Essential InSights

Core Topics for the Everyday Investor

Definitions: Equity

Definitions: Equity

The term Equity represents any ownership rights over an asset’s cash flow generation potential. As an asset class, there is no guarantee of a return on your investment, it is the most speculative of assets classes and is the only asset class that can have its intrinsic value brought to zero. But because it is ownership without end, and a right to the value in perpetuity, it is also the source of the greatest returns. The math looks like this:

\[Equity = Total Assets-Total Liabilities\]

The most common sources of Equity are stocks, your home, and other real estate assets. But equities can also include ownership in a business through your own formation, or as the result of a private placement and they also include art, royalty agreements, or leasing agreements. 

Other terms for Equity are shareholder value, book value, or stake.

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Definitions: Fixed Income

Fixed Income (or debt) represents your ownership over the repayment of a debt. Usually considered bonds, they are contracts promising the repayment of loaned money. Other forms of debt arrangements include Mortgage-Backed Securities, liens, loans, and CDs. Fixed income is called that because the return is decided on the outset – so the return is fixed from the initial offering. Because the upside is fixed from the start, the change in their pricing is less dramatic. Thus, fixed income pricing becomes less about the asset itself, and more about the prevailing rates for other options (read “current interest rate environment”). Debt is usually priced based on three variables, 1) How likely you are going to get your debt repaid, who owes the borrowed money, and what is the way they will pay it back? (Taxation, revenue, etc.) 2) how long until you are repaid your initial investment, this is called duration and indicates how long the money is at risk for. 3) the rate that the debtor is paying on the borrowed sum, usually expressed percentage as a coupon or yield. There are subcategories based on who the entity requesting the money fall into: Muni’s  – a Districts or Municipalities Debt. Usually issued to fund special projects, schools, or city and municipal improvements. In addition to the yield, these are priced for risk based on cities’ credit history, the source they plan to repay the loan (taxation or toll-based), and any available insurance they put on the bonds. Treasuries – the sovereign debt of a country. This is debt usually supported by the taxing authority of a country and its ability to create (fiat) the money they need. This is priced based on the credit rating of the country, the outlook of its currency, and the yield. Corporate – debt issued by companies and priced based on their creditworthiness. These are divided into investment grade and non-investment grade (called affectionately “high yield”) and then subdivided further. Certified Deposits (CD’s) – debt issued by banks. These are usually issued in small increments and for a short duration. The returns are insured by the FDIC (federal government) Mortgages (MBS) – These are backed by the creditworthiness of the borrower, and usually the risk is mitigated by grouping a pool of mortgages into tranches based on their collective credit rating. Collateralized Debt Obligations (CLOs) – Similar to the mortgages, this is a collection of debts that secure equipment or are backed by specialty financial arrangements.  Often backed by the repossession of accounts receivable or equipment.  

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Definitions: Asset Allocation

Asset Allocation is how we discuss the percent of assets in one of the four main asset classes. It is the balance of risk and reward and is the most reliable leading indicator of the intermediate and long term trajectory of a portfolio. The Asset Allocation is the first place we can adjust to a client individual’s goals, risk tolerance, and investment horizon. Asset allocation is often displayed as a pie chart and discussed in terms of the ratio. For example, the “60/40” is a shorthand reference to a portfolio that is 60% allocated to equities, and 40% to debt. These are used by many firms to place clients into a suitable collection of investments. The four assets classes we define in Asset Allocation are Equity, Fixed Income, Cash, and Precious metals.

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Investment Bias: Framing

Framing effect is the use of language to frame a question in a positive or negative way. Stating the same question with the right spin allows the inquirer to impart some direction on the inquired. A great example of this: Would you rather: Approve the 20% chance of killing 100 patients. Approve the 80% chance of saving 400 patients. These might be two consequences of the same decision, but they frame in a way the bleeds an emotional context into an otherwise utilitarian calculation. For investors, framing is often used to manipulate a person’s relationship to risk.  Would you rather own a 99% chance to have a 10% upside, or a 1% change to lose everything. People are more likely to spend a smaller amount of money several times, then say a large sum of money once. By framing the total costs as being something smaller, more people are likely to buy it. A great example of this is your subscription services. Very few people will sign on to a Netflix or Hulu subscription for $150/year, but have little to no problem paying $13/mo despite the irrationality. We see this routinely when a stock splits, investors unwilling to buy a single share at $1,000 have no problem buying 10 shares at $100. Framing can often be used to contaminate an investors relationship with risk. They will routinely buy and sell shares based on how the risk is framed. In fact, many investors will disproportionately reward high risk companies, higher valuations as a result of framing.

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