41. One Year Anniversary

It was Dec 27^th 2010: before Osama was killed, the debt limit crisis of the summer, and before the economic recovery started stalling, then restarting, then stalling again, then restarting again. Or something like that.

But, most importantly, it was before the first of my Investment, Demystified blogs!

I hope you, my 6 readers, have enjoyed them as much as I have. I'm looking forward to another year of writing about exciting world of personal finance and investment, and wish you all a wonderful 2012!

40. Don't Blink!

Sometimes it seems that the smarter people are, the dumber they manage their portfolios - and their lives, for that matter. In his new book, Life, Fast and Slow, the economist and Nobel Prize laureate Daniel Kahneman tries to understands why this happens. While the explanations are complex, the bottom line is pretty simple: over-confidence is the main culprit.

I've seen it again and again at my workplace: brilliant people, who are right 99% of the time, often have a blind spot when it comes to the 1% of the time where they are wrong. In other words, they assume that they're always right. I think we all know people like this. Steve Jobs was one too - and while he brought one successful product after another to Apple, he also had some dazzling failures that he could never own.

But back to Finance. Recently, I've read "Don't Blink! The Hazards of Confidence" in the New York Times, which made me think of how over-confidence is manifested in management of personal finances.

Kahneman describes how, in his army days, working as a psychologist, he and his peers never let the facts "confuse" them - they knew that their methods are sound, and any evidence to the contrary was discarded with or without reason. Analysts, astrologers and other fortune tellers have the same bias: they know they're right, they believe in their ability to predict the course of the stock market (or the stars, or what the future holds for you), and you can't confuse them with facts. Even if the facts show no correlation between their predictions and the reality: a completely random, unpredictable, efficient and chaotic market.

It's perhaps the greatest scheme of our time, that so many bright people, so many MBAs and PHDs are spending so much time in this futile pursue of a holy grail called "alpha" - these super investments that are better than yours. But perhaps the tide is changing: from Kahneman to John Bogle more and more people see that those pursuits serve no purpose, bring no benefit to investors, and only reduce average portfolio returns by their annual fees and commissions.

The amazing revelation I had reading Kahneman's article is that this is not a huge conspiracy. It is not a well-held secret, passed from one generation of financial gurus to another. It's much worse than that: they actually believe in it. Against all odds, against scientific evidence, these people and firms, many of them very smart, truly believe that they, with their superior knowledge and skills, can edge an advantage in a market that follows a random walk pattern. Kahneman recalls how he presented financial management company with analysis of their own numbers, demonstrating that the bonuses they give to their star analysts have no correlation with future success, and proving to them that any relative success is transient and random. In fact, he proved to them that their entire merit system is giving random precious gifts to people who don't deserve them. They just stared at him, said "thank you" and "goodbye" and that was it. They believed too much in their system to let the facts confuse them.

Wall Street is asking us every day: "are you going to believe us, or your very own eyes?" I suggest you open your eyes.

39. Winter Harvest

It's December, and it's time for winter harvest.

And I'm not talking about pumpkins or other vegetables. I'm talking about losses.

Each December I look at my portfolio and search for losers. This year, my foreign investment fund, FSIVX, did an excellent job tracking all non-US economies, with minimal annual expenses (less than 0.1%), and together with the rest of the world economy lost about 10% of its value. I bought this fund on the last day of December 2010 - pretty bad for an annual performance! But the reason I've just sold all of it is not because I decided  to get out of foreign markets. Remember - once you set a course, you need to stay with it. "Selling your losers and buying winners" is the same as "Selling low and buying high".

But, selling now has a huge tax advantage: all the losses can be realized as short-term capital loss, the best kind of capital loss. It can offset not only short-term capital gains, which are taxed at your marginal income tax rate, but also your ordinary income (up to $3,000 a year). And whatever you don't use in 2011, you can carry over indefinitely, to offset gains in upcoming years. In my case, for every $10,000 of loss I harvest I expect to get about $3,800 back from the IRS. Not a bad deal!

Once you sell a losing asset to harvest loss, you're left with two problems: a pile of cash, and a hole in your investment strategy. After all, I do want to be invested in foreign markets, in more or less the same amount of cash I've just raised.

What you don't want to do is to go back and buy the same investment (FSIVX, in my case). If you do it within 30 days, the IRS considers it a "wash sale", and all the tax advantage goes up in smoke.

But there's a nice loophole: you can invest the money in a similar but not identical fund without triggering a wash sale. As long as I pick a fund that doesn't track the same index as FSIVX does ("Morgan Stanley Capital International Europe, Australasia, Far East Index"), and is managed by the same company, the IRS considers it a different investment. I chose ACWX - very similar, almost identical performance to FSIVX, but tracking "MSCI All Country World Index except US" and managed by a different company. It's not my favorite fund, their expenses are higher, but they'll do - for 30 days. When I rebalance my portfolio in January (at least 30 days from now), I'll switch back to FSIVX.

To sum up, this is the schedule I propose for the tax-savvy investor:

• In December, before year end, harvest losses: sell enough losers to cover any capital gains you might have, and to offset at least $3,000 of income. The end-of-the-year timing guarantees that these losses will be used in the current tax year. Make sure you choose equivalent but not identical funds: this way you keep your financial plan and gain the maximal tax benefit. 
• In January, at least 30 days later, rebalance and switch back to your investment plan's funds. 

Happy Harvest!