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Tax Planning

Our Irrational Aversion to Taxes

Why do we favor some financial opportunities over others, even though the outcome is the same?

Articles by Betterment Editors

By the Editorial Staff
Betterment Resource Center  |  Published: August 29, 2012

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Listen to this: You have two choices. You can travel 30 minutes to buy an item tax free, or you can travel 30 minutes to buy an item at an ordinary discount of 9%. It’s pretty much the same thing right?

Apparently not. The proportion of Americans willing to travel the distance was 29% higher when the item was offered tax-free. And more than 4 times as many Americans said they’d rather invest in a bond that offered a $120 annual tax-free return than a bond that offered $160 but required a $40 tax, according to a study cited in the Harvard Business Review.

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Turns out we don’t like tax. But your wallet doesn’t care where the gains and losses come from – the overall balance is all that matters.

This is a primary example of the psychology of money. In many cases, our money decisions are not rational, but based on other biases.

Some recent research demonstrates our warped psychology of money, in this case with stock picking. The problem with trusting your gut in investing, is that the instincts you use to make decisions in other parts of your life don’t necessarily help you make smart investing decisions.

The researchers offered up four lessons for investors:

  1. Don’t use the past to predict the future: we tend to avoid the things that harm us and stick to those that have treated us well, but past performance is not necessarily an indication of future performance: “If you bought a stock in May and sold it in June for twice as much, but I, on the other hand, bought it in June and sold it for half as much in July, and now months have passed, and neither of us still own the stock, which one of us is more likely to see the stock price rise if we buy it today at 2 p.m.? The answer is that we will both see the same performance if we buy the same stock at the same time, even though we each have a very different prior history with that stock.”
  2. Discounts might signal a cheap product: We all know it’s smart to buy low, but a share price going down is not necessarily good value. It might continue to go down.
  3. Don’t ignore your emotions: This lesson is all about risk tolerance. We want to keep our emotions out of the equation, but this is easier said than done. If you know that a volatile market is likely to keep you up at night, mitigate risk with a more conservative portfolio.
  4. Sometimes, use your emotions to make decisions: “Wait a minute! You just told me to…” I know I know – what I’m saying here is that just because you don’t want to make emotional i.e. irrational decisions with your money, it’s important to approach investing with the same integrity and values with which you live the rest of your life. Investing in the stocks of socially responsible companies can be a morally and financially smart decision.
You can learn more about these lessons by reading the full article.

While these are all good lessons for stock picking, I can’t help but think – why do it in the first place? If fear, guilt, regret, pride, trust and comfort can hugely influence stock picking decisions, isn’t indexing perhaps a better approach? In most cases, it garners better returns, and allows more time for other important things in life.

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