Essential InSights

Core Topics for the Everyday Investor

Investment Bias: Information

Investment Bias: Information

Information bias is the tendency to evaluate useless or the wrong information when determining value. It’s the belief that certain commonly held data points are helpful in understanding the value of an investment, when they may not be. The key in investing is not seeing the forest for the trees, but rather the price of lumber. There is so much information that seems valuable. That is the root of this bias. Similar to the logical fallacy “appeal to authority” the source of information can create its own gravitas and feel like a value. This feeling of value, because of the source of information is the bias.

Investors are bombarded with largely useless information every day. Financial talking heads, newspapers, and stockbrokers, and it is difficult to filter through the collective biases and focus on information that is most relevant. This bias is the “value of valuable information.” One great example is the daily share price or market movements of a stock. This feels like valuable information, but usually contains no information that is relevant to an investor who is concerned about the value of a company. True fundamental valuation should be done without knowing today’s stock price. It honestly shouldn’t matter. Yet there are entire news shows and financial columns dedicated to evaluating movements in share prices on a moment-by-moment basis.

In many instances, investors will make investment decisions to buy or sell an investment on the basis of short-term movements in the share price. This can cause investors to sell wonderful investments due to the fact that the share price has fallen and to buy into bad investments on the basis that the share price has risen. Little about the near term price movements of a stock, commodity, or bond has to do with the value of its cash flow. Ideally, investors would determine the price they are willing to pay for an investment without knowing its current price. Then when confronted with the price it is selling for, only decide if it is above, or below, its value. Investors would make superior investment decisions if they ignored daily share-price movements and focused on their own willingness to pay for income.

Additionally, the Information bias tends to view pieces of information as digital, when it should be analoge. All information is not equally valuable, all the time. Likewise, information is not equally valuable across investments. An example, while the “costs of capital” metric is universally important to value investors, the output from the cost will range from business to business. So while this data point might be a leading indicator of the success of an investment in banks, it’s less valuable for technology companies.

Considering all information as quantitative over qualitative is the equivalent to saying “I’ve listened to ten medical podcasts so why would I listen to my doctor.” This Information bias exists in the belief that all “information is good” and that “all information is equally valuable” causes us to have conclusions that are false or investments that don’t reflect our intentions. Essentially, we are borrowing other people’s biases and creating a consensus of bias.

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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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