As heard on ESPN 1700’s Real Estate Radio Hour
May 9, 2012
In our practice, we talk a lot about integrating the science of financial analysis with the art of human understanding. Most of the mythology clients suffer from stem from them trying to rationalize or justify the emotional decisions they make.
- 1. Money makes you happier. Money buys you happiness.
“The two researchers – Daniel Kahneman, the 2002 winner of the Nobel Prize in economics, and Angus Deaton, past president of the American Economic Association – broke the question of whether money can buy happiness in two, examining both how people evaluated their day-to-day happiness and their overall satisfaction with life.
Not having enough money causes emotional pain and unhappiness, the researchers found. But the happiness tipping point is about $75,000 – more money than that doesn’t make a person cheerier, though it can help people view their lives as successful or better.
With every doubling of income, people tended to say they were more and more satisfied with their lives on a 10-point scale – a pattern that continued for household incomes well above $120,000.
But when asked to assess the happy hours of the previous day – whether people had experienced a lot of enjoyment, laughter, smiling, anger, stress, worry – money mattered only up to about $75,000. After that, money didn’t buy more (or less) happiness. (About one-third of U.S. households had incomes above $75,000, according to the U.S. Census Bureau’s American Community Survey. The average household income was $71,500.)”
- 2. My investment advisor is really good at beating “the market”.
Invariably when I meet someone and they find out what I do, they begin by telling my how they or their broker outperformed the market last year. Even people in the business tell me how well they did. It’s like when people come back from Vegas – NOBODY ever says they lost money.
Much to the chagrin of my colleagues, according to many academic and industry backed studies, most notably Vanguard, this just isn’t true.
Your investment advisors can’t help you outperform the market but he can and should help you avoid underperforming the market.
- 3. So I don’t need an advisor – I can pick index funds and do it myself.
This is the inverse corollary to #2.
If you are incredibly disciplined and have the time to design and rebalance the portfolio, you may be right.
However, few DIY investors have actually analyzed their risk and inflation adjusted returns over time. They have selective memory and aren’t always willing to look at the hard data. Dalbar, fortunately or unfortunately for the retail investor, has looked at the data and it shows that the average DIY investor vastly underperforms the market for the following reasons –
|INDIVIDUAL INVESTOR||INSTITUTIONAL INVESTOR|
|Lacks asset allocation strategy||Well-developed asset allocation strategy|
|Has unrealistic expectations||Understands risk/reward trade-off|
|Has short time horizon||Longer time horizon for investments|
|Attempts to market time*||Does not market time|
|Lacks alternative investments||Broadly diversified|
*either intentionally or because of emotional reactions.
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4. I’ll just pick the highest rated (or top performing) funds and fund companies let them beat the market.
The markets are very efficient and the rating process is very subjective. Over time, the average returns of the funds in a given category tend to be very close. During any given shorter-term, there will always be top performers.
Unfortunately, it is difficult to identify those top performers ahead of time. Two studies worth noting –
The odds of any of the top quartile funds of a given category over any five year fund remaining in the top quartile over the next 5 years is about 1 in 5
During any 10 year period, 60% of the top quartile funds spent 5 of those years in the bottom quartile.
There are a lot of funds to choose from and a lot of good ones, but relying simply on top rated funds based on past performance is not effective.
However, the vast choices you have in funds actually serve a purpose – it is what keeps the market efficient.
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- 5. Roth Conversions are a great idea for everyone.
Unless you know for sure that you will be in a higher tax rate in the future, it may not be such a good idea. Mathematically speaking, the only way a Roth conversion saves you income taxes is if you are in a higher bracket when you withdrawal the funds then when you converted.
The real benefit to a Roth conversion is that you do not have to take Required Minimum Distributions at age 70 ½.
If you have all the retirement income you need from other sources, the Roth IRA will let you accumulate funds and pass them to your heirs income tax free. This is especially important if your children will also be in a high tax bracket.
- 6. Take your Social Security as soon as you can get it.
Not so fast. By postponing benefits, you can increase your monthly social security check by about 8% per year. If you take the income before you really need it, you will also increase your taxable income.
One strategy that may be worthwhile for married couples is to “file and suspend” and have a spouse begin spousal benefits.