For an explanation of rebalancing portfolios click here.

For an explanation of tax loss harvesting click here.

12.2	Definitions

12.2.1 Registered Investment Advisers

An understanding of this 12-Step Program for Active Investors may lead investors to believe they can do it on their own. They absolutely can if they wish, but working with an investment adviser is still recommended. Taking the steps to gain a knowledge base of what works and what doesn't work in the market is critically important, and every investor owes it to himself to learn this information. Knowing that money managers cannot beat the market over the long run is essential when choosing an investment method. Many investors decide to manage their own investments through the no-load index funds now available on the market through various mutual funds.

Although indexing can be done on one’s own, there is a high value to working with a qualified Registered Investment Adviser (RIA). Many RIA’s have been registered with the Securities Exchange Commission (SEC) and can provide valuable ongoing advice and education. A study by DALBAR Financial Services found that active investors who invest on their own are more apt to attempt market timing and less inclined to stay invested in a mutual fund for an average of 2.6 years. This is where the investment advisor can help. A good investment advisor supports the process of indexing, encourages long-term buy and hold and rebalancing strategies, advises prudent investing through the ups and downs of the market, and builds a long-term relationship with the client.

There are myriad advisory options available to today’s investor. This plethora of resources can be confusing and disconcerting for the average investor. It is often difficult to know whom to trust. Many investors seek advice from stockbrokers, insurance sales reps, or commissioned financial planners. These types of advisers are customarily paid to sell products rather than help investors solve problems or make wise investment decisions. Investors often question whose best interest these advisors have in mind - their own or the investors’? A commissioned based pay structure often sets up the appearance of a conflict of interest to the prospective investor.

In comparison, a fee-only adviser keeps the best interests of the client in mind, because neither the advisor nor any related party receives compensation that is contingent upon the purchase or sale of any financial products. These advisors provide investors with comprehensive and objective financial advice for a set fee that reflects a percentage of the market value of a managed client portfolio (often 1%). Since the fee is dependent on the size of the portfolio, both the adviser and the client make more money as the portfolio grows.

Index Funds Advisors (IFA) is a fee-only independent financial advisor that provides optimized wealth management by utilizing risk-appropriate, returns-optimized, and tax-managed portfolios of index funds. IFA founder, Mark Hebner and the team at IFA have done extensive research as shown on this web site and the #1 ranked book on index funds. This research leads our clients to the optimal money management strategy, net of our advisory fees and taxes. IFA completely avoids the futile and unnecessary cost-generating activities of stock, time, manager, and style picking.

The IFA advice is based on the highly respected research indexes designed by Eugene Fama and Kenneth French and documented in their empirical and peer-reviewed publications, including those ranked #1, 8 and 9 out of over 10 million downloads on the Social Sciences Research Network. Our current and independent advice incorporates 79 years of IFA Indexes and Indexfolio risk and return data, third generation index fund designs and 25 years of refined passive trading techniques employed by Dimensional Fund Advisors (DFA.) IFA does not accept payments from DFA or from any other recommended investments. IFA is exclusively paid by its 967 clients for its advice on the optimal wealth management of approximately $900 million in assets under management, as of April 2007.

IFA adds value through matching people with portfolios by carefully qualifying and quantifying 5 dimensions of an investor's Risk Capacity and matching it to 5 dimensions of a portfolio's Risk Exposure. This process produces investor-specific optimal returns by applying the IFA proprietary concept of 10dRisk™. IFA obtains academically identified capital market rates of returns for its clients from about 16,000 public companies in the U.S. and about 35 other countries around the world. IFA then designs highly tax-managed and low cost trading strategies, maintains ongoing proper risk exposures through rebalancing, manages cash inflows and outflows, and provides monthly and inception to date detailed measurements of client performance relative to the IFA Indexes and other traditional benchmarks. This ongoing reporting on performance, gains, income and tax reporting is exclusively available at IFA and adds significant value since measurement is essential to improvement. IFA also provides reports detailing its clients performance since the inception of the firm in 1999, compared to the client's risk-appropriate IFA Indexfolios and the very low dispersion among clients in each Indexfolio.

12.2.2 Dimensional Fund Advisors

Dimensional Fund Advisors (DFA) now makes their low cost, institutional index funds available to individual investors through DFA approved registered financial advisors. This is a great opportunity for investors, because these funds were previously available only to institutional investors. DFA’s funds are designed based on the principles of efficient markets, diversification, asset allocation, and the relationship between risk and return. DFA works with many of the top academic financial economists who provide findings and strategies based on empirical research. DFA also minimizes trading costs that negatively affect portfolio performance.

DFA funds provide investors with the following benefits:

• Engineered exposure to risk factors that generate higher expected returns
• Low expenses
• Low taxes, including tax-managed index funds
• Improved trading and engineering that adds value to portfolio construction
• Low turnover rates due to the passive investing approach
• Asset class persistence; no style drift

How is DFA different from Madoff?

• Dimensional is regulated under the 1940 Investment Company Act of 1940.  Madoff ran a hedge fund which was not regulated under the Act.  Mutual funds are probably the most highly regulated investment entity in existence.
• The client receives statements from Schwab or another custodian, not Dimensional.  Madoff was sending his own statements out.
• Schwab is independent of Dimensional.  When the client places trades, that money goes to Schwab.  Dimensional doesn't hold any client money.  The money never comes to Dimensional.
• Dimensional uses the largest independent accounting firm in the world, PriceWaterhouseCooper.  Their existence relies on the integrity, diligence and accuracy of their reporting.
• An Net Asset Value (NAV) is calculated every day.  There was no daily NAV calculated for Madoff’s fund.  PNC (for domestic) or Citibank (for international) calculates this based off of the actual holdings in the fund entity.  Schwab (or any other custodian that receives money from the client) does their due diligence to be sure that the shares of the fund they are holdings actually represent interests in a fund that holds the securities.
• PNC and Citibank are audited.  They are commercial banks and are also highly regulated.
• The assets held at DFA's custodian are separate from the custodians’ assets.  If PNC were to cease to exist, the funds would still exist independent of them.  The fund entity would be moved to another custodian.

Index Funds Advisors (IFA) is one of the many approved RIA’s approved to offer DFA funds to individual investors. IFA provides special online services and resources that educate clients on the principles of investing, including a Risk Capacity™ Survey that matches individual investors with specific portfolios that yield optimal returns. This matching is achieved by carefully measuring an investor’s Risk Capacity™ and risk exposure. A Risk/Return Calculator and a Portfolio Simulator are also provided to compare the expected risk and returns of all 20 Index Portfolios to alternative investments.

12.2.3 Rebalancing Portfolios

Rebalancing a portfolio is very important maintenance strategy to achieve risk control and long-term investing goals. It is best for an investor to hold a portfolio that matches their Risk Capacity™, a concept that can best be measured through a Risk Capacity Survey. An annual checkup of risk capacity is a prudent time interval. Periodic rebalancing must be done to maintain a portfolio’s asset allocation or risk exposure and to ensure that the portfolio continues to reflect the level of risk an investor has the capacity to hold.

For example, after a thorough evaluation of risk capacity, an investor may be matched to an index portfolio of 65% equities, 35% fixed income. After a year of increased equity prices, the equity portion of the portfolio rises to 75%, with fixed income at 25%. Or after a market decline, you may discover that your allocation is now 60% equities and your fixed income is 40%. These shifts in asset allocation are to be expected, as index values change at different rates. Rebalancing back to the initial or target allocation keeps the portfolio at a consistent risk exposure and therefore, at a somewhat consistent expected return. In either example, a certain set of rebalancing trades would correct the asset allocation back to 65% equities and 35% fixed income.

Rebalancing on average involves selling equities high and buying low. Many investors make the costly mistake of doing the opposite, buying high and selling low, resulting in a misalignment of risk capacity and risk exposure. Selling indexes that have performed well and buying more of the indexes that have performed poorly is often an emotionally difficult task for investors, as it seems counterintuitive. This resistance to rebalancing often leads investors to either do nothing, or even worse, to sell the losers and buy more of the winners, going completely against the prudent investment principle of rebalancing. A portfolio that becomes more or less risky due to lack of rebalancing also leads to less than optimal returns, defeating the purpose of investing in a risk appropriate portfolio in the first place.

According to Michael Rosenbald at Washingtonpost.com, an AllianceBernstein survey of 1,000 investors showed that nearly 40% of investors without an adviser did not have an approach for allocating and rebalancing investments. Some 55% of those people reported that they never got around to doing it. Most startling: 70% of investors, including those with an adviser, said they are prone to change their hairstyle more frequently than they rebalance their portfolio.

Figure 12-1



There are certain times when it is wise to consider changing index portfolios because of a change occurs in the investor’s capacity for risk. These times include:

   a) when investment goals change
   b) when income level significantly changes
   c) when number of dependents changes
   d) at retirement
   e) when life conditions change - medical, emergencies, marriage, divorce, etc.

To determine the impact of these changes, it is best to take the risk capacity survey again and review the results with an investment advisor.

  

12.2.4 Rebalancing Formula

The logic behind rebalancing is that it maintains a consistent level of risk exposure. There are several rebalancing formulas that are used in the investment industry. Although rebalancing is necessary to maintain risk, it can incur transaction fees and taxes. A good rule of thumb is to test a portfolio quarterly and rebalance when necessary, which typically occurs about once a year. In addition, an investor's risk capacity should be measured once a year or upon any significant change in their lives.

What is considered a “need to rebalance” depends on what formula is used. One common approach is the 5 percent/25 percent variance trigger. This rule states that it is time to rebalance when a general asset class either a) moves an absolute 5% or b) 25% from its original allocation percentage, whichever comes first. Rebalancing among several taxable and tax-deferred accounts is a very complicated process, but necessary so that all assets can be considered. Highly sophisticated software is required with many factors to be considered, such as the need for liquidity versus the need for reduced volatility. This information has a significant impact on the tax liabilities generated by the placement of indexes in different accounts. Rebalancing is made easier when there are routine deposits or withdrawals from the portfolio because rebalancing can be achieved with the cash flows.

The 5/25 rule is best used as a flag to indicate that a portfolio should be reviewed for the possibility of placing rebalance trades. Whether trades actually get placed depends on the trades accomplishing the objective of risk control, aligning the risk exposure of the portfolio with the risk capacity of the investor. Specifically, since risk is the source of returns, the trades should result in one of the following scenarios:

1. An increase in the portfolio’s risk level back to the target allocation (which normally occurs when fixed income is sold in order to purchase equities).
2. A decrease in the portfolio’s risk level back to the target allocation (which normally occurs when equities are sold and fixed income is bought).

The potential benefits of the trades must be considered against the cost of placing trades and the potential tax consequences. In particular, short-term gains should be avoided whenever possible. In general, selling one class of equities to purchase a different class of equities does not result in a significant change in the portfolio’s risk level, as measured by the long-term historical standard deviation of returns.


12.2.5 Tax Loss Harvesting

In addition to rebalancing, taxable investors should also consider a tax-savings tool called tax loss harvesting. A market downturn provides you with an opportunity to examine your specific situation and to identify whether you can save on a future portion of ordinary income (as shown below) and on capital gains taxes that are generated each year due to distributions from your mutual funds, rebalancing of your portfolio, or the sale of funds for your cash needs. Each year taxable accounts will generate some capital gains. As noted in an on-line financial dictionary, “For many investors, tax gain/loss harvesting is the single most important area for reducing taxes now and in the future.”

Because of the tax offset value of realized capital losses, investors should consider the following strategy after stock markets have experienced a decline:

1. Sell those index funds in your taxable accounts that have declined in value by approximately 10% or more and have a minimum capital loss of about $10,000, based on your average cost basis. This sale will create a realized short term capital loss on the sold funds held for less than 12 months and a long term capital loss on sold funds held more than 12 months.

2. Then immediately invest the proceeds of the sale into a substantially different broad market index fund, such as the S&P 500 (if you are not selling the S&P 500). Please note that many index funds (especially those without transaction costs) have a minimum holding period requirement. For example, the Schwab S&P 500 funds (SWPPX and ISLCX) carry a 2% redemption fee on shares held less than 30 days. Also, since the exact value of proceeds will not be known until the close of the market, about 85% of the proceeds will be invested the same day and the remaining 15% will be invested subsequently.

3. Purchase the original funds back on or after 31 days from the sale of the original funds. This 31 day period avoids the IRS Wash Sale Rule (see p. 55 of this pdf). The IRS Wash Sale Rule states that a wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you: 1) buy substantially identical stock or securities, 2) acquire substantially identical stock or securities in a fully taxable trade, or 3) acquire a contract or option to buy substantially identical stock or securities. If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale. If you buy the substantially identical stock in your IRA, you also have a wash sale. (more on this subject)

After the 31 days, your portfolio will also be reviewed and traded as needed for the purchase of the sold funds and rebalancing, so that your overall risk exposure will be in approximate alignment with the asset allocation of your original index portfolio. Whenever IFA invests additional cash deposits or sells funds for withdrawals, we review the portfolio for rebalancing needs.

4. Report the realized capital losses to your accountant to offset future capital gains and a portion of your income, reducing future tax bills. A gain/loss report from your custodian and/or IFA will indicate the gains and losses for the tax year. Individuals can use up to $3,000 of capital losses to offset their income ($1,500 for a married person filing separately). If you realized $10,000 in capital losses, a taxpayer would be able to apply $3,000 of their net capital loss to reduce their taxable income by $3,000, leaving $7,000 in unused net capital loss. Unused capital losses can also be carried over until they are used up. If net long-term capital loss exceeds net short-term capital gain, the excess becomes long-term capital loss in the following year. If net short-term capital loss exceeds net long-term capital gain, the excess becomes short-term capital loss in the following year. The value of these tax offsets will vary with your income, your existence of long or short term capital gains, changes to the tax code and your state of residence. (see US Income Tax/Capital Gains and Losses)

Tax loss harvesting is not market timing. By transferring the money into another index fund or exchange traded fund, such as an S&P 500 index fund or ETF, investors can remain approximately fully invested (the first day is slightly less because we do not know the exact settlement price of the sales) in a broad market index that is not a substantially identical stock or security.  Additionally, certain custodians charge no transaction fees when you buy and sell their specified S&P 500 index fund. However, there are transaction fees to be paid to the custodian (Schwab, Fidelity or TD Ameritrade) for the sale and purchase of most mutual funds or ETFs. No additional compensation or fee is paid to the investment advisor (IFA).

While tax loss harvesting is a valuable tool, there are some risks associated with it. As such, one should carefully consult with a financial advisor prior to making the decision to tax loss harvest. Examples of such risks include:

1. If you sell funds at a 10% long term capital loss, buy the S&P 500 index fund and it increases by more than 5% during the 31 day interval, the value of a 10% realized long term capital loss could be offset by a 5% realized short term capital gain from the sale of the S&P 500 fund (assuming a 35% tax rate on short-term gains and ordinary income, and 15% on long-term gains, but not considering your additional state tax, if any). There is about a 20% probability of this occurring, based 50 years of monthly S&P 500 data. For this reason we will only sell funds, or combination of funds, that have losses of about 10% or more. 

If you have a 10% short term capital loss from your sale, a 10% short term capital gain from the S&P 500 index fund will be required to offset the tax benefit and it is extremely unlikely that the S&P 500 will increase by 10% in one month. In fact, over the last 50 years, the S&P 500 index has increased 10% in one month only 1.7% of the time.

2. During the minimum 31 day interval required to keep the loss, the S&P 500 index fund, or other substitute broad market fund, will almost certainly obtain a different return than the funds you sold, because they are different indexes and not substantially identical stocks or securities. This risk is the only reason the IRS allows this loss to be kept by investors. Due to the short interval of 31 days, the difference in value should be small, but there is a risk of it deviating more than 3%, which may be in excess of the tax benefit of the harvested loss, depending on your state residence. The chart below shows the frequency with which various asset classes beat the S&P 500 by 3% or more, based on 50 years of monthly returns. Over the last 50 years ending 2007, Index Portfolio 90's (an allocation of 11 equity indexes) average monthly return has been 1.14%, with a standard deviation of 4.01%, while an S&P 500 index fund has averaged 0.95% with a standard deviation of 4.13%. On a purchase of $100,000, you would expect the S&P 500 fund to earn about $190.00 less than Index Portfolio 90 over a 31 day period, with a variance relative to the standard deviation of the monthly returns. However, it would be rare that the variance exceeds $2,400, which is the approximate tax credit value of a $10,000 harvested long term capital loss for a California resident (other states will vary). If that occurs, the tax loss harvesting trades would have been done with no benefit to the investor and possibly at a cost. You should be aware of this risk before you pursue any tax loss harvesting.

Figure 12-2


3. There are transaction fees to be paid to the custodian (Schwab, Fidelity or TD Ameritrade). No additional fee is paid to the investment advisor (IFA).

Despite the risks mentioned, IFA frequently advises clients to harvest losses under the conditions described above. Of course, your decision to tax loss harvest should be carefully weighed and discussed with your accountant and a qualified fee-only advisor who carries the fiduciary standard to act in your best interest. If you would like to take advantage of IFA’s expertise in tax loss harvesting, or simply learn more about whether such action is appropriate for you, please call 888-643-3133 to speak with one of our many qualified investment adviser representatives.

Any tax or legal information provided is a summary of our current understanding and interpretation of the current income tax regulations and is not exhaustive. Investors should consult their tax advisor or legal counsel for advice and information concerning their specific situation. Neither Index Funds Advisors, Inc., nor any of its representatives, may give legal or tax advice.


12.2.5a Mutual Fund Distributions


Once you are invested and relaxed, an understanding of distributions of dividends and capital gains is important for taxable investors.

Dividend distributions normally occur quarterly for equity funds (monthly for fixed income funds) and the final quarter of the year is the highest because it also includes capital gains distributions. Fortunately, index mutual funds have a lower tax impact than actively managed mutual funds, so it is relatively less of a concern. The tax implications are only important for taxable accounts. The dates that affect distributions from mutual funds are as follows:

Record Date (for example: 12/09/08) - If you owned the fund making a distribution on this date, the Ex-Dividend Date and Payable Date amounts will apply to you.

Ex-Dividend Date (for example: 12/10/08) - This is when a particular fund makes adjustments for its planned distributions to Shareholders. The value of your account temporarily declines because the NAV (Net Asset Value) of each fund is reduced by the planned amount of distribution on the Payable Date.

Payable Date (for example: 12/15/08) - This is last date when the fund is required to pay the distribution to shareholders, although is most often actually paid earlier. The distribution amount is reinvested automatically in additional shares of the fund (unless you have chosen to receive them in cash).

1) Your account net value will be unchanged because the NAV for each fund is temporarily reduced on the Ex-Dividend Date, but then distributions are reinvested in additional shares (at the lower NAV) on the Payable Date, resulting in an account increase amount equal to the distribution, so it is "a wash" for the value of your account.

2) (For Taxable Accounts Only) Your taxable gains are increased by the distribution amounts whether paid in cash or reinvested. Even if you bought the fund shortly before the taxable distribution, the tax applies to you. This is the process that mutual funds are required to follow to pass along profits to shareholders. Because you are paying taxes on distributions, a positive result is that your cost basis increases by that amount so that future taxes are lower if you eventually sell the fund.

It is IFA’s practice to withhold purchasing those funds in taxable accounts whose estimated tax hits exceed their average return (over the last 50 years) for the time period in question. The estimated tax hits are calculated from the estimated distributions provided by the mutual fund company. For the DFA funds used by IFA, the currently anticipated 2009 “stop buy” dates are as follows:

November 9th: Two Year Global (DFGFX), Five Year Global (DFGBX), Global Real Estate (DFGEX) and Five Year Government (DFFGX).
December 7th: All remaining DFA Funds

This is not intended to be a complete explanation of the distribution process, or tax guide, and you should consult your Tax Advisor for your specific situation. (See more information here.)

12.2.6 Financial Advice

Financial advice is a prescription that guides investors to make decisions that best serve their interests. This advice is most effective when the following are carefully taken into consideration.

1. An accurate analysis of the cognitive and emotional strengths and weaknesses of investors that relate to making decisions.

2. The investor's occasionally faulty assessment of their own interests and desires.

3. The relevant facts about investing that are often ignored.

4. The limits of the ability to accept advice and to accept the results of the decisions made over time.

In the article titled Aspects of Investor Psychology by Daniel Kahneman and Mark Riepe that appeared in a 1998 edition of Journal of Portfolio Management, a very good checklist of the responsibilities of investment advisors was provided. It is useful in evaluating which advisor may be best for you. The authors asked, "How frequently do advisors do each of these items?"

1. Encourage clients to adopt a broad view of their wealth, prospects and objectives.

2. Encourage clients to make long-term commitments to investment policies.

3. Encourage clients not to monitor results too frequently.

4. Discuss the possibility of future regret concerning the outcome of their investments.

5. Ask themselves if a course of action is out of character for their client.

6. Verify that the client has a realistic view of the odds, when a normally cautious investor is attracted to a risky investment.

7. Encourage the client to adopt different attitudes towards risk for small and for large decisions.

8. Attempt to structure the client's portfolio to the shape that the client likes best (such as insuring a decent return with a small chance of a large gain). This can be accomplished in a well prepared Risk Capacity™ survey.

9. Make clients aware of the uncertainty involved in investment decisions.

10. Identify the aversion of clients to the different aspects of risk and incorporate their risk aversions when structuring an investment program.

It is clear from step one that if investors want to discover their most likely deterrent to successful investing, they need only to look in the mirror. Advisors who are aware of the above psychological factors are most likely to provide value to their client's investing experience. (See this additional article on Behavioral Finance)

In looking at the overall wealth management of an investor's estate, at least four other areas of concern are important for every investor. An independent team approach is best so that each professional is free to be critical of the others. If these are all at the same firm, you can be far less certain that you will get independent advice. An annual "Personal Board of Directors" meeting is a great idea for this team. The team should have professional in each of these areas:

1. Estate Planning:

Interview at least 3 estate planning attorneys in your area and select one that you feel comfortable with. Have the attorney prepare or review your trusts and wills. Be sure to evaluate the role of Charitable Giving and wealth transfer to children, families and/or charities. An IFA representative can assist you in evaluating attorneys. In California, we often refer clients to Leslie Daff. Also see the National Association of Estate Planners and Councils.

2. Insurance:

Find an independent insurance consultant who is not paid by any insurance products. This fee-only insurance advisor can assist you in selecting insurance products without the traditional conflict of interests that exist with insurance brokers for specific insurance products. You may need specialists that cover different insurance needs. Firms like An IFA representative can assist you in evaluating insurance consultants. Here are some examples of Fee-Only Insurance Advisors.

Scott J. Witt (WI)          www.wittactuarialservices.com
Peter Katt (MI)              www.peterkatt.com
David Barkhausen (IL)   www.lifeinsuranceadvisorsinc.com
James Hunt (NH)           www.EvaluateLifeInsurance.org
Glenn Daily (NY)           www.glenndaily.com

3. Accounting and Tax Advice:

Interview several accountants in your area and select one that you feel comfortable with. Accountants who are proactive in tax planning strategies will be able to make sure you are not paying more taxes than you should. An IFA representative can assist you in evaluating accountants. The IRS issued this Tax Tip on January 13, 2009 concerning the choosing of a tax preparer.

Read This Before Choosing a Tax Preparer (from the IRS)

If you will be paying someone to do your tax return, choose a tax preparer wisely. You are legally responsible for what’s on your tax returns even if they are prepared by someone else. So, it’s important to find a qualified tax professional.

The most reputable preparers will request to see your records and receipts and will ask you multiple questions to determine your total income and your qualifications for expenses, deductions, and other items.  By doing so, they have your best interest in mind and are trying to help you avoid penalties, interest, or additional taxes that could result from later IRS contacts.

Most tax return preparers are professional, honest and provide excellent service to their clients; you can use the following tips to choose a preparer who will offer the best service for their tax preparation needs.

• Find out what the service fees are before the return is prepared. Avoid preparers who base their fee on a percentage of the amount of your refund or who claim they can obtain larger refunds than other preparers.
• Only use a tax professional that signs your tax return and provides you with a copy for your records.
• Avoid tax preparers that ask you to sign a blank tax form.
• Choose a tax preparer that will be around to answer questions after the return has been filed.
• Ask questions. Do you know anyone who has used the tax professional? Were they satisfied with the service they received?
• Check to see if the preparer has any questionable history with the Better Business Bureau, the state’s board of accountancy for CPAs or the state’s bar association for attorneys. Find out if the preparer belongs to a professional organization that requires its members to pursue continuing education and also holds them accountable to a code of ethics.
• Determine if the preparer’s credentials meet your needs.  Does your state have licensing or registration requirements for paid preparers?  Is he or she an Enrolled Agent, Certified Public Accountant, or Attorney?  If so, the preparer can represent taxpayers before the IRS on all matters – including audits, collections, and appeals.   Other return preparers can represent taxpayers only in audits regarding a return signed as a preparer.
• Before you sign your tax return, review it and ask questions.

You can report suspected tax fraud and abusive tax preparers to the IRS on Form 3949-A, Information Referral, by sending a letter to Internal Revenue Service, Fresno, CA 93888, or call 800-829-3676. 

4. Investment Advisors:

Three critical characteristics of investments advisors include independence from all financial products and custodians, the exclusive application of a passive investment strategy and a fair price for their advice. An IFA representative meets all three of these criteria.

5. Life Planning:

Life planning is the art or human side of financial planning. In life planning you discover important goals through a process of questions. Then, using a mix of professional and relationship skills, an advisor resolves the obstacles to those goals, creates a plan, and guides you to the accomplishment of these goals in the most efficient and fastest way possible. At its core, Life Planning encourages investors to be sure they have asked and answered the fundamental question of, “what’s it for – all this money that I’ve given so much to acquire, what exactly is it for?”  Stephen Covey encourages “beginning with the end in mind” in his work around The Seven Habits of Highly Effective People.  With a better idea of your end-destination in mind, future financial planning decisions including portfolio risk exposure become both more relevant and holistic. George Kinder has pioneered and promoted Life Planning for about 15 years. He suggests that investors carefully answer these three questions. Once you have answered them in writing, your investment advisor will be better guided in assisting you to meet your life goals that apply to areas such as family, creativity, spirit, and service. Here are the three questions:

1. Assume you’ve got all the money you need. What would you do with it and how would you live?

2. You just found out you have only five to 10 years to live. How will you live those years?

3. You’ve just found out you have 24 hours to live. What did you miss? Who did you not get to be? What did you not get to do?

If you would like a good guide to charitable giving, visit the Charity Navigator. Donors often withhold giving because they are concerned the organization is not using the funds in a way they would think is appropriate. Is the CEO being paid more than you think is reasonable? Are the administrative costs to high as a percentage of donations? How does your charity's expenses compare to others. These and other important issues are answered at Charity Navigator. Please review this site before giving.



6. People and Portfolios: The Glidepath of Life:

The chart below is designed to be a hypothetical illustration of an individual’s financial glidepath through life. It illustrates the transistion from living off of your labor (Human Capital) to living off your savings (Financial Capital). Here are the assumptions for the calculation of Human, Financial and Total Capital.

Human Capital is defined as the present value of an individual’s future earnings. Of course, your salary, bonuses, inheritances, talents, skills, education, health and other factors throughout your life will likely vary from our assumptions. (see Human Capital)

Financial Capital is defined as the current value of an individual’s retirement savings.

Total Capital is the sum of human and financial capital and, hopefully, will stay constant or even increase over your life.

We assume that an individual begins working at age 22, retires at age 67 and lives until age 95. Full retirement age had been 65 for many years. However, beginning with people born in 1938 or later, that age gradually increases until it reaches 67 for people born after 1959.

Our hypothetical wage earner’s starting salary is $35,000/year and increases with inflation at 3% annually until retirement at age 67, when it reaches about $132,000. We assume an annual savings rate of 8% of gross salary (but you should strive for 10%), which is contributed to the Financial Capital and invested in the corresponding IFA iPortfolio shown. Every 5 years, the risk level drops down 5 risk units on a scale of 100 iPortfolios.

The retiree withdraws 6% per year of the accumulated Financial Capital to fund their annual expenses. Please note that a 6% withdrawal rate only meets the portfolio survival test for IFA clients, using the IFA index portfolios. Don’t try this alone at home, because lesser quality portfolios and investor misbehavior normally requires a 4% or less withdrawal rate and industrial strength emotional discipline is needed to adhere to this passive investing strategy over the entire glidepath.  The 6% withdrawal approximately replaces the paycheck and starts at about $120,000 in golden years of retirement. Expenses should be adjusted to 6% of the annual value of the Financial Capital throughout retirement.

The rate of return assumed on Financial Capital is determined by using the 81-year historical annualized returns of the changing IFA index portfolios indicated along the glidepath, which is a conservative annualized return because the period begins in 1928 and includes the Great Depression (see www.ifabt.com). If you think there will not be another Great Depression, then your Financial Capital may be higher than shown. Again, don’t try this at home alone. According to Morningstar, even do-it-yourself indexers, who understand many advantages of index funds, have been shown to only capture 82% of the index fund’s returns, due to bad investor behavior. Worse yet, other active equity fund investors have demonstrated that they capture less than 20% of what an advised index investor earns.

We assume that at a given age, the investor is invested in the IFA iPortfolio that corresponds to 100 minus the investor’s age rounded to the nearest increment of 5 and changes down one index portfolio every 5 years during their life. This 100 minus your age rule is a very rough approximation of the risk capacity and risk exposure levels for investors. Very high risk capacity investors could add approximately 20 and low risk capacity investors could subtract 20 or more from the index portfolio number. To determine your risk capacity and a corresponding risk exposure in the form of an IFA iPortfolio, please take the Risk Capacity Survey.  To personalize a retirement plan for your situation, see the Retirement Planner below this chart.

Figure 12-3



7. Retirement Planner

Do you know what it takes to develop a secure retirement? Use this calculator to help you create your retirement plan.  But before you do, here is some basic advice.

Save at least 10% of your annual income while you are still working. Once you retire and start replacing your employment income with withdrawals from your retirement savings, limit those withdrawals to about 5% of the total value of your various accounts. Clients of IFA should be safe at 6% withdrawal rates.

In other words, employees should strive to have about 20 times their annual income at the time of retirement in savings prior to retirement. If you are making $100,000 in your last year of employment, you should have about $2,000,0000 in savings, so that the 5% withdrawals will be close to the 5% or more you earn on your portfolio in retirement. You should plan on paying your taxes out of the 5% withdrawals. As you will see in the calculator below, Social Security and the percentage of your last year of income spent in retirement can alter this rule of thumb, however, you are more likely to under save and over spend. Finally, Murphy's Law does not work in your favor, so the Save 10% and Spend 5% Rule is still great advice.

For Rate of Return Before and During Retirement, a quick estimate can be found by taking 100 minus Your Age, then rounding off to the nearest unit of 5. For example: 100-57= 43, rounded up 45 and see iPortfolio 45. Click on your choice of Index Portfolio on the top navigation bar. Look up the 50 year annualized return of that iPortfolio in Figure 2 on that page and enter it as the Rate of Return, or be conservative and use the 81 year return. For example, iPortfolio 45 has a 50 yr annualized return of 9.16% as of the 50 years ending 2008. For a more accurate estimate, take the Risk Capacity Survey and review the results with an IFA advisor. On average, the iPortfolios should be reduced every 5 years to the next lower portfolio, as shown above.

Click the View Report button below the Planner to get a printable report of several retirement account balances per year, based on your inputs. View your retirement savings balance and your withdrawals for each year until the end of your retirement. Social security is calculated on a sliding scale based on your income. Including a non-working spouse in your plan increases your social security benefits up to, but not over, the maximum.

 

 

12.3

Problems

12.3.1 Active Investors Procrastinate

It is often said that investors procrastinate when it comes to changing their investments. Once a prudent strategy has been identified, investors need to take action and move their investments to the new strategy that meets the four acid tests of expected risk, expected return, expenses, and taxes.

12.3.2 Active Investors “Go It Alone”

A second problem is that investors get in their own way of success. As the legendary investor Benjamin Graham stated, “The investor’s chief problem, and even his worst enemy, is likely to be himself.” An investor may want to consider the fees paid to an index fund advisor as a casualty insurance premium, insuring the investor against himself.

12.3.3 The Media Wants Investors to Worry

The media has a propensity to alarm investors with hyped messages of gloom and doom and make people feel they need to rely on financial news shows and investment gurus for minute to minute updated information on the stock market. It benefits the media to have investors hooked into financial and economic news stories and articles.

This 12-Step Program teaches investors that index funds investing does not require constant vigilance, following daily returns, or listening to today’s star money managers. Readers have learned that prudent investing means not worrying about the ups and downs of the market. It means being able to invest and relax.

    Asset Class Allocation
Research has shown that asset class allocation is the most important factor in determining a portfolio’s expected return level. In fact, asset allocation is 100% responsible for the variance in investment performance. Since an index fund is invested solely in the securities or fixed income (positions) that comprise a discrete asset class, it possesses the same rules of ownership, characteristics, and expected performance of the comparable index.

Indexing makes it easier to rebalance and maintain a consistent asset allocation over time, rather than participate in the style drift of active management. An actively managed fund generally does not stay invested in the same asset class, so it cannot reliably capture the performance of any particular asset class. Active managers often buy and sell their fund’s securities due to the pressure to outperform the market, which results in high trading costs and the adverse effects of style drift.

    Minimization of Investment Costs
Index funds have minimal investment costs. They do not have the high annual operating expenses of active funds. These consist mainly of investment advisory fees that compensate an active fund for its manager’s efforts at stock picking and 12b-1 fees that reimburse it for its sales and marketing costs. Index funds also do not have the high trading costs characteristic of many active funds. Most of these costs are due to the efforts of active fund managers to implement their stock picking ideas to beat the market. Finally, very few index funds charge commission loads, while most active funds carry some type of load.

The investment costs associated with active funds have generally increased over the last decade, while those of index funds have decreased steadily. Although there is always the natural possibility that this gap will narrow in the future, all evidence indicates just the opposite. The investment advantages of low costs do not depend on Lady Luck.

    Minimization of Taxes
By maintaining low portfolio turnover, index funds minimize realized capital gains, which keeps capital gains taxes low. Minimization of capital gains taxes results in a comparatively small difference between an index fund’s pre-tax and after-tax performance. This makes an index fund a tax efficient investment. In fact, investing in index funds, especially tax-managed index funds, results in such low taxation that it is almost like putting your entire portfolio into an IRA. The best way for a taxable-basis investor to minimize taxes and thus more efficiently compound investment wealth is to assemble a portfolio of index funds and keep it for life.

Managers of active mutual funds typically manage money as if taxes don’t matter. As a number of studies have shown, however, taxes do matter. They actually have an enormous negative impact on investment performance. Investors who ignore this and invest in active funds are relinquishing money to Uncle Sam that could otherwise be available to compound into future wealth.

    Reliable Investment Performance
An investor who holds a portfolio of index funds is assured of the reliable investment performance of free and efficient financial markets. An index fund invested in an asset class will always earn the returns of that asset class. Thus, indexing is an investment strategy that delivers what it promises to investors.

In comparison, the returns of active funds are erratic and less reliable than index funds, sometimes outperforming the market and sometimes underperforming it. These variations in performance are caused by the market’s unpredictability. They can also result from style drift, when the fund manager modifies the fund’s asset class mix.

Both U.S. and international financial markets are becoming more efficient, which indicates that investors and money managers who engage in stock picking and time timing must take greater and greater risks to beat the market. The more educated investors become on the efficiency of markets, the more that active money managers will have to defend their investment strategies to try to beat the market.

    A Simple and Understandable Investment Strategy
Since indexers realize they cannot beat the market, they can focus on building wealth over the long run by holding efficient, globally diversified portfolios. Passive investors stay with their investments and rebalance only when necessary in comparison to active investors who constantly seek ways to beat the market, spending a lot of valuable time reading investment newsletters, reports, magazines, and other media driven publications.

    An Easier Way to Track Investment Performance
Tracking the performance of index fund portfolios against their respective benchmarks is simple, since the return earned by an index fund reflects the return of the comparable index. On the other hand, the performance of active funds is more difficult to track against any benchmark. Although many funds are compared to the S&P 500, it is not an accurate comparison.

    Increased Leverage and Compounding of Investment Wealth
Indexers can leverage their funds and thus more efficiently compound investment wealth. Since index funds carry no cash reserves, indexers are invested 100% in the market at all times. Indexers are also better able to leverage their funds because they can keep the money invested that an active investor would need to pay the commissions and high annual expenses and taxes associated with active mutual funds. Seemingly small amounts of money continually compound through the years and help to accelerate the accumulation of wealth for indexers.

    Invest like Institutional Investors
Large institutional investors such as corporate pension plans and educational endowment funds that invest billions of dollars can certainly afford to hire any money manager in the world. Yet they continue to index a significant portion of their investments. Individual investors can follow the example of these institutions and reap the same benefits by investing in DFA funds.

12.4

Solutions

Invest in Index Mutual Funds

The 12-Step Program to Index Funds has been written for investors who are engaged in any active investing practices, including stock picking, time picking, manager picking, or style picking, with the intent of educating and motivating the active investors of today to transform into active investors of yesterday.

This Program has provided research and education about the advantages of indexing over active investing. The information that has been presented shows clearly why index funds are best for achieving investors’ goals. With index funds, the stress and pressure of investing melts away, allowing the investor to receive the market returns of a diversified portfolio that is matched to Risk Capacity™, all at a very low cost. Stepping off the emotional roller coaster of active investing, a recovering or reformed active investor experiences a new peace of mind. Instead of panicking, an index funds investor can now invest, relax, and go to the beach.

In order to invest, Index Funds Advisors would be honored to assist you.  Because we have demonstrated our understanding of Modern Finance, we have been approved by DFA to purchase their mutual funds for our clients.  These funds are not available directly to individual investors.  They are designed and priced for large institutional funds.  We think of it as an investment club for the "really smart money."

Through our custodians, Charles Schwab, Fidelity Investments or TD Ameritrade, we can purchase these funds for your brokerage or 401k account.  We will need to speak to you, deliver the necessary documents to you, such as our ADV, and assist you in establishing an account with us.  Each quarter we will review your portfolio and rebalance the asset allocations as needed. If you have any questions, please call us toll free at 888-643-3133.

12.5

Summary

With index funds, the stress and pressure of investing melts away, allowing the investor to receive the market returns of a diversified portfolio that is matched to risk capacity, all at a very low cost. Stepping off the emotional roller coaster of active investing, a recovering or reformed active investor experiences a new peace of mind. Instead of panicking, an indexer can calmly invest without fear or tension.

Just like with the original 12-step program, the first step is to admit you’re powerless and your life has become unmanageable. In this case, the admission of powerlessness is a lack of control or prediction of the market movements. The climbing of the 12 steps leads investors to the light of intelligent risk management and a realization that active investing is a losing game. The painting below depicts this journey.

Painting title: Journey to Tradeless Nirvana

When investors reach this pinnacle of investing insight, they are well on their way to entering what we like to call "Tradeless Nirvana."

"Don't just do something, sit there!" IFA President, Mark Hebner, visits the NYSE and finds Tradeless Nirvana.

Congratulations on completing the 12-Step Program! It’s now time to take action, so you can invest and relax.

12.6	Review Questions

Please answer the following questions before moving on to the next Step.

1. Which is NOT a fundamental principle of prudent investing?

    a) stock picking
    b) the need to build efficient portfolios
    c) the importance of long-term investments
    d) passive investing with index funds

   

2. Why should a portfolio be rebalanced?

    a) To keep risk exposure matched with Risk Capacity™
    b) Market changes may change the balance of the portfolio
    c) An investor’s financial situation or investment goals may change
    d) Because all the day traders think it’s a good idea
    e) a, b, and c

   

3. The most efficient way to invest is:

    a) Pick your 5-10 favorite stocks and trade on these as frequently as possible.
    b) Buy the stocks that have performed the best over the last six months.
    c) Join an investment club.
    d) Invest in a globally diversified portfolio of index funds, and invest for the long run.
    e) Invest only in Treasury bills and Certificates of Deposit.

   

For a review of the 12-Step Program, watch Mark Hebner give an impromptu discussion on the program. We apologize for the low quality of this video. More video presentations on the 12-Steps can be found here and here.
Now that you have completed the 12-Step Program for Active Investors, you can send an e-mail with your phone number to info@ifa.com. We will call you to review your Risk Capacity™ Survey and to better understand your complete circumstances relative to your portfolio.