Financial Architects

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Tax Opportunities

I know you have probably heard far too much about taxes lately and I am not going to review the recent tax bill here. I want to talk about tax strategies more generally.

“No man’s life, liberty or property are safe while the Legislature is in session.”
– Gideon J. Tucker, 1866

While many people spend their lives trying to find a ten bagger, it is generally more profitable to focus on more mundane – but more certain – opportunities.  In other words, to become financially successful, both offense and defense are important.  Due to the glamour and excitement of offense, people tend to ignore important defensive strategies.  Both are vital to “winning the game.”

Taxes are one of these relatively boring yet important topics.  Here are just a few items related just to investments that people frequently overlook:

Holding the wrong types of investments in the wrong accounts.  If you have both taxable and tax-advantaged funds (IRA, 401(k), etc.), where you place various investments is important.  Not only are some holdings inherently more tax efficient than others, but different tax rates apply.  Placing the less tax-efficient investments in the sheltered accounts and the more tax-efficient investments in the taxable account can make a large and meaningful difference.

Maximizing tax-advantaged vehicles.  Not only is maximizing the use of retirement plans and other tax sheltered vehicles important (including those for educational funding), but so is wisely choosing between the various options.  In addition, there is a wide disparity in the tax efficiency of various investments held in a taxable account.  Obviously it is more important to maximize after-tax return than it is to maximize before-tax return.

Using Roth vs. traditional retirement accounts optimally.  The decision to save in a traditional IRA, 401(k), etc. vs. the Roth versions of those accounts (or the decision to convert into a Roth) is multifacted and extremely complicated but very important. (See Ruminations on Roth vs. Traditional IRAs for more information.)

Insurance vehicles.  Generally, insurance products (like annuities) are not efficient vehicles for saving even given the tax advantages, but there are cases where they make sense.

Spending down assets in the optimal order.  In retirement, there is an optimal way to liquidate investments for living expenses to minimize the tax bite. (See Tax-Efficient Spending from a Portfolio for more information.)

Taking advantage of low earning years or “room” in a relatively low tax bracket.  Occasionally an individual will have a tax year when they have little or no income due to a sabbatical, job transition, or a brief time after retirement before pensions and social security begin.  There is an opportunity to use the low bracket to save taxes in the future.

Maximizing the use of the step-up in basis.  Property is inherited as though the recipient bought it at the current value.  This can lead to large tax savings in many situations.

Harvesting losses.  As investments rise and fall in value there are opportunities to take losses to offset against gains and to a limited extent against ordinary income.

Gifting the best assets.  Whether to charity or to family, some gifts are better than others from a tax perspective. (See Charitable Giving for more information.)

As you can see, this is a very complex topic. If you are one of our clients, we are monitoring all of these issues for you but if you have any questions, please feel free to call or email us.

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Three More Mental Mistakes

Recently (here) I discussed two common mental mistakes. This month I thought I would add three more: a need to save face, improper extrapolation, and conscious weakness.

Saving Face. What I have termed “saving face” is an attempt to not feel stupid, or to avoid regret. People can go to elaborate lengths to feel they are smart and made good decisions. Here are some results of this need to avoid feeling foolish:

  • An unwillingness to sell investments at a loss (selling before it “comes back” would be tantamount to admitting an error), or selling too quickly when investments go up (if it then went back down, the selling opportunity would have been missed). As we have explained in previous newsletters, research indicates the market is reasonably efficient – this means securities tend to be reasonably priced (except in hindsight!). Therefore, whether an investment is above or below the purchase price should be wholly irrelevant to selling decisions (except for tax consequences). Imagine a stock that was at $40 and Person A purchases it, then it declines to $20 and Person B purchases it and it is now at $30. Both investors should merely decide if the stock at $30 is likely to be a good investment for the future, and if so hold it, and if not sell it. However, Person A tends to hold it (sometimes forever, hoping to “get even”) while Person B tends to sell quickly (while he has the opportunity to feel good about his intelligence and foresight in making the purchase). This is an example of loss aversion.
  • Taking risks to avoid perceived losses yet avoiding similar risks for similar gains. Here is a two question quiz to explain this. Answer truthfully!
    • You are given $1,000. In addition to that thousand, you have an opportunity to choose an additional $500 or flip a coin – tails you get nothing, heads you get $1,000. Do you take the guaranteed $500 or the coin flip?
    • You are given $2,000. However you now must either pay $500 or flip a coin – tails you lose $1,000, heads you lose nothing. Do you pay the $500 or flip the coin?

Most people would chose the guarantee in the first question and the coin flip for the second. This is mathematically irrational and occurs because of the way the questions were asked. Both questions are actually identical, and a rational person should either choose the guarantee in both, or the flip in both. (Notice in both questions the choice can be restated as $1,500 for sure or a 50/50 chance at $1,000 or $2,000.) Since the first question is phrased as going for a gain, people tend to be risk averse. Similarly, the second question is phrased as avoiding a loss so people tend to be risk-seeking in an attempt to avoid the loss. This is another example of loss aversion.

  • Buying “popular” investments and avoiding “unpopular” ones. It appears people may value large, popular companies too highly, relative to the alternatives. We believe this is attributable to this same regret avoidance. If a large or popular (“growth”) company subsequently performs poorly the investor (or portfolio manager!) won’t feel foolish (or lose their job) because he or she had lots of company and no one could have seen the problem coming. Conversely if the same problems happened to a small or unpopular (“value”) company the investor would tend to feel foolish. For this reason, it appears small cap and value companies may be systematically underpriced.

Improper Extrapolation. We use this term to refer to mental mistakes people make in evaluating information:

  • Overweighting recent data over long term data.
  • Overweighting events that have a miniscule chance of happening (lottery tickets, a mutual fund averaging 20% a year going forward).
  • Overweighting extreme events.
  • Seeing patterns where they don’t exist (securities prices are widely accepted in academia to be primarily a “random walk with drift”, market forecasters notwithstanding).
  • Changing frame of reference too slowly (e.g., as stock prices change, acting as though the “value” of the investment is still the old price). This is known to academics as “anchoring.”
  • Believing a trend must reverse itself (sometimes inaccurately called “reversion to the mean”). This is known to academics as “gambler’s fallacy.”
  • Placing undue weight on readily available information in a decision. This is known to academics as “availability bias.”

Conscious Weakness. People frequently make decisions that are irrational from an objective standpoint because they do not trust themselves and seek to restrain their own behavior. In these cases, they make decisions that are illogical to restrain their consumption:

  • Inconsistent required rates of return. Examples include having too much withheld from taxes to get a big refund check as a form of “forced” savings; simultaneously having a college savings fund in a low yielding account and balances on high interest credit cards; or refusing to use a home equity loan to consolidate higher interest loans.
  • Irrational spending rules. Never spending “principal” and consequently holding too much in bonds and ignoring inflation.

(That last category may not be a mistake in the sense that even though it’s not logically optimal it may be behaviorally optimal if it keeps someone from making a worse decision.)

Recognizing these tendencies toward illogical behavior and consciously avoiding them can improve your financial planning and help you reach your financial goals.

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Two Mental Mistakes

Most of us are prone to systematic errors in our decisions, and I would like to review two of them that seem to come up frequently. (For more, see here and here.)

The first issue is sunk costs. A sunk cost is something that is already spent or some action already taken. The logical error comes when we consider these costs when making decisions about the future. An example may help. Suppose you pay $100 for a ticket to a concert and then lose the ticket. Should you purchase another $100 ticket? Yes. Attending the concert was worth $100 when the original decision was made, and assuming you have $100 more to spend, it should be worth it still. But many people look at the $100 sunk cost (on the first ticket) and phrase the question, “Do I want to spend $200 to go to the concert?” Similarly, if for some reason on the day of the concert you really didn’t want to go (maybe the weather is terrible and you are tired), would you go anyway because of how much the ticket cost? Many people would. However, if they had been given a free ticket (or it was a free concert) they wouldn’t go. We shouldn’t proceed on paths that are no longer optimal because of the consideration of these irrelevant (at this point) costs. Some examples:

  • I can’t change careers – I have too much invested in this one.
  • We can’t abandon construction on our home – we have too much invested.
  • I can’t sell that stock – I paid double what it’s worth now.

It may make sense to stick with your career, house, investments, etc. but the decision should ignore costs to that point. We should look at it as:

  • All things considered, will changing careers make me happier than sticking with my current one?
  • Will the future value of the home to me be worth more than the estimated future construction costs plus what I could get for selling right now?
  • If I had cash instead of the stock, would I pay the current price of the stock to own it?

In short, sunk costs are irrelevant to the decision at hand.

The second issue I want to address is confusing good (bad) decisions with good (bad) outcomes. Not infrequently, poor decisions have good outcomes and poor decisions have good outcomes. For example, suppose someone offers you $100,000 to play a single round of Russian Roulette. If you decide to do so, and pull the trigger on an empty cylinder, you still made a very poor decision even though the outcome was good. Similarly, purchasing appropriate life insurance is a good decision even if you don’t end up dying while the policy is in force. Investing your retirement savings in lottery tickets is a poor decision even if you happen to win. Diversifying a portfolio is the correct decision even if your neighbor didn’t diversify and made a lot of money on a speculative stock.

In short, while it is profoundly counterintuitive, previous investments shouldn’t affect decisions and the quality of the decision is not determined by the outcome!