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What Is Correlation (and Why Would You Care)?

Here at Hiley Hunt, we try to keep the financial jargon to a minimum. But even where we may succeed, you’re likely to encounter references elsewhere that can turn valuable information into mumbo-jumbo yet to be translated.

Consider us your interpreter. Today, we’ll explore correlation, and why it matters to investing.

A Quick Take: Correlation Helps People Invest More Efficiently

Expressed as a number between –1.0 and +1.0, correlation quantifies whether, and by how much two holdings have behaved differently or alike in various markets. If we can identify holdings with weak or no expected correlation among one another, we can combine these diverse “pieces” (individual investments) into a greater “whole” (an investment portfolio), to help investors better weather the market’s many moods.

Correlation, Defined

As suggested above, correlation is more than just a quality; it’s also a quantity – a measurement – offering two important insights along a spectrum of possibilities between –1.0 and +1.0:

  1. Correlation can be positive or negative, which tells us whether two correlated subjects are behaving similar to or opposite of one another.
  2. Correlation can be strong or weak (or high/low), which tells us how powerful the similar or opposite behavior has been.

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Correlation, Applied

If you’ve been around the investment block, you’ve probably heard about the benefits of diversification, or owning many, as well as many different kinds of holdings. A well-diversified portfolio helps you invest more efficiently and effectively over time. Diversification also offers a smoother ride, which helps you better stay on course toward your personal financial goals.

But in a world of nearly infinite possibilities, how do we:

Correlation is the answer to these and other portfolio analysis challenges. By quantifying and comparing the behaviors and relationships found among various funds, factors and portfolios, we can better determine which combinations are expected to produce optimal outcomes over time.

Correlation, Calculated

Fortunately, as an investor, you don’t necessarily need to know how to precisely calculate correlations. But it’s useful to know what correlation measurements mean when you see them.

Here’s a simplified example of appealing correlation among three holdings. Each holding exhibits a satisfying level of weak or no correlation with the other two. (A holding will always have perfect positive correlation with itself, thus the +1.0 measurements.)

 

Appealing Correlation

Holding 1 Holding 2 Holding 3
Holding 1 +1.0 +0.3 –0.2
Holding 2 +0.3 +1.0 0.0
Holding 3 –0.2 0.0 +1.0

What if your correlations look more like the trio below? Because all correlations here are strongly positive, you might reconsider whether these holdings are sufficiently diversified to make the most of varied market conditions and sources of expected returns.

 

Too Much Correlation

Holding 1 Holding 2 Holding 3
Holding 1 +1.0 +0.8 +0.9
Holding 2 +0.8 +1.0 +0.7
Holding 3 +0.9 +0.7 +1.0

Correlation, Clarified

It’s worth adding a couple more clarifying points before we wrap:

Comparing Investments – First, the correlation between two holdings is not calculated by directly comparing the returns of each holding. Instead, we compare how each holding’s returns move up and down relative to its own average returns. In “Reducing the Risk of Black Swans,” co-authors Larry Swedroe and Kevin Grogan illustrate how this works:

“A positive correlation exists between two assets when one asset produces above-average returns (relative to its average) and the other asset tends to also produce above-average returns (relative to its average). The stronger the tendency, the closer the correlation will be to +1.”

In other words, two investments may seem quite different at a glance. But if you compare them to their own usual performance, and they both tend to sink or soar in reaction to the same market conditions, they are unlikely to offer strong diversification benefits if you pair them together.

Going the Distance – Also, correlation is not a “set it and forget it” number. For example, two funds may usually exhibit weak correlation, but this can shift if a bear or bull market roars in and wreaks havoc on business as usual. In short, solid analysis calls for studying correlation data across multiple markets and over time, to better understand what to expect during various market conditions. This is another reason to take care when adding new factors to your portfolio. Even if a new opportunity seems promising, you may want to wait and see how it performs over time and around the globe before you buy into the latest popular find.

Correlation, Concluded

Heeding correlation data is a lot like having a full line-up on your favorite sports team. If each player on the roster adds a distinct, useful and well-played talent to the mix, odds are, your team will go far. Similarly, your investment portfolio is best built from a global “team” of distinct factors, or sources of returns. A winning approach combines quality components that exhibit weak or no correlation among or between them across varied, long-term market conditions.

Let us know if we can help you use correlation to enhance your own investment experience.

10 Things to Do Right Now While Markets Are (Not Really) Tanking

“This is a test; this is only a test. Had this been an actual emergency …”

The truth is, the markets are not tanking as we write this piece. In fact, overall market temperatures have been so mild for so long, many newer investors have yet to weather a perfect market storm. Even if you have, you may have forgotten how panic-inducing those times can be.

This worries us. Experience and evidence alike show us how severely bear markets test investor resolve, sabotage otherwise solid plans, and just plain hurt. We’ve also seen how damaging it can be to act on rash fear rather than rational resolve during market downturns.

So let’s pretend, shall we? Just as we prepare for other emergencies by practicing how to avoid deadly blunders in the heat of the moment, here are 10 timely actions you can take when financial markets are tanking … and, frankly, even when they’re not.

  1. Don’t panic (or pretend not to). It’s easy to believe you’re immune from panic when the financial sun is shining, but it’s hard to avoid indulging in it during a crisis. If you’re entertaining seemingly logical excuses to bail out during a steep or sustained market downturn, remember: It’s highly likely your behavioral biases are doing the talking. Even if you only pretend to be calm, that’s fine, as long as it prevents you from acting on your fears.

“Every time someone says, ‘There is a lot of cash on the sidelines,’ a tiny part of my soul dies. There are no sidelines.” – Cliff Asness, AQR Capital Management

 

  1. Redirect your energy. No matter how logical it may be to sit on your hands during market downturns, your “fight or flight” instincts can trick you into acting anyway. Fortunately, there are productive moves you can make instead – such as all 10 actions here – to satisfy the itch to act without overhauling your investments at potentially the worst possible time.

“My advice to a prospective active do-it-yourself investor is to learn to golf. You’ll get a little exercise, some fresh air and time with your friends. Sure, green fees can be steep, but not as steep as the hit your portfolio will take if you become an active do-it-yourself investor.” – Terrance Odean, behavioral finance professor

 

  1. Remember the evidence. One way to ignore your self-doubts during market crises is to heed what decades of practical and academic evidence have taught us about investing: Capital markets’ long-term trajectories have been upward. Thus, if you sell when markets are down, you’re far more likely to lock in permanent losses than come out ahead.

“Do the math. Expect catastrophes. Whatever happens, stay the course.” – William Bernstein, MD, PhD, financial theorist and neurologist

 

  1. Manage your exposure to breaking news. There’s a difference between following current events versus fixating on them. In today’s multitasking, multimedia world, it’s easier than ever to be inundated by late-breaking news. When you become mired in the minutiae, it’s hard to retain your long-term perspective.

“Choosing what to ignore – turning off constant market updates, tuning out pundits purveying the latest Armageddon – is critical to maintaining a long-term focus.” – Jason Zweig, The Wall Street Journal

 

  1. Revisit your carefully crafted investment plans (or make some). Even if you yearn to go by gut feel during a financial crisis, remember: You promised yourself you wouldn’t do that. When did you promise? When you planned your personalized investment portfolio, carefully allocated to various sources of expected returns, globally diversified to dampen the risks involved, and sensibly executed with low-cost funds managed in an evidence-based manner. What if you’ve not yet made these sorts of plans or established this kind of portfolio? Then these are actions we encourage you to take at your earliest convenience.

“The key to successful investing is to get the plan right and then stick to it. This means acting just like the lowly postage stamp that does one thing but does it well. It sticks to its letter until it reaches its destination. The investors’ job is to stick to their well thought out plan (if they have one) until they reach their destination. And if they don’t have a plan, write one immediately.” – Larry Swedroe, financial author

 

  1. Reconsider your risk tolerance (but don’t act on it just yet). When you craft a personalized investment portfolio, you also commit to accepting a measure of market risk in exchange for those expected market returns. Unfortunately, during quiet times, it’s easy to overestimate how much risk you can stomach. If you discover you’re miserable to the point of breaking during even modest market declines, you may need to re-think your investment plans. Start planning for prudent portfolio adjustments, preferably working with an objective advisor to help you implement them judiciously over time.

“Our aversion to leverage has dampened our returns over the years. But Charlie [Munger] and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need.” – Warren Buffett, Berkshire Hathaway

 

  1. Double down on your risk exposure – if you’re able. If, on the other hand, you discover you’ve got nerves of steel, market downturns can be opportunities to buy more of the depressed (low-price) holdings that fit into your long-range investment plan. You can do this with new money, or by rebalancing what you’ve got (selling appreciated assets to buy the underdogs). This is not for the timid! You’re buying holdings other investors are fleeing in droves. But if you’re able to do this and hold tight, you’re especially well-positioned to make the most of the expected recovery.

“Pick your risk exposure, and then diversify the hell out of it.” – Eugene Fama, Nobel  laureate economist

 

  1. Tax-loss harvest. Depending on market conditions as well as your own circumstances, you may be able to use tax-loss harvesting to turn financial lemons into lemonade during market downturns. A successful tax-loss harvest lowers your tax bill without substantially altering or impacting your long-term investment outcomes. This action is not without its tricks and traps, however, so it’s best done in alliance with a financial professional who is well-versed in navigating the challenges involved.

“In investing, you get what you don’t pay for.” – John  C. Bogle, Vanguard founder

 

  1. Revisit this article. There is no better time to re-read this article than when today’s “safety drill” is no longer an exercise but a real event. Maybe it will take your mind off the barrage of breaking news.

“We’d never buy a shirt for full price then be O.K. returning it in exchange for the sale price. ‘Scary’ markets convince people this unequal exchange makes sense.” – Carl Richards, Behavior Gap

 

  1. Talk to us. We don’t know when. We don’t know how severe it will be, or how long it will last. But sooner or later, we expect the markets will tank again for a while, just as we also expect they’ll eventually recover and continue upward. We hope today’s drill will help you be better prepared for “next time.” We also hope you’ll be in touch if we can help. After all, there’s never a bad time to receive good advice.

“In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.’ Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”
– Benjamin Graham, economist, “father of value investing”

Charitable Giving Under New Tax Laws Understanding the Donor-Advised Fund (DAF)

No matter how the 2017 Tax Cuts and Jobs Act (TCJA) may alter your tax planning, we’d like to believe one thing will remain the same: With or without a tax write-off, many Americans will still want to give generously to the charities of their choice. After all, financial incentives aren’t usually your main motivation for giving. We give to support the causes we cherish. We give because we’re grateful for the good fortune we’ve enjoyed. We give because it elevates us too. Good giving feels great – for donor and recipient alike.

That said, a tax break can feel good too, and it may help you give more than you otherwise could. Enter the donor-advised fund (DAF) as a potential tool for continuing to give meaningfully and tax-efficiently under the new tax law.

What’s Changed About Charitable Giving?

To be clear, the TCJA has not eliminated the charitable deduction. You can still take it when you itemize your deductions. But the law has limited or eliminated several other itemized deductions, and it’s roughly doubled the standard deduction (now $12,000 for single and $24,000 for joint filers). With these changes, there will be far fewer times it will make sense to itemize your deductions instead of just taking the now-higher standard allowance.

This introduces a new incentive to consider batching up your deductible expenses, so they can periodically “count” toward reducing your taxes due – at least in the years you’ve got enough itemized deductions to exceed your standard deduction.

For example, if you usually donate $2,500 annually to charity, you could instead donate $25,000 once each decade. Combined with other deductibles, you might then be able to take a nice tax write-off that year, which may generate (or be generated by) other tax-planning possibilities.

What Can a DAF Do for You?

DAFs are not new; they’ve been around since the 1930s. But they’ve been garnering more attention as a potentially appropriate tax-planning tool under the TCJA. Here’s how they work:

  1. Make a sizeable donation to a DAF. Donating to a DAF, which acts like a “charitable bank,” is one way to batch up your deductions for tax-wise giving. But remember: DAF contributions are irrevocable. You cannot change your mind and later reclaim the funds.
  2. Deduct the full amount in the year you fund the DAF. DAFs are established by nonprofit sponsoring organizations, so your entire contribution is available for the maximum allowable deduction in the year you make it. Plus, once you’ve funded a DAF, the sponsor typically invests the assets, and any returns they earn are tax-free. This can give your initial donation more giving-power over time.
  3. Participate in granting DAF assets to your charities of choice. Over time, and as the name “donor-advised fund” suggests, you get to advise the DAF’s sponsoring organization on when to grant assets, and where those grants will go.

Thus, donating through a DAF may be preferred if you want to make a relatively sizable donation for tax-planning or other purposes; you’d like to retain a say over what happens next to those assets; and you’re not yet ready to allocate all the money to your favorite causes.

Another common reason people turn to a DAF is to donate appreciated stocks in kind (without selling them first), when your intended recipients can only accept cash/liquid donations. The American Endowment Foundation offers this 2015 “Donor Advised Fund Summary for Donors,” with additional reasons a DAF may appeal – with or without its newest potential tax benefits.

Beyond DAFs

A DAF isn’t for everyone. Along the spectrum of charitable giving choices, they’re relatively easy and affordable to establish, while still offering some of the benefits of a planned giving vehicle. As such, they fall somewhere between simply writing a check, versus taking on the time, costs and complexities of a charitable remainder trust, charitable lead trust, or private foundation.

That said, planned giving vehicles offer several important features that go beyond what a DAF can do for a family who is interested in establishing a lasting legacy. They also go beyond the scope of this paper, but we are happy to discuss them with you directly at any time.

How Do You Differentiate DAFs?

If you decide a DAF would be useful to your cause, the next step is to select an organization to sponsor your contribution. Sponsors typically fall into three types:

  1. Public charities established by financial providers, like Fidelity, Schwab and Vanguard
  2. Independent national organizations, like the American Endowment Foundation and National Philanthropic Trust
  3. “Single issue” entities, like religious, educational or emergency aid organizations

Within and among these categories, DAFs are not entirely interchangeable. Whether you’re being guided by a professional advisor or you’re managing the selection process on your own, it’s worth doing some due diligence before you fund a DAF. Here are some key considerations:

Minimums – Different DAFs have different minimums for opening an account. For example, one sponsor may require $5,000 to get started, while another may have a higher threshold.

Fees – As with any investment account, expect administration fees. Just make sure they’re fair and transparent, so they don’t eat up all the benefits of having a DAF to begin with.

Acceptable Assets – Most DAFs will let you donate cash as well as stocks. Some may also accept other types of assets, such as real estate, private equity or insurance.

Grant-Giving Policies – Some grant-giving policies are more flexible than others. For example, single-entity organizations may require that a percentage of your grants go to their cause, or only to local or certain kinds of causes. Some may be more specific than others on the minimum size and/or maximum frequency of your grant requests. Some have simplified the grant-making process through online automation; others have not.

Investment Policies – As touched on above, your DAF assets are typically invested in the market, so they can grow tax-free over time. But some investments are far more advisable than others for building long-term giving power! How much say will you have on investment selections? If you’re already working with a wealth advisor, it can make good sense to choose a DAF that lets your advisor manage these account assets in a prudent, fiduciary manner, according to an evidence-based investment strategy. (Note: Higher minimums may apply.)

Transfer and Liquidation Policies – What happens to your DAF account when you die? Some sponsors allow you to name successors if you’d like to continue the account in perpetuity. Some allow you to name charitable organizations as beneficiaries. Some have a formula for distributing assets to past grant recipients. Some will roll the assets into their own endowment. (Most will at least do this as a last resort if there are no successors or past grant recipients.) Also, what if you decide you’d like to transfer your DAF to a different sponsoring organization during your lifetime? Find out if the organization you have in mind permits it.

Deciding on Your Definitive DAF

Selecting an ideal DAF sponsor for your tax planning and charitable intent usually involves a process of elimination. To narrow the field, decide which DAF features matter the most to you, and which ones may be deal breakers.

If you’re working with a wealth advisor such as Hiley Hunt Wealth Management, we hope you’ll lean on us to help you make a final selection, and meld it into your greater personal and financial goals. As Wharton Professor and “Give and Take” author Adam Grant has observed, “The most meaningful way to succeed is to help others succeed.” That’s one reason we’re here: to help you successfully incorporate the things that last into your lasting, charitably minded lifestyle.

Dimensional’s Advisor 2017 Market Review

Happy New Year! With 2017 in the rearview mirror, we’re pleased to reflect on – and share with you – a newly released Dimensional Fund Advisors 2017 Market Review.

Overall, the view is quite pleasant for most global and domestic returns alike, even though few financial forecasters were predicting this sort of slam dunk at the outset of the year. If you think back to last January, there were plenty of reasons to wonder about the next 12 months – what with Brexit uncertainties, U.S. election upsets, continued terrorist threats hitting all too close to home, and the usual litany of other unknowns.

Digging deeper into the heady, mostly double-digit 2017 stock market returns, there’s another important theme found in this year’s data: While the profitability premium was positive across most markets, small-cap and value premia often underperformed their large-cap and growth counterparts.

These data points are relevant, because a typical evidence-based investment strategy calls for steadfast diversification across these expected sources of market premiums (as always, according to your unique financial goals and risk tolerance).

It’s especially pertinent to those who may be tilting their portfolio mix toward the very premia that happened to relatively underperform this year. If that’s you, and you’re in pursuit of these factors’ higher expected long-term returns, you may be wondering: “Should I alter my plans?”

Unless your own goals or circumstances have changed, our short, evidence-based answer is, no, probably not. As described in Dimensional’s Year in Review, “Premiums can be difficult if not impossible to predict and relative performance can change quickly, reinforcing the need for discipline in pursuing these sources of higher expected returns.”

To use an analogy, think of your investment experience as a cross-continental trek. You get to define your desired destination – although, as in real life, you aren’t guaranteed to reach it. In pursuit of your journey’s end, you also get to choose between a low, slow, temperate trail (lower risk and lower expected returns), or a potentially swifter route with more peaks, valleys and weather extremes (higher risk and higher expected returns).

Whichever route you’ve chosen for your financial journey, don’t be too surprised when you encounter what you’ve signed up for. And remember, the most likely way to achieve your goals is almost always in the form of a steadfast, forward march.

Which brings us to our fundamental advice, this and every year. If you’ve not yet put your investment plans in place, consider that among your most important New Year’s resolutions. Balance your risk and expected return exposures according to what you want and need out of the markets. After that, enjoy the balmy returns where they exist and as they last. Be prepared to soldier through the storms when they periodically arise as well.

Last but never least, let us know how we can help.

 

Year-End Reflections on the New Tax Law

We interrupt your busy holiday season with a quick post on last week’s U.S. tax code overhaul. While the ink still dries on this sweeping new legislation, you may be wondering whether there are ways you can or should spring into action immediately, before year-end, to reposition yourself for the new law of the land.

First, we want to emphasize that the new rules are not retroactive. Your 2017 tax return – the one due this April – will still be prepared under pre-reform law.

Practically speaking, this means there is probably not a great deal you must do right away. If we’re aware of particular circumstances in your life that might warrant otherwise, we will be in touch with you directly to assist – if we haven’t been already. And of course we remain on call as always, to promptly assist with any questions or requests you may have at your end.

In the meantime, here is our general take on how to position your year-end tax planning choices.

Do you value your limited holiday season time with loved ones far more than the potential to shave off some future tax dollars owed? If so, even if you might forgo potential savings, you might prefer to opt out of making any special tax-planning moves at this time (beyond those you’d be doing anyway).

Would you rather ensure every tax-related dollar is spared, even if it takes a little extra immediate time to do so? If that’s the case, there are at least two areas you may want to consider right away: your charitable giving habits, and the timing of your taxable income.

First, let’s talk about your charitable giving. By design, most Americans are likely to fare better in 2018 by taking the higher standard deduction available under the new law instead of itemizing deductions on Schedule A. If it’s likely you will no longer submit a Schedule A next year, then charitable contributions will no longer help you reduce your taxes.

BUT, if you’ve been itemizing in years past – i.e., submitting a Schedule A – you’ll probably still itemize in 2017. Thus there may be benefits to making your 2018 charitable contributions before year-end, when they might still “pay off” for you and your recipients alike (subject to existing limitations). You can write those checks directly. Or, this might be a good time to consider funding a Donor Advised Fund, from which you can distribute donations in the future while taking the tax break today.

One other general consideration as we approach year end: Many Americans’ tax rates are expected to decrease next year. Thus, if there are reasonable (legal) ways to shift any reportable income into 2018, you may end up paying less tax on it.

As always with tax planning, there are a ton of caveats, catches and exceptions to these rules of thumb. If you are thinking of taking action before year-end, we hope you’ll be in touch, so we can discuss the details with you. Either way, we will no doubt be having much deeper discussions in 2018 about what the new tax law means to your tax planning, your personal wealth and your lifetime goals. We look forward to being here for you – today, tomorrow and throughout the years ahead.

The ABCs of Behavioral Biases: Conclusion

We’ll wrap our series, the ABCs of Behavioral Biases, by repeating our initial premise: Your own behavioral biases are often the greatest threat to your financial well-being.

We hope we’ve demonstrated the many ways this single statement can play out, and how often our survival-mode brains trick us into making financial calls that foil our own best interests.

Evidence-Based Behavioral Finance

But don’t take our word for it. Just as we turn to robust academic evidence to guide our disciplined investment strategy, so too do we turn to the work of behavioral finance scholars, to understand and employ effective defenses against your most aggressive behavioral biases.

If there weren’t so much damage done, behavioral finance might be of merely academic interest. But given how often – and in how many ways – your fight-or-flight instincts collide with your rational investment plans, it’s worth being aware of the tell-tale signs, so you can detect when a behavioral bias may be running roughshod over your higher reasoning. To help with that, here’s a summary of the biases we’ve covered throughout this series:

The Bias Its Symptoms The Damage Done
Anchoring

 

 Going down with the proverbial ship by fixing on rules of thumb or references that don’t serve your best interests.

 

 “I paid $11/share for this stock and now it’s only worth $9. I won’t sell it until I’ve broken even.”

 
Blind Spot

 

 The mirror might lie after all. We can assess others’ behavioral biases, but we often remain  blind to our own.

 

 “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Daniel Kahneman)

 
Confirmation

 

 This “I thought so” bias causes you to seek news that supports your beliefs and ignore conflicting evidence.

 

 After forming initial reactions, we’ll ignore new facts and find false affirmations to justify our chosen course … even if it would be in our best financial interest to consider a change.

 
Familiarity

 

 Familiarity breeds complacency. We forget that “familiar” doesn’t always means “safer” or “better.”

 

 By overconcentrating in familiar assets (domestic vs. foreign, or a company stock) you decrease global diversification and increase your exposure to unnecessary market risks.

 
Fear

 

 Financial fear is that “Get me  out, NOW” panic we feel whenever the markets turn brutal.

 

 “We’d never buy a shirt for full price then be O.K. returning it in exchange for the sale price. ‘Scary’ markets convince people this unequal exchange makes sense.” (Carl Richards)

 
Framing

 

 Six of one or half a dozen of another? Different ways of considering the same  information can lead to different conclusions.

 

 Narrow framing can trick you into chasing or fleeing individual holdings, instead of managing everything you hold within the greater framework of your total portfolio.

 
Greed

 

 Excitement is an investor’s enemy (to paraphrase Warren Buffett.)

 

 You can get burned in high-flying markets if you forget what really counts: managing risks, controlling costs, and sticking to plan.

 
Herd Mentality

 

 “If everyone jumped off a   bridge …” Your mother was  right. Even if “everyone is doing it,” that doesn’t mean you  should.

 

 Herd mentality intensifies our greedy or fearful financial reactions to the random events that generated the excitement to begin with.

 
Hindsight

 

 “I knew it all along” (even if you didn’t). When your hindsight   isn’t 20/20, your brain may subtly shift it until it is.

 

 If you trust your “gut” instead of a disciplined investment strategy, you may be hitching your financial future to a skewed view of the past.

 
Loss Aversion

 

 No pain is even better than a gain. We humans are hardwired to abhor losing even more than we crave winning.

 

 Loss aversion causes investors to try to dodge bear markets, despite overwhelming evidence that market timing is more likely to increase costs and decrease expected returns.

 
Mental  Accounting

 

 Not all money is created equal. Mental accounting assigns different values to different dollars – such as inherited  assets vs. lottery wins.

 

 Reluctant to sell an inherited holding? Want to blow a windfall as “fun money”? Mental accounting can play against you if you let it overrule your best financial interests.

 
Outcome

 

 Luck or skill? Even when an outcome is just random luck, your biased brain still may attribute it to special skills.

 

 If you misattribute good or bad investment outcomes to a foresight you couldn’t possibly have had, it imperils your ability to remain an objective investor for the long haul.

 
Overconfidence

 

 A “Lake Wobegon effect,” overconfidence creates a statistical impossibility:   Everyone thinks they’re above average.

 

 Overconfidence puffs up your belief that you’ve got the rare luck or skill required to consistently “beat” the market, instead of patiently participating in its long-term returns.

 
Pattern Recognition

 

 Looks can deceive. Our survival instincts strongly bias us toward finding predictive patterns, even in a random series.

 

 By being predisposed to mistake random market runs as reliable patterns, investors are often left chasing expensive mirages.

 
Recency

 

 Out of sight, out of mind. We tend to let recent events most heavily influence us, even for  our long-range planning.

 

 If you chase or flee the market’s most recent returns, you’ll end up piling into high-priced hot holdings and selling low during the downturns.

 
Sunk Cost Fallacy

 

 Throwing good money after   bad. It’s harder to lose something if you’ve already invested time, energy or money into it.

 

 Sunk cost fallacy can stop you from selling a holding at a loss, even when it is otherwise the right thing to do for your total portfolio.

 
Tracking Error Regret

 

 Shoulda, coulda, woulda. Tracking error regret happens when you compare yourself to external standards and wish you were more like them.

 

 It can be deeply damaging to your investment returns if you compare your own performance against apples-to-oranges measures, and then trade in reaction to the mismatched numbers.

 

Next Steps: Think Slow

Even once you’re familiar with the behavioral biases that stand between you and clear-heading thinking, you’ll probably still be routinely tempted to react to the fear, greed, doubt, recklessness and similar hot emotions they generate.

Nobel laureate Daniel Kahneman helps us understand why in his book, “Thinking, Fast and Slow,” where he describes how we engage in System 1 (fast) and System 2 (slow) thinking: “In the picture that emerges from recent research, the intuitive System 1 is more influential than your experience tells you, and it is the secret author of many of the choices and judgments you make.”

In other words, we can’t help ourselves. When we think fast, our instincts tend to run the show; for better or worse, they’re the first thoughts that come to mind.

This is one reason an objective advisor can be such a critical ally, helping you move past your System 1 thinking into more deliberate decision-making for your long-term goals. (On the flip side, financial providers who are themselves fixated on picking hot stocks or timing the market on your behalf are more likely to exacerbate than alleviate your most dangerous biases.)

Investors of “Ordinary Intelligence”

Berkshire Hathaway Chairman and CEO Warren Buffett is a businessman, not a behavioral economist. But he does have a way with words. We’ll wrap with a bit of his timeless wisdom:

“Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

If you can remember this cool-headed thinking the next time you’re tempted to act on your investment instincts, Mr. Buffett’s got nothing on you (except perhaps a few billion dollars). But if you could use somes help managing the behavioral biases that are likely lurking in your blind spot, give us a call. In combatting that which you cannot see, two views are better than one.

 

The ABCs of Behavioral Biases (S-Z)

We’re coming in for a landing on our alphabetic run-down of behavioral biases. Today, we’ll present the final line-up: sunk cost fallacy and tracking error regret. If you would like to get caught up in our series, please click here to view the last article!

Sunk Cost Fallacy

What is it? Sunk cost fallacy makes it harder for us to lose something when we also face losing the time, energy or money we’ve already put into it. In “Why Smart People Make Big Money Mistakes,” Gary Belsky and Thomas Gilovich describe: “[Sunk cost fallacy] is the primary reason most people would choose to risk traveling in a dangerous snowstorm if they had paid for a ticket to an important game or concert, while passing on the trip if they had been given the ticket for free.” You’re missing or attending the same event either way. But if a sunk cost is involved, it somehow makes it more difficult to let go, even if you would be better off without it.

When is it helpful? When a person, project or possession is truly worth it to you, sunk costs – the blood, sweat, tears and/or legal tender you’ve already poured into them – can help you take a deep breath and soldier on. Otherwise, let’s face it. There might be those days when you’d be tempted to help your kids pack their “run away from home” bags yourself.

When is it harmful? Falling for financial sunk cost fallacy is so common, there’s even a cliché for it: throwing good money after bad. There’s little harm done if the toss is a small one, such as attending a prepaid event you’d rather have skipped. But in investing, adopting a sunk cost mentality – “I can’t unload this until I’ve at least broken even” – can cost you untold real dollars by blinding you from selling at a loss when it is otherwise the right thing to do. The most rational investment strategy acknowledges we cannot control what already has happened to our investments; we can only position ourselves for future expected returns, according to the best evidence available to us at the time.

Tracking error Regret

What is it? If you’ve ever decided the grass is greener on the other side, you’ve experienced tracking error regret – that gnawing envy you feel when you compare yourself to external standards and you wish you were more like them.

When is it helpful? If you’re comparing yourself to a meaningful benchmark, tracking error-regret can be a positive force, spurring you to try harder. Say, for example, you’re a professional athlete and you’ve been repeatedly losing to your peers. You may be prompted to embrace a new fitness regimen, rethink your equipment, or otherwise strive to improve your game.

When is it harmful? If you’ve structured your investment portfolio to reflect your goals and risk tolerances, it’s important to remember that your near-term results may frequently march out of tune with “typical” returns … by design. It can be deeply damaging to your long-range plans if you compare your own performance to irrelevant, apples-to-oranges benchmarks such as the general market, the latest popular trends, or your neighbor’s seemingly greener financial grass. Stop playing the shoulda, woulda, coulda game, chasing past returns you wish you had received based on random outperformance others (whose financial goals differ from yours) may have enjoyed. You’re better off tending to your own fertile possibilities, guided by personalized planning, evidence-based investing, and accurate benchmark comparisons.

We’ve now reached the end of our alphabetic overview of the behavioral biases that most frequently lead investors astray. In a final installment, we’ll wrap with a concluding summary. Until then, no regrets!

2017 3rd Quarter Update

If you’ve taken our past advice about ignoring the onslaught of breaking market news, you probably didn’t read Russell Investments’ recent “2017 Global Market Outlook Q4 Update.”

We’re not prone to pore over these relatively unremarkable analyses ourselves, but we do scan a representative sampling of them as part of our due diligence. That’s how we came across this intriguing statement in Russell Investments’ wrap-up:

“Our main message for the close of 2017 isn’t much different from our opening one: we maintain our ‘buy the dips and sell the rallies’ mantra.”

Great idea, but a little weak on practical application. It’s akin to suggesting that lottery players can score big … as long as they consistently pick the winning numbers!

Immediately following Russell Investments’ mantra, you’ll find this disclosure:

“These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.”

In all seriousness, we feel these sorts of reports speak inadvertent volumes about the evidence-based mantra to which we adhere. By depending on practical evidence instead of fanciful forecasts, our views are rarely subject to change – especially not in hurried reaction to current market conditions.

Instead, we continue to believe the best way to manage your personal wealth is to:

This is our mantra, and so it shall remain – regardless of the date at the top of the page.

As you view your own performance data in this context, we remain eager to hear from you. How else can we help you achieve your greatest financial goals?

 

 

 

 

Divorce Division of Assets: QDRO Part 1

One of the toughest realities to prepare for after a divorce—and especially after a difficult one—is the division of financial assets. Wealth accumulated throughout a life’s hard work could be severely and negatively impacted in a matter of months, creating problems that could continue for years if the proper details are not attended to during the divorce proceedings. That is why today we will be discussing one of the most important acronyms to pay attention to during a divorce settlement: QDRO.

What Is a QDRO?

A qualified domestic relations order (QDRO) is a court order, judgment, or decree that allows a qualified retirement plan, such as a 401(k), 403(b), or pension, to pay benefits to the former spouse (or other dependent individual) in addition to the individual who controls and contributes to the plan. Without a QDRO, the alternate payee (the person assigned to share these types of benefits) is not entitled to receive any monies the plan will pay out. A QDRO agreement does not extend to include outside workplace retirement accounts such as savings/checking accounts, houses, etc.

Steps to Acquire a QDRO

Approval of a QDRO, which is finalized when the divorce itself is finalized, is generally granted before the divorce judgment is handed down. Any competent divorce attorney will know the steps needed to obtain a QDRO during the negotiation phase of a divorce.

But let’s say that a QDRO was not drafted for approval by your spouse, the retirement plan itself, or the judge during the proceedings for your divorce. This does not mean that you are out of luck. There is still a chance that you can obtain a QDRO and receive a fair portion of your now-ex-spouse’s retirement account. Here is what you need to do in order to make that happen:

  1. Sit down with an attorney who specializes in QDROs. Generally speaking, negotiating a QDRO during the divorce proceedings makes the division of assets easier. Once that time has passed, however, meeting with a lawyer to discuss how to obtain a QDRO will still ensure that you have the best chance to receive a post-decree settlement. The American Academy of Matrimonial Lawyers is one resource you could consider using to locate an attorney who specializes in family law which includes QDROs. It is important to lay out a clear legal plan before the proceedings.
  2. Send the resulting QDRO draft to the retirement/pension plan administrator. This is the most important step in the QDRO process. If the retirement/pension plan rejects your draft, you’ve wasted valuable time, which could prove costly. Oftentimes, the plan will return a copy of the draft with suggestions for changes based on the plan’s own rules and regulations. Consulting with an attorney with expertise in the QDRO process might enable you to circumvent some of these issues.
  3. Get the needed signatures from a judge and all affected parties. Once the retirement/pension plan has given its approval, it is important to obtain signatures from a divorce judge and all interested parties. The sooner this step is completed, the closer you will be to receiving your share of the benefits.
  4. Send a copy to the pension/retirement plan. Send the pension/retirement plan administrator a copy of the QDRO for approval. This will ensure that the benefits are paid out.

The steps listed above might take only a few months to complete, if everything happens quickly. Any delay, however, will mean more time before you receive the benefits, assuming all is in order. If your former spouse remarries or dies, it will become almost impossible to get any portion of the retirement account from the employer.

Divorce is one of the most difficult events a person may have to go through in life, and the aftermath of a divorce can be harder to handle if the marital assets were not divided well. A QDRO could be one of the most important financial documents obtained during this emotionally charged period of time. Seeking advice from a team of legal and financial experts will do wonders for your financial well-being and give you peace of mind.

The ABCs of Behavioral Biases (F-H)

Let’s continue our alphabetic tour of common behavioral biases that distract otherwise rational investors from making best choices about their wealth. Today, we’ll tackle: fear, framing, greed and herd mentality. If you’re interested in reading the rest of the behavioral biases alphabet, please click here!

Fear

What is it? You know what fear is, but it may be less obvious how it works. As Jason Zweig describes in “Your Money & Your Brain,” if your brain perceives a threat, it spews chemicals like corticosterone that “flood your body with fear signals before you are consciously aware of being afraid.” Some suggest this isn’t really “fear,” since you don’t have time to think before you act. Call it what you will, this bias can heavily influence your next moves – for better or worse.

When is it helpful? Of course there are times you probably should be afraid, with no time for studious reflection about a life-saving act. If you are reading this today, it strongly suggests you and your ancestors have made good use of these sorts of survival instincts many times over.

When is it harmful? Zweig and others have described how our brain reacts to a plummeting market in the same way it responds to a physical threat like a rattlesnake. While you may be well-served to leap before you look at a snake, doing the same with your investments can bite you. Also, our financial fears are often misplaced. We tend to overcompensate for more memorable risks (like a flash crash), while ignoring more subtle ones that can be just as harmful or much easier to prevent (like inflation, eroding your spending power over time).

Framing

What is it? “Thinking, Fast and Slow,” Nobel laureate Daniel Kahneman defines the effects of framing as follows: “Different ways of presenting the same information often evoke different emotions.” For example, he explains how consumers tend to prefer cold cuts labeled “90% fat-free” over those labeled “10% fat.” By narrowly framing the information (fat-free = good, fat = bad; never mind the rest), we fail to consider all the facts as a whole.

When is it helpful? Have you ever faced an enormous project or goal that left you feeling overwhelmed? Framing helps us take on seemingly insurmountable challenges by focusing on one step at a time until, over time, the job is done. In this context, it can be a helpful assistant.

When is it harmful? To achieve your personal financial goals, you’ve got to do more than score isolated victories in the market; you’ve got to “win the war.” As UCLA’s Shlomo Benartzi describes in a Wall Street Journal piece, this demands strategic planning and unified portfolio management, with individual holdings considered within the greater context. Investors who instead succumb to narrow framing often end up falling off-course and incurring unnecessary costs by chasing or fleeing isolated investments.

Greed

What is it? Like fear, greed requires no formal introduction. In investing, the term usually refers to our tendency to (greedily) chase hot stocks, sectors or markets, hoping to score larger-than-life returns. In doing so, we ignore the oversized risks typically involved as well.

When is it helpful? In Oliver Stone’s Oscar-winning “Wall Street,” Gordon Gekko (based on the notorious real-life trader Ivan Boesky) makes a valid point … to a point: “[G]reed, for lack of a better word, is good. … Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.” In other words, there are times when a little greed – call it ambition – can inspire greater achievements.

When is it harmful? In our cut-throat markets (where you’re up against the Boeskys of the world), greed and fear become a two-sided coin that you flip at your own peril. Heads or tails, both are accompanied by chemical responses to stimuli we’re unaware of and have no control over. Overindulging in either extreme leads to unnecessary trading at inopportune times.

Herd Mentality

What is it? Mooove over, cows. You’ve got nothing on us humans, who instinctively recoil or rush headlong into excitement when we see others doing the same. “[T]he idea that people conform to the behavior of others is among the most accepted principles of psychology,” say Gary Belsky and Thomas Gilovich in “Why Smart People Make Big Money Mistakes.”

When is it helpful? If you’ve ever gone to a hot new restaurant, followed a fashion trend, or binged on a hit series, you’ve been influenced by herd mentality. “Mostly such conformity is a good thing, and it’s one of the reasons that societies are able to function,” say Belsky and Gilovich. It helps us create order out of chaos in traffic, legal and governmental systems alike.

When is it harmful? Whenever a piece of the market is on a hot run or in a cold plunge, herd mentality intensifies our greedy or fearful chain reaction to the random event that generated the excitement to begin with. Once the dust settles, those who have reacted to the near-term noise are usually the ones who end up overpaying for the “privilege” of chasing or fleeing temporary trends instead of staying the course toward their long-term goals. As Warren Buffett has famously said, “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

Well said, Mr. Buffett! We’ve got more behavioral biases to cover in upcoming installments, so stay tuned.

A New Name in College Savings Plans

The average price tag for four years at a private college exceeds $170,000, according to the College Board’s Trends in College Pricing 2014. That’s 17% higher than seven years previously. In fact, rising tuition costs are outpacing inflation at the same time that federal grant aid is lagging behind inflation.

While funding four years of college can be a challenge, research also proves that higher education remains a valuable investment. According to the College Board’s Education Pays 2013, in 2011, women with bachelor’s degrees earned 70% more than women with only high school diplomas; college-educated men earned 69% more than men who graduated from high school but did not have college degrees.

There are a variety of savings vehicles and planning strategies that can help you overcome the financial challenges and reach your education goals. One tax-efficient vehicle is the Coverdell Education Savings Account (ESA), which can be used to pay for college expenses, as well as for the cost of attending qualified K-12 schools.

With a Coverdell ESA, funds have the opportunity to grow tax deferred, and withdrawals used for qualified educational expenses, such as tuition, are tax free. A beneficiary can be anyone under the age of 18 (or older, if qualified as a special needs beneficiary). Any individual (including the beneficiary) may make contributions to a Coverdell ESA, as long as his or her modified adjusted gross income for the year is less than $110,000 ($220,000 for married couples filing joint tax returns). Other features include the following:

By expanding the definition of qualified educational expenses to include primary and secondary education expenses, as well as room and board, the Coverdell ESA is proving to be a welcome addition to the various tax-favored options for saving for educational expenses.

Note: Nonqualified distributions may be subject to an additional 10% federal tax penalty on earnings.

A Trust Primer

Many of us may perceive trusts as a complex subject better left to our attorney. However, a trust is simply a contract initiated by a grantor who agrees to transfer assets to a beneficiary, who then receives the assets as stipulated in the trust contract. A trustee, who may also be the grantor, manages the trust assets and ensures the stipulated terms of the trust are faithfully executed.

A trust is designed to help individuals manage a variety of family and tax-related estate planning concerns. Here are a few ways in which trusts can be used:

Revocable Living Trust. A revocable living trust is an estate planning trust that deeds property to an heir but allows the grantor to retain control over the property during his or her lifetime. Upon the grantor’s death, the property passes to the beneficiary, avoiding probate, which is the judicial process wherein a court appoints an executor to carry out the provisions of a will. While the revocable living trust does not provide tax savings for the grantor during his or her lifetime, the trust becomes ‘irrevocable’ upon death, and the beneficiary is then entitled to tax advantages.

Irrevocable Living Trust. An irrevocable living trust is an estate planning trust wherein the grantor does not retain control of assets or property. Through the transfer of assets or property into the trust, the grantor may be eligible for certain tax savings. An irrevocable living trust may also be used to avoid probate.

Irrevocable Life Insurance Trust (ILIT). An irrevocable life insurance trust is designed to provide tax savings through the ownership of a life insurance policy. Assets in the trust are generally not considered part of the grantor’s estate. ILITs may be funded or unfunded. With a funded ILIT, income-generating assets are transferred into the trust, and the generated income is then used to pay the premiums on the life insurance policy. With an unfunded ILIT, the grantor makes yearly gifts to the trust, and this money is then used to pay the premiums on the life insurance policy.

Credit Shelter Trust: A credit shelter trust, also called a bypass trust, is an estate planning tool used to protect assets from successive estate taxes. While current law permits an unlimited amount of assets and property to pass to a surviving spouse without being subject to Federal estate taxes, children and other beneficiaries must pay taxes for inheritances valued in excess of the applicable estate tax exclusion amount, which is $5.49 million per individual in 2017. If a married couple wishes to take advantage of a credit shelter trust, they generally arrange for certain assets to pass into the trust for the benefit of the surviving spouse, rather than passing all assets directly to the spouse. This trust, which would not be considered part of the surviving spouse’s estate—and generally does not exceed the applicable exclusion amount—may pay the surviving spouse income for life and then, upon his or her death, may pass to a beneficiary, such as a child, free of estate taxes if under the exclusion limit. In addition, the gross estate of the surviving spouse upon his or her death could pass to the same beneficiary, and up to $5.49 million in 2017 would be free of estate taxes.

Charitable Remainder Trust (CRT): A charitable remainder trust is an arrangement in which assets are donated to a charity but the grantor continues to use the property and/or receives income from it. A CRT may allow the grantor to avoid capital gains taxes on highly appreciated assets; receive an income stream based on the full, fair market value (FMV) of those assets; receive an immediate charitable deduction; and ultimately, benefit the charity of his or her choice.

Dynasty Trust: This trust is often used by individuals to pass wealth to their grandchildren free of generation-skipping transfer taxes.

A trust can be an effective way to accomplish your long-term estate planning goals, but often involve complicated tax laws. Consult with your tax and legal professionals about your particular situation and how a trust may enable you to share your wealth with family, friends, or charities.