My high school basketball coach put up a poster in our locker room. In rather large bold print it read, “Learn from the mistakes of others; you aren’t going to live long enough to make them all yourself.” Made sense then. Still does. In our financial practice, we get to witness some common mistakes in others’ thinking about money. In this issue, I want to address four of those and how to avoid them.
Starting Social Security Benefits at a Time That is Not Optimal for Your Circumstances.
This is perhaps the most egregious mistake we see. Its consequences can cost thousands of dollars, the decision generally cannot be reversed, and the loss of benefit cannot be recouped. Stop to think about it for a minute: you can begin benefits at age 62. There is no increase in benefit if you postpone starting past age 70; therefore, you have 97 different months for starting benefits. If you are married, your spouse has the same options, making the possible combinations ginormous. His or her decision is independent of yours, but their decision should be integrated with yours for maximum lifetime family benefit.
“Life’s biggest danger isn’t dying, it’s living.”
— Laurence Kotlikoff
The Wharton School conducted a study several years ago that indicated that, for most people, the decision to begin taking Social Security benefits was based on how the question was framed. If I show you how long you must live to make delaying the start of benefits pay off, (i.e., I frame the question to address breakeven), you will likely start early and take less benefit, thus betting that you will die sooner, rather than later. If I frame the questions around potential longevity risk (i.e., outliving one’s resources), most people will usually start benefits later. Dr. Laurence Kotlikoff claims, “Life’s biggest danger isn’t dying, it’s living.”
We address this question by carefully considering all the possible months between age 62 and 70 for both spouses and showing the impact on living standard after taxes. With some there are non-financial factors to consider, but this gets to the financial impact of the decision.
Failing to Prepare for the Tax Impact of Decisions.
We all make various decisions throughout the year. Many of those impact the tax bill either resulting in a refund and the government using our money without paying interest on it, or negatively, ending up with a tax surprise the following April. Hopefully, we have taught our clients that they should have us model each decision before it gets implemented. Once the transaction is complete, there is usually nothing more that can be done to change the outcome.
To deal effectively with this situation, we like to prepare an alternative scenario case study considering all the known facts (and making prudent estimates of the unknowns) for the rest of the year. Let’s say you are faced with the decision of selling a piece of rental property that you have owned and depreciated for several years. Selling the property would result in a significant capital gain. Many advisors would simply estimate the impact by using this year’s capital gains tax rate without taking into consideration the depreciation recapture rules or modeling the impact of a Section 1031 tax-free exchange. Capital losses should also be considered that could be taken to offset the gains. This is just one example that a full-blown multi-year tax projection can address. This is easily done and can save a lot of frustration and expense when tax time rolls around next spring.
Investing Without a Clearly Defined Goal.
It is human nature to focus on the near-term at the expense of considering the long-term. We want or need certain things now to feel good about a decision and our station in life. We often do that without considering the long-term. Investing is a long-term proposition, but too often, investors still don’t know exactly what that means, or even how to give a time dimension to goals. Furthermore, most investors and many financial advisors use a static return goal when a dynamic one would work better and would ultimately be more accurate. Given that more risk usually translates into greater expected return, we like to ask the question, how much return do you need to generate to meet your goals? And how much risk must you be willing and able to take to get your needed return? A good goal-setting session is needed to specify a specific, measurable, actionable, time bound, exciting, and relevant goal that is sufficiently outside your comfort zone.
Misunderstanding the Risk Your Advisor is Trying to Address.
When we ask investors what risk they are trying to minimize, they usually reply with some form of avoiding drawdown risk, i.e. the loss experienced when an investment goes down in value even for short periods. Other risks are purchasing power risk and the risk of not accomplishing goals. If you were to ask investment professionals how they address risk, most would reply that they do it with diversification among asset classes and properly allocating assets on the efficient frontier. That’s a fancy way to describe avoiding volatility risk, which is very different from drawdown or other forms of risk. Indeed, mitigating the effects of volatility is important but not an end all, be all. The lack of agreement on what constitutes risk and how to address it can result in disillusionment, if not disappointment, with your portfolio. We have addressed the different kinds of risk in a previous article but suffice it to say that the most common mistake is to live with misaligned expectation regarding risk and then to be disappointed with the result.
Remember my coach’s admonition and avoid these very common mistakes made by so many.
Scott Neal is president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Send your questions and comments to firstname.lastname@example.org or call 1-800-344-9098.