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Why the Dow Jones Reaching 20,000 Is Not As Important As You May Think

The big headline the other day was news of the Dow Jones Industrial Average (DJIA) reaching 20,000 for the first time. It’s gathered headlines all over the world. I counted 13 articles in The Wall Street Journal about the Dow 20,000. Most of the mainstream media has been quick to jump on what this means for investors, the market, and the future. And some of that thinking is flawed. This post will focus on putting this milestone in perspective for you and, more importantly, what it means for your investments.

The Dow Jones Industrial Average is probably the most iconic index. When someone says the market is up 150 points, they are referring to the DJIA. It has a long track record – about 130 years! So on the surface this milestone is impressive. It took the Dow over 100 years to reach 10,000. It took 18 years for it to reach 20,000. But it took only 42 days to go from 19,000 to 20,000. That’s the second fastest thousand point gain in history. So what does that mean for you? To answer that, we need to pull pack the curtain to understand what is the Dow Jones Industrial Average:

  • It is an index consisting of 30 companies. That’s a very small representation of the overall market and can completely misrepresent how the whole market is doing in reality.
  • The Dow Jones is 100% US stocks which represent a single asset class. On top of that, it skews heavily toward large-cap industrial companies. This may have been valuable 130 years ago when the index was first created, but the economy has changed drastically since this index was first created. No longer are industrial companies an accurate representation of the overall market like they once were.
  • A company is included in the DJIA because it was selected by a committee of the Wall Street Journal. They actively decide which companies should be included and which should be removed.
  • The common methodology to determine the weighting of each company is very unusual. Most modern indexes are weighted based on the market capitalization – the bigger the company, the larger representation it holds in the index. The DJIA weights the company based on the share price of each stock. The larger the price per share, the larger the weight in the index. That puts Goldman Sachs as the largest holding at about 8% and GE at the second lowest (about 1%). This reason for this methodology dates back to a time before computers when a simple methodology was needed.
  • Here is a technical issue – the DJIA was prone to inaccurate calculations before computers were used to track the index. In going back to the very beginning and correcting all the mistakes, the DJIA passed 30,000 last month.
  • While you can’t invest directly in indexes, you can invest in indexes the mimic and replicate the performance of the underlying index. When you total the dollar amount that tracks the DJIA, it adds up to about $36 billion. To put that in perspective – over $2 trillion track some version of the S&P 500!

As you can see, this is a deeply flawed and outdated index. It serves very little use for most investors because of these flaws. It is not a good gauge of the overall health of the market or the economy. It barely does a good job of capturing the health of industrial segment of our economy in the US. It should never compared to a broad, diversified investment portfolio. So the Dow reaching 20,000 is a big story about an out-of-date index.

Fake News and Your Investments

For readers of this blog, you know how I feel about financial journalism these days. The talking heads and the supposed experts we see on TV and read about in the news are doing a great job making people nervous and afraid to invest. It’s clearly having a negative impact on decisions most investors make. Investors tend to be nervous when the markets become volatile but when the media reconfirms their fears or exaggerate their concerns, the investor is more likely to follow the heard.

Lately, the whole concept of Fake News has come into focus as people call out poor reporting. While most of the backlash is focused on political journalism, I believe that financial journalism is even more prone to reporting of half-truths and spreading of misinformation. Journalists know how to stoke fear and anxiety for an investor with clever headlines and drawing comparisons or conclusions in ways that are factually and logically incorrect.

I hope the pressure continues and that the media can reform itself and realize they can help people stay the course in reaching their financial goals. Right now, the majority of the content from CNBC (and most media) is good for entertainment purposes but rarely would I consider it reliable or educational in nature.

What Happens When Your Retirement Plan Goes Awry

US News recently made several good points in the following article: When You Do Everything Right But Your Retirement Plans Go Wrong

I would add that a financial plan should be reviewed on a regular basis regardless of what’s occurring in the market.  The analogy we use is that a financial plan is similar to sailing a ship across the ocean.  Throughout the journey, there are many course corrections along the way.  It’s to be expected and the plan must be dynamic enough to adjust.  In some cases, investors believe that a financial plan is static and that it never changes.  It’s important to remember that a plan is good for only as long as the underlying assumptions remain valid.  If inflation increases too much or if the markets are negative for an extended period of time or some other assumption changes, it may warrant a change in the plan.

Critiquing a Financial Plan

The following article examines five young people and their financial plan (more like their lack of planning).  They are then offered some preliminary advice about how to improve their situation.  Unfortunately, in every case I found the advice to be overly simplified.  Here’s the article

And here are some overarching strategies that apply to all the case studies:

1)      Emergency fund.  Start here first and make it a priority to build an emergency fund that can cover non-discretionary expenses for 3-6 months.

2)      Save more.  If you can’t save more now, earmark any future raise toward saving.  When asked about a rule of thumb for how much to save, I’ll often respond with “Save as much as you can”.  Young people and millennials are unlikely to have pensions and with the questionable future of Social Security, the burden to save is placed on their shoulders much more than previous generations.

3)      Automate.  Make sure any savings are set to occur automatically.  The mental anguish of writing a check every month or year to a retirement account can be surprisingly difficult.  Many times it is our own biases that create obstacles to reaching our own goal and simple processes like automating our savings can have a huge impact.

4)      Disability.  Life insurance is commonly discussed when a couple has children.  But disability insurance is rarely brought up.  What’s odd is that people are more likely to file a claim for disability insurance than life insurance.  And it doesn’t apply just to physical injuries, either.  We’ve had several clients and prospects tell us about their long term disability that affects their ability to do a desk job as a result of a bad car crash.

 

The Best Stocks To Invest In Right Now

How many times have you seen that headline? How many times did it spur you to read an article and even take action? Well respected publications are famous for putting together these kinds of lists. The odd part is that every month, week, or even day that list changes. This morning I saw headlines like these “ The Best Value Plays of 2017”, “These Stocks are Poised to Grow”, “These Stocks Will Surge With Trump”.

This is part of the Fake News problem we’re dealing with. Editors and journalists know that those headlines are going to generate the clicks and your attention. They want your attention long enough for you to see the ads and don’t care at all if those investment ideas are good.

Publications and the media are in the business of selling ad space. Any recommendations should be taken with a grain salt.

An Example of Using the New Reverse Mortgage

Imagine you have a retirement account valued at $1 million, where you take a monthly distribution of $3,000.  If the market (and your account) declined 30%, that monthly distribution will become a real strain on your account.  What was originally a 3.5% rate of withdrawal would increase to a risky 5.1% rate of withdrawal.

Now imagine the same situation, but that you had a reverse mortgage.  Instead of tapping your retirements account when it is down for the year, you took your monthly distribution out of the equity in your home, thus preserving the value in the 401(k).  Because the income received through the reverse mortgage is tax free, you could take out less than you would have from your retirement account (subject to any required minimum distributions).

In some of the research we are monitoring from the Journal of Financial Planning, we are seeing these coordinated withdrawal strategies as a significant tool to improve the probability of maintaining one’s current lifestyle through retirement. Research is showing that it can extend retirement spending out another 10 years or even more.

(Some readers may think about using a reverse mortgage to take equity out of their home to invest it in the stock market.  We strongly discourage that kind of thinking.)

Reverse Mortgages, like social security, annuities, life insurance, retirement accounts, and brokerage accounts, are all tools with good and bad features.  The ideas and research being done by the academics around reverse mortgages used in coordination with other tools are very promising.  In the next 5 years, I wouldn’t be surprised if the reverse mortgage concept became a common tool used in most retirement plans.

 

Five Creative Uses for a 529 Plan

What should you do if you have extra money in a 529 College Savings Plan? Perhaps it’s left over funds used to pay for a child’s education or perhaps the child has opted not to go to college.

The common options are to change the beneficiary (to a different child or relative). But that may not be practical. Below are a few interesting ideas I’ve stumbled across over the years:

Outward Bound (Website)– This outdoor educational institution teaches people of all ages about wilderness expeditions and training. Many of their courses accept payment from 529 plans. (Details)

Study Abroad – There are examples of some people taking an educational trip abroad through a university. If set up correctly, funds from 529 can be used. (Details)

The Culinary Institute of America (Website) – One of the most respected cooking institutes in the world allows most of their college course programs to be paid for using money from a 529 plan.

Pursue a hobby – An example in this article references an individual who started a small maple-syrup farm. He wanted to learn a lot more about the science behind what he was doing and ended up taking horticulture classes at his local community college. (Details)

Go to graduate school – Maybe the children are done with undergrad. In that case, maybe they will eventually go for a master’s degree. The 529 can be used for that too.

The New Reverse Mortgage Strategy

In a recent post, I tried to dispel some of the common myths surrounding reverse mortgages that have been written since April 2015.  In this post, I will explore how the Reverse Mortgage could be used.

Instead of thinking about a reverse mortgage as a last resort after all other assets have been depleted, think about it in conjunction with your other investments and working in tandem with your 401(k) or IRA and your other investments.

The basic premise behind a reverse mortgage is that it’s a product designed to tap an illiquid investment – your home.  For many Americans, it is still one of the biggest assets they own.  When it comes to using a reverse mortgage to tap the value of the home, there are four options:

1)      Lump sum payment

2)      Annuity-like stream of income guaranteed for as long as a borrower lives in the home.

3)      Fixed payment over a fixed number of years

4)      Line of Credit (that grows at a variable rate) that is accessible as needed

It’s option four, the line of credit, that has become most intriguing. The idea is to apply for a reverse mortgage in the early years of retirement and leave it alone for the most part.  You take on the line of credit long before you actually need it because the line of credit will grow over time.  If held long enough, the line of credit could exceed the value of the home.  The line of credit grows, even if the value of the home does not. But the homeowner or the estate would only be on the hook for at most 95% of the value of the home because a reverse mortgage is a “non-recourse” loan.

On top of the flexibility it brings, there are tax benefits too – draws from a reverse mortgage are not taxable.

(Some readers may think about using a reverse mortgage to take equity out of their home to invest it in the stock market.  We strongly discourage that kind of thinking.)

This is a compelling new tool that could provide innovative solutions for many retirees.  Research is showing that it can extend retirement spending out another 10 years or even more.

Whatever You Thought You Knew About A Reverse Mortgage You Should Forget

Whatever you thought you knew about a reverse mortgage you should forget.  Here’s why:

1)            The common strategy of using a reverse mortgage after all other retirement income options have been exhausted is a recipe for disaster. Dangling a carrot in front of an elderly couple or a widow saying “You can live in your home and we’ll even pay you” has misled many people who were shocked to learn that they still needed to pay their property taxes and maintain the house, even though they didn’t have the resources to do so.  In some cases, it resulted in the elderly couple being forced out of their home.  Bottom line, the timing strategy failed the client, not the mortgage itself.

2)            In 2013, the federal government enacted the Reverse Mortgage Stabilization Act which refined regulations around these products to make them better for the retirees.  The government stepped in to make sure the products are being used responsibly.  The provisions of “the act” were fully implemented by April of 2015. Reverse Mortgages written after that date are much different than the ones written earlier.

Reverse mortgages shouldn’t be thought of as a last resort.  Rather, it should be treated as a tool and component of an overall financial plan, which we will address in future posts.  Lot’s of academic research about how these products could actually enhance overall returns regardless of your financial situation, is happening as we speak.