Deducting Hurricane Casualty Losses on Your Tax Return

Deducting Hurricane Casualty losses on Tax Return_DG_Blog Correction Image

David Garcia

David L. Garcia, CPA, CFP®, ADPA® Principal, Wealth Manager

Many of us in Florida or Texas endured major hurricane events in 2017.  If you suffered damage to property you may be able to deduct the property loss on your tax return as a casualty deduction.  The IRS has very specific rules that govern how much property loss you can deduct.  You’ll have to go beyond just estimating the value of the lost property.

First, you need to reduce any losses by the amount you are reimbursed from an insurance company since the deduction only applies to unrecoverable losses.  Next, you need to determine what your actual loss is.  The actual loss is the smaller of your tax basis in the property or the decrease in the fair market value.  Generally, your tax basis in the property is how much you bought it for.  For example, suppose you purchased a boat 3 years ago for $40,000.  The boat is now worth $32,000 and is destroyed in a hurricane.  For tax purposes, the loss is the decrease in fair market value since it is lower.

Once you’ve determined the actual loss you must reduce it by $100 and then by 10% of your adjusted gross income to arrive at the amount that you can claim as a deduction on your tax return.  To claim the deduction, you must be eligible to itemize your deductions on schedule A.  This means your total deductible expenses for the year exceed the standard deduction.

The government provides additional relief when the area you live in is a federally declared disaster area.  For example, you can claim the loss in the year of the disaster event or the prior tax year.  For further information, please click on the IRS links for Irma and Harvey below.

https://www.irs.gov/newsroom/tax-relief-for-victims-of-hurricane-irma-in-florida

https://www.irs.gov/newsroom/tax-relief-for-victims-of-hurricane-harvey-in-texas

Feel free to contact David Garcia with any questions by phone 305.448.8882 ext. 224 or email: DGarcia@EK-FF.com.

Steps for Identity Theft – Equifax

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Anne Bednarz, CFP®, AIF® Financial Advisor

As many of you have likely heard by now, Equifax (one of the three credit reporting bureaus) recently experienced an extensive data breach. Therefore, we are encouraging everyone, including those who were not directly affected by this breach, to take preventive and proactive steps to protect their credit.

We have outlined below main steps to take regarding protecting your credit and identity.  First, we believe in today’s environment a prudent step would be to enroll in a credit monitoring and identity protection service.  Additionally, two other options exist of additional protection layers, a fraud alert or a credit freeze.

Check Equifax

You can first check to see if Equifax believes your information was stolen by entering your last name and the last six digits of your social security number here. Be sure to check any names you have used in the past, such as a maiden name.

If your information is deemed to be compromised, you can go through the steps provided to sign up for a credit monitoring service called “TrustedID Premier.” However, there is skepticism in the industry regarding the effectiveness of utilizing TrustedID Premier to protect one’s credit as the service is owned by Equifax.

Below are additional options available to protect your credit:

Credit Freeze

A credit freeze does not impact any of your currently established credit. However, the freeze does make it more difficult for identity thieves to establish new credit in your name. Placing a credit freeze on your accounts will require you to “thaw” your accounts if or when you need to apply for new credit. There may also be a nominal fee to place and lift a credit freeze. Note, that it takes about 3 days for your credit to “thaw,” so be sure to plan accordingly if you foresee a need to access credit in the near future.

If you decide to move forward with a credit freeze, then you must do so at each of the four credit bureaus listed below. Bear in mind that when you enact a freeze, you will be given a PIN; this PIN must be used to “thaw” your credit report if you need to establish new credit. If you lose the PIN, you will have to go through a fairly grueling process to get another PIN reissued.

Below are links to place a credit freeze at each credit bureau.

Consumers Union provides a list of credit freeze charges by state. 

Fraud Alert

Another viable option to protect your credit is to place a fraud alert on your accounts. This option requires creditors to confirm your identity. You can place a fraud alert with any one of the credit reporting bureaus; that bureau will then notify the others. The alert will only remain active on your account for 90 days, so be sure to mark your calendar to renew if you wish to maintain the fraud alert in the future.

Credit Monitoring Services

Lastly, there are companies that can both monitor your credit and alert you of any fraudulent activity on your accounts. In addition to credit monitoring and fraud alerts, many companies also provide insurance for losses incurred due to identity theft. If you plan to utilize a credit monitoring service you should activate the service prior to placing a freeze on your credit so they are able to monitor your information; otherwise, they are locked out of the information.  You should evaluate the proper service for you based on monitoring of both credit and identity, the frequency of monitoring, and any insurance available to protect against identity theft and restoration.  Other benefits available from monitoring services are availability of credit score, credit reports, etc.

Be Diligent

Other effective methods to protect your credit include keeping a watchful eye on your accounts and immediately reporting any suspicious activity as soon as you are aware of it. Furthermore, get in the habit of implementing sound personal-finance practices such as checking your credit report at least annually, filing your taxes early, using multi-factor authentication when available, and avoiding checking your accounts when connected to public, unsecured Wi-fi.

Essentially, always be cautious when entering personal, identifying information online.

Additional Help:

Report identity theft: https://www.identitytheft.gov

Correct errors on a credit report: https://www.consumer.ftc.gov/articles/0151-disputing-errors-credit-reports

Access your free annual credit reports: https://www.annualcreditreport.com/

Data security breach list (not comprehensive): https://oag.ca.gov/privacy/databreach/list

Additional information regarding Identity theft:

 

Feel free to contact Anne Bednarz with any questions by phone 806.747.7995or email: ABednarz@EK-FF.com.

Special Needs Planning: Resources and Issues to Consider

Brian Fischer

Brian Fischer, CFA, CFP® Financial Analyst

Special needs planning is often narrowly thought of as simply creating a special needs trust. However, depending on the individual’s situation and needs, it may require much more. This article will focus on the resources and strategies available to those with special needs and their families who care for them.

Childhood

Federal legislation requires local governments to provide children with disabilities education and other related services that are designed to meet their needs. These resources include Early Intervention (EI) services for children younger than age three and special education that is directed by an Individualized Education Plan (IEP) for children up to age 21 (26 in Michigan). Taking full advantage of what is available to your child not only can help him or her reach full potential, but can also help conserve your resources and identify things to consider while planning for your child’s life after school.

It’s important to note that eligibility for special education benefits is not affected by income and asset ownership. EI services and special education vary by state; more information about each may be found at Autism Speaks1 and the Center for Parent Information & Resources.2

 Government Benefits

Government benefits are subject to strict eligibility rules. Although income and assets do not affect eligibility for special education benefits, they do affect eligibility for Social Security and Medicaid. Consequently, an important aspect of special needs planning involves protecting eligibility to receive government benefits.

While a child may not utilize these benefits prior to the age of 18, planning to preserve eligibility well in advance may be prudent. Even if monetary assistance isn’t needed, remaining eligible may be necessary to obtain services such as life skills training.

Social Security

Social Security Income (SSI) and Social Security Disability Income (SSDI) both provide income to those who meet Social Security’s disability eligibility requirements.3 SSI is a needs-based program available to those with minimal income and resources, while SSDI is an entitlement program for individuals, and possibly their dependents, who have paid into Social Security. Some information about each is outlined below.

 SSI

Assets are limited to $2,000 for an individual or child under the age 18 living at home with one parent, and $3,000 per couple or a child living at home with both parents. Some assets not counted include your primary residence, a vehicle, and household goods.

  • Monthly benefits for 2017 are $735 per individual and $1,103 per couple. These payouts are offset by income. Social Security’s calculation to measure income against these limits is rather complex and can be viewed here.4
  • Also, as an added benefit, some states provide a supplement to SSI.

SSDI

  • Benefits received are based on work history and family size.
  • There is a monthly earned income limit of $1,170. There are no unearned income or asset limits.
  • The 2017 maximum benefit per individual is $2,687 with a total family benefit somewhere in the range of 150-180 percent of that number.

Medicaid

Similar to SSI, Medicaid is a need-based program. However, Medicaid is administered on the state level. As a result, benefits and eligibility vary by state. Typically, if an individual qualifies for Social Security, he or she will qualify for Medicaid as well.

Children’s Health Insurance Program (CHIP)

This program provides health insurance to children under the age of 19 in families that are ineligible for Medicaid because their income is too high. Income eligibility varies by state.

Home and Community-Based Services

Provided through Medicaid, these services help individuals continue living at home or in the community instead of at another residence or in an institution. Services provided vary by state.

Life Insurance

Although a stay-at-home caretaker may not have income, the care he or she provides has value. Replacing the loss of this care can be expensive. As a result, it may be prudent to consider purchasing life insurance on all primary caretakers, regardless of income. The amount and type of life insurance will depend on your family’s needs. Some broad questions to ask that may help in determining what kind (term, permanent, second-to-die), if any, life insurance is to be purchased:

  • How long is the insurance needed?
  • How much can be afforded?

Keep in mind, to preserve eligibility for government benefits, it may make sense to name a trust or someone other than the special needs individual as the beneficiary of life insurance proceeds.

Special Needs Trust

A special needs trust can be an integral part of special needs planning. Generally, it can be used to preserve eligibility for government benefits and provide supplemental resources to the beneficiary. Additionally, it can set clear expectations for the use of funds. For example, giving a special needs individual’s inheritance to a sibling to manage may create confusion and the possibility of the special needs individual not getting the resources he or she needs.

There are many rules regarding the creation and use of special needs trusts, and these rules vary by state. Consider consulting a lawyer if a trust is needed. An attorney familiar with special needs trusts may be found at Special Needs Answers5 or Special Needs Alliance.6

There are two kinds of special needs trusts: first- and third-party. A first-party trust is funded by the individual with special needs or, in other words, the beneficiary. It generally is created when the beneficiary receives an inheritance or a legal settlement. A third-party trust, on the other hand, is funded by anyone other than the beneficiary. Aside from the source of funding, these trusts differ in what happens to the assets after the beneficiary dies. A first-party trust’s remaining assets pay back Medicaid, whereas a third-party trust’s remaining assets may be distributed to named heirs. (First-party trusts are also known as Medicaid payback trusts.)

If costs or limited resources make the use of a trust prohibitive, a pooled trust may be a viable alternative. Pooled trusts maintain assets for the benefit of a group of individuals under the umbrella of a single trust, thus potentially reducing costs. Funds are distributed to the beneficiaries in proportion to what they contributed.

 ABLE Plans

As mentioned earlier, keeping income and assets to a minimum to preserve eligibility for government benefits is an ongoing issue. The enactment of the Achieving a Better Life Experience (ABLE) Act in 2014 created a savings option that may provide some relief in keeping assets to a minimum to preserve eligibility for government benefits.

Features/Benefits

  • Funds in the account may be used for any “…expense related to the designated beneficiary as a result of living a life with disabilities.”7 Expenses may include basic living expenses, housing, transportation, and health care.
  • Investment earnings are not taxed if funds are used for qualifying expenses. If funds are used for unqualified expenses, taxes and a 10% penalty on earnings may apply.
  • Depending on the state, there may be a tax deduction for contributions.
  • They can potentially be a relatively inexpensive and more flexible alternative to a special needs trust.
  • If desired it can be managed/controlled by the beneficiary. This independence can be a source of pride for the beneficiary.
  • You can use any state’s plan.

 Rules/Limitations

  • The beneficiary must have been diagnosed with a disability before age 26.
  • Plan limits vary by state. However, there is a $100,000 account limit to maintain eligibility for government benefits. If the account’s balance exceeds $100,000, the individual will stop receiving Social Security benefits until the account balance is reduced to $100,000. Medicaid eligibility is unaffected.
  • There is a $14k annual contribution limit from all sources.
  • Only one account may be used per individual.

The National Down Syndrome Society has aggregated website links to the various state plans here.8

Letter of Intent (LOI)

A letter of intent is a set of instructions. Although not legally binding, it provides future caregivers the information needed to properly administer care. Information included may vary. It may be limited to medical care and financial information, or may be much more thorough with instructions describing the individual’s daily routine, for example, details describing what works and what doesn’t work for the individual while bathing or preparing for bed.

 Concluding Thoughts

There certainly is a lot to consider while planning for an individual with special needs. A few general observations that may be helpful to keep in mind throughout the planning process are:

  • Don’t wait until a crisis to act. Creating a plan now avoids needing someone to create a plan when you can’t. Without a plan, that someone whom steps into your shoes may be left guessing as to what is needed and most appropriate.
  • It can be challenging to identify and obtain available resources. Having confidence while going through this process along with being persistent and patient can go a long way.
  • Communicate your planning desires and wishes with those who are a part of the special needs individual’s life. Don’t assume the people you select to be a trustee, executor, or guardian are willing and able to perform the responsibilities that come along with those jobs.

 

Feel free to contact Brian Fischer with any questions by phone 305.448.8882 ext. 235 or email: BFischer@EK-FF.com.

 

Advocacy Groups and Other Resources 

There are numerous advocacy and charitable organizations that are focused on providing help to the special needs community. A few that may be of interest are listed below.

Early Intervention Services by State – State websites aggregated by Autism Speaks.

Resources for those with Disabilities by State – State websites aggregated by Center for Parent Information & Resources.

The Arc – The Arc promotes and protects the human rights of people with intellectual and developmental disabilities and actively supports their full inclusion and participation in the community throughout their lifetimes.9

Special Needs Alliance – The Special Needs Alliance (SNA) is a national organization composed of attorneys dedicated to the practice of disability and public benefits law. Individuals with disabilities, their families, and their advisors rely on the SNA to connect them with nearby attorneys who focus their practices in the disability law arena.10

Easterseals – For nearly 100 years, Easterseals has been the indispensable resource for people and families living with disabilities.11

Autism Speaks – Autism Speaks is dedicated to promoting solutions across the spectrum and throughout the life for the needs of individuals with autism and their families through advocacy and support, increasing understanding and acceptance of people with autism spectrum disorder, and advancing research into causes and better interventions for autism spectrum disorder and related conditions.12

Special Needs Answers – The Academy of Special Needs Planners consists of special needs planning professionals such as attorneys, financial planners, and trust officers that assists them in providing the highest quality service and advice to persons with special needs and to their families.13

Other Professionals

Find a Certified Public Accountant (CPA) – The American Institute of CPAs is the world’s largest member association representing the accounting profession, with more than 418,000 members in 143 countries and a history of serving the public interest since 1887. AICPA members represent many areas of practice, including business and industry, public practice, government, education, and consulting.15

  1. https://www.autismspeaks.org/early-access-care/ei-state-info
  2. http://www.parentcenterhub.org/find-your-center/
  3. https://www.ssa.gov/disability/determination.htm
  4. https://www.ssa.gov/ssi/text-income-ussi.htm
  5. http://specialneedsanswers.com/
  6. https://www.specialneedsalliance.org/
  7. http://www.ablenrc.org/about/what-are-able-accounts
  8. http://www.ndss.org/ableprograms
  9. http://www.thearc.org/
  10. https://www.specialneedsalliance.org/
  11. http://www.easterseals.com/
  12. https://www.autismspeaks.org/
  13. http://specialneedsanswers.com/
  14. http://www.letsmakeaplan.org/choose-a-cfp-professional/find-a-cfp-professional?gclid=CjwKEAiA9om3BRDpzvihsdGnhTwSJAAkSewLIgB1GH95lrTy3VJcGVIZSW8HPzAjHhIrZIMoPLldXRoCt3Pw_wcB
  15. https://www.aicpa.org/ForThePublic/FindACPA/Pages/FindACPA.aspx

Dangerous Measures: The Fine Art of Calculating Returns

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

The person responsible for translating the math chapter of my book, Wealth Management, into Japanese told me, “You give me much headache.” Welcome to the math chapter.

Okay, class, today we’re going to be discussing one of the most common activities for financial planners, namely, the calculation of investment returns. Accounting in some measurable way for changes in investment values is fundamental to the work of financial planners. It may come as a surprise to you that such a simple concept is fraught with danger. The danger lies in the potential misuse of valid measurements.

There wouldn’t be much room for confusion if there were only one valid measure of investment return. Unfortunately, the mathematics of finance offers many choices. Among the most common are:

  • Current return
  • Total return (holding period return)
  • Real return
  • Compounded return
  • Time-weighted return
  • Dollar-weighted return (internal rate of return (IRR) and modified IRR)
  • Arithmetic return
  • Risk-adjusted return
  • Sharp ratio

Let’s consider each and I’ll simplify the discussion by assuming that we’re referring to the income received for a full year.

Current Return

This is perhaps the most popular measure with investors and some mutual fund marketing mavens. It is frequently referred to as the yield or payout. It’s an attractive measure because it provides a simple measure of the annual payout on an investment.

Dangerous Measurs Chapter Image file - .01

Although simple, this measure has a major problem. Consider the number we use for total income. That single number doesn’t distinguish the nature of the income. Is it interest income or principal payments, or capital gains, or some combination of those? There’s no way of knowing how consistent an income stream will be in the future. I’ll promise to pay you a current return of 20 percent per year as long as you don’t ask me for any money after five years.

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Okay, let’s focus on the interest income. Will that resolve the problem? Not necessarily. The bond fund we’ve invested in may hold many premium bonds. Those are bonds that were issued when interest rates were much higher, so although we receive significant current annual income, some of that is actually a return of principal. When bonds mature they will be paid off at par not at the bonds’ current market premium value.

Now we can talk about some measures that may be more useful.

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This simple measure eliminates potential misleading factors that affect current return, but it fails to answer a number of important questions. Measuring total return is only a starting point in evaluating investment returns.

Real rate of return = Total return minus Inflation rate

Another simple but very important calculation determines what investment advisors call “real return”—how much did an investor actually make after inflation. Earning 10 percent if inflation is 3 percent would be nice, but if a few years later inflation is 8 percent and they’re still earning 10 percent total return, that wouldn’t be so nice. All our clients live in the real world, so all of your planning should be based on an “after inflation” real return.

Compounded Return

Now we’re getting to the number most investors are looking for: “What did I earn last year?” The most common measure is called the Internal Rate of Return (IRR). It’s also known as the dollar-weighted return. This calculation considers the timing of additional investments your clients made and/or withdrawals they took during the year and the return of the investments in the portfolio.

Time versus Dollar-Weighted Return

We’re not done yet, one more to go. The power of IRR to include interim additions and withdrawals from the portfolio is also its Achilles’ heel. If you’re evaluating the performance of a portfolio when you have control of the external cash flows, the IRR provides a valid measure. If you have no control of the external cash flows—when your client adds or withdraws money—you need to consider using two measures. The IRR will provide a valid measure of your client’s portfolio performance; however, it will not answer the question of how successful your recommendations were.

To answer that question, you need an alternative investment-return calculation known as the Time-Weighted Return (TWR). Basically, this measure calculates how the investment would have performed if no new additions or withdrawals had been made during the year. After all, if you and your selected money managers have no control of the timing of external cash flows, your performance should not be penalized (or rewarded) for your client’s unfortunate (or fortunate) investment timing.

For example, consider the results of two investors, each of whom invested in the same mutual fund. Investor A invested $90 at the beginning of year one and an additional $10 at the beginning of year four. Investor B placed $10 in the portfolio at the beginning of year one and $90 at the beginning of year four. Here are the results of their investments:

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So there you have it, two investors, investing in the same portfolio, resulting in six different performance numbers. What do those numbers tell us? The average annual return? Not much. The dollar-weighted return? Investor B was lucky and invested the bulk of his money at opportune times and the advice was credited with a 9 percent annualized return.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Market Timing: A Fool’s Game

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Markets don’t care about what you need.

The Trujillos visited me a few months after the technology market crashed in 2002. They were a lovely couple—both in their mid-seventies—Mr. Trujillo was dapper in his tailored blue blazer, and Mrs. Trujillo was beautifully coiffed and dressed in a lovely St. John suit (my wife’s favorite high-end store). They had scheduled the meeting after sustaining significant losses during the tech market crash. After the traditional introductory “how are you” courtesies, Mr. Trujillo came right to the point.

Mr. Trujillo (T): Mr. Evensky, our investments were decimated in the market crash and we’re desperate to recover those losses. We’ve cut our expenses to the bone. The only basic needs remaining are our club and golf dues and our annual cruise. We’re hoping that you, as a professional, can help us.

Harold Evensky (HE): Mr. Trujillo, I’m sorry to hear about your losses. Perhaps you can give me some idea of how you believe I may be of help?

Mr. T: Well, we thought that by judicious market timing and sophisticated stock picking we can earn returns well beyond what we could by just tracking the market.

HE: I understand. Tell me how you were investing prior to the market crash.

Mr. T: Given the extraordinary returns in technology and all of the news about the new era of the nineties, we were heavily concentrated in technology funds. We recognized the risk of putting all of our eggs in one basket, so we diversified among several well-respected technology funds. For a year, we were doing extremely well; our returns were more than 80 percent. Unfortunately, no one warned us prior to the market crash, and in less than a year our portfolio was down 70 percent! I still don’t understand why we lost so much. It seems that if we made 80 percent and lost 70 percent, we should still be 10 percent ahead.

HE: I understand. Let me do some analyses to see how you’re positioned so I can determine what recommendations may be appropriate. Can we get together next week?

Mr. T: That would be fine.

After the Trujillos left, I gathered the information they had provided regarding their current investments and all of their financial goals. Factoring in assumptions for taxes, future market returns, and inflation, I entered all of the information into our planning software, MoneyGuide Pro, and ran several scenarios with varying allocations between bonds and stocks.

It was bad news: no matter how I jiggled the allocations, my conclusion was the Trujillos could reasonably spend only about one-half of what they considered a bare-bones lifestyle. That’s not the sort of news a planner looks forward to sharing with a client. Unfortunately, although Mr. Trujillo said they needed a return that would enable them to maintain their lifestyle, the reality is that the markets don’t give a damn.

How about Mr. Trujillo’s solution of market timing? As I explained to David Samuel in Chapter 14, “Market Timing for Fun and Someone Else’s Profit,” trying to find the pot of gold at the end of the rainbow is not a viable investment strategy. Unfortunately, their experience with the boom and bust of their portfolio didn’t convince them of the market-timing fallacy. Rather than the impossibility of consistently making the right call on market turns, Mr. Trujillo complained that no one warned them prior to the market crash. He ignored the fact that no one warned him because no one knew in advance. If you think about it, had the impending crash been obvious to professional investors, they would have moved to cash prior to the crash. Of course, they didn’t, and across the board, professionals, including the managers of the Trujillos’ diversified funds, were blindsided, as both investors and professionals have been with every market correction and crash.

You may be thinking about people you know who managed to avoid much of the loss during a bear market, and I’m sure that’s true. In fact, one of the major arguments for active management is that it may not work all of the time, but it comes to the forefront during bear markets because an active manager can reduce his or her equity exposure, whereas an index fund must stay fully invested. Although that statement is true, the conclusion is not.

In 2013, my graduate assistant (who’s now a professor), Shaun Pfeiffer, and I researched this argument. We found two fatal flaws: 1) The majority of active managers did not avoid bear market losses. 2) Even more importantly, those who managed to avoid losses in one bad market generally fail to do so in subsequent bad markets.

As for Mr. Trujillo’s confusion about his loss versus his expected 10 percent gain, it’s a classic—and dangerous—mental math trap. Big losses have far greater ramifications than most investors understand. Suppose the portfolio was valued at $1,000,000 before the big 80 percent gain. It would have grown to $1,800,000. If it then lost 70 percent, the 70 percent was a loss on the $1,800,000 portfolio, leaving a balance of only $540,000! Even worse, to get back to the $1,000,000, the Trujillos would need an 85 percent return. Not likely.

What did I tell the Trujillos? As tactfully as I could, I walked them through the numbers and tried to explain the reality of their financial position. Unfortunately, I was unsuccessful and they continued to insist that having cut expenses to the bone, they would have to simply find someone who could help. I wished them the best but feared they would simply be digging themselves into a deeper hole with progressively less opportunity to at least mitigate the pain.

The moral? Markets don’t have feelings or morals. They do not care what an investor needs and there is no investment or strategy that has consistently provided returns well in excess of those earned in the broad markets. Consequently, if you care about your financial future, don’t base the quality of your life on hopes, dreams, and the expectation of being the first person to find that pot of gold or win the lottery. Do your planning based on the reality of the markets.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Flight to Safety: The Portfolio that Makes for an Uncertain Future

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Certainty Isn’t Safe

Harold Evensky (HE): Kirin, good to see you. Where’s Autumn?

Kirin (K): She’s out shopping. I wanted to see you alone. I’m very upset and concerned about my investments; I don’t want her to know and get worried.

HE: Kirin, what’s worrying you?

K: Well, as you know, most of my money is in a series of large, one-year CDs that I’ve been rolling over every year. A few years ago, I was getting almost 9 percent. It’s been going down every year, and now I’m facing rolling them into CDs that are paying only 1 percent! Harold, we can’t live on 1 percent.

HE: I hear you and, indeed, rates have come down significantly. We might find a bank paying a tad more, but it would be a small increase. Let’s talk about repositioning at least some money into a balanced portfolio.

K: A balanced portfolio? That sounds like it has stocks?

HE: Indeed, the idea is to balance your investments between stocks and bonds—probably somewhere in the range of 50 percent bonds and 50 percent stock.

K: Harold, forget it! The market’s too risky. No way am I buying stock.

HE: Okay, Kirin, let’s talk about designing a laddered bond portfolio.

K: What’s that?

HE: Well, we would buy a series of high-quality bonds maturing each year during a period of time. If you invested $100,000, we might buy ten bonds, one maturing in one year, the next in two years, and so on until the last $10,000 was invested in a ten-year bond. That way, if interest rates go up in a year, you’ll have the money from the maturing bond to invest at the new higher, ten-year rate, and if rates go down, you’ll have most of your money invested in bonds paying a higher return than the current market.

K: Sounds cleaver, but forget it. No way am I tying up my money that long.

HE: Okay, Kirin, I give up. Stop buying your one-year CDs and buy five-year CDs. At least they pay a little bit more.

K: Harold, no way. Long-term to me is a green banana.

HE: [By now, I was more than a little frustrated.] Kirin, go ahead make my day—die. [Normally, I wouldn’t be so blunt, but Kirin was not only a client but also a long-time friend and I thought he needed a significant wake-up call, so I went on.] If you really did die, I would be distraught because you’re a good friend, but what keeps me awake at night and should keep you awake at night is not dying and having no financial assets to support your lifestyle. As my friend Nick Murray would say, your problem is confusing safety and certainty.

CDs are certain in that you can have confidence that you will receive the interest payments promised and your full principal back at maturity. In the real world, the friction of taxes and inflation is likely to result in your certain payments buying less and less. That means your standard of living will gradually be eroded. That is not safe. The moral? Don’t confuse certainty and safety. A safe investment portfolio has a high probability of allowing you to maintain your standard of living. For most of us, that means investing in both bonds and stocks.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Irrational Investing: You’re Not the only One Who’s Nuts

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Good news! You’re not irrational, you’re human.

I just came from one of the most exciting lectures I’ve ever attended. That shouldn’t be a big surprise, because Danny Kahneman, the speaker, is a Nobel Laureate. Professor Kahneman received the Nobel Prize in economics for what has become known as Behavioral Economics. Basically, his studies brought to light the difference between the rational investor—someone who always rationally makes investment decisions in his or her best financial interest—and real people like you and me. We live in a complex world and that’s certainly true of investing.

To manage the complexities of life, we often use something called heuristics to help us efficiently make decisions in spite of complexities. Think of heuristics as mental shortcuts. Most of the time, these shortcuts work out well; unfortunately, they sometimes result in our making decisions that, when looked at objectively, seem irrational. Each of us also comes complete with a bunch of cognitive biases that lead us to create our own reality, which may not be consistent with the real world. Let me share some examples from Professor Kahneman’s lecture.

Built-In Bias

Just after being introduced, Kahneman asked everyone to look at the audience in the room (there were about one hundred financial planners in attendance). After a few seconds of our rubbernecking, he asked us to raise our hands if we believed that the quality of our planning advice is above the average represented by the other planners in the room. Well, surprise, surprise, we were all above average—just like Garrison Keeler’s Lake Woebegone, where all of the kids are above average.

The problem, of course, is that’s not rational. Half of the audience must have been below average. Professor Kahneman explained that as humans we have an innate overconfidence bias that leads us to have confidence in our judgment—a confidence greater than objective accuracy would suggest. How, he asked, might that get us into trouble when investing? Lots of ways.

We are often overconfident in our ability to pick investments or in the abilities of the money manager we love or the ability of financial media mavens to guide us to the best investments.

Kahneman told the audience about the research of Terry Odean and Brad Barber, University of California professors, who studied the trading results of almost seventy thousand households during a six-year period, accounting for about two million buys and sales. They found that investors who traded the most—those with the most confidence and the best ideas—earned an annual return 11.4 percent. The problem was that the market return was 17.9 percent. The professors’ conclusion? Overconfidence in your good idea may be hazardous to your wealth.

The best protection we have against overconfidence is to step back and apply a strong dose of humility and skepticism before we act.

Next, Kahneman put up a slide that looked something like this:

HHTHTTHTTH

TTTTTTTTTTT

He explained that it represented the results of tossing two coins ten times. He and asked which one we thought was the fair coin and which one was bogus. As sophisticated practitioners we knew instantly that the second coin was bogus: Ten tails in a row? Give me a break. In hindsight, I’m embarrassed to say we fell for the heuristic called representativeness. You know the one: if it walks like a duck and quacks like a duck, it must be a duck.

The problem is that the randomness heuristic led us astray. Had we stopped to think it through, we would have realized that getting ten tails in a row is just as random as the first toss series; the problem was it didn’t look random. Our brains, knowing a coin toss is random, took a shortcut and concluded that toss one looked random so it was authentic; toss two was obviously not random, so it must be bogus.

How can that get us in investment trouble? Ever consider investing in a fund with a Morningstar rating of less than four or five stars? Probably not; bad mistake. Use the star information as one element in your selection process, but the Morningstar ratings are not guarantees of future superior performance. You need to do a lot more research than simply defaulting to the stars as the sole selection criterion. Doing so puts you at serious risk of picking a loser and rejecting a superior investment.

Muddled Math

Professor Kahneman also introduced us to the work of Professor Dick Thaler on mental accounting. It seems that in addition to occasionally being misled by our heuristics and biases, we also stumble over what would seem to be simple math. I know this from personal experience with my clients. I remember having a visit after the tech bust from a retired surgeon, who came into my office almost in tears.

“Harold, I don’t understand. Last year I made 80 percent on my investments and this year I lost only 60 percent, yet my statement says I’m way under water!”

My client’s mental accounting told him that a gain of 80 percent less a loss of 60 percent should leave him 20 percent ahead. The reality was that his original $1,000,000 investment grew 80 percent to $1,800,000, so his 60 percent loss was on $1,800,000, for a loss of $1,080,000. The end result? A balance of $1,800,000 less $1,080,000 left him with only $720,000. It was a painful way to learn that big losses take much bigger gains to recover.

Consider, for example, a volatile investment of $100,000 that loses 50 percent the first year, leaving you with $50,000. Suppose the next year you make 50 percent, so your average return for the two years is 0 percent. Did you break even? Nope. Your $50,000 grew 50 percent to $75,000, leaving you $25,000 under water. Remember that the next time you want to risk funds in a high flyer.

Framing

Kahneman presented much more on the problems investors face because we’re human and not necessarily rational. Then he provided us with the hope that we might help our clients (and ourselves) be better investors through the power of framing.

Framing has to do with the idea that the way people behave depends on how questions are framed. Suppose I offered you two brands of chocolate bars. One was 90 percent fat free and the other contained 10 percent fat. I’ll bet I know which one you’d chose. Have you looked for prunes lately? You may have trouble finding them unless you look for dried plums. The Sunkist marketing department understands framing.

How can you use this technique to be a better investor? Here are a few ideas:

The next time your neighbor gives you a hot tip, instead of focusing on all the good things that might happen, reframe your focus and ask yourself what might go wrong. My partner, Deena, once helped a client make an important decision by pointing out that if she made the significant investment she was considering and it succeeded, she could increase her standard of living by 10 percent. However, if it didn’t pan out, she would have to work four years beyond her planned retirement date to make up for the loss. She passed on the opportunity. She may not have made a killing and missed out on taking a world cruise, but she was able to retire just when she wanted to.

Reframe your performance-evaluation horizon. Investing for retirement is investing for the rest of your life, so when evaluating your investment’s performance, keep your eye on the long-term, not the daily market gyrations. That means skip the comparisons to last month, last quarter, or year-to-date performance and look at performance over years and market cycles. Also, reframe your benchmark. You might compare your large-cap core manager’s performance to the S&P 500 but not to your portfolio. Instead, consider using a real-return benchmark—compare your portfolio return to inflation. After all, that’s what your plan should be based on.

Are you holding a position in a stock at a big paper loss, but you’re reluctant to sell because then it would be a real loss? If I asked you whether you’d buy that stock today, you’d tell me I’m nuts. You wouldn’t touch that dog with a ten-foot pole! Let’s reframe your decision. Since the cost of trading today is negligible, you could sell your investment tomorrow and have the cash proceeds in your hand almost immediately. That means by holding onto your stock, you’ve made the decision to buy it again!

The moral? We’re human, not rational, and recognizing reality and learning about some of the problems our biases and heuristics get us into and using framing to help manage these risks will make us far better investors.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Asset Allocation: The Myth of the Portfolio that Acts your Age

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Harold Evensky CFP® , AIF® Chairman

Policy research is great for policy makers but may be poison for you.

I just finished reading an article in a professional journal that reported on extensive research about how people of different ages divide their investments between stocks and bonds. It went something like this.

Our research, based on zillions of responses to trillions of questions, has determined that investors at age forty have 60 percent of their funds in stocks and 40 percent in bonds. Investors at age seventy have 70 percent in bonds and 30 percent in stock. Further analysis, to a high degree of statistical significance, has determined these proportions are close to the proper allocation of resources for the average investor of these age groups.

 Therefore, we have concluded that, based on our studies, investors should use the following formula to determine the percentage of stocks and bonds in their portfolios:

  • The amount to be invested in stocks = (100 – the investor’s age)
  • The amount to be invested in bonds = (100 – the amount invested in stock)

What a terrific solution to how you should invest your money. No muss, no fuss. All you need to know is your age and the rest is just simple math that you can do in your head. If that seems too easy, there are many companies and magazines that provide more detailed suggestions about how to invest your money based on your age. All of these approaches are based on a concept known as life-cycle investing. The general idea is that your financial needs are related to your age. The approach is endlessly popular and sounds terrific. There’s only one problem: it’s hogwash!

Wait, that’s not fair. If you happen to be a sociologist or a government policy maker, this might be terrific stuff. After all, sociology is the study of large groups. Still, it’s dangerous hogwash if you try to use it to plan your own life. Remember, sociologists are the professionals who came up with the concept of families with 1.8 parents and 2.3 children.

Since you’re probably not a sociologist or policy maker, and are more interested in your unique needs than the statistically average needs of everyone your current age, the cookie cutter—life cycle approach—to planning won’t work for you.

Let me tell you about two of my clients, the Salters and the Boones. When we first worked with them, my partners and I were amazed at how similar these two families seemed. Both families not only live in the same city, they also live in the same neighborhood, just two blocks apart, in houses of the same model, built the same year by the same builder. Mr. and Mrs. Salter and Mr. and Mrs. Boone are working professionals. When we met them they each were fifty-five years old, in good health, and they planned on retiring when they reached sixty-two. The coincidences seemed endless. We thought they even looked alike! Both had investment portfolios valued at $1,000,000 at that point, and they all considered themselves moderately conservative investors. Because neither the Salters nor Boones have children, they have no desire to leave an estate.

Well, if lifestyle planning worked, these two couples’ investment portfolios should look alike. Lucky for our clients we are financial planners and we gathered more information. Here’s what we discovered:

Asset Allocation Chapter Image file - .01

How about that? To a sociologist, these couples looked alike; to a financial planner, based on their savings rate, their retirement income, and financial goals they looked very different. Let’s see how our recommendations differed from the life-cycle solution.

Asset Allocation Chapter Image file - .02.png

Note that the life-cycle recommendation is the same for the Salters and Boones. That seems a little strange because the Boones plan on spending a lot more than the Salters in retirement, and the Salters are saving more between now and retirement and have significantly more Social Security income. The fact that their ages, risk tolerance, employment, home, health, and planned retirement dates are similar is irrelevant.

After careful analysis and based on the information specific to our clients, we made the following recommendations:

Asset Allocation Chapter Image file - .03.png

It sure doesn’t look like the 55 percent bond formula you’d get by subtracting their age from one hundred. Why the difference? In spite of similar demographics, the Salters and Boones have very different resources and goals. Remember, you’re unique and planning based on simple rules of thumb can be a mighty dangerous way to plan the quality of the rest of your life.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Life Timing: What Did Lynn Hopewell Teach Us?

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Harold Evensky CFP® , AIF® Chairman

You’re not average, so don’t plan the quality of the rest of your life based on averages.

I was sitting front row center in a big conference room at our national planning symposium; I’d been looking forward to this talk for a while. The speaker, financial planner Lynn Hopewell, was a good friend and one of the most thoughtful practitioners I knew. My partner, Deena, and I had been responsible for planning this program and we invited Hopewell to speak because he told us he had a few major concepts he wanted to share with his peers. Here’s what he shared that day:

And End Not So Near

Welcome, everyone. I have few stories to tell that I hope will be a wake-up call for the financial planning profession. The first is about my planning for an engineering client, Ms. Jane. She is sixty-three, a very successful and accomplished civil engineer, and president of a major structural engineering firm. She hired me to work with her in developing a comprehensive retirement plan. Well, since I too am an old engineer, I know how they think—detail, detail! So I worked very hard to provide Ms. Jane a plan that would resonate with her. Finally, I was sitting down with her, ready to blow her socks off, and after going through my complete analysis, I thought I had.

“Mr. Hopewell,” she said, “I’m very impressed with the thoroughness and depth of your plan. I have only one small question.”

Well, needless to say, I was beaming at the compliment and looked forward to answering her “one small question.”

She went on, “I understand that selecting a mortality age—the age the plan assumes I die and will no longer need income—is a critical element in the planning process.

“Obviously,” I said, “if we arbitrarily use a very old age, such as one hundred, we’re likely to have to tell you to reduce your spending so that your nest egg will last to that age. Of course, if you die before one hundred, you’ll be leaving a lot of money on the table that you could have enjoyed spending while you were alive. If we assume a much younger age and you’re long-lived, the consequences could be even worse because you’d run out of money before you ran out of time. As a consequence, we work hard to select a reasonable planning age.”

“That makes sense to me,” she said, “and I understand that the age you selected for the plan is based on the projected age of my death from a national mortality table.”

“Correct! And not just any mortality table. We spent quite a bit of time consulting with actuaries to determine which table reflected the most current actuarial data.”

“I understood that. What I’m still a little confused about is the meaning of that age. As I understand it, if the table says my mortality age is eighty-eight, that means half the people will have died by eighty-eight and half will still be alive.”

“Correct.”

“Well, doesn’t that mean if I plan to age eighty-eight, I’ll have a 50 percent chance of outliving my plan?”

That question hit me like a Mack truck. Ms. Jane was correct. Even worse, in thinking about it, I realized that anyone with the resources to need the advice of a financial planner was likely to have had better health care and nutrition than the average of the universe of individuals making up the mortality table. That means Ms. Jane had better than a 50 percent chance of outliving my plan. This was a major wake-up call for me and should be for any practitioner relying on a traditional mortality table. Lynn said, “After acknowledging Ms. Jane’s point and scheduling a follow-up visit to give me time to consider the ramifications of her simple question, I hunkered down in my office to consider how I might resolve this problem.”

So, I went back to my own office and did the same. After additional conversations with my actuary friends, I concluded that a reasonable solution would be to use more customized actuarial tables—those that allowed me to factor in whether the client is a smoker, nonsmoker, her current health, and whether the lifespan of her immediate family is long, average, or short. Then, using the appropriate customized table, we would select an age that represented only a 30 percent chance of her outliving the age indicated in the table.

Here’s an example that shows how big a range the mortality age can be depending on these factors:

Life Timing Chapter Image file - mortality age range

Obviously, there is no guarantee that the age selected will coincide with the client’s mortality; however, following this process is likely to provide a much more realistic estimate.

Well, Lynn was right. That was a major wake-up call, because I’d been using a standard actuarial table and mortality age for my planning assumption. That was about to change.

Even if Lynn had stopped there, this information would have justified all of the time and cost of attending the three-day symposium, but there was more. Lynn’s next story was about the ah-ha moment he had one day when developing a college funding recommendation.

College Calculations

Not long ago I was preparing a simple college funding recommendation for a client. You know how that goes. It’s a simple time-value calculation that requires input on how many years until college, how many years of college the client wants to pay for, the annual cost, and the college tuition inflation rate. My input looks something like this:

Life Timing Chapter Image file - college calculations

A financial calculation would result in a recommendation that the client set aside about $145,000 to fund this expense. When I presented this to the client, he asked how confident I was about my number. When I thought about his question, I realized the answer was not very. My estimate was what we refer to as a “point estimate.” This means that unless every assumption I made was exactly right, my recommendation would either over- or underfund the college tuition bill.

As a former engineer, I remembered that when trying to estimate the probability of uncertain events, we used a technique known as a “Monte Carlo simulation.” Developed at Los Alamos National Laboratory during the Second World War for the design of nuclear weapons, Monte Carlo is really a simple concept. Rather than making a single guess regarding a possible outcome, we make guesses about the likely ranges of the outcomes. We then simulate thousands of possible futures with different combinations of those possible outcomes.

Let’s expand the table I showed a minute ago to more realistically reflect the uncertainty in our estimates.

What we know with some certainty:

  • Years to college 4
  • What we’re making an educated guess about
  • Tuition somewhere between
  • Annual cost $30,000 to $50,000
  • College costs inflation 5 to 7 percent
  • Investment return 6 to 10 percent

With these ranges, there are many thousands of possible outcomes, for example:

Life Timing Chapter Image file - college calculations no. 2

The Monte Carlo simulation calculates for each of these examples how much money that investors would need to set aside today if they want to fully fund four years of education. If the analysis ran a thousand examples, the results, listed in order of decreasing savings, might look something like this:

Life Timing Chapter Image file - college calculations no. 3

In this case, the question was how much should you put away now if you want an 80 percent probability of meeting your goal? The answer would be $167,000, because 80 percent (800/1,000) of the simulations would have succeeded with that amount of savings or less.

Well, this was another major wake-up call for me. In hindsight, it seemed obvious that a point estimate was inappropriate and that a Monte Carlo simulation could provide a more meaningful answer. In wrapping up his discussion, Lynn reminded us that expanding the input matrix meant making more guesses. Despite the mathematical rigor of a Monte Carlo simulation, adding more guesses does not justify adding two more decimal places to the answer. His point was that we should use Monte Carlo as an educational tool and not suggest it is a mathematically accurate answer.

The Takeaways

When planning retirement, don’t assume average mortality—you’re not average.

When attempting to quantify an uncertain future, don’t default to a single estimate. Use a Monte Carlo simulation to develop an understanding of the likelihood of possible outcomes, but don’t take the results as gospel.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Market Timing for Fun and Someone Else’s Profit – Don’t Do It

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Harold Evensky CFP® , AIF® Chairman

A broker stands looking out of the window of his sumptuous office down at the marina thirty stories below with his client at his side. “See those yachts down there?” says the broker to his client. “The one on the left is mine, the one in the middle is my partner’s, and the one on the right is our office manager’s.”

“Where are your clients’ yachts?”

David Samuel: Hello, Harold. It’s David Samuel again. I know you have that AAII meeting coming up next week, but this can’t wait. My brother said he just got a call from his broker, who told him to bail out of the market at least for the next few months because the firm’s technicians said they see a major correction coming within weeks. I assume you’ve probably seen the same and agree, but I just wanted to double-check.

Harold Evensky: David, I just want to be sure I have this straight. You’re saying the broker is confident enough in his crystal ball to say that everyone should run to cash?

DS: You got it.

HE: Hum, I know he works for a big wire house; I wonder if that firm has moved all its money to cash? I don’t think so, because a move of that magnitude would have made the papers, and none of the managers we monitor have made significant liquidations recently. It somewhat makes you wonder what your brother’s broker knows that no one else does.

DS: Well, I understand that he’s been in the business for decades and he’s a senior VP at the firm, so he must know something.

HE: I’m sure he knows how to sell, because the impressive title comes with generating big commissions for the firm. There are many quality SVPs who earn their commissions from long-term quality advice.

Unfortunately, there are some who succeed by focusing on generating commissions independent of the client’s needs. That’s the basis for the old joke: “How do you make $1,000,000 in the market? Start with $2,000,000.” In deciding whether market-timing advice is something you want to follow, remember, when market timing, a broker earns a commission for the sale of each and every one of the positions their clients sell and another commission when they repurchase those positions. Here are a few things you might want to consider:

Can you name the top ten musicians of all time? The top ten baseball players? The top ten presidents? Of course, you can. We might argue about the list but most people can make up a list.

Now, tell me the top ten market timers of all time? Can’t even name one, can you? Your brother’s broker may be the first, but do you really want to bet on that?

What do market reality and statistics tell us? There are innumerable problems with market timing, including transaction and tax drag. But there are two major problems. You have to make two correct calls: 1) when to get out and 2) when to get back in. Factoring in transactions and taxes, research indicates you need to be correct about 70 percent of the time.

Markets don’t just drop precipitously, but they recover quickly, so waiting for confirmation of the end of a bear market usually means missing a significant part of the recovery. That makes for a tough hurdle.

For example: In a study covering the period 1987–2007, research found that the annualized return for someone invested for 5,296 days was 11.5 percent. Unfortunately, if you missed the ten best days (less than 2/10 of 1 percent), your return would have dropped to 8 percent,

Why would you be likely to miss those best days? Because those best days occurred within two weeks of a worst day 70 percent of the time. And they occurred within six months of a best day 100 percent of the time!

In an industry study in 2008, researchers found that although the annualized market return for the prior twenty years was 11.6 percent, the average stock fund investor earned a paltry 4.5 percent. It turned out that for most investors, market timing was mighty expensive. And, David, unless you’ve recently obtained a working crystal ball, it’s likely to also prove costly for you.

To make money in the market, you have to be in the market through thick and thin. In fact, if you remember our discussion on rebalancing, you’ll remember that bear markets are great buying opportunities for long-term investors. So, my advice is to stop listening to so-called experts spouting nonsense and go back to making money in your business.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.