Broker Check

How Many Legs Does a Dog Have?

September 27, 2019

Abraham Lincoln once posed the following question, along with providing an answer to it:
“How many legs does a dog have if you count the tail as a leg? Four. Counting a tail as a leg doesn’t make it a leg.”

Recently, I was reading an article in which the author posited that current accounting for public companies overvalues some assets, like derivatives, and discounts the potential liability of others, like stock options. He quoted Lincoln, as a way of illustrating his point.

The author was Warren Buffet’s partner, Charlie Munger. Having made billions of dollars in the stock market over the past half century – and given much of it away to charity – I suppose he would have some pretty good insight on this issue.

The overarching principle of Munger’s discussion on this topic was not actually bad accounting per se, but the incentive structure he saw as the root cause of suboptimal accounting.

Munger quoted an old German expression, “Who’s bread I eat, his song I sing.”

In other words, Munger contends that accounting firms endeavor to work for big corporations, because that is good for them. Therefore, they are incentivized, to some extent at least, to offer the most optimistic appraisal of the corporations’ assets and liabilities. At least that is his reasoning.

After all, if a Fortune 500 company, or any other company, does not like the valuation it has received from its professionals, it can always fire them and hire new ones; like a firm amenable to viewing their balance sheet through a more favorable prism.

Corporations are not perfect entities. They are comprised of people. People are imperfect and so is their decision making. And people can and often do skew decisions toward what they believe will benefit them.

Perhaps a better valuation might mean larger executive bonuses. Maybe it could lead to a higher stock price which could benefit folks financially and psychologically. Furthermore, management could be operating under the pressure of some performance benchmark.

Conceivably, some or all of these factors, and others, could be working simultaneously. If I followed Munger’s logic correctly, because the incentive structure is suboptimal, it might lead management to subpar decisions. He believes those decisions could one day result in losses for stockholders (Munger and Buffet being among them.)

This got me thinking about a “tail” that many people, perhaps even most people, continually count as a “leg” in their personal finances. That is, their retirement account balances.

I work to gain as much relevant information as possible from my clients in order to best help them when it comes to their financial planning. We go through a series of questions, so I get to understand the financial lay of their land, so to speak. Interestingly, often this process, by itself, opens their eyes to things they might be able to improve upon.

At this point in my career, I have done many such question and answer sessions with my clients. Tellingly, I rarely encounter the individual who tells me about their 401(k), 403(b) IRA balance(s) and adds something like “Please make sure to discount the money in those vehicles for the inevitable taxes I will need to pay. Cut what I have in half, just to be on the safe side.”

Why don’t they take taxes, which can be substantial, into consideration when valuing these assets? Certainly, it is not because people do not know that these vehicles represent tax postponements rather than tax savings. I can say that because I ask the people I work with if they know how their money will be taxed at withdrawal. The people I have spoken with know. I think they do not adjust for taxes because they all want to believe they are in a better position financially than they are. Once upon a time, I thought similarly.

My experience has held true, even with people most folks would consider wealthy. I think it is because we all want to believe in the best possible scenario when it comes to our finances – and other things for that matter – even when we adopt a mindset that is tantamount to willful blindness.

Lamentably, distorted beliefs will not help us reach our goals and live our dreams.

Let us happily take an honest view of our present circumstances. If after doing so, we feel somewhat less secure, great! We can work toward remedying that with planning and action.

Let us endeavor to see our reality as it is and work to make it even better. This is certainly a better option than living in a fool’s paradise. If you like, work with a financial planner you trust to help you make this happen.

Scott R. McGimpsey September 27th, 2019

This material was prepared by Scott McGimpsey and does not necessarily represent the views of the presenting party, nor their affiliates. All information is believed to be from reliable sources, however, we make no representation as to its completeness or accuracy. Neither Summit Brokerage Services Inc. nor Scott McGimpsey is engaged in rendering legal, accounting, or other professionally services. If such assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any federal, state, or municipal tax penalty. Moreover, a diversified portfolio does not assure a profit or assure protection against loss in a declining market. UNIFIED PLANNING GROUP is an independent firm with securities offered through Summit Brokerage Services Inc., Member FINRA, SIPC