As is our custom, the February newsletter contains a column on what you need to prepare for tax season. If we can be of help gathering necessary information or sending anything directly to your accountant, just let us know.
The lead column continues with the series on cognitive biases. This time we take a look at hindsight bias. Lastly, there has been a good deal of recent press on bonds and potential pitfalls in the bond market. The client question of the month examines risks to both bonds in general and municipal bonds in particular. We outline steps that can be taken to mitigate the risk.
As always, feel free to forward our newsletter on to friends or family if you think it would be useful to them and don’t hesitate to send questions or feedback about the content.
Micah Porter, CFA, CFP®
Micah Porter, CFA, CFP®
For this month’s cognitive bias, we’ll examine hindsight bias. To recap, cognitive bias results from mental shortcuts we are psychologically predisposed to use. There are a number of biases that psychologists have identified, and hindsight bias in particular is the often erroneous belief that you “knew it all along”. More precisely, hindsight bias is the conviction that you predicted the outcome of a particular event from the outset.
There have been a number of studies conducted to confirm hindsight bias, but an anecdotal example is probably most illustrative — the 2008 financial crisis. There seems to be no shortage of commentators in the press and on television who claim the fact that there would be a financial crisis was blindingly obvious – and the result should have been clear to anyone paying attention.
While I’ll grant that the housing bubble was fairly obvious to anyone paying attention – (we wrote an article about outsized real estate returns in 2005) – what was not at all obvious were the repercussions of unwinding that bubble. Each of the knock on effects – from the degree of exposure on the part of the banks to the destructive role of derivatives to the plummeting liquidity within the financial system were foreseen by a vanishing few.
One of the fundamental factors in hindsight bias is that after an event has occurred, we forget the possible number of outcomes that could have happened and the outcome that occurred becomes “obvious”. The problem with hindsight bias is that it leads investors to have more confidence in their decisions than they should have. In short, it feeds into overconfidence bias. The best way to fight hindsight bias is to document your views so you’ve got a record you can consult.
Financial Planning Tip – Preparing to File Your Taxes
Micah Porter, CFA, CFP®
The IRS deadline this year for brokerages to mail out their 1099s was February 15th, so at this point you should have all the documents you need to file your taxes (though you may want to wait a bit for reasons outlined below). What you actually received will depend upon the type of account, and whether there was any activity within the taxable account. Here’s a rundown of the most common documents:
- 1099 – for those of you with taxable accounts, you will receive a 1099 from TD Ameritrade for each account. The 1099 is used to report income on your taxable accounts. Each mutual fund or investment reports income to TD Ameritrade who consolidates this information by account.
In the past several years, all brokers including TD Ameritrade have been forced to send out revised 1099s when there are changes in income reporting by mutual funds. While we hope this won’t happen this year, we cannot guarantee that this will not be the case.
- 1099R – for those of you that have taken distributions from your IRA, you should have received a 1099 R from the custodian reporting this income. You will also receive a 1099-R for the taxable portion of any after-tax annuity distributions you received during the year.
- Realized Gain/Loss report – for clients with trades in their taxable accounts, we mailed realized gain/loss reports along with our year-end reports. If you have any questions about these reports, or if you did not receive one and believe you should have, let us know.
- Minerva Fees – we always send invoices to clients when billing for our fees, and the year-end report also reflects fees paid during the year. Management fees paid from a taxable account are tax deductible.
We’re happy to provide tax information directly to your accountant with your authorization. If we’ve done that in previous years, we’ll be in touch with you soon to see if you’d like for us to do so again this year. If we haven’t done so for you previously but you would like us to do so, just give us a call or send an e-mail and we’ll get the information out to your accountant.
Aside from gathering documentation, one other issue some of you will face is whether or not to make a ROTH or traditional IRA contribution. The contribution must be made prior to filing your return, and if you think you might want to make a contribution, you’ll need to determine if you are eligible to do so. Additionally, you’ll need to decide whether a ROTH or traditional IRA contribution would be more beneficial.
If you made an IRA or ROTH contribution last year, we’ll be in touch within the week to see if you would like to do so again this year. Lastly, for those of you that think you might like to make a contribution but aren’t sure if you can or how much you can contribute, feel free to give us a call and we can help answer those questions for you.
Client Question of the Month – Current Risks to Bonds
Micah Porter, CFA, CFP®
I’ve read that there’s cause for concern with bonds. Is that true?
The first thing to bear in mind when it comes to the bond market is its sheer size – although figures are hard to pin down, most estimates put the worldwide bond market size at roughly twice that of the stock market. And as with equities, the bond market is actually comprised of many different markets each of which trades in many different types of bonds from various issuing entities.
One of the primary markets here in the U.S. is the municipal bond markets. Munis, as they’re known, are issued by various state and local entities, typically to fund infrastructure and other long-term investments. These bonds are often attractive to investors as for the majority of these types of bonds, interest is exempt from federal taxation. Of late, though, a number of analysts have pointed to the parlous state of government finances as reason to avoid munis, but we think this is an oversimplification.
As I wrote in the year end commentary, there are many, many different types of municipals, and one of the fundamental ways in which they differ is in the collateral backing the issue. Some munis – typically known as general obligation bonds – are backed by the issuing entity’s ability to raise revenue and these tend to be very safe. Other types of bonds, however, may only have legal claim to a portion of the income stream for the project they finance – building a stadium, for example. These types of bonds tend to be much riskier, so the key is to understand what’s backing the bond in which you’re invested.
A larger concern for bond investors is an increase in inflation and potentially interest rates. Typically, when inflation spikes, bonds perform poorly, but they don’t all perform equally poorly. TIPS, or Treasury Inflation Protected Securities, can provide a hedge against inflation, as do floating rate bonds, whose coupons vary according to an underlying index rate. Bonds with shorter maturities and bonds with higher coupons fare better in a rising rate environment as well. Lastly, it’s worth bearing in some instances – particularly in the case of a bond ladder meant to provide income – you’ll hold the bonds to maturity, so short of default, any interim fluctuation in value won’t keep you from receiving your principal when the bond matures.
The bottom line is that as with stocks, there are also risks to bonds. However, understanding what types of bonds you hold and how they will likely react under different scenarios can help mitigate those risks.