A to Z of Behavioral Bias

guessesAn A to Z list of common behavioral biases with brief descriptions, examples, causes, possible mitigations and suggested further reading courtesy the Psy-Fi Blog. Each of the links below takes you to the relevant post at Psy-Fi, so have fun and think about how they apply to your own investing habits:

 

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Top 10 Mistakes Made with Beneficiary Designations

beneficiary form#1 — Not Naming a Beneficiary
By not naming a beneficiary you have most likely guaranteed that the asset will go through probate upon your death.

#2 — Not Designating Contingent Beneficiaries
If your primary beneficiary predeceases or dies at the same time as you, you’re subject to the same consequences as #1

#3 — Failing to Keep Beneficiary Designations Up-to-Date
If you get divorced, it’s essential you immediately review and update all beneficiary designations.

#4 — Naming Minors as Direct Beneficiaries
Trusts are often established to delay the time a survivor receives an asset until they are old enough to make good money decisions.  However, if you designate a minor child as an account’s beneficiary and there’s also a testamentary trust, the designation trumps the trust and the child will receive the assets immediately.

#5 — Naming Special Needs Individuals as Direct Beneficiaries
Naming a “special needs” individual as the direct beneficiary could unintentionally disqualify that individual from receiving his or her valuable governmental benefits.

#6 — Naming Financially Irresponsible Beneficiaries
Often it’s better to create a lifetime “spendthrift trust” to hold the inheritance for the benefit of the individual for his or her lifetime while protecting the assets from creditors.

#7 — Naming Direct Beneficiaries on All Assets Other than Real Estate
Very often real estate will need to go through probate even if there’s a will in place.  This process can take a year or longer during which the estate is responsible for paying for maintenance, taxes, etc.  It’s generally advisable to allow your cash accounts and/or life insurance proceeds to go through probate so the estate will have sufficient funds to support the real estate during probate.

#8 — Naming Multiple Beneficiaries on a Transfer on Death Deed
Avoid doing because all beneficiaries must agree on the realtor, sale price, and maintenance costs until the property is sold.  Getting that type of agreement is very difficult.

#9 — Naming a Child as Co-Owner of a Deposit or Investment Account
Aging parents will sometimes add a trusted adult child as the co-owner of his or her bank account.  Avoid this because it can create complicated issues around gifting, creditor issues,  and final expenses.

#10 — Naming One Child as the Sole Beneficiary of a Life Insurance Policy or Deposit Account
A parent with multiple adult children should avoid doing this because it can create a situation very similar to #9.

Source: AAII

Younger Generation Faces a Savings Deficit

student-savings

According to the Wall Street Journal,

“Adults under age 35—the so-called millennial generation—currently have a savings rate of negative 2%, meaning they are burning through their assets or going into debt, according to Moody’s Analytics. That compares with a positive savings rate of about 3% for those age 35 to 44, 6% for those 45 to 54, and 13% for those 55 and older.

The turnabout in savings tendencies shows how the personal finances of millennials have become increasingly precarious despite five years of economic growth and sustained job creation. A lack of savings increases the vulnerability of young workers in the postrecession economy, leaving many without a financial cushion for unexpected expenses, raising the difficulty of job transitions and leaving them further away from goals like eventual homeownership—let alone retirement.”

Source: WSJ

Higher Income Earners Got Better Investing Advice

selling-outThe Wall Street Journal reported this week that only the top 10% of income-earning households were able to hold onto their stock portfolios and ride the big rally over the past few years.  As a consequence, the wealth gap increased as the bottom 90% had no skin in the game as the market turned positive.

According to the Wall Street Journal:

The Fed’s Survey of Consumer Finances shows that among the bottom 90% of households by wealth, families bailed out of the stock market between 2007 and 2010—the central bank’s study is conducted every three years—and between 2010 and 2013. The total share with stockholdings declined by 4.4 percentage points. That’s the equivalent of 5.4 million households selling stocks, even as the market rebounded. Only households in the top 10% have been increasingly likely to own stocks.
This is strong evidence that the top 10% benefited from the power of having financial advisors while the bottom 90% went largely without.  Wealthy investors get better advice and are more likely to endure the pain of holding onto their stocks through down markets.

Chasing Past Performance is Expensive

vanguard-chasingA new study demonstrates that chasing the hot mutual fund is an inferior investing strategy compared to good, old-fashioned buy and hold.

Vanguard analyzed a decade of data ending December 31, 2013 across nine asset classes.  In every case the investor would have been significantly better off just sticking with the index.  On average the indexes generated 50% higher returns than the performance-chasing strategy!

Buy and hold may not be perfect, but it can be a lot better than flitting from mutual fund to mutual fund.

 

What Kind of Investor Are You?

question-mark

What kind of investor are you?  According to author William Bernstein, there are three broad groups of investors segregated by behavior:

Group 1: The average small investor, who does not have a coherent asset-allocation strategy and who owns a chaotic mix of mutual funds and/or individual securities, often recommended to him or her by a broker or advisor. He or she tends to buy near bull market peaks and sell near bear market troughs.

Group 2: The more sophisticated investor, who does have a reasonable-seeming asset-allocation strategy and who will buy when prices fall a bit (“buying the dips”), but who falls victim to the aircraft simulator/actual crash paradigm, loses his or her nerve, and bails when real trouble roils the markets. You may not think you belong in this group, but unless you’ve tested yourself and passed during the 2008–2009 bear market, you really can’t tell.

Group 3: Those who do have a coherent strategy and can stick to it. Three things separate this group from Group 2: first, a realistic appraisal of their true, under-fire risk tolerance; second, an allocation to risky assets low enough, or a savings rate high enough, to allow them to financially and emotionally weather a severe downturn; and third, an appreciation of market history, particularly the carnage inflicted by the 1929–1932 bear market. In other words, this elite group possesses not only patience, cash, and courage, but also the historical knowledge informing them that at several points in their investing career, all three will prove necessary. Finally, they have the foresight to plan for those eventualities.

“Job one for the investor, then, is to learn as best she can, to ignore the day-to-day and year-to-year speculative return in order to earn the fundamental return.” – William Bernstein

Source: Rational Expectations: Asset Allocation for Investing Adults

Sorry Banks, Millennials Hate You

A three-year study involving 10,000 millennials (born 1981-2000) reveals an overwhelmingly negative sentiment toward banks:

  • Banking is the most prime industry for disruption in millennials’ opinion
  • Banks make up four of the top 10 most hated brands for millennials
  • Millennials increasingly view banking institutions as irrelevant

banks-and-millenialsSource: FastCo

Sir Isaac Newton: Monumental Scientist, Terrible Investor

220px-GodfreyKneller-IsaacNewton-1689Most people recognize Sir Isaac Newton as one of the most influential scientists of all time, but did you know he was a horrible investor?

Newton’s experience with the South Sea Company vividly demonstrates the financial perils of chasing hot markets, getting caught up in investment bubbles, and not maintaining a diversified portfolio.

In the early 18th century the South Sea Company was established and given a monopoly on trade in the South Seas in return for assuming England’s war debt.  Investors liked the idea of that monopoly and the company’s stock began to take off.

Newton hear the siren call of the South Sea Company, invested his cash in early 1720 and managed to turn a nice profit.  But then the stock kept soaring after he had gotten out. So Newton jumped back into the stock with a lot more money than his original investment.

Newton subsequently lost 20,000 pounds, almost all of his life savings!  From this terrible outcome, Newton supposedly decreed, “I can calculate the movement of the stars, but not the madness of men.”

No warning on Earth can save people determined to grow suddenly rich.
— Lord Overstone

newton-investsSource: Sovereign Man

 

 

Market Timing & Emotions ~ Afflictions of the Average Investor

investor-results

Click to enlarge

This chart of 20 years of market data vividly demonstrates a painful lesson.  The average investor* badly trails all classes of investment assets.

The primary culprit for this deficit is ill-fated attempts to time the market and emotionally driven decisions to move in and out of the markets.

Most individuals claim to be long-term investor until their portfolio drops 10% and suddenly there’s panic.

Our primary role as an investment advisor is to help our clients have the discipline to ignore the gyrations of the markets and keep the long view when it comes to their investments.

* Average investor refers to individual investors across the United States

Code Red! 8 Ways to Permanently Wipe Out Your Retirement Savings

code-redDana Anspach at MarketWatch recently wrote about 8 financially devastating mistakes (aka “Code Reds”) that must be avoided:

1. Believe in a stock
The company you work for is doing well. You understand the potential of the business. You should own a lot of company stock. After all, it shows your level of commitment, right? 
WRONG! CODE RED!
You can lock in lifestyle by taking risk off the table. If trusted advisers are telling you to reduce risk, listen. You can’t take your “belief” in your company stock to the bank. Owning a lot of company stock doesn’t demonstrate a commitment to your company; it demonstrates a lack of commitment to your own personal financial planning.

2. Get reeled into real estate
Rental real estate is a good way to build wealth with someone else’s money, isn’t it? I mean, that’s what the infomercials say.
WRONG! CODE RED!
Investing in real estate is a profession in and of itself. With real estate prices on the rise again, don’t get reeled in with the lure of easy passive income. It isn’t as easy as it looks.

3. Follow a Tip
An opportunity to double your money is an investment opportunity worth pursuing. It could change your life, right?
WRONG! CODE RED!
Tips are great for your waiter or waitress. But where you family’s future is concerned, avoid the tips, and stick with a disciplined and diversified approach.

4. Change lanes — every year
Smart investors watch the market and frequently move money into the latest high performing investment, right?
WRONG! CODE RED!
You’ve probably noticed if you constantly changes lanes on a backed up highway, always trying to inch ahead, you usually end up farther behind. Driving this way isn’t effective; investing this way isn’t effective either. Pick a disciplined strategy and stick to it. Jumping from investment to investment is only going to slow you down.

5. Play the currency cards
Experts can deliver higher returns, right? Find someone who knows how to trade, and you’ll be set.
WRONG! CODE RED!
If experts could generate such high returns, why would they need your business? Don’t play the currency cards, the expert cards, or fall for any kind of outlandish promises. I’ve yet to see one of these programs work the way it was marketed.

6. Follow your ego
Better investments are available to those with more money, right? If you get the opportunity to participate in something exclusive, it is likely to deliver better returns.
WRONG! CODE RED!
If someone appeals to your ego, walk away. When it comes to investing, the only thing I’ve seen egos do is help someone lose money.

7. Follow their ego
You can trust prestigious people in your community. That’s why you should do business with them, right?
WRONG! CODE RED!
Checks and balances are good in government and in investing. One way to make sure checks and balances are in place is to work with an investment adviser that uses a third party custodian. The third party custodian sends account statements directly to you. The investment adviser can make changes in your account, but the transactions are reported to you directly by the custodian, who isn’t and should not be affiliated with the investment adviser.

8. Leverage up
Borrowing at low interest rates and investing in high growth assets is an excellent way to accumulate wealth, isn’t it?
WRONG! CODE RED!
Think twice before borrowing to invest. It causes ruin more often than it causes riches.

Visit MarketWatch to read Anspach’s full article.

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