Here’s the lead sentence from a July 19, 2010 report on the stock market from BTN Research:

The S&P 500 stock index fell 2.9% last Friday 7/16/10

Losing almost 3% of value in one day is a pretty big decline; for investors, July 16, 2010 was not a good day. However, it is worth noting that the July 16, 2010 decline had been preceded by eight consecutive days of gains – in the language of investors, July 16 was a “pullback.” This is the nature of stock markets; they fluctuate.

But recently, the fluctuation, or volatility, has intensified. The BTN report noted that “in the last 50 years, a 1-day gain or loss of at least 2% for the S&P 500 has occurred every 21 trading days.  Since the beginning of September 2008 (i.e., the start of the global credit crisis), a gain or loss of at least 2% has occurred every 4 days.”

In other words, for 50 years, sharp one-day changes occurred about once a month. But in the last two years, the steep moves have been happening once a week. Certainly the struggling global economy plays a part in the jumpiness of the markets, but there may be other factors at work.

The Wall Street Journal’s July 12, 2010 front-page story carried this headline:

Small Investors Flee Stocks, Changing Market Dynamics.

Two days later (July 14, 2010) , the WSJ’s “Money & Investing” section led with this title

Letting the Machines Decide

Here’s the connection.
The July 12 article noted that the last three years have seen a steady defection of individual investors from the stock market – people have sold their stocks, liquidated their mutual funds, just cashed out. The principal reasons for leaving the market were losses and volatility. In the past, some individual investors may have been willing to ride out declines in the market, or get out slowly as they saw trends changing, but the recent volatility has been most unsettling. Several interviewees mentioned the “flash crash” of May 6, 2010 as an example of the type of extreme fluctuation that motivated them to leave the market. (In one of the largest one-day drops in history, several US indices plummeted almost 10% in 15 minutes before partially rebounding.)

As individual investors leave the market, large institutional investors exert a greater influence. And more often, institutional investors are relying on sophisticated computer models using artificial intelligence to make their investment decisions. These automated investing programs, controlling large blocks of investments, can potentially trigger strong movements up or down in markets, particularly when all the programs arrive at similar conclusions to buy or sell.

For the techno-geeks, the argument for using a complex algorithm to determine investment decisions is simple: “Human beings aren’t improving,” says Spencer Greenberg, founder of Rebellion Research in the July 14th article. But a side effect of removing the human factor from decision-making is the potential for increased volatility. When the computer model indicates “buy” or “sell,” there are no emotions involved – no caution, no anxiety, no fear. Decisions are made without hesitation. So whatever happens, the results will often be seen quickly.

These trends don’t necessarily preclude individual investors from participating in the stock market. Contrarians – those who believe in selling when everyone’s buying and vice versa – might even see great opportunities in this type of scenario. But just as automation has made other processes move faster, the more machines control investing, the greater the likelihood of spikes – both up and down – in the markets.

Like other changes brought about by increased complexity, the challenge will be how to profitably integrate this development for individual benefit.

With all the political rhetoric about the economy, notice there isn’t much noise about Social Security. In the midst of the toughest economic stretch since the Great Depression, you’d think a national insurance and pension plan that is tottering toward a financial breakdown would generate some strong political discussion. Why so little dialog? Here are some thoughts.

First, the summary review: Social Security provides pension and insurance benefits for qualified recipients by collecting a payroll tax on all wage-earners. In the past, the number of wage-earners far exceeded those receiving benefits. However, increased longevity and the arrival of the Baby Boom generation on the threshold of retirement has skewed the math: At current tax rates, the Social Security Administration will not collect enough from those who are working to provide benefits to those eligible for benefits. In a word, the plan is broken.

Sifting through all the political posturing, there are only four possible real-world solutions to fix Social Security.

1. Increase taxes.
2. Decrease benefits.
3. Change the eligibility requirements.
4. Scrap the plan.

From a rational perspective, getting rid of something that isn’t working is an obvious choice. But the question that follows is “what do we do for a replacement?” Change is fraught with unknowns, both for citizens and leaders, and even good ideas can be scared away by “what might happen.” For three decades, the standard political response has been to defer making a decision, leaving the responsibility in someone else’s hands. And as long as the checks keep coming, there’s little call for change from the populace as well. The hope is “I get mine before the well runs out.”

With a sluggish economy and growing sentiment that the national government has already spent irresponsibly, the idea of raising payroll taxes for all citizens doesn’t have much popular appeal. While government leaders certainly look to squeeze every bit of revenue from the populace, politicians only rule if they get elected. Raising taxes is not a popular plank on the reelection platform this year.

20th century British scholar C. N. Parkinson observed that a “luxury once enjoyed soon becomes a necessity.” Adapting this thought to Social Security, it’s fair to say that what was once supposed to be supplementary income in old age has become a critical retirement component for many Americans. As such, it’s hard to imagine a politician seeing much to be gained by threatening to decrease benefits.

That leaves changing the eligibility requirements. In mid-July, 2010, members of Congress from both parties mentioned two possible changes. The first is to raise the Social Security retirement age to 70 for people who are 50 or younger today. The second proposal up for serious consideration is to include a means-test for benefits; those with more assets would receive smaller benefits.

Raising the retirement age is a logical response to the increased longevity of Americans since Social Security was established in the 1930s. As Patrice Hill of the Washington Post noted in a July 13, 2010 article “with people living longer and enjoying better health in their senior years, the nation simply can’t afford any longer to be paying out benefits for as long as 30 years after retirement.”

The rationale for implementing a means-test to qualify for benefits is simple economics. In the words of Ohio Congressman John Boehner: “If you have substantial non-Social Security income while you’re retired, why are we paying you at a time when we’re broke?” he said. “We just need to be honest with people.”

A means-test would represent a fundamental change to Social Security. With benefits indexed to income or assets, it is possible that some affluent workers will never receive benefits even though they will make a lifetime of payments into the plan. While this approach won’t result in an across-the-board decrease in benefits, making Social Security a clearly defined wealth transfer program has some political risk.

Twenty years ago, retirement planning was often pictured as a three-legged stool, with the legs being Social Security, the company pension, and personal savings. Today, the pension leg is rapidly vanishing from the financial landscape, personal savings have been pounded by the economy, and Social Security (if it survives) looks like it will come into play later in life. This turn of events leaves many Americans wondering if they will have a leg to stand on in retirement.

What is whole life insurance? A simple answer, one you might find on a financial information website, might describe whole life insurance as a combination of life insurance and cash value. But once you get past this basic definition, the details and workings of a whole life policy can be quite sophisticated, maybe even confusing. Writing in the January 11, 2009 Palm Beach Daily News, life insurance expert R. Marshall Jones said that:

“Until recently, permanent life insurance was arguably the financial industry’s most complex instrument…”

As with many other complex financial products, whole life insurance is the result of the integration of several basic financial ideas. The starting point for whole life is an understanding of some of the shortcomings with a simple financial instrument, term insurance.

Here’s the big issue with term insurance: As you get older, it gets more expensive. Because statistics show older people are more likely to die than younger people, insurance companies price the coverage accordingly. To illustrate, here are 50 years of scheduled premiums from a reputable life insurer for a healthy 35 year-old male non-smoker to secure $500,000 of life insurance on a yearly renewable basis.

This pricing, while accurately representing the risks assumed by insurance companies as people get older, creates a dilemma for consumers. As they live longer, and pay increasingly expensive premiums, the cost of insurance becomes prohibitive. Thus, when they are most likely to die, they may not be able to afford the insurance. From a financial perspective, the only way to “win” in this transaction is to die “young,” before the insurance gets too expensive. Given the aversion most of us have to dying, the most likely outcome of yearly term insurance is paying premiums for a period of time, then lapsing the coverage. Even though the consumer may have a real need to provide the financial protection of life insurance, the yearly renewable premium schedule creates a financial incentive to drop the protection as soon as possible – or simply forgo life insurance altogether. This is a lose-lose proposition, for the consumer and the insurance company.

Integrated Solution, Step One
One response to increasing yearly renewable premiums is leveling the premium. Instead of increasing the cost every year, the insurer determines a flat rate for a specified number of years, i.e., for a term. A typical term may be 10, 15, 20 or 30 years. The level term arrangement results in a policyowner overpaying (relative to the true annual cost of insurance) during the early years of the term, then underpaying at the end. For the 35-year-old in the above example, the 30-year level term premium is $490/yr. Compared to yearly renewable term, the level premium is more expensive for the first 10 years, then less expensive for the next 20.

To accurately price level term insurance, the insurance company must make some assumptions about the time value of money, because the “additional” premiums they collect in the first 10 years will be invested to subsidize the cost of insurance for the following two decades.

A level term premium schedule significantly resolves the problem of the cost of insurance becoming progressively more expensive in later years – at least during the term. But when the term expires, the problem returns. In our example, the cost to renew $500,000 of life insurance at age 65 is $5,025/yr. – providing the individual can prove excellent health by passing a new physical examination. Even if he is healthy, the new term is limited to 20 years (age 85). And what happens if this man lives to age 86? The scheduled renewal premium is now $207, 990! For one year!

While level term premiums help consumers afford life insurance longer, the same end-of-life problem remains: Just when you are most likely to collect on the life insurance, you may not be able to pay for it. Level term insurance is certainly a win for the insurance company because policyholders pay more premiums longer, but the financial outcome is less clear for most consumers using term insurance – they still are not likely to have an insurance benefit in force at death.

Integrated Solution, Step Two
A lifetime term policy with level premiums would solve the problem. But fairly pricing term for one’s entire lifespan creates a new problem: As illustrated by the yearly renewable table, the cost of insurance rises steeply after age 60. So even with a long time to “overpay” at the beginning, a policy guaranteed to be in-force at age 100 requires a sizable annual premium. In the case of our healthy 35-year-old non-smoker, the lifetime annual premium is $6,165/yr., more than 12 times the annual premium for the 30-year term policy. Unless the consumer has money to burn, the idea of overpaying $5,600 each year (the difference between the whole life and level term premium) for the next 30 years just to keep the premiums affordable in old age probably won’t set well. There’s just too much overpayment for too long to convince most consumers to set aside that much money for an event that may be 50 years in the future.

Enter the concept of cash value. The overpayment of premium in a whole life policy represents reserve capital the insurance company will use to cover the cost of insurance as the policyholder ages. In the meantime, this reserve capital will be invested to generate more capital. A portion of this excess cash value, and the earnings from it, is credited to a cash account tied directly to the policy. While the policy is in-force, the policyowner has the right to access this cash value, through a variety of transactions (loans, partial surrenders, dividends, etc.).

In a typical whole life policy, this cash value can eventually exceed the total premiums paid, i.e, the policyholder not only owns the insurance benefit, but has received a positive return on the premiums.

This blending of cash value and life insurance is a brilliant example of integrated thinking. A whole life policy with a level premium provides economic certainty for consumers – they know how much insurance they will have, they know how much it will cost, and (as long as premiums are paid) they know the insurance will be in-force at the end of their lives. At the same time, the larger premiums give the insurance company greater financial stability. It has greater resources to meet its contractual obligations. And during the lifetime of the policy, the owner also has access to this stable source of cash value (and its growth) as well.

Complexity begets more complexity – and more opportunities
Besides turning the life insurance benefit into an asset instead of an expense, the cash value component opens the door to other possibilities. Dividends* can be received as income, or used to pay premiums. Additional paid-up insurance may be purchased. Depending on the performance of the cash value account, additional premium requirements may change or be eliminated.

Because the benefit paid at death is now certain, life insurance can do more than provide income replacement protection in the event of a premature death. Among other things, the proceeds can be vital in estate and inheritance planning, serve as a supplement to long-term care, pay creditors and fund charities.

Some might argue that it is hypothetically possible to project similar or greater financial results by choosing to use term insurance alongside other accumulation vehicles. On paper, this is possible. But while two simple stand-alone financial products might appear to out-perform whole life in a narrow set of criteria (such as pre-tax accumulation in a 20-year period), they cannot equal the combination of benefits, guarantees and flexibility that result from using a whole life policy. The integration of level premiums and cash value, and the resulting opportunities make life insurance a win-win for all parties.

Just as whole life is a multi-faceted complex financial instrument, there are many ways to position whole life in one’s financial program. Contact us to find out how whole life might best fit your current circumstances.

*Dividends are not guaranteed, and are generally declared annually by the company’s Board of Directors.

Here’s an interesting financial transaction. See if you can follow this hypothetical example:

1. You borrow shares of stock XYZ from someone else’s portfolio.
2. You then sell the shares of XYZ and put the proceeds from the sale in your own account.
3. Over the next few days, you watch as the share price for XYZ goes down. You buy shares of XYZ at the reduced price, and use them to replace the shares you borrowed. You keep the profits (the difference between what you received for selling the borrowed shares, and the cost of replacing them).

Got it?

This is a simplified illustration of a short-sale. A short-sale is a way for an investor to make money on a stock he doesn’t own by speculating that it will lose value. Depending on your perspective, short selling can be ingenious, sneaky or evil.

Short-selling has a long and controversial history in a variety of financial markets. Some historians have found that North American fur  raders were early practitioners of short-selling, and short selling appears to have triggered the implosion of the Tulip Bulb market in Holland in the 1600s. In recent financial history, short-sellers have become famous for their profits and infamous for bringing exaggerated financial losses on others. Because of the extreme volatility that can result, financial regulators have often suspended the practice during periods of financial turmoil crisis. Napoleon supposedly declared that short-sellers were “enemies of the state,” yet a May 4, 2010 Wall Street Journal article found that several members of Congress held investments that made short-sales during the 2008 financial crisis, and renowned investor Warren Buffet has defended short-selling as a “counterweight to Wall Street bullishness.”

So, in regard to short-selling…what’s next?

Reading the opening paragraphs probably took less than a minute. But perhaps because short-selling is an unfamiliar topic and the explanation is a bit complex, it wouldn’t be surprising if your attention started to drift, even in that brief period of time. We live in a short attention span culture, and most of today’s communication mediums emphasize quick bursts of information and constantly changing inputs. When it comes to concentrated thoughts on complex ideas, most of us don’t get much practice. And that can be a problem, particularly when it comes to finances. We are conditioned to look for “what’s next?” without even being sure about what just was.

Life is complex and integrated. So is money.
Short-selling is just one idea in the financial universe. But it’s a good example of what the financial universe is like, and it also illustrates why many people struggle to obtain their financial objectives. In order to succeed, you must embrace the complex and integrated nature of the financial world. Maybe this sounds sort of metaphysical, but there are practical applications – especially if you don’t pay attention.

At first glance, short-selling seems counter-intuitive. But short-selling is actually the product of integrated thinking; you take several investing strategies, and connect them. This formula of integrating ideas to create complex and sophisticated systems is the foundation of human progress, and reflects the nature of life itself.

Complex financial transactions are part of everyday life in the United States. Variable-rate mortgages, insurance, tax-deferred retirement accounts and hundreds of other financial vehicles are comprised of integrated ideas and substantial details. There are very few “simple” financial products in the marketplace.

Given the evidence for complexity and the fact that money plays such a large role in determining our material circumstances, why do so many people seem to have a short attention span when it comes to making good financial decisions?

Does Complex Technology Make Us “Shallow Thinkers?”
Part of the challenge may be 21st-century technology. In his recently released book, The Shallows: What the Internet Is Doing to Our Brains, author Nicholas Carr says our forms of communication affect how well we handle complex thinking. “The Internet encourages the rapid, distracted sampling of small bits of information from many sources… We are becoming ever more adept at scanning and skimming, but what we are losing is our capacity for concentration, contemplation, and reflection.” Similar charges are made against television and video games. Sampling, scanning and skimming might be considered higher-level mental functions, and operating a game controller certainly requires some complex manual dexterity. But when there’s no “concentration, contemplation or reflection” to accompany these tasks, the chances for success seem less probable.

This “short attention span” dilemma is pervasive. An example is the Congressional leader who said “We have to pass the bill so that you can find out what is in it.” The final version of the bill was 2,409 pages, and many legislators admitted they didn’t read it before they voted to approve it. Regardless of your perspective on the issue, it seems like the process for reviewing and debating the bill could have been a bit more “thoughtful” if more people took the time to read it, instead of saying “we’ll figure it out after we approve it.”

Consequences
A Short Attention Span Could Mean Missed Opportunities. An Example: whole life insurance is a complex financial product; even the best life insurance representative couldn’t accurately explain all the features and benefits in five minutes or less (don’t believe it? See the next article). In contrast, there are hundreds of TV commercials for term life insurance, all conveying their message in 60 seconds. And for those dispensing financial advice to the masses, their message is to buy term. As one “expert” puts it “Keep it simple and buy term life insurance.” That is simple, isn’t it? Sounds like perfect advice for “short attention span” types.

However…in the long run, your financial situation may favor using whole life. Unfortunately, selecting term life insurance today – because it’s simple and quick – could possibly preclude obtaining whole life later. The time to pay attention is now!

A Short Attention Span Could Result in Financial Loss. For more than 20 years, Bernie Madoff’s investment operation was so complex, no one knew he was actually running a scam. Or more to the point, no one seemed to be able to pay attention long enough to figure it out. In 2000, broker Harry Markopolos said he knew in “five minutes” that Madoff’s operation was a fraud, and he reported this assessment to the SEC – in written detail. Unfortunately, it was eight years before the authorities would follow through on Markopolos’ fndings. How much money was lost because people had a short attention span?

Remember, not every complex idea works. Some projects fail because of flawed principles, others because the complexity is hiding fraud or other bad behavior. Those with an unwillingness to examine the details of their financial transactions are at great risk of being undone by their short attention spans.

Okay, I Get It… What’s Next?
How about a three-hour tutorial on the history of interest rates and inflation? That might provide some real insight into what’s next for the economy. Just kidding. If you’ve made it to the end of this article, you deserve a few summary bullet-point comments, just so you don’t suffer complexity overload.

• If you take the time to understand it, financial complexity can be a great asset.
• One of the best ways to achieve financial complexity is to use the knowledge of others. Most of the time, successful complexity is group effort. Only geniuses do it alone.
• Your best financial strategies are the ones that integrate all of your financial components – what you earn, what you own, what you owe, what you want.
• People who live in the shallows may see their financial progress go off the deep end.

WHAT’S NEXT? How about a review of your financial program, and the chance to see if a little complexity and integration could make a positive difference in your life?

Have you heard the one about the invisible gorilla?

Two researchers created a short video of two groups of students passing a basketball to one another. The video lasted about 45 seconds and was completely unremarkable, except for one thing: About halfway through the video, an actress in a gorilla suit walked into the middle of the two groups, beat her chest a few times and walked out. The “gorilla” was on-screen for nine seconds.

Researchers asked viewers to count the number of times the basketball passed between members of one of the groups. After viewing, they were also asked if they had seen the gorilla. 50% of the respondents were so focused on counting passes they never saw the gorilla!

This video, first shown in 1997, is the basis for a new book “The Invisible Gorilla and Other Ways Our Intuitions Deceive Us” by Christopher Chabris and Daniel Simons. Full of data from various experiments similar to the gorilla video (to see this video, and others like it, you can go to http://www.theinvisiblegorilla.com/videos.html), the book presents a strong argument that many of our perspectives and actions in life are distorted by “illusions.” As a result, we either miss or misinterpret much of what is going on around us. In the authors’ words, “Indeed, virtually no realm of human behavior is untouched by everyday illusions.”

One reviewer described The Invisible Gorilla as “a humbling journey into the fallibility of our thinking.” Not only are we messing up, we don’t even know it.

Chabris and Simons call the illusion in the gorilla video the Illusion of Attention. It is our “inattentional blindness” which causes us to “experience far less of our visual world than we think we do.” But this isn’t the only type of illusion that leads us astray.

There is the Illusion of Memory. Our ability to recall ideas and events – even the most significant “flashbulb moments” like 9/11, our marriage ceremony, or the birth of a child – is nowhere as sharp as we think it is. Often our memories are embellishments rather than facts, like the fish that gets bigger with each telling.

Another common mistake is the Illusion of Knowledge. Personality assessment tests often ask respondents how many authors they have read, or which concepts seem familiar. Included in the list are fictitious names, and ideas that don’t exist. Yet, many people will claim knowledge of these non-existent people and ideas. Even when there’s no way of knowing, we still think we might have known.

Closely related is the Illusion of Cause. We not only think we know what happened, we think we know why it happened. If someone told you that every time they got a haircut the stock market went up, would you laugh or start checking their calendar? There might be a correlation, but it’s tough to think there’s a causal connection between the two events, right? Of course, when someone on the business channel does the same thing comparing the Super Bowl winners and the stock market, or the price of chocolate and inflation, we think, “you know, he might be right.” In reality, there are often too many causes and too many effects to think we can discern which cause triggers another effect.

Even more challenging is the Illusion of Confidence. As Wall Street Journal reviewer David Shaywitz puts it in an article from June 11, 2010, “we profoundly underestimate our capacity to be fooled.” We too often associate confidence with competence; if people act confidently we assume it must be because they are good at what they do, or precise in their knowledge. But the phrase “con man” is short for “confidence man.” At the heart of many poor financial decisions is misplaced confidence in an individual.

Because these illusions exert such great influence over us, most of us tend to overestimate our intelligence, attractiveness, abilities, and sense of humor. At the same time we underestimate the challenges we face, and our own limited abilities to respond to them. Given these factors, it’s no surprise that we often miss what’s most important, and even ignore the warning signs telling us we are headed for trouble.

If we are all so blinded by our illusions, are good decisions impossible? Several reviews of The Invisible Gorilla have pointed to the practical ramifications of the findings. For example, the illusions concept offers a convincing explanation of why so many people make poor financial decisions. The illusions in The Invisible Gorilla offer plausible explanations for the overwhelming tendency of individual investors to buy high and sell low, or forgo disability insurance, or take a mortgage beyond their means. In fact, given the illusions that hold sway in our lives and our unawareness of them, poor financial decisions are not surprising. Rather, they are almost inevitable. How then, can individuals deal with the invisible gorillas in their lives?

Get smarter. Once you become aware of the impact of illusions on your perceptions, you can change, at least in theory. So now that you know there’s a gorilla in the video, you should be able to find it, and respond appropriately. But looking for the gorilla often means not seeing something else. As a follow-up to their 1997 video, the authors made a new one. Like the first, this one featured two groups passing a basketball and a person in a gorilla suit. But this time, other factors changed as well. First, one group member left the stage as the gorilla entered. And during the course of the film, the background curtain changed from a deep red to gold. Viewers who knew about the gorilla and were told to count the number of passes correctly noted both items – but most missed the additional changes. Focusing on one thing precluded awareness of others.

Getting smarter helps, but even if you know more about what you’re missing, it is still impossible to know it all. We simply cannot process all of the input. We can’t watch every business news channel, read every financial publication, and study every report – about gorillas, or money, or anything else. We have illusions because we must filter and prioritize. So while our filters may get better, they can’t catch everything.

Turn the decision-making over to someone else. In every experiment done by Chabris and Simons, some people did notice the gorilla, or caught other changes embedded in the tests. So while you might be easily fooled by the illusions of life, perhaps there are some people who aren’t. If only you could find one of those “smart ones” perhaps they could help you successfully manage your financial affairs, right?
Indeed, many people have achieved great acclaim for being smarter than everyone else when it comes to money. Over time, these people seem to have a knack for knowing what to do and when to do it. Probably the best-known financial savant of our time is Warren Buffet. The “Sage of Omaha” has become one of the richest individuals in the world as the manager of the Berkshire-Hathaway investment fund. Buffet might make some mistakes, but he seems to make far less than the rest of us. Many people have done well by letting Buffet be their financial stand-in.

Unfortunately, the same thought process, of getting a smarter person to handle one’s financial affairs, made it possible for Bernie Madoff to perpetuate his $36 billion investment scam for more than 20 years. Madoff’s representations of consistently above-average returns wowed potential investors and buffaloed investigators. The illusion of confidence in Madoff was so great that no one saw the underlying scam until a poor economy spurred some investors to cash out. When Madoff’s Ponzi scheme started to flow in reverse, his house of cards collapsed, leaving thousands of investors with losses estimated between $12 and $20 billion.

This isn’t meant to imply that all smart people have the potential to be con artists. Even well-intentioned people who are smarter than you may not be smart enough to avoid the pitfalls of financial illusions.

Find the perfect plan. If you can’t trust yourself and you can’t trust other people, then you might reason “let’s remove the human element”. Put a system of rules in place that leaves no room for human fallibility. Get a computer to make the decisions. This is the driving idea for formulating risk-tolerance models, target funds, and all sorts of regulatory agencies.

These plans may eliminate human decision-making, but that doesn’t make them fail-safe. First, the plans were designed by individuals – you know, those people operating under illusions. All sorts of ingenious ideas and complex computer-driven models have been failures, sometimes spectacular failures.

Second, most plans, even the ones that attempt to predict the future, are based on past experiences. This backward-looking planning technique is one of the reasons financial regulation often fails to prevent abuses (like the collateralized mortgage obligations that precipitated the housing bubble). Cheaters are constantly seeking new ways to bend the rules and game the system, however regulators are constantly behind the curve. Any adjustments they make (“we can’t let this happen again!”) only reflect what would have been the perfect plan for the past, not what will be the perfect plan for the future.

Can anything tame the Invisible Gorillas? This can be depressing. You realize that you can’t trust yourself to make all of the right moves. You can’t entirely trust other people, because even with best intentions, they’re just like you. And you can’t trust  finding a perfect plan, either. Given these truths, it’s almost logical to conclude that most of us are destined for financial ruin, and there’s not much we can do about it.

Risk Management: the Wabi-Sabi for the Invisible Gorilla. In Japanese, the phrase “wabi-sabi” represents a comprehensive world view centered on the acceptance of transience. The Wikipedia entry says a key element of wabi-sabi is finding beauty in things which are “imperfect, impermanent and incomplete.” Accepting that it may not be possible to achieve the perfect outcome, the wabi-sabi approach looks for ways to make things work.

Given the evidence from Chabris and Simons, no one – no matter how well-informed and self-aware – can ever know enough and/or be level-headed enough to avoid making some mistakes in observation and judgment. Accepting that mistakes are unavoidable, the logical response is to prepare for them. Instead of trying to avoid all mistakes, take steps to manage them. Particularly in regard to your financial affairs, a risk management approach is an effective way to handle the invisible gorillas in your world, because it acknowledges that many aspects of your financial life are “imperfect, impermanent and incomplete.” For example…

If you can’t guarantee a good investment outcome, don’t put all your money in one place. If you can’t be sure you will avoid all accidents, having insurance is a no-brainer. You may anticipate steady employment, but establishing a substantial cash reserve is always a smart decision. Instead of relying exclusively on one person to help you with your financial decisions, cultivating a team of professionals can provide either a consensus, or a range of alternatives. Risk management says: In all things, hedge your bets.

It’s not an easy sell, because risk management isn’t a concept with a lot of sizzle. There’s no promise of outrageous returns, or magic formulas, or revealed secrets of the rich and famous. But risk management is the only financial approach that can handle the invisible gorillas that often lay waste to your financial aspirations.

Even if you accept the risk management paradigm, there is still a chance that these decisions may leave you slightly dissatisfied. If one fifth of your investment portfolio delivers outstanding returns, you may wish you’d invested all of it in that account. If you don’t have an auto accident or a disability claim, the insurance premiums may seem like wasted expenditures. And if everything goes your way at work, you may be tempted to use those cash reserves for a vacation to Tahiti. You begin to think, “I’ve got it figured out.” And thus the illusions of memory, knowledge, cause and confidence begin to tug at you again. The invisible gorillas are back.

A few critics of the Invisible Gorilla have said the research seems to discourage risk-taking and initiative, which are often seen as the drivers of a healthy expanding economy. After all, if everyone is incompetent, and risk management is the best response, how will any innovation ever take place?

It may seem counter-intuitive, but good risk management allows for the most risk-taking. People with a solid financial footing can afford larger risks and have a better chance of surviving failures. It is human nature, given our propensity to embrace illusions, to believe that magic formulas exist, and all of our problems would be solved if we could just find the magic formulas and apply them to our personal circumstances. But pursuing ideal illusions can get in the way of establishing workable plans. Financial risk management should be at the foundational base of every financial program. Neglecting this fundamental element is building a financial life based on illusions.

FINANCIAL RISK MANAGEMENT MAY BE “BORING,” BUT IT WORKS.  HOW SOLID IS YOUR RISK MANAGEMENT PLAN?

It’s too early to make a definitive statement, but the fallout from the real-estate bubble may result in some fundamental long-lasting changes in Americans’ perspectives on home ownership. Not only is there the chance that fewer Americans will be able to own a house, but even those who are prime candidates for home ownership may find other options more attractive and financially profitable.

A little background:
Before 1940, slightly less than half of all American households owned a home, a percentage that had remained unchanged for more than four decades. Following World War II, the Baby Boom, coupled with government tax breaks and subsidies, rapidly increased the percentage of Americans who owned their house¹. By 1960, more than 60% of Americans were homeowners, and for a period in the late 1990s and early 2000s, the number approached 70%.² Homeownership became a standard fixture in the American Dream.

However, the allure of homeownership has lost much of its luster in the recent financial melt-down, both for homeowners and the financial institutions who initiated the mortgages to make the purchases possible. Where once only a few financial commentators questioned the financial value of owning a home, a tide of commentary is asking if the US economy would be better off with fewer homeowners and more renters. But maybe the problem isn’t how many people own a home, but what type of home they own.

When the housing market was booming through the past two decades, it was assumed that almost every homeowner could expect to cash out with relative ease, either by selling the house or taking a home equity loan. Home equity was seen as a liquid real asset, one that could be accessed at almost any time.

However, as banks have tightened their lending standards to potential homeowners, the market of potential buyers has shrunk, driving prices down. At the same time, more homes are being liquidated at discount in foreclosures and short sales, further depressing the market. In the course of the past three years, current homeowners find their home equity has substantially diminished – and isn’t very liquid.

These changes in the real estate market increasingly make homeownership a much longer term proposition. A decision to buy a home today isn’t easily undone. For those who currently own a home, it may take awhile for values to rebound, and selling the home in the future is no longer a foregone conclusion, even at reduced prices. This fundamental change in perspective regarding homeownership should compel individuals to consider questions like:

• Is there a profitable exit strategy for this house, or should I plan to live here for the rest of my life?
• What happens if an employment change requires a relocation?
• What is the projected market for my property in the future?
• What is the legacy value of my home? Is this an asset my heirs will want to inherit?

In the past half-century, the largest increase in American residential housing has been in suburban communities, and the bulk of the middle-class homeowners own single-residence dwellings in subdivisions. If you are one of these suburban home-owners, how would you answer the questions above? Can you see yourself staying in this house for the next 20 or 30 years, or into retirement? Would someone else want to live in your subdivision? And if your children or other heirs inherit this property, will they see it as a valued asset or a financial albatross?

When you consider the changing demographics of an aging population, a post-Baby Boom contraction in housing demand for single-family homes, and fewer financially-qualified home buyers, it is reasonable to think the long-term prospects for suburban housing won’t be what they have been for the past 50 years. If this is true, a different approach to homeownership might have some appeal.

A different approach.
Instead of a single-family house as the default option for real estate, look at other options. For example, think about renting a primary residence and buying a “second home” – such as a cottage, a vacation or resort property, or a even an income property in a thriving community. Under the right conditions, this strategy could have several advantages.

First, many buyers of a “second home” property could still receive tax advantages that would closely approximate those that come from owning a primary residence. Second, income from rentals (seasonally on resort properties, or year-round in residential locales) may offset many of the costs of ownership. Third, resort and vacation properties can be enjoyed by owners and their families for their recreation and destination value, both now and in the future. Fourth, renting may offer greater flexibility in adjusting to fluctuating living conditions, such as changes in employment or children leaving the nest. Fifth, if it is desirable to make this property a home in retirement, the transition is simple; you stop renting and move into the house. Sixth, a profitable rental or desirable vacation home would likely have ongoing value for heirs; a sale would not be required for them to receive value from the inheritance.

This strategy of buying a “leisure home,” while living in a rental is not a new idea. This pattern was typical of many wealthy individuals during the late 19^th and early 20^th century. They owned an “estate” in the country, and rented a workplace residence. American steel magnate and finance giant Andrew Carnegie (1835-1919) was one of the richest men in history, and he established his fortune quite early in life. When he was in his twenties, Carnegie erected a large estate home on property in Homewood, PA, near his hometown of Pittsburgh. Yet for much of the next 25 years, Carnegie resided in luxury hotels in New York City, returning to his estate during the summers or as a stop on his travels. At various times, other members of Carnegie’s family also lived at the estate, but it was never Carnegie’s exclusive residence. In later life, Carnegie established additional large estates in Massachusetts, Georgia and Scotland.

In several ways, the “titans of industry” during the Industrial Revolution mimic some of the work circumstances of people in the 21^st century Information Age. Carnegie and other businesspeople of his era were establishing continent-spanning businesses that required them to be mobile. Even though some employers may offer telecommuting options, today’s workforce opportunities often require a high level of transience. Today’s worker expects to change jobs more often, and to change their places of residence as well. While any relocation is stressful, it could be argued that renting makes moving easier from a financial perspective – there is no home to sell, no monthly mortgage payment on an empty home, and there is no equity loss to worry about.

At the same time, buying an “estate property” offers several tangible and financial benefits, both now and in the future. A well-managed income property has the potential to add revenue to your financial program. A vacation home can be a welcome getaway and a gathering place for families as they grow up and expand. In both instances, the need to sell will be lessened, which allows more time for equity appreciation, and gives owners the upper hand in deciding when and if a sale should take place. If this property stays in the family for several generations, the long-term benefit of buying estate property could be incalculable.As the turmoil from the Great Recession recedes, the fallout is revealing changes in the financial landscape. Those changes may affect the role of homeownership in the American dream. While single-family residences may still occupy a prominent place in the financial lives of many Americans, it doesn’t hurt to consider (and prepare) for other options.

DO YOUR LONG TERM FINANCIAL PLANS INCLUDE “ESTATE PROPERTY?

IF YOU FOUND AN ESTATE PROPERTY OPPORTUNITY, HOW WOULD YOU EXECUTE THE TRANSACTION?

WOULD YOU LIKE TO EXPLORE THESE, OR OTHER IDEAS WITH US?

U.S. Census Bureau:
11989 report, Historical Statistics: Colonial Times to 1970.
2 US Census Report, Homeownership by Area (focusing on homeownership from 1960-2008)

“Even if I get disabled, I’ll still work.”

Huh? How is that possible?

Ask any insurance agent who’s been in the business for awhile, and chances are, he/she has heard this statement, or a variation of it. That’s because disability is one financial topic where illusions often prevail over the facts.

For most non-retirees, their ability to earn an income is their greatest financial asset. Compensation from work puts food on the table, pays the mortgage, sends kids to college, and builds the retirement nest egg. Without an income, none of that happens. It should be easy to recognize the desirability of good risk management strategies for disability, right?

Wrong. Just like the findings in The Invisible Gorilla, people underestimate the risk of disability and overestimate the abilities and resources available to handle it. Consider these statistics:

• The government’s Social Security Administration (SSA), which provides disability benefits for most Americans, says that three in 10 people entering the workforce today will become disabled before retiring.*
• SSA also reports that the overall rate of disability is increasing among both men and women workers. In 1999, 3.6% of covered workers were receiving Social Security Disability Income payments, while in 2009, 5.1% were receiving SSDI payments. Factors behind this dramatic rise include the aging of the U.S. workforce and the recent poor economic conditions.**

When 5% of Americans are on disability claim and 30% are likely to experience a period of disability before retirement, this sounds like a situation that should be addressed. And in some ways, it is: Social Security offers some insurance, as does Workers’ Compensation, which provides benefits for disabilities occurring in the workplace. But do these programs really provide adequate risk management for disability? Again, look at the numbers:

• The Council for Disability Awareness** (CDA), an association of 16 insurance companies that comprise 75% of the commercial disability insurance marketplace, reports that 95% of all CDA Member Company disability claims are not work-related. For the SSA, 90% of all disabilities are not work-related.
• 31.2% of individuals who received long-term disability benefits from CDA Member Companies** in 2009 did not qualify for disability benefits from Social Security. While the number of workers receiving Social Security benefits has increased, only 35% of workers applying for SSDI disability claim payments in 2009 were approved; 10 years ago, the approval rate for workers applying for disability was 52%.
• In spite of the limited protection afforded by Social Security and Workers’ Compensation, the US Bureau of Labor Statistics reported in an April 29, 2010 press release* that 46% of full-time workers had short-term disability benefits and only 39% had signed up for long-term disability.

The conclusion: Many of the disabling incidents that could keep you from earning an income are not going to result in payments from either SSA or Worker’s Compensation. And half of all workers don’t have any other coverage. How does this happen?

“Many people recognize the emotional and financial impact of becoming disabled, but they tend to underestimate the consequences of not having adequate income protection,” according to insurance company vice president Kevin Farley***. Instead of insurance, they think they can rely on their savings, make adjustments in lifestyle, and get help from family members.

But mostly, people think they can define the terms of their disability. They will say…

“If that happened to me, I could still go to work.”
or…
“I wouldn’t be out that long. I’m a fast healer.”
and…
“I’m not one of those people who would milk an insurance claim.”

Hmmm. It sounds like these people are operating under some illusions. They minimize the impact of a disability, often because they underestimate the likelihood of it occurring while overestimating their ability to withstand the financial consequences.

*April 29, 2010 Press Release from Business Wire, “Most Americans Live to Work But Don’t Prepare for Illness or Injury That Could Put Their Income at Risk.”
**www.disabilitycanhappen.org
***Business Wire from Principal Financial “Despite Fears, Americans aren’t Protecting Themselves,” May 14, 2010.

…From 15 years to 18 months (but maybe 20 months is better)

Perhaps coinciding with the economic fallout from the Great Recession, the past few years have seen some significant adjustments by financial experts in regard to cash value life insurance. Rather than being seen through a black-and-white lens as either “expensive life insurance” or a “poor investment,” there is a groundswell of commentary that recognizes the unique position cash value life insurance holds in the financial universe.

One of the more prominent commentaries on this new perspective toward cash-value life insurance comes from a 2008 report by Richard Weber and Christopher Hause titled Life Insurance as an Asset Class: A Value-Added Component of an Asset Allocation. As part of their findings, Weber and Hause concluded that:

Permanent life insurance can optimize the risk/reward profile of an investment portfolio. That is, a portfolio with both fixed and equity components that includes life insurance intended for a lifetime, may deliver greater legacy and living values in conjunction with the investment portfolio – for a given risk tolerance and reward goal – than the portfolio without the intended life insurance.

In determining how to pay for permanent life insurance, Weber and Hause make another important statement:

…consumers may wish to consider paying premiums from portfolio resources rather than from income resources.

This is the idea of acquiring life insurance through asset transfers. A simple example of asset transfer would be using the earnings (such interest or dividends) from one asset to pay the premiums to establish a new asset (the permanent life insurance policy). In fact, Weber and Hause take seven pages of their 100-page report to conduct an in-depth financial analysis of this asset-transfer approach, using earnings from a bond portfolio.
The end result: greater accumulation, plus increased benefits.

Other methods of asset transfer:
Single Payments — Depending on the makeup of the assets in one’s portfolio, using earnings to fund annual premiums may not be feasible. Perhaps the principal is not large enough to generate the necessary earnings each year. Or maybe the other assets appreciate in value, but do not distribute interest or dividends. Even if the principal is large enough, some assets may be volatile, and market fluctuations could make it hard to rely on them for ongoing premiums. Also, any transfer from a qualified plan may include an ordinary income tax consequence and a tax penalty on the transferred amount.

In any of these circumstances, it might be desirable to transfer the asset into permanent life insurance in one transaction, i.e., a one-time payment instead of a gradual year-by-year series of transfers. This can be done; the challenge is determining how best to make the transfer.

Single-premium life insurance policies can be used for asset transfers. With this type of policy, one premium secures the life insurance benefit, and establishes a cash value account which grows over time as nonguaranteed dividends are credited. However, current tax law on single-premium policies restricts or diminishes some of what Weber and Hause term the “living benefits” of a permanent insurance contract, specifically the tax-favored access to cash values via either partial surrenders or loans. These restrictions apply not only to single-premium policies, but any cash-value life insurance policy classified as a Modified Endowment Contract (MEC). The MEC guidelines are quite complicated, and exist to discourage the manipulation of permanent life insurance policies into artificially tax-favored “investments” instead of true insurance policies. For most individuals who want to include permanent life insurance in their financial portfolio, avoiding the MEC classification is preferred.

Premiums Paid in Advance — To avoid the MEC classification, yet allow policyholders to fund a permanent policy with one payment, some life insurers offer another option: premiums paid in advance. The rules vary with the insurance company, but usually follow this format: After underwriting approval for an insurance policy has been authorized, the insurance company will allow the policy owner to “pre-pay” future premiums to an account with the company. These premiums will be credited with interest, and gradually transferred to pay future policy premiums. Here is an example from a leading life insurance company, reflecting current rates.

Suppose the annual premium for a 10-pay whole life policy is $5,000. Under normal payment methods, the policyowner would pay a total of $50,000 over ten years to fully fund the policy, but not achieve MEC status. In an arrangement to accept the ten years of premium in advance, the insurance company gives a discount to the policyowner reflecting the interest the company will add to the deposit. In this example, the insurance company is crediting a 4.75% annual return for the first 10 years of the agreement. Thus, instead of requiring $50,000 over ten years, the one-time premium-in-advance amount is $40,938. Each year on the policy’s anniversary, $5,000 is transferred from the advance premium account to the policy. At the end of ten years, the advance premium account is empty, and the policy is fully funded. This arrangement allows the policyowner to establish the permanent insurance policy with one payment – with all of the legacy and living benefits – even though the policy will not be fully paid-up for 10 years. Note: ordinary income taxes apply to the interest earned in the premium account.

There are other important details in connection with this advance premium arrangement which will vary by company. Typically, there is a limit on the amount that can be deposited, as well as a limit on how many years can be paid in advance. With this particular agreement, the policyowner cannot withdraw the balance from the premium account without also surrendering the insurance policy. If the policy is surrendered, the company may charge a surrender fee against the advance premium balance. Also, the interest credited to the account will be reported as income, which may or may not result in additional taxes.

Why would someone use the advance premium payment option? Paying insurance premiums from existing portfolio assets on an annual basis usually requires holding some funds in a safe and liquid account. Currently, these types of accounts may not offer annual returns or guarantees as attractive as the crediting rate in the insurance company’s advance premium account. If you already know this money is earmarked for premiums, and when adding permanent life insurance to one’s portfolio is the objective, using the advance premium payment option may be another way to increase returns and benefits, while minimizing financial risk.

Or suppose you just realized a large gain from another asset in your portfolio; a property was sold, a stock position was liquidated. You have a significant gain you want to transfer to a secure asset, such as permanent life insurance. The advance premium account serves as a conduit to affect the transfer in a clean and efficient manner. With one deposit, the life insurance program is either established or secured (the agreement can be used to pay for existing policies, not just new ones).

Of course, whether an advance premium payment option is appropriate depends on your unique circumstances. But if you are currently paying insurance premiums from other existing assets rather than income, you may want to see if this approach could enhance your asset transfer process.

It’s baaaack!

The foundation of monetary systems for centuries, gold has been considered an anachronism in modern financial philosophy, something that computers and sophisticated monetary models had made irrelevant. With the exception of a few contrarian “goldbugs” who market a doomsday view of the financial future, gold is now seen as a precious industrial metal, and its value depends on how it is used – in jewelry, dentistry, electronics, glass-making, etc. But as the shake-outs continue from the global financial crisis that began two years ago, gold has resurfaced in the financial arena. Two news items during the same week in May highlighted a return to prominence for an ancient financial asset.

• Beginning May 13, 2010, CBS News and the Wall Street Journal were among several news outlets to report on an ATM in Abu Dhabi that dispenses gold in exchange for paper money. The ATM provides updates of gold prices every 10 minutes, and dispenses both coins and bars of gold in exchange for paper money.
• Later that week, on May 17, a high-profile television stock market guru (known for his loud and animated opinions) weighed in that now was the time for investors to consider gold as an investment. Citing “Six Reasons to Buy Gold Now,” this investment expert was enthusiastically recommending gold as a “buy.”

At the same time, there is a proliferation of commercials on radio and television urging consumers to exchange their “unwanted gold” (usually jewelry) for money. So…there’s a group that says “now is the time to buy gold”, and another that says “now is the time to sell”. What to think?

Because of its chameleon-like characteristics and long history, gold holds a unique place in the financial world. It is truly a one-of-a-kind financial asset. And there are numerous ways to view gold in a financial program.

Gold as Money
One of the most common uses for gold through history has been as money. In coins or bars, gold has been a preferred medium of exchange. Historically, several characteristics have made gold well-suited as money. First, gold itself, in any form, has an almost-universal appeal. It is attractive, durable, and malleable. This means gold can be converted from its function as money into another type of asset without an exchange taking place. A person with five gold coins can melt them and recast the metal into a bracelet, or gold thread or a crown for a tooth. Second, gold is a fungible commodity, i.e., one ounce of gold is considered interchangeable with another. Possessing these two traits, almost every society was more than willing to accept gold as payment for any type of transaction. The face or national symbol stamped on the coin might vary, as would the measures of weight, but for most of the past twenty-five centuries, gold has been the universal currency. (In the early years of the United States, all sorts of gold coins circulated as money, from Spanish doubloons to American double eagles.)

While other items (such as shells or animal pelts) have also served as money, the proponents of gold argue that no other item, including all types of paper currency, is a better medium for financial exchange. Because gold is relatively rare (it is hard to extract and hard to refine), and has real value besides serving as money, there’s not enough in circulation for governments, institutions, or individuals to manipulate its value. In contrast, governments and central banks can “re-price” their money in a variety of ways, typically by increasing or decreasing the amount of paper money in circulation.

Currency manipulation is a primary cause of inflation. In the past, countries and banks have so drastically manipulated either their currency or notes of credit that they became worthless. In the 20th century Germany, Argentina and several African countries experienced periods of hyper-inflation such that their paper money systems collapsed. Instead of serving as units of value, the “money” was nothing more than small pieces of printed paper. Because of the possible dangers of paper money, some economists advocate that all paper money be backed by gold, i.e., you can always exchange a paper note for a corresponding amount of gold. Today, no countries operate on this gold standard, but in times of financial unease, gold may become “money” for people who don’t feel secure making transactions with the paper currency of a particular nation.

Gold as an Investment
Since gold has a long history as real money, it is possible to use gold as a gauge of the value of other forms of money, and to make bets as to which forms of money may fluctuate in value. For example, the market price of an ounce of gold in US dollars on May 21, 2005 was $416.27. Five years later, on May 21, 2010, the price was $1,187.80. An individual who bought 100 ounces of gold five years ago for $41,657 and sold it on May 21, would have realized a gain – in US dollars – of $76,889, which equates to an annual rate of return of slightly more than 23.3%. That sounds like a pretty good investment decision. However… If you bought 100 ounces of gold 15 years ago, in May 1995, the price was just under $400/ounce. During the 10-year period, from May 1995 to May 2005, the rate of return on a gold investment – in US dollars – was close to 0 percent. From an even longer perspective, the price of gold compared to US dollars dropped from a high of $850/ounce in January, 1980 to $481.50 two months later, then stayed in a range between $500 and $300/ounce for the next 15 years. This isn’t the type of long-term performance that most investors are seeking.

From an investor’s perspective, gold usually delivers returns when the bet is against the economy. As the TV stock guru put it, gold is for “when the mentality toward the market becomes negative.” But the trend of a nation’s economy, and human activity in general, is not downward. Down cycles are corrections, followed by new growth. This makes investing in gold primarily a timing strategy. You have to believe you know when to get in, and when to get out.
Statistically, most of us, even the experts, are poor market timers, whether the investment is gold or something else. A cynical observation is that the only people who consistently profit from market timing are those who market the idea.

A “Classic” Idea: Gold as “Insurance”
Besides the use of gold as money and as a speculative investment, there is a long financial tradition of gold as a small, permanent fixture in a financial portfolio. In the form of jewelry, coins and other physical forms from works of art to bars, gold has been viewed as another real asset, like real estate, equipment or art. These gold items were not intended to be bought and sold – they were purchased for collections, for artistic and personal reasons, and were intended to be passed on as family heirlooms.
But just in case…there was always the security in knowing that as a last resort, these items could be liquidated in the event of an extreme financial emergency. This was not an investment strategy, like a collector who buys in order to sell later. This was financial “insurance”, because regardless of whatever might happen to the collectible value of coins or jewelry or other gold objects, there was the assurance that the gold gave it some underlying value. In this context, many individuals would routinely acquire some gold or similar precious metals, primarily as things to enjoy, but with a perception of “financial security.”

Ultimately, gold is a real asset. While it is fungible and accepted by almost everyone as being valuable, its value depends on all sorts of other variables. While it can function as money, and be used to speculate on the relative value of other types of money, a case can be made that the classical perspective on gold – small amounts purchased for enjoyment, inheritance and rare financial emergencies – is one that can be most applicable to everyone.