Across My Desk: Top 10 Wealth-Management Pitfalls

Morningstar's Sue Stevens, a CFA, CFP, CPA, is one wise lady. The piece appeared in Sue's Monthly Newsletter on August 30, 2007.( A version of this article last appeared Jan. 25, 2007.)

What follows are the first five of the 10 points she makes. Next week, read about points six through 10:

"You're smart. You're well-educated. You're doing well in life. Then why are you so worried about losing it all? Or worse yet, maybe you aren't worried and you should be.

Let's take a look at some of the biggest pitfalls on the road to wealth. If you're truly going to be successful, you'll need to navigate carefully through the many hazards along the way.

1. Leaving Assets Unprotected

It's not going to do you much good to build up your wealth if you let it slip through your fingers. Any number of catastrophes can occur along the way. Have you really protected yourself and your family?

Do you have adequate life insurance? If you died tomorrow, would your spouse or loved ones have money to pay some of their biggest expenses like college or paying off the mortgage balance? Would they be able to stay in the same house and still be able to pay the bills? Life insurance can help protect the assets you've built up by sheltering them from estate tax and providing income replacement for your family. This is especially important when you have young children, a nonworking spouse, or a big mortgage. You'll want to consider these needs as you weigh the cost of life insurance.

Another potential wealth destroyer is the dizzying cost of medical care in your later years. Have you considered long-term care insurance? According to a study by the New England Journal of Medicine, 43% of people age 65 are expected to enter a nursing home at least once before they die. Many people are in denial about long-term care. If you don't have a relative or family friend who has gone through this process, you may not have given it much thought at all. For those of you who have experienced it first-hand, you know the physical, mental, and financial strain that aging relatives can bring to the whole family. Does everyone need long-term care? No. The very rich can self-insure, and the very poor won't be able to afford it. For everyone else, it's worth taking a look at these policies.

Finally, consider how you are protecting your personal property. Is your home protected from fire, weather disasters, and theft? How about acts of terrorism? Take a look at your homeowners insurance to be sure. You should also have adequate coverage on your auto insurance. If you or someone in your family had an accident, would your insurance company pay for the damage? What about lawsuits that could arise from an accident? Check to see what the underlying liability coverage is for both homeowners and auto insurance. Protect yourself from property lawsuits by purchasing an "umbrella" policy. These policies build on the underlying liability levels in your homeowners and auto policies and take your coverage up to the $1 million range. The more wealth you've accumulated, the more umbrella coverage you should carry.

2. Mismanaging Cash Flow

The most successful wealth managers know that they must be disciplined in their spending. It's so easy to let expenses creep up as you make more and more money. If you're not careful, those expenses can kill your chances of capitalizing on that wealth. The first rule of any good financial plan is to pay yourself first. Make sure you are putting away a healthy portion of your income and investing it. Don't live beyond your means.

Another aspect of managing cash flow is minimizing taxes. As your return gets more and more complex, you need to find professional help to take advantage of every deduction you're entitled to. Your accountant can also help identify other opportunities like additional retirement funding vehicles, mortgage refinancing strategies, and/or estate planning techniques. At the very least, you should be discussing ways to use capital loss carryforwards (many of you will have these) to your advantage.

During your working years, it is critical that you carry disability insurance. Many of you can purchase this coverage through your employer. Take advantage of the opportunity to protect your income should something prevent you from working. It's far more probable that you'll have a disability claim than a life insurance claim, and yet many people ignore this important coverage.

3. Mismanaging Debt

A well-run company knows how to manage its debt. You need to think about debt management in your personal life, too. How much debt is too much? Look at your shorter-term debts first--such as credit card debt, car loans, bank loans (other than mortgages), and student loans. If your short-term loans add up to more than your liquid assets are worth, you probably have too much short-term debt. (Liquid assets include cash accounts, brokerage accounts, and cash surrender value of life insurance policies.) If you find yourself in this situation, you should (at the very least) examine the interest rates you are paying on each loan and try to consolidate your debt at a lower interest rate. Home equity lines of credit work well in many situations because not only are interest rates low, but the interest is tax deductible.

Mortgages can be a good way of managing debt because you get a tax break on the mortgage interest. But even with your mortgage you should exercise some caution. Taking on more debt makes it harder to adjust should you find your circumstances change (for instance, you lose your job). If at all possible, I'd try to keep mortgage debt below 75% of the value of the property. Just paying your mortgage every two weeks throughout the year helps to cut overall interest payments over the life of the loan.

4. Neglecting Your Finances

One of the biggest mistakes I see in wealth management is plain old lack of attention. People are very busy. Sometimes personal finance takes a backseat to other more pressing matters. But if you take that approach, you may wind up feeling that the years have flown by and you haven't made much progress. Successful wealth creation takes a commitment of time.

5. Choosing the Wrong Investment Strategy

I've written entire articles about the pitfalls of investing. Even if you're able to generate a considerable amount of income, you have to know how to protect and preserve that capital.

One pitfall a lot of people have experienced in the past several years is misjudging your risk tolerance. When the market just keeps going up, it's easy to think you can handle the risk. But after seeing what happened in 2000-02, many investors rethought how much risk (or loss) is acceptable to them. Even as the market sets new highs now, it's important not to forget the risk involved.

Another common mistake is not rebalancing periodically. Many people refuse to sell if they've lost money on an investment. If your mix of stocks, bonds, and cash (your asset allocation) makes you very uncomfortable, you need to think about taking some losses and moving to an asset allocation that is in line with your ability to handle risk.

If you do realize losses, you can try to make the best of it by being tax-savvy. No one likes to lose money, but those losses can be a benefit at tax time. You can use $3,000 a year to offset ordinary income. You can net out an unlimited amount of capital gains and losses against each other. Any losses you can't use right away can be carried forward indefinitely. This is just one of many techniques you can use to create a tax-efficient portfolio...."

Next week read about points six through 10.