Yesterday financial markets across the globe reacted negatively today to Standard & Poor's downgrade of long term debt issued by the United States. Last Friday S&P lowered the rated from AAA to AA+ noting that the recent budget agreement failed to address the government's debt situation. Asian markets opened down and were followed by markets in Europe and the United States.

Despite the unprecedented downgrade, the United States is far from alone in its need to address its excessive national debt levels. The European Union has several members, including Ireland, Greece, Portugal, Italy and Spain that are struggling with debt levels that are unhealthy relative to the size of their economies.

To some extent today's stock market's reaction reflects investors' dissatisfaction with the general state of the US economy. The nation is burdened with an unsustainably large debt and its elected leaders have not demonstrated an ability craft an agreement that will result in a long term solution to the problem. At the same time, economic growth is waning, unemployment remains persistently high, and inflation is creeping into the broader economy.

The stock market is a place in which investors sometimes overreact to news out of fear, panic, and desperation. Yesterday was a good example. The broad market, measured by the Standard & Poor's 500 index, dropped by over 6%. Does that mean that the stocks which comprise this index were suddenly worth less than they were last Friday? No. It means that sellers overran buyers and drove the prices of these large companies down.

Cascade Wealth Management remains committed to the time-tested long term strategies of proper asset allocation, diversification and maintaining low costs. Our clients' portfolios, while down over the past few weeks, have not suffered the temporary losses that the selloff in the U.S. stock market would imply.

What should investors do in the midst of all of this volatility? I would suggest following the advice of Burton G. Malkiel in his opinion piece in yesterday's Wall Street Journal, "Don't Panic About the Stock Market." Malkiel, professor emeritus of economics at Princeton University is co-author of The Elements of Investing, a book I highly recommend. He encourages the investors to "stay the course." So do I.

Today the global financial markets dropped rather dramatically. The Dow Jones Industrial Average fell by 513 points. The Standard & Poor's 500 index was down 4.8%

I received the following email from another investment advisory firm:

"The financial markets have been experiencing considerable volatility in the last two weeks. We have made changes to our models because we believed this could happen. We are continuing to monitor your portfolios in light of the recent economic and political events and believe the strategy we put in place is appropriate. We will continue to provide you with updates as we study the information available to us."

They believed this could happen? Well, we all know this could happen. Moreover, it happens with some regularity over the long cycles of the stock market.

The strategy we put in place is appropriate? I'd love to know what that strategy is.

Let's not forget the following:

1. The financial markets are prone to volatility. This has been the case for 200 years in this country.
2. No one knows what will happen tomorrow, next week or next year in the stock market. If someone tells you they know what is going to occur in the stock market, run in the opposite direction.
3. The stock market generally prices securities in an efficient manner. This means that identify mispriced securities is very difficult.
4. Given that the stock market is an efficient marketplace, waste no time trying to find the underpriced or overpriced security. Instead build a well allocated and properly diversified portfolio.
5. In times of market volatility, manage your emotions and not your portfolio.

Variable Annuities - Expenses Drag Performance

With the economy weakening and the stock market faltering, investors are moving out of the stock market and seeking refuge inside annuities. Morningstar reports that investors withdrew $50 billion from stock mutual funds in the 12 months through April of this year. LIMRA reported that sales of variable annuities in the United States increased to $39.8 billion in the first quarter compared to $32.2 billion in the same period in 2010.

The problem is that investors generally have no idea how much they are paying for these insurance products. According to Morningstar the average fees for variable annuities are 2.51%. Many buy a rider that offers guaranteed minimum payments. These riders cost 1.03% on average. So, investors who buy these products can end up paying more than 3.5% in expenses.

These expenses are a significant drag on the performance of variable annuities. If the sub accounts inside the annuity earned an average of 8%, the return after fees would be 5.5%. In addition, income received from an annuity is taxed as ordinary income.

Some investors would benefit from including a variable annuity in their portfolios. But the fees make them unattractive investments for most investors.

The Debt Ceiling

Several clients have contacted me in the past few weeks expressing concern about the approaching deadline to raise the nation's debt limit.

The Treasury Department has indicated the limit must be increased by next Tuesday, August 2, or the country may default on its obligations. Unfortunately, as of today, with one week to go, our elected leaders have still not been able to craft an agreement that will increase the debt limit.

Analysts have been speculating about the impact a default could have on the financial markets. No one really knows, because the United States has never defaulted. But clearly the effect would be negative and perhaps severely so.

I would not be surprised if the stock and bonds markets both dropped fairly dramatically, if it were to become clear that Congress and the Obama administration will not reach a deal.

However, as has been the case with our other events that have shaken the market -- remember when the markets opened after the September 11, 2001 attacks or when Congress voted down the Troubled Asset Relief Program in September of 2008? -- I expect the markets would recover and in a relatively short period of time.

I have read that some investors have decided to get out of the markets until this situation clears up. This approach assumes that we will actually know when things are stable again and when it's safe to re-enter the market. I know I do not have the ability to see into the future.

Moreover, the nation's financial predicament involves much more than another increase in its debt ceiling. (There have been 74 increases since March of 1962.) The government spends considerably more than it receives in revenue. We have a national debt that is nearing the total annual productivity of the country and, if not soon addressed, will simply dominate the nation's budget. Congress and the administration have to address this imbalance or the nation will be facing the kind of austerity measures that are currently being implemented throughout the Europe Union.

I have recently read three books on the history of crashes and depressions in financial markets. I was struck by how often these events occur and by how quickly the markets recover. While we cannot predict market events, we know they will occur and we know that eventually the markets heal.

Intelligent, long term investors need to remain disciplined and resolute in the face of these events. I realize this is not particularly comforting. But I know there is no better approach.

Dimensional Fund Advisors

My blog seems like a good place to announce that Cascade Wealth Management will begin offering funds from Dimensional Fund Advisors in the very near future. I am very excited about this, as I believe DFA offers funds built on the finest academic research in the investment community.

DFA Funds are not directly available to retail investors. Investors can access them through a Registered Investment Advisor (e.g. CWM) which has been authorized by DFA to offer their funds.

DFA has several key principles:

Markets Work. DFA believes that the Efficient Markets Hypothesis (EMH) is valid. The EMH suggests that securities are generally properly priced and that it is very difficult, essentially impossible, to consistently identify securities that are mispriced. Consequently, it is misguided to attempt to outperform the overall market through active management strategies such as individual security selection and timing strategies.

Risk and Return are Related. The idea is that investors are rewarded for taking risk. The amount of the reward (i.e. return) is directly related to the amount of risk. However, the founders of DFA, Eugene Fama and Kenneth French, have developed a multifactor model which is the basis for DFA funds. I will come back to this model in a future blog.

Diversification is Essential. Portfolios should be structured to provide comprehensive diversification within and across global asset classes. Portfolio risk is composed of diversifiable or non-systematic risk and non-diversifiable, systematic or market risk (all interchangeable terms). Investors are only compensated for taking market risk. Investors must diversify sufficiently to eliminate non-systematic risk.

Structure Determines Performance. Asset allocation explains most of the variation of portfolio returns. DFA posits that over 96% of the variation in return is due to risk factor exposure. Thus, investors must get asset allocation right in order to be successful.

Look for more information about DFA funds in subsequent postings.

So what are you?

I thought I might offer my take on the differences between savers, investors, speculators and gamblers.

Saver: A saver is someone who consistently sets aside some portion of her income for use in the future. The saver delays the gratification that comes from spending today and instead reduces current consumption below what her total income would allow her to spend.

The saver puts the money that is not spent in some kind of an account that will be secure and grow modestly in value. The saver's primary objective is to preserve the monies saved. Therefore, she will likely put her funds in an account that is guaranteed by the federal government. The money might be invested in a bank product like a savings account, interest-bearing checking account, a bank money market account or a certificate of deposit. All of these bank products are eligible for Federal Deposit Insurance (FDIC) up to a legal limit of $250,000.

The smart saver will seek to put enough into "safe" investments, so that emergencies can be met from these funds. A rough rule of thumb suggests that three to six times monthly expenses should be set aside in an emergency fund. The saver can tap this fund if her car needs repairs, an appliance must be replaced, or to get through a brief period of unemployment.

Investor: An investor is someone who is willing to accept investment risk with the expectation of receiving a return proportionate to the risk. The greater the risk of loss of principal, the greater the expected return.

Savers become investors once their emergency funds are fully funded. Savers should not "invest" funds that belong in their emergency funds. However, once the emergency fund has been fully funded, the investor should become an investor as well.

The investor will consider a wide universe of investments such as individual securities (e.g. stocks and bonds), mutual funds, exchange traded funds, limited partnerships or investment trusts. In fact, there are many kinds of investment that may appeal to the investor.

Speculator: A speculator is someone who is willing to accept a very high level of risk with the hope that she will be rewarded with a very high return. The speculator accepts a very high probability that she may lose some, or all, of her investment. The risk of loss with speculation is greater than it is with investing.

There are many ways to speculate. One can purchase an interest in a wildcat oil exploration project, raw land subject to future development, a start-up company with no revenue and in many other ventures. The speculator reviews information related to an opportunity that requires funds, evaluates the risks and potential returns and decides to participate or not based on her own assessment

Gambler: A gambler is a different kind of risk taker. The gambler has no ability to assess risk. He is willing to part with money for the hope that he may receive a large sum in return. Gambling is based on random outcomes and, as a result, the gambler has no influence over the outcome. People who part with their money in casinos are gamblers.

Gamblers seem to gain satisfaction from entertaining the possibility that they may receive a large "reward" for participating in the gamble.

So, what are you?

GAO's Advice for Retirees

The General Accounting Office (GAO) released (June 2011) a study "Retirement Income: Ensuring Income throughout Retirement Requires Difficult Choices." I read the key findings and scanned the study. Here's what the GAO has to say to those approaching retirement.

Consider delaying the receipt of Social Security benefits until reaching at least full retirement age. The Social Security Administration permits recipients to start payments as early as age 62. Many Americans begin receiving benefits at this age. However, their payments would be higher by waiting to full retirement. Nearly three quarters of current beneficiaries took payouts before age 65. Those who wait to age 70 increase their benefits 32% compared to taking them at age 66.

Waiting to start Social Security has other benefits. The applicant continues to work and, hopefully, save. The period of retirement is reduced and, as a result, so is the amount of money required to fund living expenses during retirement.

The study suggests retirees may take withdrawals from their retirement savings at a rate of 3%-6%. This is a pretty widely accepted rule of them in the financial planning community.

For many this draw down rate will not produce sufficient income. The GAO suggests retirees consider the purchase of an immediate annuity which guarantees income for the life of the annuitant.

I find fee only advisors reluctant to suggest clients consider using annuities to fund retirement. Fee only advisors (and their clients) find annuities overly complex and expensive. They are often reluctant to have their clients transfer assets they may be managing to an insurance company. Further, the rates credited by insurance companies to annuities are quite low in the current investment environment rendering the effective return on annuities uninspiring.

I believe there is a place for an immediate annuity in many retirement plans. When I include immediate annuities in client retirement models, I see the model's performance improve.

The GAO study warns that many Americans are in jeopardy of living in poverty in retirement. The office calls for greater financial literacy and making annuities available in defined contribution retirement plans (e.g. 401(k) or 403(b)).