For this month’s newsletter, we return to the topic of cognitive biases, which are mental shortcuts we take that can lead us astray. In the first article below, we examine anchoring and recency bias, two biases that are frequently found among investors.
Our financial planning tip may be of help when spring cleaning time rolls around, as we look at what financial records you need to maintain. Lastly, the client question of the month deals with Medicare and the changes to coverage as a result of healthcare reform.
Thanksgiving is just around the corner, so we wish you and your loved ones a happy holiday. As always, don’t hesitate to contact us if you have questions and please feel free to forward this newsletter on to your friends or family if you think they might find it helpful.
Micah Porter, CFA, CFP®
Anchoring and Recency Bias
Micah Porter, CFA, CFP®
In our August newsletter, I began writing about cognitive biases. As a quick refresher, cognitive biases stem from heuristics, or mental shortcuts we take to quickly arrive at decisions. Such shortcuts are often necessary as we simply don’t have the time to go through an arduous process to reach each and every decision. The problem, however, is that in certain situations, these shortcuts can systematically lead us astray, and in these situations the shortcuts are known as cognitive biases.
There are a number of cognitive biases that come into play in investing, and in September’s newsletter, we examined confirmation bias, which is the tendency to seek out information that confirms our existing view and reject information that might refute it. In this month’s newsletter, we’ll examine two additional biases – anchoring and recency.
Anchoring is the tendency to base our thoughts and beliefs on a specific point of reference that may have little or nothing to do with the situation at hand. Kahneman and Tversky, two psychologists who pioneered the concept of cognitive biases, conducted a study in the late 70’s in which they spun a wheel with the numbers 1 through 100 in front of test subjects. They then asked those subjects the completely unrelated question of what total percentage of U.N. membership was accounted for by African countries. The end result was that the lower the number that appeared on the wheel, the lower the average estimate provided by the subjects.
In investing, anchoring takes many forms, among the most common of which is using the 52 week high or low price to determine if a stock should be bought or sold. The most common tendency we encounter is to anchor to the price paid for a stock. It’s not at all uncommon to hear an investor say that they want to wait to sell a stock when it “gets back to the price they paid for it”*. In those particular instances, it’s worth noting that a stock has no idea what you paid for it!
Another key bias, recency bias, is the tendency to give disproportionate weight to recent events and discount information from the more distant past. We, in effect, assume that we can draw a straight line from the present time to the future, even if such projections would be extremely unlikely. At the depth of economic crises, many assume hard times will continue indefinitely while at the height of expansion, the notion that anything could go wrong is overlooked. Recency biases helped drive the dot com bubble and it played a role in the thinking of many who cashed out as the market bottomed in the most recent downturn.
So how do we as investors guard against the biases? The most useful step is to try to recognize when the biases might be coming into play. For anchoring, ask yourself why you might be wedded to a certain value or price. If you determined your target price through an objective, quantifiable methodology, you’re likely on solid ground. To avoid recency bias, look to a broader historical context. Often the broader the timeframe you use – assuming accurate historical data is available – the better.
In future newsletters, we will look at additional cognitive biases. We will end this particular series with a discussion of the investment process here at Minerva, and how that helps us to minimize the impact of these biases.
*We would note that in this particular instance, anchoring isn’t the only cognitive bias playing a part here. In fact multiple biases often impact investment decisions.
Financial documents – what to keep and what to throw away
Micah Porter, CFA, CFP®
One question we hear frequently is what financial paperwork needs to be kept. It’s usually asked in the context of “I have no more room in my desk, can I throw some of this stuff away?” The answer is that it depends on the type of paperwork. Here are a few rules of thumb:
Brokerage statements – generally, you should hold onto brokerage statements so that you can substantiate the cost basis of the investments you hold. However, we track cost basis for our retainer clients, so unless it’s a legacy holding for which a client hasn’t provided basis, we’ll track and report that basis when the holding is sold. Additionally, basis is only an issue in taxable accounts – not in traditional IRAs and Roths.
A new wrinkle regarding cost basis is that new financial regulations require brokerages to report the basis of any securities purchased in 2011 or thereafter and subsequently sold. Mutual funds and ETFs will follow suit in succeeding years. Finally, many brokerages, TD Ameritrade among them, make their statements available online so if you do want to maintain copies of your statements, you can choose an electronic copy over a paper copy.
Tax returns and backing documentation – the IRS can audit you up to three years after your filing date if it believes good faith errors were made on your return. The same timeframe applies if you find an error and want to apply for a refund. The statute of limitations is six years if the IRS suspects you underreported gross income by 25% or more and there is no time limit for unfiled and fraudulent returns.
Bills – for large purchases for items that might be insurable, hang onto the receipt indefinitely. It might be needed for proof of value in the event of loss or damage.
Home and condo records – if you make improvements to your home, keep documentation on the cost of improvements until the home is sold. The reason is that improvements – as opposed to repairs – increase the cost basis of your home. The higher the basis of your home, the lower the taxable profit when you sell it, so it’s useful to be able to substantiate the higher basis.
Client question of the month – Changes in Medicare
Micah Porter, CFA, CFP®
What changes does healthcare reform make to Medicare? I heard that funding for Medicare had been cut.
Traditional Medicare benefits were not cut and was actually shored up in some areas, with the bulk of the cuts occurring in Medicare Advantage plans. Medicare Advantage plans are plans run by private insurers who are reimbursed by Medicare, and the plans have proven more expensive than the traditional Medicare plan. The total savings in this area are assume to be $132 billion over 10 years.
One of the biggest changes to traditional Medicare was the closing of the “doughnut hole” in Part D. Prior to HCR’s passage, when Medicare participants spent $2,700 on prescription drugs, they were responsible for any additional prescription cost until $6,154 had been spent.
In 2010, those being impacted by this hole were given a $250 rebate and in 2011, Medicare participants will receive a 50% discount on prescription drugs while in the doughnut hole. Additional subsidies are slated to be enacted between now and 2020. By that point, subsidies and discounts will pay for 75% of drug costs that were previously paid for entirely by Medicare participants impacted by the hole in Part D coverage. Lastly, wellness visits will now be covered by Medicare.