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 Ask the average investor what factors they think most affect the performance of their portfolio and you’ll likely hear answers such as the overall health of the economy, whether stocks are in a bull or bear market and how their assets are allocated.

What they usually won’t list are their own emotions, personal biases, and pre-conceived notions about money and investing. But these and other psychological factors can cause investors to make decisions that adversely affect their portfolio’s performance and work against their own best interests.

What is behavioral finance?

Behavioral finance is the study of how different psychological factors influence the decision-making process of investors. It's been said that the origins go back more than 150 years with concepts of market psychology from the publication in 1841 of the book Extraordinary Popular Delusions and the Madness of Crowds, which described the way investors acted during various financial bubbles and panics.

But the modern version of behavioral finance was developed in 1979 when Nobel prize-winning psychologists Amos Tversky and Daniel Kahneman came up with prospect theory. This theory is based on the assumption that investors value gains and losses differently and that the emotional impact from a loss is much more severe than from an equivalent gain. This is also known as loss aversion.

Behavioral finance examples

To illustrate how this works in the real world, Kahneman offered his students a proposition. He’d toss a coin and if it landed on tails, they would lose $10. Then he asked the students how much they’d need to win if it landed on heads. Most students required a payout of $20 – double what they stood to lose – in order to take the bet.

To prove that the effects of prospect theory don’t change based upon income, Kahneman offered a similar proposition to successful executives, only they would lose $10,000 on a flip of tails. Yet they, too, required double the loss, $20,000, to take the bet.

This aversion to loss can play out in a number of ways for investors.

For example, many investors won’t concern themselves with their investment portfolio as long as it’s going up, and for months, even years at a time, will pay little attention to the stock market. But those same investors, when the market enters a period of volatility and uncertainty, spurred on by the emotional impact of losses in their portfolio, will panic and sell their holdings – usually right around the time the market bottoms.

Those same investors may avoid buying back in when the market rallies because they don’t want to pay higher prices than what they sold for, or fear that if they do, the market will turn and drop again. So they just sit on the sidelines and watch as the market goes back to its old highs – and beyond.

It’s not hard to imagine. Think of the investors who, because of loss aversion, sold their portfolios on Black Monday in 1987 when the stock market dropped 23%. Or early 2000 when the dot-com bubble burst. Or during the 2007 financial crisis. Or even recently, in March 2020 when the S&P index dropped 34% due to the Covid-19 pandemic.

In every one of those cases, the stock market eventually recovered, and though past performance doesn’t guarantee future success, those investors who sold out at the bottom and never re-invested missed out on the recovery.

Adjusting behavioral biases

So what can you do to help make sure that your emotions don’t derail your investment goals? Unfortunately, not much.

Our relationship to money and the emotions that financial losses provoke in us have been formed and reinforced over decades and there is no easy way to “flip the switch” to change them or turn them off.

Having set financial goals and using an “automated” system like dollar cost averaging can sometimes help minimize the impact of emotions on your investing, but unless you’re going to avoid all news and social media for the rest of your life, there’s no way to avoid knowing when the market is in a volatile period – and that could potentially cause you to make a rash decision about your investments.

A better option is to rely on a professional, experienced financial advisor. Someone whose job is to be objective about your investments when you can’t be. But make sure that your advisor has two vital attributes: a disciplined investment approach and the experience to know how important it is to stick with it during difficult times.

If your advisor doesn’t have a disciplined investment approach or they don’t have any experience navigating volatile markets – they may panic as much as the average investor. There are a number of questions you can ask your advisor about their approach or strategies for difficult markets. If your financial advisor doesn’t have a long-term strategy for your investments, contact us.

Dollar Cost Averaging does not assure a profit or protect against a loss in a declining market. For the strategy to be effective, you must continue to purchase shares in both up and down markets. As such, an investor needs to consider his/her financial ability to continuously invest through periods of low price levels.

If you expect to inherit a 401k plan from a parent or spouse, it’s important to understand the potential tax consequences and what strategies you can use to minimize them. Unlike inherited real estate, where there is often a “step-up” in cost basis that allows the recipient to generally avoid paying any federal taxes, assets inherited through a 401k may be considered taxable income.

How those assets are taxed depends on a number of factors, including

●      The age of the 401k account holder when they passed

●      The relationship between the beneficiary and the account holder

●      The age of the person who is inheriting the 401k

When you’ll have to pay federal income taxes will depend on how you decide to receive the inherited 401k plan.

401k beneficiary rules upon death

When someone passes away, their 401k becomes part of their estate, but the rules that govern how profits and withdrawals from that 401k are taxed generally stay the same. And because a traditional 401k is funded with pretax dollars, the beneficiary will usually have to pay the taxes on withdrawals. The exception is a Roth 401k, which is funded with after-tax dollars, so withdrawals are typically fully tax-free.

The amount paid is based on the ordinary income tax rate of the beneficiary, not of the original owner of the 401k.

401k withdrawal tax rules

If you choose to keep the inherited 401k account, there are a few withdrawal rules you should keep in mind.

Required minimum distribution

A required minimum distribution is generally the minimum amount you must withdraw from your 401k retirement plan each year starting at the age of 72 (or 73 if you’re turning 72 in 2023 or later). You can withdraw more than this amount but delaying a distribution will incur a tax penalty of up to 25% of the RMD.

Hardship distribution

A hardship distribution, or hardship withdrawal, allows you to access your 401k assets immediately if you have a substantial financial need for the funds. Any 401k withdrawal due to hardship is taxed and limited to only what will cover your immediate need. To qualify for a hardship distribution, you must satisfy the necessary IRS requirements.

Early withdrawal penalty

Unless it’s due to a qualified hardship, any 401k withdrawal made before the age of 59½ will automatically incur a 10% early distribution penalty. For instance, if you withdraw $10,000, you could end up paying $1,000 on top of the ordinary income tax. This is a heavy fee that many choose to avoid by waiting until they pass the age requirement.

401k inheritance: spouse

If you inherit a 401k from your spouse and are younger than age 59½, you have a number of options:

●      Do nothing: You don’t have to do anything with an inherited 401k. You can just leave it as is and begin taking regular distributions. You will have to pay taxes on those distributions, but you won’t have to pay the 10% early withdrawal penalty.

●      Take a lump-sum payment: With this option, you receive all the 401k distribution funds at once. You will pay income tax on the full amount, but you will not incur a 10% early withdrawal penalty (assuming the money was used for medical expenses or college tuition costs). Be aware that taking a lump-sum distribution could move you into a higher tax bracket, depending on your current income.

●      Transfer ownership: If you are the sole beneficiary of an inherited 401k, you can transfer the asset into your own 401k or into an IRA. However, if you withdraw money from this account, you may be subject to a 10% early withdrawal penalty.

●      Open an inherited IRA: This option allows you to roll over funds directly from an inherited 401k into a new inherited IRA in your name. You can then take distributions based on your life expectancy and avoid the 10% early withdrawal penalty, even if you are younger than 59½.

If you are the beneficiary spouse of a traditional 401k and are older than 59½, you will generally avoid the 10% early withdrawal penalty no matter which of the above options you choose.

And if your spouse was already taking the required minimum distribution each year from their 401k when they passed away, you have the choice to continue taking them or delaying them until you turn 73. However, if you are already age 73 or older, you will usually have to take the RMD no matter which option you choose.

Inherited 401k options: no spouse

If you inherit a 401k from someone other than your spouse, you can still take a lump-sum distribution, but this may push you into a higher bracket and raise your income tax. As an alternative, you can leave the 401k as is and take distributions over time, whenever you want, and in any amount you want, as long as you withdraw all the funds from the account by the end of the 10th calendar year after the original owner’s death. You could also transfer the assets from the 401k into an inherited IRA, but again, you would need to empty the account balance by the end of 10 years.

If the person you inherited the 401k from was older than 72 and already taking RMDs as part of their retirement plan, you must continue taking them. Although, you can take out more than required and space the distributions over the deceased’s life expectancy or your own, whichever is longer.

Disclaim inheritance

There is another option that will allow you to completely avoid paying taxes on a 401k inheritance: disclaim it. If you disclaim a 401k inheritance, it will go to the contingent beneficiary, and you will have no tax issues to deal with. You could consider this option if you don’t have a financial need for the distributions or would rather it go to someone else.

It’s always hard to lose a loved one, and making financial decisions during those times can be difficult. Deciding what to do with a 401k or other inherited investments can be a complex process that depends on many other factors, far beyond what can be covered here. That’s why it is important that you talk to your financial planner and tax specialist before you make any decisions.

Contact a financial advisor today to see which 401k inheritance option is right for you.

 If too much time at home during the last year made you desire a change of scenery, you might be thinking about buying a second home. If so, you’re not alone. Here are eight points to ponder:

1. Keep the big picture in sight.

Will buying a second home negatively impact your long-term goals, including saving for your retirement and paying for your children’s college? Will it affect the cash reserves that you must always maintain? If the answers to big-picture questions like these are no, you’re likely in a good position to consider a second home. But even then, you’re wise to consult an Edelman Financial Engines planner before moving ahead.

2. Avoid acting on impulse.

Think about why you want a second home. Is it to build a family legacy someplace where your kids and grandkids can gather year after year? Do you want a place to keep your parents close by or to give your college student a campus-adjacent pad? Do you want to split locations by season – a summer residence up north and a winter one in the south? Will it someday be your retirement home? If you buy on a whim, you could end up with a second home that doesn’t adequately meet your needs.

3. Location, location, location.

Buying a second home in a town by the ocean or in the mountains might seem like a great idea, but if you live very far from that town, getting there might be so much of a hassle that you won’t go there often. If you plan to share the space with family members, it might be wise to buy a home that’s convenient for short weekend trips. If it will one day be your retirement home, it should have good access to needed resources and services.

4. Financing your second home.

You can pay all cash or get a mortgage that allows you to hold on to your cash and take advantage of today’s low interest rates – or use a combination of these. Always shop around for a mortgage. Rates for second homes are typically a bit higher than rates for a primary residence.

5. Hire a trusted real estate agent.

Buying a second home outside your area or out of state can be tricky, as residential real estate is extremely localized. Hire a local agent, who will be in the best position to advise you on the market there.

6. Experience living there.

Even if you’ve been visiting the same vacation spot for years, you need to view it from a non-tourist perspective. Rent for a while in the off-season to see how you like it and talk to locals about the pros and cons of living there.

7. Renting out your second home.

Collecting rental income creates a cash flow and can be a smart way to subsidize your vacation property, but don’t buy investment real estate with borrowed money. If you want to own a rental, pay cash. Also, learn the laws governing rentals. They vary by state, city and even by neighborhood. If it’s a condo, find out whether the condo bylaws allow for rentals.

Consider using an on-site leasing company to help you find qualified renters and to help you manage the property when you’re not there. You will need a contingency plan and additional cash reserves for the rental property if rental income dries up. You also need to plan for additional costs and repairs when renting a property, so make sure to go over the numbers with a financial planner before making this decision.

8. Consider taxes.

If you use your property as a true second home – rather than renting it out – you could get a tax deduction for mortgage interest and property taxes. However, this deduction is capped at $750,000 of total mortgage debt on both homes.

Property taxes on the second home are also deductible, but the IRS limits the total deduction for all state and local taxes to $10,000 per return. Different tax rules apply to second homes that are deemed investment or rental properties. The rules are complicated, so it’s best to talk to an experienced tax professional to learn how they would apply to you.

Whether you’re looking for a way to diversify your assets or just enjoy your favorite vacation spot more frequently, there are always pros and cons to buying a second home. In addition to these eight tips, have a conversation with a financial advisor and tax advisor to discuss your options and whether this is the right step in your financial future.