Now's A Time To Recall Financial Planning Basics

Published Friday, December 5, 2008 at: 7:00 AM EST

Just a few years ago, almost everyone knew at least one person who had made a fortune in the stock market. But then many investors lost a small fortune. For those who are wondering what went wrong, here's a refresher course in financial planning basics.

Diversification. In the late 1990’s, many investors thought diversification meant buying three computer stocks and two Internet stocks. Others assumed they were being prudent because they owned a dozen mutual funds. But true diversification means buying a range of investments in markets that do not move in lockstep with each other. Through most of the 1990s, growth stocks were the spectacular performers; in recent years value stocks have been successful. A balanced portfolio will have both. It will also include bonds. But just starting out with the right mix isn’t enough; you also need to rebalance your portfolio regularly, trimming positions that have done well and adding to others that may be poised to rebound.

Planning. Establishing clear life goals and a long-term strategy is the essence of sound financial planning. A solid plan lays out the amount you must save annually, assuming an expected average rate of return, to reach your financial targets. It prepares you for future expenses, such as a child’s college education, and unexpected setbacks, such as premature death or disability.

Saving. Money doesn’t grow on trees, but it does grow provided you invest it. The more you put aside and the longer you allow it to compound, the better off you’ll be. The rule of 72 is the easiest way to see how this works*. Simply divide 72 by your rate of return to get the number of years it will take for your money to double. For example, with an 8% return, your investment will double in nine years and quadruple in 18. A steady, automatic withdrawal from your paycheck is probably the most effective way to save. That way, you don’t miss the money, because you never see it, and you’re able to load up on assets when they’re doing poorly and reap the benefits when they go up.

Retirement contributions. The government rewards savers by offering tax benefits to retirement accounts such as 401(k)s, 403(b)s, and IRAs. In most cases, you contribute pre-tax dollars and the money grows tax-deferred, meaning you don’t owe taxes on gains until you withdraw the money. With Roth IRAs, you contribute money that has already been taxed but your withdrawals are tax-free. Either way, the boost from Uncle Sam is so generous that it’s worth stuffing as much as possible into retirement accounts before allocating to regular savings and taxable accounts.

Tax planning. Hidden within hundreds of pages of tax laws are a broad range of special breaks for taxpayers. Shifting income from one year to another, selling assets that have lost money to balance out gains from top performers, and making contributions to educational savings accounts are just three possibilities. Review your tax situation with a financial professional at the beginning of the year and again in December.

Insurance. Planning for the unexpected is the key when deter-mining insurance needs. You should have enough life insurance to meet heirs’ long-term needs. Your health insurance should include coverage of catastrophic accidents or illnesses. Disability insurance is relatively inexpensive, but could make a big difference if you need it. And you should seriously consider long-term care insurance if you don’t think your retirement income will be sufficient to pay for nursing home care.

Estate planning. Having the right estate plan will ensure that your wishes are respected. If you have substantial assets, developing a well-thought-out estate plan can minimize taxes even while you are alive and maximize the amount you are able to leave to loved ones and your favorite charities. Even if you don’t have enough in your estate to be liable for federal or state estate taxes, having a valid will can save your heirs a lot of trouble and money.

In the dying days of the 20th century, there was talk about how the old financial rules no longer applied. “It’s different this time,” everyone said. But it wasn’t all that different, and millions of investors lost ground and time on the road to their financial goals. It’s never fun to start over, but it does give you one more chance to do everything right. Taking care of these basics should prepare you well, and we are happy to help.

*The Rule of 72 is hypothetical and there can be no assurance that any investment will double within the specified time-frame.

This article was written by a professional financial journalist for Phase 3 Advisory Services, Ltd and is not intended as legal or investment advice.

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