What Can Investors Learn from Meteorologists?

What can economists and investors learn from meteorologists? Economics and finance professors in the Tippie College of Business at the University of Iowa are researching whether using multiple economic and financial models running concurrently can deliver more accurate economic forecasts than one model can. Of course, the concept of relying on a pool of models to predict the future has its roots in weather forecasting.

The researchers recently ran a series of “model pools” to see how they would predict returns on stock portfolios between 1932 and 2008. After comparing the prediction to actual market performance, they found that a two-model pool led to more accurate predictions than any one model. Better yet? The three-model pool.

Thus, the researchers concluded that model pooling can potentially produce more accurate predictions for a wide range of economic forecasts, whether it’s charting real estate values or tracking changes in unemployment.

Here’s my take: Modeling to control risk has its place, but when it comes to your portfolio, the best defense against market volatility is to maintain a diversified portfolio, stay true to your asset allocation, utilize low-cost investments, and periodically review and rebalance your portfolio.

Planning Amid Tax Uncertainty

Ben Franklin famously quipped that the only certainties in life were death and taxes. Of course, with the Bush tax cuts scheduled to sunset at the end of the year and the midterm elections capable of changing the balance of power on Capitol Hill, there is nothing certain about future tax policy. We can only surmise that taxes will, one way or another, likely increase at some point in the future.

If the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)--the official names for the “Bush tax cuts”--sunset as originally legislated at the end of 2010, tax rates on ordinary income, long-term capital gains, and qualified dividends will revert to the higher, pre-2001 levels.

This table illustrates the differences in marginal tax rates after the sunset:

      Marginal Tax Rates         Marginal Tax Rates
                 for 2010                    as of January 2011
                     10%                                 15% (indexed and expanded)
                     25%                                 28%
                     28%                                 31%
                     33%                                 36%
                     35%                                 39.6%

Investors will also face higher capital gains tax rates. On January 1, 2011, the capital gains rate is scheduled to revert from the current maximum rate of 15% back to the 20% capital gain tax rate that was in effect prior to 2003.

Also, dividends which under the Bush tax cuts were taxed for the first time at the same low 15% rate as capital gains, will be reclassified and grouped with interest to be taxed at the higher rates levied on wages. In fact, unless Congress acts before the end of 2010, next year the top dividend rate will revert to 39.6% from 15%. That’s quite a leap.

What’s an investor to do? In anticipation of higher tax rates, if your portfolio includes appreciated assets, this year might be a good time to realize some gains at the maximum capital gains rate of 15%, rather than the 20% capital gains rate currently slated for 2011.

Investors in the 15% tax bracket or lower have a greater opportunity to save. For these investors, no gains are due on appreciated assets sold in 2010 if their gains are below a specified threshold. They would, however, be taxed at the 10% capital gains rate in 2011.

You should not, however, embark on a selling spree just to avoid what you think may be higher taxes down the road. Generally, you would want to have a purpose for the cash a sale would generate. For example, it may make sense to sell investments at gains this year if you have college tuition due next year for a son or daughter.  It also makes sense to sell individual, concentrated stock positions to adopt a more diversified and properly allocated portfolio.

If you are a business owner nearing your planned exit date, you may want to accelerate the sale of your business to avoid higher tax rates in the future.

And lastly, it is important to realize that the "wash sale rules" do not apply when selling an investment at a gain.  In other words, you can sell an investment today, record your gain, and buy it back immediately without waiting 30 days like you would when you harvest losses in your portfolio.

Economic and Political Pressures Will Influence Tax Policy

It is an interesting time in our nation’s capital. The latest polls show that the Republican Party may gain more than the 39 seats necessary to tip the balance of power their way in the House. Noting in a recent blog post that control of the Senate is also up for grabs, Washington insider and CNBC commentator Greg Valliere, said the Democrats need a “pre-election Hail Mary pass.”

Valliere floats the possibility for the following scenario: What if, now that lawmakers have returned to D.C., President Obama brings together leaders of both parties and negotiates a deal to extend the Bush tax cuts indefinitely for 97% of Americans, and perhaps for two or three years for the wealthiest Americans whom he initially targeted for tax increases?

While Valliere says a tax cut deal should be a “no-brainer” given the struggling economy, he expects politics to get in the way – on both sides of the aisle. He questions whether there are enough moderates who “recognize that this is a terrible time to raise taxes on anybody” and sees little possibility that the Republican leadership that has refused to compromise thus far would do so on an issue that has great potential to help them win seats and gain Congressional control this fall.

Only time will tell. However, in the meantime tax planning is a challenge as we are still unsure how tax policy will change next year.

Yes, You Can Raise Prices in a Downturn

When was the last time you got a raise? Corporate America has been stingy with raises during the downturn, but pain has also been felt among the ranks of small business owners who have been hesitant to raise prices in a tough economy. In fact, the uncertain economy has promoted many companies to cut internal costs, and even lower prices. Over the last few months, your mailbox likely was full of flyers from local companies or restaurants offering you a deal. Late night infomercials take the marketing pitch to an extreme -- Order now, and you get two of whatever they are selling, and something tacked on for “free.” However, new research from Harvard Business School, “Performance Pricing in Tough Times,” suggests that businesses can, and should, charge more for delivering more -- even in a market downturn. Companies should compete “on the basis of initiatives for which their customers willingly pay higher prices,” says study co-author Frank V. Cespedes, a senior lecturer at Harvard Business School who spent 12 years running a professional services firm.

The key in selling your price increase, say the Harvard researchers, is that your customers understand the value represented in your pricing. To further explore the researchers’ assertion that “Pricing builds or destroys value faster than almost any business action,” check out the HBS interview where authors Frank Cespedes, Benson P. Shapiro, and Elliot Ross discuss pricing strategy and how to convince your customers that higher prices are worth the cost.

Would You Pay a Fund Manager to be Lucky?

How many of us would list luck as the key ingredient for a top performing mutual fund? That’s certainly not the message we receive from most mutual fund companies that stress the expertise and trading skill of their top managers. Interestingly, however, a new study by internationally renowned finance professors Eugene Fama and Kenneth French finds that luck plays a bigger role than skill in determining a fund’s success.

Although investors pay well over $10 billion annually in fees to managers of actively managed funds, Fama and French found that active funds’ returns actually trail their passive benchmarks by approximately the level of the funds’ expense ratios (around one percentage point per year). Furthermore, the professors found that even the small number of managers (just 3%) who cover their costs are unlikely to noticeably outperform a large, efficiently managed index fund in the future.

The current Fama and French study is another in a substantial body of academic research that clearly illustrates the folly of chasing past returns. It also underscores the wisdom of taking a passive approach to investing to secure the superior long-term results upon which your retirement depends.