Emotional Investing

We like to think that since the advent of modern portfolio management practices, investing in stocks and bonds has become a cerebral, analytical process with no room for emotion. The truth is that most investors, even institutional investors, are buffeted by emotional turbulence from time to time, and that truth is reflected in the volatility of the financial markets.

But if a little emotionalism when it comes to investments is unavoidable, too much emotion can be hazardous to your wealth. Here are four symptoms of problem emotions, financial behavior that is inconsistent with sound investment practice.

Fear of loss.  Investors are generally motivated by fear or by greed. Behavioral scientists have learned that, for many people, the pain of loss is larger than the sense of satisfaction from a gain of the same size. Similarly, some investors will accept larger risks in order to avoid a loss than they will in seeking a gain.

Taken to an extreme, fear of loss leads to investment paralysis.  An excessively risk-averse investor may park funds in ultra-safe, low-yielding bank deposits or short-term Treasury securities until a decision is made, accepting long periods of low returns. Or winning investments may be sold off too quickly in an attempt to lock in gains, while losing investments manage to stay in the portfolio indefinitely.

Following the herd.  It’s difficult to be a contrarian, to find value that everyone else has overlooked. Many people find it easier to go with the crowd, to own the current hot stock or hot mutual fund. At least that way, if the investment does poorly, one has plenty of fellow sufferers with whom to commiserate.

But when “crowd” is defined as one’s family and friends, the crowd’s investment goals may be very different from one’s own.

Hair-trigger reflexes. Markets move on news. In many cases, the first market response is an overreaction, either to the up side or to the down. Sometimes “news” is only new to the general public, and it’s already been reflected in the share price through trading by those with greater knowledge. The true importance of any news event can only be discerned over the longer-term.

Generally, it’s better to watch the market react to news than to be a part of the reaction. Remember that market dips may present the best buying opportunities but they’re also the toughest times, emotionally, for making a commitment to an investment.

Betting only on winners.  Some 85% of the new money going into domestic equity mutual funds goes to funds with MorningStar ratings of four or five stars, according to one estimate. This may be one reason that the government requires this disclosure for investment products: Past performance is no guarantee of future results. The disclosure is required because it is true.  High returns are usually accompanied by high risks; ultimately, those risks may undermine performance.

Abnormal returns, whether they are high or low, tend to return to the average in the long run. Investing on the basis of the very highest recent returns runs a significant risk of getting in at the top of the price cycle, with a strong chance for disappointment.

The alternative approach

To avoid impulsive decisions that may be tainted with emotion, one needs an investment plan.  The best way to moderate the impact of stock and bond volatility in difficult markets is to own some of each. Assets do not move up down in lockstep. When stocks rise, bonds may fall. Or at other times, bonds also may rise when stocks do. The movements of each asset class can be mathematically correlated to the movements of the other classes. Portfolio optimization involves the application of these relationships to the investor’s holdings.

Expected returns need to be linked to the investor’s time horizon. Longer time horizons give the investor more time to recover from bad years, more chances to be in the market for good years.

© 2017 M.A. Co.  All rights reserved.

Home Office Deductions: The Easy Way & The Hard Way

Beginning in the 2013 tax year, the IRS gave taxpayers a choice when it comes to the home office deduction.  To avoid the necessity of detailed recordkeeping, a new “safe harbor” deduction was created for home offices.  The simplified deduction was set at $5 per square foot of the home office space, up to a limit of $1,500 (300 square feet).

The existence of the new safe harbor and relief from recordkeeping does not change the other requirements for taking the home office deduction.  The office must be used regularly and exclusively for business.  The office should either be the principal place of business or used for administrative or management activities when the taxpayer has no other office for handling those chores.  An office kept for the convenience of the employer, such as a salesman who lives away from company headquarters might have, also will qualify.

In many cases, the actual expenses for the home office will be greater than the safe harbor.  These may include, for example, a share of utilities and insurance costs. For example, the IRS reported that for the 2010 tax year, the average home office deduction was $2,600, so many people will find the safe harbor limit too low.  The taxpayer may choose the traditional route of actual expenses instead of the safe harbor. What’s more, that choice may be made for each tax year, without regard to the choices made in earlier years. Thus, the taxpayer may alternate between methods, choosing the one most favorable each year.

The somewhat harder way

With the traditional method of calculating the deduction, a proportionate depreciation deduction is permitted for the office space. The amount of the depreciation is recaptured and taxed as income when the house is later sold.  The safe harbor alternative does not generate depreciation recapture.

The deduction for the home office may not exceed the net income of the business.  If the business is showing a loss for the year, the loss may be carried forward when the traditional method of calculating the deduction is used.  However, the carryover is not permitted with the safe harbor approach. What’s more, any carryover loss created from the actual home office expense calculations may not be deducted in years in which the safe harbor is elected.

Although the simplified deduction was intended to make life easier for taxpayers, the reality is that many taxpayers will have to figure the deduction both ways to decide which is the better way to go.

The IRS reports that the number of taxpayers claiming the home office deduction has held steady over the last six years, at roughly 3.4 million.  The aggregate value of the deductions claimed has dipped, falling from nearly $11 billion in 2010 to $9.5 billion in 2014 (most recent available data).  Most of the reduction in deductions occurred in 2013 and 2014, suggesting that there was, in fact, a significant shift to the easier way of claiming the home office deduction. The IRS does not break out those figures.

© 2017 M.A. Co.  All rights reserved.

401(k) Protection Programs

Dear Garden State Trust Company:

When I retire in about a year, I’m expecting a six-figure distribution from my employer’s 401(k) plan.  The success of my retirement turns on what I do with this money, and I’m more than a little unsettled by the prospect.  What should I do to keep my all my options open?

—LOOKING AHEAD TO FINANCIAL INDEPENDENCE

Dear Looking: 

I have two words for you: IRA Rollover.  With this arrangement, you can continue the tax deferral that your 401(k) account has enjoyed so far.  Be sure that you use a “trustee-to-trustee” transfer of the funds to avoid the 20% tax withholding that otherwise would apply to your distribution.

Will your distribution include shares of stock in your employer?  If so, you should consider not rolling those shares over, but accept them for your taxable portfolio.  Income taxes on “net unrealized appreciation” in those securities may be deferred in this manner.  Your accountant can give you more details.

You’ll also need an investment plan for your retirement money.  When you undertake this, consider your taxable and tax-deferred funds as part of one large portfolio.  The plan that you or your investment advisors come up with needs to take all of your resources into account, as well as your retirement income needs.  You are wise to be looking into these questions a year before you retire.  We can help you with all of these questions if you wish.

Do you have a question concerning wealth management or trusts? Send your inquiry to contact@gstrustco.com.

© 2017 M.A. Co.  All rights reserved.