July 2008 - Posts

• Do You Avoid Admitting Your Investment Mistakes?

  Behavioral finance studies have found that the average individual tends to be risk-averse. For example, behavioralists have found that to entice average people to accept placing bets, odds need to be in their favor. Similarly, the field of behavioral finance has found individuals tend to feel the pain of a loss more intensely than the joy from a gain. Individuals tend to avoid admitting their investment errors, and the failure to admit such errors can lead to expensive mistakes. One of the most common errors caused by the behavior known as "regret avoidance" is that investors continue to hold securities that have losses, feeling that as long as they don't sell, the loss is only theoretical, just a "paper" loss. For some, the act of selling is an admission that an error was made. This perception, plus the mental pain incurred when losses are realized, causes investors to be reluctant sellers. A Different Way to View the Situation How many times have you said to yourself, or heard others say the following: "I will sell as soon as the price gets back to what I paid for it." The right strategy is that you should only continue to hold the asset if you would buy it today. In other words, what you paid for a security should have no bearing (except for the tax consideration) on whether you should continue to hold it. Ask yourself how the stock (or mutual fund) fits into your overall investment plan. If you didn't currently own any, would you buy it today? If your answers indicate the security wouldn't fit and you would not buy any, then you should sell immediately. The reason is simple: By owning the security you are effectively making a buy decision. The same logic applies to load funds. You might be reluctant to sell load funds because you feel that the load would be wasted. Unfortunately, once the load has been paid, it becomes a "sunk cost" - gone whether you hold or sell. If you own a load fund, ask yourself whether you would buy the fund if it waived the load. If the answer is no, it would be prudent to sell. Harvesting Losses When you have an asset in a taxable account with a significant unrealized loss, you should consider the opportunity to sell and "harvest" the loss, especially if the loss is short term. Short-term losses are deductible at the higher ordinary income tax rate, instead of lower long-term capital gains rates. By realizing a loss, Uncle Sam shares some of your pain. If the asset with an unrealized loss still fits within your plan, consider these two options. First, you can sell and repurchase the same security after 30 days, avoiding the "wash-sale" rule that would render the loss non-deductible. Second, swap the asset for a similar - but not substantially identical - security. For example, sell an S&P 500 Index fund and simultaneously buy a Russell 1000 Index fund as the two are relatively comparable. After 30 days have passed, you can reverse the swap. Conclusion You can prevent the paralysis induced by regret avoidance by remembering the following: Base buy and sell decisions on a long-term investment policy. Realize losses to obtain the tax benefit. Remain true to your original investment objectives.   This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Jul 25 2008, 04:21 PM by Jim Cornfeld

• Variable Annuities

  A variable annuity (VA) is a mutual fund-type account wrapped inside an insurance policy. According to one estimate, by 2005, VAs outstanding exceeded $1 trillion. The abundance of VA sales is not a result of the demand. Instead, it seems mostly the result of the efforts of commission-based salesmen. Let's examine three investment-related motivations for considering a VA. Reason 1: Tax-Deferred Growth   Annuities allow for the tax-deferred growth of earnings. That "benefit" comes at a high price - the conversion of long-term capital gains into ordinary income. According to a 2005 working paper on VAs by Jeffrey R. Brown and James M. Poterba, "Even with a horizon of 40 years, under the [2003] new tax rates, variable annuities provide a higher net of tax return only if the expense differential is under 25 basis points." Yet, the authors estimated that the average VA has expenses of 1.65%. And holding equities in a VA also causes the loss of the potential for a step-up in basis for the estate of the investor, the inability to harvest losses, the inability to donate appreciated shares to charity and the loss of the foreign tax credit. And should the buyer need liquidity prior to age 59½, unless the distribution takes the form of a life annuity, an additional 10% penalty would apply. Reason 2: Insurance Component Among the most common version of insurance is if the policyholder dies before annuitization begins, the heirs will receive the return of premiums paid. According to a 2001 article in the Journal of Risk and Insurance, while the median Mortality and Expense risk charge is 1.15%, the benefit is only worth between 0.01% and 0.1%, depending on purchase age. Reason 3: Ability to Annuitize   Annuitization is the conversion of an annuity's value into a stream of income guaranteed for the policy holder's lifetime. While we cannot know what percent will eventually be annuitized, a 2000 paper reported that only about 1% of VAs had been annuitized. Other Negatives Investments inside the typical VA are both expensive and actively managed. Given the historical evidence on such funds, investors likely pay high prices for poor performance. Sold vs. Bought     Why are so many VAs sold? It is because it is often in the best interest of the seller, not the buyer. The typical VA involves a high commission - 6%, or even more. The high commission may be why commissioned-based annuities also come with early surrender charges. The SEC became so concerned about abusive sales of VAs that they issued an "agency alert." They have also posted information to educate investors: www.sec.gov/investor/pubs/varannty.htm. Reasons to Buy an Annuity There are actually a few situations where the purchase of an annuity may make sense. A) An individual wants to invest in a tax inefficient asset class such as REITS and does not have any room in tax-advantaged accounts. This makes sense if the annuity is low-cost, no surrender charge, and preferably has passive investment options. TIAA-CREF, Vanguard, AEGON, and others offer such VAs. Such annuities might also be good choices for those investors who currently own high cost VAs. A 1035 exchange from one annuity to another occurs without triggering taxes. B) To one degree or another, many states protect assets in VAs from creditors. Doctors worried about malpractice suits, for example, might consider VAs. Because the laws are complex investors should consult their attorney before buying a VA for this purpose. Summary Investors are often tempted to buy products that offer seemingly attractive benefits. Unfortunately, the benefits are often either illusory or are accompanied by excessive costs. This is why VAs generally fall into the category of products meant to be sold, not bought. Education (or a fee-only advisor who is unbiased by commissioned-based compensation) is the armor that can protect investors from being misled.   This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Jul 11 2008, 04:15 PM by Jim Cornfeld