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!

The Fractional Reserve Banking system in theory and practice, and arguments for and against it being used

Author: Ken L. White

The fractional reserve free banking (FRFB) system came into existence following the

realisation that not all bank deposits needed to be repaid simultaneously. Individuals or

firms that deposit money at a bank receive a deposit account, which is a liability to the bank

on their balance sheet. With these deposits, banks could lend out the money to individuals

charging interest from lenders and paying interest to and depositors.


Legally banks have authorized to provide loans that exceed the deposits it holds by a certain

multiple because it is accepted that depositors will not withdraw at the same time. The

loans that it gives out in theory come back to the bank and they can do the process again. In

contrast to other goods and services, money is not used up in consumption or production; its

ultimate use lies in the fact that it is exchanged for other goods (Davidson 2012 pp. 198).

Central banks set and regulate the reserve ratios and hold some of the commercial banks

deposits as security against the possibility of bank runs. In the case of providing confidence

to depositors, central banks insure deposits (insurance) and are a lender of last resort to

commercial banks in the event of a bank run.


FRFB was seen as a monetary and a fiscal framework for economic stability (Warburton

1952 pp. 523). There is constant debate within the Austrian School of economics as to

whether FRFB should be allowed to take place. Many have argued for the benefits of this pre

and post 2008, and the evidence provided by all parties must be analysed.


The Austrian School economists prefer a gold standard (all bank issued media fully backed

by gold) to one where banks can generate redeemable IOU’s (Selgin 2000 pp. 93). Selgin and

White (1996) argued for fractional reserve banking; however are not defenders of fiat money.

Economist like Rothbard have long argues that FRFB is inherently fraudulent (Selgin 1996

pp. 86).


Many critics condemn FRFB for three main reasons, firstly, the practice is inherently

fraudulent and it only survived because of banker’s dishonesty or government mandated

deposit insurance (Selgin 2000 pp.94).

 Secondly, critics of FRFB say that under a gold standard, any bank created exchange media

not backed by gold will fuel the business cycle. In issuing spendable IOU’s to borrowers,

banks reduce interest rates below their natural levels, promoting investment at the expense

of other producers and consumers who find themselves bidding against bank borrowers for

scarce resources. The bidding war forces up prices and interest rates, restoring the purchasing

power of the money stock to its pre-expansion level. However, when this happens resources

would have already been allocated to unsustainable projects, given the amount of voluntary

savings available from the public (Selgin 2000 pp.94).

“The collapse of unsustainable projects (subprime mortgages), followed by the consequent

restoration of a pattern of resource use something like the pattern that proceeded the issue

of fiduciary media, marks the bust and recovery stages of the business cycle” (Selgin 2000

pp.94).


Thirdly, FRFB is vulnerable to bank runs when their customers lose confidence in them,

such as in Cyprus after a proposed bailout charge on savers. Fractional reserve banks by

definition are not able to meet the demand of its depositors at a given time (Selgin 2000

pp.94). Confidence plays a great role in the banking system, as we will see later.

My belief is that most individuals are blissfully unaware of the fact that their deposits are not

backed one hundred per cent by reserves; however, with the payment of interest on accounts,

they can figure out why they are being paid for the bank to safeguard their holdings.

Borrowers, such as those who took out subprime mortgages in 2008 were to me unaware that

in an efficient, non-FRFB system, the money that savers deposited would not be available to

them.


Economists who have critiqued the FRFB system have been looking at the fraud issue from

the banks perspective, however most of my analysis will be focused on the system’s ability to

affect economic growth and the reasons HSBC faired out better than its contemporaries since

the crisis.

The ability of the banking sector to affect the business cycle, not only domestically, but also

internationally was evident in 2008 driven by continuous globalisation and the expansion of

financial institutions.  Additions to the money stock are able to aggravate the business cycle.

However, this is dependent on whether there is a pre-existing increase in the public’s demand

for money at the going rate.

Austrian Business cycle tells us that if the expansion of supply of money creates an overall

excess of money, people will spend the excess (Selgin 2000 pp.97). This increased spending

will not be offset by a reduction of spending of other individuals and this stimulation to

overall demand for goods and services together with the pattern of spending prompted by an

artificially low interest rate will have adverse business cycle consequences described by the

Austrian theory (Selgin 2000 pp.97).

Investment traps that could reduce earnings potential

Author: Ken L. White

After questions from individual investors for general advice on their investments, I have formulated some basic traps that could get them into trouble.

This applies to you if you are a speculative investor, a high net-worth individual,  have a defined contribution pension, are saving to send your kids to university or you just have a small amount of money to play with. There are some simple traps that you can avoid that will benefit your returns. 



1. Focusing on the Short-Term   

There is a tendency to fixate yourself on the latest hot trend in the market where there seems to be continuous growth (invest in technology stock in 1999). There was extraordinary growth in the technology sector from 1996-2000, this was expected to continue almost indefinitely by investors. However, the tech bubble burst leaving many investors to lose almost half of their wealth because their focus was on the short term. 

This applies to you the investor in many ways; you can avoid this by creating an investment policy statement (IPS). This is very important to all individual investors because it enforces logical, disciplined investment decision making, and it limits the temptation to make counter-productive changes to an investment programme during periods of market stress. 

Before you choose an investment, ask yourself: what is your attitude to risk? Would you be happy to hold it for the long-term? Do you think the shares represent fair value? Are there other overlooked areas which may offer better long term opportunity?


2. Putting your eggs in one basket

When creating your investment portfolio, consider that if all your assets are in a specific asset class, you are open to all the risks associated with that sector. This was the strategy used by many in the UK in the 90's and 00's where they allocated all their resources to purchasing real estate. When the housing bubble burst, they held limited portfolios and saw their wealth drop dramatically. 

Investors who took a more diversified approach would have seen a far smaller impact on their portfolio. Having a well-diversified portfolio is a key way to reduce risk.


3. Holding over-diversified portfolios


Just as holding an under-diversified portfolio is damaging, over-diversifying is dually as detrimental to an investors returns. Building a portfolio of similar stocks, earning similar returns is damaging because the rate of return for the sum of the capital would mean higher earnings if you invested it all in one stock. 

A more effective approach may be to focus on a handful of favourite fund managers investing in different areas of the market. This would provide you with a framework for limiting the risk associated with undiversified portfolios as well as increasing returns from not over-diversifying.


4. Paying too many charges


After creating an investment portfolio that brings you a value close to that of your expected return, it is counter productive to have fees and charges that reduce or eliminate the returns you achieved in the first place. 

Consider two funds, each delivering a return of 10% a year, but one with an annual charge of 1.5%, and the other with an annual charge of 1%. If you invested £10,000 in each:

• The fund with the lower annual charge would be worth £56,044 after 20 years
• The fund with the 1.5% annual charge would be worth £51,120 – or £4,924 less.

Keeping costs to an absolute minimum could mean thousands of pounds more added to the value of your investments over the long term. We can help you keep costs to a minimum by rebating part of the annual charges you pay on funds through our loyalty bonus service.

5. Not knowing your risk preference

It is interesting that many individuals do not consider risk as important as reward when creating their portfolios. If a stock gives you a return close to that of Treasury securities, it should be very close to the risk free rate of return associated with these securities. 

Your risk preference should be clear and understood; if you are a retired individual, purchasing and holding a risky portfolio, that determines all your possible consumption may not be the best idea. If you want a high rate of return, you should be aware that you are agreeing with the risk associated with this high expected return. 

There are also two phrases that all investors should know Ex Post and Ex Ante. The expected rate of return is ex ante meaning before the fact, whereas ex post means after the fact. When you are investing in assets you should be aware that very few if any are risk free and treat them accordingly. 

Ask yourself 'Can I really get a 10% return from this stock when the average rate of return in similar stocks is 3%?'. The only way to justify this higher expected rate of return is if you as an investor assumes considerably more risk than in vesting in the stock with the lower return. 

These are just five of the investment traps you could fall into. If you need any advice on other traps, just comment below. Let the conversation begin!!!!


Questions

1. What are some of the charges that you pay that reduce your overall earnings?

2. How have you reduced some of these fees/charges?