Yet another year is just about in the books. For those of us in the wealth management industry, it’s tough to find serious fault with 2010. Potential threats that could have derailed the recovery failed to materialize, and with just a few days left in the year, economic data points to a positive 2011. Clearly, things could be better – particularly with unemployment – and the recovery isn’t robust, but as we’ve long maintained, correcting the excesses that led to the most recent downturn will take time. Every year without a serious misstep or economic shock provides additional time for the economy to heal.

For this final newsletter of the year, we continue our series on cognitive bias, this time examining overconfidence bias. Our client question of the month covers some differences between the accumulation phase in portfolios and the distribution phase. Our planning tip of the month queues up our annual offering of the privacy statement and the ADV while also discussing a few upcoming regulatory changes that are likely to impact the investment industry.

Lastly, as the year draws to a close, we’d like to offer our sincere thanks for your continued confidence and support. We wish you and yours very happy holidays.


Micah Porter, CFA, CFP®

Overconfidence Bias
Micah Porter, CFA, CFP®

In this month’s continuing series on cognitive biases, we’ll take a look at one of the most aptly named biases, overconfidence bias. As the name implies, this bias involves having more confidence than one should objectively have in two general categories – the precision of one’s predictions, and the degree of certainty that one’s prediction is correct.

A few examples will help to clarify. In the realm of investing, overconfidence in precision might involve estimating the range of value of stock – assuming, for example, a gain or loss of no more than 15% within a one year period when history indicates a much wider range of values is more likely.

Another subcategory of overconfidence bias, certainty overconfidence, is demonstrated when a group claims a higher level of confidence than subsequent experience demonstrates should have been the case. Numerous studies have shown that test takers answering factual questions stated they were a good deal more confident than the subsequent test results have shown they should have been. For example, test subjects might tell the researchers they are 90% certain each answer is right, while test scores average a good deal below 90%. Those of you who are teachers might well relate to this phenomenon.

As is the case with other biases, overconfidence bias is closely intertwined with and reinforced by other biases. Overconfidence works hand-in-hand with confirmation bias, when one avoids or discounts information that runs counter to one’s decisions. For investors, overconfidence can lead to lack of diversification in a portfolio when the assumption is made that an investment can’t go wrong. As investors ourselves, maintaining truly diversified portfolios and making incremental changes only when valuations are extremely attractive or unattractive is key to avoiding overconfidence bias.

Financial Planning Tip – ADV and Privacy Policy Offering and the Impact of Financial Regulation
Micah Porter, CFA, CFP®

Each year, the SEC requires that we send out a copy of our privacy policy along with an offering to send a copy of our ADV disclosure brochure, and we’ll be sending copies of those out to all clients prior to year end. Our privacy policy has not changed, and put simply, we will not provide any client information to a third party unless legally required or the information is necessary to deliver our services.

We’ll be changing our ADV in the coming year, as the recently passed financial regulation bill mandates the ADV be re-written in plain language. We think that’s a good thing, as is any initiative which decreases financial industry jargon, but there were a few items on the wish list of most fee-only advisors that financial regulation still hasn’t fully addressed. Those are as follows:

A universal fiduciary standard – a fiduciary standard requires that advisors act in the best interest of the client at all times, and it’s a standard to which we and other Registered Investment Advisors adhere. However, that’s not the case for many brokers and although the new financial regulation bill allows for a universal fiduciary standard, insurers, brokerages and other industry players are lobbying furiously against it.

Whether or not the SEC decides to move forward with a fiduciary standard  for others remains to be seen, although we’re not particularly optimistic. In the meantime, for those of you with friends or family seeking a financial advisor, we believe their best course is to ask if the prospective advisor adheres to a such a standard.

Regulation of investment advisors – for years, Registered Investment Advisors have been regulated by either the SEC or state regulators, while brokers have been regulated by FINRA. RIAs tend to look at FINRA’s track record skeptically, as many of the abuses within the industry were carried out by brokers and others subject to FINRA’s oversight. Further, because those that FINRA oversees often aren’t subject to the higher legal and ethical fiduciary standard we cover above, their approach tends to be much more rules based than that of the SEC and state regulators. Lastly many RIAs are concerned that FINRA operates on behalf of the brokerage industry as opposed to being a consumer-oriented regulator of that industry.

Ideally from our perspective, RIAs would continue to be regulated by an organization accustomed to regulating based on the assumption of a higher legal and ethical standard. In such a situation, the governing body relies upon the standard to govern conduct, as opposed to issuing myriad rules that often don’t fit every situation and often do have unintended consequences. Regardless of the outcome, however, we will continue to operate as a fiduciary for our clients, acting in their best interest at all times.

Client Question of the Month – The Accumulation Phase versus the Distribution Phase
Micah Porter, CFA, CFP®

How does the accumulation phase differ from the distribution phase in terms of planning?

The accumulation phase refers to the period during which assets are accumulated in anticipation of funding a financial goal, with the most common being retirement. The distribution phase is reached when the portfolio is used to fund the financial goal. Return is as important in both phases, as is the volatility of the portfolio. However, in the distribution phase, a number of factors take on increased importance, among which are the following:

Tax efficiency – for clients who have an array of retirement accounts, which account is used to fund retirement can have a large tax impact. Every dollar taken from an IRA is subject to tax, while Roth and taxable account withdrawals are not taxable as income. Tax concerns also come into play in taxable accounts as managing taxable gains and income is key.

With after-tax annuities, the picture becomes even more complex as withdrawals from after-tax annuities can be fully taxable, partially taxable or not taxable at all depending upon a number of factors. Even certain types of life insurance policies with cash value can factor into the equation, as they can be tax-effective sources of cash. The key is to understand the tax treatment of each type of asset and use it accordingly.

Providing a steady income stream – we’ve often written about the idea of a safe withdrawal rate based on a percentage of portfolio assets, but the reality is the actual analysis and funding of the financial goals is more complex. Whenever possible, when rebalancing we try to ensure there is at least one year’s worth of cash on hand, plus a ladder of safe bonds to cover several years worth of additional projected needs. Balancing the need for a safe cushion with the need for a higher long-term return can be a challenge when withdrawal rates are particularly high.

For clients with multiple accounts, the process of designing the income stream becomes more complex. For IRA accountholders, the government often requires that they take a minimum distribution and that distribution needs to be considered when calculating needs from other sources.

As with tax efficiency, annuities bring a host of additional complexities to the analysis. When converting an annuity to an income stream there are often dozens of potential  payout options. Choices include whether to payout over a specified period or over a lifetime or lifetimes, and whether payments should be fixed or varied according to fluctuations in the values of the underlying investments.

Estate planning and related concernsdifferent types of accounts are treated differently in estate and related situations. Aside from trust accounts, which are highly customizable and a cornerstone of estate planning, the treatment of inherited IRAs and Roths are subject to a number of rules which impact how they should be handled both pre and post-tax. Understanding the rules for these and other accounts, along with the client’s intentions with regards to his/her estate are important in developing the distribution strategy.

Each of the above factors, as well as others, plays a role in plans we design for our clients. If you have questions about how the above issues might impact your plan, let us know.