manager selection. To efficiently pursue investment goals, you must manage asset drift.
Rebalancing is the remedy. To rebalance, you sell assets that have risen in value and buy more assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.
Why rebalance?
At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future—and there’s no reliable way to predict future returns.
Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making—an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.
Challenges and decision factors
In the real world, portfolio allocations are usually complex, incorporating not only fixed income and equity, but also the multiple asset groups within equity investing. The more complex a portfolio’s allocation, the greater is the need for maintenance.
Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance. Rebalancing also incurs transaction fees and potential capital gains in taxable accounts. Thus, while there are good reasons to rebalance, the benefits must outweigh the costs.
Given these challenges, a practical rebalancing approach will establish asset drift triggering points while leaving enough flexibility to manage costs effectively.
Defining triggering points helps investors decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations. This may be widely defined according to stock-bond mix, or more appropriately, according to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.
While rebalancing costs are unavoidable, several strategies can help minimize the impact:
• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.
• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
• Incorporate tax management within taxable accounts, such as cost basis management, strategic loss harvesting, dividend management, gain/loss matching, and similar considerations.
• Implement an integrated portfolio strategy. Rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.
Rebalancing incurs real costs that can detract from returns. We can help investors define ranges within which investment components can acceptably drift, and adopt cost-saving strategies during rebalancing, paying particular attention to tax-sensitive transactions. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.
No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.
Endnotes
1 Gilbert L. Beebower , Gary P. Brinson, and L. Randolph Hood, “Determinants of Portfolio Performance ,” Financial Analysts Journal 42, no. 4 (July/August 1986): 15-29. Gilbert L. Beebower, Gary P. Brinson, and Brian D. Singer, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47, no. 3 (May/June 1991): 40.
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.
Disclosures
Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.
Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty, and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.
Diversification neither assures a profit nor guarantees against loss in a declining market.
A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.
Tuesday, February 23, 2010
Worth Noting
Special rules apply to charitable donations for Haiti relief efforts
If you make a qualified charitable contribution after January 11, 2010, and before March 1, 2010, for relief efforts associated with the January 12, 2010, earthquake in Haiti, you can treat the contribution as if it were made on December 31, 2009. As a result, if you itemize deductions on Form 1040, Schedule A, you can elect to claim the deduction for the Haitian relief contribution on your 2009 federal income tax return. To qualify, the contribution must be made in cash. To facilitate charitable donations made via text messages, a telephone bill showing the name of the organization, and the date and amount of the contribution, will satisfy charitable deduction recordkeeping requirements.
Time running out for first-time homebuyer's tax credit
If you're in the market for a new home and hope to take advantage of the first-time homebuyer tax credit, you'll need to purchase a principal residence before May 1, 2010 (or before July 1, 2010 if you enter into a written binding contract prior to May 1, 2010). If you--and your spouse, if you're married--did not own any other principal residence during the three-year period ending on the date of purchase, the credit is worth up to $8,000 ($4,000 if you're married and file separate returns). If you--and your spouse, if you're married--have maintained the same principal residence for at least five consecutive years in the eight-year period ending at the time you purchase a new principal residence, the credit is worth up to $6,500 ($3,250 if you're married and file separate returns).
The credit is reduced if your modified adjusted gross income (MAGI) exceeds $125,000 ($225,000 if married filing a joint return) and is completely eliminated if your MAGI reaches $145,000 ($245,000 if married filing a joint return). You can't claim the first-time homebuyer tax credit if the purchase price of your principal residence exceeds $800,000. Other limitations and provisions also apply.
President's proposed 2011 budget offers Congress multiple initiatives
The proposed 2011 budget submitted by President Obama offers multiple new initiatives, including several small business tax incentives, provisions intended to promote college affordability, and tax benefits targeting the middle class. The budget that ultimately emerges from Congress will likely differ significantly from that proposed by the President, but the proposed budget is valuable in that it provides a framework for discussion over the next few months. The proposed budget includes:
For businesses-- A new tax credit of $5,000 for each new hire made by an employer, a one-year extension of 2009 bonus depreciation and Section 179 expensing limits, and requirements for employers who do not offer retirement plans to implement automatic IRAs for employees
For students-- Expanded Pell Grant limits, a permanent American Opportunity tax credit, and a proposal to strengthen income-based repayment plans for student loans (overburdened borrowers would pay only 10% of discretionary income in loan payments and remaining debt would be forgiven after 20 years)
For individual taxpayers-- A return of the top two marginal tax rates to 39.6% and 36% in 2011, and an expanded 28% tax bracket; a permanent extension of the current 0% and 15% rates on long-term capital gain, with a new 20% rate for higher-income individuals; permanent extension of the federal estate tax and the alternative minimum tax (AMT) rules and exemption amounts, at 2009 levels
New credit card provisions effective this week
The Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 included several provisions that became effective on February 22, 2010. Some of these changes could affect you:
Credit card companies are prohibited from increasing annual percentage rates (APRs) that apply to existing balances unless (1) the index on which the rate is based changes, (2) the APR was a promotional rate that has expired, (3) you failed to comply with a hardship workout plan, or (4) you're more than 60 days past due on the account; if an increase in APR is the result of you falling 60 days past due on the account, the rate will be restored to what it was before the increase if you make timely minimum payments for six months
If different APRs apply to separate portions of an outstanding balance, the amount of any payment beyond the minimum payment due must be applied to the portion of the balance with the highest APR
If you're under age 21, you won't be able to get credit unless you have a cosigner over age 21 or can demonstrate an ability to repay the debt
You can't be charged an over-the-limit fee unless you authorize the credit card company to complete the transaction that causes the balance to exceed your credit limit
If you make a qualified charitable contribution after January 11, 2010, and before March 1, 2010, for relief efforts associated with the January 12, 2010, earthquake in Haiti, you can treat the contribution as if it were made on December 31, 2009. As a result, if you itemize deductions on Form 1040, Schedule A, you can elect to claim the deduction for the Haitian relief contribution on your 2009 federal income tax return. To qualify, the contribution must be made in cash. To facilitate charitable donations made via text messages, a telephone bill showing the name of the organization, and the date and amount of the contribution, will satisfy charitable deduction recordkeeping requirements.
Time running out for first-time homebuyer's tax credit
If you're in the market for a new home and hope to take advantage of the first-time homebuyer tax credit, you'll need to purchase a principal residence before May 1, 2010 (or before July 1, 2010 if you enter into a written binding contract prior to May 1, 2010). If you--and your spouse, if you're married--did not own any other principal residence during the three-year period ending on the date of purchase, the credit is worth up to $8,000 ($4,000 if you're married and file separate returns). If you--and your spouse, if you're married--have maintained the same principal residence for at least five consecutive years in the eight-year period ending at the time you purchase a new principal residence, the credit is worth up to $6,500 ($3,250 if you're married and file separate returns).
The credit is reduced if your modified adjusted gross income (MAGI) exceeds $125,000 ($225,000 if married filing a joint return) and is completely eliminated if your MAGI reaches $145,000 ($245,000 if married filing a joint return). You can't claim the first-time homebuyer tax credit if the purchase price of your principal residence exceeds $800,000. Other limitations and provisions also apply.
President's proposed 2011 budget offers Congress multiple initiatives
The proposed 2011 budget submitted by President Obama offers multiple new initiatives, including several small business tax incentives, provisions intended to promote college affordability, and tax benefits targeting the middle class. The budget that ultimately emerges from Congress will likely differ significantly from that proposed by the President, but the proposed budget is valuable in that it provides a framework for discussion over the next few months. The proposed budget includes:
For businesses-- A new tax credit of $5,000 for each new hire made by an employer, a one-year extension of 2009 bonus depreciation and Section 179 expensing limits, and requirements for employers who do not offer retirement plans to implement automatic IRAs for employees
For students-- Expanded Pell Grant limits, a permanent American Opportunity tax credit, and a proposal to strengthen income-based repayment plans for student loans (overburdened borrowers would pay only 10% of discretionary income in loan payments and remaining debt would be forgiven after 20 years)
For individual taxpayers-- A return of the top two marginal tax rates to 39.6% and 36% in 2011, and an expanded 28% tax bracket; a permanent extension of the current 0% and 15% rates on long-term capital gain, with a new 20% rate for higher-income individuals; permanent extension of the federal estate tax and the alternative minimum tax (AMT) rules and exemption amounts, at 2009 levels
New credit card provisions effective this week
The Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 included several provisions that became effective on February 22, 2010. Some of these changes could affect you:
Credit card companies are prohibited from increasing annual percentage rates (APRs) that apply to existing balances unless (1) the index on which the rate is based changes, (2) the APR was a promotional rate that has expired, (3) you failed to comply with a hardship workout plan, or (4) you're more than 60 days past due on the account; if an increase in APR is the result of you falling 60 days past due on the account, the rate will be restored to what it was before the increase if you make timely minimum payments for six months
If different APRs apply to separate portions of an outstanding balance, the amount of any payment beyond the minimum payment due must be applied to the portion of the balance with the highest APR
If you're under age 21, you won't be able to get credit unless you have a cosigner over age 21 or can demonstrate an ability to repay the debt
You can't be charged an over-the-limit fee unless you authorize the credit card company to complete the transaction that causes the balance to exceed your credit limit
Friday, January 15, 2010
Managing Inflation Risk
As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This article explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful.
As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.
Hedging vs. Total Return Strategies
Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return that outpaces inflation over time.
Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)
Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.
In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.
To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these:
Stocks
Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.1 To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.
Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.
Fixed Income (Bonds)
Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.
Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.
Treasury Inflation-Protected Securities (TIPS)
Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.
TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.
However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.
Commodities
Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.
Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.
Summary
While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.
As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:
• Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.
• Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.
• Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.
Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.
Endnotes
1 Real return calculation: (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.
Disclosures
Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.
Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.
CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.
The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.
Diversification neither assures a profit nor guarantees against loss in a declining market.
As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.
Hedging vs. Total Return Strategies
Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return that outpaces inflation over time.
Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)
Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.
In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.
To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these:
Stocks
Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.1 To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.
Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.
Fixed Income (Bonds)
Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.
Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.
Treasury Inflation-Protected Securities (TIPS)
Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.
TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.
However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.
Commodities
Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.
Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.
Summary
While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.
As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:
• Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.
• Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.
• Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.
Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.
Endnotes
1 Real return calculation: (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.
Disclosures
Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.
Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.
CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.
The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.
Diversification neither assures a profit nor guarantees against loss in a declining market.
Friday, January 8, 2010
Federal Estate Tax and Generation Skipping Transfer Tax Expires for 2010
The estate tax is dead--at least for now. There are some who are certain that Congress will act quickly to reinstate the tax, but others aren't so sure. And, there's a question regarding the constitutionality of making any reinstated tax retroactive to January 1. This uncertainty presents a challenge. Stay Tuned!!!
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