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That's sort of the point of this whole exercise, yes. Same income, higher wealth with an advisor. It's pretty tough to control for the exact same thing you're trying to measure.

You're arguing inheritances and such, I take it? It'll have some effect, I'm sure, but I can't imagine it being as massive as these studies make it out to be(There's more than one study in this vein, and they've all shown the same thing - I just have the others in hardcopy from work, not online).

Lumifer11y00

You're arguing inheritances and such, I take it?

No. I am arguing that the paper did not examine the selection bias present (the sample wasn't random at all). I am arguing that the paper avoids talking about the direction of causation and generally about the difference between causation and correlation (for example, financial advisors are much more interested in working with richer people than with poorer people). I am arguing that the paper does not present any longitudinal results. I am arguing that this is an industry-funded paper which would never ha... (read more)

See in context

7 Financial Effectiveness Repository

by Gunnar_Zarncke

18th Nov 2014

1 min read

7

Follow-Up to: A Guide to Rational Investing Financial Planning Sequence (defunct) The Rational Investor

What are your recommendations and ideas about financial effectiveness?

This post is created in response to a comment on this Altruistic Effectiveness post and thus may have a slight focus on EA. But it is nonetheless meant as a general request for financial effectiveness information (effectiveness as in return on invested time mostly). I think this could accumulate a lot of advice and become part of the Repository Repository (which surprisingly has not much advice of this kind yet).

I seed this with a few posts about this found on LessWrong in the comments. What other posts and links about financial effectiveness do you know of?

Rules:

Each comment should name a single recommendation.
You should give the effectiveness in percent per period or absolute if possible.
Advice should be backed by evidence as usual.

General Advice (from Guide to Rational Investing):

Capital markets have created enormous amounts of wealth for the world and reward disciplined, long-term investors for their contribution to the productive capacity of the economy. Most individuals would do well to invest most of their wealth in the capital market assets, particularly equities. Most investors, however, consistently make poor investment decisions as a result of a poor theoretical understanding of financial markets as well as cognitive and emotional biases, leading to inferior investment returns and inefficient allocation of capital. Using an empirically rigorous approach, a rational investor may reasonably expect to exploit inefficiencies in the market and earn excess returns in so doing.

So what are your recommendations? You may give advanced as well as simple advice. The more the better for this to become a real repository. You may also repeat or link advice given elsewere on LessWrong.

Financial InvestingRepositoryPractical

Personal Blog

7

Mentioned in

68Repository repository

10General buying considerations?

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[-]Salemicus11y140

This is not investment advice and should not be relied on as such.

You need to consider tax when you make investment. If you do not, you are likely to invest badly. (Note: this discussion uses UK tax rates and concepts. The tax system may well be different in your jurisdiction, but the same general principles will likely apply.)

For example, suppose I invest £100,000 in the stock market for 10 years. Let's say that nominal returns are 7% (5% capital, 2% dividends, which I reinvest), and inflation is 2%. Therefore naively, I might expect to end up with £197,000 after 10 years, i.e. £161,000 in 2014 money. That's a 5% real return per year, which looks like a good investment.

But now let's say I have to pay SDRT at 0.5% on share purchases, and 38% on dividend income. Then, when you sell the shares you have to pay 28% in Capital Gains Tax (with an £11k exemption). So now you only end up with £131,000, i.e. £107,000 in 2014 money. That's a 0.7% real return per year, which looks like a terrible investment.

If I had invested in a more tax-efficient way (e.g. through an ISA, and with a fund reinvesting the dividends for me so they never become income) then I would have been able to get the full 5% real return. But I can only put £15,000 per year into an ISA, so this isn't a panacea.

Note that the difference between the 5% real return and the 0.7% real return is an order of magnitude. If I had invested in something with just half the real return of the stock market, but done so in a tax-advantaged way, it would be a better investment than investing in the stock market in a naïve way. In particular, there is no Capital Gains Tax on your primary residence in the UK.

Executive summary:

Investment returns are highly sensitive to tax rates.
Tax rates are often levied on the nominal, rather than the inflation-adjusted, gains, which makes them particularly damaging for long-term investments.
There may be legal ways to reduce or eliminate tax due on your investment.
The way that tax is levied on your investment can be far more important to your realised return than the underlying investment itself.

And so, on a meta-level:

Because taxation often matters more than the underlying investment, tax rates are a huge distortion of the market environment, favouring certain kinds of investments (housing) over others (providing capital for businesses).

[-]spectralshift11y60

I get a very different result when I run these numbers. I'm not from the UK so I may be interpreting the tax rules incorrectly, but here's the logic chain I used to model it (year one, so that it can be duplicated and logic verified);

If I invest 100,000 and pay the .5% stamp, I actually invest 99502.49
Dividends for the year would be 1990.05, of which I lose 746.27 to tax, leaving 1243.78 for reinvestment
Expected capital gains would be 4975.12 (99502.49 * 0.05)
Reinvesting the dividends of 1243.78 loses 0.5%, leaving 1237.56
Expected value at end of year 1 is 105715.2 (99502.49 + 4975.12 + 1237.56)

At the end of year ten, I expect 182334.10 in my account, which I then sell/crystallize.

The amount of tax I would pay is based on the "adjusted cost base" (google couldn't answer what term is used in the UK, but basically the amount paid for the shares). I work this out to be 118275.5, essentially buying the dividend-reinvested shares at the expected 5% growth rate during the 10 years. I then subtract the total stamp taxes paid, which I work out to be 580.43. This gives me a tax burden of 182334.10 - 118275.5 - 580.43 = 63478.17. I then deduct the 11,000 capital gains allowance. This results in a tax payment of 52478.17*0.28 = 14693.89.

Final net value of the sale is therefore 182334.10-14693.89 = 167640.21

In real terms, this is 134996.70, or a real rate of return of 3.2%

I believe the major difference in our numbers comes from the tax rate on gains.

In terms of sensitivity, I get a return of 4.84% with zero taxes (dividend and capital gains), whereas an increase to 9% (each div and cap rates at +1%) expected return gives 4.2%. This is under the assumption of the worst possible tax rates and scenarios (full sale at maximum rates). There are lots of timing methods to reduce the tax impact.

Granted, this is based on my knowledge of Canadian taxes, but I verified the UK equivalents as best I could and the differences are primarily in the stamp taxes. Most of the data is from https://www.gov.uk/tax-sell-shares/work-out-your-gain (and the related links).

[-]Salemicus11y30

It is very possible made a mistake in my spreadsheet. The numbers were intended for illustration only. Thanks for the correction.

You make a good point regarding timing taking gains. This is another way that thinking about tax can be very important.

[-]Salemicus11y70

This is not investment advice and should not be relied on as such.

The more liquid your investment, the better. If you have a theoretically valuable investment, but in an area where finding a buyer is very hard, you may find yourself either 1) forced to sell at a knock-down price, or 2) unable to exit the investment at a time of your own choosing. Therefore (ceteris paribus) you should demand a higher expected rate of return on illiquid investments.

Most liquid to least liquid:

Cash
Home-country government bonds
Publically traded stocks
Real estate
Your friend's small business

[-]Gunnar_Zarncke11y40

This probably applies mostly when you do not have enough liquid assets to winter times that might force you to sell.

[-]Salemicus11y70

That's one way it can come up, but it's a more general issue. Suppose a different, better investment opportunity presents itself - you will only be able to take it if your existing investments are liquid. Or suppose your tax circumstances change. Or any manner of things.

Liquid investments only need to be the best investment right now to be worth taking. Illiquid investments also need to be better than hypothetical investments you might get over the term of he investment, and they need to remain worthwhile across a variety of circumstances. That is a much higher threshold.

[-]Gunnar_Zarncke11y10

Agreed. This is a nice qualification for the advice to focus on liquid assets.

[-]ChristianKl11y10

Why are home-country government bonds more liquid than stocks? Publically traded stocks can be sold quite fast.

[-]Salemicus10y20

Trading shares on an exchange sometimes gets suspended, for example if the company is in financial difficulties.

[-]Alsadius11y10

The difference in liquidity there exists for institutional investors - it's faster and easier to sell a billion dollars of T-bills than a billion dollars of Amazon. For a retail investor with maybe a thousand bucks in a single position, the difference is irrelevant.

[-]ChristianKl11y20

I think this topic is rather about retail investing than about how to be an institutional investor.

[-]Alsadius11y10

Exactly my point. It's a distinction that exists in the literature, but it's not relevant here.

[-]Gunnar_Zarncke11y70

Donate 5% of all your Amazon shopping for free

[-]James_Miller11y60

I wrote this guide to Smart Investing a few years ago.

[-]Metus11y60

A change of mind: The more expensive product can be cheaper in the long run.

Meaning that you can buy disposable cutlery for a few cents or buy proper cutlery for a few bucks and keep it for years and years on end. So when buying anything consider the cost of maintaining it (repairs, taxes, insurance, ...) and of disposing it. The more expensive the item, the more thought you should give to this. My recommendations are housing and transportation.

[-]Alsadius11y70

Be careful with this advice if you're clumsy or destructive or prone to losing things. A more expensive item only lasts longer under circumstances where it's able to be used the whole time.

[-]richard_reitz11y50

It should be noted that there's a nonobvious opportunity cost here; specifically, money spent on the more expensive product can't be invested.

For example, mechanical keyboards seem like something that costs more up front that's cheaper in the long run. They cost about an order of magnitude more than membrane keyboards, but last about ten times longer, so you only need one mechanical keyboard to ten membrane keyboards, so the cost equals out in the end. Since the typing experience is much better on mechanical keyboards, by paying more up front, you essentially get a much-improved typing experience for free.

But, the extra money you spent on the nice keyboard could've been invested (or used to pay down debt) instead. If there's a an annual real interest rate of 10%, then buying 10 membrane keyboards at $10 over 10 years and investing the money you didn't spend nets $45, not counting re-investing (1). Note that these numbers are made up to make the math simple; in particular, the real real interest rate isn't that high.

Also, the membrane keyboard you buy in year 10 isn't going to be the membrane keyboard you buy in year 1.

(1) Using present value, in year 1, instead of paying $100 (cost of the mechanical keyboard, ten times the cost of the membrane keyboard), I pay $10 and invest $90 which, at 10%, yields $9. In year 2, you pull $10 out of the investment to buy the second membrane keyboard, so now you have $80 invested, yielding $8 returns. 9+8+...+1 = (9^2 + 9)/2 = 45.

[-]Metus11y20

Correct. But then again note that there is the seperate issue of depreciating and appreciating assets: I can resell the mechanical keyboard as it is usable even after years. I can not resell the membrane keyboard because it is worn out.

A more extreme example is cars: A new low-budget car loses about a third of its resale value immediately after you buy it. A used luxury car might even appreciate in value.

[-]richard_reitz11y00

Definitely. I wanted to make that point because, until I read Varian, I accepted the naive argument and not everyone here has studied economics, and the less they know, the more this entire "financial effectiveness" post is aimed at them, and this is something I found completely nonintuitive before reading about it and transparently obvious afterwards.

[-]Lumifer11y00

If there's a an annual real interest rate of 10%

Let's get realistic. The current short-term real interest rates in the US are negative.

[-]richard_reitz11y10

Well, if real interest rates are negative, everything reverses, and you should start favoring more expensive things now.

Also, it's possible to be realistic and say things like "if 2 + 2 = 5, then 5 = 2(1+1) and therefore isn't prime".

[-]Lumifer11y30

Well, if real interest rates are negative

At the moment, TIPS (US government securities that pay interest + whatever inflation turns out to be) trade at negative yield for maturities up to five years.

you should start favoring more expensive things

That's the point of monetary stimulus, among other things.

[-]Alsadius11y30

I'll admit to bias, because I am a professional financial advisor, but I'll make the case against index funds for completeness' sake.

If you have the discipline to invest a significant portion of your income, can weather storms in the market without panicking, and are in a simple enough taxation situation that you can figure out how best to shelter your income without needing professional advice, then you don't need an advisor. Empirically, however, most people do not meet this description. I know some who do, but a lot more say things like "I don't want to be bothered", or they have taxation situations that are complex enough they can't practically keep track(which is easier than it sounds - even having a company is more than enough to put you over that line), or they talk about how they sold all their investments and went to cash in January 2009. Active investments aren't terribly wonderful in their own right, but active investment with an advisor is empirically superior to passive non-advised investment for most people.

Also, the system does need some active management - passive investors are freeloading and not aiding price discovery, so if the whole market went passive then active investment would win handily. This isn't an issue right now, but it could well be if the passive school of thought gets much more prominent.

[-]ChristianKl11y10

Also, the system does need some active management - passive investors are freeloading and not aiding price discovery, so if the whole market went passive then active investment would win handily.

The kind of people who do well at price discovery are big banks with complex computer models and expert analysts. Why do you think that an individual has a got chance at playing that game?

[-]Alsadius11y10

The company I work for manages about a hundred billion dollars in our various funds. We cater to retail clients. I don't pick stocks myself - a bunch of people with three computer screens and Bloomberg subscriptions down in the financial district do that. I simply take the resulting mutual funds and sell them to people(and do a hundred other things - the investment side is probably the easiest part of my job).

[-]Sysice11y00

"active investment with an advisor is empirically superior to passive non-advised investment for most people." Can you source this?

[-]Alsadius11y00

https://www.ific.ca/wp-content/uploads/2013/08/New-Evidence-on-the-Value-of-Financial-Advice-November-2012.pdf/1653/

In particular, the research paper provides new evidence that:

Advice has a positive and significant impact on financial assets aft er factoring out the influence of close to 50 socio-economic, demographic and attitudinal variables that also affect individual financial assets;
The positive effect of advice on wealth accumulation cannot be explained by asset performance alone: the greater savings discipline acquired through advice plays an important role;
Advice positively impacts retirement readiness, even after factoring out the impact of a myriad of other variables; and
Having advice is an important contributor to levels of trust, satisfaction and confidence in financial advisors—a strong indicator of value.

[-]Lumifer11y10

The paper you quote is low-quality and does not provide ANY evidence to support the claim that "active investment with an advisor is empirically superior to passive non-advised investment for most people."

As far as I can tell all it shows is that richer people are more likely to have financial advisors.

[-]Alsadius11y00

Um...that's one of the things they control for. From the introduction:

The studies show dramatically higher investible assets and net worth of advised relative to non-advised individuals after accounting for age and income level. Average net worth for advised investors is nearly three to four times greater than that of non-advised investors, and wide differentials are observed across all age and income levels

[-]gwern11y30

Tell me something: what sort of people do you suppose would seek out a financial advisor and take their advice? Do you think all unobserved traits can be completely described & modeled as a single linear weight of 'income levels'?

[-]Alsadius11y00

Seek out? Fewer than you'd think bother to seek advice. Most people seem to stumble into it. And while this is anecdote and not data, the ones most likely to take my advice are the ones who don't want to be bothered doing it themselves, far more than any other single trait.

And no, I don't think all variables can be compensated for. However, I think that a study that tries reasonably hard to do so still does provide evidence, if evidence less convincing than the fluff makes it out to be. But it's certainly much stronger than "rich people get more advisors".

[-]gwern11y20

the ones most likely to take my advice are the ones who don't want to be bothered doing it themselves, far more than any other single trait.

Of the people who would look up and carry out the financial advice themselves an the ones who come to an adviser to carry it out, there may be some imbalance in terms of wanting to bother. Both groups are still highly selected compared to the general population: as you say, "Fewer than you'd think bother to seek advice." The results are entirely explicable by the default of self-selection, and that's much more plausible than advisors matter all that much. (Consider the example of SAT coaching...)

Where's the randomized beef?

[-]Alsadius11y00

Give me a practical model for a randomized study, please. Until you have that, let's work with the evidence we have available. And that evidence seems pretty consistent with my beliefs(that I've had since before I started this job) that advisors don't meaningfully improve investment returns per se, but they mildly improve investor tax planning, and they massively improve investor behaviour.

[-]gwern10y-10

Self-selection is the default explanation; the onus is on financial planners to show that they are helpful.

Give me a practical model for a randomized study, please.

You could... I don't know, select some people, offer half of them $1k to go to a financial planner and the others $1k in exchange for reporting on financial health, then see if the experimental group is better off a year later? This is not harder than doing things like deworming studies in Africa.

[-]Lumifer11y10

and income levels

Income is not wealth.

[-]Alsadius11y00

That's sort of the point of this whole exercise, yes. Same income, higher wealth with an advisor. It's pretty tough to control for the exact same thing you're trying to measure.

[-]Lumifer11y00

You're arguing inheritances and such, I take it?

All in all, as I said, it's a low-quality paper that doesn't provide any evidence for the claim we're discussing.

[-]Alsadius11y00

I don't know of any papers outside of industry that analyze this topic, and certainly none that do so as rigorously as you're asking for. If you have one, I'm all ears. But in the absence of strong evidence, I'm going to suggest that weak evidence trumps no evidence.

[-]Gunnar_Zarncke11y30

Meta

Discussion of the repository idea goes here.

[-]SarahNibs11y40

Unmoderated finance repository could be harmful

[-]NancyLebovitz11y00

I'm not going to recommend moderation, but having a consensus of asking people what experience they've had that's related to the advice they give would be a very good idea.

[-]SanguineEmpiricist11y00

Agreed.

[-]pinyaka11y00

I would hope so, as it's a link to your comment.

[-]Lumifer11y00

Is financial effectiveness about using money effectively (as your posts about making donations seem to imply) or is it about making money in the financial markets (as your top-level writeup seems to imply)?

[-]Gunnar_Zarncke11y10

Maximize your donations via a job

[-]Gunnar_Zarncke11y10

Add ~2% to all your donations done by credit card

[+]SanguineEmpiricist11y-70

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