Lessons

The charm of history and its enigmatic lesson consist in the fact that, from age to age, nothing changes and yet everything is completely different.- Aldous Huxley

I like Jeffrey Saut of Raymond James. I think his market analyses are some of the best around. He tends to be a bit too bullish for me but then again he comes from the sell side where that bias is expected and encouraged. You just have to know who you are reading. That thought is evident from my prior post on Jeremy Grantham.

Saut penned a great January piece called "Lessons" that I intended to get up in, well, JANUARY, but it somehow slipped through the cracks. Sometimes when that happens (me forgetting not Saut writing something good) I confine the piece "to the dustbin of history". Not this one. It's good enough to revive. Here it is:

Lessons
January 4, 2009

Year-end letters are always hard to write because there is a tendency to talk about the year gone by, or worse, attempt to predict the year ahead. Therefore, we are titling this year’s letter “Lessons” in an attempt to share some of the lessons that should have been learned over the past year. We begin with this quote from an Allstate commercial featuring Dennis Haysbert:

“Over the past year, we’ve learned a lot. We’ve learned that meatloaf and Jenga can actually be more fun than reservations and box seats. That who’s around your TV is more important than how big it is. That the most memorable vacations can happen ten feet from your front door. That cars aren’t for showing how far we’ve come, but for taking us where we want to go. We’ve learned that the best things in life don’t cost much at all.”

Charles Dickens’ classic novel A Tale of Two Cities begins with the quote, “It was the best of times, it was the worst of times.” That quote is certainly reflective of the stock market in the year gone by as 2009 should go down in the books with that moniker. To be sure, 1Q09 was ugly with the S&P 500 (SPX/1115.11) surrendering nearly 30%. From those March “lows,” however, the SPX has gained some 69%. For those that targeted the “lows” it has been a great year. For those that didn’t, it has truly been “the worst of times,” for after losing ~58% in the SPX from the intra-day highs of October 2007 into the intra-day lows of March 2009, they have not come close to recouping the monies lost in that downdraft. The lesson that should have been gleaned is that if participants would have managed the risk (read: not allow positions to go too far against them before taking some kind of action; i.e., hedge, sell, etc.), they would have missed much of the SPX’s 2008/2009 downside debacle and in turn done pretty well over the past two years. As often referenced in these missives, investors need to manage the risk, for as Benjamin Graham espoused in his book The Intelligent Investor, “The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.”

Investors should keep that quote on their walls so they don’t forget the major lesson of 2008/2009. Yet, there are other lessons to be remembered. To that point, Merrill Lynch lost two of its best and brightest in 2009 as Richard Bernstein and David Rosenberg left for less constrained environments. During their final weeks at Merrill they wrote about lessons they have learned. To wit:
Richard Bernstein’s Lessons

1. Income is as important as are capital gains. Because most investors ignore income opportunities, income may be more important than are capital gains.
2. Most stock market indicators have never actually been tested. Most don’t work.
3. Most investors’ time horizons are much too short. Statistics indicate that day trading is largely based on luck.
4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.
5. Diversification doesn’t depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio.
6. Balance sheets are generally more important than are income or cash flow statements.
7. Investors should focus strongly on GAAP accounting, and should pay little attention to “pro forma” or “unaudited” financial statements.
8. Investors should be providers of scarce capital. Return on capital is typically highest where capital is scarce.
9. Investors should research financial history as much as possible.
10. Leverage gives the illusion of wealth. Saving is wealth.

David Rosenberg’s Lessons

1. In order for an economic forecast to be relevant, it must be combined with a market call.
2. Never be a slave to the data – they are no substitutes for astute observation of the big picture.
3. The consensus rarely gets it right and almost always errs on the side of optimism – except at the bottom.
4. Fall in love with your partner, not your forecast.
5. No two cycles are ever the same.
6. Never hide behind your model.
7. Always seek out corroborating evidence
8. Have respect for what the markets are telling you.

There was another sage that left Merrill Lynch, but that was 18 years ago. At the time Bob Farrell was considered the best strategist on Wall Street, and while he still pens a stock market letter, his “lessons learned,” written back then, are as timeless today as they were in 1992.

1. Markets tend to return to the mean over time.
2. Excesses in one direction will lead to an opposite excess in the other direction.
3. There are no new eras – excesses are never permanent.
4. Exponential rising and falling markets usually go further than you think.
5. The public buys the most at the top and the least at the bottom.
6. Fear and greed are stronger than long-term resolve.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chips.
8. Bear markets have three stages.
9. When all the experts and forecasts agree – something else is going to happen.
10. Bull markets are more fun than bear markets.

With these lessons in mind, we wish you good investing in the New Year.

Grantham’s ‘Horrifically Early’ Forecasts

It seems that others are "discovering" just how prescient Jeremy Grantham can be with his views on stock market valuations. The twist? He is often too early, "costing his clients money". You can read the full Bloomberg story here.

Jeremy Grantham warned in January 2000 that U.S. equities were “more overpriced than at any time in the last 70 years due to the massive overpricing of technology and especially dot-com stocks.”

By the end of 2002, the Standard & Poor’s 500 Index had fallen 40 percent and technology shares were down 73 percent. The forecast didn’t help his firm, Grantham Mayo Van Otterloo Co., because he’d been bearish since 1997. Assets declined 45 percent in the late 1990s as customers sought out better- performing mutual funds that liked the technology stocks Grantham disdained.

Grantham said in an interview that his negative calls are often so early that investors who acted on them gave up gains before prices peaked. He recommended avoiding Japanese stocks more than two years before they started falling at the end of 1989. While his timing doesn’t deter fans like former Harvard University endowment manager Jack Meyer, it requires a delicate balancing act by GMO, which oversees $107 billion.

“We lost business like it was going out of style,” the 71-year-old Grantham said of his dot-com prediction at a Jan. 28 speech to investment advisers in Boston, the home of GMO, which he co-founded in 1977.

GMO’s funds usually don’t fully adopt his recommendations, or hedge their bets, underscoring the difference between being a star strategist and successful money manager. That’s true for the fund Grantham works most closely with, GMO Global Balanced Asset Allocation, which oversees $3.1 billion.

Setting Off Alarms

The tension between acting on a long-term vision and keeping clients happy in the short run is a fact of life for all money managers, said Charles Lieberman, chief investment officer at Advisors Capital Management LLC in Hasbrouck Heights, New Jersey, which oversees about $190 million. “The issue is: Are you willing to stick your neck out and how far?” he said in a telephone interview.

The tension is heightened at GMO, where Grantham’s warnings of investment bubbles have at times sent customers packing for firms with a more upbeat view of the markets.

“If we are too aggressive, and we don’t get it right, we run the risk of being fired,” Ben Inker, GMO’s head of asset allocation, said in a telephone interview.

Two of Grantham’s most recent forecasts were right -- and timely.

Emerging Markets

In 2007, he wrote in his newsletter that all asset classes were overvalued and it was time to sell high-risk securities. GMO’s $2 billion Emerging Country Debt Fund, which held high- yielding securities from countries such as Venezuela and Argentina, decided to stick with those investments in 2008.

“Every bet we made turned out to be wrong,” Thomas Cooper, the fund’s co-manager, recalled in an August interview, pointing out that investors sought out safer securities during the financial crisis. The fund lost 33 percent in 2008, and the following April GMO was fired by the Massachusetts state pension system as manager of $230 million in emerging-market debt.

The fund bounced back, returning 50 percent in 2009. Its 14 percent annual return over the past 10 years made it the best performing bond fund, according to Chicago-based Morningstar Inc.

“Jeremy has been a great long-term investor,” said Meyer, who ran Harvard’s endowment for 15 years until 2006, when he left the Cambridge, Massachusetts, university, to start Convexity Capital Management LP, a Boston-based fund manager. Grantham was ahead of the pack in the 1990s identifying the value of emerging-market stocks, inflation-adjusted securities and timber, Meyer said in a telephone interview.

‘No Justice’

In March 2009, when the S&P 500 index bottomed out at 676, Grantham wrote that fair value for the benchmark of the largest U.S. stocks was 900, or 33 percent higher. By July, with the index above that mark, Grantham concluded U.S. stocks had become too expensive again.

“After 20 years of more or less permanent overpricing, we get five months of underpricing,” he told newsletter readers. “There is no justice in life.”

The fair value of the S&P 500 today is 850, 23 percent below yesterday’s close of 1103.94, said Grantham. He arrives at that valuation by assuming a long-term average price-to-earnings ratio of about 15 for U.S. stocks and applying it to a long-term average for profit margins.

Grantham is chief investment strategist at GMO, whose assets have risen almost fivefold since 2000. Its more than 40 mutual funds usually require a minimum investment of $10 million and are aimed mainly at institutions such as pension funds and endowments, according to the firm’s Web site. The firm also acts as a sub-adviser on several retail mutual funds.

.....

Current Outlook

Grantham’s favorite asset class today is high-quality U.S. stocks, companies defined by high, stable returns and low debt. The allocation fund had 31 percent of its money in that category at year-end, sometimes called blue chips, according to the GMO Web site. In the interview, he said he expects such stocks to return an average of 6.8 percent a year over the next seven years, compared with 1.3 percent for all large-cap U.S. stocks.

Emerging-market stocks may rise about 4 percent annually in the next seven years, as investor enthusiasm for economic growth in developing countries carries the stocks to unsustainable levels, Grantham said.

“Why not go along for the ride?” he said. The MSCI Emerging Markets Index returned an average of 22 percent in the past seven years, compared with a gain of 5.5 percent by the S&P 500 index.

U.S. government bonds will return 1.1 percent a year over the seven-year period, according to the latest GMO forecast. The Bank of America Merrill Lynch U.S. Treasury Master Index rose 4.3 percent from 2003 through 2009.

Grantham said he expects a difficult, not disastrous, period for the economy and investments.

“It will feel like the 1970s,” he said. “One step forward, one step back.”

.....

No ‘Permabear’

Grantham dismisses his “permabear’” label, saying that in 2000 he was bullish on emerging-market stocks, real estate investment trusts and inflation-adjusted bonds. GMO data show that the three asset classes returned between 4.9 percent and 8.1 percent a year in the 10 years ended Dec. 31. The S&P 500 lost 1 percent a year over the same stretch.

Looking back on more than 40 years in the investment business, Grantham summed up his career this way: “We win all the bets but we are horrifically early,” he said.

I have benefited immensely by reading Grantham's writings and, to an extent, following his calls. My personal IRA accounts are much the better for it.

The man knows his "weaknesses". You can chart his calls against the market (as I have done) and discover that he is sometimes as much as three years (!) early with his calls. An investor would give up a portion of those gains if he switched equity exposure to bonds but -- and here is the important point-- he would sidestep large declines. This strategy isn't for everybody but it works for me.

As always, consult with your advisor if you wish to take this further.

Winter Break

Okay, so I won't be playing PineHills this weekend but a man's gotta dream! Back on Wednesday.

Annuities in 401k Plans?

Insurers and mutual-fund companies are have become aware that the decade's poor stock market performance and low fixed income yields means there's an acute danger that Americans will outlive their savings.They've responded by selling annuities as holdings for 401k plans.What's an anuuity you say? Rather than go into the details of straight annuities ad all their permutations I will point you to the explanation given by Investopedia:

Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.

Annuities can be structured to provide fixed periodic payments to the annuitant or variable payments. The intent of variable annuities is to allow the annuitant to receive greater payments if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund's investments.

That's an annuity. Picking up the story, written by Bloomberg's reporter Martha Collins:

The different ways in which annuities can be structured provide individuals seeking annuities the flexibility to construct an annuity contract that will best meet their needs. President Barack Obama on Feb. 1 called for a change in government rules to allow adding annuities to 401(k) retirement plans. While the annuities offer a steady stream of income in exchange for upfront payments, the price for peace of mind may be higher fees and less access to cash.

“You’re paying for a benefit that you may or may not use,” said Glenn Daily, a fee-only insurance consultant, referring to annuities. “These things are so complicated I doubt many people will understand what they’re buying.”

MetLife Inc. and Prudential Financial Inc., the two largest U.S. life insurers, are aiming to tap into what may become a $1 trillion market by blending annuities with target-date 401(k) funds, which shift to more conservative assets such as bonds as an investor nears retirement. The funds were used as the default investment by 87 percent of retirement plans in 2008 with automatic enrollment, according to Vanguard Group Inc.

Insurers are working with mutual-fund companies to build the guarantees into 401(k) funds because state laws require an insurance charter to sell annuities.

The income guarantee that insurers and mutual-fund companies are developing lets workers pay for an annuity in installments using their regular contributions to retirement accounts, said Garth Bernard, chief executive officer of the Boston-based Sharper Financial Group, which specializes in retirement income solutions for financial companies.

Fund Scrutiny

Legislators have scrutinized target-date funds because some lost as much as 41 percent in 2008. The funds attracted $45 billion last year, up from $28.7 billion in 2006, according to Chicago-based Morningstar Inc.

“It’s a huge market,” said Tom Johnson, senior vice president in New York Life Insurance Co.’s retirement income security business, of the potential for annuity/retirement accounts. Americans held $6.8 trillion in 401(k) plans and IRAs as of September 2009, according to the Investment Company Institute, a Washington-based mutual fund trade group. If 15 percent of those assets went to guarantees, it could mean more than $1 trillion for insurers, Johnson said.

“We believe guaranteed income is important because it locks in a level of retirement income,” said Jamie Kalamarides, senior vice president of retirement solutions for Prudential, based in Newark, New Jersey. “Most Americans aren’t saving enough.”

Prudential, MetLife

Prudential and MetLife have already introduced income guarantees designed for target-date funds. Investment-management firm BlackRock Inc. is offering to employers a target-date fund with a MetLife annuity as the fixed-income component, said Kristi Mitchem, head of New York-based BlackRock’s U.S. defined contribution.

Asset manager AllianceBernstein Holding LP is working on a similar product with multiple insurers including Axa SA, while Putnam Investments LLC expects to announce a lifetime income benefit for its 401(k) funds this year, the companies said.

Fidelity Investments, the largest target-date fund provider, offers employers a 401(k) fund with an annuity through insurer Genworth Financial Inc., said Michael Doshier, vice president of the Boston-based company’s workplace investing group. Vanguard is also exploring income stream options within its retirement plans, said spokeswoman Linda Wolohan.

Two Forms

The types of guarantees being developed vary and have trade-offs, said Bernard of Sharper Financial. One type has relatively high fees and another prevents retirees from liquidating their savings once they start receiving monthly income, he said.

Annuities and guaranteed income benefits in retirement plans can be an important safeguard against outliving savings as more Americans fund their own retirement, said Moshe Milevsky, a finance professor at York University in Toronto. Combining them with target-date funds is a concern, he said.

“Let’s not get carried away,” said Milevsky, who specializes in insurance. “To say that we are going to lever these guarantees on top of target-date funds that have not been fully tested yet, I’d be wary.” The Department of Labor endorsed target-date funds as a default investment option for employers in 2007.

The Treasury and Labor departments started reviewing public comments this month on how to make it easier to convert savings into lifetime income streams.

Government Guidance

“Many plan sponsors would like explicit guidance from regulators,” said Tom Idzorek, chief investment officer at Ibbotson Associates, a unit of Morningstar. A government endorsement would create “a rush of sponsors trying to add these to plans,” he said.

Last year, 4 percent of employers offered a plan that allowed participants to allocate a portion of contributions to an income guarantee, according to Callan Associates Inc., which surveyed 90 plan sponsors with more than $100 million in assets. The previous year, the total was 3 percent. Employers are concerned about cost, portability and how to pick an insurance provider, said Lori Lucas, defined contribution practice leader for the San Francisco-based investment-consulting firm.

Annual fees for guarantees in 401(k)s can be 95 basis points or more above the retirement plan’s investment-management fees, she said. A basis point is 0.01 percentage point.

“Those fees may reduce account values by 7 percent to 9 percent over 10 years,” said Drew Denning, vice president of retirement and investor services at Principal Financial Group Inc. The Des Moines-based firm, the fourth-largest provider of target-date funds, recommends investors wait until retirement, when they know their financial circumstances, before deciding to shift a portion of their savings to an annuity, Denning said.

Switching Insurers

Employers also are concerned that guarantees will prevent employees from exiting their retirement plans if they transfer jobs, said John Carl, president of the New York-based Retirement Learning Center, which consults plan sponsors.

“The portability of these contracts at this juncture is minimal between insurers,” Carl said. “You’re essentially locked into the program you choose -- or are defaulted into.”

That’s because an insurer calculates its annuity payments based in part on the life expectancy of a pool of individuals holding such contracts, which makes it harder to switch from one insurer to another, Carl said.

Solvency of the offering company is another impediment, said Robert Toth, an attorney who specializes in retirement plan products and services.

“How do you make a decision that the insurance company will still be here 30 years from now?” said Toth, who is based in Fort Wayne, Indiana. “Employers fear making that choice and being responsible.”

Longevity Insurance

Longevity insurance, another type of income guarantee, may be a better, cheaper option for protecting against outliving savings, said Daily, the New York-based insurance consultant. Longevity insurance guarantees future monthly income typically around age 80 and may be less expensive because “you’re only buying the tail end” of the benefit, Daily said.

“Why should you take the plunge now instead of waiting?” said Daily. “Some of these guarantees are so hard to value that you have to be an economist to figure it out.”

That's a balanced article and I compliment Ms. Collins for presenting it that way.

Reading Is Fundamental

Barry Ritholtz of the Big Picture blog is both a friend and constant read for me. I think some of his best writing is on the fundamentals of investing. See here. But today's post is about his reading list for beginning investors. It's not exhaustive. It's kind of eclectic. But it's a very good list and I can't really quibble with what he includes. Here's his list and his comments on each selection:

Introduction to Investing

Any one of these books will give you insight into investing and the markets. All three will make an essential base for future studies:


Jack D. Schwager: Stock Market Wizards : Interviews with America's Top Stock Traders

Schwager interviewed market legends at the height of their success. What makes the book so worthwhile are the consistent themes that evolve from currency traders, mutual fund managers, commodities traders, hedge fund managers. Regardless of what is being traded, there are related motifs that run throughout.

What results is not a “How to trade” book; instead, it is a book about “How to think about trading.”

This has become a seminal book on trading and investing. I actually re-read Market Wizards every five years — it is that good. Wizards was so well received by the financial community that the same author put out The New Market Wizards. Whether you read one or both of these books, you will have knowledge of the market from both the trader’s and the investor’s perspectives.


Charles D. Ellis: The Investor's Anthology: Original Ideas from the Industry's Greatest Minds

Instead of interviewing famed investors, Ellis gathered their best writings into one collection. He ends up with a series of short chapters by luminaries of days gone by. There is something worthwhile on just about every page. This is another favorite worth rereading every few years.

Maggie Mahar: Bull: A History of the Boom and Bust, 1982-2004

The best book about the past 20 years of the market, bar none. Mahar does a terrific job weaving the long tale of how things eventually reached their penultimate top in 2000. She spares no one — the government, the Fed, Wall Street, her colleagues in the financial press — all are subject to a scathing critique for their complicity in inflating the bubble.

Bull! reads like a historical work, despite the recentness of its subject. There are a surprising number of lessons buried in these pages that will reward the careful reader. I found it both fascinating and informative.

Historical Perspectives

It’s astounding how little things have changed over the past century. Yes, information moves more quickly, and computing power has allowed for a more quantitative analysis of stocks — but human nature remains immutable. (Mark's note: I thoroughly enjoyed this book.)

How I Trade and Invest in Stocks and Bonds by Richard Wycoff

Quite simply, this is one of my favorite books on the markets and investing. The fact that it is from 1923 is totally irrelevant. If I could reprint the book with each mention of “coal” replaced with “oil,” and if I substituted “Internet” for any time the word “railroads” appeared, you would have no idea when this was written. Indeed, you would think it was a current work.

There is probably more market intelligence and trading wisdom in this book per word than any other I have ever read. I strongly recommend this one.

Reminiscences of a Stock Operator by Edwin Lefevre

By now, you have probably heard the story of Jesse Livermore. If you have ever said, “The trend is your friend” or “Let your winners run and cut your losses quickly,” then you were quoting Livermore — even if you didn’t know it.

This is an absolutely exhilarating read. In fact, it is so much fun, it shouldn’t count as homework or research.Coincidentally, this was also published in 1923 — apparently a good year for market-related books. (Mark: This reads like a thriller. Couldn't put it down.)

Psychology

As a species, we are notoriously bad at understanding our own thinking and emotions. We are even worse at predicting our own behavior. Understanding your own mind and those of your fellow investors is crucial to successful investing. These books will go a long way to helping you understand your hardwired weaknesses and blind spots.

Thomas Gilovich: How We Know What Isn't So

This is one of the most influential investing books you will ever read. So many of our own foibles are detailed here that it is almost embarrassing. Everything from unsuspected biases to how we engage in critical reasoning comes under scrutiny. What it reveals isn’t pretty. Despite the genius that is human achievement, it turns out that we are all very poor at comprehending complex data and analyzing risk.

This book will help you understand how your brain: processes randomness; overlooks evidence that is inapposite to prior beliefs; selectively perceives and reinterprets data; and engages in selective recall. It’s how we all create an artificial story line to help make sense of otherwise incomprehensible data.

Once you finish this book, you will never look at investing the same way.

Note: This is purely psychology writing; If you prefer a more specific investing-related analysis, consider Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics by the same author (with Gary Belsky).

Gary Belsky: Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics

Hard-core fans of cognitive biases and economic anomalies (and other similar type of analyses) will also appreciate Richard H. Thaler’s The Winner’s Curse. Thaler is one of the most influential researchers in the field of behavioral economics.

Richard H. Thaler: The Winner's Curse

If you want to see how cognitive and reasoning deficits manifest themselves, then the seminal book on the subject is Extraordinary Popular Delusions & the Madness of Crowds by Charles Mackay. There have been a lot more booms and busts then you imagine. This book details how they came about and their impact throughout history. Fascinating and instructive stuff.

Charles Mackay: Extraordinary Popular Delusions & the Madness of Crowds

Once you understand how our brains fool us into occasionally doing idiotic things — funny, but it seemed perfectly reasonable at the time — then you can start looking for ways to avoid making those gaffes. Humphrey Neill’s Art of Contrary Thinking will show you the way. He explains why “When everyone thinks alike, everyone is wrong.” This intriguing thesis applies not only to markets, but to politics, academia, even sports.

Humphrey B. Neill: Art of Contrary Thinking


What if human nature can never learn from its mistakes? What if we are doomed to repeat the aforementioned cognitive, reasoning and behavioral defects over and again? That provocative thesis is put forth by Robert R. Prechter Jr.: Prechter’s Perspective. This is the book that explains why our own nature leads to history repeating so often.

Robert R. Prechter Jr.: Prechter's Perspective

A few caveats: I am not a devotee of Elliot Wave theory (Prechter’s school of choice). Further, I hasten to add that many of Prechter’s market calls have left much to be desired. However, his overarching perspective of human nature, and of history’s cyclical tendencies, makes for utterly fascinating reading. Even though I found myself arguing with many of the premises in the book, I enjoyed this thoroughly. The cycle geeks out there will too.

A great beginner's list!

Roth Conversion Strategies

2010 is The Year of the Roth. This has been a constant theme of mine in this blog as I attempt to highlight the opportunity and point out some of its dangers and pitfalls.

As with most strategies there is an "offensive" way to play it as well as a "defensive" way. The following article is definitely an offensive-minded strategy, involving account-splitting and characterization reversals. I hadn't thought of this. Here's what was written:

U.S. investors who convert a traditional Individual Retirement Account into two or more Roth accounts to make a bet on the market rising can save on taxes if it doesn’t.

The multiple Roth IRAs should be split among different investments, according to Joseph Spada, managing director of Summit Financial Resources in Parsippany, New Jersey, whose average client has $25 million in net worth. A conversion can be reversed if some of the assets lose value, saving $140,000 in income taxes, for example, on an account worth $1.2 million.

“The IRS is giving you a bucket of mulligans with your IRA,” said John Bledsoe, a Dallas-based estate planner, referring to the term used in golf for a do-over. Investors who convert to a Roth IRA have until Oct. 17, 2011, to undo their decisions and recoup taxes paid, said Bledsoe, author of “The Gospel of Roth,” whose average client has $100 million or more in assets.

The Internal Revenue Service lifted income restrictions this year on converting a traditional IRA to a Roth IRA, meaning U.S. taxpayers making more than $100,000 a year in adjusted income can make the transfer. There’s no limit on conversions if an investor has multiple IRAs or a cap on the amount that can be converted.

Those who switch from a traditional IRA, where taxes are paid only on withdrawals, to a Roth IRA, must pay income taxes upfront in exchange for tax-free withdrawals during retirement. A taxpayer in the top income bracket with an IRA worth $1.2 million would pay 35 percent or $420,000 in federal taxes when converting the account into a Roth IRA this year.

Three-Way Divide

A $1.2 million account could be divided into three Roth IRAs worth $400,000 each, Spada said. The first account may be invested in fixed income, the second in equities and the third in high-yield bonds. If one fund lost value, the investor would save the 35 percent tax paid on the $400,000 account, or $140,000, by recharacterizing that Roth IRA into a traditional one, Spada said.

“You don’t want to pay the tax on an account that actually went down in value,” Spada said. Undoing the conversion doesn’t change the fact you lost money on your investments, which is why investors shouldn’t take more risk than they normally would when converting to multiple Roth IRAs, he said.

Free Look

Theodore Lustig converted his family’s IRA into three Roth accounts with different asset types on Jan. 4. The 55-year-old attorney put the first account in fixed income, the second in oil stocks and the third in U.S. bank stocks.

“You have a free look,” said Lustig, who’s based in Dallas. “You have until October 2011 to see how your investments have performed.”

Lustig said he could reverse the conversion on accounts that decline or, “if everything works out,” pay a lower tax on income from accounts converted in January that rise in value.

“Even if it turns out that I will save taxes by converting, the conversion may still be undone if I just get cold feet or have unforeseen expenses and no longer want to pay the taxes on the income,” he said.

Wow. Combine a complicated law with a monetary incentive and all sorts of things can happen. Sort of like derivatives. Or securitization.

I don't have an opinion on these strategies. They purport to give a free lunch, something I don't believe exists in this world. I guess I would want to have a LONG conversation about them before I even considered them. As every tax attorney can tell you, "recharacterization"-- when used by the IRS-- is painful. So can be updated guidance, revenue rulings and tax cases. As with everything on this blog, do your own due diligence.

Focus On What You Can Control

Elsewhere I have pooh-poohed the annual ritual engaged in by pundits, investment houses and their economists, bloggers and newsletter writers of forecasting the direction of the markets over the coming twelve months. I don't think it can be done. It's financial porn. It may be entertaining to read but destructive in the long term. (Note: Readers know that I believe you CAN estimate long term returns from asset classes once you know starting valuations.)

As Larry Swedroe, investment manager and author of "The Only Guide to Alternative Investments You'll Ever Need" has said:

There seems to be some great human need for us to believe that there is someone who can tell us where the economy and the market is going. The best thing for people to do is recognize that there are no forecasters [who can do this].

What to do then? Well, in my opinion (and Swedroe agrees) you should focus on the things you can control. What are they?

(1) You can control how much you save.
(2) You can control how much you pay in taxes via tax efficient investment vehicles and strategies.
(3) You can control how much risk is embedded in your portfolio.
(4) You can control how much you pay in costs for your portfolio (advisor fees, trading costs).
(5) You can control how much volatility the portfolio is designed for.

Can readers suggest other things you can control?

ADDENDUM (2/6/10, 6:10AM)

Fidelity has now introduced a no trading fee program in 50 exchange traded funds (ETFs). Charles Schwab has done something similar. For asset allocators this is big news. Portfolios can be bought and rebalanced without costs. Since costs are a large part of the drag on individual investor portfolios, removing this drag has immediate benefits to performance. What is the downside? Temptation into frequent trading. What is in this for Fidelity and Schwab? Attraction/retention of customers.

Planning Basics: Fiscal Fitness Day

Here's an idea I think should catch on. Instead of taking a "mental health day" or a "stay-cation", why not try a "financial wellness day" (okay, two days) to get your financial life in order? That's exactly what Ron Lieber of the New York Times suggested in this July 2009 article. It's an idea that has gotten some attention. Here's what Lieber wrote:

Like many of you, I suspect, I have a never-ending, ever-multiplying list of undone money tasks. There are always a few accounts that charge too much or pay too little interest, service providers to haggle with and opaque insurance forms that beg questions. Who has time for all but the most essential items on this list on any given day? Or in any given month, for that matter?

So I decided to spend 10 or 12 hours trying to cross off every single item on my list. The goal wasn’t merely completion. I also hoped to actually gain back the money I had lost to the pay cut, either through savings or increased earnings in bank and credit card accounts.

By the strictest definition, I failed on the first count.

The list was too long to even start certain items on it, and many of the money tasks require multiple steps. The new jewelry insurance requires an appraisal. The nanny tax company needs a pile of information to get started. The will-writing lawyers don’t call back right away. At least I got these tasks started.

Financially, the total of my savings and new earnings will net out to about $2,000 annually after taxes, thanks mostly to a better savings account rate.

That doesn’t quite replace the lost income, but it’s a lot more money than I had before.

The real gain here, however, was in establishing a new ritual. I got enough done that I now plan to take a fiscal health day at least once a year, 10 hours on a weekday when all phone lines and financial institutions are open, with no interruptions except for e-mail.

Here’s a list of some of the things I knocked off or got started. Or, if you prefer movies to articles, watch the mini-documentary of my day.

HIGH-YIELD SAVINGS ACCOUNT Though Internet savings accounts that pay above-average rates have been around for some time, I haven’t needed one. Now that we’re keeping more cash around in case we want to buy a new place to live, however, it makes sense to enroll.

I put our money in an account via SmartyPig, a Web-based savings program. It pays an industry-beating 2.75 percent, though it comes with certain restrictions, like the requirement that you put at least $10 in your account each month.

CASH-BACK CREDIT CARD The new Charles Schwab Bank Invest First Visa pays a straight 2 percent back into our Schwab brokerage account. That’s 0.75 percentage points better than we were earning with our Capital One card. The Schwab card also levies no foreign exchange fees for use outside the United States.

JEWELRY INSURANCE We are paying nearly $400 annually to insure our wedding and engagement rings. Jewelers Mutual, which I’d been meaning to call for more than two years, can do it for about $250, as long as we produce an appraisal.

PHONE SERVICE We stripped our landline bare of any long distance or special features and got rid of our DSL service, which we had been using as a backup for our cable Internet connection. That will save about $500 annually, though that savings will be partly offset once we find another backup plan.

Not surprisingly, given that we’re talking about the phone company here, this task ate a bigger part of the day than any other. I had to talk to the landline people, the DSL people and the billing people to confirm a switch on the auto-payment system to our American Express card (now that Verizon finally accepts it). Of course, I waited on hold, ended up in the wrong call center and had one call dropped. But hopefully, I won’t have to talk to them again for years.

NANNY TAX SERVICE I signed up with the Nanny Tax Company in Chicago to deal with the quarterly and annual tax filings related to paying our baby sitter on the books. While this costs $425 annually plus a one-time $100 registration fee, the time savings makes this a wash, if not a net gain in money.

A representative with our bank at Schwab also explained that it would allow us to make free, regular direct deposits into our baby sitter’s account at a different bank. That means we can create a free, basic payroll service, since we’ll get help calculating withholding amounts from the Nanny Tax Company.

WILL We still don’t have one, even though we’ve been parents for three and a half years now. Pathetic and inexcusable. But it won’t be that way for long. We’re considering hiring a lawyer from New York State who is far from our Brooklyn home to save money, and I called three lawyers on fiscal health day looking to price the possibilities. Local lawyers who think this approach is foolish should sound off in the comments on this story. We will finish this task before summer’s end.

INSURANCE PAPERWORK If you’re lucky enough to have health insurance, you’re probably constantly adrift in a sea of forms that make no sense. We’re no different, but a major snafu caused us to have to switch plans a few months into 2009, throwing everything into utter disarray.

On fiscal health day, I got all of the paperwork divided into about a dozen piles to begin our assault on the benefits office and the various insurance companies involved.

WHAT TO DO IF WE’RE DEAD Merrill Lynch gives away a terrific form titled “Organizing your financial life. Critical information at your fingertips.” It’s basically a road map to sorting your financial affairs in case you fall off a large cliff, though Mother Merrill doesn’t quite market it that way. After several years of putting this off, I finally filled out the form on fiscal health day and will send copies to our families soon. There’s a link to the form from the version of this story online.

NONPROFIT AUTOPILOT In less than 10 minutes, I put a bunch of our charitable giving on autopilot. We signed up with Networkforgood.org and then asked it to charge our credit card each month and pass along the money to the nonprofit groups. No more end-of-the-year scramble to get donations out, and the institutions will receive more regular income.

Network for Good does charge a fee for its service, and it may be possible to set up recurring donations free with individual nonprofit organizations.

SHOPPING SPREE Yes, you get to have fun on fiscal health day. Gather up all of your gift cards and spend the money that’s left on them. The longer they sit, the more interest Apple or Borders or the department store will earn from your money and bigger the chance you’ll misplace the card.

We had $68.63 that had been on a Barneys card for a while, and I used it to add to my collection of colorful socks. This being Barneys, I needed an extra $15 or so to add a second pair. Still, the beautiful hosiery was a great reward for having finished a bunch of longstanding financial chores.

What a great idea! Here are some "refinements" I would make to it.

Balance pain and pleasure. Why not unplug from distractions while you do this by staying at a B&B, a nice hotel or in that cabin you've been eyeing for vacation? (Make sure all have phone and internet access. You're going to be using these heavily as you get organized.)Or at least set some time in the evening for a movie, dinner or your favorite activity as a reward to yourself. This will be hard work!

Set priorities.The night before, make a list of what you need to get done. Break it into groups. Your "A-list" should be done NO MATTER WHAT. Your B-list after your A, etc.

If you need help, get it. Some of what you may need to do could involve visits to professionals. Do you need to see your accountant? Your tax attorney or estate planning attorney? Do you have a financial advisor? How about that meeting with HR to discuss plan or benefit changes?

Do nothing else. This is going to require total commitment and focus. It's the "other things getting in the way" that has prevented you from doing this before, right? So turn off the TV, the iPhone, leave email to another day.

Good luck!