Atlanta Planning Guys

In my experience, Mental Accounting is by far the most common bias exhibited by investors.  It can also do the most harm to an otherwise well conceived financial plan.

Basically, it works like this:  Investors assign different assets to different “accounts” in their minds.  Gain and loss is typically looked at separately.  The decision to buy and sell is rarely based on the effect it will have on the overall portfolio.  Instead, this decision is based solely on its impact to that “account”.  In effect, the investor has created silos for each investment they hold.

This bias is to blame when an investor hangs on to losing investments.  If they sell, that “account” will have realized a loss….something we KNOW that investors despise.  The opportunity to sell the loser and redeploy those assets with the hope of finding a winner is lost by the urge to avoid going “into the red” with that “account”.

Investors who mentally account may sell winning investments too soon.  Eager to “chalk up a win”, an investor may sell an investment with recent success (even though that success MAY continue).  To an investor swept up in mental accounting, success is defined by “wins” and “losses”.

Spending decisions can become clouded.  Consider the situation where someone finances a car at a high interest rate instead of paying with the ample cash in a savings account.  To deplete that account would be devastating as compared to paying finance charges…..in the mind of a mental accountant.  Even though, if she paid cash, that person could replenish the savings account (with interest) by figuratively making the car payment to herself.

“What’s the formula for successfully overcoming this bias?”

It is very difficult.  We are all guilty of this bias in some way. 

The easiest way is to constantly consider how financial and investment decisions impact your personal balance sheet.  Make your “mental account” bigger.  Don’t look at each investment as an account.  Instead, view all of your investment assets (CD’s, IRA, 401(k), checking account, brokerage account, college savings, gifts from Granny) as ONE account.  And……..try, as hard as you can, to remove emotion from the decision. 

There is a popular indicator of investor sentiment that follows the net inflows and outflows into certain investments.  In a nutshell, it goes like this:

o       When investor inflows are at their peak, the market has traditionally gone down soon after

o       When investor outflows are at their peak, the market traditionally goes up shortly after

“Why is this?  Why are investors usually SO WRONG at timing their investments?”

The answer may lie in certain INVESTOR BIASES that we, as humans, have developed and intensified over time.

Misdirected Worry: More people cite being wiped out in a market crash as a greater threat to their financial security than inflation.  While both are possible, historical evidence leans towards inflation as a greater threat to financial security.  BUT, a crash seems “scarier”.

Snake-bite Effect: Investors may forego strong growth opportunities, regardless of whether or not the circumstances are different, if they were “bitten” before.  The technology bubble bursting in 2000 did more to strengthen this bias than anything else I can think of.

House Money Effect: This one is dangerous and can be very counter-productive to an otherwise prudent investment plan.  Investors may be inclined to take excess risk with money viewed as “someone else’s”.  How many times have you been at a casino playing blackjack….you’re up 50 bucks and you keep playing.  In some cases, you may even start betting more.  Once you lose it, you think “Oh well, I broke even.”  We never view it as losing 50 bucks (since you could have walked away when you were up). 

Representativeness:  Labeling an investment as “good” or “bad” using recent performance.  This bias largely explains why investors flock to last year’s hot investment (and usually at precisely the wrong time).

Bandwagon Effect: Similar to Representativeness.  This bias can cause investment bubbles to burst.  The technology bubble and the housing bubble were fostered by investors eager to “get on board”.

Overconfidence:  The belief that your judgment is better than it really is.  People who display an overconfidence bias think that they have access to better information than everyone else and are overly optimistic about their investment outcomes.  We all know one!

Endowment Effect:  The bias that creates the almost impulsive instinct to hold investments they already own.  Most people think much harder, and longer, about sell decisions than they do buy decisions.

Cognitive Dissonance: People tend to reconcile opposing positions or accept one and reject the other…..putting off difficult decisions because it makes us uncomfortable.  Many investors don’t want to think about how spending in the present relates to future savings or retirement.

Anchoring (also known as Home Bias):  People are drawn to what is familiar and comfortable.  People tend to over-concentrate their 401(k)’s with the stock of their company.  Investors also tend to invest a disproportionate share of their portfolio in investments within their own country, region, or industry.

If you should happen to catch a glimpse of Santa this holiday season…take a look at that big belt he is wearing.  Chances are he has cinched that thing in a notch or two.  Perhaps we should all approach this holiday season with fiscal responsibility in mind.  Here are just a few thoughts about getting through the holidays without a whopping credit card bill waiting for you in 2010:

Have a meeting (with the adults):  It is important to have a real discussion with your loved ones about the budget and what everyone should expect this holiday season.  Whether single or married, with or without children; we all have loved ones to think about when it comes to presents.  Some ideas here are…

• - Find out what people “really” want…no need in spending hard earned money on something they don’t want/need
• - Set guidelines for how much to spend on each family member (the same rules don’t have to apply to everyone)

Write down your budget:  How much can you spend on everything?  Commit to a figure and don’t waiver from it.  You’ll have to be disciplined and figure out how to stretch those dollars as far as possible.

• - Set up a “gift account” and put you’ve budgeted for presents in there

Most banks offer pretty low fees for new accounts…besides what is more expensive: a $30 account fee or blowing over your budget by $500?

• - Stay on target…don’t spend money on things that aren’t on the list until you have crossed off the list and purchased all your gifts

Make a list…Really!:  it helps to write down your goals.  Click here to see my post from last year about goal setting.

In the case of gift shopping, the goal is to get the presents you intended on buying in the first place.  If you have already purchased something for a loved one through the course of the year…consider yourself lucky to have crossed that one off your list early.

• - Have you been in a store during holiday shopping? They are doing everything they can to distract you and sell you something other than what you came in for

• - Knowing what you need saves time, money, and sanity
• - Helps keep you within budget

The last two years have exposed a lifetime of emotions for most investors.  Plummeting markets brought fear.  Those who held the course were rewarded with a strong, rapid recovery bringing a sense of euphoria and pride with the wise decision not to sell everything and “stick it under the mattress”.

The 1979 Tversky and Kahneman study* illustrates the impact that aversion to loss has on people’s financial decision-making.  An experiment:

One group of participants was given $1000 AND asked to choose between:

A.      A sure gain of an additional $500

B.      A 50% chance to gain an additional $1000 and a 50% chance to gain nothing

A second group was given $2000 AND asked to choose between:

A.      A sure loss of $500

B.      A 50% chance to lose $1000 and a 50% chance to lose nothing

The results of either choice posed to the two groups are identical: in choice A, both sets of participants end up with $1500 and in choice B, both sets of participants end up with either $2000 or $1000.

Here is where the behavior of humans enters………

·        84% in the first group selected the known gain (option A) rather than risk a loss (option B)

·        69% in the second group chose option B, indicating that they were willing to assume the greater risk of losing $1000 rather than face the certain loss of $500

The key findings of “Prospect Theory” were that:

·        Prospective losses bother investors much more than prospective gains please them

·        Choices people make are based on their subjective version of the situation, not on an objective reality

* Source: Lightbulb Press, An Advisor’s Guide to Behavioral Finance, 2008

A comparison of popular gifting strategies

Summary:

·        If the gift is meant to be used in 18 years (in the case of a college education) or more, I tend to favor strategies that are more aggressive and have the potential for a greater return

·        I will usually try to talk you out of buying a life insurance policy as a gift

·        529 plans (and Coverdell Education Savings Accounts) offer a tax benefit but are restrictive in how the funds may be used

·        UGMA accounts (Uniform Gifts to Minor Act – also known as UTMA or Uniform Transfers to Minors Act) are much less restrictive in how the funds may be used.

·        The tax benefits of a 529 plan couple with the flexibility of an UGMA account may lead you to consider using BOTH

On October 19^th I welcomed my first child, Olivia Hyland Chappell, into the world.  At 7 pounds, 7 ounces (21 inches) both mom and baby are doing great. 

Parents and grandparents frequently ask about savings programs for children.  The idea of creating wealth for the new loved one is very appealing.  Paying for college education or providing a little “seed money” for an eventual down payment on a home seem to be the most cited objectives, in my experience.

There are many tools that are readily available.  Let’s examine a few.

Life Insurance

This used to be one of the most popular financial gifts for newborns.  A small policy, with guaranteed cash value was purchased shortly after the birth of a child.  When the child reached 18 or 21, the policy would have cash value which could be accessed via cashing the policy in, or the policy could be continued indefinitely.  In many cases, the policy also contained a provision allowing the purchase of additional insurance when the child turned 18 or 21 (for example).

·        This strategy was easy to implement.  Back then (I am talking about the early 90’s and prior), everyone knew how to get in touch with a life insurance agent  

·        The premiums were usually very small

·        Since it was life insurance, there was no ongoing tax reporting (as long as the policy wasn’t cashed in)

·        If monthly premiums were undesirable, the parent or grandparent could usually pay the entire premium in advance

·        If the child died prematurely, there would be a sum of money available to provide for a funeral

Some drawbacks

·        Cash value accumulation is often at a rate comparable to a CD or savings account.  BUT, it is usually guaranteed

·        The death benefit is constantly being eroded by inflation.  My grandfather purchased a $5000 policy for me when I was born.  At that time (1974), it was more than the average annual salary of an American worker.  By the time I was an adult (1999), I would need at least 40 times that much insurance to provide for my family.

529 Plans

I wrote about 529 plans recently, and even though they aren’t perfect, they are still worth considering.

·        The money grows tax deferred and is ultimately tax free, if it used for qualified college education expenses

·        The beneficiary of the account can be changed (if necessary), allowing for the gift to benefit multiple people or if a child earns a scholarship or doesn’t go to college

·        The parent usually retains control of the money….even after the child reaches adulthood.

·        Funds withdrawn for non qualified expenses are subject to a 10% penalty and income tax

·        The investments in 529 plans are usually much more aggressive and involve more risk than a CD, savings account, piggy bank, or life insurance policy…….but this is a good thing

Some drawbacks

·        Accessing the money for anything other than qualified college education expenses will trigger a penalty and income tax

·        The potential tax benefits must be weighed against the restrictions in the use of the money

UGMA Account

This account provides the most flexibility for the child.  Using both an UGMA account and a 529 plan is completely acceptable and may be a smart idea.

·        Money can be used for any reason, at any time, as long as it is for the benefit of the child

·        These accounts can be easily opened at most financial institutions

·        Virtually any type of investment can be used

Some drawbacks

·        Accounts receive unfavorable financial aid status once the children apply for college

·        Kids can take control of the money upon reaching adulthood (18 to 21, depending on the state)

For the most ambitious parents and grandparents, we might recommend a combination of both a 529 plan (for college) and an UGMA account (for general wealth building).

In the 80’s and into the early 90’s there was a popular theory about life insurance:  “Buy term and invest the difference”.

Essentially, you would buy a low cost 20 year term policy and invest the difference in premium (between the term policy and that of a whole-life policy) in an investment account each month.  The idea being that at the end of the 20 year period, you would have accumulated a large sum of money in the investment account and there would no longer be a need for life insurance.

Back then, most permanent life insurance was of the whole-life variety and premiums would be due until age 100.  The policies usually built substantial cash value and may have even paid dividends.  Because of this, the difference in premium between a 20 year term policy and a whole life policy could be quite large.  In some cases, several hundred bucks a month!

There were many problems with this strategy, however:

• The assumption for the rate of return in the investment account was often 10 or even 12%
• There was an assumption that the life insurance needs in year 1 were the same as those in year 20. In year 21, this need magically “went away”
• If all payments were not made to the investment account, or if any of the money was used before the end of 20 years, the entire plan would fall apart
• Once the term policy expired, if new coverage was needed the insured’s health status would be unknown and more expensive (since he or she would be 20 years older and may not be insurable anymore)

In the late 90’s, when the stock market seemed to be going straight up, many insurance companies began to offer new types of life insurance.  These new types of insurance allowed policyholders to, basically, invest their cash value in separate accounts.  The slow and steady (and often GUARANTEED) increase in cash value of whole-life policies seemed so boring. 

But, since the policyholder was willing to take some risk, premiums for new policies were generally lower than those for whole-life policies.  This was a blow to the “buy term and invest the difference” camp.  The difference was no longer as substantial. 

After the internet bubble burst, risk-taking went out of style and guarantees were back in vogue.  Universal life insurance was about to get its moment in the sun.

Universal life insurance (UL) was similar to other types of life insurance, with one large difference.  The growth in cash value was driven by crediting rates established by the insurance company.  While these rates could (and did) fluctuate, they were guaranteed to never be below a certain amount (3% was common).

Because of its more predictable nature, UL was even less expensive in many cases.  This was true especially if the policy-holder chose to fund these policies at a minimal level. 

One of the best features of UL is the ability to design a policy to last a specific amount of time.  If you wanted your policy to last until age 90 for example, the company could calculate what you would have to pay into the policy so your cash value would be just enough to last until that date.  The policy-holder still had some risk.  If the insurance company credited less than the assumed rate, or if they had to increase their internal charges, the policy would end sooner than desired.  This risk was real.

Whole-life insurance had become virtually extinct.

AND…..”Buy term and invest the difference” was officially dead.

But it wasn’t perfect……..yet.

The policy-holder still had some risk.  Interest rates (and thus, crediting rates) were really, really low during the mid 2000’s.  Some policies that had been designed with “rosier” assumptions began to lapse. 

The insurance industry came up with a good idea:

In response to this, “no lapse, premium guarantee” (NLPG) became a popular feature of UL.  Basically, the policy-holder would forego much (if not ALL) of the cash value in their policy in return for a GUARANTEE that their policy would stay in-force for the desired number of years.  The only risk to the policy-holder was that the company would be in business when it was time to pay the claim.

Term insurance is a valuable tool: A bunch of TEMPORARY insurance for the smallest outlay possible.  But if there might be a need for insurance longer than a term policy will allow, a NLPG policy could be the right solution.  The premium is more than a term policy, but the ability to keep the policy in-force for any period of time desired may be worth the added expense.  At the very least, it is much different than it was a generation ago.

This is the second posting for my “Ounces versus Pounds” series.  If you missed the first one, here is a link: http://atlantaplanningguys.com/?p=436.  As is the case with much of the guidance that Cass and I dispense, you can’t hear enough of it.  Here are some things to consider routinely doing to make sure you and your vehicle are prepared for whatever life throws at you:

Air it up:  It seems almost too obvious that you should check the air in your tires.  However, you would be surprised how many of us are driving around with too little.  Make sure to especially check them if you’re loading the car up for a road trip or even if you’re just running some long errands around the city.  Do an internet search to find the appropriate PSI (pounds per square inch) of pressure needed in your tires and then head to a gas station to check them out.   Be sure and check the air of your spare tire also.  The spare is just as important, as the other four you ride around on, when something goes wrong.

Roadside assistance:  Everyone has their roadside assistance story.  There are plenty of ways to get roadside assistance.  Many car manufacturers offer it (at least for a few years).  If yours doesn’t, consider joining an auto club. Make sure you have some for that “just in case” moment.

Light things up:  Be sure to check and make sure all your turn signals, brake lights and head lights work properly.  Especially as we approach winter and those long days of summer turn quickly to dark mornings and early sundowns.   Not only are non-functioning lights dangerous to you, they also could lead to costly tickets.

Review your coverage:  Would you submit a claim on your insurance for $250?  How about $500?  If the answer is no, then why do you carry deductibles that are that low?  Review your policy to make sure that your coverage matches up with your willingness to assume risk.  Increasing your deductible could save you more than you think.  Additionally, there have been a few changes regarding how the uninsured motorist coverage on your policy works (http://atlantaplanningguys.com/?p=331).  Call your agent for assistance today.

Remember, everything is great when everything is well…..great.  Take a few minutes and prepare yourself for the unforeseen.  It is those that are prepared for the worst that often don’t experience it.

Whether it was your mother, father, teacher or friend…you have likely heard the phrase “an ounce of prevention is equal to a pound of cure“.  There are countless things that we can do to be prepared for whatever life should throw our way.  Here are just a few things that make a ton of sense around the house:

 Put it on Tape:  With video cameras being so prevalent, how hard would it be to take 10 minutes and stroll through you house to film what you have?  Even if it takes 20 minutes…it is well worth the trip.  Store the video on a computer zip drive, disc or the classic videotape.  Make sure it’s in a nice safe place in the event of a fire, flood or theft.

Check the batteries:  Most modern security systems have hardwired smoke detectors…but still check them.  You will still want to make sure smoke detectors work properly and all monitors should feature a test button.  You should also be keeping a flashlight or two on hand (and candles) in the event of a power outage.  It would make sense to check the batteries on them also.

For the Kids:  If you have little ones roaming about, make sure they know how to get out of the house.  Go over the procedures in the event they smell smoke, hear the alarm or think something is wrong.  Committing the path out of the house can be a life saver when things go really wrong.

Review that Coverage:  Your homeowners insurance should reflect a proper and current level of coverage for your home.  If you have made additions or improvement, bought expensive art, collectibles or jewelry, or added members to the household; these are all things that may impact the different levels of coverage for either your home or personal property.

Store it Properly:  Take the important documents and make them really safe.  This includes all insurance policies (especially home/auto/umbrella).  They make fairly inexpensive safes for your home that are fireproof.  Safe deposit boxes at the local bank work well for this too.  You don’t want there to be any disputing coverage limits when things go wrong.

You’ll thank yourself for taking the few minutes a year to take these precautions.  Hopefully you will never have to be glad you did.

 I find myself giving clients this piece of advice more than any other recommendation I make:

“Contribute to your retirement plan…as much as you can afford”.

There is a caveat to that statement, however.  If your company offers a match, and you are going to be contributing the maximum amount allowed to your plan, don’t “max it out” until the end of the year.

I know what you might be thinking:  “WHAT????  WHY????”

For 2009, the maximum amount that can be contributed to a 401(k) is $16,500 ($22,000 if you are 50 or older).  The maximum for a SIMPLE IRA is $11,500 ($14,000 if you are 50 or older).

Occasionally, we meet an enthusiastic retirement saver who relishes the fact that she contributes the maximum to her retirement account early in the year.  If her retirement plan offers a match, she could be leaving money on the table!!!

The matching formula for 401(k)’s and SIMPLE’s are based off the compensation you earned during the pay period.

An example:

• $5,000 in earnings this month
• Employee contributes 10%
• 3% employer match

RESULT: $500 from employee and $150 from the employer (3% of $5k)

 If you “max out” your contribution before the end of the year, all of the compensation that you earn after that point goes UNMATCHED.  It’s true!

A different example:

• Susie is 40 and earns $120,000 per year ($10k per month). Her employer offers a 5% match. Susie contributes 20% to her plan.
• Each month, Susie is putting $2000 into her plan. Her employer kicks in $500 (5% of $10k). During the month of September, Susie will have made her last allowable contribution ($16,500 is the maximum she can contribute).
• For the months of October, November, and December she will not get a match on her compensation since she is not contributing. You only get a match when you are contributing!

She leaves roughly $1500 on the table ($500 per month for those last three months)

Susie’s intentions were good:  Contribute as much she is allowed as quickly as she can do it.  Put the money to work as fast as possible.  Usually, that is the correct strategy.  But, this situation is unique.  To maximize her contribution AND maximize the employer match, Susie should contribute 13.75% of her salary……NOT 20%

To calculate the OPTIMAL CONTRIBUTION, divide the maximum contribution amount ($16,500) by your annual salary.  The resulting percentage will allow you to contribute the maximum while receiving the FULL match.

In Susie’s case:

• 13.75% of her salary is $16,500, so she will “max out” her contribution at the end of the year
• Since she is contributing each month, she will get the full match ($500 per month for ALL TWELVE months)

As the Jackets and Dawgs take the field this weekend for their inaugural games for the 2009 season, Cass and I are putting the final touches on our second quarter reviews.  Our clients, as well as much of the country, have endured more than their share of hard knocks in the past 18 months.  I would liken it to that passionate fan in the bleachers that watches their team go in at halftime trailing by a few points.  If anything will resonate from locker rooms across the country this weekend, it will be simply to “Stick to the Game Plan”. 

Cass and I know the game is far from over.  One might argue that it will never end.  With that in mind, it is with great gratitude that we want to thank our clients for sticking with the game plan we put in place long before this most recent market collapse (http://atlantaplanningguys.com/?p=86). 

We have been on defense for the better part of two years.  It is nice to finally see our offense take the field for a few series.  As it turns out, our game plan seems to be working: limit the downside and capture as much of the upside as possible.  In football terms, we’ve done a pretty good job of limiting opponent’s points in the red zone and taken full advantage of our scoring opportunities.  Talk to your advisor today.  Make sure your money is ready to tackle whatever the market throws at you tomorrow.  Talk with your financial advisor about your game plan.  Make sure your offense is ready to take the field.