Part two in a series of two “financial literacy basics” posts, focusing on important investment and financial planning topics that investors need to know. You can find part one  here.

April is Financial Literacy Month in America. So GuideVine asked financial advisors about money matters they think investors need to understand to be better informed about their financial plans and better understand why their planners think the way they do.

Most investors don’t know what they don’t know. This can harm their chances of saving sufficiently for retirement in a world where they’re faced with dozens of small choices that have a cumulative impact over time. Here’s a look at several principles advisors wish more investors understood.

The market moves in cycles, so honest assessment of risk tolerance is key

Most investors consider themselves to have a so-called “high risk tolerance” — or a willingness to purchase investments that promise the greatest returns, but also carry the greatest risk.

Unfortunately, they adopt this attitude when the market is on a bull run, and then tend to change their minds when the market goes bearish.

“People almost always say they’re a moderate to aggressive investor when the market is doing well, but not when it enters a down cycle,” says John Flavin, an advisor with Synergy Financial Management in Seattle. “We work to align risk tolerance with returns expectations.”

Just as aggressive investing cannot make up for insufficient saving, investors who need a particular rate of return to achieve their savings goals have to understand the risk profile of the assets they’ll need to hold to meet that goal. Either that, or they’ll have to modify either their returns expectations or their sense of risk.

Flavin says much of what he does is educate clients about the personal “required rate of return” their portfolio will need to deliver, and strategies for getting there that carry different risk scenarios. This conversation is common right now, as the market tapers off after a multi-year bull run. Investors need to understand that they shouldn’t jump out of the market just because some of their gains are slowing.

Designing an emergency cushion matters

Every investor needs an emergency cushion. But that cushion can take more forms than the stereotypical pile of cash in a low-interest savings account or collection of certificates of deposits (CDs).

Some investors can count money held in brokerage accounts or their Roth IRA as a kind of savings cushion (in an emergency they can withdraw principal), while others may choose to purchase different types of insurance products—each of which will provide a different level of coverage for short-term or permanent disabilities, accidents, death, liability etc.

While insurance doesn’t become an “asset” or source of income until disaster strikes, it protects against investors having to draw down from existing savings or retirement accounts and can prevent facing heavy expenses that cut into saving and retirement account contributions.

“Twenty years ago financial advisers just handled stocks and bonds, but you now can work on other decisions together, including how much cash to keep on hand and how much emergency funding you should have access to,” Flavin says.

“Insurance is a very important part of your financial plan, but generally nobody likes to talk about it until something bad happens.”

Tax planning matters

Many investors understand the concept that a Roth IRA is positive because this type of account promises tax-free funds in retirement. But the retirement tax landscape is far more complex than just “taxable” and “non-taxable.” Indeed, so-called “tax arbitrage” is part of a financial planner’s job, notes Erik Olson, a financial advisor at Arete Wealth in Crystal Lake, Ill.

Depending on an investor’s current and likely future net worth, their choice of retirement vehicle(s), the timing of when they begin drawing on social security, and the fact that most adults use a mix of retirement income streams to fund their later years—each with different tax rates—a bit of tax-related scenario modeling is in order. Many retirees, Olson notes, find themselves withdrawing tiers of funds—where the first $20,000 might be untaxed, the next $17,000 taxed at 17%, the next layer taxed at 15%, and so forth.

Additionally, those who use SEP IRA, SIMPLE IRA, and non-Roth retirement plans must make “required minimum distributions” starting at age 70 ½. These so-called RMDs are typically a minimum percentage of the total portfolio. This means those who have saved substantially could be required to withdraw more than they need and then pay a higher-than-necessary tax rate for the funds. For some investors, there could be tax advantages to tapping the funds in a different way or reallocating funds to different savings vehicles before entering retirement.

“It really depends on the retiree’s future asset and income mix as to whether the Roth’s tax-free status is significant for them or not,” he notes.

Understanding the difference between containers and assets in them is key

Additionally, some advisers say clients don’t always understand that a 401k or an IRA are containers for their assets, and not the assets themselves. For instance, a Roth IRA is a type of retirement account within which an investor can store stocks, funds, bonds, etc, in a tax-free manner, while an employer-offered 401k is a type of account to hold assets and where an employer may make matching contributions. Once an investor has chosen a container, they then get to decide which assets must be placed inside of it.

Additionally, many investors have been pitched, have read about, or have been provided with products they don’t entirely understand. Examples of these products might include employer-provided pension products or annuities (which convert a set dollar amount of your funds into an income stream that can pay you one of several ways in later adulthood).

Mr. Olson notes that whether an investor uses an investment product, they should always ask their advisor to help them understand how using it will impact any legacy they leave to heirs and how the product will impact their total retirement income and the way it is provided to them.


Jane Hodges

Jane Hodges

Jane Hodges is the author of Rent Vs. Own (Chronicle Books) and has written about real estate and personal finance for The Wall Street Journal, New York Times, Seattle Times, Fortune and many other publications. Follow Jane on Twitter and Google+