behavioral finance

Don’t Let Your Brain Play These Tricks on You

5 common behavioral finance traps

Key Takeaways:

  • Understanding both the “how” and the “why” of irrational behavior can be invaluable to investors.

  • Research shows that many individuals are overconfident, under-diversified, short-sighted and often swayed by the media.

  • Learn how to protect yourself from your basic instincts.



Imagine world full of “rational” people who could maximize their wealth while minimizing risk. The ratings would be terrible for every cable-TV money show and there would be a lot fewer financial advisors in business. Rational individuals would assess their risk tolerance honestly and then determine an investment portfolio that met their income needs within their risk comfort zone. However, we know that most individuals are NOT capable of being rational—research has proven this time and time again.

Behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain how and why people, especially investors, do not act in a rational manner.

First let’s look at how investors behave irrationally:

  • Their portfolios are not sufficiently diversified.

  • They trade actively with high turnover and high transaction costs.

  • Too much of their wealth is tied up in their employer’s stock or in their own company’s stock if they’re a business owner.

  • They’re over-concentrated in or stocks of companies within their own industry or their immediate geographic area.

  • They tend to buy, rather than sell, companies that are mentioned positively in the news.

  • They tend to sell their winning investments while holding onto their losing investments far too long in a futile chase back to “break-even.”

Now let’s look at five common reasons why individuals behave so irrationally:

1) Recency bias.  We tend to make our decisions—especially financial ones—based on what happened to us most recently. Suppose a stock we just unloaded zoomed up by 50 percent a week after we sold it. Ouch! Then suppose there’s an earnings miss on another stock we’re holding, even though our disciplines might tell us to sell it. We’re scared to death that the same timing mistake we just made will happen again – i.e. the stock will zoom back up right after we sell it.

2) Anchoring.  In one sense it’s about having a mental stake in the ground to give you a framework for making decisions. For example, news about new market highs is blaring every day (Dow 26,000!  S&P 2,800!). And people are saying to themselves: “New highs! New highs! It must be time to sell.” But think about it. New highs are usually a positive sign for the market. We get anchored into these numbers and they distort our thought process. As a general rule, introverted people tend to be more skeptical. And that mindset can really hurt us in our investing because you miss out on opportunities or give up on an investment too quickly. On the flip side, extroverted people tend to be optimistic most of the time, but that can also hurt you as an investor, because you tend to expose yourself to too much risk—again and again.

3) Mental accounting/fallacy of breakeven.  Picking winners is not the big problem for most investors (do-it-yourselfers and many pros). The problem is that they can’t let go of their losers. When you’re holding on to your losers, your ego gets in the way. You tell yourself: “I’m know I’m right about this stock, the market just hasn’t recognized its value yet.” Or, you tell yourself, “I did so much work analyzing this stock, I can’t bail on it now.” So, you start doing all kinds of mental accounting and then at the end you tell yourself that you’ll sell the stock just as soon as it gets back to breakeven. And that’s an ABSOLUTE KILLER in investing.

When you hold on to a losing investment for too long trying to get back to break even there’s an opportunity cost. All those months and years that your money is tied up waiting to get back to breakeven means it can’t be deployed elsewhere in a more profitable investment.

4) Confirmation bias. Let’s say you have a great investment thesis, but you want it confirmed before you pull the trigger on it. So, you run around trying to get confirmation bias from all your smart friends, your broker and the Wall Street pundits whose picks you typically like.  Unfortunately, you’ve got a self-selected group of people who generally share your world view. If you’re honest with yourself, you’ll see they’re wrong more often than right.

Confirmation bias illustrates the danger of following the news media all day long and the danger of blindly following managers who have had the “halo effect” (i.e. hot hand) for the past several years. So you dive in and start following them and it often doesn’t work out. Remember those elite gurus who predicted that the housing crisis 10 years ago would trigger the global financial crisis. They made a fortune! So many investors piled into their funds waiting for them to work their magic again—and a decade later they’re still waiting.

5) Gambler’s fallacy. This occurs when you believe a purely random event is really NOT really random and that it’s going to continue to happen into the future. You start loading up now on FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) because you think they’re going to stay hot forever. You predict the next coin flip is going to land heads because the last 20 flips also landed heads. In reality, you have no way of knowing which side is going to land facing up. It’s completely random, just like so much of investing is. Most of the time, we have no control over what’s going to happen in the market. This fallacy that you actually have control due to some event that is random that you think is NOT random.

Conclusion

Behavioral finance literature serves as a reminder why it so important to protect yourself from you basic instincts—especially when markets are volatile. Safeguarding your wealth is a responsibility, not just to yourself, but to your family and the causes you support. Don’t hesitate to contact me if you suspect that you, or someone close to you, might be drifting from your long-term financial plan.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Why Can’t You Make Better Decisions? Ask Your Ego

Key Takeaways

  • Investing is a psychology game, not an IQ game.

  • Research shows human decisions are made with 80 percent emotion and 20 percent logic—maybe 90/10 when it comes to investing.

  • Why is it so hard to let go of your losers?

 

As some of you may remember, University of Chicago professor, Richard Thaler won the Nobel Prize in economics last year. Thaler is relatively young by Nobel laureate standards, and his primary field of study (behavioral finance), is somewhat controversial to many in the numbers-driven financial advisory world. The idea that psychological research should even be part of economics has raised eyebrows for years.

 

So what is behavioral finance?

Behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain why people, especially investors (both retail and institutional), do not act in a rational manner. Think of the moniker “behavioral” as describing how and why individuals behave the way they do.


As Warren Buffet has explained many times: “Investing is a psychology game; not an IQ game.” Research shows that human decisions are made with 80 percent emotion and 20 percent logic. Some would argue the ratio is now closer to 90 percent emotion and only 10 percent logic.

Take the “disposition effect.” That’s the all-too-common situation in which investors hold on to their losers and sell their winners. It’s one of the main reasons that investors--both pros and do-it-yourselfers underperform--they can pick winners pretty effectively, but they cannot sell their losers.

Our egos are a big part of the problem. Our egos are what drive the emotional difficulty of parting with a stock that you spent so much time analyzing.  “How can I be so wrong?” you ask yourself. “Eventually my thesis will prove correct.”

Wrong!

An advisor’s job is to help you manage your behavioral biases during different stages of the market cycle. In this long-running bull market, investors start to get short-term memory lapses. In particular, greed kicks in and investors become tempted to move all their assets into equities. You and your advisor should work together to extract emotion from investment decisions and to mitigate unnecessary risk wherever possible.


Our egos get in the way

Why do we think we are so good at financial decision making when the odds are stacked against us? The simple answer can be traced to ego-- the ultimate roadblock to sound investing. According to Ryan Holiday, media strategist and best-selling author of Ego Is the Enemy, the answer is most often NO.

“One might say that the ability to evaluate one’s own ability is the most important skill of all,” wrote Holiday. “Without it, improvement is impossible. And certainly ego makes it difficult every step of the way. It is certainly more pleasurable to focus on our talents and strengths, but where does that get us? Arrogance and self-absorption inhibit growth. So does fantasy and vision,” Holiday added.

From where we sit at our firm, hubris is prevalent due to the market’s all-time highs; but again human biases are coming into play.  The 2008 crisis left us with the biggest investing hangover in modern market history. As a result, portfolio managers are scared to death about missing the next correction instead of the hyper-bullish you usually see around equities when markets are at record highs.


Many of my colleagues believe greed has kicked in, but some investors still can’t shake the nightmare of 2008-09 from their memories. Looking at the question from a different angle, we should ask: “Is the index’s standard deviation higher today?” The answer to that question is yes! That’s why it’s essential to make sure your advisors know about all your changing life circumstances, financial needs and ever-changing concerns. Understanding one’s investment psyche has become harder due to recent market volatility and geopolitical events—threats to the long-running bull market that the media constantly reminds us about.

Conclusion

As valuations continue to rise above the top quartile, many fundamental analysts can’t get their arms around being long. The problem is that they are only measuring the ‘P’ in price to earnings–the ‘E’ essentially stands for emotion.

If you or someone close to you has concerns about the viability of your current investment decisions for the near-term and long-term, please don’t hesitate to reach out. We’re happy to help.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Here's the Prescription - Avoid the Internet for Financial News

Here is a great article by:

David Jones
Head of Financial Advisor Services, EMEA
and Vice President
Dimensional Fund Advisors Ltd.

As much as I value the unfettered access to information the internet provides, I recognize the potential harm that too much information can cause.

Take, for example, a friend of mine, who was experiencing some troubling medical symptoms. Typing her symptoms into a search engine led to an evening of research and mounting consternation. By the end of the night, the vast quantity of unfiltered information led her to conclude that something was seriously wrong.

 

One of the key characteristics that distinguishes an expert is their ability to filter information and make increasingly refined distinctions about the situation at hand. For example, you might describe your troubling symptoms to a doctor simply as a pain in the chest, but a trained physician will be able to ask questions and test several hypotheses before reaching the conclusion that rather than having the cardiac arrest you suspected, you have something completely different. While many of us may have the capacity to elevate our understanding to a high level within a chosen field, reaching this point takes time, dedication, and experience.

 

My friend, having convinced herself that something was seriously wrong, booked an appointment with a physician. The doctor asked several pertinent questions, performed some straightforward tests, and recommended the following treatment plan: reassurance and education. Not surgery. Not drugs. But an understanding of why and how she had experienced her condition. The consultative nature of a relationship with a trusted professional—both when a situation arises and as we progress through life—is one of the key benefits that an expert can provide.

 

There are striking parallels with the work of a professional financial advisor. The first responsibility of the doctor or advisor is to understand the person they’re serving so that they can fully assess their situation. Once the plan is underway, the role of the professional is to monitor the person’s situation, evaluate if the course of action remains appropriate, and help to maintain the discipline required for the plan to work as intended.

 

Like my friend’s doctor, advisors may have experienced conversations with clients that are triggered by news reports or informed by unqualified sources. In some cases, all that is required to help put the client’s mind at ease is a reminder to focus on what is in their control as well as providing reassurance and (re)education that they have a financial plan in place that is helping them move toward their objectives. The benefits of working with the right advisor are demonstrated through the ability to both help clients pursue their financial goals and to help them have a positive experience along the way.

Click Here to Read More:

Here's the Prescription - Avoid the Internet for Financial News

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Investors Are Their Own Worst Enemies

Why we succumb again and again to our worst behavioral biases

By Robert Pyle


Key Takeaways

  • There are four common behavioral biases that tend to derail investors.

  • Unsettling times can bring these biases to the surface, even among normally level-headed investors and savers.

  • Learning how to detect the signs of hindsight, loss aversion, pattern recognition and recency bias can save you tremendous sums over the long term—and improve your sleep

Study after study shows that investors are often their own worst enemies. Why? Because we have emotions and we have biases, some we many not even recognize.

As investors, we tend to leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done. The past few weeks of wrenching market volatility, global economic drama and screaming headlines has caused even the most level-headed of investors to start questioning their investment strategy.

 

Don’t!

Why do we have behavioral biases?

Most of the behavioral biases that influence our investment decisions come from myriad mental shortcuts we depend on to think more efficiently and to act more effectively in our busy lives.

Usually these mental short-cuts work well for us. They can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we’re simply trying to stay afloat amid the crush of deliberations and decisions we face every day. But, these biases are not always reliable

What do they do to us?

The same survival-driven instincts that are so helpful in our daily lives can become deadly when investing. They overlap with one another, gang up on us, confuse us and contribute to multiple levels of damage done.

Even after you’ve learned to recognize your biases, they’re hard to combat. They’re your brain’s natural instincts that kick in long before your higher functions kick in. Behavioral biases trick us into wallowing in what financial author and neurologist William J. Bernstein, MD, Ph.D., describes as a “petrie dish of financially pathologic behavior,” including:

 

1.      Counterproductive trading – incurring more trading expenses than are necessary, buying when prices are high and selling when they’re low.
 

2.      Excessive risk-taking – rejecting the “risk insurance” that global diversification provides, instead over-concentrating in recent winners and abandoning recent losers.
 

3.      Favoring emotions over evidence – disregarding decades of evidence-based advice on investment best practices.

 

What can we do about them?

First, become familiar with the most common behavioral biases, so you can easily recognize them and prevent them from derailing your investment decisions.

Anchor your investing in a solid plan.  

By anchoring your trading activities in a carefully constructed plan (with predetermined asset allocations that reflect your personal goals and risk tolerances), you’ll stand a much better chance of overcoming the bias-driven distractions that rock your resolve along the way.

An alphabetic overview of behavioral biases

 

Let’s review some of the biases that come into play after a volatile year in the financial markets. We may all question the value of diversification when the U.S. financial markets outperform the international markets as they did this year (as of mid-December 2018), but there can be long periods when international stocks outperform. For more, see Why Should You Diversify.

The main behavioral biases that come into play after a volatile year are:

1.      Hindsight Bias,

2.      Loss Aversion,

3.      Pattern Recognition, and

4.      Recency Bias.


It’s tempting to think we should not have had international stocks in our portfolios this year (recency and hindsight biases), even though in 2017 international stocks easily outperformed U.S. stocks and other asset classes. We tend to rely on our pattern recognition instincts to predict the current trend into the future. It’s like using yesterday’s weather to predict what the weather will be like every day going forward into the future. Then, we start telling ourselves we don’t want to buy international stocks because we are afraid they’ll go down (loss aversion).

If you read the summaries below, see if you are feeling some of these biases this year.

1. Hindsight

 

What is it? In his iconic book “Thinking, Fast and Slow,” author Daniel Kahneman describes hindsight bias as a “robust cognitive illusion” that causes us to believe our memory is correct when it is not—it’s the old “I knew it all along” illusion. For example, say you expected an election candidate to lose, but she ended up winning. When asked afterward how strongly you predicted the actual outcome, you’re likely to recall giving it higher odds than you originally did.

 

When is it harmful? Hindsight bias can be very dangerous for investors, since your best financial decisions come from realistic assessments of market risks and rewards. As Kahneman explains, hindsight bias leads observers to “assess the quality of a decision not by whether the process was sound, but by whether its outcome was good or bad.” If a high-risk investment happens to outperform, but you conveniently forget how risky that investment truly was, you may load up on too much of it and not be so lucky moving forward. On the flip side, you may too quickly abandon an underperforming holding, deceiving yourself into dismissing it as a bad bet to begin with.

 

2. Loss aversion

 

What is it? “Loss aversion” describes the phenomenon in which most people feel the pain of losing more strongly than they feel the joy of winning. This greatly alters the way we balance risk and reward. For example, in “Stumbling on Happiness,” Daniel Gilbert argues that most of us would refuse a bet that gives us an 85 percent chance of doubling our life savings if it contained a 15 percent chance of losing everything we own. Even though the bet offers very favorable odds of a big win, the fact that there remains a slight chance that we could go broke leads most people to decide the bet is not worth the risk.

 

When is it harmful? One way loss aversion works against you is when you decide to sit in cash or bonds during bear markets – or even during bull markets when you feel a correction is imminent. Study after study shows that sitting out the markets, even during a downturn, will cause you to have a lot less money over the long-term than if you had just stayed fully invested. And yet, the potential for future loss can frighten many of us into abandoning our carefully planned course toward the likelihood of long-term returns.

 

3. Pattern recognition

 

What is it? Is that a zebra, a cheetah or a light breeze moving through the grass? Since prehistoric times, when our ancestors depended on getting the right answer, right away, evolution has conditioned our brains to find and interpret patterns. Back then it was a survival skill and that’s why, our pattern-seeking impulses tend to treat even random events (like 10 coin flips, all heads) as if they’re orderly outcomes suggesting a predictive pattern. “Just as nature abhors a vacuum, people hate randomness,” wrote financial blogger Jason Zweig, as a result of our brain’s dopamine-induced “prediction addiction.”

 

When is it harmful? Speaking of seeing red, Zweig published this fascinating piece showing how something as simple as presenting financial numbers in red can make investors more fearful and risk-averse than if they saw the same numbers in black. That’s a powerful illustration of how pattern recognition can influence us – even when the so-called pattern (red = danger) is a red herring.


Is any given stream of breaking financial news a predictive pattern worth pursuing? Or is it simply a deceptive mirage? Given how hard it is to tell the difference (until hindsight reveals the truth), investors are best off ignoring the market’s many glittering distractions and focusing instead on their long-term goals.   

 

4. Recency

 

What is it? Recency causes you to pay more attention to your most recent experiences, and to downplay the significance of long-term conditions. For example, in their book “Nudge,” Nobel laureate Richard Thaler and Cass Sunstein observe: “If floods have not occurred in the immediate past, people who live on floodplains are far less likely to purchase insurance.” That’s recency, tricking people into ascribing more importance to the lack of recent flooding than to the bigger context of being located on a flood plain.

 

When is it harmful? Of course buying high and selling low is exactly the opposite of investors’ actual aspirations. And yet, no matter how many times our capital markets have moved through their bear-and-bull cycles, recency causes droves of investors to stumble every time. By reacting to the most recent market jolts instead of staying true to their plan for long-term growth, investors end up piling into high-priced hot stocks and locking in losses by selling low during the downturns. They allow recency to get the better of them … and their most rational, evidence-based investment decisions.

 

A Behavioral Bias Overview

The Bias

Its Symptoms

The Damage Done

1. Hindsight

“I knew it all along” (even if you didn’t). When your hindsight isn’t 20/20, your brain may subtly shift it until it is.

If you trust your “gut” instead of a disciplined investment strategy, you may be hitching your financial future to a skewed view of the past.

2. Loss aversion

No pain is even better than a gain. We humans are hardwired to abhor losing even more than we crave winning.

Loss aversion causes investors to try to dodge bear markets, despite overwhelming evidence that market timing is more likely to increase costs and decrease expected returns.

3. Pattern recognition

Looks can deceive. Our survival instincts strongly bias us toward finding predictive patterns, even in a random series.

By being predisposed to mistake random market runs as reliable patterns, investors are often left chasing expensive mirages.

4. Recency

Out of sight, out of mind. We tend to let recent events most heavily influence us, even for our long-range planning.

If you chase or flee the market’s most recent returns, you’ll end up piling into high-priced hot holdings and selling low during the downturns.

Conclusion

As human beings, we’re wired to flee from danger, make snap judgements, seek recurring patterns and use the past to try to predict the future. It’s not easy putting emotions aside during times of stress. But, those who can stick to their plan and remain rational in the face of uncertainty tend to fare well in both their financial lives and their personal lives.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Year End Tax Loss Harvesting

A gift you can accept any time of year

Robert J. Pyle, CFP®, CFA, AEP®


Now is the time of year that thoughts turn to Holiday spirit, snow covered landscapes and cozy fireplaces. It’s also a great time to consider some tax-loss harvesting—maybe not what you expected in your Holiday stocking, but often a more valuable gift, courtesy of Uncle Sam. Even better, loss harvesting is a gift that you can give yourself all year round. Just make sure to ask your advisor for assistance. This is not an area in which you want to be a do-it-yourselfer.

The term “loss harvesting” can have unpleasant connotations, but a well-diversified portfolio will periodically have positions at a loss. Harvesting those losing positions helps mitigate their impact on your overall portfolio by providing a tangible tax benefit. Losses from positions sold below their cost basis can be used to offset gains from elsewhere in your portfolio—plus an additional $3,000 of remaining losses each year can be carried over to reduce your taxable income. Losses can be carried forward into future years. So, having a large chunk of losses stored up can allow for tax-free realization of subsequent gains such as when you rebalance your portfolio, sell a highly appreciated position, or want to make a gift to a child, grandchild or favorite cause.

Despite all the recent gyrations in the market, the year 2018 has been pretty flat overall for U.S. stocks. So, no tax loss harvesting opportunities this year, right? Not so fast. Chances are you have some international holdings in your portfolio that you purchased in the last year. Based on what’s happened to global markets recently, those holdings are probably down for the year. That’s going to be your first place to look for losses.

Why it’s so hard to let go

Behavioral finance studies show that people feel the pain of a loss much more than they enjoy the thrill of a gain. Investors will keep holding on to a losing position hoping the stock will eventually get back to the price at which they purchased it. Behavioral finance experts call that “anchoring.” If it’s the stock of a company they used to work for, investors will wait months, even years, to get back to breakeven (i.e. “gamblers fallacy”), because they think they know the company better than outside investors and “it’s only a matter of time” before the stock rebounds.

Don’t let your emotions and personal biases get in the way of sound decision-making. That’s why we recommend that most clients hold diversified mutual funds rather than individual stocks. You’ll get much less emotionally attached to funds than to equities, which makes it easier psychologically to sell losing positions--individual stocks are just too volatile.

Tax lot accounting

If you periodically invest in a fund, say after a biweekly paycheck, then you will have many, many positions at various cost bases. Following a market correction, your overall holding may still be showing a gain, but some of the positions are at a loss. It all depends on when you bought them. Designating the highest-cost basis lots for sales can increase the amount of loss harvesting you and your advisor can do. We have a powerful computer program that helps us scan all the different lots of the investments you purchased over the years. Then we use the HIFO cost basis (highest in first out), to sell the ones lots with the highest cost basis in order to minimize your taxes.


Wash rule

Just make sure you and your advisor are adhering to the “wash rule,” which disallows the recognition of a loss if the same, or substantially similar, security is purchased within 30 days of the sale (before or after). Through our partners at Dimensional Fund Advisors, we can offer you both tax-managed and non-tax managed funds that are similar, but which serve different purposes for tax planning.

For example, if you’re taking a loss on the tax managed fund, we can buy the non-tax managed fund and your overall asset allocation won’t change at all. Again, your overall allocation will be nearly identical, but the funds are essentially different and so the wash rule doesn’t come into play.

Your greater goals

When harvesting a loss, make sure you remain true to your existing investment plan. To prevent a tax-loss harvest from knocking your carefully structured portfolio out of balance, we reinvest the proceeds of any tax-loss harvest sale into a similar position (but not one that is “substantially identical,” as defined by the IRS). We also do this on the same day so your proceeds are not sitting in cash and you are out of the market for a day. Typically, we return the proceeds to your original position no sooner than 31 days later (after the IRS’s “wash sale rule” period has passed).


Conclusion

Loss harvesting is especially valuable when markets are highly volatile and peppered with steep drops. More often than not, we can find a position you can sell at a loss. With the left over proceeds, we can help you find a buying opportunity elsewhere that meets your investment plan and retirement goals—just not in the same fund.

Now that’s a gift that keeps on giving!

Robert J. Pyle, CFP®, CFA, AEP® is president of Diversified Asset Management, Inc. Contact Robert at 303-440-2906 | info@diversifiedassetmanagement.com.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

 

 

What Motivates Your Investment Moves?

When the stock market falls sharply as it did following the recent Brexit Referendum in the United Kingdom, it is not unusual for investors to react emotionally -- to act on impulse before thinking through the potential long-term consequences. Why does emotion sometimes cloud your judgment when it comes to making investment decisions? The answer may be found in the study of "behavioral finance."

Scholars of behavioral finance believe that investors are too often influenced by psychological or emotional impulses that run contrary to the fundamental principles of long-term planning. But the study of behavioral finance involves more than pointing fingers at past mistakes. Its proponents encourage investors to develop skill in recognizing situations that may lead them to make emotionally driven errors, so those errors may be avoided in the future.

Investor, Know Thyself

Behavioral psychologists have identified several common behaviors that may be exhibited by investors. See if you recognize yourself in any of these examples.

Fear of Regret/Risk Aversion -- The threat of a potential disappointment or a short-term loss is a powerful force that often inspires second-guessing of portfolio strategies. Common responses are to avoid investing altogether, to hold on to a losing stock for far too long in the hopes that it will bounce back one day, or to sell winners too soon -- before they may have reached their full potential.

Overconfidence -- Some investors tend to overestimate their knowledge and skills. For instance, they may overload their portfolio with stocks of a certain sector or geographic region they know well, because they are confident of their ability to understand and track these investments. As a result, they may tend to trade more actively than is in their best interest.

In addition, overconfidence may lead to irrational expectations and, ultimately, to a financial shortfall. For example, the Employee Benefit Research Institute's 2016 Retirement Confidence Survey revealed that a majority (63%) of workers are "very" or "somewhat" confident that they will have enough money to live comfortably throughout retirement, even though fewer than half have actually tried to calculate how much money they would need.1 In other words, many people may have a false sense of security based on incomplete knowledge of their situation.

Anchoring -- This behavior involves reading too much into recent events, despite the fact that those events may not reflect long-term realities or statistical probabilities. For example, investors who believe that a market surge (or downturn) will continue indefinitely may be anchoring their long-term expectations to a short-term perception. Anchoring causes investors to hold on to their investments even after an extended period of poor performance. As we all know, things change. Mental anchoring prevents us from adjusting to those changes.

Today's investor needs a plan of action to help maintain a disciplined strategy and resist making common mistakes. Work with your financial advisor to construct a fully integrated financial plan that reflects your needs and risk tolerance. Such a plan will help you avoid potential pitfalls and stay focused on the long term.
 

Source:

1.  Employee Benefit Research Institute's 2016 Retirement Confidence Survey, March 2016.


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Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
 


The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.