Monthly Archives: February 2012

How We Make Financial Decisions

Financial decision making is simply more tricky than it seems. When we make our decisions, they always seem rational at the time. In addition, economists mistakenly have looked for ways to justify our decisions as being rational. Obviously, this cannot be the case.

We often buy things on emotion. Economists would rationalize this by saying that the item we bought gave us the most utility at the time. In reality, the thing we bought could have been a snickers bar or a soda. Something with no real value, in other words. But it gave us a feeling of satisfaction. Does this qualify as a rational decision? I think not.

Many irrational decisions people make involve those that provide the most pleasure or the least pain. This casuses even the most disciplined of people to slip every once in a while. For instance, a motivated health guru doesn’t eat healthy 100% of the time.

Another decision making problem we have lies with our illusion of being able to predict the future. We are hardwired to look for patterns. Then, we take those patterns and expect trends to continue indefinitely. Obviously, very few trends continue indefinitely. Most of these trends are nearly random and regress to the mean over time.

Bull markets start once everyone has given up on a particular asset class. This makes it undervalued. Anything that’s undervalued will begin attracting savvy investors. A new trend is born. When a new asset establishes a track record of rising prices, it attracts more investors. The trend strengthens and becomes psychologically reinforcing. Usually, the asset is at or above its intrinsic value at this point.

When prices get unreasonably past their fair values, a bubble is born. A crash becomes inevitable. But its difficult to stop and cash in. This is because it’s impossible to know when prices peak. A rational investor could stand to miss a big portion of the upside because a bubble could persist for longer than one would reasonably assume.

Governments also play a big role in bubbles. In fact, they will do anything to keep the party going. Keeping interest rates low is the perfect example. Lax lending standards and rising debt levels are a red flag that a bubble exists. Examples of this include buying stocks on margin and leveraging real estate.

The nature of bubbles reflects that most investors buy near the top. If an upward trend doesn’t exist for an asset, no one talks about it. Out of sight, out of mind. Gold simply wasn’t discussed in the 1990’s. The law of large numbers would show that the asset pool was too small at the beginning of the bull market in order for the majority to have owned it. If the masses were holding any particular thing, the prices would have been higher. And no new trend could get any traction.

We make our decisions based on what others are doing. In order to achieve long term success, try looking for the assets no one else is buying or discussing.

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Filed under Finance, Investing

Think Twice Before Making Extra Principal Payments

Many homeowners are in a rush to pay off their home loans. This is not always a wise decision. First, you lose liquidity and put your home equity at a higher risk. This is especially the case if you have little cash set aside and if you have few liquid investments. You should always strive to have at least six months of savings set aside.

Consider the following two situations. The first is a homeowner who routinely pays extra on her mortgage with the intent of the home being paid off early. Yes, it is true that if you pay a little extra each month, you will pay the home off substantially faster. Now, the second homeowner only makes the minimum payment each month.

Let’s imagine that a few years go by and both homeowners lose their jobs. And can no longer make their mortgage payments. Who is better off? The first homeowner has more equity than the second owner. However, the real estate market is slow and she may not be able to sell the home before it goes into foreclosure. And, yes, the second owner is in the same situation.

That being said, the second homeowner, who had been just making the minimum payment, has more options. She knows that the bank has little incentive to foreclose on the property. This is because the mortgage balance is high. That is, the bank isn’t in a position to gain hardly anything by foreclosing. The firs homeowner is a better target for the bank because they can sell the property and recover their losses.

Let’s also pretend that the second homeowner either saved or invested the money in which she was considering paying extra on the mortgage. She now has multiple options. She can keep current on her mortgage from these savings. This is the case whether she kept the money in a savings account or invested the money in liquid investments like stocks. Or, if she stops making the payments, the bank would be in no rush to foreclose.

Banks are incentivized to foreclose on properties with low loan balances first. This is because they can recover their losses easily. A home that is underwater or has a high balance will cause the lender to incur a loss, which is why lenders are seldom in a rush to foreclose on an underwater home. This is especially the case in a weak market because it would only add to the inventory of homes for sale, which is one more thing driving down prices.

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Filed under Real Estate

Recordkeeping for Income Tax Purposes

Recordkeeping is one of the most cumbersome tasks associated with running a business. It is something that many people put off. Having your financial information at your fingertips is important for making business decisions and keeping your accounting up-to-date.

That being said, recordkeeping is required and necessary to complete your income taxes. If your business gets audited, good recordkeeping habits could prevent you from having to pay the IRS a large sum of money. You may need to provide records to keep all of your expenses. Records can consist of receipts, bank statements, credit card statements and more. Failure to provide proper evidence could cause your deductions to be disallowed.

As a small business owner, your time is valuable and limited. You should strive to get your bookkeeping done as productively as possible. This could consist of using software to do much of the heavy lifting for you. For example, QuickBooks reduces the amount of work you have to do by eliminating redundant tasks. When you print a check in QuickBooks, the expense is already posted in the proper category. It’s vital that you keep yourself form doing duplicate work.

You should also avoid commingling funds with any account that you make non-business purchases with. This is true regardless of whether your business is incorporated. In the event you get audited and the IRS agent notices that many personal items are bought through your business account, the agent will be more likely to disallow an expense. Meals and entertainment are generally 50% deductible. However, it must be absolutely clear that they were business expenses. It is always a best practice to separate personal and business transactions.

If you use your vehicle for business use, you do not have to keep track of each expense. Instead, you can track your mileage. You will be able to take a deduction based on the number of miles you drove throughout the tax year.

In addition, records are needed each time you buy or sell an asset. You need to prove what you paid for an asset in addition to what you sold it for. Assets that are capital expenditures require depreciation. That is, the amount of the tax deduction would span over the useful life of that particular asset.

One of the questions I get asked most frequently by clients is hou long is it necessary to maintain records. At a minimum, you should keep records that are within the statute of limitations of the IRS. This is generally the later of three years after you file or two years after you pay any taxes due. You should keep copies of your income taxes even longer. The statute of limitations assumes that you filed those returns and paid any taxes that were due. If the IRS has no record of a return that was filed, then there is no statute of limitations. Having said that, it’s best to err on the side of caution when maintaining your financial records.

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Filed under Taxes

Income Tax Increases Will be a Drag on the Economy

Our budget deficit woes will end up making tax increases inevitable. We are far too deep in debt to grow our way out of the problem. In addition, our deficit has become too large for spending cuts alone to fix the problem. The day of reckoning is approaching faster than anyone had imagined before the financial crisis hit.

Simply put, higher income taxes are a drag on economic growth. They take money away from private investors and put it in the hands of government. We know from history that governments are poor allocators of capital. Government operates at a much lower level of productivity than the private sector.

Government expenditures, unlike private businesses, have a flat to negative multiplier effect on the economy. The historical data was outlined in This Time It’s Different by Reinhart and Rogoff. In comparison, the private sector generally has a positive multiplier effet on the economy. That is, each new dollar invested by businesses and investors will boost economic growth. Government expenditures, on the other hand, drain money out of the economy.

Tax increases often follow financial crises. This is because a financial crisis leads to bailouts of multiple companies, usually banks. Governments tend to borrow a big portion of this money, thus raising the budget deficit. In addition to bailouts, government expenditures also rise from economic stimulus programs. This is because a bad recession almost always follows a financial crisis. At the same time, tax revenues drop after a financial crisis because individuals and businesses are making less money; thus, having less taxable income. This is why banking and financial crises result in a downward spiral.

In the end, deficits have to be dealt with. Governments try to fix budget problems through inflation, reduced spending, and tax increases. Tax increases often fail because they lead to slower economic growth or could possibly trigger another recession. The result of the tax hike is even lower profits for businesses and less income for individuals. Therefore, the intended tax increases can generate less tax revenue for the government. In some situations, this only makes the problem worse.

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Filed under Economy, Taxes