The Endowment Effect

Deciding when to sell a stock or a mutual fund can be difficult, especially when that unwanted stock or mutual fund resides in a taxable account. To be sure, there are a number of strategic reasons to hold positions you want to sell. This is the time of year, for example, when many investors resist the urge to sell because they would prefer to push the capital gains into the next tax year. But many of the reasons that investors hold onto positions are not so strategic in nature.

In their book, Why Smart People Make Big Money Mistakes, Gary Belsky and Thomas Gilovich examine a host of psychological mental tendencies that make selling any investment, even a bad one, so challenging. Research demonstrates, for example, that most investors tend to overvalue whatever it is that they already own. This is described, according to behavioral finance, as the “endowment effect,” and its influence is very powerful.

To illustrate the power of the endowment effect, Richard Thaler divided a Cornell economics class in two. Half the class received school coffee mugs as a gift; the other half received nothing. Then Thaler held a coffee mug auction. The students who did not own a coffee mug already, on average, were willing to pay only around $2.75 to acquire a mug. The students who already owned a coffee mug, however, had much greater sense of the value of their mug. On average, these students needed to be offered around $5.25 to sell their mug. This study and others like it, demonstrate that one of the primary side-effects of already owning an asset is the owner values that owned asset as much as twice as much as it is actually worth.

With the endowment effect in mind, it is easy to understand why so many portfolios are littered with positions that should be sold but are not. The psychology behind the impulse to hang onto what you already have is understandable, but it should be kept in mind because it is not always helpful or strategic.

Market Analysis Video –
September 2014

While stocks held up well during the summer, they pulled back in the first month of fall, which is not surprising as September has been the weakest month for the stock market historically. Since 1896, the Dow Jones Industrial Average has produced an average price return of -1.1%. It is one of only three negative months on average historically, and it is the worst-performing month by a wide margin (0.9%).

In this year’s edition of September, U.S. stocks followed their historical trend by falling -1.4% according to the S&P 500 Index. Foreign stocks continued their run of underperformance versus U.S. stocks…

Please watch the video below for our complete Market Analysis.

Click here to read our complete Market Analysis.

Top Five Mistakes in Portfolio Design Part 2

This is second part of our compilation of the top five most common investing mistakes committed by individual investors. Mistakes one and two can be reviewed in last week’s post, Top Five Mistakes in Portfolio Design Part 1. Read this week’s post for mistakes three through five.

3. Overconcentration to One Sector

Sector overconcentration often stems from common investing mistake #2. Investors hold too much of a single stock, and whatever industry that stock resides in is also overrepresented in the portfolio.

The familiarity bias plays a role in this common error. People invest in what is familiar and comfortable to them. Studies show that if you work in a specific sector that you are more likely to invest in that sector. This can lead to overconcentration. Studies also show that people like to invest in local companies. Being from the Bay Area, we often see overconcentration in stocks like Apple, Google, and Pandora, which leads to an overconcentration in the tech sector. If we were headquartered in Texas, it would likely be an overconcentration in the energy sector that we routinely encounter.

Sector overconcentration is not as big an issue as an overconcentration in one stock because you still have enough diversification to avoid company-specific risk, but entire sectors do run into trouble from time to time. The Dow Jones US Technology Index lost over -80% of its value during the tech crash that occurred in the 2000-2002 bear market. During the 2007-2009 financial crisis, the Dow Jones US Banks Index lost a similar amount.

To combat sector overconcentration, we suggest keeping the sector allocations in your portfolio within 10%-15% of its market allocation. For example, the health care sector comprises 13% of the S&P 500 Index. By following this diversification rule, you would have no more than 28% of your portfolio invested in the health care sector.

4. Not Enough Foreign Exposure

This is actually one common investing mistake that we regularly see from both professional and do-it-yourself investors. We believe it stems, in part, from archaic asset allocation advice that recommended 10% to 20% of equity portfolios be invested in foreign stocks many years ago. Interestingly, most portfolios we see today still have a foreign stock allocation in this range.

The other culprit is the home bias. As described in mistake #3, people like to invest in what is familiar and comfortable to them. This means that U.S. citizens have more of an allocation to U.S.-based companies than they should. (Interestingly, this home bias shows up in other countries as well.)

This mistake has not cost U.S. investors much because the U.S. stock market has been among the best performing markets in history, but things could change in the future. The Japanese stock market performed admirably for decades as the Nikkei Equity Index gained over 16% per year from 1950 to 1989. But since the start of 1990, the index is down almost -60%. Japanese investors who fell prey to the home bias have suffered miserably.

From a diversification standpoint, it is important to have various geographic exposures as well. The U.S. comprises roughly half of the global market capitalization, so a diversified global equity portfolio would have half of its assets invested in foreign stocks.

5. Inappropriate Level of Risk

Part of the portfolio analysis we perform for each client when they first come to us is an assessment of risk in the portfolio. Often we find that the risk level of the portfolio differs greatly from the amount of risk the investor is comfortable taking and/or the amount of risk they need to be taking to reach their financial goals.

Each investor has a specific comfort level with risk. Some can tolerate lots of volatility and significant losses; others cannot. It is simply a reflection of the fact that human beings are wired differently. A well-designed portfolio reflects this with a risk level that is tailored to the investor’s risk tolerance. However, we often see portfolios that contain levels of risk that are far from the investors risk tolerance. This applies on both ends of the risk spectrum—risk-averse investors with portfolios that are full of high-risk investments and risk-tolerant investors with portfolios that are full of low-risk investments.

Not only is it important to have a portfolio within your risk tolerance, but it is important to have a portfolio that will likely produce the type of return necessary to meet your financial goals. In our analysis of portfolios, we often encounter situations in which investors who need high rates of return are invested in low-risk/low-return investments. We regularly see the flip side as well. Some investors are in such good financial shape or have such modest goals that they don’t need much in the way of return to succeed. However, these investors are often in high-risk portfolios designed to produce high levels of returns. But because they don’t need those high returns, why take the extra risk?

❯ To make sure your portfolio is in line with your risk tolerance and financial goals while avoiding common investing mistakes, it is best to consult a professional wealth manager who can help you figure out your risk tolerance and the required return to meet your financial goals with a financial plan.

Top Five Mistakes in Portfolio Design Part 1

When clients first come to us exploring the possibility of hiring a professional wealth manager, we ask them to bring copies of all of their investment account statements, so we can perform an analysis of their portfolio.

Being in business for over 23 years now, we have reviewed hundreds of portfolios, and we’ve seen many common investing mistakes repeated over the years.The portfolios vary widely based on who designed them. There are clear tendencies and attributes that signify a portfolio constructed by a professional money manager versus a do-it-yourself individual investor. Based on our extensive experience in analyzing portfolios, we have compiled a list of the top five investing mistakes we see from individual investors in the design of their investment portfolios:

1. Too Much Cash

“Cash is king” the old saying goes, and it still holds some truth, even in this 0% interest rate environment. Cash provides a buffer for emergencies, and a source of income in bear markets if you’re living off your portfolio and don’t want to sell at depressed values. Cash also gives you the ability to be opportunistic in declining markets by providing the liquidity necessary to buy when others are selling.

But there is a limit to how much cash you want to maintain, especially in this 0% interest rate environment. We advise keeping six months to two years’ worth of non-discretionary living expenses in cash as a reserve fund. Add a bit more if you want to have an “opportunity fund” to have the liquidity to buy into declining markets, but cash should never exceed 10% of your total portfolio. At that point, it starts to become a significant drag on your returns given that it’s likely earning close to nothing.

Unfortunately, we often see individual investors holding much more cash than that. In fact, it is not unusual to see cash comprise 30% or even 40% of an individual investor’s portfolio. The reason usually stems from a fear of losing money or an uncertainty of how to invest it.

2. Overconcentration to One Stock

Investors have a tendency to fall in love with certain stocks. This often stems from one of three factors:
a. The stock has been in their portfolio for a long time.
b. The stock has performed very well for them in the past.
c. They work for the company.

We often see situations in which one or more of these factors lead investors to hold a position in a stock that represents 50%, 60% or even 70%(!) of their investment portfolio. This is simply much too high an allocation as it flies in the face of the prudent principles of diversification, but it is unfortunately one of the most common investing mistakes we see. No matter how long the company has been around or how well it has done in the past, bankruptcy is always a risk for an individual company. That means the stock could lose all of its value at any point in time. That is why you want to diversify your portfolio across many companies as it significantly reduces your exposure to company-specific risk.

As a product of prudent risk management, we recommend that no individual stock comprise more than 10% of a portfolio. This is especially true in the case of company stock. With company stock, you run the risk of losing your job if the company runs into financial difficulty. The last thing you want is to lose a significant amount of your portfolio at the same time you lose your income and benefits. Just ask the former employees of Enron or Worldcom.

❯ Check our blog next week for mistakes three through five of the most common investing mistakes and how to avoid them.

Market Analysis Video –
August 2014

The summer weakness in U.S. stocks was confined to just one month this year as the S&P 500 Index more than recouped its losses from July with a strong performance in August—up 4.0% for the month.

Overseas the foreign-based MSCI EAFE Index fell -0.1% in August. The loss was primarily driven by Japan, where we no longer have exposure. Europe, where we continue to hold some investment, was up 0.4%. Emerging markets continued their positive winning streak, advancing for the seventh month in a row—with a 2.3% gain in August. We continued to add to our position in emerging market stocks in August…

Please watch the video below for our complete Market Analysis.

Click here to read our complete Market Analysis.

Stocks, Not Stockings

Imagine life without a checking account. Imagine walking in to your local bank and being refused service, simply based on your gender. Today women walk into financial institutions, open accounts, withdraw monies, and interact with private bankers without a second thought. However, it was not always this way.

In the 1800s most state laws made a woman the legal dependent of her husband after marriage. For the most part, a woman could not open bank accounts, enter into contracts, or apply for a loan, no matter her age or education. Gradually rights to control wealth began to improve. In 1862 California passed legislation which vastly improved the financial independence of women. For the very first time, women were allowed to open their own individual checking accounts. Yet despite the updated laws, women did not flock to banks immediately. Ladies of the time largely thought of banks as masculine and untrustworthy—not to mention the spittoons and cigar smoke. Instead of depositing their savings into a bank, women would tuck large wads of folded bills into their stockings. It is estimated that on any given day, the women of San Francisco carried around $2 million in their stockings. (The historical information in this paragraph is based on an interesting Wells Fargo Bank web posting.)

Nowadays, many of us are more concerned with stocks than stockings. More women than ever are taking control of the finances, holding 60 percent of all personal wealth. According to the Harvard Business Review, women in the U.S. control $20 billion in annual spending. So this begs the question: how do women of today build financial strength for their future?

Attend The Women’s Roundtable!
Taking charge of your financial future is what we talk about at The Women’s Roundtable. How about joining us on September 24, 2014 at 6 pm for wine and cheese? It is a great forum to share your thoughts and concerns and to see how we can provide support and guidance.

RSVP by September 22 at 800.700.0089, ext. 100 or

Pay Attention to Corporate Earnings and a “Goldilocks Economy”

For most of 2014, the market has been able to shrug off the unsettling news coming out of Ukraine and now out of Gaza. U.S. corporate earnings for the second quarter ending June 30 were 5.6% higher than the second quarter in 2013. The 5.6% earnings growth rate reflects a slower pace, but there are positive aspects to slow and steady growth. The description “Goldilocks Economy” is beginning to reappear in the business press, a reference to an economy that is neither too hot nor too cold, but just right for sustainable growth.

This steadiness in earnings growth in this so-called “Goldilocks Economy” has a parallel trend in jobs growth. July 2014 was the first time since 1997 that 200,000 or more jobs were added for the past six months in a row. This confidence and momentum is now drawing more people back into the job market. The Wall Street Journal reports that 141,000 people re-entered the job market in July because now they see evidence that they could become employed again.

These positive trends have enough wind at their back that consumer spending could produce continued steady growth in earnings, and business is showing more confidence with increased capital expenditures. Although international tensions caused one of the worst weeks for investors in a long time, the core momentum driving corporate earnings will not be turned back easily.

Not long ago, there was great fear and anxiety about the Fed beginning to taper its bond buying program. The expectation was that once the Fed began to taper, the market would sell off dramatically. The Fed has been tapering its bond buying now for several months, and corporate earnings and the market took it in stride. Beneath the horrible international drama, there is a steadiness to our economy that deserves our focus and attention.

Market Analysis Video –
July 2014

Stock markets declined globally in July. The S&P 500 Index fell -1.4%. It was the first down month for the U.S. market since January and only the second monthly loss in the last 11 months, which demonstrates how calm U.S. markets have been recently. Overseas, the MSCI EAFE Index dropped -2.0%. Europe, which is our main focus abroad, declined -3.8%.

The current bout of European weakness relative to the United States began in May, so July represented the third consecutive month of underperformance. The region has yet to trigger a sell signal within our discipline, but continued weakness may lead to that soon. While valuations in Europe still remain attractive, we need the performance momentum to improve soon to justify investment there. Cheap valuations are always appealing, but investing on value factors alone can often take years to pay off if it ever does at all…

Please watch the video below for our complete Market Analysis.

Click here to read our complete Market Analysis.

Saving for Retirement: The 4% Rule

Most people’s primary concern about saving for retirement is outliving their money and facing poverty at the end of life.  For that reason, a lot has been written about the so-called 4% Rule.  Essentially what the 4% Rule suggests is that, upon retirement, you should be able to withdraw 4% of your portfolio balance and do so annually for 30 years with the confidence that you will not run out of money during retirement—even if you had the bad luck of retiring into the worst equity markets in U.S. history. The research that supports the 4% Rule assumes an allocation of 60% stocks and 40% bonds.

However, most Americans have not saved enough to meet their retirement needs with a 4% withdrawal. For those who have not saved enough for retirement, their withdrawal rates will likely be too high to support 30 years of retirement. But even those who have saved well enough to live by the 4% Rule will be disappointed to learn that withdrawal rate rules are precarious at best. If we look abroad for a moment, we can test the fragility of such rules. Relative to other stock markets around the world, the U.S. stock market has a very good history. Many stock markets in other countries do not have a market history strong enough to support even the oppressive sounding 4% Rule.

If a citizen of Italy, Belgium, France, Germany or Japan, for example, unwittingly retired into a historically bad time for that county’s stock market, sticking to the 4% Rule would have run their portfolio into the ground. To safely fund 30 years of retirement in those countries in the worst market environments would require withdrawal rates of 2% or less.

This is not to bash foreign stock markets. It is more to point out that generic guidelines have hidden flaws. To our knowledge, the best way to safely fund 30 years of retirement is to  create a financial plan and use it as an instrument to strategically vary withdrawals overtime. This tactic allows one to adapt to whatever kind of market one retires into as it unfolds. No one knows the future, but by being responsive to it, one creates the chance of withdrawing significantly more than 4% in many years without compromising the ability to fund 30 years of retirement.

“The Women’s Roundtable: Taking Charge of Your Financial Future” September 24.
6 – 7:30 pm at the Oakland office of Bell Investment Advisors, 1111 Broadway, Oakland, above the 12th Street BART station. For more information about The Women’s Roundtable and how to register for the wine and cheese gathering, click here.

Saving for Retirement:
What Will Be Your Story?

Many websites and financial professionals touting retirement savings plans offer little more than off-the-shelf plans that express the end result as a dollar amount. Generally, the instructions for achieving the goal are common sense—such as: max out your 401(k) contributions, invest your money wisely, create a budget and live within your means. A key ingredient often missing is the very personal and unique part of the plan that recognizes and honors your vision of retirement. You can save for a target amount, but in the end, it’s an arbitrary number unless you know you are saving for the life you want.

“Saving for Retirement: Never Too Early, Never Too Late” was the topic at The Women’s Roundtable June 25 wine and cheese gathering at Bell Investment Advisors. While the discussion included the obligatory checklist (e.g., “maximize your 401k contributions…check!”; “don’t leave any employer matching contributions on the table…check!”), what resonated most with the group were the personal stories of women who put their retirement dreams to the test with a customized financial plan.

An example was Nancy, a life-long saver, who has contributed the maximum amount allowed to her retirement account. She received a contribution from her employer each year. She was also able to put away excess cash into her savings account each month. She could see her savings balances increase each month, yet she was not sure when, or if, she could retire. In the end, adding up all the numbers gave her just a number, not a plan.

When Nancy signed up for financial planning, the exercise began with her vision of retirement, not with a photo of a beach or a woman taking an art class, or someone else’s dream of retirement. Her plan focused on the life she wanted to live. Her financial plan was grounded with the real goal of creating the life she envisioned. Certainly the success of Nancy’s plan was dependent on the amount she had saved for retirement, but what she found in the process was:

  • She is a great saver but keeping too much in cash.
  • She needed to put her money to work more productively.
  • She saw the importance of seeking investment advice, as in other areas of her life, from a professional.
  • The life she envisioned in retirement required a specific income that was attainable if she stayed true to her plan.

So, what’s your story? Are you ready to stop wondering, and hoping you can retire? Join us at the next gathering of The Women’s Roundtable this fall, and take charge of your financial future.

“The Women’s Roundtable: Taking Charge of Your Financial Future” September 24.
6 – 7:30 pm at the Oakland office of Bell Investment Advisors, 1111 Broadway, Oakland, above the 12th Street BART station. For more information about The Women’s Roundtable and how to register for the wine and cheese gathering, click here.