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Cognitive Biases and Investment Decisions

Cognitive errors in how people process and analyse information can lead them to make irrational decisions that can negatively impact business or investing decisions.1

Anchoring Bias Some investors anchor their investment decisions by fixating on a targeted result. Calculations that determine results ahead of investing in a fund portfolio can result in only thinking about future fixed results, disallowing for ongoing flexible guidance. An advisor can study the historical data, performance, and trend changes within the sector(s) in which the fund performs.

Recency Bias When we overvalue the latest information available about investments, we can develop a bias about what we’ve heard most recently and may not be looking at the big picture. In uncertain times, having an experienced advisor guide you in assessing the potential based on valid analytical data is wise.

Loss Aversion Bias The fear of losing money while investing can cause harm to inexperienced investors; for example, in March 2020, when the Dow Jones Industrial Average (DJIA) quickly dropped below 20,000. On November 23, 2020, the DJIA edged back over 30,000, higher than pre-March, 2020, as did the S&P 500. Investors who do not exercise patience during such times as the above period may experience an irretrievable loss. The Loss Aversion Bias only focuses on avoiding losses. Such bias often misguides an investor to miss out on good opportunities for gains.

Confirmation Bias If an investor looks only for information that affirms existing beliefs while discounting contradictory information, important facts may be left out of a decision process. Talking to a certified advisor may make you less apt to miss essential findings that may help you decide for the best. Advisors have access to many investment analysts and pertinent information on a broad field of market investment knowledge. 

Bandwagon Bias Investor tips can circulate among others who may not be tried and proven investors. If not assessed carefully, one might make a hasty investment decision. First, ask your advisor for their opinion – and make an informed decision.

1 Investopedia

How market volatility can work for the investor

What is market volatility? Volatility is when prices of stocks and equity funds increasingly shift in value up or down. When a low-volatility period is followed by increases in volatility, stock markets may begin to offer lower prices, which can effectually present lower-priced fund units, both offering a buying opportunity for the investor.

The stock market can both gain value in a “bull market” and can have periods of slowdown referred to as a “correction” or, if more prolonged, a “bear market”, which can occur during a recessionary period.

Many investors have seen their investments increase dramatically since the 2008-9 financial crisis that affected all the world’s markets. Further, since 2020 during the pandemic, the market has experienced remarkable gains as investors moved into another bullish period of growth after an extreme correction based on fear in mid-March 2021 occurred. Many of these investors have also witnessed a remarkable bull market taking many stocks and equity funds much higher than their previous years’ valuations. Conversely, investors who unwisely sold their holdings out of fear lost money.

The ideal strategy exercised by most successful contrarian investors like Warren Buffet is to buy investments when others are fearful and sell their holdings at lower prices.

When buying opportunities abound The market can experience increased volatility due to fears such as various wars, debt crises of countries, economic slow-downs, or mitigating inflation with rising interest rates.

Nevertheless, wise investors think positively during periods of higher volatility, relying on the professionals managing their investment portfolios.

Predesigned investment plans are necessary Though periods of volatility occur, exercise patience while maintaining a balanced and well-diversified portfolio according to a prescribed investment plan.

Plan with your advisor to establish a buying plan when others may be fearful. Market cycles of volatility are normal and expected.

 

How to prepare to qualify for a mortgage

When you apply for a mortgage, there are several questions that a lender may ask that you can prepare for. They will want information relating to:

The primary information they will need.

  1. Employment and income
  2. A summary of your outstanding debts
  3. Cash reserves, bank account cash, investments, and other assets
  4. The down payment that you have on the property you are purchasing and is it your own money
  5. Will the loan also be to consolidate any debts?
  6. What will be the use of the property?
  7. What is the equity you now have in your current home, if applicable?

Employment and income.

  • Who is your employer?
  • How much income do you make, and can you provide payment receipts/stubs?
  • How long have you been working at your job?
  • Is your income a salary or other income such as sales commission?

Your liabilities.

  • What are your outstanding debts?
  • What commitment level per month do you have to pay debts?
  • What is the cost per month for auto loans?
  • How much of your income goes to pay off credit cards, and what is the gross credit card debt?
  • How much money will be left after you pay for your down payment and closing costs?
  • If you are refinancing debts, how much debt will your mortgage cover and reduce your equity?

What you will use the real estate for:

  • Will this be your residence?
  • Will you rent a portion of the home out?
  • Is it an investment property?

Property type

  • A condominium?
  • A duplex?
  • A single dwelling?

Responses that can work in your favour:

  • I have steady employment with the same employer for two-plus years.
  • I carry little debt with a debt-to-income ratio of 25 per cent or less.
  • The mortgage is only for a home purchase.
  • My down payment of at least 30 per cent of the sales price with my own money.
  • The cash reserves will pay several months of the mortgage payments once the property closes.

Responses that can work against you:

  • Self-employed or contract worker.
  • High debt with credit cards maxed out, with a total debt-to-income ratio of more than 30 per cent.
  • The property will be renovated for rental use.
  • The liquid cash situation is tight once everything is paid after we close the deal.

The Fundamentals of Financial Independence

Here are some essential strategies that will help you achieve financial independence. It is important to get solid advice to design a plan that incorporates planning values such as those noted herein.

Separate your savings from your investments. Before you begin to invest for a long-term financial goal, you’ll need to save for an emergency fund – up to six months’ worth of your salary. Then you are prepared for an unexpected expense such as an engine job on the car, a leaky roof or loss of employment. Otherwise, you may need to tap into your investments intended for retirement or other purposes.

Budget based on your income, not on your desire. Plan to spend less than you earn and don’t take on debt that your future income cannot service. Budgeting is based on your income, not on your past spending habits. Total your monthly expenses such as housing, utilities, food, clothing, child-care, transportation and debt repayment. This sum should not exceed 75% of your after-tax income.

Invest by paying yourself first. You will only beat the habit of procrastination if you focus on paying yourself first. A rule of thumb: save 10% to 20% of every paycheck. You can achieve such investing by purchasing units in a potentially promising investment fund systematically, using an automatic payment program.

Use beneficial debt to build equity. Minimize and pay off consumer debts – monies borrowed to purchase cars, clothing, vacations, stereos and other gadgets that devalue over time. Acceptable debt can help you achieve an education or mortgage a home.

Differentiate your risks. Inflation risk will compete with long-term investment risk. Equity investment funds or the stocks of many companies are not guaranteed, meaning there is a risk. Yet equities have a much better chance to outpace the adverse risk of inflation—or as some have humorously termed shrinkflation—when compared to a savings account over time. Inflation is the single most significant long-term risk. At 4% over 20 years, inflation will cut the value of today’s purchasing power by half.

Determine to diversify. A properly diversified portfolio will hold several types of funds, including a mix of equity funds. Equity funds should differ in terms of what sector of the economy they invest in, such as agriculture, technology, mining, or finance. Though each fund would hold many stocks, make sure they diversify among the various sectors. One sector may gain while another may lose some value, balancing over time. Equity funds can also diversify by country (such as holding domestic, US and global funds); investment style (such as growth funds or value funds); or company size (such as small, mid, or large-cap). Consider adding bond funds to the mix to diversify even more.

Optimize your portfolio. If you can optimize your portfolio, you may minimize the risks to help your return on investment. To truly optimize, one needs in-depth knowledge only obtainable from a professional whose job is to study funds as a speciality. To diversify in a balanced manner, one needs to weigh many factors concerning economic sectors, managers’ styles, company size, and foreign economic conditions.

The Registered Education Savings Plan (RESP) for Educational Planning


Facts about an RESP

A Registered Education Savings Plan (RESP) is a savings plan registered with the government that can help you save for your child’s post-secondary education.

Money invested in an RESP grows tax-deferred. The government helps contribute to your savings with education grants.

Later in life, as your child enrols at a qualifying post-secondary institution, you can withdraw the funds for educational purposes. The payments made from these funds are called Educational Assistance Payments (EAPs).

Invested income and government grants received when withdrawn from the RESP are taxable. You do not pay tax on the contributions you made using your own money. Then these amounts are taxed in the tax return of the student – usually with little or no tax payable as students generally will be in the lowest tax bracket.

How do RESPs help my money accumulate?

  • Starting to use an RESP for your child early, while they are young, gives you more time for your contributed funds to grow.
  • The Canada Education Savings Grant (CESG) will match 20% of annual contributions, up to $500 per year
  • These contributions can continue until you reach the lifetime limit of $7,200 per child
  • Investing your Canada Child Benefit can assist you while saving enough to qualify for the maximum CESG amount

Federal Government-funded education grants

The Government of Canada supports saving for a child’s education by offering grants to a child’s RESP – offering you additional funds to accumulate educational savings.

The Canada Education Savings Grant (CESG)

The basic Canada Education Savings Grant (CESG) increases your year by year contribution by 20%, up to $500 per beneficiary each year to a lifetime limit of $7,200 per beneficiary. Additional CESG grants may be available, depending on your income.

Please talk to us for more information about the RESP and the CESG grant as it applies to your province.

Source: CRA

Plan your RRSP Ahead to Reduce Taxable Income

It pays to plan your RRSP contributions before the end of the year to reduce your taxes that will be due on the current taxable year. To achieve this, assess your income and calculate how you can optimise the use of an RRSP to reduce your taxable income.

You may have Carry-forward Contribution Room

If you have not previously invested up to your maximum RRSP contribution limit, CRA allows you to carry over unused contribution room into future years for an indefinite period. Look on your Notice of Assessment.

What can you deduct on your tax return?

You can claim a deduction for:

  • contributions you made to your Registered Retirement Savings Plan (RRSP), Pooled Registered Pension Plan (PRPP) or Specified Pension Plan (SPP)
  • contributions you made to your spouse’s or common-law partner’s RRSP or SPP
  • your unused RRSP, PRPP or SPP contributions from a previous year

You cannot claim a deduction for:

  • fees charged to buy and sell within a trusteed RRSP
  • amounts you pay for administration services for an RRSP
  • the interest you paid on money you borrowed to contribute to an RRSP, PRPP, or SPP
  • any capital losses within your RRSP
  • employer contributions to your PRPP

What is the deadline to contribute to an RRSP, PRPP, or SPP for the purpose of claiming a deduction on your tax return?

The Income Tax Act sets the deadline as “on or before the day that is 60 days after the end of the year”, which is March 1st except in a leap year, when it will be February 29th; or where the deadline falls on a weekend, it may be extended.

Can contributions be made to a deceased individual’s RRSP, PRPP, or SPP?

No one can contribute to a deceased individual’s RRSP, PRPP or SPP after the date of death. But, the deceased individual’s legal representative can make contributions to the surviving spouse’s or common-law partner’s RRSP and SPP. The contribution must be made within the year of death or during the first 60 days after the end of that year. Contributions made to a spouse’s or common-law partner’s RRSP or SPP can be claimed on the deceased individual’s tax return, up to that individual’s RRSP/PRPP deduction limit, for the year of death.

What is not considered an RRSP, PRPP, or SPP contribution?

The following are not considered to be an RRSP, PRPP, or SPP contribution for the purpose of claiming a deduction on your tax return. We can point out the special rules that apply if you:

  • repay funds that you withdrew under the Home Buyer’s Plan
  • repay funds that you withdrew under the Lifelong Learning Plan

Note: It is recommended that you get more information on this subject by calling our office or your accountant.

How is your RRSP/PRPP deduction limit determined?

The Canada Revenue Agency generally calculates your RRSP/PRPP deduction limit as follows:

The lesser of:

  • 18% of your earned income in the previous year, and
  • the annual RRSP limit

Minus:

  • your pension adjustments (PA)
  • your past service pension adjustments (PSPA)

Plus:

  • your pension adjustment reversals (PAR), and
  • your unused RRSP, PRPP, or SPP contributions at the end of the previous year

Source: CRA

Can life insurance collateralize business bank debt?

How banks view lending money to business owners.

Banks follow established rules, which include asking a business owner to collateralize a loan, not just with business assets but also with personally owned assets, such as a principal residence and cottage. Collateralization can require collateralising a spouse’s co-owned assets, even if the business is incorporated.

Add to that a possible collateralization of any assets of a partner or adult child (and their spouses) who also share in ownership. Small business owners can lose their shirts if they default on a loan.

What if an owner dies? It is unwise to assume that a good relationship with the bank will continue if the heir of a small business or a partner is not in favour with the bank manager. Bank managers can change or apply strict policies while reassessing the leniency shown to previous owners or administrators.

Eliminate doubt in a family business, such as a farm, by insuring the oldest owners and succeeding generations using joint-first-to-die policies or individual life insurance policies. In the case of a non-family business, each owner/partner should be insured to cover the company’s debt. When the life insured dies, the tax-free life insurance proceeds can be used to pay back loans, win back ownership, and discharge any personal assets liens.

What if there is a critical illness? For the same reason, small business owners should consider purchasing a critical illness (CI) insurance policy for each principal business owner and key persons. CI insurance could pay off a considerable bank debt if one were to experience a significant illness such as a heart attack or stroke. One could become incapacitated and need to be bought out by a partner or an heir (there should be a buy-sell agreement in place). The risk of a loan being called increases when an owner-manager is sick, and the bank manager loses confidence in the debt-paying influence of that owner.

How can I reduce Probate or Estate Administration fees?

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After the death of an individual, every estate must file a final (or ‘terminal’) tax return. All assets are deemed to disposed of at the time of passing, and this can trigger probate fees and other expenses.

A certificate of appointment (“Probate”) or Estate Administration Tax (EAT) is not always necessary to actualize the transfer of certain assets. Much depends on how the asset is held during one’s lifetime, and the value of the asset transferred.  Some institutions will not require probate for assets under a certain amount.  Concerning jointly-owned real property, and bank or investment accounts, these assets will pass to the surviving joint tenant by right of survivorship.  In cases where joint ownership of assets is considered for estate planning purposes, it would be prudent to obtain legal advice.

Life Insurers offer life insurance policies, segregated funds, and term funds, which may designate one or more primary beneficiaries, and further contingent (secondary) beneficiaries, allowing probate/EAT to be circumvented entirely, enabling direct access to those funds without joint ownership or survivorship of a joint tenant. Segregated funds and term funds are classified as deferred annuity policies, and as such, these assets can help lessen the overall fees charged on your estate. Monies pass privately and directly to your beneficiaries, outside of your estate and the probate process.

Concerns for Estate Planning

In Ontario, Probate fees were the forerunner of the new Estate Administration Tax (EAT), which is to shift to the Minister of Revenue. An Executor/Trustee will now have to file a detailed summary of assets that are distributable under the will. The Ministry reserves the right to take up to 4 years to assess, or the right to reassess, making the Executor/Trustees responsible for that reassessment.  Executors and beneficiaries may face liabilities if estate assets distribute before assessment or reassessment.  How does an Executor reclaim assets already distributed?

Assessment powers are not minor With the introduction of the estate administration tax (EAT), the government has given the Minister of Revenue audit and verification powers patterned after the federal Income Tax Act, thus giving the Minister of Revenue the right to assess an estate in respect of its EAT liability.

Estate trustees may be personally liable for the claims of creditors that cannot be paid as a result of an improper estate distribution. It will be an offence for an estate trustee to fail to make the required filing with the Minister of Revenue or where anyone makes, or assists in making, a false or misleading or omitted fact in connection with the estate trustee’s filing. Because offences are punishable by fine, imprisonment or by both, errors and omission insurance may be needed by executors handling larger estates.

Potential Legal Issues for Estate Trustees and Executors
Imagine if you are a personally chosen friend of a deceased person with $1.5 million in assets, who previously selected you as Executor/Trustee of his or her estate. Though duty-bound, you may feel that the risk is now very high if an error occurs. Consequently, you may want to off-load the potential liability to a professional accountant and lawyer to present all the documentation for EAT.

Consider that the costs of such a transfer of liability could rise to the maximum of 6% per professional (two professionals would mean 2 x 6%) of the value of the Estate. This could bring the total cost of dealing with EAT to a maximum of 13.5% of the estate value. In the above case, fees could cost upwards of $202,500.

Segregated and Term funds may offer investors an edge over other investment products in the province of Ontario when it comes to planning someone’s Estate. Segregated and Term funds also offer estate privacy of the distribution of money under the insurance act.

Note: Not applicable in Québec as notarial wills do not need to be probated by the court and, for holograph wills and wills made in the presence of witnesses, probate fees are minimal.

 

How do I protect the finances of the Successor of my Business?

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Here are ways to protect your successor financially.

  • Allow the potential successor to get involved in managing important team projects. Try to increase the successor’s financial insights and general responsibilities over time. Allow independence while ensuring that the right professionals assist the successor, such as a good accountant and insurance agent.
  • Consider visiting other family businesses that have transferred their business through continuity planning.
  • Establish mentors and advisors for the successor. Consider setting up a board of directors if one is not in place. Implement leadership training programs.
We do not suddenly become what we do not cooperate in becoming.— William J. Bennett

Protect your assets during Succession in the following ways:

  • Cover your key persons. Use life and disability insurance to cover the cost of replacing an owner, successor, contingent successor, or a key executive in the event of death or disability.
  • Ensure debt redemption. Life insurance proceeds can pay off bank loans and other liabilities—paid at the owner’s death. Also, consider critical illness insurance, which would pay up to $2,000,000 if the proprietor were to become critically ill.
  • Provide income replacement insurance.  Disability insurance benefits can provide income to an owner, successor, or key executive if disabled over specific periods. The payment paid as a benefit to a disabled insured, places less payroll burden on the company.
  • Fund a buy-sell agreement. Life and disability insurance proceeds can fund a buy-out upon death or disability, where two or more owners are in business (effective for current or succeeding generations).
  • Fund a stock redemption. When other members of the family own stock, you can buy life insurance for the owner and make the successor the beneficiary. This will provide cash upon the owner’s death to allow the successor to buy the stock of, say, sisters or brothers, based on a pre-determined formula related to equalizing the estate.
  • Fund capital gains tax liabilities. If significant capital gains will impair the company, reduce personal assets, or disallow a legacy of a cottage or other asset, use a permanent life insurance product designed to pay off all capital gains liabilities.
  • Create capital to equalize your estate. In the future event where one child will inherit the company, life insurance can be purchased by the owner or spouse to pay the non-involved children a tax-free cash benefit in predetermined amounts, clear of probate. To avoid resentment, you can inform these children that they will be treated fairly in the overall estate.
Let him, who would move the whole world, first move. — Socrates

Maintain relationships during succession

  • Keep your banker informed. What would your banker do if something happened to your firm’s current owner? Who else knows of the company’s loans or actual financial status? Introduce your successor (and the succession plan) to your banker and review all the company liabilities. Reveal your life insurance planning to the banker that can offset liabilities in the balance sheet.
  • Sustain client relationships. Introduce your successor early on to your key clients. Perhaps host client appreciation events.
  • Harmonize the successor with the constituency. The key players will help the company survive, including critical suppliers, influential families within and without; shareholders you hope will seek minimal dividends instead of future growth; employees, especially those holding company stock; and the key executives.
  •  Diversify sources of retirement income. Keep your retirement investments separate from your business. Consider purchasing segregated funds, separating your assets from the company while reducing exposure to creditors. Avoid investing your profits into the business without developing your independent retirement resources. Thus, you will not need to rely on the company to create an ongoing retirement income, though you may receive dividends and income from the business.
  • Move towards financial independence of your business. Though you leave a legacy to your successor(s), you can ensure that the inheritance will have sufficient funds to survive during and after the succession. Drawing from your retirement savings can reduce dependency on business income (or dividends).