« May 2005 | Main | July 2005 »

June 15, 2005

How Our Emotions May Affect Investment Decisions

The biggest obstacle in making good investment decisions is probably our emotions. Numerous studies over the years have found that investors have certain psychological biases that get in the way of making purely rational decisions such as the following:

  • We look for patterns in life, even when they don’t exist. Thus, when the market is going up, we think it will continue on that track indefinitely and we continue to invest as the market gets higher and higher. When the market is going down, we fear it will continue to do so forever and avoid investing, even when prices are attractive. This causes investors to buy high and sell low, the opposite of what they should be doing.

  • We would much rather avoid losses than obtain gains. Thus, we tend to hold on to stocks with losses for an inordinate amount of time, hoping the stock will get back to breakeven so we won’t have to admit we lost money. On the other hand, we tend to sell investments with gains too quickly, so we can lock in those gains.

  • We become more risk tolerant when we have gains on investments. As those gains disappear, however, investors become more risk averse because their principal is at risk. This can lead to selling when investments are at market lows.

  • We tend to attribute investment successes to our own ability and market losses to matters outside our control. During the bull market of the 1990s, many investors believed their gains were a result of their keen investment savvy, rather than a result of the overall rise in the market. But as the market started to decline, those same investors often blamed factors outside their control, which led to inaction.

Using Financial Reports to Predict a Slowing Economy

Reports of slowing growth or earnings declines can severely punish a stock’s price. So that you aren’t surprised by this type of news for your stocks, look out for these three warning signs when you review financial reports:

  1. Accounts receivable growth: Accounts receivable represents amounts owed to the company by customers for goods received. Receivables typically track sales, therefore as sales increase, receivables increase and vice versa. When accounts receivable start to increase significantly faster than sales, find out why. Some possible reasons include: the company is not following up with slow paying customers; customers are withholding payments due to product dissatisfaction; customers don’t have cash to pay bills; or the company is providing longer payment terms to increase sales. All of these situations can forewarn you of potential problems.

  2. Lower gross margins: Gross margins represent the profit made on products before considering overhead, marketing, and research and development costs. Declining gross margins mean either that the company is cutting prices to maintain market share or production costs are increasing and the company can’t increase prices to compensate. Both are warning signals for future earnings shortfalls.

  3. Cash flow: Reported earnings are based on numerous accounting decisions, which can change over time. Cash flow, however, measures how cash has flowed in and out of the company’s bank account. Thus, it is often viewed as a better gauge of results than reported earnings. If net income is increasing but cash flow is decreasing, this could be a sign of a potential problem.

Just because a company experiences one or more of these red flags doesn’t mean it will necessarily have sales or earnings disappointments in the future. However, if you find these situations, review them carefully to ensure there is an appropriate explanation. Also you may want to consider listening to management conference calls to get additional "color" on the true long-term outlook for the company.

Useful Investing Tips

Having your money grow competitively over the years is both a combination of good planning and a little luck. Although there is not much you can do about the luck part of it, you can implement some basic principles to put the odds in your favor on the planning side of things. Here are 6 important concepts to consider:

  1. Realize that saving and investing are two different concepts. Saving involves not spending current income, while investing requires you to take those savings and do something with them to earn a return. Saving often becomes easier when it is separated from the choice of where to invest. Find ways to make saving as automatic as possible, perhaps through payroll deductions or monthly checks to an investment account. Many internet banks, such as ING Direct, allow automatic transfers of your excess checking account funds into higher yielding savings accounts.

  2. Develop an asset allocation plan to guide your investing. One of the most critical investment decisions you’ll make is how to allocate your portfolio among the major investment classes, such as stocks, bonds, and short-term investments. Part of your plan should include a review of your investments on at least an annual basis, making adjustments to keep your asset allocation percentages in line.

  3. Don’t let fears about risk prevent you from making investment decisions. All investments contain risk, so understand how risk affects different investments. Even seemingly safe investments, such as bank accounts, are subject to purchasing power risk, or the risk that your return won’t outpace inflation.

  4. Put time on your side. If you have ambitious financial goals that require significant sums to achieve, one of the best moves you can make is to start saving as soon as possible. With time on your side, even modest sums can grow to significant sums.

  5. Chasing the highest returns is a difficult game to win. Much of the financial press is devoted to covering investments with the best performance for the last quarter, year, three years, etc. Many people then switch to these high performers, only to find that they purchased at a high for that investment. It often makes more sense to carefully consider investment alternatives, selecting those you would be comfortable owning for several years.

  6. Realize that help is only a phone call away. The investment world has become very complex, with a vast assortment of investment vehicles now available. If you need help with your investment decisions, call and get the information you need.

June 14, 2005

Taxes and Investing Strategies

One of your portfolio’s largest expenses is probably taxes. Ordinary income taxes on short-term capital gains and interest income can go as high as 35%, while long-term capital gains and dividend income are taxed at rates not exceeding 15% (5% if you are in the 10% or 15% tax bracket). One way to help keep your portfolio growing is to invest in a tax-efficient manner. Some suggestions include:

  • Contribute to your 401(k) plan. Contributions are made on a pre-tax basis, so you don’t pay income taxes currently (Social Security and Medicare taxes are paid) and earnings grow on a tax-deferred basis until withdrawn. In 2005, you can contribute a maximum of $14,000 to a 401(k) plan, although plans typically limit your contribution to a certain percentage of your pay to ensure the plan complies with nondiscrimination rules. Individuals over age 50 may be able to make an additional catch-up contribution of $4,000 in 2005. Many employers also match your contribution, so you get additional funds at no cost to you.

  • Make contributions to an Individual Retirement Account (IRA). In 2005, you can contribute a maximum of $4,000, plus those over age 50 can make an additional $500 catch-up contribution. Investigate whether you’re eligible to contribute to a traditional deductible IRA or a Roth IRA and then decide which option is best for you. While you can’t deduct your contributions to a Roth IRA on your tax return, your earnings grow tax free as long as you make qualified distributions from the IRA. With a traditional deductible IRA, your contribution is deductible on your current-year income tax return, and earnings grow tax deferred until withdrawn.

  • Carefully decide which investments to hold in tax-advantaged and taxable accounts. Gains from investments held in retirement accounts, such as 401(k) plans and traditional IRAs, are taxed at ordinary income tax rates when withdrawn, rather than the lower capital gains tax rates. While it may make sense to hold investments that produce ordinary income or that you want to trade frequently in retirement accounts and investments that generate capital gains in taxable accounts, factors such as your investment period should also be considered.

  • Analyze the tax consequences before rebalancing your portfolio. Portfolio rebalancing is a taxable event that may result in a taxable gain or loss. In general, avoid selling investments from your taxable portfolio for reasons other than poor performance. Bring your asset allocation back in line through other methods.

  • Consider municipal bonds or stocks generating dividend income if you are in a high tax bracket. Since municipal bond interest is exempt from federal, and sometimes state and local, income taxes, your marginal tax bracket is a major factor when deciding whether to include municipal bonds in your portfolio. Thus, you should determine how a muni bond’s yield compares to the after-tax yield of a comparable taxable bond. Since dividend income is taxed at rates not exceeding 15%, stocks that generate significant dividend income may be a good choice for high tax bracket investors.

  • Look into purchasing a home. Owning a home has significant tax advantages. Mortgage interest and property taxes can be deducted on your tax return, reducing the cost of owning a home. Mortgage interest is deductible on up to $1,000,000 of original debt incurred to purchase a principal residence. Additionally, interest paid on up to $100,000 of home-equity debt is deductible on your tax return. When you sell your home, significant capital gains can be excluded from income. You can exclude $250,000 of gain if you are a single taxpayer and $500,000 of gain if you are married filing jointly, provided the home was your primary residence in at least two of the preceding five years. You no longer have to purchase another home to qualify for the exclusion.

  • Consider tax-advantaged ways to save for college. If you are saving for college, take a look at Education Savings Accounts (ESAs) and Section 529 plans. The annual contribution limit to ESAs is $2,000. While you can’t deduct the contribution on your tax return, earnings grow tax free as long as funds are used for qualified education expenses. With Section 529 plans, you can contribute up to $55,000 to a qualified plan ($110,000 if the gift is split with your spouse) in one year and count it as your annual $11,000 tax-free gift for five years. Distributions from state-sponsored plans to pay qualified higher-education expenses are excluded from income if made after 2001 and before 2011. Distributions from private college and university plans are excluded from income if made after 2003 and before 2011.

Make Rebalancing Your Portfolio A Habit

We all know we should rebalance our portfolios periodically to ensure they stay in line with our targeted asset allocation. Why, then, is it so difficult for us to do this? The primary reason is that rebalancing goes against our basic instincts. With rebalancing, you are generally selling those investments performing well to purchase those that are underperforming, which just doesn’t seem to make sense. It might help to remember that by rebalancing, you are following a fundamental investment principle — you are buying low (those investments that are underperforming) and selling high (those investments that are performing well).

Numerous studies have shown that rebalancing reduces the volatility in portfolios, often with increased returns. Keep in mind that you set your asset allocation strategy because you believed those were the appropriate percentages of various investments that you should own. Thus, you need to make rebalancing a habit so your portfolio doesn’t become more risky than intended. There are three basic approaches to rebalancing:

  1. Rebalance annually. You can choose a date to rebalance, perhaps at the beginning of the year, when you receive your annual statements, or at the end of a specific quarter. On that date every year, compare your current allocation to your target allocation. Any allocations off by a designated percentage would require rebalancing. Once you have rebalanced, don’t be tempted to make other rebalancing changes during the year.

  2. Rebalance based on your views about current market conditions. With this approach, rather than one specific percentage for each asset class, you might have a target range. For instance, you might allocate from 30% to 50% of your portfolio to large-capitalization stocks. Depending on your views of the market, you might want to allocate near the low or high end of that range. Thus, your allocations will change as your views about the market change.

  3. Rebalance whenever your allocation moves from your target allocation by a designated percentage. With this rebalancing method, you monitor your portfolio more frequently, perhaps monthly. Once your allocation moves from your target allocation by a certain predetermined percentage, you rebalance your portfolio.

With all three methods, you need to decide how much variation you are willing to tolerate in your portfolio before you rebalance. Several factors impact your decision:

  • Correlation: Correlation is a statistical measure of how one asset class performs in relation to another asset class. Assets that are not highly correlated can help reduce the volatility in a portfolio. Thus, the lower the correlation between assets, the less variation you should tolerate. Being off target will have a greater impact on your portfolio when the variation is between low correlation assets.

  • Volatility: You should tolerate less variation in assets that are more volatile, since this can quickly add more risk to your portfolio.

  • Costs to trade: Some assets may be illiquid or difficult to sell, making them expensive to trade. In those situations, you may be willing to tolerate more variation in your allocation percentages.

  • Taxes: Before rebalancing, you need to consider the tax ramifications of doing so. Especially if rebalancing would result in short-term capital gains subject to ordinary income taxes, you may be willing to tolerate more variation in your allocation percentages. However, there are other ways to rebalance without causing a taxable event, such as: rebalancing in tax-deferred accounts; making new investments in underweighted assets; redirecting periodic income to the underweighted portion; or taking withdrawals from the overweighted portion.


Seeking Alpha Certified
Creative Commons License
This weblog is licensed under a Creative Commons License.

Privacy Policy - Terms and Conditions - Site Map - About Company - Contact Us
Link to Us - Partners - Advertiser Center - Newsroom

© ManagingMoney.com. All Rights Reserved.
Image Domain - Las Vegas Web Design Services