If only investment decisions were rational

Posted by on Dec 4, 2014 in Uncategorized | 0 comments

If only investment decisions were rational

More good investment advice from our expert, Frederick Saide, president of Scotch Plains-based Foundation Insurance Services.

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Listening to drive time radio psychologists dispense daily psychobabble, makes me think of Orson Welles and radio’s big moment 75 years ago. Some people realized “War of the Worlds” was entertainment, but others did not. It remains arguably the most widely known delusion in United States history.

If investor decisions were entirely rational, there would be no need to understand the principals of behavioral economics. The theory was developed by Amos Tversky and Nobel Prize-winner Daniel Kahneman and simply states investors and markets are not entirely rational. Translation, we’re irrational about saving and spending money.

Behavioral economics are not limited to financial services and investing. It was featured in the movie “Moneyball,” which made famous a method of evaluating professional baseball players based on their actual performance rather than a perception of how they might perform in the future.

Where are we going with all of this? Very simple.

In 2003, the Dalbar Survey of Investor Returns found the average mutual fund investor earned only 2.6 percent annually from January 1984 to December 2002 during a bull market, compared to annualized inflation of 3 percent and an S&P 500 return of 12 percent.

Similarly, the decision about when and how to claim Social Security is no different. The strategy usually chosen is reaching age 62 and filing rather than based on sound analysis and winds up hurting recipients in the long run.

These are a small sample of the questions I continually hear:

•I want the money now before Social Security goes broke. Social Security is funded by the Payroll Tax and the program has tremendous popularity. Claiming early only leaves money on the table. If you are over 55 any future changes will not materially impact you. If you are 25 you will have time to adjust. The Center for Retirement Research at Boston College states, “Don’t start benefits early because you think Social Security has money problems …You won’t get more if you do.”

•I want to delay drawing down on my investment portfolio until I absolutely have to act. When you delay Social Security, you will have to draw income from your portfolio. It is important to understand that the stock market is subject to volatility, sequence of return risk, and sequence of choice risk. How are these risks magically more secure than guaranteed payments from the government? Understanding this issue is critical to the long-term success of your portfolio. Every advisor should help clients focus on the bigger issue to delay Social Security payments to age 70 will produce a 76 percent higher payment than taking at age 62.

•All of my planning and saving was done with age 62 in mind, and I am now ready to start receiving payments. This one needs more space than my editor will allow. The only thing to do is fully explain the impact of taking Social Security early on both the individual and their spouse. Run simulations and claiming strategies so the impact on taking income from tax deferred accounts is included in the retirement plan. Do not ignore taxes on both the currently tax deferred assets and on Social Security. And if you are working with your or your client’s accountant, don’t assume they are familiar with provisional income. At a recent workshop I did for 35 accountants, only three raised their hand when I asked about provisional income.

Frederick Saide is founding president of Foundation Insurance Services. Contact him at freds@foundationinsuranceservices.com.

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