The Investment Scientist

Archive for October 2017

blog_155_it1_roland_berger_tam_artikel_richard_thaler_image_caption_w768.jpgA few days ago I got the news that Richard Thaler won the 2017 Nobel Prize for Economics. If you don’t know about his work yet, you should. He, Danield Kahneman (2002 Nobel Prize) and the late Amos Tversky are considered the founding fathers of Behavioral Economics. His insights have a great deal of practical application and here I am trying to sum it up in one page for you.

Does The Stock Market Over-react?

This is the title of his paper published in The Journal of Finance in 1985. I read the paper for the first time when I was a PhD student at Carnegie Mellon University. The short answer to the question posed by his title is YES. He found that the market tends to overreact and reverse itself. When you look at five year intervals, stocks that did best in the previous five years tend to underperform over the next five years compared to stocks that did worst in the previous five years. What can you learn from that? Don’t be a hot stock (or fund or sector) chaser.

Myopic Loss Aversion
Richard Thaler coined this term to describe a cognitive bias many investors have which causes them to be afraid of short term loss to the detriment of their long term wealth. As an investment advisor, I encounter this a lot. The question I get the most is, “What do you think the market will do in next few months?” Implicit in the question is their fear that the market might drop and their desire to avoid it. The fear of loss causes many investors to abandon the market prematurely. What can you learn from that? Be oblivious to the market. This sounds counter-intuitive, but it’s the same advice given by another Nobel Prize winner, Daniel Kahneman.

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17724.jpgPresident Trump unveiled his tax reform proposal two days ago. I must say that it by and large follows the contour of my best guess from six months ago. Here is an updated summary:

  • Corporate tax rate will be reduced from 35% to 20%.
  • Estate tax will be eliminated.
  • The number of tax brackets will be reduced from seven to three, with the top rate going down from 39.6% to 35%.
  • The standard deduction will double while personal exemptions and many itemized deductions (with the exception of mortgage interest and charitable donations) will be eliminated.

However, there is one big surprise that will affect many small business owners and maybe even physicians/dentists in private practice.

That is, the tax rate on pass-through earnings will be set at 25%!

I own such a pass-through entity, MZ Capital Management, through which I deliver my wealth management services. The earnings of the firm are not taxed at the firm level, rather they pass through to my tax return as personal income, thereby subject to my personal income tax rate. Since I am in the second highest tax bracket, the marginal tax rate on my pass-through income is currently 35%. (If I had not set up a defined benefit plan for myself, my marginal tax rate would have been 39.6%. This belongs to another article on tax mitigation.)

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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