My last post mentioned at the end that many people purchase annuities for the guarantees.  I thought I would expand on that by posting here an analysis I did a few years ago of some examples of “market linked” or “equity linked” products with some sort of guarantee.  These “guarantees” are attractive propositions to those who are understandably gun-shy after watching the market plummet by about half.  They aren’t outright theft in the way that schemes perpetrated by Bernie Madoff, Allen Stanford, and others are, but they are harmful to investors all the same.  These gimmicks are extremely popular in insurance products and perform similarly.

Product One

An advisor at one of the largest investment firms emailed the pitch below to his clients recently.  The firm’s name has been removed to protect the guilty, but it is otherwise unchanged:

[Firm Name] is rolling out our market linked CD today:

(Get market performance on your insured CD without risk of losing $)

* Must be purchased by September 8, 09.

* Linked to S&P

* Approximately 5.5 yr term

* Performance Cap: 45-65%.

* FDIC Insured?  Yes up to $250K

* Downside risk: None, if S&P has a negative return at end of term, 100% of principal is returned.

* Minimum purchase: $ 4000.

The blue line was blue in the original, presumably for emphasis, even though it is clearly inaccurate.  “Market performance” is simply not available without risk in this product or any other.  The performance cap ended up being 60%, as it had been in earlier offerings, which is obviously not “market performance.”  Now, here are the problems:

1. The tax treatment is horrible. Owning stocks gives capital gains.  This product delivers all ordinary income, which is taxed at a higher rate.  Worse, the investor is taxed on the income during the 5½ year term even though nothing is received until the end.  (This is called “phantom income” in the tax world.)
2. This product is massively illiquid. During the term, there is no active market in which to sell the CD and get the money back, and the investor is not able to cash it in prematurely.  Hedge funds don’t even have 5½ year lockups.
3. The “S&P” mentioned is the S&P 500 price only index. The S&P 500 was created in its current form on March 4, 1957.  Using all of the monthly returns from April 1957 (the first full month after its creation) through August 2009 (the last full month before this CD was to be purchased), the average annual return for the S&P 500 was 9.65%.  Without the dividends, it was only 6.13% – a not insignificant 3.52% annual difference.
4. The gain is capped at 60%. In other words, compared to investing in the S&P 500 outright, in exchange for guaranteeing investors won’t lose money over a 5½ year period, the firm is taking 3.5% off the top (from the dividends) and then 40% of the rest of the return.

Of course, if investors are spared from some truly horrific results, it still might be worth it.  But since the investor is only getting 60% of the returns, what if he or she simply put 60% of the funds in an S&P 500 index fund and the other 40% in something conservative like 5-year government bonds?  On average, the CD would have returned 4.86% (annualized), the 60/40 portfolio 9.42%.

In short, the investor who bought into the pitch gave up an average of 4.55% per year (difference due to rounding) for the downside protection.  Again, that may have been worth it if the protection was frequently needed or if when it kicked in it averted catastrophe.  There were 564 rolling 5½ year periods from April 1957 through August 2009 (when I did this analysis).  The CD outperformed the simple 60/40 portfolio … once – the period ending in September of 1974.  Here it is graphically:

As you can see, generally it isn’t even close.

Product Two

Here is the description from the documentation:

The Notes Linked to the S&P 500^® Index due August 29, 2014 are senior unsecured debt securities of [Wirehouse] that provide (i) the possibility of a return, subject to a cap, if the ending level of the S&P 500 Index (the “Index”) increases from the starting level, (ii) the possibility of an 8% contingent minimum return so long as the ending level of the index does not decline by more than 40% from the starting level, (iii) return of principal if, and only if, the ending level of the Index is not less than the threshold level and (iv) full exposure to decreases in the level of the index from the starting level if the ending level is less than the threshold level.  If the ending level is less than the threshold level, you will lose some, and possibly all, of the original offering price of your notes. [To their credit, emphasis in the original.]

Here are the issues:

1. It is massively illiquid with a four-year lockup of the investment.
2. The “8%” return is holding period return (henceforth HPR) over four years – not annualized.
3. The upside is capped at 60-70% HPR, or 13.34% annualized (using the midpoint of 65% for the calculations.)
4. The tax treatment is ordinary income and is probably phantom income during the term (the IRS position is unclear).
5. The investor is an unsecured creditor of the company issuing the note during the term since he or she doesn’t actually own the underlying investments.

Given those issues, ideally this is held in a tax sheltered account, the firm stays in business, the investor doesn’t need or want the funds for four years, and the S&P 500 performs as it has historically.  Using month-end data for every rolling four-year period since the inception of the S&P 500 (March 1957), never (out of the 593 rolling periods) was the ending value of the S&P below 60% of the starting value over a four year period, so the massive downside never occurred and thus isn’t isn’t reflected in the analysis to follow, and the investment got “capped” at the 65% return 101 times (17 percent of the periods).

Essentially, this is a simple options strategy:

1. Buy zero coupon bonds that at maturity will be worth 108% of the original investment.
2. Buy a four year S&P 500 call with a strike price 8% above the current value.  (8% was already received from the bonds; this gets the rest of the return.)
3. Sell a four-year, European-style, call (that means it can only be exercised at expiration) with a strike price at 165% of the market value (this limits the upside to the cap).
4. Sell a four-year, European-style put with a strike price at 60% of the market value (this captures the downside risk that exists with this product).

It looks pretty good at first glance.  It never lost money; the worst return was 1.94% annualized – the 8% HPR – and it had average annual returns of 6.99%.  While it certainly underperformed stocks, that isn’t an appropriate comparison since stocks experienced far more downside even over a four year period.  In fact, the return on the note during that period is exactly the same as five year treasuries have earned, so it is far more similar to fixed income.

So what would be a fair comparison?  I mixed investments in the S&P 500 (total return) and five year constant-maturity treasuries to get a portfolio of equivalent risk.  A 25% stock/75% bond mix never had a return lower than 9.19% – higher than the 8% “guarantee” from the note, and of course this investment is much better in terms of liquidity, taxes, default risk, etc.

The returns on the 25/75 mix are one percent higher on average as well.  So, when purchasing the note, essentially the investor gives up 1% on average in exchange for worse ancillary features.  In addition, the risk, as measured by standard deviation, of the 25/75 mix is lower.  This isn’t a great comparison because the note has the ends of the distribution truncated, which is why I used minimum return as the risk metric.  The index data I used doesn’t have expenses, but since SPY (the S&P 500 ETF) has an expense ratio of 9 bps and an equivalent treasury ETF (the 3-7 year iShare) would be 15 bps it doesn’t change the conclusion at all.

Also, keep in mind that although the “knock-in” if the market is down in price by more than 40% (excluding dividends) never happened in the last 50 years of data used here, if it did happen the investor would get killed in this note versus the 25/75 mix.  And “killed” is not an exaggeration (though it is clearly metaphorical).

To make the comparison fair, and incorporate that downside risk, the investor would buy the 25/75 mix and then sell four-year naked puts with a strike at 60% of the current price.  I don’t know of many advisors who would think that was a prudent strategy.  It would make the historical returns even better because the investor received the option premium and yet was never exercised upon.

Here is the graph of hypothetical historical performance, without including the extra income on the blend strategy from selling a naked put (essentially the red lines would be even higher):

Product Three

An advisor was extolling the virtues of “Reverse Convertible Notes” to me, so I asked him to send me the prospectus.  Here is what I found:

The investment is a 6-month note that pays 10.15% (annualized).  But, if over that six months Exxon stock (the reference security used in this case) trades below 85% of its initial value, and is below 100% of the initial value at the end of the period, the investor gets the stock value rather than the original investment.  (This is called being “knocked in.”)  Overall this sounds attractive, but…

Using data back to 1970 (which is all I had handy) on XOM (Exxon), the investor would have been “knocked in” 22% of the time.  Thus 78% of the time the investor got (annualized) the 10.15%.  The other 22% of the time the investor gets the (annualized) 10.15% plus either the original investment (if the stock is back over the original price), or the value of the stock.

It may seem surprising, but since the upside is capped while the downside is unlimited, the average 6 month return from the strategy is a loss of 0.71%  Thus investing in this note underperforms burying the money in the yard (on average).  Obviously it has huge negative skewness and excess kurtosis which is fatal in combination.  Here is the frequency distribution:

Clearly these are a poor investment.  It is equivalent to buying fixed income while selling naked puts.  If the stock performs as it has for the last 40 years, the compound return from this strategy (annualized) is -1.99%.  So why was the advisor so excited about something that on average loses money?  Well, most of the time (80%), it did fine so the client is happy, not realizing they have done the equivalent of buying a coastal home with no insurance that gets washed away periodically.  The other years it seems great!

More importantly, and all too typically, the advisor got paid a lot to not look at it too closely.  The commission on this product is 1.75%.  So, since this is a six month deal, if they keep rolling them (which is what this advisor did), the brokers are getting 3.5% every year!  Commissions of that magnitude should have been a blindingly obvious sign that this is a poor deal for the investor.

In conclusion, these types of products are complicated, gimmicky, and ubiquitous, but the lesson is old: “There ain’t no such thing as a free lunch.”

To make a case for annuities, advisors often compare the most expensive, tax-inefficient mutual funds to the most inexpensive variable annuities.  However, an objective analysis, will find that annuities appear to be poor choices in most (but not all) cases.

To fairly compare the two (and remove compensation considerations), I used a 0.30% marginal cost gleaned from the cost of a Vanguard “no load” annuity.  The 30 basis points are in addition to the underlying cost of the funds – vastly lower than the additional costs of most annuities that are sold.

Annuities made a lot more sense when the ordinary income and capital gains rates were the same.  Now, annuities have to overcome both higher rates (ordinary income vs. capital gains) and higher expenses.  Given a long enough time horizon, the 100% tax-deferral theoretically may overcome these disadvantages.  Seeing if that is true is the point of this exercise.

Six factors impact the decision:

1. Rate of return – higher returns favor annuities; lower returns favor taxable accounts.
2. Ordinary income tax bracket – lower ordinary income tax brackets favor annuities; higher ones favor taxable accounts.
3. Capital gains tax bracket – higher capital gains rates favor annuities; lower ones favor taxable accounts.
4. Tax efficiency of taxable alternative – tax-inefficient, high-turnover investments favor annuities; low-turnover approaches favor taxable accounts.
5. Time horizon – long time horizons favor annuities; short horizons favor taxable accounts.
6. Annuity cost – the lower the marginal cost of the annuity over the comparable mutual fund investment, the better it will compare (obviously).

Also note that I am not talking about immediate annuities which can have a place in a portfolio as insurance against the additional costs of a long life.

Here is one example:

1. Investment rate of return – assume 10%, the long-term stock market average.  (In reality, it would be somewhat lower due to the expense ratio of the subaccount/fund, ad due to lower expected returns currently but using this relatively high number should favor the annuity.)

2. Tax bracket – assume the most favorable case for an annuity, 25% ordinary income and 15% capital gains. (This is most favorable because the spread between the rates is lowest.)

3. Tax efficiency – assume a 50% portfolio turnover.  This is extremely inefficient and would favor the annuity.  I have assumed that all gains are long-term, however.  This implies an advisor would not be foolish enough to select funds for a taxable account that throw off short-term gains.  (In reality, I think a 10% turnover in a taxable account is more reasonable for a competent advisor.)

4. Annuity cost – as mentioned earlier, I used a 30 bps marginal cost to the annuity.  This attempts to remove compensation confusion from the analysis.  In other words, if the total expenses are 1.15% for a fund, the annuity would be 1.45%.  In this example, the net return ends up being 10.0% for the fund and 9.7% for the annuity.

In short, I have tried to use reasonable factors that would favor the annuity.  Using the numbers above, we solve (using my spreadsheet calculator here) for the time horizon necessary to make the annuity a better investment than the taxable alternative.  In this case the breakeven is 26 years.  In other words, a rational investor should not place in an annuity any funds he or she will need within the next 26 years.  If we change any one assumption, it just gets worse.  For example:

1. If the portfolio turnover is 10%, a 49-year time horizon is required to favor the annuity.
2. If the net investment is 8% instead of 10%, the breakeven becomes 34 years.
3. If the ordinary income tax bracket is 35%, the breakeven is 42 years.
4. If the ordinary income tax bracket is 15% or lower, the breakeven is never (because of a 0% capital gains tax rate).
5. If we make a conservative assumption that the market will return 8%, and our alternative is a passively managed investment with a 10% turnover (in essence combining 1 & 2 above), the breakeven is 62 years.

Some other factors:

1. In the case of death, the heirs are vastly better off with a taxable investment because of the step-up in basis.  The odds of dying in the early years (when the investor would be likely to have losses) are trivial vs. the odds of dying in much later years (when the odds are in favor of large embedded gains).  Remember, if there aren’t big gains, the taxable investment will be better; it is therefore irrational to use an annuity for “protection” for the very small chance that someone will die when it will be worse if they live.

2. Taxable accounts allow tax loss harvesting much more easily and efficiently.  Annuity losses have to exceed the 2% of AGI threshold, and the taxpayer must itemize.

3. If the investor needed the money early, he or she could be vastly worse off in three potential ways:  1) surrender charges, 2) the time period was too short to favor the annuity alternative, 3) early withdrawal penalties for pre-59½ distributions.

4. Using an annuity increases the standard deviation of returns relative to the taxable alternative.  This is contrary to what is desired.  In other words, for any given time horizon there is a rate of return where annuities and the taxable alternative are equivalent.  If the investment experience has been good (i.e. better than breakeven), then the annuity will be the superior choice.  If the investment experience has been bad (i.e. below breakeven), then the taxable alternative would have been better.  In other words, when purchasing an annuity, very good returns get better, and very bad returns get worse.  This is undesirable in most cases.

5. Finally, sometimes an advisor has placed an annuity inside of an account that is already tax advantaged.  The rationale is that the client is risk-averse and wants this “protection” even with the higher costs.  The expected payoff is computed by multiplying the average percentage the account is likely to be down (when it is at a loss), times the probability of being down, times the probability of dying.  This figure would be compared to the marginal cost of the annuity vs. the alternative investment in the account.  My calculations show this to be a bad bet because the probability of dying is too low – unless the annuity owner is in his or her nineties.

Let me dilate further on #1 above.  The death benefit has a computable value that will be greatest the very first year of the annuity because the investment has a positive expected return.  Even if some losses are bigger in years after the first one, the chance of them happening goes down even faster.  Using a mortality table, we can compute what a rational investor should be willing to pay for the insurance.  Still, that isn’t the whole picture because if the annuity has increased in value, the heirs lose on the tax treatment, and the odds of being up are much higher than of being down.

So, no matter what the mortality is, even if the investor dies after the first year, the annuity “protection” is a small net loss unless future investment performance will be dramatically worse than history. And, if that assumption is valid, purchasing an annuity is not optimal because high returns are required for it to make sense if the investor lives.  Note that that is the best year!  After year one, it gets dramatically worse. This means the “protection” is on average worth much less than zero because of the adverse tax treatment.

If the annuity is purchased within an already tax-advantaged account, we can ignore the second part of the analysis above and simply look at the benefit vs. how much the annuity costs (the incremental cost over an alternative mutual fund).  The downside protection is only worth the probability of being down, times the average magnitude, times the probability of death.  There are no annuities inexpensive enough to make sense in a tax-advantaged account, unless life expectancy is less than about 5 years.

Despite what our foregoing analysis, if an investor wants/needs to hold very tax-inefficient investments, and does not have sufficient “room” in tax-advantaged (e.g. retirement) accounts, and does not need the income generated, annuities can be the correct solution to put a tax-efficient “wrapper” around those inherently inefficient vehicles. (Tax inefficiency is a function of both the tax rate and the amount recognized each year.  Treasury bonds in the late 1970’s or early 1980’s for example were very inefficient holdings.)

Finally, annuity salespeople will claim that people don’t buy (i.e. they aren’t sold) the “plain vanilla” annuities I have used in my examples above.  That they are actually buying some sort of market guarantees or protection.  It is hard to debunk this because the products are changed constantly so it is like playing whack-a-mole, but I would simply point out that it is impossible for insurance companies to offer returns without the commensurate risk. They can do this with other types of insurance only because the risks are uncorrelated (all the houses don’t burn down at the same time).  In the market all the investments do tend to decline simultaneously so there is no advantage to risk pooling.

 

Tax loss harvesting is the sale of securities in a taxable account that have declined in value since their purchase in order to recognize the loss for tax purposes.  Most people (including professional financial advisors) do this at the end of the year determining whether the transaction is worthwhile by comparing the immediate tax savings to the transaction cost.  This is not optimal two different ways.

First, positions should be evaluated throughout the year for opportunities to save on taxes; there is no reason to wait until the end of the year.  Because investments tend to go up more than down and there is little serial correlation in the market, taking losses when they are economically meaningful is prudent.

Second, the calculation of tax savings and costs is more complicated than it first appears.  Consider first the standard analysis:

• Assume the original investment was $10,000.
• The investment has declined in value to $9,000.
• The investor is in the 15% tax bracket (i.e. this will offset other long-term capital gains).
• An equally attractive alternative investment that is not a wash sale violation is available.
• The transaction costs are $20 for each trade ($40 total – one sell and one buy).  Transaction costs should include not only the explicit commissions but also bid/ask spread costs and market impact costs.

This appears to be the proverbial “no brainer” – spend $40 to save $150 (a $1,000 loss times 15% tax savings).

In fact, given the information above, whether this is a prudent strategy or not is undeterminable.  Three key pieces of information are missing:

• How long does the investor expect to keep the “old” investment in their portfolio if they don’t harvest the loss?
• What will the tax bracket be at that time for that transaction?
• What is the hurdle rate for the return on this strategy?

Let’s assume if the investor doesn’t sell to take the loss it would be sold in 5 years anyway for some reason (perhaps we estimate this by simply knowing the investor has a 20% portfolio turnover rate).  Further, assume the tax bracket at that time will continue to be 15%.  The future transaction costs aren’t relevant since it will be sold at that point anyway – it doesn’t matter which investment it actually is.

At this point, it is simply a time value of money problem.  With tax loss harvesting, the investor saves $150 in taxes now less the $40 for transaction costs for a net of $110.  However, in 5 years the cost basis is $1,000 lower than it would have been had the old investment been kept.  Thus, the tax bill at that time is $150 higher than it would have been.  Essentially the $110 now cost $150 in five years.

Since the rate of return that will grow $110 to $150 in 5 years is 6.40%, this selling is only advisable if the current tax savings can be invested to earn more than 6.40%.  Alternatively, it can be viewed as an opportunity to borrow at 6.40% for 5 years.  That might or might not be attractive depending on the situation.

To recap, tax loss harvesting is more attractive to the extent:

• The loss to be harvested is large.
• The transaction costs are low.
• The alternative investment is attractive.
• Future tax rates will be low.
• The investment will probably be held for a long time.

Conversely, tax loss harvesting is unattractive if:

• The loss to be harvested is small.
• The transaction costs are high.
• The alternative investment is unappealing (such as keeping cash for 30 days to avoid the wash sale rules and then repurchasing the original investment).
• Future tax rates will be high.
• The investment will be sold shortly anyway for unrelated reasons.

Tax gain harvesting is potentially advantageous when a taxpayer finds themselves facing a lower rate in a particular year than they are likely to face in the near future.  The optimal strategy is frequently to harvest those gains and pay the taxes early, but at the lower rate.  For investments that will be held for the long term, but not too long, it may be optimal to sell and lock in the gain at the lower rate and then immediately repurchase the investment.  This would mean that only future gains will be taxed at the higher rate.

To prevent taxpayers from selling investments at a loss to get the tax deduction and then immediately repurchasing the investment (or doing something roughly equivalent economically) there are what are known as “wash sale rules” that disallow taking the deduction until the investment is “really” sold.  These rules do not apply to recognizing capital gains.

Many investors may have large carryforward losses.  The current tax code only allows the recognition of $3,000 per year of capital losses against ordinary income.  The remainder is carried forward to future years where it may be used against subsequent recognized gains.  For taxpayers in this situation, recognizing gains early will not be advantageous as they are not actually being taxed at the long-term gain rate, but rather simply using up some of the accumulated losses.

Assume a stock was bought for $50,000 and is now worth $150,000 and would incur taxes of $15,000 (a 15% rate) if sold this year and that the same sale in the future would incur taxes of $20,000 (a 20% rate).  If it is anticipated that the investment would be sold in ten years but instead is sold now and repurchased, the investor pays $15,000 today to avoid taxes of $20,000 in ten years.  That is a rate of return of just 2.92% (annualized).  It would probably be better to invest the $15,000 instead of paying taxes and earn enough to pay the $20,000 later with money left over.  (This simplistic analysis ignores transaction costs from the “extra” trades and taxes on the alternative investment, so the return is slightly overstated.)  Conversely, if it is anticipated that the investment would be sold in two years rather than ten, the rate of return is 15.47% (annualized).  That is compelling.  To recap, capital gain harvesting is more attractive to the extent:

• There are substantial embedded capital gains on investments in a taxable account
• The investor does not have offsetting recognized losses or loss carryforwards
• The investment will be sold anyway in a relatively short period of time.

Here are a few common investment mistakes (in no particular order):

Selecting investments without an overall plan. Many people have accumulated a hodge-podge of funds and individual securities without considering how they fit together.  They have a collection rather than a portfolio.  The individual investment selection (within the same asset class) is one of the least important parts of the process.  This is confusing because it looks very important.  It is true that selecting superior investments would make a huge difference to your results, but research shows that to be nearly impossible.  Because the market is a fantastic clearinghouse of information, securities are generally priced “correctly” leaving no opportunities to profit from superior investment selection.  In other words, markets work.  The following factors, even though they may seem extraneous, are just a few of those that should be considered in structuring a portfolio:

• Projected cash flows (when money will flow into or out of the portfolio)
• Capital markets assumptions (the expected return, risk, and correlations of the investments available in the market)
• Tax possibilities and probabilities
• Human capital (the value of future labor income, and the level of certainty)
• Debt (ceteris paribus more debt should be balanced by a more conservative portfolio)
• Pensions, including Social Security (the funding/risk level, the survivor benefits, whether there are COLAs, etc.)
• Inflation possibilities and probabilities

Not being properly diversified. In general, you are rewarded for taking risk with higher returns.  However, this does not apply to diversifiable risk.  In other words, stocks are riskier than cash, and one stock is more risky than owning a portfolio of many stocks.  However, you get rewarded (with higher expected return) for owning stocks over cash but not for only owning one stock.  Why?  Because you can easily mitigate that risk by owning many stocks.  The worst form of this mistake is also the most typical.  People frequently accumulate large amounts of their employer’s stock.  This is a very risky strategy, not only from an investment portfolio perspective, but also because in the event of a problem in their company or industry, they could find themselves both without a job and with a diminished investment portfolio simultaneously.  It is almost impossible to have a properly diversified portfolio (technically defined as eliminating non-systematic risk) using individual securities.  Mutual funds or exchange-traded funds are the appropriate vehicle for building a diversified portfolio for the typical investor.

Not staying with the plan. Consider a simple situation where you have determined having 60% of your investments in stocks and 40% in bonds is optimal.  Suppose the stock market then goes up dramatically so the allocation is no longer 60/40.  What should you do?  Many people, happy to see their stocks soaring, plow more into those investments (remember the late 90’s in stocks? 2006 in real estate?).  Conversely, suppose that stocks plummet (as in 2008).  Many people want to move money from stocks to something safer.  Both of these reactions are wrong, but not for the reason most people think.

Academic research has shown there is little serial correlation in the capital markets in the short run (either positive or negative).  In non-technical language, that means what has happened has little or no short-term predictive power over what will happen (again despite what you hear in the media).  The fact that stocks go down does not indicate they will continue down or that they “must” come back.  If stocks (or any other asset classes) go up, that does not mean they will come down.

The reason to rebalance the portfolio (keeping transaction costs and taxes in mind) is that the 60/40 allocation has the risk/return profile with the highest probability of meeting your long-term financial goals.  The losses incurred from missed opportunities or increased risks from trying to outsmart the market can be significant.

Ignoring costs. Many people focus on obvious costs like commissions and fees (which average about one percent of your investments annually for professional help), but completely ignore hidden costs.  For example, most people (and advisors) overtrade because they feel a high need to “do something” even if it is wrong.  The advisor frequently does this not out of malice but due to overconfidence in trading ability or to justify his or her existence.  It is difficult to charge fees for inactivity; however, inactivity is generally called for.  Making a change is not free.  Transaction costs, ranging from the bid/ask spread to commissions to market impact costs, must be overcome before making a profit on each trade.  Insurance products (for investing), separately managed accounts, hedge funds, etc. are all products that tend to have excessive costs.

Another cost is taxes.  Reducing turnover, actively harvesting tax losses from a taxable account, and paying attention to asset location (locating tax-inefficient holdings in tax-sheltered accounts and tax-efficient holdings in taxable accounts) may add from one-half up to one percent to the annual return.  Obviously, individual situations can vary a great deal.  Many advisors and investors do not harvest tax losses effectively because they believe in negative serial correlation (because it went down it must “come back” – see number three above) and because it is difficult emotionally to admit being wrong (though investing shouldn’t be about emotion), and selling something that has declined seems like admitting error.

An opposite error is occasionally made by focusing excessively on taxes.  The objective is to maximize after-tax return not to reduce taxes.  An example of this mistake would be holding municipal bonds when your tax bracket is too low for that to make sense.  Generally, the best way to reduce costs is to use index funds or exchange-traded funds and a “tax aware” advisor.

Ignoring conflicts of interest. The financial media, while not wishing you ill, have a primary goal of attracting an audience.  “10 Stocks to Buy Now!!!” does just that.  A discussion of buying and holding boring index funds and treasury bonds does not.  Stockbrokers charging commissions have an incentive to overtrade.  Investment advisors charging fees (e.g. us) have incentives to keep you leveraged to increase assets under management (i.e. don’t pay off the mortgage).

Also, many advisors get higher pay (directly or indirectly) for selling “in-house” products, though they generally have poor relative performance and higher costs.  Some firms have fee schedules that give the advisor huge incentives to tilt an asset allocation toward more risk.  (One of the largest firms, at least the last time I saw the fee schedule, was paying its advisors as much as 60% more for using stocks over bonds).  I believe most advisors do have good intentions, but often compensation issues can cloud judgment.

There are obviously many other mistakes people can make in their investments, but in my view, these are the main ones.

I thought I would quantify the returns for delaying Social Security retirement benefits.  A retiree with a FRA (Full Retirement Age) of 66 could claim 75% of their benefit at age 62.  Using mortality tables (RP-2014) we can compute the return for waiting:

Total Dataset		Blue Collar		White Collar		Bottom Quartile		Top Quartile
M	F	M	F	M	F	M	F	M	F
3.8%	4.4%	3.4%	4.2%	4.3%	4.7%	3.3%	4.3%	4.4%	4.7%

Important notes:

1. Because SS benefits are adjusted for inflation, these are real rates of return on government-guaranteed, creditor-protected, payments.  Thus these returns should be compared with real returns on government bonds (TIPs) which currently range from -0.23% on a 5-year to 0.90% for a 30-year.
2. For married couples the return is even greater for the higher benefit spouse to delay, regardless of the relative ages.  (Because there is some chance, however tiny, that the lower benefit spouse will live longer, a married couple will always have a higher expected return from the higher benefit spouse delaying than that same individual would if they were single.)  If the lower benefit spouse is female and significantly younger, the expected returns from delay can be very significant.
3. Most folks reading this (and their clients) will tend to be the white collar or top quartile folks.
4. Taxes should be considered in the decision as well.  A higher SS benefit might cause higher SS taxation later, but it also provides an excellent opportunity for partial Roth conversions, etc. in the years before the benefits are begun. On balance I would expect waiting will be even more advantageous for the typical client when these other opportunities for exploiting the low income years are included in the analysis.
5. The main financial planning risk for most people is outliving their resources (a combination of a long life and low investment returns) so increasing a government-guaranteed life-long income stream is more valuable than the rates of return indicate because it is most helpful in the worst situations.

Here are the figures for continuing to delay from 66 to 70 (an increase from a full benefit to 132% of it):

Total Dataset		Blue Collar		White Collar		Bottom Quartile		Top Quartile
M	F	M	F	M	F	M	F	M	F
2.2%	3.0%	1.7%	2.8%	2.8%	3.4%	1.6%	2.8%	3.0%	3.4%

Again we see that the worst case scenario for delaying is still significantly higher than an equivalent investment.

Here are the full returns for waiting from 62 all the way to 70 (from 75% of the full benefit to 132% of it):

Total Dataset		Blue Collar		White Collar		Bottom Quartile		Top Quartile
M	F	M	F	M	F	M	F	M	F
3.0%	3.7%	2.6%	3.5%	3.6%	4.0%	2.5%	3.5%	3.7%	4.0%

For those born after 1959 FRA is 67 rather than 66. Here is the return for that cohort for waiting from 62 to 70 (from 70% of the full benefit to 124% of it):

Total Dataset		Blue Collar		White Collar		Bottom Quartile		Top Quartile
M	F	M	F	M	F	M	F	M	F
3.5%	4.2%	3.1%	4.0%	4.1%	4.5%	3.0%	4.1%	4.2%	4.5%