By Larry Swedroe
In my book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” there’s a detailed discussion on how investors can choose the right asset allocation for them, with the focus being on determining one’s ability (capacity), willingness (tolerance) and need (the rate of return required to achieve a goal) to take risk.
To help with issues surrounding the willingness to take risk, risk tolerance questionnaires have become a very popular. Unfortunately, as Joachim Klement showed in his article, “Investor Risk Profiling: An Overview,” published in the June 2018 CFA Institute Research Foundation brief “Risk Profiling and Tolerance: Insights for the Private Wealth Manager,” the “current standard process of risk profiling through questionnaires is found to be highly unreliable and typically explains less than 15% of the variation in risky assets between investors. The cause is primarily the design of the questionnaires, which focus on socioeconomic variables and hypothetical scenarios to elicit the investor’s behavior.”
He went on to explain that there are three problems questionnaires typically fail to address: Our genetic predisposition affects our willingness to take on financial risks, the people we interact with shape our views, and the circumstances we experience in our lifetimes—in particular, during the period psychologists call the formative years—influence our outlook.
Being aware of biases at least gives us a chance of addressing them, either on our own or with the help of a financial advisor. Michael Pompian provides guidance on behavioral biases in his article, “Risk Profiling Through a Behavioral Finance Lens,” for the aforementioned CFA Institute Research Foundation brief. (Pompian also is the author of the 2012 book “Behavioral Finance and Wealth Management,” which I recommend for both investors and advisors.)
In his article, Pompian places biases into two broad categories: cognitive and emotional. Cognitive biases have to do with how people think and result from memory errors or faulty reasoning.
He writes: “There are two types of cognitive biases: belief perseverance and information-processing biases. Belief perseverance biases concern people who have a hard time modifying their beliefs even when faced with information to the contrary. It is a very human reaction to feel mentally uncomfortable when new information contradicts information you hold to be true.”
Emotional biases are the result of reasoning that is influenced by feelings, especially during times of stress.
Pompian then analyzes four different investor types—conservative, moderate, growth and aggressive—and reviews the biases likely to be present with each type.
Their risk tolerance is low and they tend to make emotional errors. Being worriers, they tend to place great emphasis on financial security and preserving wealth, and to obsess over short-term performance. They also are slow to make investment decisions because they are uncomfortable with change and uncertainty. Their behavioral-bias orientation is emotional:
- Loss aversion: Feeling the pain of losses (especially realized losses) more than the pleasure of gains, they tend to hold onto losing investments too long.
- Status quo: They feel safe keeping things the same, even if they are not working optimally.
- Endowment: They assign greater value to an asset they already own than to a prospective purchase.
- Anchoring: They tend to cling to investments, anchoring on a specific price (such as the purchase price, or a historic high).
- Mental accounting: Treating different pockets of assets differently, they tend to use a “bucket” approach instead of evaluating the portfolio as a whole.
Their risk tolerance is moderate and they tend to make cognitive errors. They often do not have their own firm ideas about investing, instead following the lead of their friends and colleagues. They tend to be comfortable with the latest, most popular investments, often without regard to a long-term plan. In addition, they often overestimate their risk tolerance. Their behavioral-bias orientation tends to result in cognitive biases such as:
- Recency: The predisposition to recall and overweight recent events and/or observations and to extrapolate patterns where none may actually exist.
- Hindsight: Belief that investment outcomes were predictable.
- Framing: The tendency to respond to situations differently depending on the context in which a choice is presented (framed). For example, when questions are worded in a “gain frame” (e.g., an investor is asked to suppose an investment goes up), a risk-taking response is more likely. When questions are worded in a “loss frame” (e.g., an investor is asked to suppose an investment goes down), risk-averse behavior is the more likely response.
- Cognitive dissonance: When a person believes something is true only to find out that it is not, he or she tries to alleviate discomfort by ignoring the truth and/or rationalizing decisions (often ending up throwing good money after bad).
Moderate investors also tend to make the emotional error of regret-aversion bias, which is the fear of taking decisive action because they worry that, in hindsight, whatever course they select will prove unwise. Regret aversion can cause moderate investors to be too timid in their investment choices because of losses they have suffered in the past.
Their risk tolerance is moderate to high and they tend to make cognitive errors. Growth investors tend to be active investors who are often strong-willed and independent thinkers. They also tend to be self-assured and “trust their gut” when making decisions. However, when they do their own research, they may not be thorough enough with due diligence tasks. They also can be subject to maintaining their views even when those views are not supportable. Some growth investors may appear obsessed with trying to beat the market and may hold concentrated portfolios. Their behavioral-bias orientation tends to be cognitive and reflect biases such as:
- Conservatism: The tendency to cling to a prior view or forecast at the expense of acknowledging new information.
- Availability: Estimating the probability of an outcome based on how prevalent that outcome appears to be in one’s own life.
- Representativeness: Representativeness bias occurs due to a flawed perceptual framework when processing new information. To make new information easier to process, some investors project outcomes that resonate with their own pre-existing ideas.
- Self-attribution: The tendency of people to ascribe their successes to their talents and to blame failures on outside influences.
- Confirmation: The proclivity actively to seek information that confirms one’s claims while ignoring or devaluing evidence that discounts them.
Their tolerance for risk is high and they tend to make emotional errors. They often are the first generation in their family to create wealth. They are even more strong-willed and (over)confident than growth investors, which often leads to chasing high-risk investments. They also tend to change their portfolios as market conditions change, which often creates a drag on investment performance. Finally, they are often “hands on” and want to be involved in the investment decision making. Their behavioral-bias orientation is emotional, tending to exhibit the following biases:
- Overconfidence: An overestimation of one’s quality of judgment, often leading to failure to diversify and concentrated positions in risky assets.
- Self-control: The tendency to consume today at the expense of saving for tomorrow.
- Affinity: The tendency to make irrationally uneconomical consumer choices or investment decisions predicated on how one believes a certain product or service will reflect held values.
- Outcome: Focus on the outcome of a process rather than on the process used to attain the outcome, leading to confusing luck with skill.
- Illusion of control: Believing that one can control or at least influence investment outcomes when, in fact, one cannot. That often leads to persistent “tinkering” with investments.
Behavioral biases can cause even the most well-developed and well-thought-out investment plans to fail. One reason, as physicist Richard Feynman noted, is that “the first principle is that you must not fool yourself and you are the easiest person to fool.” The best cure for such biases is to become educated about them so that at least you are aware you can be subject to them. Perhaps you can even learn to overcome them. If you recognize that isn’t the case, or don’t have sufficient knowledge to invest on your own, you can consider hiring a fiduciary advisor who can help you overcome any particular behavioral biases you might gravitate toward.
For those interested in learning more about behavioral biases, I recommend Nobel Prize-winner Daniel Kahneman’s book, “Thinking, Fast and Slow,” and my own book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them.” The latter covers 77 mistakes, both cognitive and behavioral.
This commentary originally appeared July 12 on ETF.com
By Joe Delaney
Have you ever heard money can’t buy you happiness? Truer words were never spoken. However, as someone who has worked in the financial world for decades, I can do tell you money can be a useful tool to get you there.
I recently participated in the Laguna Beach Aquathon, an annual event dating back to the 1980s. Participants start at Emerald Bay and head south for about 7.5 miles of swimming, bouldering, and running along the coastline to the finish at Three Arch Bay.
If that sounds challenging, it is. So why would I do it? What does this have to do with money and happiness?
MONEY AS A TOOL TO ACHIEVE THE JOY OF PHILANTHROPY
While there is no registration fee to participate in the Aquathon, participants are expected to make a donation. It has been a charitable event for years. In fact, thanks in part of Aquathon donations, the Miocean Foundation was able to announce a successful completion of its mission to clean up all 42 miles of Orange County’s coastline that have public beaches.
This year our donations went to support the Laguna Beach Junior Lifeguard Foundation. The cause is near and dear to my heart, of course, as a former Laguna Beach lifeguard myself. The organization “supports the professional, physical and mental development of Ocean Lifeguards and Junior Lifeguards of Laguna Beach.”
But philanthropy alone is not why I have done this every year for eight years.
MONEY AS A TOOL TO ACHIEVE THE JOY OF FRIENDSHIP
Going down for the Sunday event always means a whirlwind 48 hours. I stay with old family friends of my parents in their amazing cliff front home. I never get tired of that view, or of the hospitality they show me.
Then I meet up with friends I’ve gathered along the way from various past lives: lifeguarding, UCLA and, more recently, fellow members of my ProVisors group. My friend Adam and I have been doing it the longest. We bond over this event as we make amazing memories, overcoming the adversity of the sometimes cruel ocean together.
MONEY AS TOOL TO ACHIEVE (SCIENTIFICALLY-PROVEN) HAPPINESS
As I have written about before, friendships like these aren’t just nice to have, they are essential for our health.
Harvard did a study of over 700 men over a period of eight decades, and discovered those with close social connections report being happier. They live longer. Their happiness even helps lessen physical pain in old age. Alternatively, declining physical health and brain function is associated with isolation. Insecurity in our relationships negatively affects memory over time.
The evidence appears clear. Maintaining friendships means maintaining health. Making good memories actually affects our ability to retain memory and have quality of life into old age.
WHAT’S THE GOAL?
I always ask clients this question. If you come into my office and tell me you want to make more money in the stock market, or that you want to save up more for retirement, or really anything at all, I’ll ask you: what’s the goal?
Having money is a means, not an end. The question we all have to ask ourselves is, what do we want to use our money to accomplish?
My goals are to live healthy, live long, live well, be grateful and give back. I therefore believe there may be no greater financial investment I can make than the ones that enable me to make lasting memories with my dearest friends while supporting causes I care deeply about.
Your goals may be a little different, but I’ll bet we share this much in common: we want to have, and to share, happiness.
Money can’t buy it, but it sure is a great tool to help us get there.
Becoming more engaged with your finances can be a daunting task — the decisions you make are important and the amount of information can be overwhelming. In this video, however, Katie Keary shares five ways you can become more involved with your money. The best news is you can start at your own pace, and you don’t have to go it alone.
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By Kevin Grogan
Our recommendation on asset location is to prefer holding tax-inefficient assets in tax-advantaged accounts. In our view, the expected return of an asset is close to irrelevant when determining where to locate it. This guidance applies to Roth as well as to traditional IRAs. For many, this can seem counterintuitive, given that much of what investors find in the financial media generally discusses locating the highest-expected-return asset classes in the Roth account.
This article is broken into two sections. First, we will discuss how a security’s expected return and risk characteristics can change based on where the asset is located. Second, we will walk through a Roth-versus-taxable-account asset location decision using after-tax asset allocation.
Section One: Asset Location’s Effect on Expected Return and Risk
The following table indicates the principal effectively owned by, return received by, and risk borne by individual investors in each savings vehicle. As shown, in contrast to bonds and stocks held in a Roth IRA, for bonds and stocks held in a tax-deferred account, the investor effectively owns each dollar of principal multiplied by one minus the tax rate on it but receives 100 percent of the returns and bears 100 percent of the risk.
|Tax-deferred account||1 – tax rate||100%||100%|
|Bonds||100%||1 – tax rate||1 – tax rate|
|Stocks||100%||1 – tax drag||1 – tax drag|
To illustrate the risk and return sharing of bonds held in taxable accounts, we assume bonds have a 3 percent expected return and a 4 percent standard deviation (a measure of risk), as well as that the investor is in the 25 percent tax bracket. We also assume bonds earn returns of -1 percent, 3 percent and 7 percent in three years; that is, they earn the mean return and one standard deviation below and above it. The standard deviation of these returns is 4 percent. Assuming the 1 percent loss is used to offset that year’s taxable income, the investor’s after-tax returns are -0.75 percent, 2.25 percent and 5.25 percent for a standard deviation of 3 percent. In this case, the investor receives each dollar of pretax return minus the tax rate on it and bears each unit of pretax risk less the tax rate.
When stocks are held in taxable accounts (with cost bases equal to market values), the investor owns 100 percent of the principal, but their after-tax return and risk is reduced by a tax drag, specifically the taxes due on dividends and realized capital gains. The tax drag number depends upon how actively the stocks are managed, but for purposes of this example, we will assume that 15 percent of the return on stocks is lost to taxes each year. (This effectively assumes that all capital gains are realized 366 days after the stocks are purchased.)
To once more illustrate risk and return sharing properties of taxable accounts, we assume stocks have a 7 percent expected return and a 19 percent standard deviation. Stocks, we further assume, earn pretax returns of -12 percent, 7 percent and 26 percent in three years; that is, they earn the mean return and one standard deviation below and above it. The standard deviation of these returns is 19 percent. If the loss is used that year to offset long-term capital gains, the after-tax returns are -10.2 percent, 5.95 percent and 22.1 percent for a standard deviation of 16.15 percent (or 85 percent of the pretax standard deviation).
The key message from these examples is that the same underlying asset can have different expected return and risk characteristics depending upon the type of savings vehicle in which it is located.
Section Two: Asset Location and Roth IRAs
Using the framework from the first section, we can evaluate asset location decisions when it comes to Roth IRAs versus taxable accounts. This section assumes the investor will use all assets in his or her lifetime and is not designating Roth accounts for future heirs. If the investor is designating the Roth for heirs, then this account is effectively being managed for a purpose other than retirement and should have its own Investment Policy Statement.
The following are our capital market and tax assumptions:
|Expected return on stocks||7.0%|
|Expected return on bonds||3.0%|
|Standard deviation on stocks||19.0%|
|Standard deviation on bonds||4.0%|
|Tax rate on stocks||15.0%|
|Tax rate on bonds||35.0%|
Assume that our hypothetical investor has $200 split evenly between a taxable account and a Roth. Let us also express the investor’s risk tolerance in terms of acceptable volatility, and, in this case, the client is comfortable with a portfolio after-tax standard deviation about 9.7 percent.
One way to accomplish this would be to locate $100 of bonds in the taxable account and $100 of stocks in the Roth account.* The following table has the results:
|Scenario 1: Incorrect Location|
|After-Tax Expected Return||After-Tax Expected SD||Start $||End $ Pre Tax||End $ After Tax|
The portfolio has an after-tax expected return of 4.5 percent and an after-tax standard deviation of 9.6 percent. At the end of the one-year period, the investor wound up with $208.95.
An alternative way to get to the 9.7 percent after-tax standard deviation would be to locate the assets in the optimal manner, with $100 of stocks in the taxable account and a 15/85 mix in the Roth account.*
|Scenario 2: Correct Location|
|After-Tax Expected Return||After-Tax Expected SD||Start $||End $ Pre Tax||End $ After Tax|
The after-tax standard deviation of Scenario 2 is roughly the same as Scenario 1, even though the portfolio contains a higher allocation to stocks. The reason for this is that the government shares in the volatility of the stocks held in the taxable account. The after-tax expected return is higher in Scenario 2 than in Scenario 1, and the investor winds up with $209.55 at the end of a year.
The key insight from Robert Dammon, Chester Spatt and Harold Zhang’s 2004 Journal of Finance paper, “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing,” is that Scenario 2 will have a higher after-tax expected return than Scenario 1, regardless of what the stock and bond returns are, as long as the following two conditions are met:
1. The tax rate on bond interest is greater than the tax rate on stock gains and dividends.
2. The interest rate on bonds is positive.
This is true even if we assume all stocks are taxed every year. In reality, some of the stock returns are tax-deferred even if the stock holding is in a taxable account. The size of the improvement in after-tax returns is exactly equal to the interest rate on bonds multiplied by the difference in tax rates.
Let’s look at one more scenario where the investor’s risk tolerance is expressed in terms of actual dollars allocated to stocks and bonds. In this scenario, we will say our investor wants a 50/50 asset allocation.
Scenario 1 still applies, but Scenario 2 has too much invested in equities. Scenario 3, then, locates $100 of stocks in the taxable account and $100 of bonds in the Roth.*
|Scenario 3: Correct Location|
|After-Tax Expected Return||After-Tax Expected SD||Start $||End $ Pre Tax||End $ After Tax|
Scenario 3 provides exactly the same after-tax expected return as Scenario 1, but with less volatility. The reason for this is that the government is partaking in the volatility of the portfolio’s stocks.
It is important to recognize that the government shares in the risk and return of assets located in taxable retirement savings vehicles. Therefore, a bond or a bond fund held inside a Roth is effectively a different asset than the same bond or bond fund held in a taxable account. Using the assumptions from our last example, the return and risk for a bond held in a Roth IRA are 3 percent and 4 percent, but only 2 percent and 2.6 percent for the same bond held in a taxable account.
By employing this framework, we learn that the best assets to hold in the taxable account are those that make the best use of the preferential long-term capital gains treatment. This will typically be stocks, as long as the investor is willing to avoid short-term capital gains.
* This scenario is hypothetical and being presented for illustrative purposes only. It relies on the capital market assumptions cited in this article.
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