FINANCIAL PLANNING

Financial planning, for many investors, consists of randomly scattered investments in varying amounts with only a hope of having enough money when they need it. Since many investors think financial planning is too much work, they skip the all important groundwork and jump headfirst into the investing part of the plan. This method has produced more than its' share of failed plans.

This report will give a comprehensive overview of financial planning. Picking the investments is the fun part of the plan, so it gets saved for last. Before any investment is looked at, before any stock report is read, before a prospectus is ordered, there is some work to be done.

Look In The Mirror
You start your financial plan by looking at yourself, not the stock market or the latest issue of "How To Get Rich On Mutual Funds". You need to do a cash flow report and a net worth report. A cash flow report is simply adding up all of your expenses and subtracting them from your income. This shows you how much excess cash flow you have for a regular investment plan. (If your expenses are higher than your income, then you need to rearrange your investments to make up the difference.) A net worth report shows your assets minus your liabilities. Most people have never seen all their assets and debts added up on a single sheet of paper. Sometimes it surprises, other times it scares them. Along with this, a good financial plan will include an asset allocation review and a risk review.

Then you determine your investment objectives. "I just wanna make money" is not an objective. Your objectives need to be quantified so that you can tell if you are on track or not. Saving for your kids' college may be a noble endeavor, but without a target, you might come up short. Your retirement might not be as restful as you expected if you have to get a part-time job due to poor planning.

On the back of this newsletter are future value charts that will help quantify your future goals. If you are saving for college, retirement or a house, these charts will give you a good idea of your future target.

Next you have to take a realistic look in the mirror. How much risk can you tolerate? This is not an easy question to answer because there are various types of risk other than just principle risk. How much risk you can tolerate will determine your investments and investment strategy.

This is where you can start your asset allocation. You should take a look at your monthly expenses and have at least 6 months of expenses available in cash investments. (money markets, checking, savings, T-Bills) Anything else should be invested. The three major investment categories include cash, stocks and bonds. The future value charts will tell you what to expect at different rates of return. Your own risk tolerance will determine how much risk you should take. You should never invest in anything that causes you to lose sleep.

Top Down Research
Once you have determined your own personal financial situation, your objectives, your risk tolerance, and your desired asset allocation, you are ready for the next step. This is an economic overview, or top down research. Macro-economic trends are the "big picture" if you will, and determine what sectors of the economy and industries will do well and which will have a downturn. The rise of the automobile was a macro economic trend that benefitted some industries and destroyed others. (Buggy whips, for example.) The rules of supply and demand must be recognized here. Today, networking is a major macro-economic trend. But there are a large number of companies all rushing into the same field. Too much supply and not enough demand means there will be more losers than winners in this trend. Many natural resources, such as oil, corn and wheat, are at or near all-time low inventory levels. Demand is rising as third world countries industrialize. This is a major macro-economic trend that will provide more winners than losers because there are so few players, and demand is rising.

The style of investing that is in vogue today says you don't need an economic overview. All you have to do is study a company's fundamentals, in a vacuum, and invest in the best run companies. This is a perfect example of not seeing the forest for the trees. Studying companies without any kind of an economic outlook leads investors into buying good companies that go nowhere. Ex: "XYZ On-Line" is the best run computer on-line service company. Because of it's good balance sheet, and recent move to the NYSE, many analysts rate it a buy. But everyday, computer owners are bombarded by free Internet access offers. This is cutting into XYZ's subscriber base and they are losing subscribers monthly. XYZ has tried to compete by stepping up its' own free offers, cutting into its' profit margins. XYZ is a company out of step with a macro-economic change within its own industry. It is unlikely it would be able to reverse the spiral downward, and they analysts that don't see the industry trend will be caught by surprise when earnings are lousy.

Many investors will say that you can't know the big picture because there are too many variables. (So they don't even try to develop a macro-economic view.) By doing this they have effectively eliminated some of the most important input into a financial plan. It's like dressing in the morning without knowing if it is summer or winter, rainy or sunny.

The items that need to go into a macro-economic overview include interest rates, inflation, the stock market, commodities, especially oil and grains, labor, politics, economic growth, debt levels, international trade, international markets, taxes and the metals markets, among others. The more information that goes into your overview, the less any single item has an influence. A solidly built economic view will insulate the investor from playing the "number of the day" game that causes some much volatility in the markets today. (Your asset allocation may be changed at this point.)

Once your economic overview is in place, the sectors of the economy and industries that will benefit from this view will become evident. (As will those that will be hurt.) According to some studies, just getting the industry right is half the battle. Ned Davis Research has shown that the worst performer in the right industry is usually better than the best performer in the wrong industry.

Now you can start looking at companies. You need to be aware of the industry leader, the up and comer and the turnaround candidate. You need to know why one company within the industry is doing well and why another is not. This is referred to as fundamental analysis, the study of individual companies. (Your asset allocation gets further refined as you determine how much should be in various sectors and how much should in various companies within the sectors.)

Stock Picking
The next step is to determine if you should buy XYZ or ABC stock. Again, you need to start with a top-down approach. You need to know if the market itself is a good value or not. This is determined by a number of factors including price/earnings ratio (P/E), dividend yield, price/book ratio and price/cash flow ratio, among others. The market normally trades with a dividend yield of about 4 -5% and a P/E ratio of 13. A dividend yield under 3% indicates substantial risk, over 8% would be low risk. A P/E ratio over 18 is high risk., under 10 is low risk.

Each industry has its' own set of variables that indicate value. Growth companies tend to trade at P/E multiples over 20, banks tend to have P/E's under 10. It is important to know how the stocks within an industry trade. Sometimes there can be a wide variance of P/E ratios and dividend yields within an industry group. A little bit of research usually will clear up the disparities.

Now, finally, (if you've read this far you get bonus points) you can start to pick stocks. You have a firm economic view, you have determined the best industry groups, now you can pick out the stocks within the groups. The list should be relatively clear which are the best values.

Now is the tough part. You can't let emotion get involved. Just because XYZ might be your favorite company, if the stock is overvalued, you should not buy it. This is the toughest concept for any investor to understand. Not all good companies have good stocks. A company can be great on paper, but it's stock be a dog. Thanks to the cyclical nature of the stock market, today's overvalued hot stock can become tomorrow's overlooked, undervalued gem. Just because a stock is overvalued today, don't ignore it, you may get a buying opportunity in the future if the stock drops. (Assuming the fundamentals have stayed the same)

Buying Bonds
Bonds aren't as flashy as stocks, but they can play an important role in a financial plan. A key determining factor for bonds is interest rates. If rates are rising, bonds drop in value. If rates are dropping, bonds go up. It is that simple. Corporate bonds have some extra factors like ratings and conversion factors that can add to their potential for gains.

Zero coupon bonds are a very under-utilized investment. They allow an investor to target money to mature at a specific point in the future. The investor pays only a fraction of the face value, and the interest continues to accrete to maturity value in the future. It is a good tool for college planning or retirement planning. Also, if you have no need for current interest income, you should use zero coupon bonds.

Since interest rates are so important to the value of bonds, the maturities of bonds should be managed properly. If rates are rising, you should shorten the maturities of your portfolio. As rates decline, you should lengthen the maturities. Do not be afraid to to own 30 year bonds. As interest rates decline, they usually have the most capital appreciation of any of the maturities.

This is not a a complete review of all the investments available. Annuities, municipal bonds, commodities and international investments all could have a place in a well diversified financial plan. How these should be used is much more specific and should be discussed in a personal review with a qualified advisor.

"...wisdom is found in those who take advice" (Proverbs 13:10)

MFS Heritage Planning

Creating a Household Budget

Planning For Major Purchases

Organizing Your Financial Records

Keeping Taxes in Perspective

Is a Seperately Managed Account For You?

Understanding Seperately Managed Accounts

Reducing Debt

Understanding Seperately Managed Accounts

Understanding Seperately Managed Accounts

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