Monday, June 29, 2009

Why Investors Do What They Do: Herding

It is okay to look at the winners and losers, for mutual funds they are posted quarterly while stocks are posted daily. It is also okay to want to align yourself with the winners while foregoing the losers. It is only called herding when the winners see a large influx of new investors because of past performance, an indicator that is usually disclaimed as not indicative of future results. But the actual act of buying into any investment with the hope that the current top is not actually a top but a lower rung on an ever-rising ladder.

The cautionary warnings about just such a strategy often fall on deaf ears. Few folks have the patience to wait out an investment that has performed well in the hope that if they shift their investment to a high-flying fund, they will do even better. There are several things to consider before doing this and lessons to be learned if you have ever done something like this.

First off, funds that maintain a steady amount of growth usually take all of the cost factors into consideration. Among those factors, turnover stands out. Many high flying funds that find themselves on the top ten lists, at least in the short-term, usually have very high turnover - which means, higher than average trading costs, a new manager that has shifted priorities or simply a manager rearranging where they are as the quarter or year ended. Turnover incurs trading costs that are directly passed down to the shareholder. Sometimes, they even create a taxable event if the fund has sold numerous winners from the portfolio to reposition the fund for another round of winning.

Those steady growth funds are often referred to as value funds. Value funds tend to look for undervalued, better performing companies. Growth funds, which dominate the marketplace, tend to look for companies that have more potential than proof of success. This leads to a higher underlying risk and increased turnover risk. While they may actually grow in value, these types of funds often undercut those profit numbers with higher than average fees.

Secondly, mutual fund investors often fail to consider the size of the fund or the size of the companies that the fund invests in. While there are thousands of companies to chose from, the majority of these companies are actually much smaller, more volatile because of their size and although they offer growth, they seldom have the long-term track record to prove investment-worthy.

And lastly, investors who herd seldom take into account the geographic area of those underlying investments. While the world faces the same economic challenges, the recovery will vary from one region to the next. Some parts of the global economy may recover more quickly (such as emerging markets) while more industrialized nations such as the US will take longer to embrace the economy recovery.

In Emilio Barucci's book "Financial Markets Theory" he describes herding as an "effect [that] arises because other decision makers may have information important for the decision maker". He points out that "fund managers care for their performance because their compensation, their career and the probability of being chosen in the future by investors depend on their performance relative to an exogenous benchmark or to the performance of other fund managers." He notes that the presences of these features, while not saying competition is bad, results in investor herding.

It should also be noted (and this comes as a warning as well) that herding is most prevalent after a crisis. But herding is usually based on a weaker set of reporting requirements, opaque regulations, somewhat lower accounting standards, reputation and most importantly, potential. Alan Lewis wrote in his 2008 book "The Cambridge Handbook of Psychology and Economic Behaviour that there is absence of knowledge on the subject when it comes to long-term results or opportunity suggesting that there are "deeper, structural underpinnings of investor behaviour [sic], including their investment beliefs and the way investors justify their behaviours to others."

Next up: Regret

Thursday, June 25, 2009

Why Investors Do What They Do: Diversification

In his classic book "Portfolio Selection" co-Nobel prize winner Harry Markowitz describes his topic as something other than securities selection. He suggests that a "good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies."

Diversification often involves numerous human emotions and misuse of it is often the result of some of the topics we have already discussed (loss aversion, narrow framing, anchoring and mental accounting with herding, regret, the impact of the media and optimism all as yet discussed). But diversification is a way to avoid being wrong. It is a way to avoid regret. And when you are wrong, you tend to be really wrong.

These feelings of "wrong-ness" are often the result of events beyond our control. Non-economic influences can derail the best efforts of an investor along with weather, military actions, even the health of the President. As Markowitz suggests: "Uncertainty is a salient feature of security investing".

In order to avoid too many economically obscure references to diversity we will boil the discussion down to two theories: the expected utility theory and the case-based decision theory. The first theory suggests that if the investor is indifferent to an investment, in other words they are so similar that she/he doesn't care either way, that this actually becomes a form of risk aversion and hardly ever produces good long-term satisfaction with those choices.

In the instance of Case-based decision theory, Mohammed Abdellaoui offers the following from his book "Uncertainty and Risk": "it is assumed the decision-maker can only learn from experience, by evaluating as act based on its past performance and on the performance of acts similar to it." This leads to chance decisions.

But what is often overlooked is that not only do you decrease your chances of being wrong, you by default increase your chances of being right. Diversification will spread the risk and as a result of that, may allow you to miss the next hot stock or mutual fund. Because it is impossible to pick the future based on the past - recall the reminder that past performance might not play a role in future results - diversification makes the chances of getting some of the hot property but not all of it.

Consider this simple question: if Rome is located between 41°54' North Latitude, which American city lies at a similar latitude - Boston, Atlanta or Miami? Most folks when asked this question go with either Miami or Atlanta and do so with more than reasonable assurance that they are correct. But Boston, with 42° 21' 29" N is actually the closest by comparison.

Unfortunately, as Robert Hagin author of "Investment Management" points out that people when people make investment mistakes - something that can afflict both professionals and non-professionals, they fail the old adage of "a problem is not what up don't know; it is what you do know."

The most difficult part of investing is removing guesswork and the wishful thinking you may have for the act. Not easy by any means. But much easier if you don't overthink the act of spreading your risk.

Next up: Herding

Tuesday, June 23, 2009

Why Investors Do What They Do: Mental Accounting

Many of us can rattle off the balance in our set-aside accounts, the small stashes of money we allot for some special purpose. These accounts, whether they be for a down payment on a house or a vacation have been designated for something and when you mentally account for this money, you put a barrier around your access to it.

These are essentially illiquid accounts - at least in your mind. This type of thinking and the ability to strictly categorize is a special talent that many of us have and some of us need to work on. If you are able to keep even so much as a general budget of your household, you are probably using this kind of separation technique to make sure ends meet and the other accounts you have set-aside do not become victims of a small loan.

Retirement accounts, even those with restrictions on how you may access the principal amount you have contributed (penalties for early withdrawal, tax consequences) are good examples of this kind of behavior. Setting aside money to grow and adding to it on a regular basis is mental accounting. These kinds of accounts are often of the traditional 401(k) and IRA variety. It should be noted that one of the major selling points of the Roth IRA and Roth 401(k) is the access you have to your principal.

Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past. This is a cost trade-off that you make using this type of accounting error. Another example might be a bond fund that entices investors with a high yield but the underlying investment is losing capital.

(This last example is why there may be a flaw in the thinking that we overload a portfolio with dividend paying investments at the end of our careers. Once we begin drawing down the underlying investments, the dividends will also fall and this will lead to a quicker drain on the account.)

Much of this has to do with our love affair with our investment picks. Only the most hardened among us can engage in the cold-calculations that stock pickers really employ. Listen for the insincerity when a talking head on television begins a conversation about an investment with "we really like this stock...". That is, until something changes.

Mental accountants ignore these warning calls and often miss selling winners when they are winners and even worse, selling losers when they are losers. This throws the whole diversification within a portfolio out of whack. While we are still working, it pays to focus how we bracket our investments. Keep in mind that studies have proven beyond a doubt, bets on long shots increase as the last race approaches.

If you find evidence that an investment has changed, and some suggest that loss aversion plays a role in this type of mental reasoning, you need to reposition your portfolio. This is not as hard as it seems nor does it require as much time as you might think.

It does however require you open your statements when they come each quarter or look at them online once a month. Set-up a Google alert for each underlying investment (a good retirement account should have no more than eight mutual funds and as little stock as possible) or build a sample portfolio at anyone of the sites that provide the free service. At the first hint of doubt, investigate and make a decision on what you should do with the whole of the portfolio as the benchmark, not the performance of the individual holding.

Next up: Diversification

Friday, June 19, 2009

Why Investors Do What They Do: Anchoring

So far, we have discussed loss aversion and narrow framing, trouble spots in any investors view of what they are trying to do. They may be investing in their retirement plan or simply making an economic (better yet, one with financial implications) decisions, but we often, as studies have shown, begin from some point of what we know. This is referred to as anchoring.

Unfortunately, anchoring is a bias. It is often included among other similar cognitive biases such as memory bias (which effects how we recall a situation after the fact) and confirmation bias (depends largely of what you already know and uses this information to skew your perception of what really is). Each alters what we see with something we already know and this drives businesses, who want to anticipate what you will do and more importantly, what you will buy and confounds psychologists, who have twisted the lab questions done on test subjects in every conceivable way only to find out that we have numerous cognitive influences mucking up the works.

But anchoring is particularly dangerous when it comes to investor reaction. An anchor is basically an expectation. We are not the kind of shoppers who go into a store, find a good and before we flip the price tag, try and determine what we will pay for it. But it is a good experiment that you can conduct on yourself. Time after time, you will find your expectations of the cost of the good, be it a television or a dress will be altered by what you perceive.

You will try and narrow down your choices to one that seems to be what you think something is worth. But that narrowing of thought, trying to get closer to the price tag (and feeling very smug if your bias towards the cost is exactly what the cost is) will not work across a broad spectrum of goods. In lab tests, subjects merely get "a good" and know little about what it is. But as soon as the item is revealed, adjustments are automatically made.

We generally have no real anchor when we begin investing except for the money we begin the process with. This becomes the anchor if you have nothing in the account. But in a upwardly moving market, an investor can quickly get swept up in a constantly readjusting balance. Once money is made, a new anchor is created in your view of that portfolio.

Investing however is never quite that simple. While we all enjoy growth, we tend to lose focus on the fickleness of the markets and the underlying worth of whatever it is we are buying. If a stock or a mutual fund has had a great run of it, even topping the top ten lists, investors will not see this as the top but the new value on which to anchor their expectations.

Consider what cognitive abilities (or biases) you may have used or borrowed from someone else. You watch the business news channels hoping for a tidbit of relevant information about which security you would like to buy. You peruse the web looking for confirmation of what you would like to believe is true. But what you are really doing is looking for an anchor using someone else's anchor to support your decision.

If analysts make forecasts or predictions based on past performance and then offer the disclaimer that future results are not guaranteed. They have used past results to anchor their bias as to whether things look rosy or the future is bleak for the stock.

Anchoring is tougher on a retirement account largely due to the set and go approach that most investors use in these types of accounts. Unless severe market downturns capture our attention in the news, we tend to leave these accounts to their own devices, channeling a portion of our earnings into them each week.

But when we do look at those quarterly statements, and many of us have for the first time in a while, we have an idea of where we should be. And it will be much higher than is probably reported. That's because we aren't so good at making predictions or estimates.

Look at it this way. Suppose you invested a thousand dollars in an IRA account and added $100 a week to that account. Over the course of 25 years you would have put $114,429 (adjusted for inflation at 3% on the real value of $131,000 actually contributed) in the account. If the money grew over that period at a modest 5%, which for that stretch of time is below average even with last year calculated into the mix, you would have added almost $135,000 in earnings (also adjusted for inflation).

Now suppose your portfolio balance of $249,402 dropped 30% or $74,802. Wouldn't you still be in the black? With an inflation adjusted contribution of $114k, haven't you protected your money and even grew it by $40k. Because you constantly shift your anchor or readjust your estimates higher, your expectations follow.

This is due in large part to a small target. Your balance may have grown substantially since you began investing but what occurred caused you to miss the target. I am not a shooter but I know that when a person does aim and fire, they are often narrowly focused on the target when in fact we should be making broad sight adjustments.

Next up: Mental Accounting

Friday, June 12, 2009

Why Investors Do What They Do: Narrow Framing

In our previous discussion about loss aversion, we looked at what was the beginning of Kahneman's prospect theory. Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk. More importantly, a discussion about regret.

When you (or as you are often referred to when being discussed by economic types, an agent) moves into the stock market, be it through individual ownership or through mutual funds, you are changing your wealth allocation. Obviously, the easiest measure of wealth is more tangible elements such as what you get paid (human capital) which also includes what you may have saved (not invested) and the worth of your real assets, such as your home. Once you commit a certain portion of either of those two assets to the investment of your choice, you begin to open the door to regret.

This regret is the result of accessibility and the misuse of the different decision rule. Accessibility is what it is: information that is readily available almost instantaneously through any number of mediums and the ability to enter into the market without restrictions. The different decision rule is described in Walter L. Wallace's book "Principles of Scientific Sociology": [the agent]"chooses whichever means optimizes the end in question". This thinking is looking for what could be crudely referred to as the most bang for the buck. Freud called this the pleasure principle.

Narrow framing demands a high equity return both now and in the future. Does this take into account market shifts, both up and down? Not really nor is a realistic approach in the long-term. But loss aversion and narrow framing are not separate thinking.

One of the most famous examples was described by Paul Samuelson, a noted economist, Nobel Prize winner and the person who bridged theoretical and applied economics. When he offered to flip a coin, the prize being $200 if the flip went his colleagues way of loss $100 if the flip went Samuelson's direction, the colleague declined on both accounts. This is loss aversion. When the perception that the loss is greater than the possibility of winning, the investor tends to freeze.

The different decision rule is often described as a way to optimize the end so as not compromise or to incur the minimum amount of cost. Luigi Guiso of the Einaudi Institute for Economics and Finance Via Due Macelli in Rome tested narrow framing using the lottery question, much like Samuelson's coin flip. What he discovered was that if you allow the subject of the test to have time to think about their personal economic and financial situation before you asked them whether they would like to win twice as much as they might lose, they were more apt to attempt to try the game of chance. He wrote: "attitudes towards regret and reliance on intuition rather than reasoning are likely to drive the tendency to frame choices narrowly."

In their book "The Routines of Decision Making" By Tilmann Betsch and Susanne Haberstroh, the authors suggest that the more routine a decision is - such as investing for retirement - the more likely a person was to resist forecasting. In other words, even if the recent economic downturn had been forecasted, and in some instances it was, the person who might be most at risk of losing value in their 401(k) because of out-sized risk or an overabundant share of their portfolio in their company's stock, might have ignored what was obviously a warning. The markets had routinely ascended along with the value of the portfolio and they had seen this as a reoccurring event that probably would not end in the foreseeable future.

This problem is best manifested in the doctor's office. Your physician gives you news about your health that you are skeptical about or might be life-altering depending on your decision. How do you decide how many second or third opinions you garner to help you decide? Suppose those decisions don't jive with how you are feeling?

Next up: Anchoring

Thursday, June 11, 2009

Why Investors Do What They Do

A recent report done by Dalbar, inc. of Boston suggests that investors often do things that hurt what they are attempting to do in numerous ways. Using information aggregated from the Investment Company Institute (, a company that tracks and support the mutual fund industry), The Standard and Poors Company (the standard bearer of indexes) and Barclays (which publishes an index of bonds), the company has found that there are numerous influences, both external and internal, that have an effect on how well a portfolio of mutual funds (or stocks for that matter) perform over the short-term and long-term.

They identify nine areas where investors thought they were right, when they were in fact, ignoring signals that the approach they were taking may have led to, even exacerbated losses rather than gains. The report cites these facts from the study to support these claims:

* For the 20 years ended December 31, 2008, equity, fixed income and asset allocation fund investors had average annual returns of 1.87%, 0.77% and 1.67%, respectively. The inflation rate averaged 2.89% over that same time period.
* Equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500 Index.
* Bond fund investors lost 11.7% last year, versus a gain of 5.2% for the Barclays Aggregate Bond Index. This disparity is largely due to the underperformance of managed bond funds caused by mortgage-backed securities.
* With an annual loss of 30% last year, asset allocation fund investors fared better than equity fund investors.

The first of these nine areas, which we will examine over the next nine posts, deals with loss aversion. Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made.

While risk and uncertainty have their place in the investment world, how people react under those conditions was the subject of a paper done by noted psychologists Kahneman and Tversky titled the Prospect Theory. They realized that "since loses loom larger than gains, it appears that humans follow conservative strategies when presented with a positively framed dilemma, and risky strategies when presented with negatively-framed ones." They also noted that numerous influences enter into the equation including normal behavior, habits the investor might already have and the personal characteristics of the decision maker.

How you frame the argument (in an investor's mind), even if it is the same problem, directly affects how the investor reacts. Frame it negatively, and the reaction often leads to risk taking; frame it positively and the investor will chose a risk averse solution.

The battle between what "would happen" if a decision is reached is often overshadowed by the repeated decision making based on what has already occurred. Economists refer to this as a continuous process suggesting that an investor might become overconfident and that generates irrationality.

Martin J. Pring once said, "For most of us, the task of beating the market is not difficult, it is the job of beating ourselves that proves to be overwhelming." According to a Stanford University Business School paper published in July of 2006, "the principle of loss aversion is not derived from any theory of behavior or more basic psychological principles, but is an ad hoc principle introduced to account for a range of phenomena involving tradeoffs between losses and gains." In other words, most investors seek the status quo.

And to change the status quo, investors need a motive. What happens if those motives are fuzzy or ill-defined? The paper, written by David Gal cited an experiment done by Kivetz and Simonson which "offered diners a reward program in which they could receive a free meal at a dining hall after having paid for a certain number of meals. In a between subject design, they found that sushi lovers would actually prefer a reward program which required the purchase of 10 sandwiches and 10 sushi platters to a program which required only the purchase of the 10 sandwiches. Although the former option was dominated by the latter, sushi lovers perceived a relative advantage in that they would likely have eaten the sushi anyway. Based on this relative advantage, sushi lovers inferred that they were getting a "bargain" in an absolute sense."

When information is fuzzy though, it is difficult to determine what the status quo actually is. If you were offered a 50% chance of losing $100 or a 50% chance of winning a $100, the trade-off might seem relatively straightforward. The better bet is to not take the bet at all. What is needed although is a clear preference of what the status quo is.

Loss Aversion does exist but it is difficult to define and hard to expect. Studies have shown that historical data (past performance indicators) often lead us to make these decisions and yet, that same historical data may have little to do with what we may gain, or lose.

Next up: Narrow Framing of Investment Decisions

Tuesday, June 9, 2009

Retiring with a Plan: Is the Roth 401(k) Conversion Worth Trying?

In 2010, you will be allowed to convert not only your current 401(k) plan but your IRAs and any 401(k) plan you might have rolled over into an IRA. The question: is rolling your retirement money into a Roth 410(k)the right move to make?

As with all financial decisions, this takes a little bit of planning and consideration. The conversion will cost you money, mostly in tax dollars paid because your 401(k) plan, IRA or rollover action, saved you from paying on taxes that a Roth 401(k) will require you to pay.

Traditional plans defer those taxes. But once you opt for the Roth 401(k) or even a Roth IRA, the taxes on the transferred amount will need to be paid. This is because the money invested in a Roth is done after taxes. The first consideration is whether you will be able to pay those taxes.

A Window Of Opportunity
You do have a window of opportunity though. Taxes due on these types of conversions in 2010 are payable in 2011 and you have two years to pay them. Estimate the taxes on what you have in these accounts based on your ordinary income tax rate. There are no penalties other than this in the conversion. But depending on the size of your account balance, you will need to set aside this amount starting before you make the conversion.

The simplest way to do this is to set aside the money in a separate account - preferably away from your emergency account. (An emergency account is savings set aside for emergencies and if you can have a minimum of three months set aside, you are well ahead of what you neighbor probably has.) On the other hand, this money should not be invested either. This is cash for taxes and has no risk potential. Some of you might be tempted to put it in a taxable indexed mutual fund to get some work out of the cash, but this would not necessarily be the wisest choice.

This is also an opportunity best used for those who are above the current $100,000 a year income threshold. These folks have been unable to save more for their retirement because of this ceiling. Expect this group to do this in droves - if they are smart. For the rest of us, the transition may not be worth it.

Many of us are underinvested as it is. We cannot accurately see what the future tax rate will be on these invested dollars yet we can be assured that we will not have the same tax rate as we do know. If studies are correct, most of us will be in a far lower tax bracket, lower than most of assumed we would be in come retirement.

Keep in mind that if you do exceed the AGI (adjusted gross income) of $100,000 the conversion doesn't necessarily mean that you will be able to contribute more. There is way around this. If you were to make nondeductible contributions to a Traditional IRA and roll them into a Roth IRA in 2010, but only the contributions, not the investment gains, that part of the rollover is not taxable. The gains on those "nondeductible" contributions would however be taxed.

Ultimately a Tax Issue
Phase-outs are linear, meaning what you make determines the level of contribution. Because this is a tax issue and you should always consider speaking with a tax professional first, the following is just a guide to see where you fall in terms of income, phase-outs and contribution levels.

If you are a Single filer, your Roth contribution limit is reduced when your modified AGI or adjusted gross income exceeds $101,000.00, It is eliminated completely when it reaches $116.000.00

A person wishing to determine their contribution status if they are Married Filing Jointly will find their limit is reduced when their modified AGI exceeds $159,000.00 and is eliminated completely when it reaches $169,000.00. When it falls in between those amounts, the linear contribution phases in. For instance, if you were half way between, your contribution would be reduced by 50%.

Another tax filing status might affect your contribution levels differently. A person Married but Filing Separately, (and) Living Apart would find their Roth contribution limit is reduced when the AGI income exceeds $101,000.00. It would be eliminated completely when your modified adjusted gross income reaches $116,000.00

Those choosing the Married Filing Separately, or Other has a limit as well. These folks will find their contribution is reduced when their modified AGI exceeds $0 and is eliminated completely when your modified adjusted gross income reaches $10,000.00.

Once it exceeds those limits, you will not be allowed to contribute.

But as with all financial investments, they are not static. They may in fact be worth less. Because of that, you may want to look into a IRA Recharacterization.

Sunday, June 7, 2009

Retiring on Time: The 401(k) Accumulation Problem

There have been numerous reports over the years that we have a problem with self-direct retirement plans such as the 401(k). These reports suggest that we are not taking full advantage of the process and worse, we underestimate how much of what we may have accumulated in these 401(k) plans will be available as a percentage of our retirement income. In other words, we simply have not used the plans the way they were intended and we haven't invested enough.

Everyone who has a 401(k) has heard this before: invest at least what your company matches. The company match is the best way a business can help their employee invest in the future. There is no obligation to do this, just as there was no obligation (unless contracted through a labor organization) to fund a pension. As pensions disappeared and 401(k)s stepped in to replace these defined benefit plans, companies began helping employees direct their savings by offering a matching contribution of up to, and sometimes more than 3%. That meant, in order to get the full company match (the free money the business was going to deposit into your account) you needed to put at least 3% of your pre-tax income away.

For most folks, 3% is not even missed. In fact, many people could contribute up to 5% without changing their take home pay. Because the contribution to the plan is done before taxes are taken out, the after-tax take home is almost identical to what it would be had you had 5% taken out before taxes.

So why are so many of these plans not only underfunded but under-invested? I believe that there are two reasons, neither of which has been fully addressed. One is the fact that company stock is, for the most part, what is offered by the matching contribution, not the funds in available for investment. Far too many companies saw their generosity as simply creating a larger shareholder base. These "shareholders could not sell the stock and because of that, were forced to hold what they may have wanted to sell or redirect into other more lucrative investments in the plan's portfolio of offerings. Eliminating this practice may have saved hundreds of millions of retirement dollars. Two is the lack of understanding about that pre-tax math benefit I just mentioned.

According to a recent report from Boston College, which opens with the caveat that what is being reported may no longer apply in light of the economic downturn, suggesting that it might be worse rather than better, they found "In theory, a typical worker who ends up at retirement with earnings of about $50,000 and who contributed 6 percent steadily with an employer match of 3 percent should have about $320,000." That $320,000 potential account balance was, for the sake of the study considered simulated. Why? Because the report continues with this fact: "actual holdings of $78,000 for those 55-64 are dramatically lower than those simulated for the hypothetical worker." (As low as $54,000 on average.)

Add a thirty percent loss due to the market downturn, the possibility that job loss or other financial hardship forced some folks to tap those accounts for day-to-day needs, and the chance that like so many folks I have spoken with recently, switched all of their holdings to a target-dated type of mutual fund (one that picks a retirement year and readjusts portfolio holdings from risky but only mildly so to conservative as they age and near the target date) and you have a real problem on the horizon.

Generosity Wains
With six million people out of work and more yet, disparaged, business realize that this benefit (along with insurance in many instances) is not worth maintaining. Losing this match is not the end-all for this type of plan. Although it does make it more difficult to grow without the free money.

Not impossible but somewhat harder. More companies than ever are suspending the matches until they see some sort of economic change. Some have reduced the dollar for dollar basis to half of that amount, contributing fifty cents for every dollar contributed. Some have explained that halting the company match is better than cutting the workforce by 3%.

While it is difficult to determine whether this employer generosity will ever resume to the pace it was on prior to 2008, some things have not changed. The employee who still had a job was not likely to change their contribution rate based on the news. And less than half of those eligible for these plans, used them. The good news: the last time we had a similar downturn (2001), the suspension of company matches was only temporary.

Match or no match, you must keep putting money into these accounts.

Match or no match, you should, if possible increase your contribution.

Match or no match
, you should not withdraw any of these funds no matter how bad things get.

Match or no match, the report concludes that: "The time may have come to consider returning 401(k) plans to their original position as a third tier on top of Social Security and employer-sponsored pensions."

Thursday, June 4, 2009

Trash Talking Mutual Funds

As I drift around the web, I inevitably end up on some other blogger's site as they talk about investing, mutual funds or retirement. While everyone is guaranteed an opinion online, these missives may be as balanced as a morning spent watching Fox News.

And sometimes, I leave a comment of my own. Today, was one of those days.

Dr. Scott Brown, Ph.D., a.k.a. The Wallet Doctor, is a successful futures trader, real estate investor, and stock investor. Dr. Brown who hold a Ph.D. in finance from the University of South Carolina wrote: "These funds are also sold and managed on pure hype, short term trading, and with key information withheld from the public."

He continues after explaining briefly the history of how mutual funds grew, leaving out key tax code changes that created the 401(k) and the IRA during the time frame in question. He adds: "Many mutual funds are able to cheat the public with excessive fees because investors don't understand how these big costs destroy their profit. Mutual funds have no interest in educating investors because it is easier to hoodwink the ignorant!

"Don't put your trust in mutual funds unless they are fully indexed." And even though Mr. Brown suggest that he knows what the SEC really thinks about funds, he never does tell us what they are doing to regulate the industry.

So I asked Dr. Brown: "Tell me I am wrong":

Indexed mutual funds are too tax efficient to be locked inside a retirement account such as a 401(k).

While the low costs (fees) are always attractive and can lead to more profits, all index funds are not created equal nor do they charge the same fees. Some make up for their low fee structure by charging the individual investor $3,000 or more to make an initial contribution - far more than anyone would suggest the average investor plunk down at any one time.

Mr. Levitt did have a great deal of trouble back in 1993 (he referred to the former SEC chairman's divesting of common stock into mutual funds and some of the difficulty he had with transparency). But the industry has come a long way since and while it has further to go, the journey is at least headed in the right direction.

Actively managed mutual funds are far better for the average investor than buying individual stocks for three reasons: they can offer diversity and research; they can offer the ability to purchase new shares without charging each time you do, and they take they mental maniac out of the investor experience - the one that wants to sell on the way down, buy on the way up and mostly fails at determining their own risk tolerance.

Yes, far too many funds chase the same stocks. But it is the ETF that causes the wildest, end-of-the-day trading and market gyrations - not mutual funds.

Most folks equate the failure of 401(k) retirement accounts on mutual funds when in fact, more folks were invested in their own company stock, often upwards of 50% of the portfolio and often because this was the only way to get the company to match.

The creation of so many mutual funds is a result of the mimic effect. Those 500 funds that were in existence in 1980, that grew to over 8,000 by 2003 were the result of marketplace diversification. They sliced and diced the markets down into ever increasingly specific areas. Yet you fail to mention the same sort of slice and dice market done by the ETF markets.

Now that the SEC is back in the hands of an administration that cares, I expect their job will be much more focused and far less scattered than it was over the last eight years.

Mutual funds, while not perfect are much better than they were and are improving all of the time.

Monday, June 1, 2009

SIMPLEs and UNI-DBs for Small Businesses

When the tax laws were written for small businesses, they were often much more generous. For instance, an employer with only him/herself as an employee can save enormous amounts of money for their retirement - far more than the employee or business owner at a much larger company.

Today we discuss the SIMPLE IRA and the Solo or Uni Defined Benefit Plan for small business in the last of our three part series.

The SIMPLE IRA, named because those letter stand for savings incentive match plans for employees, are a much cheaper and far less complicated way for small employers to establish and administer than a traditional 401(k).

This type of plan is indeed easier to manage and implement but there are a few rules you need to keep in mind before choosing a SIMPLE IRA plan for you and your employees. You are required to make a contribution for every worker who receives $5,000 or more in compensation. It doesn't have to be a lot but it has to be something up to but not exceeding $11,800 for the calendar year 2009.

The contributions may resemble an employer match, just like those used when larger companies match employee contributions to their defined contribution plans (401(k)) But the employee must first elect to contribute to the plan themselves and your match to their contribution can not exceed 3% of their salary.

Employers may also choose to make the contribution on the employees behalf, contributing up to 2% of each worker's wages, whether the worker contributes to the plan or not. This "non-elective" mandatory company match of 2% is required to be made on behalf of every employee.

Aside from the fact that the plan cost less to administer, the strings that tether the SIMPLE IRA might not be right for you or your company.

SIMPLEs have a built-in special tax penalty of 15% that is added to the 10% early withdrawal penalty for SIMPLE IRA withdrawals made within the first two years of opening a SIMPLE plan. Although your retirement plan should not be considered a source of income, this penalty can make it more difficult to access that money in times of dire emergency. (But please, consider every other option first before withdrawing built up investments in these plans.)

Because of that string, a SIMPLE IRA can be much less flexible than a 401(k) plan for the average small business. Keep in mind the following while considering this type of plan. Will you be the only employee? If so, a Solo 401(k) might be best. If you are planning to grow your business slowly, adding employees on as needed, you should consider that contribution requirement. An employer must make contributions for all eligible employees and while they are doing so, no contributions can be made to other qualified retirement plans.

The contributions you make to the employees plan belong to the employee immediately after they are posted. This immediate vesting can be troublesome for some seasonal type of employers who do not expect to retain employees or demand their loyalty for a long period of time.

Should you as an employer decide to end the plan, you must wait until the calendar year is completed and while you are waiting, you are obligated to continue with payments to the employee's plan. And here is something else you should consider: no loans are allowed.

If you however fit this profile: older than 50 and earning more than $120,000 per year, have no more that four employees, been in business for at least three or more years and are willing to make mandatory contributions to the plan for three consecutive years of $45,000 or more, there is possibly no better plan on the planet better than this one.

But these plans can be quite a bit more complicated and require you have help with the legalities. But you will find it well worth it especially if you are earing or expect to earn those sums now and in the near future.

KEOGH plans were put to the wayside with the creation of SIMPLEs. If you still have a KEOGH plan in place, the paper work to rollover the plan is relatively straightforward but still must be done by a plan professional. But I believe that if you do rollover a KEOGH, you, your employees and your retirement future will much better off for the effort.

FEATURE Solo or Self Employed 401K Solo-DB SEP-IRA
Eligibility One person only. (Multiple owners and spouses allowed, but no other employees) Business owner and up to 4 employees

No limit on number of employees.

(most organizations

prefer the

401K )

Key Features

Low Cost

($0 to $25/yr)

Contributions to plan are discretionary.

IRS form 5500-EZ filing required for balances over $250,000

Roth 401k feature

Annual Fees

(about $1600/yr +)

Offers the largest tax-

deductible retirement

contribution permitted

by law


contributions for at

least 5 years

Very Low cost

(about $15/yr)

Contributions to plan are discretionary.

contributions are

made for one

employee they must

be made by the

employer for all

eligible employees

Loans Loans are allowed Loans are allowed No Loans
Contribution Limits * See Self Employed Owner Only Calculator or Contribution limits for max contribution limits.
Deadline to open plan December 31 or End of company’s fiscal year
December 31 or End of company’s fiscal year Up to time of tax filing
Deadline to contribute to plan


contributions must be

made by the

employer's tax filing

deadline plus



contributions must be

made by the

employer's tax filing

deadline plus

Before the employer's

tax filing deadline

plus extensions