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Understanding What Investors Really Want In 60 Seconds

April 22, 2011 Leave a comment

What’s good about taxes?

April 5, 2011 1 comment

Few of us like paying taxes and most of us have blueprints for ideal tax systems in which we pay less. The message we send to our elected officials was summarized succinctly by Senator Russell B. Long: “Don’t tax you, don’t tax me, tax that fellow behind the tree!” Our distaste for taxes can be a force for bad, as when it drives us into hiding taxable dollars in offshore accounts. Yet it can also be a force for good, as when it drives us into saving for retirement. Debates about the relative tax benefits of Roth IRAs and regular IRAs often miss their most important benefit. Both Roth IRAs and regular IRAs harness our dislike of taxes into retirement savings.

Investment companies cater to our dislike of taxes. “Nowhere on any tax form does it say you can’t be crafty,” winks an advertisement by an investment company, offering tax-free mutual funds and the picture of a smiling man next to a swimming pool. “How to send less to the IRS,” promises an advertisement by another investment company.
High returns are the utilitarian benefits of tax-free funds; investors who send less to the IRS keep more of their investment returns. But tax-free funds, IRAs and 401(k) accounts have expressive and emotional benefits as well. We express ourselves as high-income investors, with status as high as our tax brackets. We express ourselves as smart, savvy, wily and crafty, which is what it takes to avoid taxes. Pride at avoiding taxes is emotionally satisfying, but the emotions accompanying taxes extend to anger and hatred. We are angry when taxes rob us of personal freedom or when they are wasted by politicians and bureaucrats. “Well, Mr. Big Brother IRS man, let’s try something different, take my pound of flesh and sleep well,” wrote Andrew Joseph Stack III in February of 2009, just before flying his plane into an IRS office building, killing an IRS employee and himself.

My mechanic sent a postcard offering “Tax Break Specials,” saving me the cost of sales taxes. He must know that his typical customers prefer small savings in the form of tax breaks to more substantial savings in the form of cash discounts. We dislike taxes so much that we are willing to forego $5,000 to save $4,000 in taxes. Here is an experiment by Abigail Sussman and Christopher Olivola.

Imagine circumstances where you earn an annual salary of $50,000 before taxes at an American company. Now pretend you are offered a position at one of two European branches at a $75,000 salary. The good thing about Country A is that your daily commute will be 60 minutes shorter than in Country B. The bad thing about Country A is that food would cost you $5,000 more than in Country B. Which country would you choose?

Now imagine identical circumstances except that the bad thing about Country A is that you would pay $4,000 more in taxes than in Country B. Which country would you choose? The first of the two circumstances was presented to one group of people and the second was presented to another group. It turned out that more people in the United States and Britain chose country B when they could save $4,000 in taxes than when they could save $5,000 in the cost of food.

We want to pay no taxes and the pain taxes is especially searing now, days before April 15th. May I alleviate your pain by reminding you that the pain of taxes drives you to greater savings for a more comfortable retirement?

Further reading

Abigail B. Sussman and Christopher Y. Olivola, “Axe the Tax: Taxes Are Disliked More than Equal Costs,” (presented at the 1st Annual Boulder Summer Conference on Consumer Financial Decision Making, June 27–29 2010).

Financial Advisors are Financial Physicians

September 16, 2010 Leave a comment

Good financial advisers are good financial physicians. Good advisors posses the knowledge of finance, as good physicians possess knowledge of medicine, and good advisors add to it the skills of good physicians: asking, listening, empathizing, educating, and prescribing.

Physicians face “non-complying” patients who do not take their prescribed medicine as instructed, and financial advisors face non-complying clients who imperil their future by spending too much in the present. Compelling clients to comply is a difficult task when clients are young athletes or actors. ”These kids are making serious money,” said Scott Feinstein, a financial advisor. ”They don’t realize the pressure that friends and family will put on them. They don’t have the maturity to say no.” One young client called to say that he wanted to buy a $35,000 watch. “What time does it say?” asked Feinstein. “Ten minutes after 3,” answered the client.”Mine says 10 after 3 too, and it cost me 60 bucks,” said Feinstein. “Put the watch down.”

Larry Ellison, the head of the Oracle Corporation, is one of the richest men in the world and a winner of America’s Cup sailing competition. But the life of his financial advisor is difficult. Documents in a trial revealed that Ellison lives well. His annual “lifestyle” expenses amount to $20 million. A villa in Japan costs $25 million, a new yacht costs $194 million, and preparations for America’s Cup cost $80 million. The documents include emails to Ellison from his financial advisor. One email said “I know this e-mail may/will depress you. However, I believe it’s my job to address issues you’d prefer not to confront. You told me years ago that it’s OK to raise the “diversification issue” with you quarterly….Well, I’m doing so. View this as a call to arms.”

Fees come between financial advisors and their clients as they come between physicians and their patients. “I have a million dollars in my portfolio,” thinks a client. “I don’t mind paying a fee for the management of stocks. Stocks are complicated and I cannot manage them on my own. But the management of bonds is easy and cash needs no management at all. Why am I paying you a fee for these?” Financial advisers hope that clients would understand the value of their services and the fairness of their fees, yet fees are difficult to discuss because clients regularly misperceive the value of the services of financial advisors.

Imagine that you are seeing a physician because your stomach hurts. The physician asks many questions, examines your body, provides a diagnosis and concludes with education and advice. The examination, diagnosis, and education are free, says the physician. All you have to pay is the price of the pill you received. That would be $200, please.

Financial advisers act regularly as the physician in this story. Financial advisors frame themselves as investment managers, providers of “beat-the-market” pills, when they are, in truth, mostly investor managers, professionals who examine the financial resources and goals of investors, diagnose deficiencies, and educate investors about financial health.

Financial advisors are not capricious as they frame themselves as managers of investments when, in truth, they are mostly managers of investors. They merely respond to the perceptions of investors. They do so by framing fees for managing investors as fees for managing investments. “12b-1 fees” are one example. The fees were originally designed to help mutual fund companies attract new investors and eventually save investors money as funds grow and their costs decline. Yet the fees go to financial advisors who recommended the funds to their investors, and payment to advisors can extend into decades, long after money was placed into the funds. Mary Schapiro, the chairwoman of the Securities and Exchange Commission, is critical of 12b-1 fees. “Despite paying billions of dollars, many investors do not understand what 12b-1 fees are, and it’s likely that some don’t even know that these fees are being deducted from their funds or who they are ultimately compensating.” The S.E.C. is drafting new rules “designed to enhance clarity, fairness and competition when investors buy mutual funds.” Yet Robert Kurucza, partner in a law firm serving mutual fund companies, noted the downside of the proposed SEC. rule. 12b-1 fees compensate financial advisors for investment advice they continue to provide decades after they have placed clients into funds. Decreased compensation is likely to decrease advice.