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Core Topics for the Everyday Investor

Investment Bias: Mental Accounting

Investment Bias: Mental Accounting

Mental accounting occurs when a person views various sources of money as being different from others. This looks different for different people, but a few examples are money earned at a job may be viewed differently than money from an inheritance, or money as income from stocks different from income at work.  This affects the way the money is saved, spent, or invested. The partitioning of money as different from other money allows us to create new rules for it. Money “won” is more easily spent, then money “earned.” This is the root of the bias, that the source of money changes its inherent value. 

Mental accounting shows up all too frequently in  investor portfolios. People construct  emotional connections to cash flow, or stocks in ways beyond their inherent value. Clients have held onto a position because it was staked by family members and this was a gift to them they wanted to remember. Thereby creating the falsehood that some money is more emotionally important than others. Another common mistake is when people have employee stock purchase plans to buy company stock. As owners they feel more loyal to the company even if it’s a bad investment.

By creating the ‘new rules’ for a set of money, we allow ourselves the space to improperly discount an expected return. Clients have often said, “I’m willing to take on more risk with my inherited money than I am with my 401(k).”  This belief that money is distinct and separate is irrational and allows not only for an improper calculus of the risk, but also creates the space for more severe biases to enshrine themselves in the investment methodology.

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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: 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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