Is holding illiquid assets an easier way to save because humans are myopic?

Author: Ken L. White

VS

Myopia

Most people, even savers find spending money an easy task. This is because the physical money we hold in our wallets, safes and banks are the most liquid assets. Humans are more at ease with spending than they are with saving, we are myopic and place more emphasis on short term satisfaction.

Hyperbolic discounting is a time inconsistent model of discounting that the human mind uses when making spend save decisions.

Proposition 1: I offer you £100 today guaranteed or £200 next week with a 95% probability of you getting the money, which would you choose?

Many of you would choose the £100 today because you view this as the higher pay-off, whereas in reality the greater pay-off is (£200*95%)=£190 next week. This basic concept that induces humans to take the lesser pay-off is myopia. In making the decision to take the £100 today you are in effect saying that it is worth more than the 95% chance of the £200 next week, which we calculated to be £190. This is not rational behaviour because we know £100<£190, so why make that decision?

The dangers associated to myopia don't end at my proposition, they are far reaching. Consider a goal of locking away £10000  for 5 years in a fixed rate bond paying 7% pa. If this sum of money is a large percentage of your income it is unlikely that you would be willing to tie it up for that period of time. However, if you had £10000 and could afford to buy a relatively new sports car, this would be an easier proposition. The value of the car in 5 years will be half what you paid for it, but the value of the savings you have in the account would be £11193, or a 12% gain over the period. The short term satisfaction gained from spending on goods drives us to lose out on opportunities to amass wealth.

How to combat myopia

One way to limit the impacts of myopia on your wealth is by holding illiquid assets, this could be precious metals, property, livestock, land, jewellery etcetera.  Having to turn these assets into the physical money we use everyday before being able spend it is a tool that will help you save more. The process of getting your assets to market, getting a fair price for them and completing the transactions is one that allows an investor time to think about their long term goals and hence stop the process, thereby retaining wealth.

My personal favourite for this strategy is to accumulate the money necessary to buy 1 oz. bars of gold then buying one. They usually trade for less than £800, so are easy enough to convert to cash if it is really necessary,  but significant enough for me to not  want to sell one so I can go out on a Friday night and party. Creating these types of strategies are very important to long term wealth creation and maintenance. Another option is to put your money in government or corporate bonds. These should limit some of the urges associated with holding cash.

One the higher end of the scale holding over £80000 in the bank puts an individual at risk because the government insurance only covers up to this amount in bank accounts (you could have £80000 in different account once the banks are not under the same umbrella and the money will still be insured). Instead of holding the cash, converting it into an illiquid asset may help with the negative impacts of heuristics on your personal wealth as well as gaining you higher long term returns than a current account.

The key

The key is to keep what you need to get by as liquid money (coins, notes, bank account) and tie the rest up in illiquid mediums such as those suggested. After repeating this process for an extended period of time you should see a marked change in how you process situations of saving versus spending and therefore this should help you amass more wealth at a faster pace and keep it for longer periods.

Any questions just let me know!

2008 Financial Crisis and who benefited from it

Author: Ken L. White

A bubble in the US housing market precipitated the financial crisis of 2008 and lead to

markets around the world being affected (Soros 2008 FT). There was excess money in the economy 

as a result of an artificially low interest rate and when all the credit worthy borrowers no 

longer demanded the money, financial institutions turned to ones who were able to repay 

loans at the lowered interest rate (riskier borrowers). These sub-prime mortgages would 

have only been the problem of the US if banks did not package the toxic assets with other 

assets and sell them on to third parties around the world. The inability of these third party 

institutions to verify what exactly made up these financial securities was a key factor in how 

high the velocity of trade in these assets was. Returns were dependent on these borrowers 

repaying their loans at the prevailing interest rates, which proved to be impossible due to the 

lines of credit on individuals and firms being restricted leading to massive defaults. 


Under FRFB, the artificially low interest rate attracts individuals who would otherwise be 

unable to borrow; they are able to do so and pay the lower rates once borrowing continues 

by other individuals in the future. This is the (X+r controversy); the banks provide X 

amount of money and require X plus interest. This model is unsustainable unless individuals 

continue borrowing and most of them repay debts. However, game theory tells us that what 

is optimum for an individual is not always socially optimal. The moral hazard problem arises 

when banks know that there is a bailout clause in the form of the government, should they get 

into trouble because the economy and banking system are interconnected. 


The crisis was similar to others that have occurred since world war two; however, it marked 

the end of credit expansion based on the dollar as the international reserve currency (Soros 

2008 FT). Soros (2008) states, “The boom bust process usually revolves around credit and 

always involve a bias or misconception”; this is usually a failure to recognise a reflexive, 

circular connection between willingness to lend and the value of the collateral, highlighting 

the myopic nature of individuals. 


The easy access to credit generated demand for houses that push the property values up, 

leading to more availability of credit. The bubble was created when individuals attempted to 

refinance their mortgages at a profit (Soros 2008 FT). Quantitative easing (QE) allowed the 

process to continue whenever there was trouble in order to stimulate the economy.

Market fundamentalism became popular in the US in the 1980’s; fundamentalists believe that 

markets always tend towards equilibrium. However, without government intervention they 

would not survive, so it was the government, and not the markets themselves that prevented 

the breakdowns.  


It is argued that had the products (securities) not become too complicated to calculate the 

risks associated with them, the financial system would not have crashed as it was the inability 

for objective organizations (government and credit rating agencies) to rate them that lead 

to banks being deceptive. The quantitative easing programme could have continued its 

successful trend of economic stimulation. 


The financial crisis affected the UK’s banking system as a whole. Many of the major 

institutions found themselves in dire need of liquidity in the form of government loans 

(bailouts). The government has a controlling stake in the Royal Bank of Scotland and a 

minority stake in Lloyds banking group resulting from the bailouts provided.

Since 2008

The government has sold some of their stake in Lloyds at below market price and still managed to make a profit. This sale sparked a ‘feeding frenzy’ among investors, only somehow the government managed to prevent some of them from gaining access to what the were providing. So the UK government profited from this investment (bailout of the banks) and those institutional investors  who purchased the shares sold by the government profited from this sale because of arbitrage (under arbitrage you are able to buy at a below market price and instantly make a profit by selling at market price to buyers, while taking on no risk).

The taxpayers who assisted in helping bail out these financial institutions received nothing from this initial sale of shares, however it is anticipated that within the next year more shares in Lloyds held by the government will be sold.

Some other stakeholders have feared off even worse than the investors and the government. These are the individuals who are in receipt of less now than before the crisis because of loss of jobs, inflation eating away at what wealth they do hold, falling house prices (outside London) and pensioners (those whose portfolios comprised of stocks and property).

Questions
1. How have you been impacted by this crisis if you have been living in the UK?
2. How much of your portfolio consisted of stocks (from financial institutions) and what was the capital loss or reduction in wealth faced by selling or holding on to these stocks?
3. Have the lower interest rates had a noticeable favourable impact on your mortgage repayment (if variable) and how long do you expect this to last?

A brief discussion of behavioural finance (biases) and investment

Author: Ken L. White

An introduction to behavioural finance!!!!




Michael Pompian (2006) provides an in depth coverage of behavioural biases that affect
investors and their portfolios and even more importantly, how to manage these biases to the
benefit of the investor. Heuristics or biases are rules of thumb that allow us to deal with
informational deluge (Montier 2007).

Defined by Pompian as ‘the application of psychology to finance’, behavioural finance has
become an increasingly dominant part of investing and investment strategy, especially since
the run up in stock prices in the 1990’s, the dot com bubble and the recent financial crisis.
The human aspect of markets is the reason that bubbles form and burst. Markets would all
clear immediately and prices would reflect all information available if they worked in line with
traditional finance and economics.

Two of the most common biases that investors display are overconfidence and overoptimism
that stem from the illusion of control and the illusion of knowledge (Montier 2007). People
are poorly calibrated in establishing probabilities- events that they are certain to happen are
often less than 100 per cent certain to occur (Pompian 2006). An investor who has a large
amount of historical data on a company and its stock price and performance does not
necessarily make the best decision.

The illusion of knowledge is the tendency of investors to believe the accuracy of their
predictions or forecasts increases with more information (Montier 2007). For investors to
understand the importance of information, a Montier (2007) quote best explains; “The
simple truth is that more information is not necessarily better information; it is what you do
with it, rather than how much you have, that matters” . In analysing the FTSE 100 as a whole
and finding the link between it and the money supply and the index price, it should give
investors a better picture of where their success comes from skill or spurious reasons (their
knowledge and skills or upward or downward trends in the market).

Tests done by Slovic (1973) to assess confidence versus accuracy in relation to bets made
by bookmakers as a function of information sets, shows a relatively constant rate of
accuracy with a smaller information base of five data points. Accuracy also remains at a
similar level with forty data points 15 per cent. On the other hand, confidence at five data
points is around 17.5 per cent, but when the amount of data points increased to forty, it
increased to over 30 per cent. Instead of trying to acquire more information than competitors
do, investors should make better use of the information they have.




The illusion of control refers to people’s belief that they have influence over the outcome of
uncontrollable events (Montier 2007). An example of this is an individual’s willingness to pay
four and a half times more for a lottery ticket that contains numbers they choose rather than
a random draw of numbers (Montier 2007). Here information also plays a major role as the
more of it the investor has the more in control they feel.

Another important bias that investors should be weary of is self-attribution. The significance
of this on portfolio performance is that investors use the bias as one of the key mechanisms
for protecting self-image. Humans have a tendency to attribute positive outcomes to skilful
decision making and negative outcomes with bad luck or chance. Applying this to investor
behaviour, it could be represented by individuals holding on to losers and selling winners
(Shefrin & Statman 1985) meaning their portfolio performs below its optimum.

The opportunity to learn from past mistakes is very important to investor’s future success;
the self-attribution bias is one of the key limitations to investor learning as they do not
recognise mistakes as mistakes.

The anchoring bias mentioned earlier, researched extensively by Tversky and Kahneman
(1974) and highlighted by research asking participants to solve eight factorial (8!), presented
in two different ways gave vastly differing results. The first was 1*2*3*4*5*6*7*8 or second
8*7*6*5*4*3*2*1; the median answer on the first scenario was 512; the median answer on
the second scenario was 2250. So people appear to anchor on the early numbers in forming
expectations; the actual answer is 40, 320 (Montier 2007). This sort of anchoring applied to
investors in the stock market could have drastic consequences with regard to their earnings
potential. A stop loss strategy is an example of a tool that investors could use to limit losses
and combat the anchoring bias.

Northcraft and Neale (1987) highlight anchoring by real estate agents in the housing market;
this goes to show that anchoring bias can affect any asset market. Areily et al. (2003)
highlights the influence that even irrelevant anchors, such as the last two digits of an
individual’s social security number can have on valuing an asset, and the dangers this plays
on their perception of the maximum purchase price they are willing to offer.
If an investor forms his anchor by latching on to the current market price, this can be
hazardous as anchoring has obvious implications for valuations. The degree of anchoring is
heavily influenced by the salience of the anchor. The more seemingly relevant the anchor,
the more people will tend to cling to it (Montier 2007). An example of an anchor that would
lead investors to make losses by holding their position too long is the purchase price or a
previous price high in the share they own





I have not provided a reference page as the authors name and date of the publication should be sufficient for you to find the necessary literature.


Questions

1. Are you aware of any biases that may affect your investment portfolio?

2. Have you been anchored to a position without reasonable merit for doing so?

3. Have you been affected by the self attribution bias in your daily life outside of investing?