University of Chicago’s Richard H. Thaler, one of the founders of behavioral finance, was awarded the 2017 Nobel Prize in Economics for shedding light on how human weaknesses such as a lack of rationality and self-control can ultimately affect markets.
People who are not financial experts frequently turn to investment advisors to manage their portfolios. But many smart people use advisors to overcome very common psychological obstacles to financial success.
The 72-year-old “has incorporated psychologically realistic assumptions into analyses of economic decision-making,” the Royal Swedish Academy of Sciences said in a statement on Monday.
“By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes,” it said.
Thaler developed the theory of “mental accounting,” explaining how people make financial decisions by creating separate accounts in their minds, focusing on the narrow impact rather than the overall effect.
He shed light on how people succumb to short-term temptations, which is why many people fail to plan and save for old age.
It does not take a Nobel Prize to understand that people often make decisions based on emotion. We do it all the time. We judge people based on first impressions. We buy things not because we need them but because of how they make us feel. We go along with the crowd because we seek the approval of the people around us. When markets rise we persuade ourselves to take risks we should not take. When markets decline and our investments go down we allow fear to overcome our judgment and we sell out, afraid that we’ll lose all of our money.
Professional investment managers have systems in place that allow them to overcome the emotional barriers to successful investing. It begins by creating portfolios that are appropriate for their clients. Then, in times of stress, they use their discipline and stick to their models, often selling what others are buying or buying what others are selling. This is the secret to the old Wall Street adage that the way to make money is to “buy low and sell high.” By taking emotion out of investment decisions professional managers take a lot of the risk out of investing.
When you’re over 70 ½ and have a retirement plan you have to start taking money out of the plan (with rare exceptions). But even if you remember to take annual RMDs (Required Minimum Distributions) you could use help preparing for and managing the process. This includes reinvesting RMDs you don’t need immediately for living expenses.
It isn’t as simple as “Here’s your RMD, now go take it.” Baby Boomers often retire with IRA and 401(k) balances instead of the defined benefit plans their predecessors often had. And the rules are often complicated. Take the retiree who has an IRA and a 401(k) that he left behind with a previous employer.
Many are surprised to learn that they have to take separate RMDs on their 401(k) and their traditional IRA. RMDs must be calculated separately and distributed separately from each employer-sponsored account. But RMDs for IRAs can be aggregated, and the total can be withdrawn from one or multiple IRAs. That’s one of the reasons that advisors suggest rolling your 401(k) into an IRA when leaving an employer for a new job or when retiring.
Steep penalties apply. The failure to take a required minimum distribution results in a penalty of 50% of the RMD amount.
According to a 2016 study from Vanguard, IRAs subject to RMDs had a median withdrawal rate of 4% and a median spending rate of 1%. For employer plans subject to RMDs, the median withdrawal rate was 4% and the median spending rate was 0%. A mandatory withdrawal doesn’t mean a mandatory spend. Most retirees don’t need the income they are required to take from their plans. As a result the money usually goes right back into an investment account.
If you have an investment account that is designed for your risk tolerance and goals, the money coming out of your retirement account should be invested so as to maintain your balanced portfolio.
For questions on this subject, please contact us.
Even the savviest investor can have a bad year. Buffett’s Berkshire Hathaway is down over 11% in 2015.
The reason for the decline is the declining price of oil and other commodities. Berkshire Hathaway has a big investment in railroads that make much of their money hauling commodities such as oil and coal.
It also has big positions in American Express and IBM which declined 24% and 13% respectively this year.
If you broke even this year you beat the “Wizard of Omaha.”
There is a great deal of misperception about the merits of passive vs. active investing.
First, let’s define terms for people who are not familiar with investment styles. Passive investing is buying all the stocks in an index, like the S&P500. Since there is no research involved and the only time an index fund makes a change is when there’s a change in the index, costs are kept low. Active investing, on the other hand, means that a fund manager looks at the stock market and buys those stocks he thinks will go up and avoids those that he believes will go down. Obviously he won’t be right all the time, but if he’s a good manager his selection will result in a fund that will do better than average.
That’s a simple explanation. It doesn’t get into factors such as value vs. growth, risk adjusted returns and other nuances. But it’s the basic concept.
Much is made about expense ratios and average returns. A lot of this confusion is the result of marketing by John Bogle, the founder of Vanguard Funds who made a fortune by promising his clients that they would never do better than average … and that was a good thing.
So why didn’t investing legend Warren Buffett give up stock picking and put his money in an index fund? Because he’s a good stock picker who can add value and get a better return on his money than a stock index. And Buffett isn’t the only one.
There are money managers who can add value to a portfolio, a better risk-adjusted return than the market. And there are managers who do worse. Knowing the difference requires years of research and expertise. That is what we at Korving & Company provide to our clients. We create a diversified portfolio of mutual funds tailored to the needs of our clients using funds managed by individuals who have demonstrated that they can add value over and above an index.
Without that, many investors are better off being average.