Human Psychology - post 1

Human Psychology is the biggest influence in money decisions, and unfortunately, it is often totally wrong.

Most people, if not all, look at financial decisions the wrong way. When it comes to money, the human brain is just not very good at analyzing things very well. Simply put, human psychology gets in the way. I’ve heard other advisors and writers advocate working with people’s biases and poor rationalization; that a good advisor should try to accommodate people’s emotions. I disagree. It is true that like a doctor, an advisor needs to have empathy for his clients and a rapport that puts his clients at ease. A doctor with a poor bedside manner will not be well liked. An advisor cannot afford to be disliked. However, the advisor needs to educate and teach the client the correct way to analyze his money, just a like doctor must ultimately try to cure a patient or keep him healthy even if the patient believes in other treatments that are not effective.

Let me give an example of how perspective can drastically change the human behavior of someone, even if the outcome is unchanged. Which of the following would you consider more likely to occur?

1. Someone receives a cash bonus from his employer, and then turns around and takes the entire proceeds (after tax) and buys his employer’s stock with it.
2. Someone receive a stock bonus award from his employer and simply keeps the stock.

Most people would think that the person is scenario 1 (but not 2) is crazy. However the two outcomes are identical. People who receive stock from their employer think nothing is wrong keeping the stock, but they would never sink 100% of their paychecks into their company’s stock. The only difference is that in scenario 2 the company went ahead and bought the stock for you, but there is no reason to keep it! Here is human psychology at work, and it can be explained by a physics law: a body in motion stays in motion and a body at rest stays at rest. People receiving employer stock awards should think of scenario 1 and immediately sell the award, but they don’t, and it is due to a failure of perspective.

Stay tuned for the next post on how bank and insurance agents love to sell stuff that won’t lose money; a pitch designed to take advantage of our aversion to loss and risk.

The IRS in action

Checkout this article about how the IRS routinely sends out tax refunds on fraudulently filed tax returns. Instead of focusing on stopping criminals from blatantly stealing our tax dollars, the IRS continues to harass un-credentialed tax preparers thinking this will close the "revenue gap" of uncollected tax revenues.

Here is a better idea: fix your software systems so you can actually match reported data with tax returns and leave honest tax preparers alone so they can do their jobs. CPAs and attorneys don't need government protection.

Drinking the Kool-Aid

When I worked for a hedge fund on Wall Street a common term among the equity analysts was “drinking the Kool-Aid”. They used the term to describe other analysts who believed the b.s. that the management of covered companies would spew during conferences or meetings. Of course, they didn’t refer to the term when they believed the spew from their favorite companies nor did they refer to the term when describing their own job.  I quickly realized the futility of picking winning stocks and I began to wonder whether other analysts actually believed that they could pick winning stocks (drinking their own Kool-Aid) or did they realize that they could not and just did their job because of the fat fees they could skim off of deluded investors?

Which is worse? An investor that is too stupid to realize that beating the market is a fool’s game or one who realizes this but is dishonest enough to still take investor money? You can be the judge of that but the question remains which of the two scenarios is true?

An article in the Wall Street Journal answers this question, at least for one analyst who runs his own hedge fund. Paolo Pelligrini was an analyst for hedge fund manager John Paulson who made billions by betting against the housing market during the bust (he actually bet against the packaged mortgage products). Pelligrini was the analyst who helped Paulson structure the bets that resulted in the windfall. He grew rich because of this and then went off and formed his own fund, but he invested a large amount of his wealth in one of Paulson’s funds, and was badly burned. He drank the Kool-Aid and believed that he and Paulson could actually consistently beat the market.  The market proved otherwise. He should have taken his luck provided windfall and turned to index funds. He was taught an expensive lesson. Don’t make the same mistake.

Are million dollar mortgages cheaper?

An article from the Wall Street Journal writes about a study where the authors concluded that mortgages that are more than $1M have lower interest rates than smaller mortgages. The reason- the inability for the borrower to deduct all of the interest. The mortgage interest deduction is limited to your first $1,000,000 in loan balance (plus $100,000 in home equity lines/2nd loans). The authors suggest that lenders know this and are essentially charging a higher rate below $1M to capture some of the taxpayer subsidy themselves.

Therefore, does it pay to apply for a larger than $1M loan and then pay down the balance immediately to get the balance down to $1M so your interest is fully deductible? We'll run the numbers and let you know, but this is an interesting bit of information.

Link to the WSJ/Smart Money article here.

Link to the actual study here (we haven't read it yet).

When should I begin collecting social security?

This is a question that many retires struggle with. Unfortunately, there is no one size fits all answer to this question, especially when you are married or have an ex-spouse that you were married to for at least 10 years (being married for 10 years allows you to collect social security on your spouse's earnings record). Which is why a customized analysis should be performed based on your particular circumstances (something that we do at Inner Circle Platinum Advisors LLC for clients). However, social security should be properly viewed as an immediate annuity that is indexed for inflation, and if you are married it pays out for 2 lives (the two lives even applies to ex-spouses with 10 years of marriage before divorce).

This article on smart money is about delaying social security and explains how waiting is the same as buying an immediate annuity whose pricing can't be matched by private insurance companies- though I would disagree with the author's assessment that social security offers such a good deal because it isn't worried about profits, doesn't need to market and uses a "fairer" life expectancy table. Social security is mispricing their benefits because 1. they don't change pricing based on sex, 2. they don't change pricing based on prevailing interest rates, 3. they don't base pricing based on the life expectancy or health of the recipient. So the product is mispriced, being especially beneficial to women, married people and the healthy. This comes at taxpayer expense- an insurance company couldn't do this because it would go bankrupt. This is good for the recipient because they can take advantage of the benefit (and one should!) but it is bad for the system in general.