Essential InSights

Core Topics for the Everyday Investor

Investment Bias: Anchoring

Investment Bias: Anchoring

Everyone has heard a mantra about first impressions and their lasting impact. That works for investors too. Because our brains thrive on recognizing patterns and the relationship one element has with another. This mental phenomena is called anchoring

This want for your brain to resort to a reference point and “work form there” is helpful when trying to process new information. But it’s negative when trying divine the “value” of something. Traditionally investors think of an investment as being good or bad, by looking at the point where they bought it. This is anchoring, and backwards looking. Telling me where you purchased a stock tells me very little about its current value. Anchoring bias is the tendency to rely too heavily on, or anchor to, a past reference or one piece of information when making a decision. In this case, the purchase price. 

Many studies work with anchoring to prove how the mind works. He’s an example:

Take the last two digits of your phone number and answer this questions:

A good bottle of wine should cost how much more or less than those two digits? 

_ Your digits  _ wine bid

The bias has already taken place and caused the brain to focus on the arbitrary number. The impact is done. It should come as no surprise the people with lower phone numbers bid less for the wine as a group, those with higher digits bid more. All come from an arbitrary reference point that contaminates the valuation process. 

This happens a lot in investing, a person buys a stock at $10, and the other person buys the stock at $15, the stock has recently dropped from $25 to $20, the person with a $15 entry is more likely to sell then the person at $10. But both are wrong because they use the purchase price in their valuation. The $10 buys may hold too long, and the $15 buyer may sell too soon, but the valuation of the stock should be determined regardless of the entry. The bias has taken its toll on both investors.

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Other Related Topics:

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: 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: 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: 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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