Increasingly, the Internal Revenue Service has been chasing the big tax cheats and top earners to uncover missing tax revenue.  But don’t think you’re immune to an IRS audit just because you’re a middle-class working stiff. Often, a simple mistake or an honest deduction in an area rife with abuse means that you could wind up getting audited anyway.

Most average Americans think their chance of an audit is slim, and that’s not altogether untrue. Millionaires and big corporations have a higher chance to be audited because they have a higher tax obligation. Beyond these big guys, only about one percent of individuals taking home less than $200,000 annually are audited each year.  But while IRS is understaffed, it isn’t foolish; systems are in place to identify those most likely to be tax cheats, and separate them from run-of-the-mill filers, regardless of income levels. If your return boasts something the IRS sees as a red flag, it can dramatically increase the likelihood of an audit to your 2012 filing.

Here are five important items on your tax return that could grab unwanted attention from the tax man:

• Not reporting all your income

This may seem obvious, but you must declare every penny you earned. Even the slightest variation from your filing and official IRS income records will set off red flags.  If you briefly held a temp job or did one or two freelance projects, you better track down the extra 1099s and W-2s no matter how small the income. If you miss them, there’s a chance the IRS will flag your return simply because the numbers don’t add up.

The IRS has more information about income:

Tax Topics: Types of income

Publication 531: Reporting Tip income

• Minor mistakes on major information

A common audit prompt is a simple mistake regarding crucial information. Maybe you mixed up some numbers in your spouse’s Social Security number or forgot to carry the two when adding up your adjusted gross income. The mistake may be honest, but unfortunately, IRS auditors don’t like mistakes.  Double check every single line before mailing your form – especially if you’re a do-it-yourself filer.

• Home office deductions

These deductions were abused for years by people who did a little work in the den in exchange for a lot of tax benefits they might not have deserved. The IRS frequently audits those claiming home office deductions, making them prove “exclusive use” for business purposes.  This is not to say you can’t claim a home office, of course, and those who are eligible can win big deductions for property taxes, utilities and insurance, among other items.

However, complying with IRS guidelines is key, or your deductions won’t survive the audit. That means no double-duty with the office functioning as a guest bedroom or a playroom for the kids, and avoiding seemingly benign dual uses, including stowing skis or Christmas ornaments in the closet.

For more information: Requirements for using the home office deduction

Publication 587: Business use of your home

Form 8829: Expenses for business use of your home

• Frequent business vehicle use

Just as it’s easy to mix personal with business use in a home office, business vehicles are ripe for unqualified deductions and a red flag for auditors. Listing a business vehicle use on your tax form can warrant IRS attention whether you deserve it or not.  This doesn’t mean you can’t claim a business vehicle, but make sure you have a detailed log with the date, destination and mileage for each trip – and that you don’t include stop-offs for coffee or dry cleaning.

It’s very rare for a vehicle to be solely for work without a single personal trip all year, so be honest when you file, and be aware that heavy business vehicle use means the tax man could likely come looking for your mileage log down the road. For more information:

2012 standard mileage rates

Instructions for Form 2106: Employee Business Expenses

• Business “entertainment”

If you’re self-employed, it’s tempting to claim lots of meals and travel on your tax return. However, while Schedule C allows for big-time deductions, it also historically has been a source of big-time overstatement. That means the IRS watches these kinds of items like a hawk.  If you’re claiming business-related trips and entertainment, it’s crucial to keep detailed records and receipts of who was there and event specifics. Many Americans try to sneak in personal expenses, and that means even honest filers risk a red flag by claiming these kinds of deductions.

Tax topic: Business entertainment expenses

Check out IRS.gov for resources regarding proper deductions and how to deal with an audit, including helpful tips on proper record-keeping for self-employed taxpayers.

“I have read the bill and can’t find the spending cuts, even with an electron magnifying glass,” complained Representative Trey Gowdy of South Carolina, a Tea Party Republican, to the New York Times after Congress passed its fiscal-cliff-averting legislation. Gowdy might have fared better if he’d used an electron microscope, but he was certainly on target with regard to Social Security and Medicare. Other than some minor technical adjustments to Medicare spending, the compromise deal doesn’t include any broader reforms that might slow the growth of the two major retiree benefit programs. Instead, the bill enacts higher tax rates on individuals earning $400,000 and couples earning $450,000 – and reinstates a Social Security payroll tax that will hit people at all income levels.

Reuters

Policy-debate masochists needn’t worry: Entitlement reform won’t be out of the headlines for long.  The new bill puts off a wide range of automatic spending cuts — agreed to during the 2011 debt-limit debate — for just two months, and deficit hawks are saying they plan to press for bigger structural changes when the wrangling begins over those cuts. Social Security and Medicare together make up about 37% of federal spending today, and Medicare’s share of the budget in particular is growing fast, so if there’s ever to be a grand budget bargain, something will eventually have to give here.

That Social Security payroll tax hike, however, is not insignificant. The employee share of the tax will rise two percentage points, to 6.2% from 4.2%–discontinuing a tax cut that was passed as a stimulus measure in 2011. All wage and salary earners pay that tax on the first $113,700 of their income (up from $110,100 in 2012); the Wall Street Journal estimates that the tax increase will amount to about $200 a month for an individual earning the cap maximum. All in all, the nonpartisan Tax Policy Center estimates that the payroll tax increase will reduce workers’ paychecks by about $115 billion in 2013.

Some reformers will be glad to see that tax cut die: Encore contributor Alicia Munnell, director of the Center for Retirement Research at Boston College, is one of many who’ve argued that making the tax cut permanent would make Social Security’s long-term financing shortfall look much worse. Of course, unlike many other changes in the bill, the payroll tax restoration will eat into lower- and middle-income paychecks. Some of those households may get some consolation from the fact that the new deal also extends the earned-income tax credit and the child tax credit for lower income families

Cliff deal spares retirees—for now – Encore – MarketWatch.

We tend to think of the greatest investors – say, Peter Lynch, George Soros, John Templeton, Warren Buffett, Benjamin Graham – as being mostly or entirely skillful.

Graham, of course, was the founder of security analysis as a profession, Buffett’s professor and first boss, and the author of the classic book The Intelligent Investor. He is universally regarded as one of the best investors of the 20th century.

But Graham, who outperformed the stock market by an annual average of at least 2.5 percentage points for more than two decades, coyly admitted that much of his remarkable track record may have been due to luck.

In the Postscript chapter of The Intelligent Investor, Graham described “two partners” of an investment firm who put roughly 20% of the assets they managed into a single stock – a highly unusual departure for the conservative managers, who normally diversified widely and seldom invested more than 5% or so in any one holding.

The stock went on to a more than 200-fold gain, and the investment managers didn’t sell it – even though they couldn’t justify keeping it on the basis of their typical standards of valuation.

In short, they broke their rules to buy the stock, and they broke their rules to keep it.

Graham added:

Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

Are there morals to this story of value to the intelligent investor? …[One] is that one lucky break, or one supremely shrewd decision — can we tell them apart? — may count for more than a lifetime of journeyman efforts.

The company was Geico. The investment fund was Graham’s own, Graham-Newman Corp. The value of the holding went from a little over $700,000 at the outset to more than $1 billion at its peak.

In a footnote, Graham explained that the original deal to buy Geico nearly fell apart when he and his partner, Jerome Newman, in negotiations to buy the stock from Geico’s founders, quibbled over a $50,000 accounting entry. “By dumb luck they got what they insisted on,” he recalled.

The next time you find a fund manager boasting about how skillful he is at picking investments, remember that the great Benjamin Graham credited much of his own phenomenal success to luck alone.

Was Benjamin Graham Skillful or Lucky? – Total Return – WSJ.

More than 90% of economists polled said Congress won’t raise tax rates on all Americans in January and a similar percentage say budget slashing will be deferred, according to National Association for Business Economics survey of 48 professional forecasters released Monday.

But avoiding what’s largely seen as a threat to the economy is unlikely to spark more robust growth in the next year. The economists predict the gross domestic product will increase by 2.1% in 2013, a tick below the 2.2% advance they anticipate for 2012.

The forecast suggests that businesses and consumers will likely need to wait well into next year before details of a fiscal cliff deal are finalized, even if a framework is agreed to in the next few weeks, said Nayantara Hensel, an economist at the National Defense University and one of the report’s authors.

“The view is that this will be a gradual process,” she said. “Once the gridlock in Congress is broken, that is going to improve business investment and consumer confidence.”

Indeed the economists forecast that the economy will accelerate during the year. They predict growth at just a 1.8% rate in the first quarter, but expect a 3.0% pace by the fourth.

The lackluster first-quarter reading would likely be even lower if not for a boost from rebuilding in the wake of superstorm Sandy. Of those surveyed, 86% say Sandy will increase first-quarter GDP growth but cut into gains during the current quarter. The storm struck the Northeast in late October.

The economists expect business investment and consumer spending to taper from the pace seen in 2012, but they are bullish on continued improvement for the housing market. The consensus forecast calls for residential investment to grow 12% and for home prices to increase by 3.5% in 2013.

They see the unemployment rate edging down slightly during the year, from 7.9% in the first quarter to 7.6% in the fourth.

While the U.S. is expected to continue its modest growth, Europe could experience new problems, many of the economists said.

“A portion of the panelists expect that the European financial crisis will worsen in that Spain, Italy, and Ireland may require bailout packages,” Ms. Hensel said.

Almost half of those surveyed said Spain will require a larger bailout package in 2013 than previously anticipated and a third believe Italy will receive a bailout in 2013. About one-fifth of respondents say Ireland will require more aid and a similar amount see Greece breaking from the euro currency.

Avoiding Fiscal Cliff Won’t Spur Growth – Real Time Economics – WSJ.

By Milton Ezrati

It is popular these days to compare current hard times to the Great Depression. The temptation is easy to understand. Because the events of the 1930s carry high drama and not a little romance, they make a good lead for almost any article. Of course, there are enough differences between these two events to render such links misleading from time to time, but one very fundamental and important parallel does exist: As in the Great Depression, the crisis of 2008–09 has muddled perceptions about how the economy works and undermined people’s confidence that they can assess policy and anticipate future events accurately. The attendant insecurity has fostered a general reluctance in the business community, which, in turn, has muted all economic responses, even to the best-conceived policies.

The extent of this muddling was clearly evident in the recent election campaign. Still, through the fog, two basic narratives have emerged: On the left of the political spectrum are the neo-Keynesians, led by New York Times columnist Paul Krugman. This group would ratchet up government spending and borrowing still more than it has been, in order to “jump-start” the economy. On the right, apart from the bias against big government, the analytical focus seems to lean toward monetary policy. This group would have the Federal Reserve, as well as the Bank of England, the European Central Bank (ECB), and other central banks keep markets well supplied with liquidity, effectively greasing the wheels of commerce until more fundamental healing can occur. There is dispute within this camp as to the appropriate extent and duration of such monetary easing, but this general approach seems to be where the bulk of their analytical effort has gone.

Paul Krugman and the neo-Keynesians have argued strenuously against any concern over the size of government or budget deficits. They contend that even higher levels of borrowing and spending would foster enough growth ultimately to pay for themselves with added tax revenues. Krugman and his colleagues, University of California at Berkeley economist Brad DeLong prominent among them, continue to argue this line despite the failure of the massive 2009 stimulus effort to accelerate the economy. Even President Obama admitted that there simply are not enough “shovel-ready” projects to allow the stimulus to work. Rather than be chastened by that failure, however, they simply claim that the effort, massive as it was, was simply insufficient. They point out how, in the setting of the Great Depression, it took the truly massive spending for the Second World War to get the economy going. So far, Krugman and company have resisted the temptation to advocate a declaration of war.

Outside the narrow confines of this analytical approach, it seems that the explanation for the failure of neo-Keynesian policy may lie less in its size than in John Maynard Keyne’s own writings. While he advocated government spending, he also emphasized that government stimulus can only have an impact beyond itself when it inspires what he called the “animal spirits” of businesspeople. In other words, government spending can only prompt a general recovery, according to Keynes, when business is willing to capitalize on it with its own spending and hiring. Unfortunately, the present environment of uncertainty and doubt has dampened such spirits. The same reluctances were evident during the Great Depression. The government in the present environment has further dampened those spirits by vilifying businesspeople and threatening to tax away much of the income they might gain from capitalizing on the government’s efforts. Little wonder, then, that the 2009 stimulus had no lasting impact, or what economists call “multiplier” effects. The same problem raises doubts about Professor Krugman’s demands for still more spending.

Curiously, this combination of tax threats and limited confidence may explain why the monetary solution has also failed thus far to get the economy back on track. Fed chairman Ben Bernanke and other advocates of this approach have already poured huge amounts of liquidity into the system, and when confronted with the muted economic response, they have simply argued for more. Even the stock market has failed to respond fully. Though up dramatically from its lows, prices still remain depressed next to less-risky assets, such as Treasury notes and high-grade corporate bonds. No doubt the confusion and concern about what might happen has also made business and the public reluctant to take full advantage of the ocean of liquidity offered by the Fed.

This problem is evident not only in the still disappointing state of the economy but also in the benchmarks used by the Fed itself. Currency in circulation and bank reserves—two things that the central bank controls directly—have surged under the influence of this easy monetary policy. In the past two years, according to the Fed, bank reserves have jumped 15.5% a year, and the so-called monetary base, which adds currency in circulation to measures of bank reserves, has increased at a 21.1% annual rate. But because the lack of confidence has made banks reluctant to lend and the public reluctant to borrow, for either business or personal use, only a portion of these reserves has flowed into actual circulation. The broad M2¹ measure of money circulating in the economy, for instance, has increased at only 7.9% a year during this time—faster than the economy, to be sure, but clearly slower than the Fed intends.

It would seem in the circumstance that time offers the only solution. Whatever tax policies eventually go into effect will presumably relieve the public and the business community of uncertainty on this front.If the government ultimately takes more, at least people and business will be able to plan and so are more likely to take advantage of either fiscal or monetary stimulus. The uncertainties over how the economy works will also resolve themselves in time. Even a disappointingly slow-growing economy can reestablish in people’s minds a notion of what the future holds, whether accurate or not, and so erase the sense of lingering confusion that emerged from the shock of the financial crisis and the severe recession that followed it. In the meantime, the slow pace of advance will continue to dominate, with all the disappointment and frustration it brings.

Economic Insights: Stuck in the Muddle with You.

An estimated 7 million Americans will reach the age of 65 by the start of 2013, and many will no doubt be thinking about retiring.

But even if falling off the “fiscal cliff’ is avoided, some financial experts are warning anyone thinking about trading in their paycheck for a retirement fund next year.

“It’s kind of a perfect storm in 2013 when you think about it,” said Jason Wheeler, CEO ofPathfinder Wealth Consulting.

“With questions about taxes, spending cuts, the markets, health care—and then put those together with the number of seniors wanting to retire or will lose their jobs—the year could be a rough one when it comes to retirement,” he said.

Topping Wheeler’s worry list seniors are taxes.

“The magnitude of what a retiree will pay on their investments could really hurt their finances,” he said. “And right now we don’t know what that will be.”

If no deal is reached to solve the fiscal cliff by Dec. 31, the Bush tax cuts end and rates go higher on capital gains and dividends.

As it stands now, the top tax rate on capital gains will jump to 23.8 percent from 15 percent and the top tax rate on dividends nearly triples to 43.4 percent from 15 percent. And any fiscal deal will likely include higher tax rates so seniors had better count on that when they plan for their retirement, said John O. McManus, CEO of McManus & Associates, a trust estates law firm.

“Many seniors may want to postpone retirement in 2013 because they just don’t know what their tax rates will be,” McManus said. “If the markets don’t perform well and tax rates go higher, seniors will have a lot less money to spend. There’s a lot of uncertainty about where this will all end.”

But McManus said even planning for tax increases won’t be easy.

“If someone retires in January but a deal isn’t reached until March, will tax rates be re-retroactive? That’s a big risk for someone thinking about retirement,” said McManus.

More seniors than ever are depending on defined contribution plans to fund their retirement as traditional pension programs decline. Only one in five people in the private sector actually have a pension plan in place, according to the National Institute on Retirement Security.

And though the most recent IRS data show that more than 63 percent of taxpayers with qualified dividend income are age 50 and older, some 23 percent of workers don’t participate in a retirement plan—leaving many seniors unprepared for their golden years.

“The vast majority of people don’t have the money to retire,” said financial planner Bill Losey, president of Bill Losey Retirement Solutions. ”For instance, they don’t max out the contributions to their 401(k)’s. I think people need to have two to five years’ worth of expected income before they can think about retiring.”

Another part of the storm facing seniors in 2013 is Social Security. Retirees will see an increase in their payments—but only by 1.7 percent, less than the 3.6 percent they got in 2012. That’s because the payments are adjusted to inflation—which Wheeler said is low but not low enough.

“Food, clothing, gas, everything is inching up in price while salaries remain low,” he said. “Seniors will feel the pinch if they retire next year.” (Read More:Inflation Climbs.)

Inflation hurts those seniors who looked to fixed income investments like bonds, for retirement funds, said Chris DeGrace, first vice president for private wealth management at SunTrust Investment Services.

“Given how low interest rates are and will be for the next few year with what the Federal Reserve is doing, it’s going to be hard for seniors to generate needed income,” DeGrace said. “There will be more stress on them to find other types of guaranteed income streams.”

If their incomes are going down, seniors face rising health care costs in 2013.  A report from Fidelity Investments found that a 65-year-old couple in 2012 would need an estimated $240,000 to cover medical costs through their retirement—a 50 percent increase from 2002. That figure will likely increase to $260,000 next year.

And those on Medicare will see their monthly premiums go up from $104.20 in 2012 to $120.00 in 2013—as well as increased taxes on the wealthy to help pay for Obamacare.

“More and more people are going to be responsible for their health care costs as they get older,” Wheeler said. “Even with Medicare, and as companies stop providing coverage to their retirees, those costs loom large for seniors.”

While 2013 presents unique problems, analysts say that in the end, planning for retirement never comes at an easy time, fiscal cliff or not.

“Seniors need to think about that if they leave the workforce, can they get back in, no matter what the year?” said Losey. “Are they retiring because they need a break? I’ve had clients say three to six months later that they want to work again because they are bored. And these days it’s difficult for seniors to get jobs that pay well when companies are hiring younger people at lower salaries.”

“It’s not to say that 2014 will be a better year to retire,” said McManus. “There are a always a lot of things people can’t control, like the markets and global issues. I’m just saying that if you think about retiring in 2013 you need to take care and take caution.”

But it turns out the agency’s rules for required withdrawals from retirement accounts could provide a framework for retirees trying to calculate how much of their savings they can safely withdraw every year and minimize the risk of running out of money.

For individuals who have spent decades building a nest egg, crafting a withdrawal strategy is a critical and complicated task. The challenge: anticipating potential swings in the value of investments while providing a relatively predictable level of income.

The biggest risk, of course, is pulling money out too quickly and running out of savings. The flip side to that error—withdrawing money at too slow a pace—isn’t a dire predicament. But there’s no sense in making the golden years feel like they’re made out of tin.

For years, many financial advisers and mutual-fund companies have embraced a withdrawal rate of 4% as a reasonable number for retirees. The math is relatively simple: Pull 4% from savings in the first year of retirement; then, in subsequent years, increase that dollar amount by the rate of inflation.

With this approach, a retiree with $400,000 in retirement savings would withdraw $16,000 in the first year of retirement. Then, with 3% inflation, the retiree would withdraw $16,480 in Year Two.

This approach carried the endorsement of complex computer models designed to rate the odds of retirees running out of money under scores of different stock- and bond-market scenarios.

Problems arise, though, when investors and advisers regard the 4% rule as set in stone. Consider the dramatic collapse of the stock market in 2008.

If our retiree’s original portfolio of $400,000 loses one-third of its value in Year Two of retirement, a withdrawal of $16,480 would equal just over 6% of the remaining funds. If markets don’t recover quickly, withdrawals of that size could raise the risk of the retiree running out of money.

“The problem with the 4% rule is that it doesn’t really respond to investment returns,” says Anthony Webb, a research economist at the Center for Retirement Research at Boston College. As a result, “this notion that if you spend 4% of your savings, you’re at very, very low risk of outliving your wealth…is nonsense.”

Mr. Webb, along with a colleague, Wei Sun, were intrigued by the IRS guidelines. They crunched their own numbers and found that a retiree could craft an effective plan for withdrawing savings by adapting the agency’s tables for so-called required minimum distributions from individual retirement accounts, mandatory for those reaching age 70½.

The strategy based on IRS rules may seem a bit wonky at first, but it’s relatively simple. Rather than withdrawing a set dollar amount every year as with the 4% rule, a retiree withdraws a percentage of his retirement savings. That percentage rises slightly every year. The idea is to avoid the kind of outsized withdrawal during a market setback that could hurt the retiree later in life.

For example, at age 70, a retiree would take 3.65% of his savings; at age 71, the withdrawal rate would be 3.77%. By age 80, the percentage to be withdrawn is over 5%—and nearly 9% at 90 years old. The details on the withdrawal rates can be found on the Boston College retirement center’s website, crr.bc.edu/category/briefs/.

One problem with the RMD-based formula is that, on its own, it could lead retirees to take relatively small withdrawals when they are in the early years of retirement and larger dollar amounts when they are older. Many retirees may prefer to have larger withdrawals early on when they are better able to travel and are still vigorous.

To offset this, the Boston College economists layered on a recommendation that retirees also withdraw any income and dividends generated by their investments.

Christine Fahlund, a senior financial planner atsays that while the RMD strategy is a “neat idea,” retirees may be uncomfortable with its key element: that the dollar amount of money at their disposal can go down if the markets go down.

For many people, a goal of the 4% rule is maintaining a particular lifestyle, says Ms. Fahlund. But with the RMD approach, a retiree might have to throw a budget out the window in the teeth of a bear market.

That issue could be offset by having multiple years worth of cash needs already set aside. That approach, useful with any withdrawal strategy, negates the need to cash out of investments when they drop sharply in price.

IRS Guide for Retirement Payouts – WSJ.com.

Storm-Proof Your Financial House | Fox Business.

by Robert P. Seawright

Barry Ritholz (of The Big Picture and a Sunday Business columnist at The Washington Post) recently contributed Investors’ 10 most common mistakes to The Washington Post Business Section quarterly investing section. It’s a commentary that he has been working on for a while — the ten topics are listed with links to longer discussions of each common mistake here. I created my own investing “checklist” (here) in response to Barry’s original list. For yet one more iteration of the theme, I offer my list of Investors’ 10 Most Common Behavioral Biases.  There are a number of others, of course, and more will continue to be uncovered.  But I think that these are the key ones.  Your suggestions of important ones I have missed are welcome.

1. Confirmation Bias. We like to think that we carefully gather and evaluate facts and data before coming to a conclusion.  But we don’t. Instead, we tend to suffer from confirmation bias and thus reach a conclusion first.  Only thereafter do we gather facts and see those facts in such a way as to support our pre-conceived conclusions.  When a conclusion fits with our desired narrative, so much the better, because narratives are crucial to how we make sense of reality.
2. Optimism Bias.  This is a well-established bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy. Indeed, we live in an overconfident, Lake Wobegon world (“where all the women are strong, all the men are good-looking, and all the children are above average”).  We are only correct about 80% of the time when we are “99% sure.” Fully 94% of college professors believe they have above-average teaching skills (anyone who has gone to college will no doubt disagree with that). Since 80% of drivers  say that their driving skills are above average, I guess none of them drive on the freeway when I do.  While 70% of high school students claim to have above-average leadership skills, only 2% say they are below average, no doubt taught by above average math teachers. In a truly terrifying survey result, 92% students said they were of good character and 79% said that their character was better than most people even though 27% of those same students admitted stealing from a store within the prior year and 60% said they had cheated on an exam. Venture capitalists are wildly overconfident in their estimations of how likely their potential ventures are either to succeed or fail. In a finding that pretty well sums things up, 85-90% of people think that the future will be more pleasant and less painful for them than for the average person.
3. Loss Aversion. We are highly loss averse.  Empirical estimates find that losses are felt between two and two-and-a-half as strongly as gains.  Thus the disutility of losing $100 is at least twice the utility of gaining $100. Loss aversion favors inaction over action and the status quo over any alternatives. Therefore, when it comes time for us to act upon the facts and data we have gathered and the analysis we have undertaken about them, biases 2 and 3 – unjustified optimism and unreasonable risk aversion – conflict. As a consequence, we tend to make bold forecasts but timid choices.
4. Self-Serving Bias. Our self-serving bias is related to confirmation bias and optimism bias. Self-serving bias pushes us to see the world such that the good stuff that happens is my doing (“we had a great week of practice, worked hard and executed on Sunday”) while the bad stuff is always someone else’s fault (“It just wasn’t our night” or “we simply couldn’t catch a break” or “we would have won if the refereeing hadn’t been so awful”).
5. The Planning Fallacy.  In his terrific book, Thinking, Fast and Slow, Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” It’s a corollary to optimism bias and self-serving bias. Most of us overrate our own capacities and exaggerate our abilities to shape the future.  The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.  It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect.  It’s why the results we achieve aren’t as good as we expect.
6. Choice Paralysis. Intuitively, the more choices we have the better.  However, the sad truth is that too many choices can lead to decision paralysis due to information overload.  For example, participation in 401(k) plans among employees decreases as the number of investable funds offered increases. We are readily paralyzed by too many choices.
7. Herding. We all run in herds — large or small, bullish or bearish.  Institutions herd even more than individuals in that investments chosen by one institution predict the investment choices of other institutions by a remarkable degree.  Even hedge funds seem to buy and sell the same stocks, at the same time, and track each other’s investment strategies. That affinity fraud  (e.g., Bernie Madoff fleeced the Jewish community to which he belonged) is so common is definitive evidence of herding.
8. We Prefer Stories to Analysis.  As noted above, narratives are crucial to how we make sense of reality.  They help us to explain, understand and interpret the world around us.  They also give us a frame of reference we can use to remember the concepts we take them to represent.  Perhaps most significantly, we inherently prefer narrative to data — often to the detriment of our understanding.  Keeping one’s analysis and interpretation of the data reasonably objective – since analysis and interpretation are required for data to be actionable – is really, really hard even in the best of circumstances. A corollary to this problem and to confirmation bias is what Nassim Taleb calls the “narrative fallacy” — looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen.
9. Recency Bias. We are all prone to recency bias, meaning that we tend to extrapolate recent events into the future indefinitely. As reported by Bespoke, Bloomberg surveys market strategists on a weekly basis and asks for their recommended portfolio weightings of stocks, bonds and cash.  The peak recommended stock weighting came just after the peak of the internet bubble in early 2001 while the lowest recommended weighting came just after the lows of the financial crisis. That’s recency bias.
10. The Bias Blind-Spot. I have written many times about the cognitive biases which plague us and make it difficult for us to make good choices, including (obviously) here.  Knowing about them is imperative if we are going to deal with them.  We would always be wise to factor in these biases when performing analysis and making decisions. Unfortunately, we all tend to share a “bias blind spot” — the inability to recognize that we suffer from the same cognitive distortions that plague other people. Here is a wonderful (both hysterically funny and achingly sad) example.

Investors’ 10 Most Common Behavioral Biases | Above the Market.

The so-called “fiscal cliff” – a term coined by Federal Reserve Chairman Ben Bernanke – refers to the combination of tax increases and spending cuts scheduled to be implemented automatically in January, 2013 without peremptory Congressional action.  As things stand now, the payroll-tax holiday will end, which means a tax increase for workers of as much as 2% of wages. Income-tax rates will also revert to pre-George W. Bush levels, raising taxes for nearly all taxpayers. Across-the-board cuts in domestic and, particularly, defense spending are triggered as well.  The spending cuts will go into effect because Congress couldn’t reach a deal last year during the debt ceiling crisis to reduce the deficit by at least $1.2 trillion.

If Congress does nothing, the good news is that these three factors will likely drive the budget deficit to less than 1 percent of GDP by 2018 and then stay below that level through 2022, at which point demographics and health care cost issues lead it to start rising again.  The bad news is that these same three factors will be a major drag on an already weak economy, triggering a recession and the loss of about 2 million jobs, according to a Congressional Budget Office report issued in August.

Both presidential campaigns have been largely silent on the matter, in large part because few voters will like the plausible solutions. “The silence from both presidential campaigns and the Congress of the United States has been thunderous on this question,” says William Galston, a senior fellow at the Brookings Institution. “Nobody wants to talk about it because all of the choices are so difficult.”  The only (partial) mention of the issue during the presidential debates came during the final debate on Monday night when Governor Romney criticized half of the “sequester” – cuts to defense spending – while President Obama, in a surprise move, simply declared that the sequester “will not happen.”

Let’s hope he’s right.  But 74 percent of voters say neither candidate has done enough to inform the public about his plan for the fiscal cliff, according to a poll released last week by Center Forward.  And the consequences of any failure to cut a deal could be enormous.  Indeed, few people have made money betting against the stupidity of Congress.

Most experts expect that the sudden rise in taxes coupled with the significant spending cuts that characterize the fiscal cliff will have a harsh impact on an already struggling economy.  According to J.P. Morgan economist Michael Feroli, $280 billion would be pulled out of the economy by the sun-setting of the Bush tax cuts; $125 million from the expiration of the Obama payroll-tax holiday; $40 million from the expiration of emergency unemployment benefits; and $98 billion from Budget Control Act spending cuts.  In all, the tax increases and spending cuts make up about 3.5% of GDP, with the Bush tax cuts making up about half of that.

The CBO isn’t quite so negative.  Back in August, the CBO predicted that the pain would be short-lived and relatively mild pain. The U.S. economy would go into a shallow recession in the first half of 2013 — shrinking about 0.5 percent over the year — before roaring back. According to CBO, the economy would then grow at a rapid clip of 4.3 percent per year between 2014 and 2017. As a bonus, America’s short-term deficit problem would mostly vanish.

However, in Europe, heavy austerity seems to have crippled growth in countries like Spain and Greece. The International Monetary Fund recently released a report conceding that tax hikes and spending cuts can inflict far more damage on weak economies than previously thought.  Moreover, this report from the Levy Economics Institute called into question the CBO’s forecast that the U.S. economy can get back to full potential by 2018 even if we go over the fiscal cliff. It argues that there’s no way to make the numbers work unless you assume that U.S. households are about to go on an unprecedented borrowing binge.  Since every indicator suggests that U.S. households are actually rushing to pay down their debts right now, the CBO forecast appears dangerously optimistic.

Fed Chairman Bernanke has warned about the potential impact of the fiscal cliff. He gave a speech on the economy earlier this month and asked Congress to address the issue, albeit not yet.  Earlier this year Bernanke stated that “there is absolutely no chance that the Federal Reserve would be able to have the ability whatsoever to offset that effect on the economy.” The Fed, in the minutes of its April meeting, said that if lawmakers don’t reach agreement on a plan for the federal budget, “a sharp fiscal tightening could occur at the start of 2013.” Uncertainty related to the fiscal cliff “could lead businesses to defer hiring and investment” and weigh on economic sentiment, officials worried at the meeting. Agreement on a long-term plan could alleviate some of that uncertainty.

Former CBO Office Director Doug Elmendorf argues that fear of the fiscal cliff is already imperiling growth and Moody’s Investor Service warns that in the absence of policies that “produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term” they may downgrade the rating on U.S. sovereign debt.  BlackRock, the world’s largest money management firm, has warned that if a solution is not crafted, it may even be time for investors to head for the exits and turn to emerging markets instead.

On the other hand, a resolution of the fiscal cliff – which would likely include at least a partial extension of the Bush tax cuts, a patch on the Alternative Minimum Tax and extended unemployment benefits – could result in a significant market rally.  If such a resolution happens along with better Chinese growth than expected and no further disasters in the European debt crisis, the market upswing could be surprisingly strong.

Most experts assume that the U.S. would not be so foolish as to pull a “Thelma and Louise” and drive off the fiscal cliff.  Politicians in Washington, Wall Street assumes, won’t be that stupid, self-destructive and shortsighted as to let that combination of the expiration of the Bush tax cuts, the end of the reduction in Social Security taxes and the imposition of automatic budget cuts send the U.S. economy back into recession.

We can only hope.

The Fiscal Cliff | Above the Market.