When Bad Decisions Happen to Good People
Fear isn’t always logical but that doesn’t make it any less real. For example if you had a scary dream, would it be more likely to feature an alligator, a bear, a shark, a snake or a deer? According to author Jason Zweig, the deer is by far the most dangerous animal in the United States because deer-strikes (and attempted avoidance thereof) cause many more deaths every year than do fatal encounters between humans and alligators, bears, sharks and snakes combined.
How do fears play out in the world of finance? Research in the somewhat obscure field of behavioral economics suggests that losing or gaining the same amount of money is perceived quite differently. For most people, losing $100 is about two and a half times more painful than gaining $100 is pleasurable. That being the case, perhaps it’s not surprising that, when it comes to investing, people seem to be more afraid of a market crash leaving them destitute (less than a 2% chance in any year) than of inflation eroding their nest egg’s purchasing power (a 100% chance during most normal lifetimes).
Even though some people are reluctant to join the fray of investing in the stock and bond markets, Warren Ward Associates’ long-term focus almost always requires us to propose some version of that strategy to our clients. Very few people have so much capital that CDs alone will provide enough money to last a lifetime. As new clients hear (and regular readers have already learned), we begin our investment process with a series of evaluations. These help us discover an individual’s likely tolerance for market fluctuations and what role money plays in her or his life. After that, we employ a customized version of a Nobel Prize-winning strategy known as Modern Portfolio Theory. This process apportions investments into multiple sectors of the markets with the intent of reducing portfolio volatility. Although far from perfect, it is a tool we utilize to help our clients avoid as much of the “pain” as possible, while still maintaining sufficient performance to deliver most of the “pleasure”.
Everyone knows that “beating the market” is difficult, especially over long periods of time. My recent article called Time in the Markets vs Timing the Markets, features some very revealing data on the topic. According to multiple studies, not only do most individual investors not beat the market, they often do significantly worse due to the poor timing of their investment decisions. A common scenario involves fear keeping an investor out of the market during a period of rising stock prices. At some point, perhaps after a couple of good years, that investor may go ahead and take the plunge, only to find that the market is about to correct again. For example, consider the “dot com” boom of the late 1990’s. As has been true in every previous market correction, those who waited and invested only after repeatedly hearing others talk about how “easy” it was, suffered losses during the correction of 2000. Having joined that party late, they probably sold their tech stocks at a loss, making them that much less likely to return to the markets than before - even as lower prices became available.
Even though a vast amount of “do it yourself” information exists, especially since the advent of the internet, survey results have not changed: individual investors still struggle. Because investing has proven so difficult for so many, let me suggest that attempting to achieve an “average return” might be a more sensible goal for most investors than “beating the market”. Using that as a target, investors might find themselves under reduced pressure, thus less fearful and perhaps better able to make decisions.
Evaluating investment returns does not necessarily involve complex formulas. Many print and on-line services offer historical data, allowing you to contrast your own results to those of various indices. Simply comparing your account values “then” and “now” with index values over the same period will automatically take into account all costs related to the investments, along with the performance of the markets themselves. As you evaluate your portfolio’s performance, it might also be a good idea to consider the value of the time spent away from work or leisure activities, time which is an integral part of the “do it yourself” equation.
While obtaining information has become ever easier, the challenge of interpreting and applying the data has not. Deciding whether to invest on your own or with the help of an advisor like WWA is not likely to be easy. Our clients tell us that the time and anxiety saved are easily worth our fees. Perhaps trying to reduce your own fears about investing through considering a less ambitious goal would be a good place to begin. If you are having trouble setting goals, scheduling one of our no charge “get to know you” meetings might be a good first step. Please feel free to contact us if you’d like more information.
One for You, Nineteen for Me . . .
One of my favorite poets, George Harrison, wrote those lyrics for the Beatles’ song Taxman almost 40 years ago. Although US rates have never quite reached the 95% level at which George was taxed in the UK, they always seem high enough that planning for them makes sense.
I have just returned from the first of several tax update schools which I will attend this year, trying to keep abreast of the changes which will affect our clients. With four new laws and many updates to assimilate, I thought I’d share at least some initial observations.
The past twelve months have brought an interesting combination of tax breaks intended to stimulate the economy: increased deductions for business use of automobiles (to encourage vehicle purchases), extension of reduced capital gains tax rates (to encourage people to sell property and spend the money on something else) and the mailing of stimulus checks so people have some money to spend. All of this, of course, will reduce potential tax revenues, perhaps by as much as $150 billion dollars.
Those reduced capital gains tax rates of 5% and 15% are not, in fact, the lowest ones available. For individuals with an Adjusted Gross Income (AGI) below $41,500 (or a couple with an AGI below $83,000) the rate is 0, yes, zero. This provides a great opportunity for people who qualify to reduce their cost basis in at least some appreciated assets, whether property or securities.
Congress also acted to extend some other tax breaks, including the one available to those who have reached age 70½ and must take Required Minimum Distributions from IRAs. If they choose, these individuals can continue to make direct transfers from their IRAs to qualified charities. Although there is no deduction for the gift, there is no tax on the withdrawal which provides a greater benefit.
On the other side of the coin, tighter restrictions continue on the valuation of clothing, household items and automobiles which are given to charities. New for this year, appraisers are to receive increased oversight. In hopes of increasing tax revenue, whistleblower rewards have been increased to 30% of the amount collected by the IRS for those willing to "turn-in" someone who has cheated on their taxes.
I think the biggest break overall relates to those who have gotten in over their heads in the depressed real estate market and must "walk away" from a mortgage. In the past, if someone abandoned a home and the lender forgave the difference between the amount owed and the amount realized from an eventual sale, that difference was treated as income to the mortgage holder and therefore taxable. The new rule states that up to $2 million of forgiven mortgage debt is not income and therefore not taxable. Although Congress was slow to act, they made the provision retroactive to January 1st, 2007 and a subsequent law extends the tax break until December 31st, 2012. That figure seems extreme to those of us living in the Midwest but Congress clearly intended to settle the issue once and for all whether dealing with someone in Columbus, Indiana or Palm Beach, California.
To encourage home purchases, buyers who are required to obtain Private Mortgage Insurance (PMI) may now consider those premiums to be interest, making them deductible. In addition, there is a new first-time homebuyer’s credit of up to $7500. Although actually an interest-free loan, it provides additional incentive for people to start buying homes again.
By now, most taxpayers will have received a stimulus check (or electronic deposit). Those who did not qualify this year will have a chance to try again next year. Twenty million middle-income taxpayers who might have had to deal with the Alternative Minimum Tax (AMT) have been granted additional relief. This too should leave people with a bit more money to spend.
On a procedural note, the IRS has provided additional clarification on which of a divorced couple gets the exemption for a child. It has also increased the mileage reimbursement rate to 58.5 cents. With gasoline rates falling as the dollar gains strength, I suspect 2009 will bring the first ever lowering of that rate.
Taxes must be collected so that our government can continue to operate and there are a range of opinions about who does or does not pay their fair share. According to the IRS website, here’s a breakdown of which earners paid what percentage of income taxes collected for 2006. Each row includes the one above it, i.e. the Top 1% are also included in the Top 5%.
|
AGI threshold |
% of all taxes paid |
|
|
top 1% |
$388,806 |
39.89 |
|
top 5% |
$153,542 |
60.14 |
|
top 10% |
$108,904 |
70.79 |
|
top 25% |
$64,702 |
86.27 |
|
top 50% |
$31,987 |
97.01 |
|
bottom 50% |
<$31,987 |
2.99 |
In the early 1950’s, US tax rates involved many more brackets than today including a marginal rate of 92%, quite close to what George Harrison once had to pay. Although economics has famously been called "the dismal science" it is, in fact, much more an art. Whether recent changes in tax codes and rules by Congress and the IRS will have the desired result remains to be seen. I will certainly continue my study of the topic and hope to share what I learn.
