Financial Architects

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Decision Making (again)

I did a post on decision-making years ago (here) but I wanted to share some more on it.  As financial advisors, our “product” is really wisdom (as I’ve said before), and it turns out we are wiser about other people’s situations than we are our own. This has two implications, 1) our clients (even our very wise clients) need us, and 2) we need wise advisors ourselves (or strategies to get distance on our issues) no matter how wise we consider ourselves to be.  (I’m blessed to have Anitha.) From Aeon:

… When inspecting the results, scholars observed a peculiar pattern: for most characteristics, there was more variability within the same person over time than there was between people. In short, wisdom was highly variable from one situation to the next. The variability also followed systematic rules. It heightened when participants focused on close others and work colleagues, compared with cases when participants focused solely on themselves.

These studies reveal a certain irony: in those situations where we might care the most about behaving wisely, we’re least likely to do so. Is there a way to use evidence-based insights to counter this tendency?

My team addressed this by altering the way we approach situations in which wisdom is heightened or suppressed. When a situation concerns you personally, you can imagine being a distant self. For instance, you can use third-person language (‘What does she/he think?’ instead of ‘What do I think?’), or mentally put some temporal space between yourself and the situation (how would I respond ‘a year from now’?). Studies show that such distancing strategies help people reflect on a range of social challenges in a wiser fashion. In fact, initial studies suggest that writing a daily diary in a distant-self mode not only boosts wisdom in the short term but can also lead to gains in wisdom over time. The holy grail of wisdom training appears one step closer today.

Related, here’s an excellent decision-making flowchart:

Also, you may be able to get the wisdom of crowds … without the crowd, as shown in this paper. Here’s the abstract:

Many decisions rest upon people’s ability to make estimates of some unknown quantities. In these judgments, the aggregate estimate of the group is often more accurate than most individual estimates. Remarkably, similar principles apply when aggregating multiple estimates made by the same person – a phenomenon known as the “wisdom of the inner crowd”. The potential contained in such an intervention is enormous and a key challenge is to identify strategies that improve the accuracy of people’s aggregate estimates. Here, we propose the following strategy: combine people’s first estimate with their second estimate made from the perspective of a person they often disagree with. In five pre-registered experiments (total N = 6425, with more than 53,000 estimates), we find that such a strategy produces highly accurate inner crowds (as compared to when people simply make a second guess, or when a second estimate is made from the perspective of someone they often agree with). In explaining its accuracy, we find that taking a disagreeing perspective prompts people to consider and adopt second estimates they normally would not consider as viable option, resulting in first- and second estimates that are highly diverse (and by extension more accurate when aggregated). However, this strategy backfires in situations where second estimates are likely to be made in the wrong direction. Our results suggest that disagreement, often highlighted for its negative impact, can be a powerful tool in producing accurate judgments.

Finally, from Annie Duke:

Investing is hard, because you need to answer these questions:

  • Am I being disciplined or stubborn?
  • Am I being foolish or staying ahead of the curve?
  • How useful is market history?
  • What if it really is different this time?
  • Do I have enough?

See also:

As Voltaire observed, “Doubt is an uncomfortable condition, but certainty is a ridiculous one.”

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Response to Low Expected Returns

What should be the response to a low return environment (i.e. high prices on stocks and bonds)? I have touched on this before (here for example), but it seems like it might be time again.

If returns are lower than they were in the past, but risks are the same (i.e. the return per unit of risk is now lower), there are three perfectly rational responses:

  1. Keep your portfolio the same but realize you will not get the returns you once did with that portfolio.
  2. Decrease the risk in your portfolio.  Since you are not getting paid as much for taking risk you decide to take less of it.
  3. Increase the risk in your portfolio.  Since you desire a certain level of return the only way to get it is to increase risk.

Now, the problem is that although the options above are opposed to each other, they all make sense and are rational.  But we have to pick one.

I don’t have a simple answer though.  I think it depends on your resources compared to your needs.  For example, if someone is wealthy (compared to their needs, not in absolute terms) the correct choice is probably different from someone who is not at all wealthy (again, relative to need).  For example, suppose we have three families, each newly retired, and each need $120,000/year. Social Security/pensions/whatever are expected to provide $40,000.  That means $80,000 must be provided by the portfolio.  One client has an $1,600,000 portfolio; one has $2,000,000 portfolio; and one has a $2,400,000 portfolio.

  • The family with the $1,600,000 should probably have a slightly more aggressive portfolio than they would have in a higher return environment.
  • The family with the $2,000,000 should probably have the same portfolio they would have in a higher return environment.
  • The family with the $2,400,000 should probably have a slightly less aggressive portfolio than they would have in a higher return environment.

I think.  This answer is tentative, provisional, and preliminary!

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Wealth Taxes

I have been thinking about wealth taxes that have been proposed and it occurred to me that we already have a few of them (property taxes are one, I’ll get to the other below) but we don’t think of them as wealth taxes. That led me to think about some other illogical tax items. This is just about the items related to capital gains; I may or may not go on to other topics in future posts.

I wrote up some reform ideas a few years ago here and here but this is new.

Here are a few oddities just to illustrate some problems. Let’s assume that inflation is 3% (and always was); long-term capital gains rates are 20%; short-term capital gains/ordinary income rates are 40%; and corporate tax rates are 25%. The numbers aren’t really important, but I want to be able to do some simple examples with nice easy round numbers that are close to what exist though not exact (state taxes, Medicare surcharges, brackets, etc. would all change them for various taxpayers anyway).

  • Situation 1: Taxpayer Alpha bought Stock X 20 years ago for $100,000 and it has grown at an average compounded rate of 3%. Since inflation has been 3% the real wealth has not increased. Nonetheless, if sold the taxes would be about $16,000 [($100,000 * 1.03^20 – $100,000) * 20%]. This is a wealth tax basically set at the rate of inflation times the tax rate (so in this case 3%*20%), but only collected upon disposition so there are some compounding differences. Our taxpayer, in purchasing power, is $16,000 poorer. We have had low inflation for so long I don’t think people appreciate the damage that income taxes combined with inflation do.
  • Situation 2: Taxpayer Alpha dies and leaves Stock X to Taxpayer Bravo. There are no taxes. (Step-up in basis.)
  • Situation 3: Company X pays a special dividend (qualified) of $80,000. Taxes would be $16,000.
  • Situation 4: Taxpayer Charlie buys Stock Y one year ago for $100,000 and it is now worth $180,000 (roughly the same as the previous example). Since it has not been a year-and-a-day, sales would result in taxes of $32,000.
  • Situation 5: Taxpayer Delta buys Stock Y one-year-and-a-day ago for $100,000 and it is now worth $180,000. Sale would result in taxes of $16,000.

You get the idea, the first three situations are economically identical, yet the taxes are different. Worse, there is no actual (real) gain, yet taxes are assessed. This is why using qualified plans/IRAs, Roths, etc. is so vital. That is the only way to avoid paying taxes on phantom (inflation) gains. (Assuming all qualified plans/IRAs are exclusively funded with pre-tax dollars.) The last two situations are nearly identical, but the taxes are wildly different.

So here is my modest proposal. All of these should be adopted simultaneously, not in isolation, as they work very well together, not nearly as well individually. I’m not trying to minimize (or maximize) taxes, I’m trying to make the economic reality of a situation give rise to appropriate taxes. Anyway:

  1. All income tax rates for a given taxpayer should be the same marginal rate, no special long-term capital gain or qualified dividend rates. This eliminates the “gaming” that is sometimes done to turn earned income into a capital gain (carried interest for example). This would raise tax liabilities. (But stay with me, it gets better.) A flat tax would be even better, because the sale of large value items (real estate for example) could kick someone into a higher bracket than they would normally be in.
  1. Companies should get a corporate tax deduction for dividends paid. This removes the tax incentive to use debt rather than equity. It also means that the rationale for a special dividend rate to compensate for double taxation is removed. (Under current rules/rates above a company makes $20, pays 25% in taxes leaving $15, pays it out in a dividend taxed at 20%, the taxpayer nets $12. With my change, the company makes $20, pays it out in a dividend and it is taxed at 40% leaving the taxpayer the same $12.) This would lower tax liabilities to the company. (It would also incent management to distribute earnings rather than horde them and empire-build.)
  1. Step-up in basis on death should be eliminated. Carry over basis eliminates the economic dislocation from holding property that would otherwise be sold, waiting for the owner to die to avoid tax and leave the heirs more. This would raise tax liabilities. It also, given that we have a progressive tax structure, aligns taxes with the economic situation of the heirs. A “starving artist” heir would pay little or no taxes, a neurosurgeon heir would pay much more. That seems fair.
  1. Since we have eliminated the step-up in basis, we can eliminate estate taxes now too. This would also free up many very expensive tax attorneys and CPAs to do something socially useful. This would lower tax revenue.
  1. Investment assets held longer than a year have the basis indexed for inflation. So there is no more tax on growth that isn’t real. The stock bought for $100,000 that grew to $180,000 over 20 years at 3% inflation would have no tax due. A 20-year bond bought for $100,000 with 3% interest (remember inflation is 3% too, so this is zero real return) would have taxes on the 3% paid each year (at 40% rate). But upon maturity, the bonds would have a capital loss equivalent (roughly, you have compounding issues again) to the interest paid. So the taxpayer, having received no real return, pays (roughly) no tax. This structure means that the effective tax rate on stocks is still a little lower than bonds given that dividends are usually lower than interest so you are ahead on the time value of money, particularly on growth stocks, but then the company didn’t get a deduction if they had earnings. This would reduce tax revenue.
  1. Repeal the $3,000 limit on taking losses against ordinary income. Since all the rates are the same there is no point to this. (And it means the bond buyer in the earlier example, can actually use the real loss upon maturity.) This would reduce tax revenue.
  1. Section 121 can be repealed (the home sale exclusion of $500,000/$250,000). Since we are indexing to inflation everyone only pays taxes on real appreciation. The current method penalizes people who 1) buy expensive homes (the “free” appreciation is in dollars, not percentages), and/or 2) don’t move. If I buy homes for $1,000,000 and move every five years I will probably never pay taxes on it. If I buy a home for $500,000 and don’t move for 30 years I probably would. That seems … odd. This would probably raise tax revenue, but it could conceivably go the other way. I don’t have data (and behavior would change).

This is just a guess, but I think doing all of that probably wouldn’t materially alter taxes paid (in aggregate) but it would remove a lot of uneconomic behavior that people engage in for tax reasons.

Of course there is zero chance of this being cleaned up logically…