Emotions: Are they costing you in your investments?

By Ara Oghoorian, CFA

Have you ever bought an investment, only to see it slowly decline in value? Or do you currently own an asset worth half the price you paid for it? If you answered yes to either of these questions, don't worry, you're not alone. You see, our personal experiences, emotions, and attitudes impact our investment decisions much more than we realize. Our unwillingness to sell that losing stock is not because of flawed investment analysis, but rather as human beings, we have a difficult time separating our emotions from personal investment decisions. This is something economists call behavioral finance.

Sit in on almost any finance class, and you will surely learn about traditional finance theory. Traditional finance theory assumes that investors approach their investments in 3 ways, they: diversify assets; avoid risk; and make rational decisions. However, behavioral finance, which is the interaction between traditional financial theory and the emotional reactions to events, makes evident that investors (a) do not in reality diversity; (b) seek to avoid losses, not risk; and (c) are not rational decision makers. Let's take a closer look at each characteristic.

The first assumption in traditional finance is that investors diversify by putting their assets among different investments such as international stocks, domestic stocks, and small-cap stocks. It also assumes that investors look at their total portfolio as a whole and not just the risk characteristics of each asset. Behavioral finance, on the other hand, shows us that just the opposite is true: investors segment their assets, and practice what is known as mental accounting whereby the investor organizes investments into different pools depending on their stated purpose, such as a vacation fund or a shopping fund. For example, mental accounting is when you view your tax refund as new found money, or if you spend your birthday or bonus cash on new shoes you wouldn't have otherwise bought because you think of that money as independent from your budget. Most of us practice this flawed mental accounting without realizing it, but research has shown that individuals that practice mental accounting tend to have less diversified portfolios and are exposed to more risk because they fail to look at their entire portfolio. Behavioral finance also tells us that investors do not evaluate risk on a portfolio level, but on an individual asset level. For example, one might avoid investing in commodities because of their high volatility and perceived risk, but what they don't realize is that when commodities are combined with a well diversified portfolio, they actually minimize portfolio risk and enhance returns.

The second theory in traditional finance assumes that investors avoid risk and select investments with low volatility.  However, studies by psychologists Amos Tversky and Daniel Kahneman of PrincetonUniversity found that investors actually prefer to avoid losses, not necessarily risk. In their seminal research titled "Prospect Theory," Tversky and Kahneman asked respondents to choose between two scenarios: (a) a sure gain of $500 or (b) a 50 percent chance to win $1,000 or nothing at all. They also asked respondents to choose between another set of scenarios: (a) a sure loss of a $500 or (b) a 50 percent chance to lose $1,000 or nothing at all. Respondents overwhelmingly chose the sure gain over the chance to win more, and the chance to lose more/break-even over the sure loss. The psychologists concluded that "investors prefer an uncertain loss to a certain loss, but prefer a certain gain to an uncertain gain." These results show that investors prefer to avoid losses, rather than seek to avoid risk all together. When investors avoid loses instead of risk, they tend to have overly conservative portfolios because they avoid investments that they perceive to have high risk.

The third assumption in traditional finance is that we are all rational decision makers; we evaluate all the available facts in an unbiased manner, make our investment decisions, and are unaffected by our emotions. However, in the market downturn of 2008-2009 we saw that investors are not always rational, and that they exhibit cognitive errors that cause emotions to dictate their actions. Economist Richard Thaler from the University of Chicago has identified several behavioral biases that impact investment decisions. According to professor Thaler, individual investors are overconfident in their ability to analyze financial data. For example, Stan-Investor buys a stock for $50, but now it is only worth $25; Stan-Investor refuses to sell because he is still confident the true value is $50, and that everyone else is wrong. Professor Thaler states that investors exhibit frame dependence, in that our risk tolerance is dependent on the current circumstance. For example, if our stocks are going up and up (like during the dot-com era), we tend to increase our risk tolerance and take greater risks; but if our stocks are declining in value (like during 2008 - 2009), we reduce our risk tolerance and become more conservative.

The subject of behavioral finance is relatively new; in fact, there are only a handful of universities that actually teach it, yet its significance is more important now than ever before. The US financial landscape has changed dramatically in the last 20 years. The responsibility to save for one's retirement has shifted from the employer or government to the individual through the use of accounts such as 401ks and IRAs. While company pensions and Social Security are a guaranteed form of retirement benefit, 401ks and IRAs are not, which means emotions (both positive and negative) will play a much greater role in investment decisions and whether you have enough money to retire. The best way to avoid letting your investments fall victim to emotions is to consult with a Fee-Only financial advisor who will make investment suggestions and decisions, based not on emotions and behavorial biases, but on what is in your financial best-interest.

Ara Oghoorian, CFA is the president and founder of ACap Asset Management, Inc., a "Fee-Only" financial advisory investment management firm specializing in working with medical professionals. Contact Ara at  aoghoorian@acapam.com or on the web at www.acapam.com for a complimentary consultation.

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Geopolitical Risk Returns

By Jon Ulin, CFP

On Friday, January 28, the S&P 500 lost nearly 2% as it suffered its biggest down day since August 11, 2010. The decline was triggered by escalating protests in Egypt that were fueled by soaring prices, sagging employment, and social media. In addition, the potential for spreading unrest to lead to the closure of the Suez Canal, a geographic choke point where two billion barrels of oil pass each day, pushed up oil prices by 4% on Friday.

The riots in Egypt were the catalyst for a stock market that was already vulnerable to give up some gains from overbought conditions and some disappointing earnings reports.

The market was overbought and due for a pullback. Going into Friday, the Dow Jones Industrial Average was poised to be up nine weeks in a row, a hot streak not seen since the nine-week period ending April 23, 2010 when the stock market peaked and began a 14% decline over the following 10 weeks. Also, heading into Friday, the S&P 500 was as farabove its 200-day moving average as it was back on April 23, 2010.

After a solid start to the earnings season, disappointing earnings reports from some big companies weighed on the market.  Amazon.com Inc., the largest online retailer, forecasted first-quarter profit to come in lower than analysts had expected. Microsoft, the leading software maker, reported that Windows sales missed the average analysts' target for the fourthquarter of 2010. Ford Motor Co., the second-largest U.S. automaker, said fourth-quarter profits fell sharply, well below analysts' expectations.

The firestorm that erupted last week over who will succeed the ailing 82 year old Egyptian President Hosni Mubarak-and by what process that succession will take place-is likely to spread into this week, as well. The United States is the primary benefactor of the Egyptian regime. After Iraq, Afghanistan, and Israel, Egypt is the largest recipient of U.S. assistance, including $1.3 billion in annual military aid, according to the U.S. State Department. The powerful military has provided Egypt with its four presidents since the monarchy was toppled in 1952 by a coup. The Mubarak government has sustained Egypt's status as an ally of the United States and has reliably supported American interests in the Middle East. Whatever happens, the key American concern is that when the conflict is resolved, Egypt will remain an ally. 

We devoted a full chapter in our Outlook 2011, published in late November, to the subject of geopolitical risk in 2011. In the publication we laid out four conclusions regarding the market impact of foreign policy in 2011:

• Increased volatility in global markets
• A tactical investing approach becomes more important
• Greater regional selectivity with global investments
• Rising opportunities for profit and loss with oil-industry investments 
• Oil prices are often driven by geopolitical events. As we noted when we published our Outlook 2011 back in November, all signs point to the strong possibility of more geopolitical risk-driven volatility in the price of oil in 2011.

In recent years, individual investors have favored emerging markets perceiving them to have better growth prospects leading to stronger returns and lower risks. However, as part of an increased emphasis on a more tactical investing approach in 2011, investors with global exposure could benefit from taking a more active and selective approach to the regions of the world in which the prospects of international tension remain high (such as Northeast Asia and the Middle East) versus those where the potential for conflict is fairly low (such as South America).

Investors are wondering what happens now within Egypt and what is next for the region.  Within Egypt, if the conflict lingers and oil traffic is disrupted, any oil supply impact would be temporary since crude shipments could be rerouted.  Even after last week's rise, oil prices remain below their high for the year. At current levels, we do not expect oil prices to threaten our outlook for 2.5-3% economic growth in 2011.

Regionally, the unrest appears to be spreading. The Egyptians were inspired by the Tunisian uprising two weeks earlier that resulted in the ousting of that country's longtime dictator. However, it is not a foregone conclusion that popular revolts will spread further and more governments may topple.  For example, the protests in Algeria have largely been contained and the 2009 protests in Iran were eventually neutralized by the ruling government. Unless it inspires major uprisings in Saudi Arabia, Nigeria, or other major oil producers, we expect the market and economic impact will be modest.  While we expect the spillover in the region to be contained, we also expect more geopolitical event-driven volatility in 2011.

Ulin Financial Group is a comprehensive wealth management and financial services branch in Boca Raton. We are backed by LPL Financial. Please visit our website at www.ulinfinanicialgroup.com for more information or to request a complementary portfolio review.

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Afraid of Outliving Your Assets?

Andrew K. Jones, CFP®,

Departure from the work force is a time to anticipate, but often, fears about money can dampen the joy of retirement.  The fear of outliving one's assets is common among those who are preparing for and entering retirement.  Increased life span, inflation, stock market volatility, and the possible need for assisted living can all create financial strain. It is imperative to have an understanding of what your expenses will be in retirement in order to create a plan to cover these costs. The good news is that with proper planning and knowledge of what your finances may look like, you can prepare for retirement and reduce your anxiety.

One of the first expenses to consider is the possibility of any lifestyle change, including home renovations and travel plans.  It is important to plan for these because there will always be unexpected or non-routine costs such replacing the roof, purchasing a new air conditioning unit or buying a car.  If travel is in your plans, be sure to budget for it.  Remember, since life spans are increasing, you may want to project all expenses to age 100, especially if there is a history of longevity in your family.

An expense to avoid is the carry-over of debt.   Pay off your mortgage  and credit cards now so you will not have interest and principal payments that can drain the money you had earmarked for retirement. If you feel you cannot pay off your existing home's mortgage prior to leaving the workforce, it may be wise to consider downsizing to a less expensive living situation.  

As you near the age of retirement, delaying withdrawals from your portfolio becomes more important than extra savings. For example, by simply earning 7% annual returns on your investments with no withdrawals from your retirement accounts you can almost double the size of your retirement assets in ten years.

Delaying retirement is another important way to protect your investment portfolio's longevity.  If you don't want to keep your current job for ten more years, consider a career change, part-time work, or even start your own business!  One more way to reduce investment portfolio withdrawals in retirement is to postpone Social Security benefits from age 62 to age 67, or even to age 70 (which also increase your benefit amount). Use the Social Security website estimator to calculate your Social Security benefits at different retirement ages:  www.ssa.gov/estimator/.

Inflation can become your investment portfolio's biggest adversary. Inflation has averaged close to 3% historically, so as your goods and services increase in cost your investment portfolio needs to keep up with these costs. In retirement you may wish to lower your investment portfolio's volatility by including income-producing investments such as bonds, but it is also important to have some growth assets such as stocks and real estate in order to keep up with (and hopefully outpace) inflation. Consistent, safe withdrawals are important in protecting your investment portfolio's lifespan.  Large withdrawals (even for a short period of time) can be detrimental to your investment portfolio's ability to survive your retirement years.  Try to keep your annual withdrawals at around 4% if you want your portfolio to last to age 100. 

One of the most difficult expenses for which to plan, both financially and emotionally, is the possibility that you can no longer care for yourself.  Assisted living and nursing home costs can be very expensive, particularly if one spouse moves to assisted living care while the other spouse continues living at home. One option to protect your retirement savings is long-term care insurance which will shield your assets should you suddenly have the additional monthly expenses of paying for assisted care. 

Retirement is a time to relax and enjoy. Create a plan for yours today!

Andrew Jones, CFP®   is a 2006 graduate of ClemsonUniversity with a BS in Financial Management.  He is a full time member of both the Financial Advisory Team and the Investment Team at Abacus Planning Group, Inc.  As a member of the Financial Advisory Team, Andrew works closely with clients to understand their goals in order to develop and implement a comprehensive financial plan to achieve those goals.  As a member of the Investment Team, Andrew manages portfolio administration and assists the team with investment research and due diligence. Andrew earned his CFP® designation in 2010