Outcome Bias
In a 1988 study Jonathan Baron and John Hershey presented participants descriptions of several different medical situations facing a doctor. The descriptions included what the doctor knew, the treatment provided, and the outcome. However, in some instances the outcome was described as a success, while in others it was deemed a failure. All the other factors (available data, treatment, etc.) were identical. Here is where the bias appears; by a factor of around 5 to 1 the successful outcome was rated as representing higher quality decision-making. This result appeared despite the fact that 88% of the participants agreed that the outcome shouldn’t be included as a factor in rating the quality of the decision. When combined with the tendency to give more weight to the most recent events (myopia) this has many investors beating themselves (or their advisors) up when the market turns against them. Even a really well considered decision can go bad, so take a deep breath and stick to the plan. Even House, M.D. loses one once in a while. Particularly if the loss was related to a macro event (market drops, housing slows, and the like) then hindsight bias comes along and beats on you some more.

Hindsight Bias
Whenever the equity markets (stocks) have a big move the market “experts” appear within minutes of the close to explain what happened. These pundits always explain events with great confidence. The impression you walk away with is that any dope should have known that was going to happen if they just paid attention. Where were all these experts before the market went south? They didn’t know either, they are just good talkers. Markets experts humbly admitting their surprise doesn’t make for good television/radio/print/internet/pod-vidcast ratings. This is where experience can help. I remember a market newsletter writer that predicted the 1987 crash. She translated that success into huge circulation for her newsletter. It would have been more impressive if she had not also predicted the crash of 1984, and 1985, and 1986. If you do not remember the crashes in 84, 85, & 86 that’s because there weren’t any.

We can see this in the news this week. There is a lot of “buzz” about the Hindenburg Omen. This technical indicator has triggered before every major market drop for years. That sounds good. However, the omen has triggered four times for every drop. Its’ accuracy is only 25%. Interesting, but not a reason to buy ammunition and hide under the bed.

Don’t let hindsight and outcome bias beat you up. The markets are by nature unpredictable and no approach works every time in all situations. Stick to your plan. There is nothing wrong with adjustments, but if the plan was sound to start with, it will likely work out just fine.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Another part of his psych-out is our tendency to view the most recent short-term performance of a long term investment as more important than the long term performance. That is a fancy way of saying we tend to be short sighted when evaluating performance. We weigh the most recent events more heavily than long-term issues. Even when there is a 30-year time frame we tend to evaluate performance and make decisions on what has occurred in the past year or two. When you combine this tendency with Loss Aversion you get Myopic Loss Aversion, an even more damaging behavior. For example: An investor places $100 in an investment and has great returns. Over the course of five years the money doubles to $200, then the crash and the investment drops 25% to $150 dollars. Even though the average return over the six years was about 7% the typical investor remembers the drop from $200 to $150 most acutely, and emotionally feels cheated even though they experienced a solid return. This emotional reaction occurs even if the investment has outperformed its’ peers. If you want to read more about this track down a study by Shlomo Benartzi and Richard Thaler from 1995, “Myopic Loss Aversion and the Equity Premium Puzzle” (currently available in PDF format here).

If you understand that your emotions, (your “gut” can be your enemy as well as your friend in finance) you are better equipped to make an objective decision about your future. Before you jump to an action, take the time to look at the long-term performance of your investment as well as your actual experience and compare those figures to the average performance of that type of investment. Simply refuse to take a leap until you know where you really stand.

In the next post we will take a look at Hindsight.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Sometimes numbers are so big that they stop having any real meaning to individuals. The budget deficit here in the US is a good example. Some time in the past year US deficit spending went from the Billions to over a Trillion, while the actual debt is over 13 trillion. Once you get past nine zeros most people just see “big number”. Really, from an individual perspective what’s the difference between millions, billions, and trillions? (Note: if you are not sure, consider running for congress.)

So when we start looking at the kinds of numbers it takes to have a secure retirement it can be overwhelming. Worse yet are advisors (myself included) who tend to throw in inflation, interest rates, guarantees, insurance, alpha, beta, risk, return, and a ridiculous number of factors when trying to introduce a plan. We are full of opinions that contradict what the other advisor said (or ourselves). It is all overwhelming and confusing. Most financial issues have significant complexities. A favorite quote of mine from H.L Mencken is, “For every complex problem there is an answer that is clear, simple, and wrong”.

The unfortunate downside of the huge numbers, complexity, and contradictory information is that folks become overwhelmed and do nothing. All the information creates sensory overload and we respond by hunkering down and freezing. However, the big rig of the future just keeps coming right at us and we better determine what we’re going to do and get moving or risk road-kill status.

So what to do? First is accepting that reality is complex. Yes, the number is big, but that doesn’t mean it is unattainable. Yes, there are a lot of moving parts to a financial plan, but they can be integrated. Know that you will need to dedicate some time to developing a good plan and be wary of those who promise a simple and clear answer to complex problems. Just keep moving.

While you are gathering data and developing a plan don’t lose sight of basics: strive to maintain a positive cash flow, saving is better than not saving, debt is not your friend, and set & pursue realistic goals.

Remember that big numbers are just a lot of smaller numbers put together. Even if the amount you can save today seems insignificant when compared to the target, every amount helps get you closer to success.

To address the complexity of planning you should seek out a planner. (That may seem a bit self-serving but hear me out.) Look for someone who focuses on planning and not product sales. A good planner will take the time to both understand your situation thoroughly and to help you understand how a suggested solution works. The National Association of Personal Financial Advisors has a great set of questions to ask a prospective advisor in the “Financial Advisor Diagnostic” at www.napfa.org/tips_tools/index.asp. That should help you find an advisor who meets your needs.

The most important thing to avoid is the tendency to do nothing. Just keep moving forward toward those long-term goals.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

The Wealth Effect
“Asset Bubbles” form when the short-term demand for a given asset outstrips the supply. Eventually the market for nay given asset will stabilize, either by a drop in demand, an increase in supply, or some combination of the two. The problem is that the sudden increase in some asset’s value creates the impression that it will continue (temporal proximity bias – a topic for another day), so folks want to get in on the “action” creating even more demand and pushing prices higher. At some point there is a trigger event and people’s impressions change. Usually this creates a drop in demand, which puts downward pressure on the price, and the whole thing reverses rather dramatically. In the last twenty years we have seen this cycle in stocks, oil, and real estate. The real estate bubble was particularly impactful because so many people own homes. We are seeing a similar pattern in treasuries and gold now. Sorry if I am insulting your favorite metal (and maybe this time is different) but if it looks, feels, and smells like a bubble I will treat it like a bubble.

The bubble burst has a pretty dramatic impact on its own, but the impact of the “POP” would be much easier to take if it was not for the “Wealth Effect”. The wealth effect is a form of “equity-itis”, a misperception of our wealth based upon the equity we have in value-inflated assets. We begin to think of ourselves as wealthy because we own something that has increased in value dramatically and our increased net worth leads us to spend in line with our new-found wealth. I know what it feels like. My home tripled in value over a decade, and then promptly dropped 50% from the high. Bummer.

Imagine that you have a steady, disciplined, financial life. Your spending is in line with your net worth and you save a bit each month. Then someone walks up to you and hands you a closed box. Somehow they convince you that the box has a million dollars in it, that it is your money, and that you can tap into the money anytime you want. You go home feeling much wealthier. How would that affect your life? Would you expand your lifestyle? Would you buy a new home, a better car, or take a dream vacation? When you come back from your month in the Caribbean, you drive your new BMW to your new mini mansion and get ready to pay the bills. So far all is good, but when you open the box it only holds a half million dollars, or a quarter, or maybe nothing at all. Suddenly you are in trouble. You have to sell the house, give up the car, and are cutting back on everything to pay off the card you booked the cruise on. It is bad enough when it happens to you, but when it is happening to most of your neighbors as well: it is called a recession.

This financial psych-out is an easy one to fall into, especially when everyone around you is doing the same thing. The thing is to learn from the pain of others (or your own pain) and manage credit with the caution it deserves. Just because your house or your portfolio is big today, don’t assume it will be tomorrow.

In the next entry of this series of Financial Psych-outs, we’ll take a look at “Financial Inertia.” Stay tuned!

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Layer it on thick
It seems that most large retailers have some sort of credit card and the vast majority of stores take plastic. If asked I am sure that these stores would say that it is for customer convenience, but there is another reason that retailers accept these proxies for money: the “layering” effect. It is the same reason casinos use chips for gambling. The further the proxy for money is away from “real” money the more psychological distance we feel from the act of spending. Casinos have learned to take advantage of this psych-out. If we laid ten and twenty-dollar bills down on the craps (or roulette, or poker) table it would have a much greater impact in our heads. We see bills and coins as potential items for our life. When we see things that represent food, fuel, and shelter scooped up by the blackjack dealer it scares us a bit. However, colorful plastic chips do not have the same impact, so no money on the table means customers are more willing to part with these plastic proxies for rent money.

You don’t gamble? I bet you still use plenty of proxies for cash. Paying for that Venti Mocha with a Starbucks gift card just doesn’t hurt quite the same way as handing over a fiver. For the real whammy we can now combine online bill pay services with our credit cards. Our employer deposits our earnings directly into a bank account. We then buy a new TV with our Visa card and do not see the bill for a few weeks. When the charge shows up on the credit card statement (delivered electronically) we direct the bank to pay the bill via on-line bill pay. Each layer between cash in our pocket and the purchase makes the loss of the cash a bit more comfortable, and the sale a little easier.

It would be difficult to give up the electronic money world, but this proxy effect can lead us to make poor money decisions. So try to give up the electronics for just one month. For one month convert your paychecks to cash for just a bit so you can see it and feel it. Then, for the whole month pay as many things as possible with cash and use checks for the rest. Odds are your landlord or mortgage company will insist on checks, but your supermarket, gas station, and local Starbucks will be perfectly happy with taking cash. Keep track of where and how you spend your cash. At the end of the month you will be shocked at where you spend your money, and will have found several ways to spend less.

Next week in Financial Psych-Outs Part 2 we’ll tackle “the wealth effect”…

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

It’s now putting much more emphasis on the size of your balances and how close they are to your total credit limit. It’s a behavior trigger that creditors see as a bigger worry than ever. So the best thing you can do for your credit score is to get your balances down to under half of your credit limit.

Even better, pay them off entirely and use them only when you know you can pay them off at the end of the month. Inactive accounts will ding your credit score, but quick payments can only help.

The latest revision in the FICO system will actually allow a bit of lenience on late payment – something that might affect more than a few consumers with the downturn in the economy. Obviously, this won’t mean that someone can chronically pay late, but once or twice won’t make the same impact as in earlier FICO versions.

Yet credit utilization – the amount of credit you’re actually using relative to your credit limit – is a much bigger deal simply because high balances are still prevalent among consumers. From the lender’s perspective, high balances mixed with a tough economy means a higher risk of default among customers.

So, one more time. What’s a good target utilization rate for all your revolving credit accounts? No more than 50 percent of your credit limit, and if you can get it significantly lower than that over time, that’s a good plan. The lower your credit utilization, the better your score.

What does that mean for ordinary Americans who don’t meet that under-50 percent goal? It means you shouldn’t be applying for new credit or refinancing for awhile, and that includes something as innocuous as a department store charge.

So maybe that means deferring gratification for awhile until you get things under control. But look at it this way – you can use this time as a way to develop more knowledge about credit and be in a better position long-term. Here are some things you need to know:

You’ll need at least a 740 score for the best rates: You’ll often hear that credit scores of 700 and up will get you best customer status with lenders. That’s true, but you need to aim significantly higher. For the lowest rates and best terms, you need to get your credit score above 740 (the top credit score, by the way, is 850), so keep that target in mind.

Budget: If you’ve never reviewed your spending and picked out areas where you can cut, you’ve never done a budget. Start tracking your spending either on paper or with financial planning software (such as DebtDasher) and start pinpointing what spending you can shift over to paying off debt.

Get some advice: Remember that debt is just one part of your overall financial picture. It might not be a bad time to sit down with a financial planner to talk about your debt issues, planning for retirement, your kids’ college education and any other key financial goals.

Monitor your credit reports: Remember that you have the right to get all three of your credit reports — from Experian, TransUnion and Equifax — once a year for free. You can do so by ordering them at AnnualCreditReport.com. Order them individually at different points in the year. That means you’ll get an extended picture of how your credit picture looks because the three bureaus feed each other the latest information. You’ll also be able to clean up errors as you find them — errors can drag down a credit score – and you’ll also keep an eye on identity theft. Oh, and make sure you use the site above and avoid the businesses that use “free credit report” in their title or a singing pirate as their spokesperson. It’s easy. If they ask for your credit card number, don’t do business with them.

Make electronic payments: Electronic bill payment will allow you to save on postage while guaranteeing on-time payment, and the budgeting advice mentioned above will allow you to put a few more bucks toward getting that loan or credit card bill paid off. It’s important to always pay more than the minimum payment on your bill – otherwise your balance will barely move.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Worry about retirement seems to be widespread. A January survey by the National Institute on Retirement Security noted that 83 percent of Americans are concerned about their ability to retire.

Yet the worst thing you can do is tap or give up on your retirement funds. No one can know with any certainty when the investment markets will rebound, but even if you can contribute something, you stand to gain once markets start to rebound. Even more important, you risk penalties and the lost potential for earnings if you turn your back.

Before you make a move, seek out some advice. It’s a good idea to check in with an expert such as a Certified Financial Planner™ professional to see where your retirement funds stand in light of all your finances before you do anything.

In the meantime, here are things you can do to put your retirement funds in better shape.

Don’t stop funding your 401(k) under any circumstances: In March, the Spectrem Group, a Chicago-based consulting firm, reported that 34 percent of U.S. employers have reduced or eliminated matching contributions to their defined contribution retirement plans – which include 401(k)s and 403(b)s – since January 2008. The Pension Rights Center reports that besides the Big Three automakers, dozens of major companies have cut back their match, including Motorola, Starbucks, and JPMorgan Chase & Co. It’s a significant impact. US News & World Report recently reported that for a worker who earns $50,000 annually and receives a full employer match of 50 cents to the dollar on six percent of his or her pay, the match cut means $16,000 less for retirement. An employer dropping its contribution is bad news, but you should make every effort to keep up with your contribution because if you don’t, you’ll miss valuable tax deductions and the chance to build your funds more effectively for the long term.

Stay invested: Because no one precisely knows when the market is headed up or down it’s best to stay invested at a time when everyone is waiting for a rebound. Keep in mind that the market’s top performing days typically come at the start of a recovery, so leave your money in your 401(k) and IRAs.

Keep in mind that withdrawing or borrowing your funds can be costly: If you have an emergency situation, be careful. Workplace 401(k) plans do allow for hardship withdrawals, but you might have an option to take a loan, which would save you the taxes and the 10 percent penalty that accompany hardship withdrawals for account holders under the age of 59. The majority of 401(k) plans allow you to borrow up to 50 percent if your vested account balance or $50,000, whichever is less.

Adjust your spending so you can save more: If you have an existing Roth or traditional IRA or other means of saving for retirement, do whatever you can to get more money into these accounts. It may not come close to meeting the shortfall from losing an employer’s contribution or the chance to add to a 401(k) after you’ve lost your job, but it’s critical to keep some savings going.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Last week June’s numbers were released. It was an unpleasant decline of 125,000 non-farm payrolls reported. However, this includes the layoff of 225,000 census workers. Private sector payrolls increased to 83,000, more than double last month. This is really good news, though the private sector needs to add more than 100,000 jobs a month just to keep up with population growth. Also, the unemployment rate dropped to 9.5%, though this is not particularly good news as the drop is mostly a result of workers becoming discouraged and giving up. The market responded negatively to the good news.

The market is not a great indicator in the short term. Sometimes the market treats bad news as neutral and good news as good news. Not right now though. Right now the market treats good news as neutral and bad news as bad. Don’t expect a nice uptick in stocks until the market shakes the blues.

Let’s get back to the unemployment rate. This number is an important indicator of mood and economic activity, but it is a bit deceptive. The rate is a measure of the percentage of people who have or want a job and don’t have a one. A person is said to want a job if they have actively looked for work in the prior four weeks. This is supposed to weed out those people who do not want to return to the workforce. In an extended downturn (or slow recovery) a number of workers become discouraged and quite looking. The drop in the unemployment rate is more a result of a reduction in those who are actively seeking work rather than a real increase in total employment.

The headlines will cover these signs of weakness, trumpeting the poor showing as compared to the average post-war recovery. However, this slow recovery, particularly in employment, was what we saw for the last two recoveries (1991 and 2002). We may need to adjust our expectations; the jobless recovery may be the new normal in the information age. It is neither good nor bad, it is just the way it is. Unless you need a job, then it is just bad.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

Coordinate college support with overall estate planning: Grandparents should look at their support for their adult children and grandchildren as an overall part of their estate strategy. A CFP® professional, in concert with estate and tax experts, can help grandparents and their adult children settle a series of estate issues at one time, saving time, money and worry later.

Consider the 529 plan option: A 529 college savings plan is an investment vehicle operated by a state or educational institution designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Service Code, which created these plans in 1996. If parents have set up a 529 plan for their child, grandparents can contribute to that plan or they can set up their own 529 plan account with their grandchild as the beneficiary.

Watch the fees: No matter what savings or investment options you choose, make sure you’re not overpaying fees. A stock mutual fund may charge in excess of 1 percent of assets; you can certainly find quality mutual funds that charge less. Two good resources: Morningstar.com can provide you a general review of most mutual funds you might be considering. The second is the Security and Exchange Commission’s online Mutual Fund Cost Calculator which can help you determine how the fees and other costs associated with the fund will add up over time.

Offer some investing training wheels: Grandparents have a unique relationship with their grandchildren. They can teach without “lecturing” like their parents, and for that reason, they might consider setting up an investment account with a small balance that the kids can monitor and discuss under the supervision of the grandparent.

Make the grandkids beneficiaries: Naming your grandchild as the beneficiary of a retirement account or insurance policy can be a tax-smart way to provide financial support for college or possibly a first home.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.

The first step involves a talk between grandparents and their adult children. According to 2008 research from The Hartford Financial Services Group, 65 percent of grandparents surveyed reported that they plan to contribute financially to their grandchildren’s college education, but that less than one third of all survey participants talked with their adult children about those plans.

Statistics show the amount of money that transfers from grandparents to grandchildren is substantial even before college. Hartford reports that more than 40 percent of grandparents spend more than $2,000 annually on their grandchildren before they reach 18 years old. And once it’s time for the kids to head off to school, over half of grandparents who plan to contribute will give more than $10,000, with a quarter of those planning to give more than $30,000. That’s a nice chunk of college.

A visit to a CERTIFIED FINANCIAL PLANNER™ professional can help grandparents and their adult children coordinate a gifting strategy that makes sense. In the meantime, there are several options to consider:

Communicate: Adult children and their parents might find it difficult to talk about money issues in general, but discussing a positive goal like funding a child’s future can pave the way to make discussions later about the grandparents’ estate issues and end-of-life care a little easier to handle. But initially, these discussions will hopefully deliver a reality check. The Hartford survey points out that 60 percent of the grandparents surveyed believe that financial aid will be the most likely way their grandchildren will pay for college in an era where federal aid is declining and grants and scholarship cover only an estimated 15 percent of total college costs.

Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.