Behavioral Finance: Mental Accounting (2008-07-28)

Behavioral Finance: Mental Accounting

(2008-07-28) by David John Marotta

The essence of successful financial planning is using your money to meet your life's goals. In the process, one dollar is as good as another, but curiously our minds do not perceive it that way. We tend to fall prey to the fallacy that behavioral finance calls mental accounting, commonly known as the "two-pocket" theory of money. We treat money differently depending on its source.

It is as though we put earned income in one mental pocket and money we did not expect in another. Studies show we are much more willing to spend money impulsively out of this second pocket.

Our supposedly rational mind objects to mixing the money from the two different pockets. But our minds are tricking us because dollars are completely interchangeable.

To clarify, we are not talking about budgeting. Earmarking dollars for vacation, big-ticket purchases, house payments, college savings and toward retirement is clearly positive and very much encouraged. This type of positive mental accounting aligns perfectly with meeting your financial goals.

But the type of mental accounting that gets us in trouble is what happens when the way we acquired a dollar causes us to ignore our careful planning and spend it differently.

Imagine a university graduate student who budgets enough for rent and food and hopes to save $500 every month, but her take-home pay is only $1,500. Then she sells her textbooks at the end of the semester and finds herself with an extra $250. Rather than putting the additional $250 toward savings, she indulges in luxury items until she's sure she has spent all the money.

Put yourself in this student's situation. In your mind, it is as though you have $1,500 in one pocket where you put serious earned money and stick to your budget. In the other pocket, you put the $250, which you now regard as play money, and rationalize that you should only use it to make frivolous purchases.

Most of us find this tendency so strong and irresistible, we would all do well to find ways to forestall the impulsive spending that slows progress toward achieving our financial goals. Allocating your money to meet your needs and desires is an important step in the financial planning process. But first you must gather all the money available in a single pool and allocate it according to your family's priorities. The source of the money shouldn't matter. When it does, we cause ourselves unneeded harm.

Studies show that gamblers rarely leave the casino as winners. The reason is not simply because the house has an edge on every game. Mental accounting is also the problem. Gamblers consider their winnings as house money and reason that they can keep on gambling for free. So most gamblers only stop playing when they are losing.

Research has also revealed that when people receive money unexpectedly, they make impulse purchases, typically quite soon afterward. If the amount is significant, perhaps more than $10,000, they may spend 40% to 50% of their windfall. If the amount is small, such as $1,000, they may actually spend two and a half times more than they received.

This propensity is the hope behind the recent stimulus checks Americans received from the government. The rebate was designed to be a relatively small amount, $1,800 for a family of four. Even when people say they plan to use the rebate to pay down debt, they are already engaging in mental accounting, thinking of the money differently simply because of the source.

In polls, Americans claim they will spend only 18% to 40% of the rebate. But if we tracked their actual spending, mental accounting would have badly misled them.

Perhaps they will pay off some of their debt or put money into their 401(k). But most Americans will jump at the chance that they have some extra money to justify a purchase they would not otherwise have made. And they will probably do it more than once.

In fact, studies suggest that average consumers will spend an astonishing additional $4,500 in relatively small purchases simply because they received a $1,800 check: extra money on eating out, electronic toys, and large appliances. Children may be given their $300 as though it somehow belongs to them, and husbands and wives may rationalize using the money as an excuse to make that purchase their partner considers unnecessary. Past research supports the prediction that consumers will spend 250% of their rebate check without even realizing it.

Even the most rational of us who receive money this way spend more as a result. The psychology behind this thinking is so strong, we can safely assume we are all influenced by it.

Thus found money, the green stuff we do not earn or save, is easily spent, wasted, and risked. Most lottery winners are broke or worse within five years of their win. Unfortunately, winning encourages the worst tendencies of those with the temperament to play the lottery in the first place.

Although mental accounting is described as the two-pocket theory of money, I propose adding a third pocket. Earned income is linked to planned purchases in one pocket. Some money is gained unexpectedly and too often provokes impulse spending in the second. But in the third pocket, we could put automatic income, that is, money gained from investment interest, dividends and appreciation. Mental accounting often leaves this third pocket in an investment account to compound and appreciate, helping us reach our long-term goals.

You can't spend apart from increasing your lifestyle. And when you increase your lifestyle, you increase by large multiples what you will need in retirement to support that lifestyle. Here's a sobering fact: Every time you increase your spending by $1, you need $23 more in your investments when you retire.

If you get and spend an extra $1,000, you will need $23,000 more in retirement to support your increased lifestyle. You can spend your way into financial troubles, but you can never make your troubles worse by saving.

Another error of mental accounting is to differentiate between income and appreciation. If one stock trades at $100 per share paying a $6 dividend, it's equivalent to another stock that pays no dividend whose share price rises from $100 to $106 per share. Some people mistakenly think the dividend-paying stock is better during retirement and the appreciating stock is better when you are younger.

Now there is a small distinction: The dividend-paying stock forces you to pay the capital gains rate on the dividend paid, whereas the appreciating stock allows you to defer the capital appreciation until later. But the difference in tax treatments doesn't matter once you are retired. And it's much less relevant now that qualified dividends are taxed the same as capital gains. In retirement you can simply sell appreciated stock and pay the capital gains to generate cash for withdrawals.

The real difference between dividend-paying stocks and appreciating stocks is in the type of company. A company with little growth potential, such as a utility, pays its profits out to shareholders in dividends. A different company, perhaps a restaurant with ambitions to open branches across the country, uses its profits to expand. As it does so, it generates more profits from more locations, which drives the share price up. Both types of companies provide portfolio returns that you can spend in retirement.

If you struggle with self-control, only taking the dividends allows you to limit your withdrawals. But it may also cause you to adjust your asset allocation to maximize dividends, putting all of your net worth in one type of investment.

The biggest mistake occurs when people believe they need interest and dividends to generate cash in retirement. As a result they put too great a percentage of their portfolio into fixed-income bonds and do not invest enough in stocks that will keep up with inflation and provide appreciation for the end of their retirement.

The source of your money, whether from interest, yield (dividends) or capital appreciation should not matter.

Part of the emotional push toward using a two-pocket theory of money may stem either from an effort to be disciplined or a failure to do so. In general, people both want to enjoy the money now and also plan for the future. This dilemma between a short-term and long-term focus requires a measure of discipline and willpower that most people don't have. So they fudge by feeling guilty about using hard-earned money frivolously but fall prey to using easily received money quite carelessly.

There is an upside, however. You can use mental accounting to your advantage by using that third pocket of money and automating as much of your savings as possible. People tend not to count money that is automatically deducted from their paycheck as money they can spend. Increasing the amount you have withdrawn in your 401(k) or 403(b) account is an easy way to use the third pocket to your advantage.

It is also just as painless to have money transferred regularly from your checking account into an investment account. This automatic savings puts money into a mental accounting third pocket from which it is very difficult to spend emotionally. Add to this account any money you receive unexpectedly, and you will be well on the way to securing a successful retirement.

from http://www.emarotta.com/article.php?ID=294

Behavioral Finance: Anchoring (2008-07-21)

Behavioral Finance: Anchoring

(2008-07-21) by David John Marotta

Rational analysis is essential to making smart investment decisions. Unfortunately, our first reaction to a complicated situation, usually instinctive, often does not serve our best interests. The field of behavioral finance studies how and why we make economic decisions.

Researchers have identified dozens of mental shortcuts. One heuristic that the brain uses to solve complex evaluations is to make an initial guess and then adjust from that point as we receive additional information to find a better answer. This mental process is called "anchoring."

Anchoring is one of the root psychological flaws that pushes otherwise brilliant people to make financial mistakes. It's critical to admit this heuristic is hardwired in your brain or you will continue to succumb to it. To avoid making serious financial mistakes, you must become a vigilant contrarian.

In the mental process of anchoring, we begin with some tentative solution to our problem and then we seek a better or more accurate solution. For example, we walk onto a car lot and note the sticker price, and we use that number as our starting point for negotiations. We know we can buy the car for that amount, and we start the process of seeking to get a better price.

Studies have shown that the higher the first price we are given, the higher will be the final price we end up paying for the exact same item. Stores sometimes bump their prices 30% higher before a 30% off sale because they understand this principle. Sellers on eBay may set a "buy-it-now" price artificially high simply to induce higher competitive bids.

We use mental anchoring more when we are unfamiliar with what the right answer is supposed to be. Conversely, the antidote to anchoring is to have done your homework and be able to evaluate the anchors you are given. Doing your research online before setting foot on the car lot helps you step into the process with the ability to analyze the reasonableness of that sticker price.

To understand how paradoxically our minds can work, researchers have shown that even when we know the anchor is a completely random number, it still has a significant effect.

For example, ask a friend to use the last three digits of his Social Security number to form a date somewhere between A.D. 0 and 1000. Next, ask him if he thinks Attila the Hun died before or after that date. Finally, ask him what year he thinks Attila the Hun died. People with a higher last three digits of their Social Security number tend to guess a much higher date for Attila the Hun's death.

We are not rational creatures.

The antidote for this type of anchoring is doing the extra analysis to evaluate the answer more rationally. In other words, those who actually know the date of Attila the Hun's death do not succumb to the mental fallacy of anchoring on the last three digits of their Social Security number.

Anchoring is like finding ourselves sitting in a chair in a pitch-black room. When we stand up, we keep one hand on the chair and reach as far as we can in each direction to try to get a feel for our location. The anchor of the chair keeps us from straying too far from our original point. The answer, of course, is to turn on the lights.

Most investors feel like they are in the dark. Sometimes having too much information to evaluate equates with having no information at all. Consequently, we anchor on the latest market movements or the high-water mark of what something was worth.

Although nearly all of us seem to say we are long-term investors, our tendency is to be swayed emotionally by the most recent short-term movements in the markets. We want to invest more in sectors that have recently been doing well, and we want to avoid, eliminate or reduce sectors that have recently dropped in value.

One study found that because of moving in and out of mutual funds at exactly the wrong moments, investors in mutual funds experience returns that underperform the very funds they were invested in, by 2.2 percentage points annually.

Funds are more likely to take new deposits after performing well but less likely to perform that well going forward. Similarly, funds that have not performed as well take in much less in deposits or have net redemptions but usually do not continue to underperform quite as badly. Investors experience returns that underperform because they buy the fund high and sell it low.

This isn't to say you should stay in a poor mutual fund with high fees and expenses. But moving in and out of mutual funds to catch hot sectors of the economy produces returns that badly underperform a simple buy-and-rebalance strategy.

Even the investment news falls into the trap of describing past performance in the present tense. They say, "This stock is going up" or "This stock is plummeting" when what they really intend is simply to describe the most recent short-term past trend.

Given that 98% of daily stock market movements are noise, for long-term investors this is like saying, "We are bumping to the left" when driving on an old gravel road. Monthly stock movements are no better. They are 76% noise. Again, for a long-term investor, talking about monthly stock movements can be likened to saying, "We are curving right" when driving on a winding country road. Even annual returns have about 46% noise. Sometimes you need to drive south for an hour before you pick up the interstate. Only when you start looking over a 10-year time horizon can you safely describe your direction and say, "We are heading west."

Investors tend to fixate on relative past performance. If their portfolios have gone straight from 100,000 to 120,000 over the past year, they are happy. If their portfolios rose to 150,000 before dropping back to 120,000, however, they are upset and depressed. People anchor to the high-water mark of their portfolios and are only satisfied when they hit an all-time high.

Avoiding the mistakes that stem from anchoring requires adopting an investment philosophy that does not depend on historical prices and past performance. Adopt an investment philosophy that dampens rather than amplifies trends. If your philosophy is to panic and sell at corrections and then wait to get back into the markets after they are appreciating again, your emotions amplify any losses.

Learn to be a contrarian and rebalance your portfolio regularly. Set buy and sell targets. Monitor an objective stock evaluation. Pretend you don't already own it and you have to buy it at the current price. Make half a mistake, sell some and take some profit off the table.

One of the first principles of investing is humility. Knowing that your first instinct is probably wrong, doing nothing is often better than doing something quickly. Hence minimizing trading, being patient and investing in the markets going up is an excellent way to tune out the noise of short-term movements.

Second, if your instincts are often wrong, and the markets are inherently volatile, plan on some of your investments losing money. Therefore avoid leverage or options that could amplify a mistake to a loss that might jeopardize your financial goals.

Finally, practice setting an asset allocation that provides diversification. Regular rebalancing to a target allocation gives you the best chance of meeting your goals and an objective standard to practice contrarian investing by selling what has gone up and buying what has gone down.

from http://www.emarotta.com/article.php?ID=293

Foreign Freedom Investing 2008 (2008-07-14)

Foreign Freedom Investing 2008

(2008-07-14) by David John Marotta

You can both diversify for safety and boost your returns by adding international investments to your portfolio. In the past year, international stocks performed 2.5% better than U.S. stocks. And developed countries with the most economic freedom returned an additional 4.4% more than the international index.

None of these returns, however, were positive. During the one-year period ending June 30, 2008, the S&P 500 index lost 13.12%. The MSCI EAFE Index of international developed markets lost 10.6% (in U.S. dollars). Significantly, 10 of the most economically free countries only lost 6.2%.

These premiums for investing oversees in countries with the most freedom are even more impressive for longer time periods. Over the past five years, the S&P 500 has averaged 7.6% and the EAFE Index 16.7%. In striking contrast, the countries with the most economic freedom averaged 21.5%.

Put some money into the "emerging markets" category, and you can gain even greater diversification and returns. Emerging markets, as measured by the MSCI Emerging Markets Index, actually gained, appreciating 4.6% (in U.S. dollars) in the past year. They have averaged a whopping 29.8% over the past five years. Of course, there is a caveat. Emerging markets are inherently more volatile than the markets of more developed nations.

If you have a very small account, investing in one good international fund is sufficient. For slightly larger amounts, a savvy asset allocation might be to invest two thirds in the MSCI EAFE Index and one third in the MSCI Emerging Markets Index. Using this technique, you would have only lost 5.5% in the past year and averaged 21.0% over the past five years.

For larger accounts, use a more complex asset allocation for further diversification. Take advantage of the fact that economic growth often flourishes in countries with the greatest economic freedom. We use the Heritage Foundation's measurement to select those places that combine the greatest economic freedom with large investable markets.

Since 1994, the Heritage Foundation Index of Economic Freedom has used a systematic empirical measurement of economic freedom in countries worldwide. Their conclusions clearly show that economic freedom and higher rates of long-term economic growth go together. Investors can use the study to select countries for their foreign stock allocation.

According to the Heritage Foundation, "Economic freedom is defined as the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."

The foundation bases a country's economic freedom score on 50 measurements. They fall under these 10 categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.

Although all 10 boost economic growth, some, such as investment freedom, are more significant to outside investors. Others, such as monetary freedom, are more critical to that country's own citizens.

Only 17 countries out of 157 scored high in investment freedom, which measures the ability of capital to flow freely in and out of the country. Free countries impose few or no restrictions on foreign investment. Thus they represent the greatest opportunities for investment. More than a third of the world imposes serious restrictions on the ability to run businesses, purchase real estate or transfer capital. These countries are best avoided.

A number of the countries ranked high in economic freedom have exchange-traded funds (ETFs), such as Hong Kong, Singapore, Australia, Canada, Switzerland, United Kingdom, the Netherlands, Germany, Sweden and Austria. These funds track each country's market index and offer a convenient and inexpensive way to invest there. ETFs combine the liquidity of individual stocks with the diversification of an index fund. They also typically carry lower expense ratios than most mutual funds.

For larger accounts, we recommend you invest half of your assets using the simple technique just described. A third is invested in the MSCI EAFE Index fund and a sixth in the MSCI Emerging Markets Index fund. The other half is divided among the 10 countries with the most freedom whose markets also accommodate a country-specific ETF.

Canada had the best returns over the past year, mostly because of its emphasis on energy stocks, earning 13.9%. In the same time period, 8 of the 10 countries cited earlier beat the broad MSCI EAFE Index. Only two (the United Kingdom and Sweden) fell short.

Japan, with the world's second largest economy, has demonstrated more financial freedom in recent years. But government spending is greater than a third of its gross domestic product. And a large number of legal restrictions on capital make investing in Japan quite problematic. It is ranked below average in government size and financial freedom and lower than we would recommend in the important investment freedom category. These restrictions push the country down to the 17th most free economy. We can attribute Japan's malaise after its own stock market bubble to its lack of economic freedom and the government's overly aggressive interventions. Former prime minister Junichiro Koizumi's changes made the country a more attractive place to do business. It remains to be seen if these changes are significant enough.

Diversifying your foreign investments is just one critical element of an optimal asset allocation. Building balanced portfolios that are more likely to meet your financial goals doesn't happen by accident or by working with someone whose interests are in conflict with yours. Visit the website of the National Association of Personal Financial Advisors at www.napfa.org or call 1-800-366-2732 to find a fee-only advisor in your area.

from http://www.emarotta.com/article.php?ID=292

Rebalance Accounts Regularly (2008-07-07)

Rebalance Accounts Regularly

(2008-07-07) by David John Marotta

A year ago when the markets were all setting new highs, people were asking what they should do with their retirement portfolio. I answered, "Rebalance." Now that the market is setting new lows, I get the same question, and my response hasn't changed.

Rebalancing requires discipline. You set a target asset allocation for your investments and then periodically buy and sell different investments to stay focused on your objective. Without rebalancing, those categories that do well may continue to grow as a percentage of your portfolio until they significantly underperform the markets. The ones that do the best often bubble and finally burst. Rebalancing avoids this needless anguish.

Investing in an S&P 500 index fund does the opposite of rebalancing. The S&P is a capitalization-weighted index. A stock's capitalization is the total outstanding shares multiplied by the stock's current price. Therefore, those stocks whose price has appreciated comprise a greater share of the index. The S&P automatically increases its holding in stocks that have gone up and decreases its holdings in stocks that have gone down. This is the opposite of what you want.

Having the right asset allocation in the first place is an essential part of rebalancing. Rebalancing back to an S&P 500 allocation misses the emphasis on value stocks that will help your portfolio returns.

Stocks that have decreased in price have a lower price-to-earnings (P/E) ratio. They are called "value stocks." These stocks on average do better than growth stocks. But capitalization-weighted indexes such as the S&P 500 miss this method of boosting returns.

Several new investment products tout what is called "fundamental indexing." They set target allocations based more on earnings than price and therefore gain a value tilt. This is a good strategy, but the funds using it are currently charging higher fees and expenses than necessary. As expenses on these funds drop, they may prove to be a better investing strategy. In the meantime, you can develop a less expense asset allocation with the same value tilt simply by putting part of your asset allocation into a value fund. Adding a large-cap value fund to your S&P 500 fund will emphasize those stocks with a low P/E ratio. A value fund will sell stocks whose price has appreciated enough that they are no longer considered value. And it will buy stocks whose price has dropped enough for them now to be considered value.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining how well behaved your portfolio returns will be.

Even if you are creating a very aggressive portfolio, including some fixed-income investments actually increases returns. Stable investments provide some cash on the sidelines, and having cash to buy stocks after a market correction both boosts as well as evens out your investment returns. Thanks to the effect of compounding, smoother returns produce better returns.

Periodic rebalancing is the simplest and most common method. Waiting for an asset category to exceed some threshold and then bringing the allocation back within some tolerances seems to produce slightly better returns and lower volatility. Although different ways of rebalancing produce somewhat variable results, the method you use is not as important as committing to a regular rebalancing plan.

Crestmont Research studied the difference in returns between rebalancing every year versus every two years in varying types of markets. They found that in secular bull markets, rebalancing less frequently had a slight 0.3% annualized advantage, but in secular bear markets, rebalancing more frequently had a more significant 1.3% advantage. Another study of the same time period verified smaller advantages for even more frequent quarterly and monthly rebalancing. And a study of the Yale endowment attributed 1.6% of its portfolio returns to rebalancing.

Making an extra percentage point a year is significant. The Crestmont study concluded, "In choppy and volatile markets, a more frequent rebalancing approach can add significant additional return to an investor's portfolio. Based upon recent secular market history, the risk (cost) of more frequent rebalancing in secular bull markets is far less than the opportunity from more frequent rebalancing in secular bear markets."

Crestmont's observation is true because a secular bear market does not simply go down every year. Rather these markets often swing up and down wildly. The Crestmont study analyzed the secular bear markets from 1966 to 1981 and concluded that rebalancing more frequently made the difference between experiencing positive or negative returns.

Keep in mind what rebalancing in a secular bear market means: buying stocks after they have gone down and selling stocks after they have gone up. Probably the point at which more frequent rebalancing pulled ahead the most was 1973 and 1974 when the market dropped 17% and then 28%, and more frequent rebalancing meant putting more money back into the markets. Then in 1975 and 1976 when the market rebounded 38% and 18%, respectively, it provided better results.

Rebalancing is as daunting as putting more money into the markets now after our recent declines. But it is also as prudent as taking profits off the table a year ago when the market was setting new highs. Rebalancing, always a contrarian move, helps investors make those emotionally difficult but safer and more profitable decisions.

Portfolio design and rebalancing is both a science and an art. It may be helpful to understand the physics of why a spinning ball hooks and bends. But when you are playing golf or soccer, it is the execution and follow-through that produces the desired outcome. Knowing that rebalancing boosts returns is useless unless you as the investor have the time, discipline and nerve to follow through and actually strike the ball.

Untended portfolios can quickly become more volatile. Thus frequent watching of a portfolio is required even if frequent rebalancing is not the best methodology. Watching your portfolio every day and choosing strategic inaction allows you to seize the day when the portfolio is significantly far enough out of balance to warrant action.

How frequently you need to water your garden is totally contingent on current weather conditions. Similarly, when you should rebalance your portfolio depends more on what the markets are doing than the calendar.

Rebalancing need not trigger a taxable event. You can do it when you are adding to your portfolio or during retirement when you are making withdrawals. Another way of rebalancing without triggering capital gains is to make the changes in your traditional or Roth retirement accounts. You can also pay dividends and interest in cash rather than reinvesting them. Then use this cash to rebalance by purchasing more in the asset category, which has done the worst lately. But even if you have to trigger capital gains, the capital gains tax is at an all-time low and will probably be raised in the future. So go ahead and rebalance your portfolio and generate those capital gains.

If your portfolio had the right asset allocation to begin with, we would currently be advising you to add to U.S. stocks or withdraw from hard asset stocks or fixed income. However, most of the portfolios we see for the first time already have too much U.S. stock and little, if any, hard asset stocks. Again, getting the right asset allocation is always the first step to rebalancing.

Watching the asset allocation balance on a portfolio may not seem like a very active strategy. But because it can increase your returns by over a percentage point a year, it is worth the time and effort. At a minimum, you should have a target asset allocation and an easy way to rebalance it at least once a year.

from http://www.emarotta.com/article.php?ID=291