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The Lure of Excitement is Killing Your Returns

Reposted from huffingtonpost.com

Dan Solin, Contributor
Author of the Smartest series of books
Happy young couple jumping into the pool while holding a bunch of balloons
Spend two minutes watching this video. Financial journalist, Robin Powell, interviews author Allan Roth about the lure of excitement to investors. Roth correctly explains this appeal. He notes we want to feel like we’re in control and “know what’s going on”. He observes how the securities industry uses our emotions “against us”, because it’s in their economic interest to do so.

If the industry dispensed sound, responsible advice, and told investors to limit their holdings to broadly diversified stock and bond index funds, it’s revenues would decline and many would go out of business.

The appeal of “doing something”

Roth’s views explain why recommendations from Jim Cramer about how to build a “North Korea-proof investment portfolio” appeal to some (albeit a dwindling number) of ill-informed investors. Cramer and other pundits foster the belief that investors need to “do something” to deal with current events. The “something” can range from “fleeing to safety” (like overweighting your portfolio in gold) to changing the mix of stocks you hold in your portfolio to favor those likely to prosper in the event geopolitical tensions continue to escalate.

Here’s what Wall Street and its shills in the financial media don’t want you know:

There’s no credible data that making adjustments to your portfolio as a reaction to publicly disseminated news does anything but harm your expected returns.

The dismal performance of tactical asset allocation funds

If anyone could profit from this “some something’ strategy it would be tactical asset allocations funds. These funds forecast the returns of asset classes and then adjust their holdings to purchase those likely to outperform. You’d think the professional managers of these funds would have insight far surpassing the talking heads in the financial media.

You’d be mistaken.

Most of these funds historically underperformed Vanguard’s Balanced Index Fund (VBINX). Reviewing this data, author Larry Swedroe had this takeaway: “Bottom line: big fees poor results. In other words, TAA [tactical asset allocation] is just another game where the winners are the product purveyors, not the investors.”

Keep this data in mind the next time Cramer and others encourage you to “do something.” They’re encouraging you to engage in a form of tactical asset allocation, which appeals to your emotions but is contradicted by strong evidence.

Who’s really smart?

Another way to combat your natural instinct to “take action”, is to ask this question. What’s the really smart money doing?

Before you respond, it’s important to define “smart money.” The media wants you to believe managers of hedge funds and self-styled experts who appear of cable news are “smart.”

I don’t quarrel with this characterization. They have been able to convince millions of investors to entrust them with their money and pay huge fees, despite the fact that the track record of most of them has consistently underperformed comparable index funds, which are far less expensive. But being “smart” enough to take advantage of you makes them uniquely unsuitable to give you advice.

Who qualifies as “smart” money? Academics who spend their life studying the financial markets and publishing the results of their research in peer reviewed financial journals.These academics include Ken French, Eugene Fama, Robert Merton and many others.

These researchers (many of whom have Ph.D in Finance) study the science of investing. It’s based on sound research and not musings or speculation. They have identified the real sources of investment returns and rejected “costly speculation and guesswork.” The fund family that has pioneered this academic approach to investing is Dimensional Fund Advisors. You can learn more at its website.

If you asked these professionals what they are doing to “North Korea proof” their portfolios, they would look at you in stunned silence.

You have a choice when you invest. Follow the pied pipers on the financial media who have few qualifications and little or no data to support their musings, or study the science of investing.

The “excitement” of “doing something” gets old fast when your returns continue to underperform low management fee index funds.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

Any data, information or content on this blog is for information purposes only and should not be construed as an offer of advisory services.

Glasses on Retirement Summary

Choosing Between Roth and Traditional IRA’s

Among the most important decisions investors make is their choice of location for assets within the various alternatives available for retirement (tax-advantaged) accounts. Allocating between a traditional IRA (a pretax, tax-deferred account) and a Roth IRA (a post-tax, tax-free account) can have a pronounced impact on retirement outcomes, given the $14 trillion in tax-advantaged retirement account assets at the end of 2015.

David Brown, Scott Cederburg and Michael O’Doherty contribute to the literature on retirement asset location with their June 2016 paper, “Tax Uncertainty and Retirement Savings Diversification.”

The modeling approach they adopt accounted for investor age, current income and taxable income from outside sources in retirement, as well as the highly progressive income tax regime now in place. The authors point out that “the marginal rate for a single taxpayer with inflation-adjusted income of $100,000, for example, has changed 39 times since the introduction of income taxes in 1913 and has ranged from 1% to 43%.” This creates considerable uncertainty.

Because risk-averse investors (and most investors are risk averse; it’s generally only a matter of degree) dislike uncertainty, this should create a preference for Roth accounts, as they “lock in” the current rate, eliminating the uncertainty associated with future changes.

On the other hand, a traditional account, which offers retirement savers the benefit of deducting current contributions, allows investors to “manage their current taxable income around tax-bracket cutoffs, which is valuable under a progressive structure.”

Another benefit of traditional accounts, the authors write, is that “the progressive tax rates faced in retirement provide a natural hedge against investment performance. Investors with poor investment results and little wealth in retirement will pay a relatively low marginal tax rate, whereas larger tax burdens are borne by investors who become wealthy as a result of good investment performance.” This creates tension between the traditional and Roth options.

Who Should Use The Roth Structure?

The authors state: “Roth accounts are primarily useful for low-income investors who can lock in a low marginal rate by paying taxes in the current period.” They add that because “future tax rates are more uncertain over longer retirement horizons” and their analysis of historical tax changes suggests “that the rates associated with higher incomes are more variable,” eliminating “exposure to tax risk is particularly attractive for younger investors with relatively high incomes and correspondingly high savings.”

The authors continue: “Despite high current marginal tax rates, and contrary to conventional financial advice, these investors benefit the most from the tax-strategy diversification offered by Roth accounts.”

Brown, Cederburg and O’Doherty concluded: “Whereas conventional wisdom largely supports choosing between traditional and Roth accounts by comparing current tax rates to expected future tax rates, the hedging benefits of traditional accounts and the usefulness of Roth accounts in managing tax-schedule uncertainty are important considerations in the optimal savings decision.” They note that, for wealthy investors, their analysis shows “tax-strategy diversification is particularly attractive, despite their high current marginal tax rates.”

The authors also examined their findings’ economic implications: “Our results are of practical importance to employers and regulators who determine the retirement savings options available to employees. In particular, broadening access to Roth versions of workplace accounts would provide investors with important tools for managing their exposures to tax risk. Given that these accounts are available under current regulations, encouraging the widespread adoption of, and education about, employer-sponsored Roth plans could substantially improve investors’ welfare.”

What the authors found provides investors with the proper framework to make informed decisions regarding the asset location of their retirement savings and the diversification of tax risk.

This commentary originally appeared July 27 on ETF.com

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