Tag Archives: investing

Behavioural Economics: People value Gains and Losses differently

By John De Goey, CFP, CIM

Special to the Financial Independence Hub

Prospect Theory is a concept that explains how people react when faced with gains and losses in the markets. The early research that went into it was done by Amos Tversky and Daniel Kahneman, two prominent social scientists. The latter went on to win the 2002 Nobel Prize in Economics and write the runaway international bestseller ‘Thinking Fast and Slow,’ which deals with human quirks in behaviour and decision-making. The broad subject is referred to as Behavioural Economics (BE).

I find it fascinating that many people who give financial advice are unaware of the BE research or, if they are aware, do nothing to incorporate it into the advice they give. The implications of the old saying that those who ignore the lessons of history are condemned to repeat them are enormous.

Investors are feeling cocky

That’s especially true with Prospect Theory, which is vitally important in the summer of 2021 because markets have been on an absolute tear. The result is that investors are feeling confident and cocky. One might even say that many have let their guard down. When things go up with so few meaningful interruptions and no specific, readily identifiable storm clouds on the horizon, a dangerous kind of comfortable complacency might set in.

Many people I speak with these days seem unconcerned by the recent run-ups. Despite a series of potential danger signals such as inflation, deflation, the Delta Variant, and implications of climate change, they seem unperturbed.

Kahneman and Tversky showed that, for mostly emotional reasons, people put more weight on perceived gains over perceived losses and that, when presented with a choice offering equal probability of outcome (i. e., a gain of $1,000 vs. a loss of $1,000), most will choose the potential gains.

Advisors as Behavioural Coaches

For that reason, Prospect Theory is also known as the loss-aversion theory, and it offers a simple example of the risk associated with Optimism Bias. Simply put, people like to focus on positive outcomes: often to the minimization or exclusion of other possible ends. Continue Reading…

Amnesia and the Inevitability of Cycles

By Noah Solomon

Special to the Financial Independence Hub

Cycles are inevitable. They have persisted since markets have existed and will endure for as long as humans engage in the pursuit of profit. In prolonged up cycles, people are euphoric, bid up prices to unsustainable levels, and sow the seeds for subsequent misery. Similarly, severe price declines result in unsustainably pessimistic sentiment, pushing prices down to bargain levels, thereby sowing the seeds of the next up cycle.

Neither bull nor bear markets continue indefinitely. Despite this incontrovertible truth, every time an up or down cycle persists for an extended period and/or to a great extreme, the “this time it’s different” crowd becomes increasingly pervasive, citing changes in geopolitics, institutions, technology, and behavior that render the old rules obsolete. But then it turns out that the old rules do apply, and the cycle resumes.

The persistence of cycles is in large part the result of the inability of investors to remember the past. According to legendary economist John Kenneth Galbraith:

“Extreme brevity of financial memory…. When the same or closely similar circumstances occur again, sometime in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”

Will the True Driver of Market Cycles Please Stand Up?

Without a doubt, macroeconomic factors such as interest rates, inflation, fiscal policy, GDP growth, unemployment, etc. exert a significant influence on the ebb and flow of markets. However, in our view, fluctuations in psychology have the greatest impact on cycles. More than any other factor, changes in sentiment are what cause shifts between hospitable to treacherous markets, and therefore between gains and losses.

In market cycles, most excesses on the upside and the inevitable reactions to the downside (which also tend to overshoot) are the result of exaggerated swings of the pendulum of psychology. Even the father of value investing and Buffett mentor, Benjamin Graham, acknowledged the tremendous influence of psychology in his allegory about “Mr. Market.” Depending on his volatile mood swings, Mr. Market will buy assets at unrealistically high levels or sell them at bargain basement prices.

The following graph offers a succinct and accurate portrayal of investor psychology at different parts of the cycle.

In bear markets, the dominant psychology in the markets is represented by line C, where investors demand generous risk premiums to compensate them for taking risk. In these environments, valuations are undemanding, prospective returns from bearing risk are high, and chances are good you that will be rewarded for taking risk.

As the cycle progresses and markets begin to rise, the dominant psychology shifts to line B, which represents the “happy medium” where investors are neither overly pessimistic nor blindly optimistic. In such environments, people require adequate compensation for taking risk, valuations are neither depressed nor excessive, and you can expect returns that approximate the long-term historical average.

Lastly, during the latter stages of bull markets when prices have risen significantly over a period of several years, the general mindset of the investing public shifts to line A, where investors become euphoric and adopt a lopsided desire for return with little regard for risk. In such environments, people require scant compensation for bearing risk, valuations become unrealistic, and losses become more likely than gains.

In essence, the pendulum of investor psychology is heavily influenced by the recency bias of what has happened over the past several years, swinging between collecting gold bars in front of a wisp during the bad times (line C) and picking up pennies in front of a steamroller at market tops (line A).

S&P 500 Index: Investor Psychology and Subsequent Returns

The table above demonstrates that the mood shifts of investors can have a dramatic impact on returns. With respect to the current environment, we are more confident about where we are not than where we are. It’s difficult to make the case that market participants are despondent and are demanding huge risk premiums for investing. In our view, market psychology is currently somewhere between lines A and B.

Except for the short lived Covid-induced swoon of early 2020, governments and central banks have been successful in maintaining the bull market that began in March 2009 after the global financial crisis. This has increased confidence in the Fed put and emboldened investors. Although nobody can know for certain whether it is possible to engineer a perpetual party by plying its attendees with ever-increasing stimulus, we wouldn’t bet the farm on it!

The Elusive Happy Medium: Average Doesn’t Mean Normal

In the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, investor psychology seems to spend much more time at the extremes (lines A and C) than it does at a “happy medium” (line B). At any given point in time, markets are more likely driven by greed or fear rather than greed and fear. Either “Risk is my friend. I need to buy before I miss out” or “I just don’t want to lose any more. Sell before it goes to zero” are far more likely to dominate markets than equanimity. Continue Reading…

Reframing the RRSP advantage

I’ve read a lot of bad takes on RRSP contributions and tax rates over the years. One that stands out is the argument that you should avoid RRSP contributions entirely, and focus instead on investing in your TFSA and (gasp) your non-registered account. This idea tends to come from wealthy retired folks who are upset that their minimum mandatory RRIF withdrawals lead to higher taxes and potential OAS clawbacks. They also seem to forget about the tax deduction generated from their RRSP contributions and the tax-sheltered growth they enjoyed for many years leading up to retirement.

I’m hoping to dispel the notion of an RRSP disadvantage by reframing the way we think about RRSP contributions, RRIF withdrawals, and tax rates. Here’s what I’m thinking:

Most reasonable RRSP versus TFSA comparisons say that it’s best for high income earners to prioritize their RRSP contributions first, while lower income earners should prioritize their TFSA contributions first.

The advantage goes to the RRSP when you can contribute at a higher marginal tax rate and then withdraw at a lower marginal tax rate, while the advantage goes to the TFSA when you contribute at a lower rate and withdraw (tax free) at a higher rate.

If your tax rate in your contribution years is the same as in your withdrawal years then there’s no advantage to prioritizing either account. They’re mirror images of each other.

Related: The next tax bracket myth

This comparison focuses on marginal tax rates. But is this the correct way to frame the discussion?

Marginal Tax Rate vs. Average Tax Rate

Isn’t it fair to say that an RRSP contribution always gives the contributor a tax deduction based on their top marginal tax rate (assuming the deduction is claimed that year)?

But when you look at retirement withdrawals, shouldn’t we focus on the average tax rate and not the marginal tax rate?

An example is Mr. Jones, an Alberta resident with a salary of $97,000 – giving him a marginal tax rate of 30.50% and an average tax rate of 23.59%

Alberta MTR $97k

If Mr. Jones contributes $10,000 to his RRSP he will reduce his taxable income to $87,000 and get tax relief of $3,050 ($10,000 x 30.5%).

RRSP deduction

Fast forward to retirement, where Mr. Jones has taxable income of $60,000 from various income sources, including a defined benefit pension, CPP, OAS, and his $10,000 minimum mandatory RRIF withdrawal.

The range of income in each tax bracket can be quite broad. With $60,000 in taxable income, Mr. Jones is still at a 30.5% marginal tax rate, but his average tax rate is just 19.33%. That’s right, he pays just $11,596 in taxes for the year.

Alberta MTR $60k

Conventional thinking about RRSPs and marginal tax rates would tell us that Mr. Jones should be indifferent about contributing to an RRSP in his working years because he’ll end up in the same marginal tax bracket in retirement.

But when we consider all of our retirement income sources, why do we treat the RRSP/RRIF withdrawals as the last dollars of income taken (at the top marginal rate) instead of, say, income from CPP or OAS or from a defined benefit pension? Why would Mr. Jones’ $10,000 RRIF withdrawal be taxed at 30.5% when it’s his average tax rate that matters? Continue Reading…

How to generate Passive Income 

Image Credit: Pixabay

By Mike Khorev

Special to the Financial Independence Hub

Many of us strive for financial security; luckily, passive income investments open up the opportunity to make extra money on the side. 

All you need is the willingness to put in some fundamental groundwork: you don’t necessarily need savings to kickstart your investment. There are plenty of options when it comes to generating passive income that go far beyond the realms of compound investing. Here are some fresh ideas to get you started.

1.) Investments

Exchange-traded funds (ETFs)

Exchange-Traded Funds, known as ETFs, are a great way to invest in the stock market without needing to research individual companies. Investing in ETFs provides both capital gains and dividends. Diversify your investments to receive the maximum benefit. ETFs are rather low maintenance and yield a lower risk than regular equities.

Dividend-paying stocks

Feel the benefits of dividend stock investments with a range of stocks yielding up to 5% dividends. The hardest part is knowing which stocks are worth investment. The best way to generate larger profits is to choose dividends that come with franking credits. Stock market unpredictability is no secret, be willing to face a sudden rise and fall in value or cut dividends altogether.  

Robo-advisors

If you’re looking for an affordable financial advisor to manage your investments, Robo-Advisors could be for you. They personalise automated trading decisions based on your financial targets, limits and time frames for a fraction of the cost. They are one of the most passive forms of income. 

2.) Real estate

Rental income

Rental yield can be one of the most profitable forms of passive income. Experts state that small apartments containing 1-2 bedrooms have more success on the market generating returns of over 8%. Real Estate Agents will handle legal documentation, rent collection, and advertise your property for a recurring fee of 5-12% of the monthly rent.

Airbnb

Airbnb is a thriving marketplace with host’s estimated monthly earnings sitting at $924 per month. While properties are free to list, hosts are charged a 3-5% service fee and are liable to income tax. Many hosts invest earnings into outsourced housekeepers to maintain passiveness. 

Real estate investment trusts (REITs)

REIT investments are perfect for those who are interested in real estate without the responsibility of sustaining individual properties. Typically, REITs support non-residential buildings such as offices, apartment complexes, and retail centres. Commercial buildings are famous for yielding large profits, passive income will be paid in the form of dividends.

3.) Content creation and advertising

Affiliate marketing

Affiliate links are more negotiable than ever, not only do they support affiliate businesses, they are also a manageable form of passive income. Invest some time into digital content creation that generates healthy volumes of traffic. Aim to recommend products you truly believe in to build a trusting relationship with your audience and boost clicks.  Continue Reading…

Embracing Uncertainty: Do Nothing and hope Nothing Happens but don’t make me Think

By Noah Solomon

Special to the Financial Independence Hub

One of my favourite quotes is attributable to the late, great economist John Maynard Keynes. During a high-profile government hearing, when a critic accused him of being inconsistent, Keynes responded, “When the facts change, I change my mind. What do you do, sir?”

Being uncertain of what to do and/or scared of being wrong can cause investors to cling to their existing strategies and portfolios regardless of changes in the economic backdrop or market environment.

Another cause of investor inertia lies with the wealth management industry, which generally espouses a “do nothing and hope nothing happens” approach to investing whereby clients are encouraged to adopt a static, buy-and-hold approach and refrain from making any significant changes to their portfolios, regardless of changes in the investment environment.

The behavioral explanation behind the abdication of action in favor of passivity is nicely summarized by the following quote:

“You see, Dr. Stadler, people don’t want to think. And the deeper they get into trouble, the less they want to think. But by some sort of instinct, they feel that they ought to and it makes them feel guilty. So they’ll bless and follow anyone who gives them a justification for not thinking.”

– Ayn Rand, Atlas Shrugged

Despite this tendency to cling to the status quo, the fact remains that refusing to change your portfolio in response to changing conditions has historically been one of the costliest mistakes in investing.

Sometimes It’s OK to Do Nothing (But it’s really hard to know when)

When asked what went through his mind when he listened to his own music, jazz legend Miles Davis responded, “I always listen for what I can leave out.” Davis meant that there are times when less is more: restraint can be more effective than action. As is the case with music, there are investment climates in which it’s best to do nothing.

The value of sound risk management varies depending on the market environment. The ability to manage risk has little value when conditions are favourable.  During a bull market that occurs against a backdrop of attractive valuations, low leverage, and a favourbale economic climate, risks are minimal and any move to take profits and reduce risk will likely make you worse off: just sit back and enjoy the proverbial ride. Conversely, there have been (and inevitably will be) times when risk management and flexibility can prevent a great deal of financial (not to mention emotional) pain.

So far so good: swing for the fences and make huge returns in favourable markets and apply the brakes to avoid losses when conditions turn hostile. But wait! To pull this off, you need to do the impossible and successfully predict exactly when markets will turn from favourable to hostile and vice-versa. In other words, you need to be consistently right … or do you?

It’s not just about Being Right. It’s also about What you Do when you’re Wrong

People put too much emphasis on being right. One explanation for this is that people get psychic income from being right:  taking profits on winning positions makes them feel good. Conversely, accepting a loss forces us to admit we were wrong, which can be psychologically challenging even for professional investors. The net result of these opposing reactions is that investors often strive to maximize their percentage of winning vs. losing positions. While this strategy seems like a good idea, it can lead to highly sub optimal results. Continue Reading…