NetWorthwww.bmonesbittburns.com

Summer 2014

Mind Games: What Behavioural Finance Can Teach You About InvestingInstitutional investors long have had an unofficial rule they call the Odd LotTheory. Its premise is that when small investors (those who purchase investment shares in small lots rather than in multiples of 100) buy, that’s a signal for larger investors (those who buy in multiples of 100 or more) to sell.

Does it hold true?Of course, individual investors can be successful stock pickers. A recent study conducted by Joshua Coval, a professor at Harvard Business School, concluded that one in five individual investors is able to consistently produce above average equity returns. However, the study also found that the vast majority of investors don’t fare as well.

Why do so many individuals underperform the markets over time?

That’s a question that economists and psychologists have been studying for more than three decades. This field of study is called behavioural finance and its goal is to develop a framework to explain why people make the decisions they do about their money. What they’ve discovered is that when it comes to investing, rational choices don’t always apply. What investors know, and what they actually do are often very different.

Mind over moneyAccording to a 2011 study by leading research firm DALBAR, Inc., “Investment results are more dependent on investor behaviour than on fund performance.” The report also showed that most of this underperformance is due to psychological factors that translate into poor timing when it comes to buying and selling investment shares.

So what are these behaviours and what can you do to avoid them? Consider the following:

OverconfidenceOptimism is a great thing to have in life, assuming it’s grounded in reality. Yet many investors overestimate their ability to beat the market, even when they have failed to do so in the past. Overconfidence can keep investors from meeting their goals because they may save or invest too little if they overestimate returns. It can also keep them from learning from their mistakes.

Rather than letting overconfidence derail your long-term plans, experts suggest taking a steadier route to building financial security by adopting a consistent monthly investment plan. Although

In this issue

• Mind Games: What Behavioural Finance Can Teach You About Investing

• Hear the Wedding Bells THEN Give the Gift

• Taxation of Investment Income Earned in Personal Holding Companies

• In Trust we Hold the Family Cottage

About BMO Nesbitt BurnsBMO Nesbitt Burns is one of North America’s leading full-service investment firms. It has been committed to helping clients meet their investment objectives and goals since 1912. Today, BMO Nesbitt Burns is focused on meeting the needs of individual investors through a customized approach to wealth management. Along with our industry leading research, BMO Nesbitt Burns was ranked highest in client loyalty by Ipsos Reid, 2013 Full Service Brokerage Report.* As part of BMO Financial Group, BMO Nesbitt Burns also provides clients with access to one of the broadest selections of wealth management solutions and services available today.

Visit us online at www.bmonesbittburns.com

NetWorth Summer 2014

Mind Games: What Behavioural Finance Can Teach You About Investing continued...

dollar cost averaging doesn’t guarantee a profit and can’t protect against loss in a declining market, it can help you ease into the market, buying more shares when prices are lower and fewer shares when prices are high. Over time, this can help lower the total average cost per share you pay for your investments.

Herd BehaviourRemember the dotcom bubble of the late 1990s, early 2000s? Like many investing fads, the driving force behind this behaviour is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. But as so many investors painfully learned, chasing the herd can be risky. That’s because focusing on short-term performance can hinder your potential long-term success.

The lesson here? Before you jump on the bandwagon, do your homework and remember: Past performance does not guarantee future returns. Understanding what you’re buying and why is essential to making the right decisions for your unique circumstances and long-term investment goals.

Loss AversionBehavioural finance teaches us that as investors, we tend to value gains and losses differently. In fact, some studies suggest that people feel a decline in the value of their investments twice as keenly as they do an increase of the same value. As a result, many investors are more willing to sell their winners than they are to dump a losing investment.

If you recognize loss aversion as part of your behaviour, how do you overcome it? Start by (a) building a broadly diversified mix of investments to help soften the impact of market volatility on your overall portfolio; (b) rebalancing your investments on a regular basis to ensure your portfolio is right for your particular goals, risk tolerance and time frame; and (c) keeping your focus on your overall progress, not the short-term ups and downs of your portfolio.

AnchoringBehaviourists have demonstrated that when it comes to making investment decisions, most people are strongly affected by “anchors,” or points of reference, that may or may not be relevant to the decision at hand. In other words, they tend to embrace information that supports their view rather than seeking information that contradicts it.

The next time you think you have the market figured out, or you think you’ve spotted a portfolio manager who is on a winning streak, step back and look more closely. Are you seeing the markets through your own lens of hopes and projections or are you making decisions based on fundamentals and facts? Remember, successful investors base their decisions on a variety of inputs in order to gain the truest picture possible of an investment’s prospects.

The BMO Wealth Institute provides insights and strategies around wealth planning and financial decisions to better prepare you for a confident financial future. Let’s discuss if you would like to read other interesting reports from the BMO Wealth Institute.

1 Maccaro, James, An Early Approach to Contrarian Investing, Working Money, The Investors’ Magazine, 2011, Working-Money.com 2 DALBAR, Inc. 2011 Quantitative Analysis of Investor Behaviour (QAIB) – Highlights, March 2011, www.dalbar.com

Hear the Wedding Bells THEN Give the Gift

Protection of family assets from the ravages of divorce suffered by their adult children is an important goal of many high net worth individuals’ estate planning. Strategic gifting to adult children can advance this goal. For example, at law, gifts and inheritances received during marriage are (in the right circumstances) excluded from division of property in the event of divorce or death of the recipient. Additionally, a valid marriage agreement may exclude property acquired during marriage from communal division upon divorce or death. Thus, if you are contemplating transferring significant assets

to your adult children, the optimal time frame for such transfers for purposes of asset protection is after the date they marry.

By delaying the gifting until after the date of your child’s marriage, you have engaged the protection of property provided for in family law, with respect to the exclusion of property from equalization claims upon divorce or death. Since the matrimonial home is treated differently at law in that it is not subject to protection from division even if it is gifted after the date of marriage, it is necessary to take further protective measure by way of attaching a Demand Promissory Note to encumber the couple’s matrimonial home. With respect to any other property you may wish to gift to your married child (not associated with the matrimonial home), executing a Deed of Gift can provide the protection you seek, as evidence that the property was not acquired during marriage but rather, received as a gift, during marriage.

Lastly, as referred to above, by entering into a valid marriage contract it is possible to achieve asset protection where exclusion of certain property from communal property division upon divorce or death is desired. It is important to seek professional advice in your jurisdiction before implementing a planning strategy.

NetWorth Summer 2014

Many investors hold investment portfolios in a personal holding company. It is important for these investors to understand the various tax implications of earning investment income through a holding company. Tax considerations can be quite different from owning investments personally, because a corporate structure introduces a number of other considerations.

This article is designed to briefly outline the Canadian tax implications for a Canadian resident individual earning investment income through a personal holding company (PHC). A PHC, often referred to as a “Holdco” or “Investment Holding Company” is not a defined term in the Income Tax Act, but rather a term adopted to define a corporation which holds assets; typically income-generating investment assets. A PHC is usually a Canadian-controlled Private Corporation (CCPC) which is accorded special tax treatment under the Canadian tax legislation, including the refundable tax treatment of investment income described herein.

How is Investment Income Taxed in a PHC?Generally investment income tax rates for a PHC that is a CCPC are similar to the tax rates of an individual in that interest is taxed at the highest rates, capital gains at the lowest rates and Canadian dividends in between (or lower). However, the taxation is somewhat more complicated for a PHC earning investment income than an individual since there are two levels of tax to consider (corporate and personal). Accordingly, an investor earning income in a PHC will primarily be concerned with the aggregate (net) corporate and personal tax liability of earning investment income through a corporate structure, in light of the ‘integration’ principles in the Canadian tax legislation (described below).

Tax “Integration” of Investment Income The concept of integration within the tax legislation for CCPCs seeks to make an investor indifferent (from a tax rate perspective) between earning investment income personally, or indirectly through a PHC. This is a concern since an individual earning investment income directly pays only one level of taxation, whereas someone earning investment income through a corporation will pay tax at two levels (i.e., corporate tax on the investment income earned in the corporation and personal tax on the distribution of the after-tax income to the individual shareholder; which is typically received as a dividend). Integration attempts to equalize the ultimate tax paid in either scenario. Through the use of various corporate tax accounts, such as the Capital Dividend Account (CDA) and Refundable Dividend Tax on Hand (RDTOH), as well as other tax mechanisms (e.g. dividend tax credit, and dividend refund), distributions from a PHC may result in a refund of corporate tax previously paid and/or will be subject to a reduced personal rate of taxation as partial compensation for this high initial corporate tax paid. This integration methodology seeks to equalize the aggregate amount of corporate and personal tax paid in a PHC structure, with the level of tax paid for investment income earned personally that is subject to only one level of taxation.

However, the integration system is imperfect and may break down such that a pre-payment of tax or a tax cost from double-taxation may result; particularly on higher-taxed investment

income. As a result of the higher 2014 tax rates on ineligible dividend income, the tax cost of earning investment income through a PHC has increased for 2014. Depending on the relevant provincial personal and corporate tax rates, this tax cost is generally 3 - 4 percent on interest income, but ranges as high as 6 percent (PEI and Manitoba).

Foreign Investment IncomeIn addition, it is important to note that a higher tax cost may apply to a PHC on foreign investment income that is also subject to foreign withholding tax at source. Although a foreign tax credit (FTC) will generally be available to reduce the Canadian corporate tax otherwise payable, the reduced Canadian tax will also reduce the addition to the refundable tax (RDTOH) account which in turn reduces the (dividend) refund available to the corporation when it pays a taxable dividend to the shareholder. In other words, the RDTOH account is smaller where a FTC has been claimed since the system will not provide a refund for tax that was ultimately not paid to Canada (because of the FTC claimed). Accordingly, the ‘integration’ system breaks down somewhat leading to some inefficiencies which may create a higher tax cost to earning foreign income (subject to foreign withholding tax) through a corporate structure.

However, in reviewing the investment options within your PHC, the additional annual income tax costs of holding US (or other foreign) securities in a PHC should be weighed against the investment benefits of diversification, to the extent that foreign securities are not held in other accounts. If US exposure is desirable, the higher annual income tax costs in a PHC should be weighed against the benefit to Canadians (who are not US citizens) of using a Canadian holding company to shelter US securities from US Estate Tax.

The taxation of holding corporations is complex and the com- mentary provided herein is only of a general nature. Let’s discuss if you would like more information or a copy of our concept sheets entitled “Understanding Personal Holding Companies” and “US Estate Tax for Canadians” and be sure to work with your tax advisor for assistance in your particular situation.

Taxation of Investment Income Earned in Personal Holding Companies

If you are already a client of BMO Nesbitt Burns, please contact your Investment Advisor for more information. The comments included in this publication are not intended to be a definitive analysis of tax applicability or trust and estate law. The comments contained herein are general in nature and professional advice regarding an individual’s particular tax position should be obtained in respect of any person’s specific circumstances. BMO Nesbitt Burns Inc. provides this commentary to clients for informational purposes only. The information contained herein is based on sources that we believe to be reliable, but is not guaranteed by us, may be incomplete or may change without notice. The comments included in this document are general in nature, and professional advice regarding an individual’s particular position should be obtained. ® “BMO (M-bar Roundel symbol)” and “Making Money Make Sense” are registered trade-marks of Bank of Montreal, used under licence. ® “Nesbitt Burns” is a registered trade-mark of BMO Nesbitt Burns Inc. BMO Nesbitt Burns Inc. is a wholly-owned subsidiary of Bank of Montreal.

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7/14

In Trust We Hold the Family CottageYou may be one of many Canadians who know the joy of cottage ownership. You may wish to keep the cottage in your family for generations but you agonize over how the succession of the cottage will occur. There are several strategies which can be employed to deal with the succession of the cottage if it is to stay in the family. One of the strategies involves creating a family trust to hold the family cottage for the benefit of generations to come. The transfer of the cottage to a family trust can occur during your lifetime or after your death.

There are a variety of advantages to holding a cottage in a family trust. For example, although the transfer of the cottage to a trust will trigger an immediate capital gains tax payable (with the exception of a transfer to an Alter Ego or Joint Partner Trust), to you as a taxpayer, future capital gains tax on the property will accrue to the beneficiaries. It is possible to shelter some or all of the gain from tax by applying the principal residence exemption (subject to the 1/2 hectare restriction) to the cottage which is owned by the trust, so long as the beneficiaries actually use the cottage regularly. An additional tax related advantage is that if you transfer your cottage to the family trust during your lifetime, then upon your death the succession of the cottage would be a private matter and, the value of the cottage would not be subject to probate tax. There are a number of non-tax related advantages to holding the cottage in a trust, particularly in circumstances involving a reconstituted family (a “blended family”). In this situation, using a trust allows for the occupation and enjoyment of the cottage by one or more family members, while preserving the capital in the trust, namely, the cottage, for others.

Often the transfer of a cottage to a family trust is accompanied by a co-management agreement or a trust agreement that includes terms of trust which address issues such as:

1. Establish a fund or other structure to pay for maintenance, repairs and improvements.

2. Establish a mechanism for making decisions regarding the property.

3. Assign responsibilities for day-to-day tasks. 4. Set a schedule for alternating use of the property.5. Outline what happens if one owner/beneficiary defaults on

his/her obligations. 6. Establish what happens when an owner/beneficiary dies or

becomes incapacitated.

There are also a variety of disadvantages to holding the cottage in a family trust. One such disadvantage is the rule regarding a deemed disposition of all trust assets every 21 years. While there are strategies to alleviate the effect of this rule such as the application of the principle residence exemption to the taxable gain, or, distribution of the cottage to the capital beneficiaries just prior to the expiry of the 21 years, those strategies may create further complications. For example: If the beneficiaries of the trust own their own homes, applying the principal residence exemption to the disposition of the cottage may jeopardize their ability to use the exemption with respect to the same years of ownership, upon disposition of those homes. Another disadvantage is that in the event of divorce and depending on the circumstances, a beneficiary’s interest in the family trust may be vulnerable to family law claims. Lastly, where the cottage is transferred to a trust during your lifetime, and, depending on the terms of trust, family relations and, who the controlling trustees are, it is possible that you may no longer have access to nor enjoyment of your own cottage, because you no longer own it.

It is important to seek professional advice in your jurisdiction before implementing a planning strategy.

NetWorth Summer 2014