Investments

Investments

Mental Accounting and Other Cognitive Biases

By Echo Huang, CFA, CFP®, CPA

Imagine that you decide to go to see a new movie.  You hand the cashier at the counter a twenty dollar bill. She gives you back a ten dollar bill and a ten dollar ticket. But when you get to the theater door, you realize you don't know where your ticket is. It's just lost. Do you think you'd pay ten dollars for a new ticket, or would you just head home? If you're like most people, you might be tempted to head home. In fact, when the psychologists Kahneman and Tversky presented this problem to college students, fifty-four percent of people said they'd probably just head back home. 

But now imagine a different scenario. This time, you hand the cashier at the counter twenty dollars. This time, she gives you back two ten dollar bills, so that you can easily pay ten dollars at the door to get in. But when you get to the door, you realize that you can only find one of the ten dollar bills. The other one's not in your purse or your pocket. It's just lost. Would you pay ten dollars for the movie or just head home? if you're like most people, you'd probably still go see the movie. In fact, when Kahneman and Tversky presented this problem to college students, eighty-eight percent of people said they'd probably go to the movie anyway. 

The different responses to these cases illustrate a bias known as "mental accounting."  Mental accounting bias is an information-processing bias in which people treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.  Mental accounts are based on such arbitrary classifications as the source of the money (salary, bonus, inheritance, gambling or business profit) or the planned use of the money (leisure, necessities).  

Overcoming Six Emotional Biases to Have a Successful Investing Experience

By Echo Huang, CFA, CFP®, CPA

A recent study by DALBAR, a financial research firm, has confirmed that investors who try to time the stock market often dive into the market at the top and flee at the bottom. This fact has actually caused investor results to significantly lag the broader markets over the long haul. 

DALBAR's most recent study shows that over the last 20 years, through December 31, 2017, the S&P 500 has produced an average annual return of 7.20%. However, over that same period, the average equity fund investor has earned only 5.29%. Bloomberg Barclays US Aggregate Bond Index has produced an average annual return of 4.98%.  However, over the same period, the average fixed-income fund investor has earned only 0.44%. 

Most of traditional economic and financial theory is based on the assumption that individuals will act rationally and consider all available information in their decision-making process, and that markets are efficient.  Behavioral finance challenges these assumptions and explores how individuals and markets actually behave.  

Emotional biases are related to feelings, perceptions, or beliefs about elements, objects, or the relations between them, and can be a function of reality or of the imagination.  In the world of investing, emotions sometimes cause investors to make suboptimal decisions.

Cognitive errors, in fact, are more easily corrected than emotional biases.  Cognitive errors stem from faulty reasoning, therefore better information, education and advice can often correct for them.  Most cognitive biases can be “moderated” - to moderate the impact of bias is to recognize it and attempt to reduce or even eliminate it within the individual.

In this post, we'll examine the six key emotional biases, the consequences of the bias, and offer guidance on detecting and overcoming the bias.  The first step is to be aware that these biases exist and then take actions to overcome them in order to have a successful investing experience.

  1. Endowment bias is an emotional bias in which people value an asset more when they hold rights to it than when they do not.  Investors may irrationally hold on to securities they already own, a bias particularly true regarding their inherited investments.  An investor may hold an inherited municipal bond portfolio due to their emotional attachment, when a more aggressive asset mix may be more appropriate.  

Should I Change My Asset Allocation When I'm About to Retire?

By Echo Huang, CFA, CFP, CPA

It takes years to accumulate and grow your nest egg with disciplined saving and investing to an amount where you finally feel comfortable hanging up your spurs and starting the next phase of your life, Retirement.  Now you are about to start ticking off the items on your bucket list; perhaps traveling with family to amazing destinations, pursuing your passion in music or the arts or volunteering with some non-profit organizations. Your portfolio, on the other hand, must continue to work hard for you in order to last at least your lifetime, and that can be 30 years or more.  

In this post, I would like to share what I think you should consider to review your portfolio and make adjustments as needed.

Although it's hard to go very wrong with a simple 50% stock/50% bond mix, there aren't any one-size-fits-all asset allocations for retirement portfolios. An individual's age, retirement income such as social security and pension income, withdrawal rate, and risk profile, among other factors, can all dictate higher or lower equity or bond weightings.  

  1. Allocation to Equity (stocks).  Assume that you have an average appetite for risk, you can take your age, subtract from 110 to determine how much of your portfolio should remain in stocks.  For example, if you are age 65, then allocate 45% to equity and 55% to bonds and cash. If you have longevity gene in your family history and your personal life expectancy is over age 90, consider using 120 instead of 110 to calculate your equity allocation.  As a general rule, you don't want to have too much money tied up in cash, and while you most definitely need an emerging fund going into retirement, that money should be in its own separate account.

Why Invest in Bonds?

By Echo Huang, CFA, CFP®, CPA

In the year 2017, the US Bonds’ return was just 3.54%, much lower than stock market returns. Globally, stock market returns were great in 2017: US Stocks (measured by S&P 500 Index) 21.83%, International Stocks (measured by MSCI EAFE Index) 25.03% and Emerging Market Stocks (measured by MSCI Emerging Markets) 37.28%. Bonds, they say, are a pretty boring asset class. The stock market is far more exciting. That’s where the biggest returns are found and it’s also the segment that the financial media tends to focus on.

Bonds have been out of favor for several years, with low interest rates not seen for several decades resulting in tiny yields. Why should you invest in bonds at all?

Should You Invest in Bitcoin?

By Echo Huang, CPA, CFP®, CFA

In the past year myriad stories of how some people have become super rich by buying Bitcoin have been circulating on the internet. Even my ballroom dance instructor asked me last December if I had been investing in Bitcoin and when it would be the right time to get in. With all the hype, do you feel you may be missing out if you don’t own bitcoins? Should you invest in Bitcoin?

Before you make a decision to invest in Bitcoin, it is critical to understand what it is and how to evaluate the price of Bitcoin along with its potential risks and returns.

Alternative Fixed Income Strategies in a Rising Interest Rate Environment

By Echo Huang, CPA, CFP®, CFA

After a long wait, the Fed finally did raise the federal funds rate by 0.25% last month.  You may not have noticed the impact in your financial statements yet, but investing in fixed income is becoming more challenging, because traditional bonds with fixed coupons or longer maturities typically recede in price as interest rates rise.  Bonds have performed well in the past decade but even they may struggle to deliver the total return you expect over the next few years.  So what can you do to reduce the interest risk in your portfolio?

Hedged Equity Strategy - Targeting A Smoother Ride for Equity Investors

By Echo Huang, CPA, CFP®, CFA

As the US stock markets have done well for the past 8 years, many investors wonder if their portfolios are positioned well for potential market corrections.  Though it is impossible to predict the future, expecting volatility in the coming years is a safe bet.  Market volatility is normal, and feeling uneasy about a lower portfolio value is normal too.  Historical analysis shows that pullbacks of 5% have occurred about once a quarter, and pullbacks of 10% are likely to occur once per year.  Large pullbacks greater than 20% tend to occur just once per market cycle.  It is especially important to be mindful about how to dampen portfolio volatility in the later stages of the business cycle.

With the memories of large losses in stock markets in year 2008 when S&P 500 Index lost 38%, many investors feel like allocating more to bonds and cash now to reduce volatility of portfolios.  However, while bonds are part of a diversified portfolio, bonds are not paying much interest and the value of bonds tend to go down as interest rates are likely to increase in the future.  Money market funds are earning less than 1% and are not likely to provide returns exceeding inflation.  At Echo Wealth Management, we have considered various alternative strategies to reduce equity risk and have implemented three equity alternative strategies in our client portfolios.

What Are Your Portfolio Performance Expectations?

In the story of Alice in Wonderland, Alice arrives at a fork in the road and wonders aloud which road to take. A smiling Cheshire Cat appears and asks her what her destination is, to which she replies, “I don’t know.” The toothy cat then proffers the only possible response, “Well, then it doesn’t matter.”

While it’s not the type of exchange that might actually occur in our lives, it should, especially as we consider our financial future. For many people, who have yet to clearly define their financial destination, it probably doesn’t matter to them which path they choose, if they choose a path at all. That may be one way to explain why many Americans are not on track to meeting their retirement goals, or worse, why most couldn’t tell you where they stand today in relation to their goals.

2016 Could Be a Bumpy Ride

The Start-of-the Year Selloff Reflected Fear More than Fundamentals

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In 2016, greater risks on a number of fronts are likely to increase the frequency and magnitude of volatility spikes for investors. 

Understanding Investment Risk

All investors – be they conservative, moderate or aggressive – need to understand that the level of returns they expect to generate is directly related to the amount of risk they are willing to assume – the higher the return, the higher the amount of risk one needs to take. It probably doesn’t dawn on most people that, regardless of where you put your money, you assume some element of risk. For instance, if you focus solely on keeping your money safe from the possibility of loss, you risk not accumulating enough money to meet your goal. In this case, trying to avoid “market risk” increases your exposure to other types of risk, such as “inflation risk” or “longevity risk.”

Essentially, you need risk in order to generate the level of returns you will need to achieve financial independence. However, risks can be managed far more effectively than investment performance. You can’t predict the direction of the financial markets, or which mutual fund will outperform the others; however, you can mitigate risk and even have it work for you through proper asset allocation and portfolio diversification. By including a mix of assets and securities that act as counterweights to one another, a risk aware portfolio can capture returns wherever they might occur while reducing overall portfolio volatility.

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