Essential InSights

Core Topics for the Everyday Investor

Investment Bias: Illusion of Control

Investment Bias: Illusion of Control

Illusion of Control is the deeply held belief that we can control the otherwise uncontrollable. It is the same behavior that a person shooting dice might exhibit. They will throw it harder, blow on the dice, hand them to a “luckier” proxy, or will them to have a certain result. Regardless of the behaviors of the dice throwers, the results are largely the same. This feeling of control over the randomness of dice is the same investors who feel their ownership can affect an outcome. Let’s define an important distinction here. While the chance of a return or loss can be mitigated through research and due diligence, the belief that you are somehow the catalyst for a result is the bias your mind fabricates. 

Investing is a probabilistic exercise. The variable inputs of mathematical, factual, and economic factors likely improve the conditions for a desired outcome. But they are not deterministic. The Illusion of control can trick you into believing that investing is deterministic, and that some level of expertise can divine the outcome.

The illusion of control causes investors to become overconfident in their decision making process, or to underweight the severity of risk mismeasurement. By entrenching the investor in the belief that somehow their actions may have a wider effect on the market. The illusion of control is likely most prominent when someone “goes to cash” or starts market timing. While some investors have seen a benefit from timing the market, the belief that investors have some success over such behavior is widely disproven. The belief that the impulse to exit the market was proper and prudent, and that behavior may have an effect on the broader market is the same as the biased gambler who believes they can influence the outcome of a dice roll.

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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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