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%

 

There are a number of things that need to be addressed in financial planning, including, but not limited to:

• Insurance & risk management
• Employee benefits
• Estate planning
• Retirement planning
• Portfolio allocation

Those items generally can be taken care of and forgotten about until you experience a life change of some sort (retirement or job change, marriage or divorce, new child, etc.) but there are a few maintenance items that are also important, but perhaps overlooked.  It is a best practice to do these things annually.  To remember, many people tie it to either their birthday, the new year, or when they file their taxes.

Credit Reports

We encourage our clients to request a copy of their credit reports for two reasons.  First, many people find inaccuracies on their reports.  While most of these are minor, occasionally there might be something significant enough to impair your credit.  The ideal time to discover this is not when you are trying to secure a new home or job.  Second, it will give you early warning of identity theft or fraud.  While many people are concerned with computer hackers stealing their identity, the more mundane methods are still the most prevalent.  A salesclerk stealing a credit card number or a relative stealing a check and forging the signature may not make headlines, but they are still classified as “identity theft.”  Periodically checking your credit report will ensure that you quickly become aware of irregularities in your accounts.

There are a few ways to monitor and protect your credit.  First, a number of services have sprung up that will notify you immediately if something looks suspicious.  While these may give some peace of mind, they probably are not worth the fees for most people since you can get copies of your credit report for free and monitor it yourself.  Similarly, you have no doubt seen many offers for credit protection insurance.  Many people don’t realize that consumers are only liable for the first $50 of fraudulent charges on their credit (not debit) cards (more details here).  Thus, if you are being charged five dollars per month for the insurance, there would have to be fraudulent charges more often than every ten months for this to make sense.

As an aside, many experts also recommend not putting outgoing mail (such as bills) containing checks in your mailbox.  Criminals do sometimes steal the checks and “wash” (using chemicals) the writing (except the signature) off of the check giving them a signed blank check.  It is recommended that outgoing mail with checks be placed in a mailbox that is only accessible with a key.

The easiest way to request your credit report is to go to annualcreditreport.com and follow the steps.  Be aware that you will have to get the report from each of the three services separately.  Also, to verify your identity, each of the services may ask you various questions (“What was your address in 1998?”, “Into which range does your current mortgage payment with ABC Bank fall?”).  If you do not have internet access, you may also request the reports by calling toll-free 1-877-322-8228.

Because there are three main credit reporting agencies and you can request one free report annually some overachievers request one every four months from a different agency.

If you want more information about your credit score (as opposed to your credit report), see here.

Social Security Statements

If you are still working, it is recommended that you get a copy of your Social Security statement each year.  (You may have noticed that as of 2011 you no longer automatically get these in the mail each year, but they were partially reinstated in 2014 so workers get one at ages 25, 30, 35, 40, 45, 50, 55 and 60.)  By reviewing your statement you can see estimates of your disability, future retirement, and survivors benefits (it assumes your current earnings level continues, which is probably correct for most people).  More importantly, since those estimates will change little from year to year, you can verify your earnings and Social Security and Medicare taxes were reported accurately.  This will let you know if someone else is using your Social Security number to report wages, if your employer hasn’t forwarded on the payroll taxes that were withheld, or if there is some other snafu.

To create an account, go to, www.ssa.gov/myaccount. To verify your identity you will have to answer some questions (just like with requesting your credit report) that only you are likely to know the answer to.

Statement of Net Worth

Arguably the best single metric of financial prudence and progress is tracking change in net worth over time.  If housing or investment values collapse (e.g. 2008) net worth will obviously decline, but in general, an increase in net worth year-over-year is a great measure of, as Ed Koch used to ask, “How’m I doin’?”

Net worth is simply adding up the fair market value of what you own (what everything would sell for currently) and subtracting what you owe.  For example, suppose in the last year you had the following changes:

• You contributed $18,000 to your 401(k)
• The principal on your mortgage was paid down (through regular monthly payments even) by $10,000
• You sold a car you no longer needed for $20,000
• Your portfolio declined by $15,000
• Your house appreciated by $10,000

Then your change in net worth is $23,000 for the year ($18,000 + $10,000 – $15,000 + $10,000 = $23,000).  The third item, the car, is irrelevant as one asset (the car) was merely swapped for another (cash) and didn’t change your net worth this year.  The sale of the car may improve it in subsequent years if the $20,000 is placed in something that increases in value rather than a depreciating vehicle.

Rather than the way I did it thought, you should actually make a list of all assets and liabilities and the dollar values each year and compare them to the previous years.

Conclusion

Each year I encourage you to practice good financial hygiene by checking your credit report, obtaining your Social Security Statement, and computing your net worth and comparing it to last year.

Financial advisors disagree vehemently about (at least) three topics:  fees vs. commissions, active vs. passive management, and the subject of this article:  permanent life insurance vs. taxable investments.

Assumptions & Observations

First, a few general comments before I discuss the specific factors impacting this decision:

• While both investment and insurance vehicles may have poor performance, excessive costs, etc., I see no reason to assume one to have consistently superior gross performance over the other. Too often the best products from one type are compared to the worst products of the other type biasing the outcome.  A fair comparison would be a very good, inexpensive life insurance policy versus a very good, inexpensive investment vehicle.

• Many people act as though they consider insurance proceeds to be free money. There is no printing press creating money in the insurance company’s basement.  In the long run, premiums are merely returned to the policyholders (unequally however) less a haircut for administrative expenses, commissions, profits, etc.  Remember the most fundamental general rule is TANSTAAFL (There Ain’t So Such Thing As A Free Lunch).  There are two possible exceptions to this with life insurance:  1) If you die prematurely, (earlier than the actuaries predicted) you “win.”  Of course, this benefit is offset by the reverse, if you live longer than expected, you lose.  2) There may be tax advantages from the insurance that make it superior.

• Estate taxes are frequently presented as the rationale for purchasing life insurance. To the extent the insurance is out of the estate (in an ILIT for example), the annual gifting could be made in cash to the beneficiaries directly.  The beneficiaries could then do this same analysis (taxable investment vs. insurance) to decide whether they should invest the gift (or any other funds for that matter) in an insurance vehicle.  While it is true that funds may be needed for liquidity at death, the gifts could be invested in a taxable account to accumulate that liquidity.  This brings us back to the “die early and win” versus the “die late and lose” issue mentioned previously.  If estate liquidity is needed in the short run, term insurance can be purchased and taxable investments used to accumulate the liquidity for the long run.

Factors

This brings us to the specific factors that impact this decision.  All of these don’t have to be true to make buying a permanent policy advisable, but the more that are true and the greater the extent to which they are true the more a permanent policy would be advantageous.

• Mortality – Because most people have a risk of lasting longer than their portfolio, compounding this risk would be irrational. Considering that insurance purchases are good if you die prematurely and suboptimal if you live a long time, purchasing permanent insurance as an investment (as opposed to for income replacement or other risk reduction) is generally irrational.  Thus, in regard to this factor, it would seem that permanent insurance should only be purchased by those with little or no risk of outliving their resources.

• Income Taxes – Higher tax brackets favor the life insurance policy unless the policy is lapsed. Then, the detrimental treatment of gains being taxed as ordinary income rather than capital gains tends to make the taxable investment more favored.  Additionally, using insurance removes the option of tax loss harvesting.  Note also that while insurance proceeds are income tax free so are capital gains if the investment is held until death for the step-up in basis.  While no taxable investment is perfectly tax efficient, equity index funds or ETFs would be very close.  If the investments in question are very tax inefficient (REITs, HY Bonds, or other fixed income – particularly in a high interest-rate environment) or have very high turnover, some sort of insurance wrapper (such as an annuity) may be appropriate if there are not enough assets in an IRA or similar vehicle to shelter those assets from current taxation. In addition, there is a risk that the tax code changes in the future causing the death benefit to be income taxable.  Thus, permanent insurance should only be purchased if there is a) a high degree of confidence that death benefits will continue to be income-tax-free in the future, b) tax-advantaged vehicles, such as a 401(k), deductible IRA, Roth, etc., have been fully utilized, and c) tax inefficient investments would otherwise be held in taxable accounts because retirement accounts are not large enough.

• Flexibility – Taxable accounts obviously have almost unlimited investment choices as well as the advantage of being able to cash out completely at any time without cost (other than taxes). Cashing out insurance policies in the early years frequently incurs very large losses as many expenses are front-loaded.  This can be thought of us the equivalent of an enormous contingent deferred sales charge (back-end load) that lasts, in many cases, for decades.  Also, cashing out in later years will incur ordinary income taxes rather than capital gains as mentioned previously.  Thus, permanent insurance should only be purchased if there is almost no chance an unforeseen contingency will cause the funds to be needed during the insured’s life.

• Insurance need – Life insurance is more favorable to the extent that it is needed anyway for risk reduction. Thus, permanent insurance is more advantageous when a term policy would otherwise be purchased anyway.

• Bad M&E effects – This is a little complicated. Essentially, in a variable permanent insurance contract, there are two components of the death benefit from the insurance company’s perspective:  1) The cash value of the policy and 2) the difference between the cash value and the death benefit – known as the “amount at risk.”  Each year, a Mortality and Expense charge (M&E) covers this second amount.  Essentially, the account is charged for one year term insurance.  This has pernicious effects.  If investment performance is good, the amount at risk decreases reducing the M&E charge and making the policy perform even better.  Conversely, if the investment performance is bad, risk increases, the M&E charge is higher, and the policy performs badly.  Thus, good results get better, and poor results get worse in the investment portion of the insurance.  Thus, permanent insurance policies must be monitored regularly and fully funded.

• Creditor Protection –  Life insurance is usually not subject to claims of creditors, but it depends on state law.  Thus, if there is significant worry about losing assets to creditors permanent life insurance may offer shelter.

Conclusion

The purpose of financial planning is to maximize your happiness across multiple contingencies.  The worst-case scenario or “perfect storm” for most people is living a long time and receiving poor investment returns simultaneously.  In this case, you may have to fund the insurance more than you want to (or can afford to), or if it is lapsed or cashed out, there may be taxes due at a higher rate (ordinary income vs. capital gains).  In that case, permanent insurance will be much worse than a taxable investment.  Conversely, in the event of premature death and/or very high investment returns, the insurance vehicle may well prove superior.  Making good outcomes better at the cost of making bad outcomes worse is generally not the correct approach because people are typically risk averse rather than risk seeking.

Rebalancing, according to Wikipedia, is “the action of bringing a portfolio of investments that has deviated away from one’s target asset allocation back into line.” How to do that optimally is the subject of this post. Below is a sample allocation to facilitate the following discussion of rebalancing. It should not be construed as a recommended portfolio in any way.

Asset Class	Target Allocation
U.S. Large Stocks	20%
U.S. Small Stocks	10%
Foreign Stocks	10%
REITS	10%
High Yield Bonds	10%
Investment Grade Fixed Income	40%

 

 

Following are the factors involved in rebalancing (in no particular order):

• Due to the momentum that exists in the markets, rebalancing should be done slightly less frequently than it would be otherwise. Allowing an asset class that has grown (decreased) through good (poor) performance to remain overweight (underweight) can add value. Even if momentum effects don’t add value net of costs as a trading strategy, not rebalancing is costless. Academic research has indicated that if rebalancing mechanically on a time schedule (monthly, quarterly, etc.) the optimal period is probably between one and two years.

• If cash flows are expected soon, it may be prudent to delay rebalancing. If a deposit into the portfolio is expected, those funds can be used to perform the rebalancing with trades that would have to be done anyway to invest those funds. Similarly, if cash will need to be distributed from the account soon but not immediately, it may be prudent to wait until that trade is required and use it to perform, at least to some extent, the rebalancing.

• If it is a taxable account, the recognition of capital gains should slow rebalancing while the recognition of losses should speed it. Note that I am not advocating that taxes should drive the asset allocation, but merely that at the margin, taxes should have some impact on whether and when an asset class is brought back into balance. Waiting until a holding becomes a long-term capital gain will almost always be appropriate. Also, in a taxable account where the owner’s life expectancy is not long, allowing asset classes that have grown “too large” to remain that way to capture a step-up in basis at death may be prudent. The trade-off between a “sure” gain (if anything in the tax code can be considered a sure thing) of 23.8% (or even more if there are state taxes) of the gains vs. slightly higher risk from not rebalancing must be weighed.

• The transaction costs are important as well. Generally this involves not just the commissions, but also the costs from overcoming the bid/ask spread and the market impact costs. These can be particularly large when the security is illiquid. Obviously, the lower the transaction costs, the more frequently rebalancing should occur.

• The magnitude of the discrepancy is a factor as well. For example, an asset class that is 10 basis points (0.10%) out of balance is almost certainly not worth “fixing.” On the other hand, one that is 1,000 basis points (10.00%) out of balance almost certainly is.

• The correlation of the asset classes that are out of balance matter as well. For example, suppose U.S. Large Stocks have grown to be 25% of our allocation, at the expense of Investment Grade Fixed Income which is now at 35% (versus the target allocation specified earlier). Given the dramatic differences between those two asset classes, rebalancing may well be prudent. Conversely, if U.S. Large Stocks have grown to be 25% at the expense of U.S. Small Stocks at 5%, the correlations and risk/return profiles are so similar that “fixing” it may be unnecessary.

• The size of the portfolio matters as well. If the U.S. Large has increased to 22% while the Investment Grade Fixed Income has decreased to 38%, that may or may not be worth fixing. If the total portfolio is valued at $100,000, the amount of the rebalancing trade is a mere $2,000 – probably not worth the transaction costs. On the other hand, if the portfolio is worth $10,000,000, the trade would be $200,000 which might make sense.

• If there is a better investment option available, rebalancing may be more attractive. Suppose our allocation to Investment Grade Fixed Income is slightly high with U.S. Large Stocks being low, but it hasn’t risen to the level that would normally trigger a trade. However, we have a slight preference for a different fixed income investment but not enough to warrant a trade. In conjunction with a slightly out-of-balance portfolio though it might make sense, fixing the out-of-balance condition would be two trades. Changing the fixed income allocation would also normally be two trades. But if we do both simultaneously it is only three trades: sell all the current fixed income and buy stocks and the replacement fixed income vehicle.

• The number of asset classes to fix will affect the decision to rebalance as well. For example, suppose that U.S. Large has 24% while U.S. Small has 6%. Doing two trades to fix that may make sense (depending on all the other factors we have discussed). But if U.S. Large Stocks has 24% while U.S. Small Stocks, International Stocks, High Yield bonds, and REITS each are at 9%, the number of transactions – and thus the transaction costs – may make it imprudent.

• The sensitivity of clients to trades may impact the decision as well. Clients in fee-based accounts are probably relatively insensitive to an additional trade, while a client in a commission-based account may be suspicious that the trade was done purely to generate another commission. This is a problem, and may lead to too little rebalancing in commission-based accounts to reduce this perception of over-trading (even if there isn’t any). So, oddly, a commission-based account can lead to too little trading from an objective standpoint, but it may still be optimal to maximize client happiness.

• Academic research in the field of behavioral finance shows humans in general, and men and professionals in particular, have a propensity to over-trade. This is probably related to over-confidence and a need to “do-something” even if it isn’t particularly helpful (see Congress for example). When in doubt, don’t trade is probably a good rule.

The complexity and inter-relatedness of these factors is why we don’t use an automated system to rebalance our client portfolios. Rather, at least quarterly, we review and evaluate all the portfolios manually in light of the above factors to determine what trades, if any, should be made.