Most financial planners and investment advisors focus on your investment portfolio and its performance against various indexes.  While your investment portfolio is important, it’s only part of the picture.  Your overall net worth is a much better measure of your financial well being and your ability to achieve your goals.

Functional Asset Allocation is a holistic approach to net worth management and growth.  Its most basic premise is that there are three major categories of assets – interest-earning, real estate, and equities – and that each category has a fundamental function or purpose.

The purpose of the interest-earning category, which includes cash and bonds, is capital preservation.  These investments protect against deflation and ensure that you will have a reliable cash flow while keeping this part of your portfolio safe.

The real estate category includes your personal residence, real estate that produces income (rental property, for example), and nonproductive real estate (including vacant land and second homes).  The purpose of real estate is to protect against inflation through the opportunity to leverage your investment by mortgaging the property.  It also fulfills the function of personal use and enjoyment.

Equities produce profits during times of prosperity.  They are the growth engine of your net worth.

Once you understand the function of each asset category you see how questions like “Should I invest in stocks or bonds now?” are fundamentally flawed.  Under Functional Asset Allocation, the three asset categories don’t compete against each other on performance or yield.  The better question is “Do I have the right investments in each asset category, and am I properly balanced across all three categories so that I can achieve my goals and worry less about my finances?”

We can help you answer that question with a resounding “Yes.”

If you have worked with a financial advisor, you are likely to have a good understanding of risk tolerance, but you may not be as familiar with risk capacity.

Both are important in determining how much risk you should be taking in your portfolio for your unique financial situation.

Defining Risk Tolerance and Risk Capacity

Risk Tolerance is a psychological factor – it is all about your behavior and mental attitude. It is related to how well you can handle downturns in the market. An investor who can sleep well at night, and not sell investments when the market goes down 30% or more, has a high-risk tolerance; an investor who obsesses over a down market, panics, and sells, has a low-risk tolerance.

Investors with a higher risk tolerance would typically have a higher percentage of their portfolio allocated to equities (stocks) and riskier fixed-income investments, such as high-yield bonds. Even though these investors are exposed to greater potential loss, they also have the potential to get higher returns.

Investors with a lower risk tolerance would typically have a lower percentage of their portfolio allocated to equities, and a higher percentage in lower-risk assets such as government treasury bonds and CDs.

Although understanding risk tolerance is important, it should not be the only determining factor in how much risk an investor should take in their portfolio. Risk capacity, as explained below, is also a very important factor to consider.

Risk Capacity has to do with the impact a market downturn would have on your ability to reach your goals. This is different from risk tolerance, which is about how you feel about risk and how much risk you are willing to take. Risk capacity is about whether you can financially afford to take a certain amount of risk.

Factors affecting risk capacity include your time horizon for when you need to tap into your investments, the withdrawal rate needed from the portfolio, the length of time you need to draw from the portfolio, the availability of other assets, and the amount of liquidity needed now and in the future.

Risk Capacity Examples

As an example, consider Jim, who is single and 35 years old, has 30 to 35 years until he plans retirement, has sufficient liquidity, has a stable corporate job in a profession with strong demand, and does not foresee a need to tap into investments prior to retirement. Based on this information, Jim has a high-risk capacity at this time. Given his overall financial situation, he can afford to take on higher risk in his portfolio. A major market downturn would not have any material effect on his financial well-being.

Now consider Laura, who is also 35 years old, but her situation is quite different. She owns her own business, supports a family of four, has an unstable job outlook as her business is still struggling to survive, and does not have sufficient liquidity as she puts almost all earnings back into the business. She has 30 to 35 years until she plans retirement just like Jim; however, she needs to tap into her portfolio in the next few years to help support her family while building her business. Based on this information, Laura has a low-risk capacity at this time. Given her overall financial situation, she cannot afford to take on as much risk as Jim in her portfolio. A major market downturn in the next few years could have a negative impact on her family’s financial well-being.

Notice in these examples there is no mention of each investor’s risk tolerance. We have no idea whether they have high or low-risk tolerances, and we did not need to know this in order to determine their risk capacity.

Combining Risk Tolerance with Risk Capacity

Now that we have an understanding of the risk capacity of our investors, how would risk tolerance be applied to their situations? First, assume Jim has a low-risk tolerance and is not willing to take on the amount of risk his risk capacity indicates he could. That is perfectly okay because he has to be able to sleep at night and not worry about his investments, and it does not affect his financial well-being. Next, assume Jim has a high-risk tolerance and is willing to take the amount of risk indicated by his risk capacity. That is okay too, as explained above in the analysis of his risk capacity.

Consider Laura – assume she has a high-risk tolerance and would be willing to take on more risk than her risk capacity indicates. Just because she feels she could handle the higher risk, it does not mean she should take higher risk than her risk capacity indicates, because she cannot afford to take on more risk at this time.

Summary

Risk tolerance is difficult to quantify since it is based on your emotions and ability to handle major market downturns. Because risk capacity is based on your goals, it can be more easily quantified. It takes into consideration factors such as your need for cash and liquidity, your investing time horizon, the length of time you need to draw from the portfolio, and your ability to withstand a major market downturn without affecting your goals or harming you financially.

Here are a few rules of thumb to use as a guide to help determine risk capacity:

• When the need for liquidity increases, risk capacity decreases.
• When the time horizon increases, risk capacity increases.
• When the importance of the investments increases, risk capacity decreases.

Your risk tolerance and your risk capacity may be aligned with one another, or they may not. Both are likely to change over time depending upon where you are in your financial life cycle and depending upon your unique circumstances along the way, which is one reason why a financial plan needs to be monitored and adjusted regularly.

Steven Clark, CFP®, EA

Coconut Creek, FL

With final exams in May and June for colleges, universities and high schools, thousands have marched for their graduation ceremonies. Whatever the age of your graduate, you should introduce them to the power of the Roth IRA. More than anything, it is an incredible gift to the young with their low taxes and time on their side. With Roth IRA accounts you invest money with a mutual fund company or brokerage firm. You don’t get the upfront tax break as you do with a traditional IRA or 401(k), but you get back something more valuable in the form of tax free growth for the rest of their lives.
Grads can deposit up to $5,500 into a Roth every year, as long as they have earned that much income for the year and have an adjusted gross income under $120,000. If you have the extra cash flow, I recommend the “parent match” for the Roth IRA to get them up to their maximum contribution. Convincing your grad to salt away funds for the future may not be the easiest sell. See if you can use the following points to convince them.

The Power of Starting Now. If there’s one thing that a college grad has on most of us, it’s time. Let’s say they were able to put $5,500 a year into their Roth IRA for the next 10 years. After that they stop their contributions. If you assume 9% annual growth in the account, by the time they reach retirement 30 years later they will have $1.1 million in their account. All of that growth came out of $55,000 of contributions.
If instead they wait for 10 years to get started on the Roth and then make 30 years of $5,500 contributions, the numbers look good but not as compelling. With that same 9% growth, your grad would end up with $750,000 in their account 40 years from now. And they had to make $165,000 of contributions. Start your grad saving now to get over $1 million in tax-free growth versus less than $600,000 if your grad starts in 10 years.
Tax-Free for Life. Putting funds into a Roth IRA instead of a traditional IRA is a wager that taxes in the future will be higher than the taxes they pay today on income. With your new grad most likely in a low-income tax bracket and the recent tax law changes, this is a good bet to make. Once you put funds in a Roth IRA, you will never have to pay taxes on them again as long as your withdrawals are qualified. For most people that means waiting until age 59½ before they access their Roth earnings. Unlike traditional IRA and 401(k) accounts, with a Roth your grad won’t have to pay income taxes on the proceeds when they need the funds.
You Can Get It Back. Life often happens while you’re making plans. What if your grad ends up needing the funds? They may worry that if they require the Roth money for other purposes, it will be unavailable in some sort of retirement vault. A little-known trick of the Roth IRA allows your grad to withdraw the contributions that were made into the account. We consider Roths to be tax-free gold and don’t generally recommend this step. But if you need the money, you can always get your Roth IRA contributions out free of tax or penalty regardless of your age or circumstance.

Dave Gardner, CFP®, EA
Boulder, CO

Benjamin Franklin was born in Boston on January 17, 1706, the 10th son of a soap maker. For the next 84 years he lived one of the most remarkable and productive lives of any American ever. Among his many achievements, he gained prominence as an author, an inventor, a political theorist, a scientist, a statesman, and a diplomat. He was one of America’s first truly wealthy citizens, and he is well described as one of our country’s founding fathers. Some have even referred to him as the “First American.” Few in our history have played such a prominent role in the affairs of their day. His intellect was boundless, and his interests were many and varied. He shares his wit and intelligence with us today through his writings and the sayings and witty aphorisms he published in his “Poor Richard’s Almanac.” I think just about everything we need to know to be financially successful today we can learn from a man who lived over 200 years ago. Consider some of Franklin’s sage advice with me, and I think you will agree.

He was a strong proponent of public education:  1) An investment in knowledge pays the best interest. 2) By failing to prepare, you are preparing to fail.

He understood that risk played a role in investing:  3) Nothing ventured, nothing gained. 4) Vessels large may venture more, but little boats should stay near shore.

He understood the role time plays in investing:  5) Time is money. 6) He who can have patience can have what he will.

He was a strong proponent of thrift and the importance of saving:  7) For age and want save while you may; no morning sun lasts a whole day. 8) Beware of little expenses; a small leak will sink a great ship. 

He understood the importance of personal responsibility and hard work: 9) Motivation is when your dreams put on work clothes. 10) There are two means to increase your wealth. Increase your means or decrease your wants. The best is to do both at the same time. 11) Diligence is the mother of good luck.

He understood the limitations of wealth and the limited role it plays in the life of the truly successful person. 12) Money has never made man happy, nor will it; there is nothing in its nature to produce happiness. The more of it one has, the more one wants. 13) Great beauty, great strength, and great riches are really and truly of no great use; a right heart exceeds all. 14) Don’t judge a man’s wealth or godliness by their Sunday appearance. 15) Wealth is not his that has it, but his that enjoys it. Success has ruined many a man.

Even in that chauvinistic age, Ben recognized the role of a good woman:  16) A good wife and health is a man’s best wealth! 

Ben Franklin made these observations on the potential problems a democracy could face over 200 years ago. His warnings seem eerily loud, clear, and pertinent for us today. 17) When the people find that they can vote themselves money that will herald the end of the republic. 18) The U.S. Constitution only guarantees the American people the right to pursue happiness. You have to catch it yourself.

These are only a tiny sampling of Franklin’s financial wisdom, but with these few pearls you now know about all you need to know to be financially successful. Franklin says that we should educate ourselves, be willing to take some risk, and have the patience to let time work its magic. We should be willing to work hard; be industrious as he would say, and don’t expect others (or the government) to do for us what we can do for ourselves. He cautioned us to keep money in perspective and recognize that it should not be an end unto itself, but simply a tool for doing good. He warned us that money by itself will never make us happy, and we see the evidence of that all around us.

Benjamin Franklin is one of my favorite historical characters. His genius was well-recognized in his time, and he achieved fame, wealth, and the respect of his peers. We are fortunate that he was there to share his wisdom as our country was being born. We would do well to heed his words today as they are as relevant now as when he first spoke them. I often caution my readers that though far from the most important thing, still, money matters. I believe that Franklin had a similar thought in mind when he observed, “There are three faithful friends in our life: an old wife, an old dog, and ready money.”

Michael Ryan, CFP®, MBA

Hendersonville, TN

No investment advisor can honestly tell you that they can make you an additional 10% return on your investments. However, I can honestly say that I can, in many instances, save you 10% of your investments through good tax planning. How, you ask? I’ve got a lot of strategies. Taken altogether, they form what we’re calling “Tax Alpha”.

It’s pretty complex, so let’s put some building blocks in place first.

• Tax-deferred “qualified retirement money” (deductible IRAs, 401ks, etc.) is going to be taxed when you take it out.
• Social security is untaxed if you live on social security and a small additional income. But if you have more than a minor amount of retirement income, social security becomes taxable. During that time when your social security is phasing in as taxable you’re paying at either a 27.75% tax rate (if you were otherwise in the 15% bracket) or a 46.25% tax rate (for those who thought they were in the 25% bracket.) These high rates are a combination of the tax on your retirement income plus the additional tax on your social security income. Additional retirement income can also cause dividends and long-term capital gains to go from 0% to 15% taxed: it’s a bitter reality that sneaks up on people taking IRA distributions!
• If you make over $85k single or $170k married filing joint, there’s a surcharge on your Medicare premiums that works as a de facto extra tax. This is called the IRMAA threshold and it sounds like a good idea (“tax the rich”) until you realize that higher Medicare premiums hit people who are merely taking distributions from their retirement plans for large purchases (like buying the RV they were saving up for, or paying for a nursing home).
• Required Minimum Distributions (RMDs, sometimes called MRDs) are the government’s way of saying “we’ll let you defer taxes so you can save more when you are young, but not forever.” When you turn 70 ½, you must start paying taxes on a required minimum amount each year. Required distributions typically start after you’re on social security and that’s when you discover you’re in the highest tax bracket of your life. (Not what you meant to do when you deferred the taxes, was it?!?)
• If you are in a low tax bracket, your tax rate on long-term gains and qualified dividends is currently at 0%. That means sometimes we can sell a stock to harvest the accumulated gain at 0% federal income tax!
• People talk about simplifying taxes as if it were all about changing the tax rates. It really isn’t! Taxes are complex because you have so many ways to earn income, and so many ways to take deductions and credits. The actual tax calculation is easy-peasy. It’s determining what your taxable income (after deductions and credits) is that is subject to much of our strategizing.

So, a tax-focused comprehensive planner (that’s me) accounts for tax ramifications when providing investment advice. We look at several things at the same time:

• how much cash you need to fund your goals
• what tax bracket are you likely to be in after age 71
• how much room for additional income you have left in the same or lower tax brackets before age 71
• all while paying attention to the IRMAA thresholds that increase Medicare premiums

I have a truly scary Excel spreadsheet to help solve these problems. I also use various tax planning tools. But without getting into numbers, here are some examples.

Fran and Alex are retirees in their 60s. They need $50k/year to fund their retirement goals. They decide to delay taking social security until age 70. They still need money to live on now, though. Let’s say they have $200k in after-tax money (plain old savings or investment accounts) and $900k in qualified retirement money (IRAs).

In this case I’d run some calculations to see what tax rate bracket they’ll be in when they’re 71, and I’d convert as much as possible of their Traditional IRA into Roth IRAs each year to pay lower taxes now rather than later. During the clever Roth conversion years, they live on the $200k after-tax money. The Roth conversions protect the IRA money from ever being taxed again, and reduces the size of their eventual required distributions after age 70 ½. The desired net effect avoids having their required minimum distributions being taxed in a 10% higher tax rate bracket.

Here’s another case: Sage is still working, still accumulating, still growing assets. All of Sage’s money is in workplace plans. When Sage retires, quite possibly not until age 70, there’s going to be a massive required distribution (RMD) hitting at the same time as social security payments start. The trick here is to consider some other strategies; QLACs, donor advised funds, and the Roth side of a 401k.

Dale is early-career but has an inheritance. In Dale’s case we’d pay attention to tax-loss harvesting of inherited taxable investments; have Dale contribute as much tax-deferred income as he can at high brackets; but use Roth contributions if Dale is in low tax brackets.

Everyone loves to save taxes. An investment advisor who is tax-focused and considers comprehensive financial planning goals will do a better job for you than the typical investment advisor. I am a member of the Alliance of Comprehensive Planners and that’s how we work.

Wendy Marsden, CFP®, CPA, MS

Greenfield, MA

Today I might be crazy. I signed up for the 2017 CrossFit Games. I have only been participating in CrossFit since last July; I am not a top athlete; I am not highly competitive; I have no hope of making it to the regional games for my age group; and I will not even rank highly in my gym. So, why sign up and participate? Because, without hurdles to overcome or goals to achieve, it’s easy to lose track of where you are heading or even where you wanted to go in the first place.

This morning’s MET-CON at “the box” was a cardio killer. Our trainer said it was the hardest of the week because the first Games workout is on Friday. Yikes, that’s coming up fast. For the next five weeks, everyone participating in the games will compete at their home “box” with the same workout and log results. The top scores will move on until the elite from across the country gather this summer to compete in the finals.

If there isn’t hope of any substantial outcome, why compete? I decided to compete because I made a commitment last July to give CrossFit a one-year opportunity to see what it could do for me. I made the commitment, so I will give it 100% until the end of the year. If that means pushing myself to do more than I thought I could, then that is what I will do. I’m already stronger than I’ve ever been. But, I can do more.

I could work out at the local gym or at home. Would I push myself as hard? No, absolutely not. Unless you have crazy determination and focus, it’s important to seek outside guidance to move beyond where you are today. The best will always tell you that without the guidance of their coach or a mentor, they wouldn’t have gotten where they are today.

In my financial planning practice, I push clients to set goals, break them into small bites and develop timelines for completion. Unfortunately, I don’t receive much feedback that clients are taking advantage of the power of goal setting. Dr. Gail Matthews, a psychology professor at Dominican University in California, did a study on goal-setting with 267 participants. She found that you are 42% more likely to achieve your goals just by writing them down.

So why not write them down? My uneducated guess is a fear of failure. But, if you wrote down a goal, be it financial, lifestyle, personal growth, career, health, etc., and do only one thing toward achieving the goal, won’t you be farther along than if you didn’t take any action? How is that failure? It’s not; you should praise yourself for any progress you’ve made. Then, reassess the goal, redefine the interim steps, and recalculate the goal date.

Forbes reports a remarkable study about goal-setting. Harvard’s MBA graduate students were asked if they had set clear, written goals for their futures, as well as specific plans to transform their fantasies into realities. The result of the study was that only 3% of the students had written goals and plans to accomplish them, 13% had goals in their minds but hadn’t written them anywhere, and 84% had no future goals at all. Think for a moment which group you would belong to. After 10 years, the same group of students were interviewed again and the results were astonishing. The 13% of the class who had goals, but did not write them down, earned twice the amount of the 84% who had no goals. The 3% who had written goals and plans for them were earning, on average, 10 times as much as the other 97% of the class.

So, what does my competing in the CrossFit Games have to do with financial planning? Absolutely nothing for someone at my level. But it has everything to do with living my best life. What commitments will you make to live your best life? Will you write them down? Will you share them with your financial planner, life-coach, mentor, trainer so you have your own personal cheerleader in your corner?

Kelly Adams, CFP®, EA

Novi, MI

Remember the first time an adult you respected told you, “If you’re having a difficult time deciding what is the right thing to do — just listen to your gut. Deep down, if it’s right, you’ll feel it.”

That’s exactly how I felt the first time I was introduced to the concept of appreciative inquiry. After years of providing excellent financial planning service to my clients, the traditional model I’d been trained in just didn’t feel right anymore. As a successful financial advisor helping clients build their net worth, I was questioning the impact I was having. Sure, I was helping them make more money through better investing and financial strategies, but I felt strongly that there was more that I should, and wanted, to be bringing to the table in these relationships.

So I started searching for a way of serving clients that felt right. Then I found Appreciative Moments, by Dr. Ed Jacobson. Appreciative inquiry (AI) is a conversation model that engages stakeholders in self-deter-mined change. The diagram to the right does a pretty good job illustrating the process of building on the existing positives in a client’s life. My first exposure = Mind Blown. This felt right.

Advice vs. Guidance: Yes, There’s a Difference

I was great at giving my clients financial advice. What I discovered through AI was that even more valuable is the opportunity to offer clients guidance. Advice gives recommendations to solve a problem. Guidance helps someone figure out how they can solve their problem. In my current practice, AI gives me a great communication tool to empower my clients. Through AI, I help them discover their true passions and motivations, and set truly personal, meaningful goals that catapult them into their optimal life.

Let me share an example of why AI is now embedded in our practice.

As I was sitting with a colleague the other day, we started sharing tidbits of interesting stories we are reading on social media. After a few minutes, she stopped. “Frank, what do you think about this?” she asked, handing the phone to me. I did a quick scan. The blogger had started canning his own food (and just put up 24 jars of pickles). What started out as a test to see how much money he could save putting up his own fruits and vegetables quickly became an obsession. He shared how he delightedly told his friend — also his business coach — how he was saving an average of $1.30 a jar by making his own pickles. His friend-coach’s response, “You’re not really saving money; you’d make more money using the time you spend canning to grow your business.” In other words, according to the ‘friend-coach’, Time = Money = Value.

Appreciative Inquiry and True Client-Centered Conversations

The article my colleague shared with me that day was a perfect example of traditional advice given in a financial planning relation-ship. However, I wanted to deliver a different level of professional service to clients — one that helps them identify and achieve their true life’s purpose – their optimal life. The operating assumption of Life Guidance is that more money is not the answer but rather a means to achieving one’s optimal life. Appreciative inquiry is the heart of the financial life guidance process. We want to understand, “What is good here? How do we get more of it?” “Did the author say whether he enjoyed making pickles?” I asked my colleague. “What?” “Maybe he enjoys making pickles,” I speculated. “Maybe, the smell of pickles reminds him of time spent with his extended family, his grandmother. Maybe,” I continued, “he loves the feel of the jars as he fills them and the challenge of measuring the ingredients for the perfect taste. Maybe the real payoff for him is the satisfaction of coming up with different recipes and sharing something he created with others. Maybe his time is really being spent on building business – a new pickling business! “If his friend-coach didn’t ask any of these questions,” I continued, “and the author didn’t ask himself or even know to ask — how does he know the real value of each jar of pickles?” Being empathetic, asking those probing questions — questions that encourage our clients to truly focus on their emotions and the motives for their behaviors — this is the value added using appreciative inquiry.

Make Your Own Pickles

By using appreciative inquiry techniques, we can all build richer experiences and relationships with those we care about. When we are truly appreciative and inquiring, we want to ask questions that help us connect with others and appreciate the positives. This is the beginning of true conversation and discovering what’s truly important to that client. The next time you speak to your spouse or your child, instead of asking them, “How was your day?” try it differently with, “Tell me what was great about your day.” See what happens. See how they respond. See how you feel.

Frank J. Corrado, CFP®, CPA Holmdel, NJ