Month: September 2017

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.

Given the unrelenting pace of change in the tax laws and in the economy, coupled with the ordinary changes in personal and family circumstances, any estate plan is bound to go out of date sooner or later. Sometimes planning failures may be remedied post mortem, sometimes not. Here’s a happy example.

Oskar Brecher died in 2016 with an estate of some $8 million. His last will and testament had been drafted in 1989. The federal estate tax had seen many important changes since then.

Brecher’s will left his surviving spouse the minimum amount needed to reduce federal estate taxes to zero, with the balance passing to a credit shelter trust, a routine approach to estate tax minimization at the time that his will was drafted. This was long before the major estate tax reforms of 2001, after which many states decoupled their death taxes from the federal template. Brecher died a resident of New York, which in 2016 had an estate tax exemption of $4,187,500, significantly lower than the $5,450,000 federal estate exempt amount.

Application of Brecher’s formula would result in a credit shelter trust of $5,450,000. A trust that large and not protected by the marital deduction would trigger a New York estate tax of $505,455, leaving $2,044,545 for the surviving spouse. The estate’s heirs petitioned to have Brecher’s will reformed, so as to reduce both federal and state death taxes to zero. In that case the credit shelter trust would be only $4,187,500, and the surviving spouse would receive $3,812,500.

The trust beneficiaries did not oppose the reformation, and the Surrogate’s Court granted the petition. Said the Court: “… reformation as a general rule is only sparingly allowed…however, the courts have been more liberal in their regard to petitions seeking reformation when that relief is needed to avert tax problems caused by a defective attempt to draft a will provision in accordance with the then tax law or instead caused by a change in law, subsequent to execution of the will, that renders a tax-driven will provision counterproductive. The central question in such a case is whether the clear wording of the subject instrument subverts rather than serves the testator’s intent.”

Moral of the story. This estate had a sympathetic judge. The better course is to have a professional review of your estate planning documents after major tax law changes. Relying upon a 37-year-old will is expecting too much from an initial estate planning consultation.

©2017 M.A. Co. All rights reserved.

How could someone who earned $650 million over 17 years be broke? That’s the question the actor Johnny Depp recently put to a team of forensic accountants and his new business manager, according to a Vanity Fair article (“How Did Johnny Depp Find Himself in a Financial Crisis?,” August 2017). The team determined that Depp’s business managers of 17 years were guilty of mismanagement, breach of fiduciary duty, and disbursing funds without Depp’s knowledge, and the team filed a lawsuit seeking $25 million.

The business managers, who never had been sued before, fired back with a lawsuit of their own. A partial list of why Depp went broke, according to them, was that Depp owned:

• 14 residences, including a chateau in France;
• a 156-foot yacht, which was expensive to maintain;
• 12 storage facilities filled with memorabilia, such as collectible guitars and art;
• $30,000 worth of exotic wines flown to him monthly; and
• he employed 40 full-time employees, costing $300,000 per month.

As an example of his extravagant lifestyle, Depp spent $5 million for a memorial service for his idol, journalist Hunter S. Thompson. A 153-foot cannon was built at Thompson’s home to blast his ashes into the air.

The business managers seek damages of $560,000 and a statement by a court declaring that “Depp caused his own financial waste.” The trial is expected in January.

Adding guidance to an inheritance

Although Johnny Depp may be an extreme example of financial management failure, it is stories such as these that cause some wealthy parents to wonder about the financial capacity of their own heirs. Even responsible adults have been known to have moments of weakness when faced with a large inheritance.

That’s why so many are turning to trust-based inheritances. When the trust is administered by a professional trustee, such as us, the beneficiaries get financial management according to the terms of the trust, along with investment management of the trust assets. There’s no guarantee that a trust will last for a lifetime, but it does improve the odds for lifetime financial security.

By the way, Depp paid 10% of his income to his business managers and his lawyer, some $65 million over 17 years. Our fee for trusteeship is well below that percentage. Ask us for details.

©2017 M.A. Co. All rights reserved.