Chances are you have a 401(k) plan at work. And the chances are you’re not making nearly enough of it. A new year means a new leaf: This is as good a time as any to start turning that around.

If you’re letting your 401(k) languish, a report released over the holiday season shows that you’re not alone. According to the latest study by the Employee Benefits Research Institute, a think tank in Washington, most of us continue to neglect our 401(k) plan. The median account contains a balance of just $18,000, says EBRI.

Good luck with that.

Here’s a five-step plan to fix your 401(k).

1 Take control.

Take a look at the full range of investment choices available to you. That should include, at a minimum, a handful of low-cost domestic and international stock and bond funds. If your plan doesn’t even offer those you should talk to the people in charge at your employer and insist that they move to a better plan.

Many people are too intimidated, or busy, to choose their portfolio. If you’re in that camp, your plan will have dumped your money into a default portfolio—such as a low-yielding but “stable” fund, or a target-date fund ostensibly designed for someone of your age.

There is nothing inherently wrong with these funds. But that doesn’t mean you can rely on them, either.

These default options aren’t designed for your best interests, but for the best interests of your plan provider. Instead of maximizing your likely returns, they are designed to minimize the provider’s risk of a nasty lawsuit.

As a result, your money may well be sitting in a poorly designed portfolio that guarantees mediocre performance. Target-date funds, for example, are a great idea in theory. In practice, most are far too heavily weighted toward U.S. stocks, and they use a cookie-cutter approach to investing.

Consider the alternatives available to you.

You also should understand if your company makes matching contributions, and, if so, how much it will match. There’s no good reason for missing out on a company match. It’s also a good idea to find out if your plan allows such things as personal loans: This may offer you access to cheaper capital than a bank, although there are risks in borrowing from your plan.

2 Cut your costs.

Many 401(k) plan providers stock their plans with high-fee mutual funds. That’s great for them, and bad for you. Most mutual funds are far too mediocre to justify hefty fees, which just soak up a lot of your investment returns. A fund that charges you an extra 1% a year may end up costing you most of the tax benefits of your plan.

There are managed investment funds out there that are worth the money, but few of them—if any—are likely to find their way into a 401(k) plan. If you’re stuck with plain-vanilla funds, you are going to be better off going for the ones with the lowest costs. Nearly all the time your best options will be the low-cost index funds.

3 Lighten up on U.S. stocks.

Most people keep most of their stock-market investments in the U.S. It’s safer, right? I mean, it’s the home market so it’s less risky than foreign stocks, yes?

That’s what conventional wisdom says, but it’s hooey. Investors sell themselves short by investing too much in the U.S.A. You’re already overinvested here anyway—you have your life and career here.

And U.S. equities start 2012 looking relatively expensive. U.S. stocks today are somewhere between modestly and heavily overpriced when compared to such metrics as average earnings or the value of corporate assets, according to data from the Federal Reserve and data tracked by Yale University economics professor Robert Shiller.

The dividend yield on the Standard Poor’s 500-stock index, at just 2.1%, is very low by historical standards.

Predicting future stock-market returns is notoriously difficult. But based on current valuations, the U.S. stock market seems to offer a mediocre bet.

4 Look internationally.

Many 401(k) plans go light on international investment options. The real reason is simply the incompetence and complacency of plan sponsors.

But if your plan offers international options, take advantage. The turmoil of 2011 has left many overseas stock markets looking like a good value.

Western European markets fell nearly 30% from last year’s peak. Japan’s Nikkei 225 index is now lower than it was during the tsunami panic nearly a year ago. Emerging markets from Brazil to India, the investment hotshots of 2010, have dropped dramatically out of fashion again. Their stock markets crashed last year.

These offer some excellent buying opportunities.

Emerging markets account for about a third of the world economy, and their share is growing. Developed overseas markets, meaning Europe, Japan and Australasia, account for about two-fifths. They are on sale, and most people are underinvested there.

5 Review your bond funds.

As a general rule, your 401(k) and other tax shelters are where to hold the bond portion of your portfolio. That’s because bonds are much more vulnerable to taxes than stocks.

Bonds generate most of their returns through coupons, and those are usually taxed at ordinary-income tax rates. By contrast, stock dividends and capital gains generally get taxed more lightly.

Right now is, admittedly, a risky time to invest in U.S. bonds. Yields on U.S. Treasurys have slumped to historic lows. Any pickup in the economy, and inflation, could send bond funds tumbling.

While Treasury bonds offer meager yields here, look at any corporate bond funds. That includes investment-grade bonds and more volatile high-yield bonds.Both offer somewhat better yields. Emerging-markets bonds offer particularly good opportunities, argues investment guru Rob Arnott, chairman of Research Affiliates. They pay higher interest rates than those in the U.S., while their governments’ finances are actually in better shape.

It’s crazy that most 401(k) plans offer such a limited range of investment options. Paradoxically you don’t get full control of your money unless you leave your employer, when you can roll the plan over into a self-directed individual retirement account. But your 401(k) still represents a great investment asset, and this is a good time to get it into shape.

Write to Brett Arends at brett.arends@wsj.com

Article source: Wall Street Journal

 

By 2030, around 20 percent of the U.S. population will be 65 and older, up from 13 percent today, reckons the Census Bureau. There’s a gloomy theory on how that will affect stocks. As boomers earned and saved in the 1980s and 1990s, the market soared, the thinking goes. As they retire and draw down their savings, share prices could deflate.

Nonsense, concluded the Government Accountability Office in a 2006 study. Baby boomers own less than a quarter of the U.S. stocks and bonds held by U.S. savers, so their influence on prices is overstated, according to the authors. Anyhow, many old folks spend down their assets slowly and continue to save.

But if there’s one thing economists can be counted on for it’s to publish perfectly contradictory, equally convincing findings. Researchers for the Federal Reserve Bank of San Francisco recently wrote that the historical link between age distribution and stock returns suggests the boomer retirement “could be a factor holding down equity valuations over the next two decades.”

These two divergent views would seem to prescribe radically different investment approaches, with a steep penalty for guessing wrong. But maybe not. What boomers will really want in retirement is more investment income, says Savita Subramanian, a strategist for Bank of America Merrill Lynch. “If you think about it, yield is scarce at the moment, and competition for it is only going to increase.”

To her first point, on average over the past 50 years, investors who spent $1 million on 10-year Treasury bonds could have looked forward to a yearly income of $67,000. At recent rates, the same investment would provide just $21,000. And the percentage of dividend-paying firms in the SP 500 index fell to 75 percent in 2010, from 94 percent in 1980.

The dividend decline is beginning to reverse, however. The percentage of payers hit 78 percent in 2011. Still, some companies can afford to pay much more: SP 500 companies distribute barely one-third of their operating profits as dividends their stingiest amount ever. Nonfinancial companies in the index hold more than $1 trillion in cash.

Companies in the best position to supply boomers with steadily rising dividends in coming decades will be rewarded with plenty of demand for their shares, says Subramanian. She recommends a could-would-should strategy for investors looking for such firms. Companies that could raise payments include those with plenty of cash and modest debt. Firms that should are those with high returns on equity and stable earnings despite slow growth. And companies that would are those that most likely already are. A recent screen for all these attributes produced the firms below.

• Baxter (BAX)
• Coca-Cola (KO)
• Deere (DE)
• 3M (MMM)

Article source: Wall Street Journal

 

Investment-research firm Morningstar Inc. on Tuesday unveiled a forward-looking ranking system for mutual funds to supplement the company’s closely watched one- to five-star ratings.

Chicago-based Morningstar says the new system—which grants funds a gold, silver, bronze, neutral or negative ranking—is meant to predict which funds will outperform their peers in the future.

By contrast, the star ratings are granted based on past performance after adjusting for risk and sales charges. The stars are widely used by investors and financial advisers in choosing funds to buy and often are touted in promotional materials.

The new ratings are based in part on past performance, but also employ other quantitative and qualitative measures including the fund’s expense ratio, Morningstar’s perception of the fund manager, the fund’s parent company and the fund’s investment strategy.

Of the 349 funds that Morningstar already has rated under the new system, 155 achieved the highest “gold” rating, while eight received a “negative” rating.

The company initially focused on larger funds and ones that it had formerly deemed “analyst picks,” said Russel Kinnel, Morningstar’s director of fund research. It expects that the balance of negative and positive ratings will become more even over time.

The Wells Fargo Advantage Ultra Short-Term Income fund, which is rated four stars under the old system, received one of the negative ratings under the new one.

“We believe in the management team’s investment process and have comfort in their credit analysis and risk-management capabilities,” a Wells Fargo spokesman said in a statement.

On the other hand, the Clipper Fund, which has one star, earned a gold designation.

If the new ratings catch on, the implications for fund managers could be significant. More than 122% of mutual-fund inflows over the last five years have gone into funds that are now rated four or five stars, according to Morningstar. The number is greater than 100% because one-, two- and three-star funds have seen net outflows over that period.

“We still get calls that say, ‘Hey, why haven’t you gotten me out of this two-star fund?’” said Tim Courtney, chief investment officer of Oklahoma City-based wealth manager Burns Advisory Group Corp.

Mr. Courtney said there was a widespread misperception among investors that the star ratings were meant to indicate a fund’s quality, and that he hopes the new system will help change that.

Write to Joe Light at joe.light@wsj.com

Article source: Wall Street Journal

 

In the cycle of investment life—boom, bust and aftermath—the lessons only become clear after it’s too late.

So it goes with a once-hot real-estate investment that has left wreckage in its wake and a fresh reminder: When there’s a simple way and a complicated way to solve a problem, the middleman will almost always make more money off the complicated solution—but you might not.

Between 2004 and 2008, investors bought $13 billion worth of securities often called tenancies-in-common, or “TICs,” according to OMNI Real Estate Services of Salt Lake City. Also known as 1031 exchanges after a part of the tax code, TICs are complex deals that enable the sellers of real estate to roll their proceeds over into other properties without incurring capital-gains tax. TICs were tailor-made for a real-estate bubble.

The deals were structured as privately placed securities that don’t trade; up to 35 investors can own stakes in a TIC, while a newer format can be held by up to 499 investors. The buyers get a stake in the rental income—and potential sale—of one or more commercial, retail or residential properties.

Properly structured, 1031-exchange securities can enable investors to shelter real-estate sales from capital-gains taxes, to obtain regular income and to bequeath the asset to their heirs in a tax-efficient manner.

But Wall Street took an idea that is suitable only for a limited number of specialized, wealthy clients and sold it to ordinary investors—in some cases with disastrous results.

Consider what happened to Mary Boston, 70, of Dunlap, Tenn. In 2007 she and her husband, Lavaughn, sold their local theater for $1.2 million, net of debt. Their tax preparer suggested that a financial adviser might be able to help them arrange a 1031 exchange.

The couple sank the $1.2 million—essentially their entire liquid net worth—into two TICs that gave them a stake in two apartment complexes, one in Georgia and one in Texas. The offering documents projected an annual yield of 6.5%.

The couple had no previous investment experience, and Mrs. Boston says she told the adviser that they had a “conservative and moderate” appetite for risk, with “income” as their investment objective.

Section 1031 exchanges must be executed on a precise, tight schedule. Mrs. Boston says she repeatedly raced back and forth to Chattanooga, Tenn., to send required documents by overnight delivery. But she says her adviser warned that it would “cost a lot of money” to undo the transaction.

After the deals closed, the Bostons, along with other investors, had to pony up more money when one of the properties became entangled in lawsuits. Between the capital they added and legal fees, says Mrs. Boston, the couple has sunk roughly $70,000 more into the property.

Meanwhile, the monthly income on their investment has fallen from about $5,000 to $300—and is projected by the property manager to dry up entirely next month. Vacancy rates have spiked, partly because of negative publicity after a double homicide this summer at one of the apartment complexes.

The Bostons are seeking redress through arbitration with the financial adviser. With the case pending, the adviser’s current firm, ING Financial Partners, declined to comment or to make her available.

Small TICs like the Bostons’ weren’t the only ones that had problems. Two big TIC sponsors, DBSI and Sunwest Management, raised nearly $1 billion, then sought bankruptcy protection in 2008 and 2009 after their deals went bad.

Amid the bad publicity and a drought of bank lending, the industry’s transaction volume fell by 95% from the peak in 2006 to the trough in 2010.

But the few conservative sponsors left are making a minor comeback. Patricia DelRosso, president of Inland Private Capital, estimates that her firm will raise about $160 million in 1031-exchange deals this year, double its levels last year. Bill Winn, president of Passco, another sponsor, reckons that offerings will be up around 20% over 2010.

If you’re considering a 1031 deal, proceed cautiously: It probably makes sense only if you are already planning to sell a property and to reinvest the proceeds into other real estate assets, say tax experts.

Otherwise, it’s hardly worth paying a 7% or greater commission just to avoid a 15% capital-gains tax. Plus, there is no secondary market for these assets, so “you’re toast if you need to sell” before the properties are ultimately resold, says Brandon Balkman, executive director of the Real Estate Investment Securities Association, a trade group.

The next time someone comes calling with a complex, high-fee product, remind yourself—before it’s too late—that there probably is a simpler, cheaper alternative.

—
twitter.com/jasonzweigwsj

Write to Jason Zweig at intelligentinvestor@wsj.com

Article source: Wall Street Journal

 

If you are a gold investor, you’re probably quite pleased with yourself right now. It’s been one of the best-performing investments this year.

Indian stocks are down 16.5% so far, bonds have been middling, with 7% to 10% returns but gold – that’s been stellar with its 22% gain over the last year.

A customer tried gold bangles inside a jewelry showroom at Noida in the northern Indian state of Uttar Pradesh in this April 21, 2011 file photo.

So, today being Dhanteras, an auspicious day to buy gold, perhaps you won’t think twice about investing in the yellow metal. But you should.

Will gold continue to gain value from these high levels? Yes, said Bollywood actress Hema Malini recently. She said that the recent price gains are clear evidence of why it will continue to be a good investment.

Ms. Malini aptly summed up how thousands of gold-lovers – who don’t actively follow gold demand or supply markets or euro-zone crises — think.

The argument that price will go up simply because it has risen in the past is not exactly a logical investment case. But science can explain this thesis.

Many of today’s gold lovers are inflicted with what psychologists call the “recency” effect – the tendency of human beings to give most importance to what has happened in the recent past.

We experience this every day.

Think back to your last work performance review. Most likely, it was determined by what you did or didn’t do in the few weeks or months before the review date.

If you had to decide whether to watch a new movie, you’ll likely base your decision on the last couple of movies made by that movie’s director or actors. You won’t seek out all the movies made by the director in the last 10 years to make the most rational assessment.

These are examples of how our current behavior is often driven largely by a handful of recent experiences, as opposed to an average of experiences over a long period of time.

It won’t hurt you too much if you pick a bad movie to watch but recency bias can have harmful consequences when investing your money. This is what propels individuals toward “hot” investments, often after they have reached their peak.

“The average person buys more aggressively in response to recent price rises,” said Terrance Odean, a finance professor at the University of California Berkley, in the neuro-science book, “Your Money Your Brain.”

Mr. Odean, who has studied 3 million stock trades by 75,000 American households, added that it’s not just yesterday’s boom that spurs buyers. “What makes people buy is a combination of very recent rises and any longer-term ‘trend’ of rising prices that they might perceive,” said Mr. Odean.

This “trend” is basically a few instances we put together in our minds to create a pattern.

Coming back to gold, for instance, my mother will argue that gold’s price has gone up over the long term. It was at around 330 rupees ($7) per 10 grams in 1973 and was recently trading at 26,300 rupees ($530) per 10 grams more recently.

This long-term trend is at best a fallacy. Prices of everything have gone up over the last four decades. Even milk – as per my mother’s recollection – has gone up by as much or more!

The fact is, when adjusted for inflation, gold is more than 30% below its price in 1980.

Still, we get carried away with its recent performance.

Money managers and fund companies are well aware of this recency bias and use it to sell us their products.

They’ve been launching several gold-investment funds this year, which aim to provide the return of gold without having to own physical gold. HDFC Asset Management Company introduced such a fund earlier this month, and last week IDBI Asset Management Ltd. launched its offering.

If gold is a good investment today at $1,612 an ounce, then it was an awesome investment in 2007 when it cost just $750 an ounce, right?

Yet, more than two-thirds of the 18 gold-oriented mutual funds that are available in India today were launched after 2010. Why didn’t we see a rush of gold funds in 2007?

Because at that time fund companies were busy launching stock funds when — you guessed it — stocks were booming. The Sensex gained 50% in 2007.

Investors who joined the stocks bandwagon then because of recent price gains, were in for a rude shock. In 2008, the Sensex lost more than half of its value.

So-called investment experts are not much better at getting away from this recency bias. Numerous stock market pundits today will advise you to buy stocks of fast-moving consumer goods, like toothpaste-maker Colgate-Palmolive (India) Ltd. and food products company Nestle India Ltd., which as a group have gained nearly 9% over the last year.

But if you want to make money, don’t you want to buy something cheap which you can sell for a higher price later?

Even if you are not a stock investor and haven’t been hurt in recent stock market crashes, it doesn’t hurt to learn from other people’s mistakes. Your brain is wired pretty much the same way.

Think about that before you decide to buy gold as an investment this Dhanteras.

Write to Shefali Anand at shefali.anand@wsj.com

Article source: Wall Street Journal

 

Few workers are happy with the performance of their 401(k) plans in recent years but how much blame should be placed with employers?

Not much, according to recent court rulings in which companies including Bank of America Corp., Exelon Corp. and Unisys Corp. racked up legal victories over workers who contended their retirement plans steered them toward costly investments.

But the litigation is having ancillary effects: Experts say the cases are prompting employers and regulators to reshape 401(k) plans to provide more investment choices and better disclosure about fees.

The recent court rulings are the most high-profile to date in the roughly three dozen lawsuits filed over the past several years challenging 401(k) plans, the main retirement vehicle for millions of Americans that collectively hold $3 trillion in assets.

The cases typically hinge on the way 401(k)s are packaged and marketed. In many plans, companies hire an outside investment firm to run the plan. Instead of being paid directly, those firms take a cut of the fees associated with the investments. Critics charge that those arrangements obscure—and ultimately inflate—costs for workers.

The suits can hinge on seemingly small differences in investment fees, generally amounting to one percentage point or less of investment balances each year. But because of the large dollar amounts in 401(k) plans and the decades employees spend saving, there can be millions in profits at stake for fund firms, according to court documents, and a sizable chunk of workers’ retirement nesteggs.

Employees of Edison International won a victory last year when a federal district court sided with workers claiming that the company’s 401(k) fees were excessive. And the recent court losses haven’t discouraged new suits. Indeed, in one high-profile case, Ameriprise Financial Inc., itself a company that sells financial advice, is facing a lawsuit accusing it of favoring its own funds in its 401(k) plan over investments with better track records.

Some legal experts believe conflicts between the Edison ruling and more recent ones foretell a protracted legal battle. “Eventually the Supreme Court will get involved,” predicts Boston-based lawyer Marcia Wagner, who specializes in employee-benefit law.

Edison, which has appealed its case, says it is “committed to providing a wide array of high-quality investment options” in its 401(k) plan. Ameriprise called the suit it faces a “copy cat” and plans to “vigorously defend it.”

Despite conflicting judgments, many in the 401(k) industry credit the recent lawsuits with helping spur a new set of Department of Labor disclosure rules targeting the same compensation arrangements.

Among changes being implemented next year: Plan packagers will have to tell employers how much they deduct from investment fees to run plans, making it easier for these companies to compare costs. Workers will also get charts designed to make it easier to compare fees among funds and evaluate administrative costs.

At the same time, many employers have begun to tweak plans voluntarily. The number of large 401(k) plans that offer investors access to a “brokerage window,” which gives workers a wide range of mutual funds in addition to those on the plan’s menu, climbed to 29% this year from 26% in 2009, according to a biennial survey by pension consultant Aon Hewitt. Plans have also been adding index funds, especially in areas beyond large-company U.S. stocks like fixed income and international stocks, Hewitt finds.

The index fund “influx is not just because of the cost, but because of the lawsuits,” says Hewitt analyst Pamela Hess. “Because they are cheap, nobody can say you are doing the wrong thing.”

Write to Ian Salisbury at ian.salisbury@dowjones.com

Article source: Wall Street Journal

 

In the game of blackjack, you can ‘double down’ on a hand by doubling your bet for one more card from the dealer.  (When playing blackjack, your goal is to create a hand that is as close as possible to 21 without going over)  This action allows you to take additional risk for an immediate payoff.  Within the community of people who enjoy the game of blackjack, most will tell you that it is advantageous to double down on an eleven, or possibly a ten.  The principal reason for this is because cards with a value of ten have a higher concentration than other cards.  Because of this, it is advantageous for players to increase their risk in certain situations because of an increased probability for a higher payoff.

In the world of investing, there are both times to increase your exposure to risk for a higher payoff, and appropriate situations.  The problem which arises is that many people end up taking excessive risk to chase returns.  In this situation, it is rarely the optimal time to take more risk in the hopes of earning a higher return.

Currently, there are many people from the baby boom generation who are currently ‘doubling down’ with their retirement accounts by over-weighting their portfolios in high-risk ventures such as emerging market stocks and speculative real-estate in an attempt to pump-up the value of their nest egg before retirement.  The risk of this strategy is that your nest egg could crack just before it hatches.

The hidden danger of highly volatile investments is that the risk of loss generally stays hidden until market disruptions push the value of multiple asset classes down simultaneously.  In this case, there is not enough time to adjust your portfolio before it has been significantly burned.  These types of situations are especially dangerous, because the market tends to change very abruptly as relevant news and information develop.  For people who are approaching retirement, volatility can be especially dangerous.

This is not to say that investors shouldn’t take risks . . . it is very difficult to generate returns in excess of bond or money market yields without taking risks.  The caution is that you should be aware of the risks that you are taking, and not allow yourself to fall into a false sense of security because the market hasn’t had a significant downward movement lately.  Large returns generally require that you take large risks.  If you are currently earning large returns, chances are that you are at risk for a large adjustment.  It is very important to make sure that a significant downward adjustment in value of your risky investments will not place you in a situation that you can’t recover from.

Thus, when deciding whether to ‘double down’ on your investment strategy, it is critically important to understand whether you are in a situation where such a decision is optimal.  Are your personal emotions constructed in such a way that a dramatic shift in market valuation will cause excessive nervous tension?  In most cases, investors are their own worst enemy … we allow our emotions over the movements of our portfolio value to influence our actions in a way that frequently moves contrary to our rational thoughts.

Thus, investing becomes a battle of reason vs. emotion.  Our reason frequently tells us to make decisions that would appear to be quite smart by most objective standards.  Reason typically evaluates decisions based on their inherent merits.  However, not all of our decisions are made rationally.  Instead of making our investing decisions based simply on the merits of a particular investment, we allow ourselves to be influenced by the other people we have seen being successful in making money.  When the market is going up, our emotions want to double-down on what we have seen as being successful.  When the market is going down, our emotions want to run for the hills and retreat from the perceived danger of the investing world.

As it turns out, the movement in market perception of a particular investment does not necessarily change the underlying fundamentals.  Many investments that are fundamentally sound experience negative market news, and other investments that lack solid fundamentals will experience upward escalations in market valuation that defy reason.  In the former case, it is important to avoid the emotional pull to bail-out on an otherwise solid investment strategy.  In the latter example, it is important to avoid the temptation to increase our investment, simply because the price has gone up and we hope that it will go up some more.

In the end, it is important for each of us to understand the extent to which our emotions compel us to ‘double down’ on what may turn out to be a highly risky strategy.  All of our decision should be made because of what we judge to be best for our well-being.  Achieving our desires will require that we take risks of some manner along the way.  However, it is important to ensure that all of our decisions are being made consciously instead of re-actively … rationally instead of emotionally.  This will help us to make sure that we don’t double-down on risky situations that we are not emotionally prepared to deal with.

 

Taking a loss is hard to take. But avoiding a loss can be much worse.

U.S. stocks have lost some $4 trillion since their peak in October 2007, but investors aren’t fleeing the market en masse. So far this year, according to investment-research firm Morningstar, investors have taken $14 billion more out of U.S. stock mutual funds and exchange-traded funds than they have added. That is less than 0.4% of the total assets of U.S. stock funds.

Can losing money feel good? Recent experiments show that reward circuits in the brains of investors who have losses will fire intensely whenever money-losing holdings have an uptick in price. Jason Zweig has details on The News Hub.

In other words, while some investors have taken their losses, most are grimly sitting on them.

That could be a mistake. Research published in 1998 by behavioral-finance professor Terrance Odean of the University of California, Berkeley, showed that individual investors are 50% more likely to sell a winning stock than a loser—even though, on average, the stocks these investors sell go on to outperform while those they hold onto underperform.

Why the reluctance to bail? Selling an underwater asset, says Mr. Odean, “isn’t primarily about economic loss, it’s about emotional loss.” Once you sell below your purchase price, he believes, you can no longer tell yourself, “I still made a good choice, and it’ll come back.”

Individual investors aren’t the only ones who can’t make peace with their losses, according to numerous academic studies. Mutual-fund managers who cling to losing stocks underperform, by roughly four percentage points annually, the managers who cut their losses.

Christophe Vorlet

While some investors have taken their losses, most are grimly sitting on them.

On average, professional futures traders and stock traders hurt their returns by clinging to their losers. Real-estate investment trusts hang onto properties that are losing money longer than they keep those that are in the black.

Unpublished research presented at the annual meeting of the Society for Neuroeconomics earlier this month sheds new light on this old problem. Neuroeconomics is an emerging field that combines the techniques of neuroscience with theories from psychology and economics to study financial behavior.

In one study, led by Gregory Berns of Emory University, people lay inside a brain scanner while deciding to hold or sell an investment; the price of the asset changed randomly up or down. The researchers focused on the ventral striatum, a region of the brain that has been shown to respond to rewards, particularly when they are unexpected.

When an asset was underwater and its price rose, activity in the ventral striatum of the typical person in the experiment was “blunted,” or insignificant, rather than robust. “Many of the participants told us they had hope for a rise,” says Andrew Brooks, a co-author of the study. Perhaps because these people got what they expected, an uptick in price “wasn’t surprising,” Mr. Brooks says, and therefore didn’t excite this part of the brain’s reward center.

That suggests that many investors who are losing money may automatically assume—rightly or wrongly—that their position is bound to recover.

Other research at the meeting pointed to a second flaw in how investors might think about losses. A study led by Camelia Kuhnen of Northwestern University found that people are much worse at estimating whether a bad investment will produce mild or severe losses than they are at predicting whether a winning investment will generate small or large gains. “Learning [about probabilities] is particularly faulty,” Prof. Kuhnen says, “when people are in a bad environment with losses left and right and they have their own money at stake.”

There are several steps that can help you dump your losers.

First, get a second opinion, from a financial adviser or an investor you respect, on your money-losing positions. Ask not whether you should sell the investments, but rather if they are worth buying at today’s price. If the answer is no, consider selling.

Measure how long you hold your losers and your winners. If you hang onto your money-losing positions much longer than your winners, then put yourself on a regular schedule of looking for losses to harvest. (You don’t have to wait until December.)

Taking a loss is easier when you think of it as a swap—in which you replace a loser with a new investment in a similar (but not identical) asset—rather than a sale. That makes taking action easier, since you aren’t forced to admit that your original judgment was a complete failure.

Finally, realize that a loser can change from a liability to an asset when you close it out at a loss, since you can use losses to offset up to $3,000 of ordinary income on your tax return.

“Think about the term ‘harvesting your losses,’” suggests Meir Statman, a finance professor at Santa Clara University. “That should put you in mind of strolling in an orchard picking ripe peaches rather than rotten losses.” Just be sure to check with your accountant to make sure the loss is worth taking.

Article source: Wall Street Journal

 

One of the ideas that has become quite pervasive within the minds of investors is the notion of a “good stock” or a “good property” to own.  This notion stems from a general desire on the part of most people to own things of quality.  In our personal life, this frequently manifests itself as a desire to own a comfortable home, and a reliable automobile.  Quality gives us a feeling of safety and security.  Thus, it seems completely natural to want our investments to be the stock of a high quality company, the bonds of a high quality corporation of government, or a property that is desirable in both its quality of construction and location.  The problem with this view is that it only provides one half of the information that you need to determine whether an investment is a good deal.

The second half of this investing puzzle is price.  Put bluntly, the quality of a stock, bond, or property investment only matters in relation to its price.  This means that a ram shackled, blighted property can be a phenomenal deal at a certain price.  The stock of media darling companies such as Apple, Google, and Amazon can all be terrible investments at a certain price.  It is certainly true that high-quality investments can frequently justify a higher price than lower quality investments.  However, it is equally true that any investment can be a spectacular deal if the price is right.

The key for investors is to determine when the price of a high-quality stock, bond, or property is over-valued, or conversely when the price of a lower quality stock, bond, or property is under-valued.  Any investment is a good deal at one price, and a poor deal at a different price.  Unfortunately, it is frequently very difficult to determine exactly where these two boundaries are drawn for any particular investment.

When estimating the appropriate price for a particular investment, there are two relevant factors that need to be considered.  The first is the expected future price, the second is expected future cash flow, and the third is taxes and inflation.  When combined, they will create a holistic picture of the value for any particular investment.

Expected Future Price

• In the world of stock and real estate investing, this is referred to as appreciation.  Fundamentally, it represents the expectation that the future price of an investment will be higher than the price you paid to purchase it.  This is frequently referred to as the ‘buy low, sell high’ philosophy.  For most investors, this is the primary source of value that they see.  Stock market tickers report the price of securities, and the Multiple Listing Service reports the price of properties.
• However, the ubiquitous availability of price information frequently causes people to over-emphasize price appreciation as a source of value.  It is most certain that price appreciation is an important source of value for investments, but it is certainly not the only value vector.  The fact that so many people focus on market prices has made them become very volatile over the past few years.  Values for stocks, bonds, and real estate have all fluctuated significantly.  This has made future price appreciation very difficult to predict.
• In addition to all of this, there is one further characteristic of price that investors must take into consideration.  In order to capture the benefit of price appreciation, you must sell the investment.  This means that watching the value of your stocks or real estate skyrocket means absolutely nothing unless you sell and lock-in the gain.  Thus, in order to realize the full gains from future price appreciation, it means that you must sell at the right time.  In practice, this is very difficult to do and frequently results in selling while values are still going up.

Expected Future Cash Flow

• Another key characteristic of what makes a good vs. bad deal for investors is the cash flow that is produced.  In the case of stocks, this comes from dividends.  In the case of bonds, this comes from interest payments and the future return of the bond face amount.  In the case of real estate, this comes from rents that are paid by tenants for the use of your property.  The importance of cash flow to the value of an investment is that it represents a current, tangible return.  Typically, investments that produce the best cash flow don’t always have the best appreciation.  However, they also tend to be less volatile since the price tends to be more highly correlated with the rate of cash generation than the market expectations for future price increases.
• The way that most investors articulate the future cash flow of an investment is through its yield.  In simple terms, the yield of an investment represents its annual cash flow divided by the price paid for the asset.  In the case of stocks, the “dividend yield” is the annual dividends divided by the current market price.  In the case of rental real estate, the “capitalization rate” is calculated by dividing the annual net operating income of the property by the purchase price.  In the case of bonds, the discounted future value of all payments is compressed into an internal rate of return, which is articulated as the bond yield.
• In most cases, the rate of cash generation for an investment is much less volatile than the market price of that investment.  Stocks that pay dividends tend to adjust their dividend rate at a much slower rate than the market value gyrations of its price.  Rents from income properties tend to shift much more slowly than the value of the property.  Bonds typically feature a fixed interest and repayment price, with their market value being determined by the movement in yield rates for similar instruments.  When market yields increase, the price of bonds currently on the market go down.  When market yields decrease, the price of bonds currently on the market go up.

Taxes and Inflation

• The final key characteristic that differentiates good vs. bad investments is inflation and taxes.  Inflation represents the erosion of you investment’s purchasing power and taxes represent the amount of your gains that need to be paid to the government.  One of the oldest and most important concepts in finance is that “It’s not what you make, it’s what you keep” … fundamentally, this means that the “real” rate of return for your investments is much more important than the “nominal” performance.
• Starting with inflation, it is important to understand that when the amount of money in circulation expands more quickly than the amount of goods and services being traded, it creates upward pressure on prices.  For some asset classes, the effect of inflation is relatively benign, for others it is beneficial, and for some it is devastating.  By and large, property values tend to be lifted in proportion with inflation, while cash flows from dividends and rents are also increased by inflation.  Some stocks move up with inflation, but certainly not all.  On the other hand, bonds with a fixed interest rate are destroyed by inflation since it de-values the interest payments.  Conversely, fixed-rate debt that you owe is wiped away by inflation as the dollars you use to re-pay the loan become less valuable.
• Another key characteristic to understand is taxes.  Different types of income are subject to different rates of taxation.  Generally speaking, income that is earned from a job encounters the most taxes.  Income that is earned passively encounters less taxes, and income earned from capital investment encounters the least taxes.  Astute investors also understand the impact of legitimate business deductions, non-cash expenses such as depreciation, and deferring capital gains through a 1031 exchange to reduce their tax burden down to the legal minimum.  In many cases, it is tax advantages that turn a good investment into a great investment.

Ultimately, it is the responsibility of each person to determine what constitutes a superior investment deal.  Since people have different appetites for risk, there will always be a variety of investors bidding for a variety of assets.  What is most important for the individual investor to do is take an honest assessment of their personal investment tolerance and make decisions that incorporate all of the major value factors.  By balancing the future price, future cash flow, inflation risk, and tax characteristics, it will allow you to build a strong portfolio of optimized deals.

 

One of the trends that many people experience in the world of investing is a noted tendency to become ‘gun shy’ when they experience volatility in their investments.  The reason for this is because our psychological makeup is much more afraid of loss than joyful over gains.  This leads many people to either become irrationally risk averse, or to take risks that they are not aware of in a desire to achieve safety.  The problem this creates is that fear of loss can make people blind to the opportunity for gain.

Volatile stock markets are hard to weather out.  Watching your house lose value triggers an impulse to run for safety.  However, safety is an illusion.  Just because the value of something doesn’t fluctuate very much doesn’t mean that it’s safe.  The price that is typically paid for value stability is low rates of return.  These low rates of return can significantly impede your ability to grow long-term wealth.  Acting to avoid losses frequently involves the same actions that avoid gains.  Thus, in attempting to protect your financial future, you may be inadvertently handicapping your financial futures.

You Lose What You Do Not Make

One of the consistent ideas in finance and economics is the notion that you gain what you do not lose, and you lose what you do not make.  Most people are very familiar with the notion of avoided losses, but blind to the idea of lost gains.  The reason for this is because the lost gains are largely invisible.  We are unaware of them because we did not see them.  In this way, many people have allowed themselves to take risks that they didn’t even know are present.  The most insidious of these is the risk of inflation.  Future price increases will erode the purchasing power of dollars that you own.  If your investment capital does not grow at a sufficient rate, it may be worth less (in real terms) when you retire than it is now.

This can be particularly damaging since it is unlikely that the government will be able to finance its entitlement obligations without significantly inflating the currency and eroding the purchasing power of people’s savings, investments, interest income, and annuity payments.  It is likely that most people will need a substantial amount of investment income in addition to whatever is provided by the government in order to avoid a significant decrease in their standard of living during retirement.  In most cases, this can only be accomplished by taking on the risk of losses that accompany exceptional investment opportunities.

Over-Reaction to Recent Trends

In general, people tend to over-emphasize events that have happened recently.  In the current environment, this has led to excessive pessimism about investing.  One example of this phenomenon in practice is a general tendency for people to view the recent real estate collapse in multiple markets across the country as a harbinger of risk with real estate investment.  While this risk looms large in the minds of potential investors, it is accompanied by the opportunity for tremendous gains if investors possess the insight and intelligence to act.  Prices have been significantly depressed in some areas (pushed below the cost of construction in a number of cases), and can present the potential for amazing rates of return.

The opposite side of this phenomenon was the stock market bubble of the late 1990′s and the real estate bubble of the mid 2000′s.  In both cases, people grew to believe that values would constantly go up, and that they could never come down.  A similar sentiment is now being expressed about the price of gold.  In all of these cases, the values do not go up indefinitely.  The same frenzy behavior that drives them up subsequently drives them back down when new buyers disappear, and people rush to cash out before the price crashes.

Fundamentals are Key

The bottom-line for any era of investing is to focus on fundamentals.  The long-term success of any investment strategy is solely dependent on its underlying fundamental value.  Speculation can drive the price above or below its fundamental value for a while, but it cannot keep it there permanently.  All values eventually regress toward their equilibrium value.  Astute investors target investments with an equilibrium value that is likely to grow so that they are not captive to market cycles.  Buying at the “bottom” of a market correction is much harder to do in real life than in hindsight.  It is much better to target exceptional fundamental value and invest for long-term gains.

It can be very difficult to overcome the fear of incurring losses and undertake compelling investment opportunities.  Doing so requires that one muster the courage to act against the grain of popular sentiment.  It can be surprisingly difficult to do, since there is comfort in following the crowd.  However, comfort and profit rarely come at the same time.  If you are seeking profits, it will probably require a departure from your comfort zone, and if you ware seeking comfort, it will probably mean the forfeiture of profitable opportunities.

In the end, each person must find the investment strategy that suits them best.  Some are more comfortable with risk than others, and some are more comfortable with active investment than others.  Regardless of your comfort level, it is important to understand that some risks will always be inherent in capturing gains.  Similarly, risk is inherent in avoiding losses.  All decisions that we make involve some kind of risk.  It is our responsibility to make sure that we are aware of the risks we are taking in the pursuit of gains.  It may well be that these risks are much less dire than the consequences of playing it safe.