As noted by the Employee Benefit Research Institute, only 29% of today's retires have more than $100,000 saved and invested for their future. By contrast, 44% have less than $24,999. What do you need to do to ensure you end up on the right side of this spectrum? Saving 15% of your gross income, save early, and save often.

Would You Pass the Chalkboard Test?

Could you explain your investment strategy if you were handed a piece of chalk and directed to a chalkboard? How did you choose the investments within your portfolio? Common responses include, “I invested in what a friend or co-worker recommended,” or “I invested in what performed well last year.” For most, the honest response is a simple “I’m not really sure.”

At Net Worth Advisory Group, we believe an investor’s ability to adequately pass this “chalkboard test” is crucial to their long-term success. Saving for retirement requires a different investment approach than does ensuring that resources are available and secure over a short period. How can an investor be confident they are taking appropriate actions if they aren’t sure how they chose their investments?

Net Worth Advisory Group ensures that our clients are capable of passing the “chalkboard test.” This four-step process is how we recommend investors design their investment portfolios:

Step One: Asset Allocation – Stocks, Bonds, and Cash

This is the most important investment decision you’ll make because it has the largest impact on both risk and return. A simple approach to determine an appropriate mix of stocks vs. bonds is based on age (for example, take the number 110 and subtract the investor’s age; the answer equals the percentage of a portfolio to invest in stocks). An asset allocation based on age makes a portfolio more conservative at the appropriate time by reducing the allocation to stocks as retirement nears. Additionally, be sure to consider the risk associated with the asset allocation you choose. Examine how such an allocation performed during historical bear markets and be sure you can endure that degree of short-term loss.

The “bucket approach” is a more involved asset allocation strategy that considers spending needs. For more information on this strategy, view the second article in this month’s newsletter or click here.

Step Two: Diversification Across Different Asset Classes

A baseball team prepares by placing nine players across the field because they never know where the ball will be hit. Similarly, diversification of investments is important because we never know which asset classes will do well and which won’t.

Diversification lowers risk because it reduces the volatility of a portfolio. It creates ‘zig-zag’ relationships between asset classes so that when one investment is down, another will be up. These relationships are created by diversifying across asset category (stocks vs. bonds), size (large, mid and small cap), style (growth vs. value), and geography (U.S. vs. international).

The 2000’s are referred to as “the lost decade” for the S&P 500, but a diversified portfolio vastly outperformed the market as a whole. For instance, most stock categories lost nearly 40% in 2008, but government bonds gained 23%. Further, when the tech bubble burst in the early 2000’s, most growth stocks suffered but value stocks made huge profits. Clearly, diversification enables gains during bull markets while minimizing losses during market pullbacks.

Step Three: Selecting the Best Investments

If you decide to buy mutual funds, then you want to have criteria for how to select the best fund managers. Here are some of the standards Net Worth Advisory Group uses:

1. Determine the asset category, such as large cap growth or small cap value.
2. Find funds that outperform their peers. Look for funds that performed in the top 25% of their asset category over one, three, five, and ten year time periods.
3. Choose managers that have at least 10 years of experience.
4. Look for low expenses. Total fees, covering your financial advisor, investments, and transaction costs should be no more than 2%.
5. Make sure the fund outperforms its benchmark index (S&P 500 for large cap, Russell 2000 for small cap, etc.).

*Note: Net Worth Advisory Group often identifies the top mutual funds in each asset category and then purchases the individual stocks owned by those funds. This strategy is more cost effective and allows more control over the tax implications.

Step Four: Maintain, Review, Rebalance

Every six months you should tune-up your investment portfolio. Your allocation will get out of alignment over time because some assets will appreciate faster than others. When this happens you should rebalance to make sure you’re allocated properly and not taking extra risk. Always consider tax consequences and costs associated with rebalancing your accounts.

You should also review the performance of your investments to see if they’re still meeting the criteria you set. If a fund isn’t keeping up with its peers, then flag it and give it a chance to redeem itself. If flagged funds continue to underperform, then replace them with funds that meet your criteria.

As you conduct your routine checkups, make sure you maintain sound investment behavior. Don’t panic when you see the market experiencing a pullback. Remember, when you built your portfolio you accepted a certain amount of risk. If you used the bucket approach to determine your allocation then the money invested in stocks is for the long-term, so expect some short-term uncertainty. Stay the course and make minor adjustments when necessary.

Summary

This four-step strategy is the foundation of the static portion of client portfolios at Net Worth Advisory Group. This strategy can be supplemented by various tactical strategies, which you can learn more about by speaking with our advisors.

Our clients understand the investment strategies they are utilizing and can be confident they are appropriately pursing their retirement goals. If you or your financial advisor isn’t following a clearly defined strategy that you could express on a chalkboard, contact Net Worth Advisory Group for a portfolio upgrade to ensure your approach matches your goals.

The Bucket Approach

According to various studies, the first of which was published in Financial Analysts Journal in May, 1991, stock selection accounts for only 4.6 percent of investment returns, while market timing is responsible for only 1.8 percent. Meanwhile, the proportion of assets allocated to stocks, bonds and cash was found to account for 91.5 percent of investment returns.

Proper asset allocation ensures the portfolio represents the investor’s risk tolerance. If too much of the nest egg is held in stocks and the market tanks, the investor is more likely to panic and sell. In doing this, the investor buys high and sells low.

Picture three buckets. The first bucket should contain money that will be withdrawn from the portfolio within three years. The second bucket contains funds that will be used in four to ten years. And finally, the third bucket holds money that will not be needed during the next ten years.

The money in the first bucket should be invested in liquid, cash-type investments such as money market or savings accounts. This is short-term money which should not be exposed to market fluctuations.

The second bucket, holding intermediate-term money, should be invested in bonds. Although bonds fluctuate in value, they are not as volatile as stocks. However, bond returns are usually a significant improvement on cash-type investments. Constructing a bond ladder by purchasing bonds that mature each year will refill the cash bucket once a year.

The long-term money in bucket three is invested in stocks. This seven-year money is the growth portion of a portfolio and will fluctuate with the market. An investor doesn’t need to worry about a down year in the market because these stocks will not be sold for at least seven years, which is plenty of time for the market to recover. In fact, it took the U.S. stock market seven years to recover from the Great Depression. Thus, an investor utilizing this strategy would have survived the worst investment climate in history without selling assets at a loss.

This strategy provides a consistent source of income when it is needed. Money from the cash bucket can be used to meet living expenses, a bond will mature each year to replenish the cash bucket, and stock positions can occasionally be sold to replenish the bond portfolio. If the market has a poor year, stocks can be held for an extended period to avoid selling during a down market. This strategy will increase the probability that funds will be available to meet any planned expenses ranging from retirement, to business expenditures, to college tuition.

The market pullback of 2008 forced many investors to sell investments at an undesirable time. Speak to your financial professional about developing an asset allocation that represents your risk tolerance and provides sufficient liquidity to prevent having to sell your nest egg at a loss.

Are You Better Than The Average Investor?

The latest study conducted by DALBAR shows that from 1991 through 2010, the average equity fund investor realized an average annual total return of 3.8%, while the S&P 500 Index provided an average annual total return of 9.1%. Similarly, over the same time period the average fixed-income investor obtained an annual rate of return of just 1.01%, while the Barclays Capital U.S. Aggregate Bond Index returned 6.89%.

Research indicates that investment decisions can be affected by a variety of issues, including "herd mentality," overconfidence, pride and regret. There is also a tendency to respond much more strongly to losses than to gains, a tendency that drives many investors out of the markets during acute declines. Thus, this difference in returns is largely attributable to investors getting in when times are good -- essentially buying high and selling low.

The lesson here is that a consistent financial plan helps investors focus on the long term and avoid the type of habits displayed by the average investor.

Are Social Security Benefits Taxed?

Ever wondered if your Social Security benefit is subject to Federal tax? Well it depends on your annual household income. The following chart tells you how much of your Social Security benefit is taxed at various income levels:

Tax Rates - 2012 and Beyond

The following chart illustrates the Federal tax rates that will be applied to various income levels in 2012:

Additionally, the following standard deduction levels and personal exemption will apply to all 2012 tax filings:

Finally, the following chart details the changes in tax law that are scheduled to occur in 2013. Notice the increase in the capital gains tax, that dividends will be taxed as ordinary income, and that the top tax rates are scheduled to rise:

Consequently, it may make sense for some investors to recognize certain long-term capital gains or ordinary income in 2012 while rates are low.