Securing your finances

As a small-business owner, you constantly worry about your company's performance. And if you invest in the stock market, your interest in other companies' performances becomes greater—especially now that so many public corporations are facing some serious financial issues. Stock market volatility has required investors to become more savvy and, sometimes, more conservative. It all can seem complex, but achieving financial security does not have to be difficult.

The roaring '90s

During the 1990s, preserving and growing your wealth was much easier than it is now. Let's face it: Even for an average investor, it was difficult to lose money in the markets during that decade. For one thing, there was the furiously paced, upwardly spiraling stock market and, more specifically, the technology phenomenon.

Investors fell in love with technology companies and the hope their products brought for the future. People became market geniuses by placing money into just about any technology stock. And those who made their livings giving financial advice could seemingly do no wrong. Bonuses paid to brokers, money managers and advisers reached unprecedented highs as client accounts ballooned.

Just how good were the returns? For 1999, technology mutual funds claimed a performance record of 135.5 percent. That means if you invested $100,000 at the end of 1998, you had almost a quarter of a million dollars at the end of 1999. Although the stock market as a whole was performing incredibly well with a robust return of 23.6 percent during that year, the technology sector clearly was "where it was at."

Unfortunately, as with many things that seem too good to be true, it was. By the time 2000 started, investors were ignoring warnings that the returns they were seeing were absurd. Despite the fact stocks were trading years ahead of anticipated earnings, investors still could not hand over money fast enough to buy more shares.

In just the first three months of 2000, $33.7 billion was thrown into "can't miss" technology funds alone. And as demand stayed ahead of supply, stock prices continued upward.

The tide turns

In March 2000, the bubble popped. The sudden end was fueled partly by Federal Reserve Chairman Alan Greenspan formally proclaiming stock prices bore no connection to real value. This statement shortly followed Greenspan's announcement that the only reason stocks were selling at their lofty prices was simply a case of "irrational exuberance."

As a result, the markets began their slide. Short-term-minded advisers and stockbrokers were left without solutions as their clients' portfolios began to plummet. Nondiversified portfolios heavily weighted with technology holdings and "hot stocks" were exposed to the greatest risk of loss and suffered tragically. Many investment managers' and brokers' lack of qualifications was made evident as these advisers simply were unable to help their clients recoup their losses. Years of investment growth were lost for the many unfortunate investors who lacked a portfolio built to withstand the down years.

How bad was the fall? From March 31, 2000, through March 31, 2001, the average technology fund return was -61.6 percent. The $100,000 many saw turn into $235,500 was down to $91,415. If you were unfortunate enough to start buying at the high of March 2000, you saw $100,000 turn into $38,400.

Investor confidence was shattered. Individual and institutional investors began selling more furiously than they had been buying during the boom. Meanwhile, the economy was visibly weakening. Greenspan soon confirmed what many of us already knew—the U.S. economy officially was in a recession.

Then came Sept. 11, 2001. The attacks of that day threw an already fragile investor psyche into a complete tailspin and temporarily crippled the heart of the U.S. financial center. Just as during the bear market of 1973-74, distraught investors thought they had nowhere to turn. Even investors who desperately had hoped their shares might miraculously return to their once high values began selling their shares.

There was seemingly nothing left that could make matters worse until corporate accounting scandals began to surface. One by one, corporate leaders were charged with everything from securities fraud to embezzlement.

The economy slid downward leaving many investors to ask, "Where can I invest, and whom can I trust?" With many issues still unresolved, many investors still are worrying whether their wealth could have been or will be preserved. Some are even forced to confront the possibility that the lifestyles to which they had become accustomed might forever be compromised.

How to survive

During these uncertain times, how do you properly plan for your financial security while coping with the volatility of the markets?

First, the good news: Times like these have happened before (even worse, in fact), and markets always have bounced back. The patient investor with a well-constructed portfolio has been more than handsomely rewarded for sitting through turmoil.

The sad news is we can be relatively certain we will have to relive times such as these again. As long as the United States bases its economy on capitalistic principles, the markets will be cyclical.

You can stay ahead if you learn to build your portfolio with the big picture and market history in mind. If you learn to reduce your portfolio's volatility and decrease your potential for loss, you will benefit when the market turns.

Choosing an adviser

After the crash began, investors soon realized a majority of stockbrokers and investment advisers simply don't have adequate knowledge to build portfolios that will withstand punishing down years. Stockbrokers and advisers may be licensed, but licensing and practical knowledge are two different things. It's one thing to learn some necessary concepts, principles and securities laws to pass a certification test, but it is quite another thing to truly understand and specialize in portfolio management and all it entails. It is yet another thing to remain unbiased in investment selection and put all one's knowledge to work wholeheartedly in a client's best interests at all times.

Remember, stockbrokers and many financial advisers earn their money from commissions, and commissions bring with them an inherent conflict of interest. It is only human nature for a broker to recommend investments that may pay higher commissions. And the only way for brokers to make money is to repeatedly move your money around. Putting you in a well-thought-out, comprehensive, long-term plan might be the best thing for you but doing so could bankrupt your stockbroker.

This is why you need an adviser who earns his income strictly from fees. Fee-only advisers charge a fee for creating a plan that will attain your financial goals and managing your assets. Because the fee is not affected by the investments you hold, any potential conflict of interest is eliminated. Your money only is moved if it should be moved as part of your investment plan.

Essentially, fee-only advisers, particularly those who have gone through the arduous training required to earn the Certified Financial Planner designation, are skilled with hundreds of hours of investment management theory and practice. Stockbrokers simply don't have a comparable level of expertise or knowledge and, as commissioned salesmen, have no reason to obtain it.

Arthur Levitt's book Take on the Street: What Wall Street and Corporate America Don't Want You to Know reveals many of the deplorable practices of stockbrokers and brokerage houses. Levitt started his career as a stockbroker, owned his own brokerage house and eventually became chairman of the Securities and Exchange Commission.

Levitt writes: "Brokers now have to become fee-based, and they've got to embrace the same fiduciary responsibility that advisers have. They don't today."

Investment advisers who earn their incomes from creating comprehensive investment plans and/or collecting fees based on assets under management have vested interests in their clients' portfolios and their growth. The fee-only adviser formula for income is simple: If you make more money, your adviser makes more money. If your portfolio loses money, your adviser's income goes down.

What to do now

Regardless of whether you decide to create and manage your own portfolio or hire an adviser, try to remember the following basic tenets of building a solid portfolio for the long term:

1. Realize there is a reason Wall Street is not located in Las Vegas. You can't bank on achieving your financial dreams by randomly throwing money at hot stocks or funds. You can invest properly and reap the rewards slowly.

2. When making investment decisions, leave greed out of it. If your investment capital is diversified and allocated properly, you never will have to worry about making (or missing) a big killing. You will come out ahead by following a solid plan that is sure and steady. Resign yourself to that, and you've won half the battle.

3. Have faith in the United States. The U.S. capitalistic society is founded on the principle of turning a profit. The markets surely reflect that. Bear markets have come and gone repeatedly. Those who have consistently and wisely invested through these cycles have come out winners.

4. Include bonds in your investment strategy. Even if you are extremely aggressive when investing and can withstand market ups and downs, you still must have an income stream that bonds provide to ensure your portfolio's value is maintained through all market conditions. By mixing income-generating investments with growth-oriented investments, your portfolio will be poised to grow and sustain its value.

5. Include stocks in your investment strategy. If you believe you must have safety above all else by avoiding stocks completely, you will lose money as inflation eats away at your buying power. For example, $1 of buying power in 1974 became 27 cents worth of buying power in 2000. This example shows you need at least as great an investment growth rate as the inflation rate just to keep the buying power you have now. Although your age is a factor in determining your proper amount of stock holdings, you must have some stocks in your portfolio even if you are the most conservative investor.

6. Diversify. If your portfolio is diversified properly, it will withstand turbulent markets and provide double-digit returns in good times. There are so many sectors in which to invest that, by staying diversified, you should have no trouble avoiding the types of losses we have seen during the past few years.

7. Don't pay exorbitant fees for your money management. Studies have proved you can achieve the same or better returns with low-expense-related investments and management as you can with high-expense-related investments and management. Remember to ask your adviser what the expenses connected with each investment are and whether he is earning any compensation from commissions rather than fees. The adviser should be able to explain to you, in detail, exactly how his income will be made. If your adviser is fee-based, make sure the mutual funds he promotes don't pay him a separate commission. If funds pay separate commissions, re-evaluate whether the funds fit your long-term plans or your adviser is pushing them because there is a hidden incentive to do so.

8. Stick with a conservative, long-term approach. Forget about market timing and believing you or your adviser can pick market tops and bottoms. If you are diversified and allocated properly and rebalance periodically, you never will have to worry about catching tops and bottoms. You will avoid nasty transaction fees incurred when "trading" versus investing.

9. Your portfolio should be as unique as you are. People have different standards of living and lifestyles to maintain, and all investors have different goals. Your portfolio must be customized to accomplish your financial goals, taking into account your age, income needs, portfolio size, life situation and future needs. Also, your financial plan must be adaptable should your life situations change. Your adviser should be able to tell you how your long-term plans will be affected by lifestyle changes and how to incorporate new ideas into your plans.

Take control

Whether you take the responsibility of ensuring your financial future or leave it to an adviser, use the guidelines in this article as the basis for your money management. By doing so, you can trust that even a few bad market years should not seriously affect what you have accumulated nor should your present or future lifestyle or plans be threatened. You also get a bonus benefit from following these steps: When you read your account statements, you'll have peace of mind. After all, isn't that really what your investments are supposed to bring you?

Carl Sanger is owner of Serenity Wealth Management LLC, New York.

Useful investment terms to know

Active management: The process of buying and selling individual stocks to obtain higher returns than those offered by the market.

Aggressive growth fund: A mutual fund that aims for high capital gains with little or no regard for risk. These funds are more volatile than average growth funds. Some funds may even invest in speculative bets, such as derivatives and options, to increase gains. It has been proved that these types of funds often take unnecessary risks for short-term gains while not producing any better gains during the long-term than less aggressive funds.

Alpha: The degree to which a manager's or fund's return differs from that of its benchmark. For example, a fund holding a broad array of stocks that is actively managed may be compared with the Standard & Poor's 500 Index. An alpha of +0.2 percent indicates the fund produced a positive return of 0.02 percent more than the index for the period being studied.

American depository receipts (ADRs): These shares are issued by a U.S. bank representing shares of stock in a foreign company. The shares are traded on the U.S. stock exchanges making it easier for U.S. investors to invest in foreign companies. Trading foreign shares in the United States eliminates the time difference and higher costs involved if U.S. investors attempted trading these shares on the foreign exchanges.

Annualized return: A return rate approximating a total return for a full year.

Asset allocation: The process of dividing one's investment capital into securities representing broad asset classes, such as domestic large-cap stocks, domestic small-cap stocks, foreign stocks, etc.

Asset class: A securities category, such as stocks, bonds, real estate investment trusts, large-cap stocks, etc.

Average return: The simple average of returns during a period of time. This return, when advertised, usually is of little use as an indicator of how an investment has performed. It almost always is larger than the annualized return and often misleading. Always use the annualized return when researching an asset's historical return.

Bond: A debt issued by a corporation or government.

Book value: A company's common stock value minus its liabilities, preferred stock value and intangible assets (such as goodwill). This is what a company would be worth if it went out of business.

Capital gain: The amount by which an asset's selling price exceeds its initial purchase price. A realized capital gain is an investment that has been sold at a profit. An unrealized capital gain is an investment that hasn't been sold but would result in a profit if sold.

Closed-end fund: A fund with a fixed number of shares outstanding traded at an exchange. The price of a share in a closed-end fund is determined solely by market demand.

Commission: The amount paid to a broker to execute a trade.

Correlation: The degree that two investment classes move in relation to each other. For example, large-cap stocks may move closely in relation to stocks in the Standard & Poor's 500 Index. Conversely, small-cap stocks may not mirror moves at all similar to the Standard & Poor's 500 Index and would be said to have little correlation. It is important to diversify your investment capital into asset classes having little correlation to each other.

Coupon: The regular interest payment made to a bond holder during a bond's life. A coupon of 6 percent on a $1,000 bond means $60 in interest will be paid (usually in two semiannual payments of $30).

Cyclical stock: A security that has periods in which it rallies and declines with economic conditions. Examples might be aircraft companies, paper companies and automobile companies. The opposite might be a drug company whose products are not at all dependent on economic factors.

Diversification: The act of allocating assets among investments with different returns, risks and correlations to minimize risk.

Dividend: A taxable payment declared by a company's board of directors for shareholders. Dividends usually are paid quarterly by companies that are not experiencing much growth. In other words, they pay dividends from retained earnings rather than reinvesting that money in the company.

Expense ratio: The amount of fees paid yearly to run a mutual fund, including management and advisory fees, overhead costs and advertising fees.

Growth fund: A mutual fund whose primary focus is on growth stocks. These are stocks of companies experiencing significant earnings or revenue growth rather than companies that pay dividends. The hope is that these companies will continue to increase in value allowing for large capital gains. These types of funds are more volatile than other types of funds and generally rise more in bull markets and fall more in bear markets.

Index fund: A mutual fund designed to capture the return of a specific market sector by investing in virtually all the companies in that sector. Examples of this might include Standard & Poor's 500 Index fund, a short-term bond index fund, etc.

Initial public offering (IPO): The initial, or first, public sale of a company's stock. Once these shares are traded, all future trading is said to be done in the secondary market.

Investment plan: A comprehensive plan that takes into account the rate and amount of investment contributions, proper asset allocation and diversification, rebalancing and possibly other factors to achieve an investor's financial goals. The importance of having a written investment plan cannot be overstated.

Large-cap stock: Shares issued by companies with market capitalizations greater than $6 billion.

Load fund: A mutual fund sold with a sales charge over and above all other fees charged in the expense ratio. Legally, loads up to 8.5 percent may be charged. Studies have proved that, over time, on average, funds with loads perform no more than funds without loads. It is my opinion that no-load and low-load funds should only be used.

Micro-cap stock: Shares issued by companies that typically have market capitalizations of less than $50 million.

Mid-cap stock: Shares issued by companies with market capitalizations from $500 million to $8 billion.

Mutual fund: A portfolio of stocks or bonds managed by an investment company. Mutual funds provide individual and institutional investors the diversity they need at lower costs than would be paid if the securities were bought individually.

Net asset value (NAV): The cost, per share, of a mutual fund.

No-load mutual fund: A mutual fund sold without a sales charge.

Open-end fund: A mutual fund open to all investors without affecting the fund's share price. Contrary to a closed-end fund, an open-end fund is not actively traded on an exchange. This type of fund creates new shares on demand as new investors contribute or existing owners make additional contributions.

Par value: A bond's maturity, or face, value.

Portfolio: A collection of investments owned by the same individual or organization.

Price/earnings (P/E) ratio: The value you get when you divide a stock's price by its earnings per share. A stock that sells for $10 per share and has $2 in earnings per share has a P/E ratio of 5.

Rebalance: The process of reallocating investment capital after a given time period to ensure constant diversification. In other words, you would take the gain from an asset that performed extremely well and place money into an asset class that underperformed to keep the amount of money invested in each the same. This ensures you buy low and sell high on a constant basis.

Return: The change in the value of an asset or your portfolio as a whole during a period of time.

Small-cap stock: Shares issued by companies with capitalizations between $20 million and $3 billion.

Turnover: The portion of a portfolio that is traded during a given period of time, usually one year. For example, for a portfolio with an annual turnover of 200 percent, the average dollar is reinvested twice per year. The more turnover a portfolio has, the more expensive the portfolio will be to its investor because it will incur more charges from trading expenses and have greater realized capital gains.

Value stock: A stock selling at a discount from its perceived value.

Yield: The percentage of a security's value that is paid as a dividend.