No single investment performs well under every condition. If a large portion of your portfolio is over concentrated in one type of investment and bad news causes its value to drop unexpectedly, your financial security will be put in jeopardy.

Riding the waves

You cannot control the factors that cause investment prices to fluctuate, you can diversify your portfolio to help smooth out the ups and downs. Diversification spreads your assets among a range of different quality investment vehicles. This means your personal investment success isn’t tied to one investment.

A well diversified portfolio includes

• Cash and cash equivalents
• Fixed income investments like bonds, mortgage funds and GICs
• Growth and income investments such as dividend or balanced funds
• Growth investments such as mutual funds that offer the chance for greater capital appreciation

Watch your weight

You also need to diversify your investments within each category. No more than five percent of your overall portfolio should be in any one company and no more than 25 percent of your overall portfolio should be invested in any one fund.

In your investment plan you should outline what percentage of your portfolio should be allocated to each of the above categories. Every three to six months you should re-examine your portfolio and make sure that it still within the ranges defined by your plan. If they’re not, rebalance and stick to your plan.

Diversification and sticking to your asset allocation does not guarantee a profit, but it will serve to minimize your losses when things go badly.

Investment success depends on buying and holding quality investments in a well-diversified portfolio. My last post discussed the importance of developing an investment plan. The quality and success of this plan also depends on the quality of the investments you own. A long-term approach to investing is the best way to take advantage of growth opportunities and to minimize certain investment risks. This takes both time and discipline.

Anatomy of a quality investment

When buying bonds, it’s important to focus on those rated investment grade. When buying stocks, no single attribute defines quality, but, generally speaking, you should look for companies that are well-managed with long track records of growth and performance. Another thing to look for in quality stocks is a regular history of dividend payout.

Mutual funds and segregated funds, with reasonable fees, that own these types of stocks and bonds are also quality investment vehicles. When selecting a fund, it’s best to look for funds with a 10-year track record and ones that don’t hold the top performing spot for the previous year. It’s likely that the fund managers took a lot of risk to reach those returns and the level of risk means that those returns are likely unsustainable. Any fund you select should fit into your long term investment plan.

Aggressive investments can be appropriate for some investors, but more often than not they shouldn’t make up an entire portfolio.

The golden rule

The golden rule for investing: If it sounds too good to be true, it probably is.

You shouldn’t jump into the investment world right away. First, you need to establish a solid insurance portfolio of life, disability and critical illness insurance. Second, you should establish a liquidity fund. Third, you should get rid of debt. Once you’ve moved through these three steps, then you can start developing an investment plan.

The stock and bond markets offer hundreds of attractive investments every day. The tricky part about investing isn’t identifying an attractive investment; it’s identifying what you should own. The most important factor in determining what investment you should own is your long-term objectives.

Write it down

You can easily find investments that will help you pay for your child’s education or your retirement in 10 or 20 years. Many people will abandon quality investments if there is a temporary decline in the stock market. That’s why a written plan is so important.

Successful investing requires specific objectives and steps for achieving them. It also requires discipline and more than a little patience. A written investment strategy can help provide all of these.

Stay focused

This written plan should define your long-term goals, investing time frame and risk tolerance. Use your strategy to guide your investment decisions and your written plan will help you to stay focused. A written plan will also help you say no to potentially speculative investments that might become temporarily popular.

A critical illness is a life threatening or altering condition that often strikes with little or no warning. In Canada, one in two men and one in three women will suffer from heart disease (Heart and Stroke Foundation, 2004) and 1:2.3 men and 1:2.6 women will develop cancer (National Cancer Institute of Canada, 2004).

Most people are insured if they die from one of these diseases, but very few are insured if they survive. The good news is that more people are surviving. 80% of hospitalized heart attack patients survive and 80% of stroke patients survive (Heart and Stroke Foundation, 2004). However, survival does not ensure financial or emotional well-being.

Surviving a critical illness can place a huge financial strain on a family – lost income, renovations

Critical illness (CI) insurance is designed to address this concern by providing a benefit while the insured person is still alive. This benefit is extremely important when someone suffers a serious illness that affects their ability to earn income or reduces their life expectancy.  

The benefit paid out by critical illness insurance is paid in a tax-free lump sum. How the benefit will be used is up to the patient. It can be used to replace lost income, pay for medical services, make a necessary home renovation, pay off debts or even to take a final vacation if the critically ill is expected to die.

There is a waiting period before the benefit is paid out. The benefit period can range from 14 to 30 days, but usually falls closer to 30. Once this waiting period is satisfied, the lump sump will be paid out regardless of whether they are expected to live or die.

What classifies as a critical illness?

Under a CI policy the insured must suffer a certain critical illness as defined by the policy. There is no standard definition of critical illness but the standard illnesses covered are heart attacks, cancer and stroke. You can find CI policies that will cover addition illnesses and some will cover up to 24 illnesses and will pay you even if you lose loss of independent existence.

In case stuff happens, but what if stuff doesn’t happen?

Another option, or rider, to look for is the return of premium. For example, Great West Life has a CI policy that will return you 100% of your premiums after a certain period if you don’t make a claim. This means that DI and CI offer you a chance to recoup your premiums that can then be invested for your retirement if you never make a claim.

3 crappy ways to cover the expense of a critical illness

Having a policy in place that will pay you a tax-free lump sum benefit is extremely important. For people that don’t have a CI policy there are four common ways to cover the costs associated with a critical illness:

RRSP withdrawal

Withdrawing a lump sum from your RRSP could result in a huge tax liability. For example, let’s say you are at a 40% tax rate and you need $70,000. Before tax you would need to withdrawal more than $130,000. You don’t just lose the tax money, you also lose the possible growth. If you would have left the $130,000 in your RRSP it would have growth substantially – after 20 years with an average return of six percent it would be worth more than $400,000.

Borrowing

A lender may charge a borrower with a known critical illness a higher rate of interest. On top of that problem is that you may have to leave your job because of your illness and that means that you will be applying for credit without employment income. If you can get a loan of $50,000, the 10 year cost assuming an APR of 8.25% is $73,151 and the 20 year cost is $101,208. Using a loan to cover your critical illness is complicated further because chances are you either won’t have a job or won’t be working as much.

Selling assets

There are three problems with selling off your assets, such as your home or cottage.

Timing the market is complicated and you can end up having to selling in a down market.

You run the risk of having to sell in a market like we saw in 2008 and the early part of 2009. Some times it is extremely complicated to find a buyer and when you need to money immediately, this is not a safe option.

Finally, it will reduce your overall net worth, hinder your future ability to get access to cash and reduce the inheritance you can leave to your children or heirs.

A critical illness policy will provide you with the assets you need if you survive a critical illness. You won’t have to worry about liquidating your RRSP, borrowing money or selling your home. Try to find a CI policy with a return of premium option and you’ll get 100% of your money back if you never make a claim.

For most people, the ability to earn an income is their most important financial asset. If this is taken away, they will not be able to sustain their standard of living or repay their debts. While a person’s most important asset is their ability to earn an income, very few people have their income properly insured.

The most common concern about disability insurance (DI) is the cost. People don’t like paying for something that they might not use. This hesitance has always confused me. People pay for house insurance, car insurance and even trip cancellation insurance, but they won’t pay for disability insurance.

People who work for a company or institution may have group disability coverage through their employer. However, many people are self-employed, don’t have a group plan or don’t have a group plan that provides enough disability insurance. If you are one of these people and suffer from an illness that causes a prolonged disability, chances are around one in eight, you could easily lose everything that you’ve worked for.

Non-cancelable DI

Some disability plans can be cancelled by the insurer at any time. Make sure you avoid these. You want to make sure that the disability insurance policy you sign is a non-cancelable disability plan. Under this type of plan, as long as you are paying your premium the insurance company must renew your plan.

A non-cancelable disability insurance policy will pay out a monthly benefit if you suffer a disability. The payments do not start right away after the insured suffers a disability. Before payments are issued, the insured must satisfy the waiting period. The waiting period is the period of time between when you are classified as disabled and when you will begin to receive your monthly benefit. Waiting periods are usually 31, 61, 91 or 121 days and this can be adjusted when you are getting quotes on your policy. If you are concerned about cost, an easy way to lower your monthly premium is to extend your waiting period. A 91 day waiting period is typically the best bang for your buck.

How much is enough?

It is important to note that most insurers won’t cover 100% of your monthly income. The most an insurer will usually provide is 75%.

There are two ways to determine how much disability coverage you will need:

1. Determine your total amount of recurring monthly expenses and apply for that amount.
2. Determine how much money you make in a month and apply for 75% of that coverage.

Get the base model or upgrade?

There are several options that you can and should add to a DI policy.

• Waiver of premium benefit – If you become disabled, the insurance policy’s premiums will be paid for by the insurance company.
• Future purchase option benefits – If you are purchasing a DI policy at the beginning of your career you should look into a future purchase option. This option allows the insured to purchase additional monthly benefits on certain dates without provided any evidence of insurability.
• Cost of living adjustment (COLA) – You can choose to have your monthly benefit increase with the Consumer Price Index (CPI) or you can have it increase at a fixed percent, for example, four percent per year. Some policies will allow you to switch back and forth between a fixed percent and the CPI options.
• Return of premium – This is an excellent way to solve the problem that most people have with insurance. You pay a bunch of money to cover you in the event of a disability, but you might never suffer from one. With the return of premium option you will be eligible to receive a return of a percentage of your premiums at certain dates if you don’t make a claim. For example, my DI policy gives me back 50% of my premiums every seven years. If I get my premium back, I’ll use it to top off my investments.

Protect your most important asset

Disability insurance protects your most important asset, your ability to earn an income. If you are worried about the cost or that you’ll spend a lot of money you can solve those problems. A good DI policy is essential when you are building the foundation of your financial security plan.

Once you have life insurance and disability insurance, the next thing you need to look at is critical illness insurance. This will be the topic of tomorrow’s post.

The foundation of any financial security plan begins with the proper insurance. There are three types of insurance that are necessary for a well-crafted financial security plan: life insurance, critical illness insurance and disability insurance. This post is going to deal with the most common form of insurance: life insurance.

Life insurance allows people to address the financial risks of dying too soon. If you die too soon you may still have financial obligations that will be passed on to loved ones. Some common uses of life insurance are to provide an estate for heirs, funds to provide an income to survivors or financial resources to help children pursue their education.

There are two questions that you need to answer when thinking about life insurance: How much? What kind?

How much?

The first question can only be answered by figuring how much money you need to cover final expenses. Final expenses include such things as burial expenses (they average $10,000 to $15,000), taxes due upon death, total debt and any amount you want to leave to support loved ones or a charity upon death.

Once you have the amount of life insurance that is necessary you need to ask yourself the next question: What kind?

Term or perm?

The next step for figuring out the right need for insurance is to decide which of the above needs are temporary and which are permanent. Term insurance is the most cost-effective way to insure against risk that will disappear over time. Typical uses of term insurance are to cover debt, pay for a child’s education and cover replacement income.

Term insurance provides coverage for a certain specific period of time. You can usually find term insurance policies with durations of one, five, 10 or 20 years or sometimes for a period that ends when the person turns 65 years old.

Most term policies provide an option that allows the insured to renew the policy with the same death benefit without medical questions. This is a renewable term insurance policy. Another useful option to add to a term insurance policy is a convertible option. Adding this option offers an opportunity to convert a portion of the contract or the whole contract to a permanent insurance policy.

Adding renewable and convertible options to a term policy mean that if your final expenses unexpectedly increase you will be able to increase the amount of permanent insurance you have without medical questions.

Permanent coverage

My favorite form of permanent insurance coverage is whole life insurance. With permanent coverage, as long as you pay your premiums you will always have coverage in place.

I prefer whole life insurance because it offers a cash surrender value (CSV). The policyholder can take out loans against the CSV; this isn’t an option available with term insurance contracts.

Another benefit of a whole life policy is that there are non-forfeiture options available to the policyholder. Non-forfeiture options can protect the policy from lapsing if, for some reason, you miss a payment. Again, term insurance contracts don’t provide policyholders with this option.

The first step in creating a plan to achieve financial security is the most overlooked. It’s not insurance, saving or investing. The first step is taking the time to craft a plan. While each person’s situation is different, there is a safe way to work your way towards financial security and independence. There are a few steps:

1. Get insured
2. Get liquid
3. Get rid of debt
4. Get into the market
5. Get rid of your mortgage
6. Get ready to give

When you work your way from step number one through to the final stage of financial security you are gradually managing risk, becoming liquid and creating and protecting wealth.

A financial security plan involves planning for both the wealth accumulation and distribution phases of your life. During the wealth accumulation phase you pay down debt and invest your money to increase your net worth. The steps listed above will help you plan the wealth accumulation phase of your life.

The steps listed above will not only help you craft a plan that will increase your net worth, but will also put wealth accumulation in the context of risk management. With proper insurance coverage and a liquidity fund you will be prepared to handle the unexpected events that can come your way when you least expect them.

My first post elaborating this plan will be out tomorrow and will be titled: “Insurance – net sexy, but necessary”.

So, the new year is closing in on us quickly. During the last quarter of 2009 my financial planning practice and my research consultancy both kicked into a higher than expected gear. My research projects have been cleared up and will now be able to committ more time t my site. Consider it a new year’s resolution. My apologies and I will no doubt have to work hard to earn back my readers.

One of my new year’s resolutions is to have an official launch for Savings Chronicle in 2009. Another feature I will be adding to this site is the SC US Equity Portfolio. I have been selecting US based stocks based on certain value-based calculations. Beginning tomorrow, I will be updating my portfolio’s contents and performance on a monthly basis.

Happy New Year’s and best wishes for 2010,

Kent

Savings Chronicle was featured in a post today over at Money Highway called, “Investing and Money Rules of Thumb“. If you haven’t read it yet, you should.You

Thanks again for the mention,

Kent

The difference between term and whole life insurance is an important one to understand. Without understanding the difference between term and whole life insurance, you won’t be able to tell whether you are properly insured, under insured or over insured.

Temporary needs

The key to understanding the difference between term and whole life insurance comes down to temporary versus permanent coverage. Term insurance is in place for a specific period of time, or term. You can get term insurance ranging from five years to 30 years in some cases. Once the specified term expires, your coverage goes out the window.

Now, there are several riders you can add to your term insurance contract that will modify your coverage, but each rider usually makes your coverage a bit more expensive. One beneficial rider is the guaranteed renewal rider. With this kind of rider when your term expires, your insurance contract will automatically renew itself. This type of insurance coverage can be beneficial if you have a temporary insurance need, but aren’t exactly sure how temporary.

The most common use for term or temporary insurance is to replace the “mortgage insurance” your bank tries to sell you (and often succeeds). Term insurance is an excellent replacement for the bank’s mortgage insurance because when you use term insurance your coverage never decreases and you have control over how to spend the payout.

Permanent needs

Whole life insurance is often recommended for permanent needs, such as final expenses and income replacement at death. Usually, whole life insurance will come with a premium and death benefit that remains level for the entirety of the contract. Also, the insurance policy will build up a cash value that operates as a reserve. The cash value of the policy will usually end up equalling the death benefit if the insured individual lives to 100.

The two most common types of whole life insurance are participating and non-participating. With participating (or par) whole life insurance, any profits derived from the policy are refunded to the policy holder in the form of dividends. Non-participating whole life insurance does not offer this kind of refund. While insurance companies often argue this cash value is a benefit, others consider it a form a forced payment.

Whole life insurance isn’t the only form of permanent coverage. There is also universal life insurance, but it is often expensive and complicated. The most affordable form of permanent insurance coverage is term to 100. Term to 100 coverage often blurs the difference between term and whole life insurance.

Term to 100 (T100) coverage is a stripped down version of whole life insurance. It does not build up a cash value and this means the premium will be cheaper.

Most properly insured people have term insurance to coverage any mortgage that exists and a form of whole life insurance. I’ve been progressing through the various stages of financial well-being. When you are trying to get your finances in order, first you need to develop a small emergency fund. Then you need to start your debt snowball.  Once you’ve paid off your high-interest debt you need to increase your emergency fund so that it can cover a few months worth of expenses. These are the basics, the very bottom level of your financial pyramid. Included at the most basic level is proper life insurance. Once you are properly insured, have enough savings and reduced your debt, you can move on to the next level in the financial planning pyramid – saving for retirement.