TedCo Software Financial Matters Blog

The Bias sisters can really mess with your head. If you are judging your own performance or that of an advisor these two odd behaviors can prevent you from pursuing a sound investment strategy. The Bias sisters, outcome and hindsight, are quite vain and spend most of their time looking in a mirror (a rearview mirror).

Outcome Bias
In a 1988 study Jonathan Baron and John Hershey presented participants descriptions of several different medical situations facing a doctor. The descriptions included what the doctor knew, the treatment provided, and the outcome. However, in some instances the outcome was described as a success, while in others it was deemed a failure. All the other factors (available data, treatment, etc.) were identical. Here is where the bias appears; by a factor of around 5 to 1 the successful outcome was rated as representing higher quality decision-making. This result appeared despite the fact that 88% of the participants agreed that the outcome shouldn’t be included as a factor in rating the quality of the decision. When combined with the tendency to give more weight to the most recent events (myopia) this has many investors beating themselves (or their advisors) up when the market turns against them. Even a really well considered decision can go bad, so take a deep breath and stick to the plan. Even House, M.D. loses one once in a while. Particularly if the loss was related to a macro event (market drops, housing slows, and the like) then hindsight bias comes along and beats on you some more.

Hindsight Bias
Whenever the equity markets (stocks) have a big move the market “experts” appear within minutes of the close to explain what happened. These pundits always explain events with great confidence. The impression you walk away with is that any dope should have known that was going to happen if they just paid attention. Where were all these experts before the market went south? They didn’t know either, they are just good talkers. Markets experts humbly admitting their surprise doesn’t make for good television/radio/print/internet/pod-vidcast ratings. This is where experience can help. I remember a market newsletter writer that predicted the 1987 crash. She translated that success into huge circulation for her newsletter. It would have been more impressive if she had not also predicted the crash of 1984, and 1985, and 1986. If you do not remember the crashes in 84, 85, & 86 that’s because there weren’t any.

We can see this in the news this week. There is a lot of “buzz” about the Hindenburg Omen. This technical indicator has triggered before every major market drop for years. That sounds good. However, the omen has triggered four times for every drop. Its’ accuracy is only 25%. Interesting, but not a reason to buy ammunition and hide under the bed.

Don’t let hindsight and outcome bias beat you up. The markets are by nature unpredictable and no approach works every time in all situations. Stick to your plan. There is nothing wrong with adjustments, but if the plan was sound to start with, it will likely work out just fine.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

We humans are an odd lot, and we have some odd behaviors wired in us that are not always helpful in the realm of personal finance. Loss Aversion is just such a behavior. First documented by Daniel Kahneman and Amos Tversky in their 1979 paper “Prospect Theory: An Analysis of Decisions Under Risk”, Loss Aversion is the tendency to perceive the impact of a loss as greater than an equal gain. Other studies have indicated that losing a sum of money is twice as painful as receiving the same sum is pleasurable. So, losing $100 creates twice as much pain as gaining $100 creates pleasure. That’s why casinos use chips and other proxies for money; they want to reduce the pain of losing. When viewed clearly you can see that the change in net worth is the same, but there is something about possession and loss that wires us to have never wanted to have the asset in the first place. It creates a skewed understanding of portfolio performance. As a financial adviser, I’ve had clients that express very high tolerance levels for risk until a loss appears on the statement, and then they become very unhappy. I try to avoid these clients.

Another part of his psych-out is our tendency to view the most recent short-term performance of a long term investment as more important than the long term performance. That is a fancy way of saying we tend to be short sighted when evaluating performance. We weigh the most recent events more heavily than long-term issues. Even when there is a 30-year time frame we tend to evaluate performance and make decisions on what has occurred in the past year or two. When you combine this tendency with Loss Aversion you get Myopic Loss Aversion, an even more damaging behavior. For example: An investor places $100 in an investment and has great returns. Over the course of five years the money doubles to $200, then the crash and the investment drops 25% to $150 dollars. Even though the average return over the six years was about 7% the typical investor remembers the drop from $200 to $150 most acutely, and emotionally feels cheated even though they experienced a solid return. This emotional reaction occurs even if the investment has outperformed its’ peers. If you want to read more about this track down a study by Shlomo Benartzi and Richard Thaler from 1995, “Myopic Loss Aversion and the Equity Premium Puzzle” (currently available in PDF format here).

If you understand that your emotions, (your “gut” can be your enemy as well as your friend in finance) you are better equipped to make an objective decision about your future. Before you jump to an action, take the time to look at the long-term performance of your investment as well as your actual experience and compare those figures to the average performance of that type of investment. Simply refuse to take a leap until you know where you really stand.

In the next post we will take a look at Hindsight.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Sorry for the extended break between posts. Vacation’s over now so we’re ready for Part 3: The Number Crush

Sometimes numbers are so big that they stop having any real meaning to individuals. The budget deficit here in the US is a good example. Some time in the past year US deficit spending went from the Billions to over a Trillion, while the actual debt is over 13 trillion. Once you get past nine zeros most people just see “big number”. Really, from an individual perspective what’s the difference between millions, billions, and trillions? (Note: if you are not sure, consider running for congress.)

So when we start looking at the kinds of numbers it takes to have a secure retirement it can be overwhelming. Worse yet are advisors (myself included) who tend to throw in inflation, interest rates, guarantees, insurance, alpha, beta, risk, return, and a ridiculous number of factors when trying to introduce a plan. We are full of opinions that contradict what the other advisor said (or ourselves). It is all overwhelming and confusing. Most financial issues have significant complexities. A favorite quote of mine from H.L Mencken is, “For every complex problem there is an answer that is clear, simple, and wrong”.

The unfortunate downside of the huge numbers, complexity, and contradictory information is that folks become overwhelmed and do nothing. All the information creates sensory overload and we respond by hunkering down and freezing. However, the big rig of the future just keeps coming right at us and we better determine what we’re going to do and get moving or risk road-kill status.

So what to do? First is accepting that reality is complex. Yes, the number is big, but that doesn’t mean it is unattainable. Yes, there are a lot of moving parts to a financial plan, but they can be integrated. Know that you will need to dedicate some time to developing a good plan and be wary of those who promise a simple and clear answer to complex problems. Just keep moving.

While you are gathering data and developing a plan don’t lose sight of basics: strive to maintain a positive cash flow, saving is better than not saving, debt is not your friend, and set & pursue realistic goals.

Remember that big numbers are just a lot of smaller numbers put together. Even if the amount you can save today seems insignificant when compared to the target, every amount helps get you closer to success.

To address the complexity of planning you should seek out a planner. (That may seem a bit self-serving but hear me out.) Look for someone who focuses on planning and not product sales. A good planner will take the time to both understand your situation thoroughly and to help you understand how a suggested solution works. The National Association of Personal Financial Advisors has a great set of questions to ask a prospective advisor in the “Financial Advisor Diagnostic” at www.napfa.org/tips_tools/index.asp. That should help you find an advisor who meets your needs.

The most important thing to avoid is the tendency to do nothing. Just keep moving forward toward those long-term goals.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

A large component of the work I do with individuals is to gain a clear understanding of their relationship and understanding of money. There is an increasing body of study that looks at the link between how we perceive money and worth and the reality of wealth. Over the next few entries I want to touch on six issues of Behavioral Finance that may be impacting your understanding of money and hindering your financial success. These points are far from the only psychology of money issues, and they are not universal, but they are fairly common issues that most folks will see in their financial life.

Layer it on thick
It seems that most large retailers have some sort of credit card and the vast majority of stores take plastic. If asked I am sure that these stores would say that it is for customer convenience, but there is another reason that retailers accept these proxies for money: the “layering” effect. It is the same reason casinos use chips for gambling. The further the proxy for money is away from “real” money the more psychological distance we feel from the act of spending. Casinos have learned to take advantage of this psych-out. If we laid ten and twenty-dollar bills down on the craps (or roulette, or poker) table it would have a much greater impact in our heads. We see bills and coins as potential items for our life. When we see things that represent food, fuel, and shelter scooped up by the blackjack dealer it scares us a bit. However, colorful plastic chips do not have the same impact, so no money on the table means customers are more willing to part with these plastic proxies for rent money.

You don’t gamble? I bet you still use plenty of proxies for cash. Paying for that Venti Mocha with a Starbucks gift card just doesn’t hurt quite the same way as handing over a fiver. For the real whammy we can now combine online bill pay services with our credit cards. Our employer deposits our earnings directly into a bank account. We then buy a new TV with our Visa card and do not see the bill for a few weeks. When the charge shows up on the credit card statement (delivered electronically) we direct the bank to pay the bill via on-line bill pay. Each layer between cash in our pocket and the purchase makes the loss of the cash a bit more comfortable, and the sale a little easier.

It would be difficult to give up the electronic money world, but this proxy effect can lead us to make poor money decisions. So try to give up the electronics for just one month. For one month convert your paychecks to cash for just a bit so you can see it and feel it. Then, for the whole month pay as many things as possible with cash and use checks for the rest. Odds are your landlord or mortgage company will insist on checks, but your supermarket, gas station, and local Starbucks will be perfectly happy with taking cash. Keep track of where and how you spend your cash. At the end of the month you will be shocked at where you spend your money, and will have found several ways to spend less.

Next week in Financial Psych-Outs Part 2 we’ll tackle “the wealth effect”…

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

As the economy worsened, not only did retirement funds drop in value with the market, but also many people have been tempted to tap savings as a way to cut debt or otherwise shore up their finances after a job loss. Still more have found that employers have dropped matching contributions to shore up their own finances.

Worry about retirement seems to be widespread. A January survey by the National Institute on Retirement Security noted that 83 percent of Americans are concerned about their ability to retire.

Yet the worst thing you can do is tap or give up on your retirement funds. No one can know with any certainty when the investment markets will rebound, but even if you can contribute something, you stand to gain once markets start to rebound. Even more important, you risk penalties and the lost potential for earnings if you turn your back.

Before you make a move, seek out some advice. It’s a good idea to check in with an expert such as a Certified Financial Planner™ professional to see where your retirement funds stand in light of all your finances before you do anything.

In the meantime, here are things you can do to put your retirement funds in better shape.

Don’t stop funding your 401(k) under any circumstances: In March, the Spectrem Group, a Chicago-based consulting firm, reported that 34 percent of U.S. employers have reduced or eliminated matching contributions to their defined contribution retirement plans – which include 401(k)s and 403(b)s – since January 2008. The Pension Rights Center reports that besides the Big Three automakers, dozens of major companies have cut back their match, including Motorola, Starbucks, and JPMorgan Chase & Co. It’s a significant impact. US News & World Report recently reported that for a worker who earns $50,000 annually and receives a full employer match of 50 cents to the dollar on six percent of his or her pay, the match cut means $16,000 less for retirement. An employer dropping its contribution is bad news, but you should make every effort to keep up with your contribution because if you don’t, you’ll miss valuable tax deductions and the chance to build your funds more effectively for the long term.

Stay invested: Because no one precisely knows when the market is headed up or down it’s best to stay invested at a time when everyone is waiting for a rebound. Keep in mind that the market’s top performing days typically come at the start of a recovery, so leave your money in your 401(k) and IRAs.

Keep in mind that withdrawing or borrowing your funds can be costly: If you have an emergency situation, be careful. Workplace 401(k) plans do allow for hardship withdrawals, but you might have an option to take a loan, which would save you the taxes and the 10 percent penalty that accompany hardship withdrawals for account holders under the age of 59. The majority of 401(k) plans allow you to borrow up to 50 percent if your vested account balance or $50,000, whichever is less.

Adjust your spending so you can save more: If you have an existing Roth or traditional IRA or other means of saving for retirement, do whatever you can to get more money into these accounts. It may not come close to meeting the shortfall from losing an employer’s contribution or the chance to add to a 401(k) after you’ve lost your job, but it’s critical to keep some savings going.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Start early: While many families don’t turn to relatives for help until there’s an immediate need, earlier planning almost always produces better results. Grandparents already know that saving for a child’s college education is easier if it starts at birth. The same is true for the next generation, so grandparents or adult children need to set a plan in place as early as possible for maximum benefit.

Coordinate college support with overall estate planning: Grandparents should look at their support for their adult children and grandchildren as an overall part of their estate strategy. A CFP® professional, in concert with estate and tax experts, can help grandparents and their adult children settle a series of estate issues at one time, saving time, money and worry later.

Consider the 529 plan option: A 529 college savings plan is an investment vehicle operated by a state or educational institution designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Service Code, which created these plans in 1996. If parents have set up a 529 plan for their child, grandparents can contribute to that plan or they can set up their own 529 plan account with their grandchild as the beneficiary.

Watch the fees: No matter what savings or investment options you choose, make sure you’re not overpaying fees. A stock mutual fund may charge in excess of 1 percent of assets; you can certainly find quality mutual funds that charge less. Two good resources: Morningstar.com can provide you a general review of most mutual funds you might be considering. The second is the Security and Exchange Commission’s online Mutual Fund Cost Calculator which can help you determine how the fees and other costs associated with the fund will add up over time.

Offer some investing training wheels: Grandparents have a unique relationship with their grandchildren. They can teach without “lecturing” like their parents, and for that reason, they might consider setting up an investment account with a small balance that the kids can monitor and discuss under the supervision of the grandparent.

Make the grandkids beneficiaries: Naming your grandchild as the beneficiary of a retirement account or insurance policy can be a tax-smart way to provide financial support for college or possibly a first home.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Though many grandparents have taken a hit to their portfolios recently, and seen little growth over the past decade, careful planning can ensure a healthy contribution to the education and to their grandchildren’s future.

The first step involves a talk between grandparents and their adult children. According to 2008 research from The Hartford Financial Services Group, 65 percent of grandparents surveyed reported that they plan to contribute financially to their grandchildren’s college education, but that less than one third of all survey participants talked with their adult children about those plans.

Statistics show the amount of money that transfers from grandparents to grandchildren is substantial even before college. Hartford reports that more than 40 percent of grandparents spend more than $2,000 annually on their grandchildren before they reach 18 years old. And once it’s time for the kids to head off to school, over half of grandparents who plan to contribute will give more than $10,000, with a quarter of those planning to give more than $30,000. That’s a nice chunk of college.

A visit to a CERTIFIED FINANCIAL PLANNER™ professional can help grandparents and their adult children coordinate a gifting strategy that makes sense. In the meantime, there are several options to consider:

Communicate: Adult children and their parents might find it difficult to talk about money issues in general, but discussing a positive goal like funding a child’s future can pave the way to make discussions later about the grandparents’ estate issues and end-of-life care a little easier to handle. But initially, these discussions will hopefully deliver a reality check. The Hartford survey points out that 60 percent of the grandparents surveyed believe that financial aid will be the most likely way their grandchildren will pay for college in an era where federal aid is declining and grants and scholarship cover only an estimated 15 percent of total college costs.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Schedule a holiday budget and credit check: When the triumphant freshman returns home for the holidays, schedule some R&R, home cooking and the first reading ever of their fall budget figures and their first credit reports. Since credit reports can be ordered online, parents and student should sit down with each of the child’s three credit reports from Experian, TransUnion and Equifax and review them for activity and errors. Since everyone is entitled to one free report from each of the agencies each year, go to www.annualcreditreport.com for theirs.

Help them open their first IRA: If your 18-year-old child is earning wages by working part-time at school, at home during breaks or for your own company, have them open a Roth IRA in a growth fund. Make sure they understand this is essential to their future savings so they don’t cash it in. Ask your planner about this.

Discuss identity theft: Personal financial data left on laptop computers, cell phones and other electronic devices can be readily stolen on campus or in a dorm or roommate environment. Tell your son or daughter to keep all paper records in a safe place and introduce passwords to keep all their digital information safe.

Get them networking: Internships and jobs in their chosen field during summer breaks can give your student a head start on their career path. Encourage them to research these opportunities in their freshman year so they’ll be in the front of the line when it’s time to apply.

Handle mistakes carefully: Most kids will make money mistakes in college. If they overdraw a checking account or overdo it with their credit card, make the criticism constructive but firm and always come up with a corrective plan you’ll work on together.

This time of semi-independence can be a great learning time for your children, but it is only semi-independence. Help them through it and the lessons they learn will pay dividends for the rest of their lives.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Bank smart: Students need to get some familiarity with the banking system before they head to college. Kids generally should set up a checking account on campus, but talk to them about debit options and fees, particularly for overdrafts, which are sky-high at many banks now. Also ask your child to ask the bank about direct-deposit options if you’re planning to deposit money for their tuition or agreed-to spending needs. Check to see if there are branches of the bank you choose both near campus and near home. This makes it much easier for parents to make deposits.

Work with them to set up their first emergency fund: A young person should get used to the idea of savings and reserves for unforeseen events such as emergency trips home or related expenses. Make it clear that late-night pizza is not an emergency. (OK, late night pizza is an emergency, but not that kind of emergency.)

Put the student in charge of maintaining her financial aid: Each year, the FAFSA (Free Application for Federal Financial Aid) is due in June. State applications are due earlier. While parents need to run the financial aid process, students need to be equally aware of how their education is paid. Everyone should file the form whether or not you think your child may be eligible, and your child should be searching for scholarships at all times. By the way, legitimate scholarships never charge fees and are typically open to all applicants for consideration. It might also make sense to take your child to your tax preparer to make sure you’re taking advantage of any income tax opportunities.

Make them budget: If they’re leaving for college with a new computer, consider giving them personal finance software to track their everyday expenses and make sure the computer has a security password. (Keeping track of spending by calculator is fine, too.) Work together to determine necessary realities about everyday expenses, tuition and financial aid. Then tell your kid that when he or she comes home at Thanksgiving, you will sit down again to review those figures and make reasonable adjustments. You obviously need to trust your kids, but you might want to do this for as long as it takes them to develop solid and consistent money habits.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

The National Center for Public Policy and Higher Education reported last December that college tuition and fees increased 439 percent from 1982 to 2007 while median family income rose 147 percent. The report also noted that student borrowing has almost doubled since 1998.

The most worrisome statement to come from the report? That if current trends continue, our country might be without an affordable higher education system in 25 years.

This is why it’s crucial to train incoming college freshmen in critical personal finance skills. Before you send your child off to school, make sure you cover the following lessons:

It’s never too early to plan: If you think your words won’t hold enough weight – or you need some guidance yourself – consider bringing in an expert such as a Certified Financial Planner™ professional. It’s never too early to deliver the message that how a child manages his money in college will set the stage for how well she manages it in adulthood. A planner can help a child focus on spending and debt issues in college, but it also makes sense to discuss how your student will save for a home and a car. That might force some smart spending, saving and investing decisions while she’s still in school. Once your child gets the message, consider a meeting for yourself.

Focus on credit: It’s one thing for a teenager to use their parents’ credit card while they’re still living at home. It’s quite another when they get their first taste of freedom hundreds of miles away, often without the parents’ knowledge. Parents should opt to co-sign the student’s credit card but keep it in the student’s name. That way, parents will know when financial missteps occur, which will be a strong incentive for the student to keep his credit rating clean for the next four years. Most important: Parents should do whatever it takes to make sure the child doesn’t sign up for any credit cards on campus where they’ll be bombarded with offers.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.