Financial Architects

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Risk Tolerance

Many firms use “risk tolerance” questionnaires to determine this for their clients, but a client’s risk tolerance isn’t a static measurement like their height; it varies over time.

“Risk tolerance” is a terrible term because it encompasses three different factors:

  • Risk capacity – how much risk the client can afford to take.
  • Risk propensity – how much risk the client is comfortable taking.
  • Risk recognition – how much risk the client thinks there is.

Frequently all three are muddled together, but even at best the last two are usually combined.

As mentioned above, one of the long-standing issues with risk tolerance (with that muddled definition) is that it isn’t stable, and it appears to be the third item, the recognition, that is the issue. During bull markets people don’t have higher risk propensity, they just think there isn’t any risk! During bear markets, they think there is lots of risk and act like their risk tolerance has declined. It hasn’t – they just feel like there’s more risk present.

Questionnaires won’t get you anywhere on that.

Instead, we have a conversation with clients using some market history (from Ruminations on Investment Philosophy):

From peak to trough, U.S. stocks declined in nominal dollars by 45 and 55 percent in 1973-1974, 2000-2002, and 2007-2008. Therefore, during poor markets, investors should expect the risky portion of their portfolios to decline by approximately half. The “risky portion” is everything that is not investment grade bonds or cash. This is the necessary pain to achieve the higher returns that are expected from risky assets. This is not a “worst-case” scenario, it is the periodic expected case. If stocks did not occasionally experience losses, they would cease to be priced attractively enough to earn superior returns. It is our job to make sure client portfolios are positioned at an appropriate level of risk and that our clients do not increase their risk-taking when things look rosy (e.g. 2006) and do not decrease their risk exposure when the outlook is frightening (e.g. 2008). [Emphasis in the original]

As part of the conversation, we tie the information to their specific situation: “You have a $5,000,000 portfolio which we have recommended be invested 60/40. That means you could wake up in a year and it would be worth $3,500,000. Imagine that has happened and the media is screaming that the wheels are coming off of capitalism/civilization, and we are going into another great depression. How would you feel?”

Then, we let them talk. They still won’t be able to accurately judge how they would really feel in that situation, but we can get a sense of where they are. It helps if they are older and have been through bad markets with significant funds. Having gone through the GFC with a $200,000 portfolio, while still working, and not panicking is not the same as going through something similar now, retired, with a $4mm portfolio.

Advisors should almost always think in percentages, but often clients react to dollars.

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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.