Attwell Asset Allocation, Inc.

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Certainly the stock market is not for everyone. The most recent market collapse has probably increased the number of individual investors that hold that sentiment. While nothing else historically has provided the returns common stocks have, for most they are long-term investments that require a good stomach for volatility of asset value in today's market. When you consider that the historical risk-free rate of return is commonly considered 6% and the market over the long haul averages 10%, an investor could get over the long-term 60% of the market returns without taking any of the risk associated with investing in common stocks. Now if you are taking on greater than market risk to outperform the market and are still seeing returns less than the market returns or less than 10%, some investors feel more comfortable with lower risk lower return investments. The basic asset allocation pyramid theory is that some of the following investments should form the base or foundation of your pyramid (portfolio) especially older investors with shorter time horizons to retirement.

While you could never build the wealth investing in low-risk/low-return assets that you could in owning a growth stock like Microsoft long-term, you do eliminate the volatility of asset value and can sleep well at night. There's no question that investments in common stock are a gamble, and for those who don't want to live with the risk of that gamble, safer alternative investment options are the only choice. For those investors, in addition to annuities, the universe of choice among low-risk/low-return investments is not very large or very exciting.

Government Issues: Regardless of what anyone ever tells you, the ultimate safest investment you could ever make is a United States government obligation. No one has ever lost a dime in a United States government obligation held to maturity. You may want to thank the Father of our country, George Washington, who following the American Revolution impressed upon our founding fathers the vital importance of paying the investors in the bonds sold to pay for the War. From then on the United States government has never defaulted on a government issue.

The problem with U.S. government obligations is not one of safety but rather the same problems you have investing with the entire low-risk/low-return asset class. Credit risk or the ability of the guarantor to pay back the principal to the investor is not usually a problem with low-risk/low-return investments but interest rate risk and inflation rate risk are. Interest rate risk, sometimes called re-investment risk, is the fact if you invest in a low-risk/low-return investment today you may not have the liquidity or be able to sell your investment to re-invest in the same type of investment at a later date that is now paying a higher rate of return at the same risk. You are stuck in a lower yielding investment while the market is now providing higher rates of returns at the same risk. This risk is why investors buy short-term government obligations when interest rates are considered low and longer-term government obligations when interest rates are high. Interest rates go up, bond prices go down. If interest rates go down, bond prices go up so if the market moves against you and you sell your U.S. government bond short of maturity you can take a loss on your principal. This can come at quite a shock to someone who was told they were investing in the ultimate in safety vehicle. This is why we urge caution when investing in annuities or any of the investment vehicles in this asset class. In some ways it is more complex than investing in common stocks. Where you invest your money and how liquid that investment is at any given time in the economic cycle is paramount. For example you may be able to get out of a short-term government bond without loss of principal to take advantage of higher returns the market is now providing than if you are invested in a long-term government bond or annuity!

The inflation risk is the most often overlooked risk as if you are invested in a government bond with a coupon rate of say 4.5% and inflation is running at a pure 3% plus you are paying taxes on your gains. You can actually get a very low rate of return and in some cases a negative rate of return. Inflation risk is almost universal to the low-risk/low-return asset class, as long as we have inflation.

We have discussed the major risks associated with this asset class but regardless of the risk inherent in this asset class for those not comfortable with the minimum volatility associated with a portfolio that includes common stocks this asset class is where they should be invested. We list the following summary of choices within this investment class and to the best of our ability have listed them in order of credit worthy risk or the ability of the guarantor to repay the obligation to the investor.

This summary is not a complete statement of all investments available in this asset class
nor does it include all material factors and risks.

It is not a solicitation or offer to invest.

The ultimate in safety: United States government obligations held to maturity. The principal value of an investment in a government issue is at risk if the security is sold prior to maturity. Along with the government bond section reading the paramount feature of bond investing in the corporate bond portion is vital to the understanding of investing in government bonds as well.

Zero Coupon:

A bond that matures at a fixed future date at a determined value sold at a discount to its principal future value with interest imputed but not paid over the life of the bond. Imputed interest is reported to IRS as taxable income even though none of the imputed interest is paid. Zero Coupons are very similar to the old government bonds bought at a discount held and cashed in at a future date for an appreciated value. Zero coupons with the coupons attached are far more sensitive to interest rate changes than Government Notes and Bonds. Historically a popular vehicle to save for college and retirement in tax deferred accounts as you can more easily target the value at maturity.

Treasury Bills:

A US Government debt security with less than 1 year maturity. T-bills do not pay a fixed interest rate as they are sold through an auction process at a discount from its par value.

Treasury Notes:

A US Government debt security with a maturity greater than 1 year, less than 10 years at a marketable, fixed-interest rate.

Treasury Bonds:

A US Government debt security with a maturity over 10 years at a marketable interest rate usually issued with a minimum denomination of $1,000.

Government Issues

Zero Coupons
3 Month Bill
6 Month Bill
2 Year Note
5 Year Note
10 Year Note
30 Year Bond

Bank Money Market Savings:

These more or less have taken the place of the old passbook savings accounts, where the bank teller would update your little booklet when you made a deposit or withdrawal. The difference in these money markets and the money market funds listed below are that these are FDIC-insured. The funds invest in highly liquid and low risk securities such as CDs which are insured by the FDIC. The interest rate paid usually varies depending on how much money you keep in the savings account. Although very safe, they have probably the lowest return available of all investments.

Certificates of Deposit:

These investments are offered by banks and insured by the FDIC, up to applicable limits and generally only $100,000 per investor and issuing institution. With CD accounts, you must keep the money invested for a specific period of time, and in return, you earn a specified interest rate. If you cash in your CD before the specified period, you probably will be subject to a penalty fee.

Money Market Funds:

These are open-ended mutual funds that pay interest at money market rates. The funds invest in highly liquid and low risk securities such as CDs or treasury bills listed above with taxable and non-taxable funds available for investors. Basically they are a securities market dealing in short-term debt and monetary instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid. While they are considered very safe investments, only some are insured by the FDIC. It would be possible to lose money in a money market fund.

Municipal Bonds:

Municipal bonds are debt securities issued by a state municipality or county to finance capital projects. Such projects might include the construction of highways, bridges or schools. Municipal bonds are purchased for their favorable tax treatment; income from municipal bonds is tax exempt but the capital gains are not. These are favored investments by those in high income tax brackets since many of them are exempt from federal taxes and most from state and local taxes. Municipal bonds are often considered second in safety only to U.S. government obligations; some are even insured. While the tax exempt status is attractive, it is only beneficial if you are in a high enough tax bracket to benefit. While they are tax exempt, they are also at a very low fixed return so unless your tax equivalent yield is higher than what you could obtain in a taxable alternative, it would not make investment sense to own them.

Fixed Annuities:

The major advantage of fixed annuities is until you start receiving payments, the investment compounds at a fixed interest rate that is tax deferred. Annuities don't have fluctuations in principal value against market interest rates but surrender charges instead, if sold prior the end of the annuity period. They are not a liquid investment and should only be bought if you intend to hold them for the annuity period. Annuities basically come from the concept of annual payments. The basic investment means the insurance company makes fixed dollar payments to the annuity holder for the term of the contract. Sometimes this occurs until the annuitant dies if the annuitant annuitizes (start receiving payments) the annuity for a lifetime income. There are a myriad of variations but in some contracts the insurance company keeps the remaining principal after the annuitant dies. So in effect you are taking a gamble that you will live long enough to outlive your principal invested with the insurance company. From this concept comes the old philosophy that every time someone annuitizes an annuity a gun goes off on the front lawn or the insurance company because they won the battle. Unless you know for sure how long you are going to live we don't recommend annuitizing an annuity in this way because if you pass away early then your heirs will not get back the full value of your investment. The insurance company guarantees both earnings and principal and while it is a guaranteed investment the guarantee is as strong as the insurance company. There are a plethora of variations on this product including single premium, deferred, index, variable and even bonus annuities. Some can have a purpose in safe investing and some don't have a good purpose for any investor in any investing. There are a lot of whistles, bells and frosting when it comes to insurance products, much of it for the benefit of the insurance company and not the investor. It is not the purpose of this section to discuss all of them. Annuities are insurance products and thus deserve special attention.

There is a case the annuity salesman often presents in seminars to senior citizens to drive a wedge between an investor and his current financial advisor, who has his client invested in a diversified portfolio across most asset classes. Some annuity salesmen masquerade as financial advisors including Certified Financial Planners (CFP). The truth is that some financial advisors, certified or otherwise, are really glorified life insurance product sales people. I am not sure you should call yourself a Certified Financial Planner if all you do is sell annuities. Be very cautious of the financial advisors that sell only one product. Be wary of the financial advisors that insist that you completely divorce yourself from your current financial advisor before they will sell you anything or do business with you. It is commonly known with regard to production for commission salesmen in the financial services industry, regardless of what they call themselves or what licenses or designations they hold, the ones who specialize in one area often make considerable higher incomes (commissions) than those that diversify their product base across asset classes. This doesn't necessarily make them fraudulent or disreputable, but it should raise a red flag for the investor, not only for caution of fraud but because of the fact he can only do one type of investment for you and whatever percentage of your portfolio you need that one investment is actually how much you need them. While it is of great benefit for the annuity salesman if the investor puts his entire portfolio into a high commission annuity or even several annuities, it is not necessarily a benefit to the investor to do so. Diversification is one of the foundations of investing. You don't violate this fundamental even if you are investing your entire portfolio in one asset class. Without question this type of concentration is safer when the concentration is in low-risk/low-return assets as opposed to high-risk/high-return assets, but it is not professional money management and it has its costs usually in high commissions, lower returns to the investor and sometimes higher tax rates at the end of the rainbow. More than one investor got to retirement and dealing with the tax rates wondered what happened to the lower-income, lower-tax bracket he was told he would be in at that stage of his life.

While we are not arguing that annuities have a proper place in a diversified portfolio or against tax deferred investing which do have great advantages, we are arguing that it is difficult to make a case for an entire portfolio being concentrated in annuity investments. Although I know some pure money managers would argue the case, why would you ever invest money in an annuity? As an investment vehicle you are going to get a low-risk/low-return investment so it is certainly safe but no more safe than government obligations held to maturity so you have to shop the rate of return. From a pure flat coupon rate of return you will be surprised at how similar CDs, government obligations and annuities are. Ah but they are tax-deferred and tax deferred investments grow at a much faster rate giving you a larger portfolio at the end of the rainbow, you say. Certainly that can be a major benefit but many money managers believe the tax effect after distribution is almost the same as if you paid the tax man along the way investing in government obligations. The theory is you pay a rather large commission to own this tax-deferred investment and by the time you get to the end of the rainbow the return on investment often can be more or less the same as if you invested in government obligations and paid the tax along the way. How do you know you are going to have less income and be in a lower tax bracket when you reach retirement? Government obligations are safer than insurance products and often the very investments the insurance company invests your annuity money in for the growth of the insurance company. While we think annuities can have a place in portfolio management, we think they should be invested in with caution and in justified percentages of a diversified portfolio even if you are investing your entire portfolio in the low-risk/low-return asset class. The case could probably be made while this investment vehicle is attractive to people in higher tax brackets for what appears to be while investing rather than taking distributions the tax deferred benefits it is an investment vehicle probably over bought by the wealthy investors and under purchased by middle class investors. Nonetheless two final conclusions: if you have not exhausted all available IRA funding options, you may not need an annuity and no matter what any insurance salesman/financial advisor tells you we find it very difficult to justify buying an annuity into an IRA or other tax sheltered portfolio. Why would you want to pay a commission for a tax deferred investment to be in a portfolio that is already tax deferred? While the government has authorized annuities to be in IRAs, we can think of no reason to invest in an annuity in an IRA. While we think there are few reasons to put an annuity in a 401(k)/IRA one good reason for small portfolios is to prevent yourself from running out of money with a guaranteed stream of income for life with an annuity.

If you have an interest in investing in annuities for a specific financial objective we would caution you to do your homework and buyer beware. There are more variations on annuities with more whistles, bells and gimmicks than you can imagine so feel free to contact us regarding information on annuities

Mortgaged Backed Obligations:

Also known as collateralized mortgage obligations (CMO). With a mortgage backed obligation, investors loan money to a home buyer or a business providing a way for small regional banks to offer mortgages to their customers that they otherwise might not be able to lacking the assets to repay the loan. These investment vehicles allow them to become a kind of broker between home buyers and the investment markets.
Mortgage backed obligations known as pass through certificates are investment vehicles representing partial ownership in a pool of mortgages. Principal and interest from the individual mortgages pay the principal and interest on the mortgage backed obligation. A key point here is while the mortgages are guaranteed usually by the government the obligations are not necessarily guaranteed! They might be guaranteed but keep in mind in a overall market failure no one is going to buy unsellable paper except at fire sale prices.

These securities are issued and backed by government sponsored corporations like the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae). Each offers a different version in the securities they issue. Ginnie Mae obligations are best known and most widely owned simply because they are backed by the Uncle Sam. Fannie Mae is government sponsored and trades as a public company.

Some financial advisors think mortgage backed obligations are one of Wall Street's best keep secrets for safer investments. While these securities provide income they can provide capital appreciation to the investor as well. The capital appreciation usually would require interest rates fall which makes them a doubled edged sword in that if interest rates rise you can see loss of principal just like a bond. The difference here is you can hold them for the long-term and hope interest rates reverse but unlike a bond you cannot hold them to maturity and recover your principal! While they are very safe with regards to credit worthy risk they are quite risky with regards to market risk or the economic cycle risk. They are traded actively so they are a very liquid investment like U.S. government issues but that liquidity might not be there in a overall market failure. In a market failure you could probably sell but at significantly reduced prices possible reducing principal.

They need to be bought right and sold right within the economic cycle. In other words like a stock, some market timing is required. For that reason and the fact you cannot hold them to maturity and recover your principal like a bond they are probably not for the novice investor but rather for sophisticated investors. Mortgage backed obligations are popular with some investors because their risk reward relationship is very similar to U.S. government T-bills, notes and bonds but can provide a couple of percentage points higher rate of return. The fact of the matter is the extra 2% if you get it comes with significantly more risk. Remember you cannot hold a mortgage backed obligation to maturity and recover your principal along with the coupon. In a failing market you can only hold them and hope you recover your principal if and when the market recovers.

Commercial Paper:

A short-term negotiable and usually unsecured promissory note that requires payment of monies at a certain date. They are not collateralized so commercial paper is almost always issued by firms whose credit-rating is excellent. This is about the only way the paper would be accepted as a trading vehicle. Commercial paper is sold at a discount and usually reaches maturity within six months. Commercial paper provides cash for the firm issuing the paper and an excellent short term rate of return for the buyer but it is a market more or less for those investing $100,000 or more. This is mostly an institutional market for sophisticated investors but for those who are not in this league they can buy a Commercial Paper Money Market Fund that would probably provide good short term returns but understand there is no FDIC guarantee.

Life Settlement Contract:

A Life Settlement is the one-time, lump sum purchase of an existing life insurance policy. The insurance industry often refers to these investments as viatical settlements, senior settlements and life settlements. The settlement will always be larger than the policy's cash surrender value otherwise they wouldn't sell the policy to an investor they would simply surrender it for the cash value. The benefit to the recipient is they have use of the funds for whatever they choose while they are alive. Policy holders of any age may qualify generally if they have a terminal illness that estimates a twelve year or less life expectancy. The investor purchasing the life insurance policy would become the owner and the policy beneficiary and is known as the settlement provider. The investor will pay all premiums until the policy matures or the death benefit is triggered. The Life Settlement Provider (Investor) profits by purchasing the existing life insurance policy from the current owner at a discount from the death benefit. The income and capital gains from Life Settlements can be subject to taxation. These are relatively new as an investment vehicle. They have an obvious phenomenal benefit to the recipient and handsome profits to the settlement provider in addition to providing a social redeeming service to terminally ill individuals. Nonetheless beware, you can tell the pioneers as they are the ones with the arrows in their backs! There has been some outright fraud in this arena with investors being bilked out of large sums of money. While they can be safe and profitable if done correctly they are more or less for sophisticated investors and even then you should probably engage a qualified attorney.

Investment Grade Corporate Bonds:

The last investment vehicle we will include in our safer alternative investment section. Buying a corporate bond is loaning your money to a corporation for a predetermined period of time which is the maturity. The bond's par value is usually $1,000 which is the face value of the bond and the same amount the lender will be repaid at the maturity date of the bond. The corporation issuing the bond must also pay you the time value of money which is the coupon or interest rate in exchange for using your money. These interest payments are made periodically but usually every six months until the bond matures. The major considerations of investment prior to investing in a bond are the credit worthy risk of the corporation issuing the bond, the interest (or coupon) you will receive, the maturity date of the bond when the issuing corporation must pay back the principal to the lender and any call features that allow the corporation to call the bond in (pay the principal back to bond investors) prior to the bond maturity. This creates three important factors: the interest rate or coupon, the yield of your investment to the call date feature of the bond and the yield of your investment to the maturity date of your bond. Investing in bonds from well established credit worthy companies has significantly less risk than investing in corporations having financial problems. Bonds that are rated less than investment grade are more risky and called junk bonds with a much higher risk of default. Corporate bonds have higher coupons or interest rates because they have default risk that government bonds have never had. The United States Government has never defaulted on a bond; corporations have. Corporate bonds may have less capital appreciation than government bonds but they are the same in that you can suffer a loss to your principal investment with changes in the market interest rates.

Paramount feature of bond investing

As with government bonds not held to maturity if market interest rates go up the market value of your bond sold before maturity goes down. No one is going to give you $1,000 for a 6% coupon bond if quality corporations are now issuing new bonds for 8% you will have to take a loss to sell it on the open market before maturity. If you hold a corporate bond to maturity you will not lose money on your principal investment. If market interest rates go down you usually should see capital appreciation in the market value of your bond if sold prior to maturity and a bond investor probably should take those profits prior to maturity. You are not going to sell that bond at the $1,000 you paid for if it has an interest rate coupon of 8% and now quality companies are issuing new bonds at only 6% because market interest rates went down you will want a premium for the price of that bond.

While corporate bonds may be less sensitive to principal value against market interest rates than government bonds this market feature is the same for government bonds as corporate bonds and paramount to understanding investing in bonds. This element of investing in bonds has soured many investors to fixed income, driving them to invest in annuities because they didn't understand the bond market. They thought they were buying a safe investment only to find losses on their principal when they had to sell the bonds prior to maturity in a higher interest rate market.

The solution to this problem is not putting your entire portfolio in annuities which don't have fluctuations in principal value against market interest rates (they have surrender charges instead if sold prior the end of the annuity period) but to have quality portfolio management. You would not want to invest in a 30-year maturity bond when interest rates are very low because when interest rates go up you are going to lose money on the principal value on your bond. The answer is to invest in shorter maturity bonds when interest rates are low and longer maturity bonds when interest rates are high. Sounds simple but executing it is not nearly as simple especially when you are buying at a time when interest rates are not at the extremes of the market cycle.

As most of this fixed income asset class corporate bonds offer little protection against inflation because the interest payments are usually a fixed amount until maturity and as previously stated probably the most overlooked risk of this class. The fixed interest payments are taxed at the same rate as income in taxable accounts. Nonetheless corporate bonds offer an excellent source of income, especially for retirees and are also highly useful for tax deferred retirement savings accounts that allow you to avoid taxes on the semiannual interest payments. We cannot think of any way investment grade corporate bonds would not be preferable to an annuity in a tax deferred retirement savings account.

Preferred Stocks:

Preferred stock is ownership in a company similar to common stock but the investor can but usually doesn't have any voting rights like common stockholders. Preferred shareholders have one advantage over common shareholders. In the event of liquidation they are paid off before the common shareholder but still after debt or bond holders. With preferred shares investors have a guaranteed fixed or variable dividend hopefully a higher dividend than you could get in a bond but not necessarily. You may expect an overall greater return or yield if the preferred share price appreciates. The investor takes a greater risk in a preferred stock than a bond so they are seeking greater total return. Like a bond, preferred stock may also be callable, meaning the company can purchase back the shares from preferred shareholders at anytime hopefully for a premium.

Preferred shares are offered by a wide range of companies in the risk/reward relationship and it is important to remember that it's called a stock because it is a stock and you can see serious depreciation in the price you paid for it which can mean serious decreases in your principal. While preferred stocks are thought of as safer than common stocks because they are a mix between a stock and a bond that is not always the case. Preferred stocks run the full gamut of the risk/reward relationship from very safe credit worthy blue chip companies to very speculative penny stock type companies and should be invested in with the same amount of due diligence as common stock or any investment for that matter.

The major investment objective here is to provide a higher dividend than available in a common stock and not have the market or principal value volatility you see in common stock. The real objective is capital appreciation increasing your overall total return without taking the risk of owning a common stock. This isn't always achieved as the volatility in a preferred stock can be as great as a common stock. The beauty of investing in a preferred stock when all goes well is achieving significantly higher rates of return sometimes even outperforming the market but taking significantly less risk than investing in common stocks.

The dividends in preferred stocks are taxed at the ordinary income tax rate so if the preferred stock pays a higher dividend you will likely pay more taxes on it. Tax equivalent yields can be calculated so you know what total return you need to make in a preferred stock to make it worth your investment while to own it in your tax bracket. Investor caution here as rates of return on preferred stock can be very close to the rates of return on corporate bonds and corporate bonds are usually less risky. Bottom line is if you invest in preferred stock the investment should outperform all the other categories of investments in this investment class as you are taking more risk to own a preferred stock.

Preferred stocks can be an excellent source of income as well as total return. They can be very appropriate for retirees and are also excellent investments for tax deferred retirement savings accounts that allow you to avoid taxes on the dividends and capital appreciation. If a preferred stock was not preferable to an annuity in a tax deferred account you would buy investment grade corporate bonds not an annuity. Preferred stocks trade on the exchanges and NASDAQ in the same way as common stocks.

In conclusion while normal asset allocation models are probably thought of as having three major asset classes of risk/reward, safe, growth with moderate risk and aggressive growth, in actuality you construct a separate pyramid of asset allocation within each class. So in effect if your focus or financial objective is safer investing you can construct a portfolio within the safer class that would use guaranteed investments such as CDs and government bonds in larger percentages as the foundation and filter in the corporate bonds, annuities in taxable accounts and preferred stocks attempting to achieve a higher rate of return than you could achieve if you invested your entire portfolio in the guaranteed assets. Achieving a higher rate of return with this strategy can achieve rates of returns on investments closer to and sometimes outperforming the average stock market returns. For example if you could achieve a return of 7% to 8% in this manner the question that begs answering is why would you take the market risk or greater than market risk of owning common stocks when you when you could obtain 70% to 80% of market returns with very reduced risk compared to the risk of owning common stocks.

There is no age requirement to invest in this manner you just have those financial objectives which would include giving up higher rates of growth and the kind of wealth building potential that the higher risk/higher reward common stocks provide. Each of the individual investments within this risk/reward class can be bought through mutual funds. There are government bond funds, corporate bond funds, preferred stocks and hybrid funds including some with the single investment objective of safer investments or higher total return at reduced risk. One caveat when using funds for your objectives in this area, while the investments in the funds may or may not be guaranteed the mutual funds are themselves not guaranteed!

If you would like more information on constructing such a portfolio with or without mutual funds feel free to contact us for a free preliminary consultation.