Over the last decade investors have been faced with a tremendous amount of volatility in the financial markets.  The “technology bubble” was the first obstacle investors ran into and unfortunately had to bear with for over two years before the markets began to recover in late 2002.  That recovery lasted for around five years and culminated in late 2007 when the Dow Jones hit its all time high.  Unfortunately, this high was short lived and in 2008 investors saw one of the worst market corrections of their lifetimes!  So has this decade been a waste for investors? Are their depictions of the market over the last ten years correct? Hardly, as long as you were properly diversified.

The graph below shows the performance of various benchmark portfolios and how they have fared over the past ten years.  The green line tracks a well-diversified all stock portfolio.  What this graph shows is that if you wanted $100,000 today, you would have needed to invest $64,500 ten years ago to achieve that.  The blue line shows the returns of a moderate portfolio (50% stocks, 50% bonds), which is a more realistic holding for most investors.  With a moderate risk portfolio, an investor could meet his $100,000 demand today with an investment of only $59,200 ten years ago!  I know these are double digit annualized returns we are looking at, but to see this kind of growth in supposedly a “lost decade” seems pretty good to me. 

Now, let’s take a look at how your investments would have done over a longer period of time.  The graph below shows the path of those same benchmark portfolios over a time period of 32 years; a time horizon more indicative of what many investors face during their years of saving.  In this case, a mere $4,500 was needed back in 1979 to reach our goal of $100,000 today.  That equates to over a 10% annualized return!

The “investment rollercoaster” of the past decade has played with many investors’ emotions and has been hard to handle.  However, for those who have stayed the course and were properly diversified, you are better off for it. 

It is times like these that we need to step back and look at the bigger picture and realize that the recent volatility is nothing more than a few potholes on the road to your financial success!

Financial Results
As a firm, Rockbridge continues to grow steadily.  Over the past two years we’ve grown the amount of assets under management by 20% from $194 million to $232 million.  While the markets have contributed to this increase, most of this rise is due to new clients who have discovered our firm via a referral from a current client or through our website. 

Surprisingly, a significant number of our new clients have found us via our website after searching for a local fee-only advisor.  We’ve invested in website improvements to bring our story to more people.  We don’t have an advertising budget and rely on referrals as our main source of new clients. 

Our Business Model is a Winner
While our clients know this, it’s worth repeating.  Rockbridge is a fee-only Registered Investment Advisor (RIA).  Our only source of revenue is from fees paid by clients.  We have never accepted a commission from a product we recommend.  The fee-only RIA business model has experienced steady growth while commission-based brokers continue to lose market share as individual investors discover the value of working with an objective fee-only investment advisor. 

Our Fees Are Modest
Our mantra continues to be “costs matter.”  The amount an investor pays in investment costs will definitely affect their standard of living.  We continue to have a relentless focus on costs for our clients.  Each year, Charles Schwab surveys the advisors they service.  Rockbridge participates in order to benchmark our firm against others like us.  The survey revealed that our management fees are less than our peers.  Our fees for a typical client average .50% of assets managed versus our peers whose fees average .67%.  Lower investment costs mean more money in our client’s pocket.

Education Never Ends
Our firm is part of a study group of likeminded advisors committed to the passive investment philosophy.   We meet quarterly in New York City to discuss investment strategies or products and compare notes on our business practices.  The insight we get from these meetings makes us better advisors.  We also continue to be a member of The National Association of Personal Financial Advisors (NAPFA).  NAPFA is the country’s leading professional association of fee-only financial advisors—highly trained professionals who are committed to working in the best interests of those they serve.  NAPFA holds several training events throughout the year that we are proud to be a part of. 

Plans for 2012 and Beyond
We will continue to meet with clients to review their investment plans.  There is no way to predict future returns; however, we are confident that markets will reward investors for taking investment risk over the long term.  Expected future returns may not be as high as in the past, as articulated in Craig’s accompanying article, so we will continue to help clients determine the right amount of risk to take in order to meet their financial goals.

Changes in technology and new investment products are introduced at an ever increasing pace.  We take time to evaluate new technologies and products on a regular basis.  We spend money on technologies that make us better, more productive advisors.  We are slower to make changes involving new investment products since many are designed to maximize profit  for their own companies, not necessarily for their investors.

Our strategic plan for the next three years calls for modest growth both in new clients and firm revenue.  Our five professional advisors have capacity to help more individual investors.  As the baby boom generation is poised to start retiring, we look forward to referrals from our clients and professional networks. 

Recent regulatory changes to be enacted in 2012 will shine a light on the abuses in the 401(k) marketplace, especially for small employers.  At Rockbridge, 31% of our revenue comes from managing 401(k) plans for small business owners.  We are poised to be an objective partner for other small firms who care about their employees and their retirement goals. 

In conclusion, we continue to be passionate about our investment philosophy and thoroughly enjoy working with and educating our clients.  Personally, I enjoy coming to work every day surrounded by smart, confident, passionate people.

It is unusual for the S&P 500 to move so little from one year to the next, but it is also unusual for it to behave the way we “expect” it to behave.  Since 1926 the average annual return has been about 11%, and yet over those 86 years, the annual return has fallen between 8% and 13% only 6 times.  The range has been -43% to +54%.

TWO – Regardless of the returns we realize, markets are volatile.  
In other words, we often experience the risk without realizing the commensurate level of return.

2011 certainly felt like a rollercoaster, and the stock market was indeed volatile.  Yet was that volatility unusual considering world economic events?  The experts at Vanguard say no, and provide evidence in a recent paper.  Their evidence is based on a comparison of economic volatility and market volatility, which turn out to be closely correlated.  Moreover, they show that the volatility of the economy and markets was higher in the 1970’s than it has been over the past five years.  Risk and return are related, but we only observe the correlation in the long run.

THREE- When “everyone agrees” on the likely direction of a market (or prices, or interest rates) they can still be wrong.
At the beginning of 2011 “everyone agreed” that interest rates had to rise from current levels.  Bill Gross was one prominent expert who put his money where his mouth was, declaring that U.S. Treasury yields were so low they did not adequately compensate investors.  He sold Treasuries out of his portfolio.  It turned out to be a spectacularly bad decision as Treasury rates fell further and his fund, PIMCO Total Return, the largest bond fund in the world, underperformed.

What is a reasonable range of expected returns…
We have all read the standard performance disclaimer, “Past performance is no guarantee of future returns.”  That warning has rarely been more important or relevant than it is today.

Bond returns have now outperformed stocks over the past ten years.  Mutual fund investors continue to pour money into bond funds in response to stock market volatility and, we assume, in part because of attractive past returns.

Vanguard published a paper in November 2011 that tried to answer the question, “What is a reasonable range of expected returns for a balanced portfolio of stocks and bonds based on present market conditions?”  For the full paper, click here:  https://advisors.vanguard.com/iwe/pdf/ICRLYVE.pdf?cbdForceDomain=true

They present several interesting conclusions including:

•  Expected returns for a 50% stock/50% bond portfolio are 4.5% to 6.5% nominal and 3.5% to 4.5% in real terms (after adjusting for inflation).  This result is modestly below the average since 1926 (8.2% nominal and 5.1% real) but better than the past decade.

•  Expectations for the next decade are driven by the current level of bond yields, which are highly correlated with future annualized returns from bonds.

•  The chart below shows expected returns for a more risky portfolio (80% stocks/20% bonds) more consistent with the historical average while the expectation for a less risky portfolio (20% stocks/80% bonds) less likely to achieve historical results.

Real (inflation-adjusted) returns

Notes:   Percentile distributions are determined based on results from the Vanguard Capital Markets Model.  For each portfolio allocation, 10,000 simulation paths for U.S. equities and bonds are combined, and the 10th, 90th, 25th, and 75th percentiles of return results are shown in the box and whisker diagrams.  The dots indicating U.S. historical returns for 1926-2010 and 2000-2010 represent equity and bond market annualized returns over these periods.  The equity returns represent a blend of 70% U.S. equities and 30% international equities; bond returns represent U.S. bonds only. 

Sources:  Barclays Capital, Thomson Reuters Datastream, and Vanguard calculations, including VCMM simulations, and index returns.

•  With ten-year Treasury rates below 2%, it is irrational to expect bond returns over the next decade to be anything like the past decade, and nearly impossible mathematically.

•  Stocks, on the other hand, appear reasonably priced, capable of providing average historical returns, and quite likely to do better than the past decade, which began with stocks very highly valued (Price/Earnings ratios well above historical averages.)

Conclusions/Take-Aways

1.  Expect returns from balanced portfolios to be below historical averages over the next decade due primarily to low bond yields.

2.  The incentive to take stock market risk (relative to bonds and cash) may be as high as it has ever been.

3.  Chasing the bond returns we have seen over the past decade is ill-advised.

4.  Taking more stock market risk may be tempting, but comes with greater volatility.

5.  Most investors should stay the course, with a balanced portfolio that reflects their long-term tolerance for risk.

Medical insurance is not like any other insurance you have.  Some common insurances, like home owners and auto, may be required by lenders and or state authorities, but you hope you never have to use it. You really have little choice on how much coverage or how much to pay.  Medical, however, is much more personal in that most of us have a pretty good idea of what medical services we will need from year to year.  Of course there will be unexpected illnesses or accidents from time to time.  But overall, we can estimate our medical needs and how much they may cost.

So, we base our coverage on what premium we can afford, how many doctor visits we expect, what drugs we need, and how much risk we are willing to take with major medical expenses.  High costs of health care pretty much dictate that we must have at least some protection against doctor and hospital visits that could lead to financial ruin. For example, my heart cath last year was expensed at $16,000.  How would I have paid for that without insurance coverage?  What if I had been diagnosed with a blockage that needed surgery?  My out-of-pocket amount was $150.  I can handle that, but not $16,000.

There are many, many questions you need to ask yourself and the insurer when deciding on what coverage type and coverage plan is right for you.  Here are a few to get you started.

How much insurance do I need?

You may know the number of primary care and specialist visits, what prescriptions, and what lab tests you will have in a year’s time, and what they may cost.  If you don’t know, you better find out so you can decide if extra insurance is worth the premium.  Why pay a monthly premium of up to $200 per person, in addition to standard Medicare, if you don’t expect that there will be claims?

What is my basic health status?

A person with a history of heart problems, diabetes, back pain, eye problems, or any other regularly occurring health issues requiring hospitalization or specialist care can expect the possibility of them recurring during the year.

Which type of additional insurance should I get?

Medicare is standard and (somewhat) understandable.  The Medicare Advantage and Medigap plans require lots more analysis to understand their options and coverages.  They all are unique as to costs, restrictions, claims processing, etc.  Learn as much as you can about how each would work for you.  Don’t assume that the highest premium plan would be best for you.

What is a Medicare Advantage Plan (MA Plan)?  Is it Medicare?

MA Plans are a form of Medicare administrated by private companies approved by Medicare.  They must cover all of the services of Medicare (except Hospice) but can charge different out-of-pocket costs and have different rules for referrals, doctors, facilities or suppliers.  For instance, a recent visit to an urgent care facility cost me $35 under my MA Plan, where original Medicare would have been $0.  All MA Plans are not the same as to premiums and coverage, so they must be examined to determine how they work for your individual situation.  You must still carry and pay the premium for Medicare Parts A & B.  MA Plans are not Supplemental Plans.

  What is a Supplemental Plan?  (Also called Medigap)

This is insurance that can help pay some of the health care costs not covered by Medicare, like copayments, coinsurance, and deductibles.  They are standardized policies, but different insurance companies may charge different premiums for the same exact policy.

 Do my doctors participate with this plan?  Some plans provide “in network” and out of network coverage, with a different co-pay for each.  Using the latter usually means you pay more and have more paperwork to complete a claim.  Ask your doctors if they “participate” with any plan you choose.

How much will I pay for prescription drugs?    Are they covered under this plan?

Medicare A & B does not include coverage for prescription drugs.  One recent mailing from a private insurer showed a monthly Rx premium of either $40.30 or $89.70 for the same coverage I now get for $0 premium.  One friend of mine has the same plan as I and doesn’t even think he has drug coverage.  He does, but hasn’t needed to use it.

Additional Questions:

 What if I travel, go south for the winter?

What kind of plan should I get just to make sure I would not suffer financially if I had a serious illness or operation?

What would Medicare have paid if I didn’t have Medicare Advantage or a Medigap plan?

How do I access details on line?

What if I have other company retiree coverage?  Should I keep it or change?

The questions and personal issues go on and on.  By now it should be obvious that this is a very complex area and the best way to address it is to go to the seminars put on by most, if not all, of the insurance companies.  Bring your “Medicare & You” booklet.   Be an informed consumer!

Here is the communication from Schwab to advisors:

We want to make you aware that the indices for the Schwab Small-Cap Index Fund^® (SWSSX) and the Schwab International Index Fund^® (SWISX) will be converted from Schwab’s propriety indices to the Russell 2000® Index and the MSCI EAFE Index, respectively. Although these conversions will not happen until December 14, 2011 and December 20, 2011, we are required to mail a 60-day notification to your clients invested in either fund as of October 14, 2011. Additionally, as of November 1, 2011, the Schwab Small-Cap Index Fund’s expense ratio will decrease from 19 basis points (bps) to 17 bps. You may review a copy of the prospectus supplements here and here.

The Russell 2000 Index is an established index that measures the performance of the small-cap sector of the U.S. equity market. The Russell 2000 is a subset of the Russell 3000, representing approximately the 2000 smallest issues and approximately 10% of the total market capitalization of the Russell 3000.¹ The MSCI EAFE Index is an industry-recognized index composed of MSCI country indices representing developed markets outside of North America—Europe, Australasia, and the Far East.

Converting to these indices from Schwab’s proprietary indices offers more transparent fund management for all segments of investors, plus better tracking and comparison data from third-party providers. Lowering the expense ratio of the Schwab Small-Cap Index Fund offers a better investment value for your clients.

Both funds have performed as expected against their respective benchmarks in the past.  We believe these are positive changes and both funds will  continue to be excellent representatives of their respective market segments.

Please give us a call if you have any questions or concerns about the changes.

Rockbridge Investment Management is a firm that prides itself on controlling the controllable when it comes to investing, thus addressing the issue of investment costs is something we don’t take lightly.  The average cost to invest in mutual funds with the typical brokerage firm is 1.5%, while here at Rockbridge the typical client pays around 0.25%.  Are we just sweating the small stuff? Let’s find out!

Let’s take a look at an American family with a combined income of $75,000 who is saving 10% a year for forty years and is getting a fixed rate of return.  Can an extra 1.25% in expenses make that much difference in their standard of living during retirement?  The graph below shows the impact that fees can have on a portfolio – the results are staggering!  The family with the low cost portfolio retired with over $2,000,000, which should allow them to comfortably draw around $100,000 from their portfolio each year during retirement!  On the other hand, the couple who had higher portfolio expenses only accumulated $1,500,000 at retirement, giving them only a $55,000 draw from their account on an annual basis, after taking into account the lower balance and the higher continuing expenses.

(Assumptions:  A couple saving $7,500 annually for 40 years with an 8% fixed rate of return.  To make withdrawal rates equal in retirement, I used a 5% withdrawal rate for the low cost portfolio and reduced the other portfolio’s rate by the difference in fees.)

The notion of not sweating the small stuff is very important; it helps cancel out the everyday noise in our lives, allowing us to focus on living and pursuing our dreams.  However, most of our dreams include a comfortable and fulfilling retirement, and a nearly fifty percent reduction in retirement spending may be a factor in that dream being reached.  But I will let you be the judge of that!

Here are some of the key things to consider when choosing coverage for 2012:

1. Medicare Parts A & B provide basic adequate hospital and medical coverage.  There is no requirement for additional insurance.  Many people are satisfied with only Medicare A & B and no additional coverages.
2. If you are newly eligible for Medicare, make sure you contact Social Security and discuss your options to enroll.  Medicare coverage is too important financially to pass up.
3. Everyone’s health situation is unique, so no one plan or option “fits all”.  Choosing or rejecting additional coverage beyond Medicare depends on each person’s age, health, physicians, prescriptions, budget, etc.  A married couple might have two very different health plans because their needs dictate it.
4. The Medigap and Medicare Advantage plans are sold by insurers.  By this I mean that an individual can’t just buy one on the internet without discussing it with a representative.  This is valuable for the consumer, because there are so many important factors to consider.
5. Insurers are holding seminars to discuss what their products cover and what they cost.  If you have any doubts about what you need, attend one or more of these seminars and get the benefit of a large group discussion with others who may have the same questions as you.
6. Take a friend or relative with you, someone who is familiar with your financial and/or health situations.  Two heads are better than one.

Don’t procrastinate or just assume that your current coverage is best for you.  The older we get, the less likely we are to risk a change, even though it might be a substantial financial saving.  Inertia is the easy way out, though not necessarily the best.

A few years ago, when I no longer had coverage through my employer, a friend suggested a Medicare Advantage Plan, something I had never heard of.  They said they were paying no premiums and had very good coverage.  I didn’t believe them, assuming they weren’t giving me the whole story.  My wife and I and several good friends met with their plan representative and I became convinced that this type of plan was best for me.  For various personal and health reasons it was not best for some of the others, but I switched to a Medicare Advantage Plan and still am covered with the same company, under a similar plan, pay $0.00 premiums, and am saving hundreds of dollars every year.  My wife has a slightly different plan with the same company because her health needs are different.  But her premiums, like mine, are $0.00. There are also plans that include premiums and offer a higher level of coverage on certain items.

There is a medical plan out there that is best for every situation.  You just have to find it.  I am not recommending any specific plan type or insurance company, just advising each person to do what is best for them.  In my next post I will try to be specific about what questions to ask and how to find the plan that is right for you.

Social Security
Deciding when to start Social Security benefits is one of the most important decisions aging baby boomers will make.  The Social Security Administration www.ssa.gov/ has a wealth of resources available online.  And the local office representatives can provide the facts given your own personal circumstances.  However, they will not give you advice on when to start taking Social Security.  Our firm took a look at the options and summarized the information in a recent blog post on our website www.rockbridgeinvest.com/medicare-etc-cost-emphasis/.  While we are not experts on all aspects of Social Security, we can help evaluate your options and provide excellent resources to assist you with making this very important decision.

Medicare
Retiree healthcare costs are also a major growing concern for baby boomers.  Many will delay retiring to age 65 when they become eligible for Medicare health benefits.  Our resident expert, Dick Schlote, has been navigating the Medicare maze for the past few years and has agreed to write a series of blog posts on the subject.  You can find his first Medicare blog post on our website www.rockbridgeinvest.com/medicare-etc-cost-emphasis/. 

Our main job at Rockbridge is to prudently manage our clients’ investment portfolios.  We also strive to expand our knowledge in other important areas of financial planning, such as Social Security and Medicare.  We continue to develop our website into an excellent resource for our clients and friends of the firm.

2.  Diversification provides a remarkable amount of protection from volatility.  Information in the charts below is taken from the same Vanguard study mentioned above.

3.   The only way to fully participate in the up days is to be able to withstand the down days.  Volatility refers to moves in both directions. 

4.   Remember that you are investing and not trading.  “Sitting out” the current volatility is an appealing notion, but timing the market is something better left to speculators and traders.  Trying to benefit from correct predictions of short-term moves in the market is not a long-term investment strategy.

5.   “The market has been volatile and just dropped dramatically – what do I do now?”  This is a bad question and bad questions do not lead to good investment decisions.  A better question would be, “Am I still taking an appropriate amount of risk considering my goals and time horizon?” 

Sticking to your disciplined investment strategy is a better response than panic.  When stock prices tumble and bond prices soar, it provides an opportunity to rebalance your portfolio by taking some profits from the bonds and buying stocks at reduced prices.

Equity Markets
The third quarter of 2011 saw the value of small stocks and international stocks fall more than 20%, which is generally considered a bear market correction.  Large domestic stocks (S&P 500) did a bit better but fell nearly 14% in the quarter, dropping into negative territory for the year at -8.7%.

Fixed Income
Government bonds, on the other hand, had a stellar quarter, defying logic and many experts’ expectations, by rising in value after S&P downgraded the U.S. Government debt rating.  The broad bond market index, which is dominated by government securities, rose 4.7%.  The value of TIPS (Treasury Inflation Protected Securities) rose even more than the general bond market, as hope for economic recovery diminished, and action by the Federal Reserve drove expectations for real interest rates further into negative territory.  Based on the pricing of Treasury securities, and TIPS, the market now expects inflation to average less than 1.8% over the next ten years with ten-year government bonds providing a return above inflation of a meager 0.20% on average.  Government bonds of shorter maturities are expected to provide returns less than inflation, so investors’ purchasing power will diminish. 

Return Expectations
We cannot predict future returns, but it can be instructive to examine assumptions built into current market pricing.  As mentioned above, the expected return on ten-year government bonds is barely above the expected rate of inflation, driven by dismal expectations for economic recovery, extremely accommodative monetary policy, and fear of another financial crisis coming out of the euro zone.  This is well below the long-term average, which is about 2% above inflation.

Stocks on the other hand appear priced to provide future returns more consistent with their long-term risk premium of 6-8% above inflation.  The S&P 500 index is at a price level first achieved in 1998, but since that time the Price/Earnings Ratio for the index (price paid per dollar of expected earnings) has fallen dramatically.  So today’s price reflects a lower, and perhaps more realistic, assumption of growth in dividends and earnings.