Faults of the Individual Investor to Avoid (Reasons for Impartial Advice)

Individual investors historically act as a contrary indicator. That is, looking at recent events, they assume that a market going up will continue to go up, or that a falling market will continue to fall. The individual investor fixates on the past, as if it will continue, rather than gauging the future. With this perspective, the behavior of the individual investor is to buy at the peak and sell at the trough, hence making them a contrary indicator to what will really occur. Countering this behavior takes substantial discipline, experience and information, and usually a good advisor.

A good advisor should add value through asset allocation and fund selection, but foremost by guiding you to counter bad investment behaviors. You need to stay invested when you fear a fall and sell when you are convinced of sure upswings. Advisors need to provide value-added guidance that will:
(1) avoid giving any serious weight to short-term indicators;
(2) avoid trying to pick “winners”;
(3) closely examine expenses, as high costs result in much lower net returns;
(4) investigate riskier classes as a component of a good overall asset allocation (e.g., emerging markets);
(5) look for funds that stick to their own goals, rather than trying to match any index, as such discipline pass off over time;
(6) take a contrarian view at times because too often a fund doing well at a given time will ultimately revert to the mean of all funds; and
(7) be clear with clients on the risks being taken (that is, measure the risks for say a bond differently than stocks).
All these are ways in which advisors increase the chance that you achieve good investment returns over time.

Recent history provides a good example. With the crash in 2008, we spoke to many clients and started a flow of e-mail updates and strategy suggestions. This became our newsletter on our web site. The key advice was that, if you have a good allocation, and good investments, stick to your long-term plan, do not sell. Those of our clients who followed the advice returned to their pre-crash peak values by last year, something none of us thought would be possible so soon. However, those that sold were selling as investments declined in value. Moreover, they had no clear signal in mind as to when to reinvest. That meant that most missed the rise of greater than 11% in the beginning of 2009. That upswing can never be regained. Therefore, they sold at a low point and were forced to buy back in at a higher point.

How could those that stayed invested be back to their peak when most indices have not returned to their all-time highs? A well-managed portfolio, employing good asset allocation, will not drop as much so it will have less to recover to be “whole.” Therefore, it could regain its peak value more easily, and with less risk. Again, this points to all that we have published before on the need for asset allocation analysis and diversification within each investment type as well as among investment types. It also makes clear how important not losing capital is: losing 50% requires a 100% gain to recover, while losing 25% takes only a 33% gain.

Good investing will lead you to avoid the behaviors that constitute what Carl Richards dubbed the “Behavior Gap” (April/May issue of Morningstar Advisor), meaning the gap between investment returns and investor returns. Simply opting for index funds is not a quick fix that works. Instead, individual investors require guidance. They can have the best possible investment approach “only to blow it up completely with one big behavioral mistake at the wrong time.” He goes on to write that all approaches are tested over time, so the advisor’s role is one of helping “rid the world of negative behavioral alpha, to close the Behavior Gap.”

In another article, he writes that “ … if 83% of mutual fund investors are getting advice from advisors and are doing poorly, maybe we advisors are part of the problem. (See First, Do No Harm by Carl Richards 02-10-11) To state the opposite side, “Still the trend seems clear. Investors who were inclined to invest for the long term were likely to have better returns. A look at how the markets have worked during the past 10 years illustrates why that is. We had two bear markets and two dramatic rallies. Those who sold equities in the bear market missed out on the rally and therefore nearly all would have been better off riding out the bear market.” (Inside the Vanguard Science Project Vanguard’s more-patient shareholders outperformed the rest. by Russel Kinnel 05-05-11)

Investors doing all the work with no advisors have access to good tools, such as E-Z Planner for retirement planning, but that can be dangerous. Again, the risk of bad input, generating bad outcomes, comes from the same issues of perspective and bad investment behavior. With an objective source to counter your own bias or “bad investment behavior,” this can be avoided. For example, in addition to the investment issues reviewed above, most individuals understate spending. “Oh, yes, we did buy [something] last year, but that was a one-time event.” Each year will have “one-time” events. Building a good plan takes some means by which tough questions like cash flow and investment risk are addressed. Otherwise, the best software will produce results with erroneous conclusions.

Conclusion
You need terrific discipline or good advice to resist psychology of risk aversion and the urge to use recent events as a gauge for what will occur next. Otherwise, your investor returns will fail to match investment returns over time.

Having said that, what is the Next Step:
First, review how your portfolio performed in recent times, did you react from fear and leave your strategy or hold on?
Second, review your portfolio; does it fit your risk tolerance and financial goals?
Third, take a second look at your portfolio, but from a contrary perspective; did your answer on risks match the actual investments made? (For example, someone claiming worry about the economy should not be 80% in US stocks.)
Finally, check to see if the portfolio, with any on-going savings, will be sufficient to achieve your financial goals. If you are not certain, then advice from an objective source could make a substantial, and very important, difference.

Need help? Contact us!

New Estate Planning Pitfalls – Need for careful planning and follow-through

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 gives us a two year window for significant estate tax planning, ending December 31, 2012. However, this comes with some serious planning issues. Here are two:

One pitfall of the new law: The new portable credit requires a proactive election by the executor at the first death. Like the frequent failure to make proper QTIP and GST allocation elections, this is an area subject to risks. For example, if the assets are in trust, the survivors may choose not to appoint an executor, missing the opportunity to save the unused credit for the second death.

Also, the portable exemption amount only applies to the unused exemption from the last spouse. For multiple marriages, only the most recent spouse’s amount is available. In addition, an election must be made in the estate of the first spouse to die to preserve the unused exemption and allow for its use by the last deceased spouse.

Second, old trusts that had too much going to the credit portion, the beneficiaries of which are not your spouse, then he or she could be left with very little from your estate.

Please see Estate Planning Overview for definitions and tax impacts, and “to do” list.

Estate Planning – Techniques for Reducing Taxes in Large Estates

The change in the tax law from the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 gives us a two year window for significant estate tax planning, ending December 31, 2012.

Instead of a $1 million lifetime cap, you can now gift up to $5 million. When your spouse joins in, a major amount of wealth can be transferred. This makes it important to act now, because the law could change in for 2013.

Leveraged Gifting – you can use a defective irrevocable trust (the defective grantor trust is discussed below) to fund an installment purchase of assets from you to the trust over time. The trust is “defective” so that there is no taxable transaction and no gain; it is as if you are selling to yourself. With the installment sale, a note is used and has to bear interest at the IRS mandated rates, the lowest rate of interest allowed. The goal is to repay the note using appreciated assets, where the transfer back to you is also not taxed, and complete the repayment before you die. If it is not completed, the note is an asset taxable in your estate.

Dynasty Trust – you can use the increased generation skipping transfer tax (GST) to pass more to grandchildren and future generations. Again, the new limits allow you to pass far more on to future generations.

Life Insurance Trust – an irrevocable trust that holds insurance for whatever purpose you design, while be excluded from your taxable estate. Your trustee would purchase insurance on your life. The risks of this alternative are that it is irrevocable and that the cost of the permanent insurance is very high.

Second-to-die Life Insurance – a trust that purchases second-to-die life insurance crates a source to pay estate taxes while not increasing the taxable estate.

GRAT – Another alternative is the grantor retained annuity trust (“GRAT”), which uses some portion of your unified credit as a window through which to pass assets at a discount created by the IRS tables that tell us what the asset gifted will be worth at the end of the term of the trust. You receive annuity payments during the term and the principal passes to your children at the end of the term. (This is why it must be funded with “excess” wealth – if you give the trust a term of 20 years but live many years thereafter, there will be many years during which you have foregone the benefit of the assets gifted). The expectation is that the principal will actually be worth more than the amount you gift to the trust, with such increased value escaping estate taxes. Under the new law, there are no GRAT or value limitations.

Cautions: First, the securities laws will treat you as the owner of trust assets for any restrictions on dealing with publicly traded stock. Second, if you die before the end of the term, assets revert to your estate and the structure collapses to look as if nothing was done. Last, a twist: if you stipulate that the trust will not terminate at your death, you substantially reduce the amount that gets thrown back to your estate, reducing the risk of not living through the term of the trust.

Tax inclusive and exclusive – the Sam Walton strategy can used when you want to transfer more than your unified credit alone will allow. If you make a taxable gift, it is tax exclusive (the tax comes from other assets). Thus, the tax is calculated as a percent of the gift. If you die owning the asset and it then passes to your children, it is tax inclusive as the tax is calculated as the total amount, so less of the assets pass to your children. QPRT – The qualified personal residence trust (“QPRT”) uses the unified credit and discount of a future value like the GRAT but applies it to your residence. Thus, both the benefits and risks are similar; it is the asset that differs.

“Defective” grantor trust – The “defective” grantor trust is effective for gift tax purposes and “defective” for income tax purposes so that assets are not included in your estate and yet you pay the tax on their appreciation. Paying the income taxes without any gift tax cost effectively gives away additional wealth. Again, you can leverage this with an installment sale.

Family Limited Partnership – the family limited partnership (“FLP”) is a partnership that you form, acting as the general partners and the limited partners. You transfer assets into the FLP such as any commercial real estate or your shares in your company. When this is complete, you can gift limited partnership interests to your children. Because only the general partners have any say in the management of the FLP, the IRS allows for a discount to the value of the limited partners interest. This discount is 35 to 40%, so more is passed to children without using up your unified credit. Unlike the other alternatives delineated below, when you transfer limited partner interests, your children receive the benefit now. In addition, you have the burden of tax returns for the FLP, as well as tax liability for children who may not receive distributions from the FLP to cover the taxes.

Charitable Remainder Trust – This charitable remainder trust (“CRT”) is a trust that pays a fixed annuity to you and then distributes the remaining principal to charities. You get a gift charitable deduction for the net present value of the future distribution to charities.

Charitable Lead Annuity Trust – This reverses the CRT, where a trust that pays a fixed annuity to charities selected by its trustees and then returns the remaining principal to you or to your estate. You get a gift tax deduction for the actuarial value of the annuity payments to charities or an estate tax charitable deduction.

Caution – you have an investment risk in each vehicle, where failing to generate the larger principal value in the future that you count on to use the strategy will frustrate its purposes. This is the risk of selecting assets that are expected to soar in value but instead collapse. Therefore, none of these alternatives should be considered until you are comfortable that you have “excess” wealth to pass to your children or to a charity and comfortable that you can make a commitment to do so that cannot be reversed. If you say “no” out of lack of comfort or confidence in any strategy, then you will want to stick to a basic plan for now.

What about the Future? Most observers expect the $5 million exemption to stay, along with the 35% estate tax rate. The exemption could be lower, or the rate increased. All of this is reason to review the ideas below and then update your estate plan.

Please see Estate Planning.