Drop us a line...

Send Message

Talking Finance

It’s my mug

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 30 July 2016.

People are becoming increasingly aware that our emotions and psychological biases play an important role in how we approach investment decisions. The relatively new field of behavioural finance attempts to explain how these biases influence our actions and decisions, usually for the worse unfortunately. Instead of being calm and rational when confronted with complex decisions regarding risk and return, we instead tend to let our base instincts and emotions take over. The end result is generally an unpleasant one from a financial perspective.

One of my favourite psychological biases is called the endowment effect. This is one which most people can relate to and is simple to understand. The endowment effect was illustrated by an experiment conducted by three researchers, Kahneman, Knetsch and Thaler, in 1990. In the experiment a number of volunteers were divided into two groups. The first group were given a coffee mug and told it was theirs to keep. They were then asked what price they would accept to sell the mug. The second group of volunteers weren’t given the mug, but were shown the same mug and asked what price they would offer to buy the mug. As you might expect, the first group who ‘owned’ the mug expected an offer to buy the mug that was on average much higher than the price the second group, who didn’t have a mug, thought was a reasonable price for the mug. Remember, this is the same mug, with a random bunch of volunteers. The only difference was that the first group, the owners of the mug, felt that it was worth much more simply because they owned it. In essence, value is ‘endowed’ on the mug (hence its name, the endowment effect) simply through the act of ownership.

The endowment effect translates very easily to the stock market. If I owned Telstra shares, for example, the endowment effect suggests that I’m likely to think they’re worth more than they really are, or the price that buyers are prepared to pay for them. So instead of selling at an appropriate price, I’m likely to hang on, waiting for my unrealistic price to be reached, which may never happen. And so another bad investment decision gets added to the tally. The emotional feelings associated with ownership have outweighed the rational decision-making process we all like to think we follow. If this has happened to you, don’t feel too bad, you wouldn’t be the first and certainly won’t be the last to feel like a mug.

“*”

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 16 July 2016.

One of the unheralded wonders of the modern world has to be the humble asterisk. You know, this one ‘*’. When you start looking for it, you find it everywhere. Mobile plan and insurance advertisements on television; advertising billboards on the side of the highway; even politician’s promises. Ok I made that last one up, but if there was ever a worthy place for an asterisk it would be at the end of every sentence ever uttered by a politician. Examples include the following: “There will be no carbon tax under the government I lead*” and “…no cuts to education, no cuts to health, no changes to pensions*”. See how much better those sentences read if you include an asterisk? The asterisk immediately alerts you to the fact that what you’ve just read is subject to a bunch of caveats and conditions which essentially render the promise or commitment worthless. No side of politics or politician is blameless in asterisk abuse either; mastery of the asterisk appears to be a mandatory skill for acceptance into parliament.

Unfortunately the finance industry is also prone to asterisk abuse. The industry is fertile ground for making grand statements subject to a bewildering range of conditions. “Earn a guaranteed return of 19%!*” is the type of statement that you frequently see in investment advertising. The asterisk, of course, will tell you that the term ‘guaranteed’ only applies to the timing of the payments, such as, ‘we guarantee to pay you on the 15th of the month, but we make no guarantee that there will be any money to actually pay you’. Another common statement might be “Our growth investment option earned 15% last year*”, where the asterisk tells you that such a return assumes no fees, no taxes, that you invested at the market lows and sold out at the market highs and won the Second Division Powerball lottery and added the winnings to your investment. Seldom can so much be said by just one alphanumeric character, as when you wield the power of the asterisk.

Asterisks cannot be defeated of course, they can only be understood. The presence of an asterisk should be a blaring, flashing, vibrating warning light that you are at risk of being duped. This risk can only be managed by reading the nearly invisible small print which accompanies every asterisk. This is where the truth lies. Where you find out about the fees, costs, impossibilities and improbabilities of the headline statement. Don’t ignore the asterisk, it’s not your friend!*

*Unless of course you want to be a politician

Use the Force, Jack!

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 2 July 2016.

Our kids have recently discovered Star Wars and now spend their days whacking each other on the head with their light sabres while yelling out ‘Use the Force Luke!’ and ‘Feel the Power of the Dark Side!’ I probably didn’t help their Star Wars obsession by buying them each a Stormtrooper mask. It’s quite something when a Stormtrooper wakes you up at 4 in the morning, wielding a flashing light sabre and yelling ‘Daddy I’ve got to do a wee!’ As you would expect of one of the greatest movie stories of all time, Star Wars has a number of investment lessons for prospective investors (and no, mastery of the Force is not going to allow you to know which shares are going to go up before they actually do – I believe that’s part of the Dark Side, is also known as insider trading and comes with a spell at Long Bay Jail).

The first Star Wars investment lesson is this: just like Yoda, great things can come in small sizes. Don’t ignore a company just because it’s small; all big companies started out as small ones. Investing in smaller companies can provide a significant element of growth to your portfolio. Of course, just like Yoda tended to speak in riddles and was maddeningly difficult to understand, small companies can be difficult to accurately assess and value. What price do you put on a two-week old company run by two uni drop-outs from their garage? Sometimes nothing, sometimes it turns out as valuable as Apple or Microsoft. The second Star Wars investment lesson comes from Chewbacca: sometimes the best investment can be a little bit ugly and hairy and you’ve got to scratch beneath the surface to fund the gem within. Sometimes an unloved, unpopular and generally disliked investment can provide the best returns. Being contrarian and not following the herd can yield great results – just be sure that what you’ve found really is Chewbacca and not a cranky bear that wants to bite your nose off.

Finally, an important Star Wars lesson comes from that big slobbery thing known as Jabba the Hutt. He’s the one who freezes Han Solo in carbonite for use as a nice wall hanging, all over an unpaid loan. The message here is this – you may be good-looking and captain the Millennium Falcon, but too much debt can stop you in your tracks as effectively as a collapsed black hole. Watch your debts Luke! One more bonus lesson from Star Wars – if you do buy your kids light sabres, get them the foam ones first, it’ll save a lot of tears that can’t be fixed by any amount of Force.

Let go of the anchor

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 18 June 2016.

In an ideal, theoretical world, human beings are all rational, clear-thinking individuals, able to make perfect decisions and choices every time. The reality however, is very different. We’re an emotional bunch, prone to letting our fears, aspirations and biases override our common-sense. Our emotional biases also unfortunately impact our investment decision-making. One of the most common biases is that of ‘anchoring’. Anchoring is the tendency to erroneously assign too much importance to irrelevant information. For example, you might buy shares in a company for $5. Bad news causes the share price to fall, but you refuse to sell, stating that you’re going to wait until it gets back to $5 before selling. The $5 level is irrelevant, it just happened to be the price at which you bought the shares. It has no relevance at all in regards to the current value of the investment. If you had bought in at $4.50 you would probably use that as your trigger level. Neither figure carries any importance except that which you assign them in your own mind. You’ve become irrationally anchored (or fixated) on a random price and this anchoring is affecting your decision-making. If it’s a poor investment it should be sold, rather than hoping it’ll get back to your break-even.

The problems associated with anchoring are not restricted to just the stock market. Most people have had a conversation with someone who is selling their home who says something along the lines of “…well I paid $400,000 three years ago, so if I can get that back I’ll be happy…” Again, that’s anchoring. The price you paid for your home however many years ago has no bearing on its value today. You should assess the value of your home (or shares) on its merits, with no consideration of what you paid for it. Of course, because we are emotional beings, that’s hard to do. Too easily we entangle our decisions with our emotions. Avoiding the problem of anchoring can be difficult; it’s impossible to just ‘forget’ what you paid for your house or shares. One way is to get someone else to make the decision for you, someone who is not subject to the same anchoring bias. Someone who doesn’t care about the price you paid is more likely to make an objective decision on the value of your shares (or house). And a mountain of academic research has shown that objective decision-making, at least in an investment context, is far better than an emotion-driven process. So next time you need to make such a decision, let go of your anchor or ask somebody to do it for you.

Nothing lasts forever

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 4 June 2016.

Due to an equipment failure, I have recently been on the lookout for a new microwave. The now inoperable microwave which we had owned, was only around four years old, so I was less than thrilled to be having to replace it so soon. This seems to be the way with electrical appliances these days – last year our washing machine stopped working after less than five years and also had to be replaced (just as costly to fix as to buy a new one, according to the repairman). In both cases it seemed that the mechanical gremlins had arrived way too early – a 2007 study into the ‘Life Expectancy of Home Components’ by the US National Association of Home Builders estimated that microwaves and washing machines had life expectancies of 9 and 10 years respectively. On a human equivalent, both of my appliances died in their forties, a very early passing.

When it came time to look for a new microwave, I naturally started with the internet. It turned out the microwave I needed to buy was the Panasonic NE-691, loved by its owners and with the oldest working example being nearly 40 years old. As should be expected however, Panasonic stopped making that model decades ago; probably too reliable I imagine. Now you’re lucky if you can coax a few years out of your latest appliance; where an appliance was once seen as an investment, they’re now nearly throw-away items.

When it comes to shares and investing however, you should expect more than a few years of gainful ownership. That’s not to say that investing is a set and forget approach, far from it. Changes in management, technology, the economic environment and consumption patterns are just a few of the factors which influence the performance of a company over time. The trick is to find the balance between the day traders who think 10 minutes is a long time to be a shareholder, and those who think the ‘buy and hold forever’ approach is the way it’s done. What’s certain is that the average holding period (the length of time investors typically hold their shares before selling) has been falling over time, by some estimates now averaging only 5 days in the United States. Some companies can be safely held for years, others need far closer scrutiny. They’re all different, so do your research, as I should have done before buying the microwave with the four year expiry date.

Look at that swing

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 21 May 2016.

There’s no doubt that every job has both its advantages and disadvantages. If you work for an airline in any capacity, you probably get as many cheap flights (good) and small packets of peanuts as you can bear (bad). Work at Bunnings for example, and you probably own a small fortune’s worth of power tools (which is good) that you never use (which is bad). My father’s chosen career was a professional golfer, which had the advantage of ensuring that we were never short of golf clubs to choose from (at one point I remember counting 50 sets of clubs stashed in various spots around the house), but the downside of having a professional golfer in the family was that we spent a lot of time at golf courses. If you liked golf that wasn’t too bad, but if you thought there were better things to be doing than spending 12 hours a day at the course, you were in trouble.

One benefit of hanging around so many golf courses however, was that you got see how differently people played golf, even the professionals. No golf swing is exactly the same, generally a result of the person’s body shape, height and coaching (or lack thereof). Some golf swings are beautiful to watch – smooth, balanced and rhythmical, think Tom Watson or Adam Scott here. Others are decidedly ugly and look like the golfer is trying to bash in a snake’s head with a shovel – I don’t want to be mean, but Jim Furyk and Craig Parry probably fall into this category. The thing is though, you don’t need the most beautiful golf swing to be a successful golfer. Jim Furyk, for example, has won 27 golf tournaments, including the US Open. Craig Parry has won 23 times and both golfers have made a pretty good living from golf (US tour earnings alone of $65 million and $8 million respectively).

Just like a golfer’s swing, in investing there is no one right or wrong approach. Everybody has their own needs, fears, feelings and objectives – there’s no single solution which perfectly covers every situation. For some people the stock market is a risky and dangerous place they need not enter; for others, an ‘investment’ in a fiery thoroughbred race horse is just perfect. The point is, your approach to your finances and the right solution for you is going to be different from everybody else. Just like golf, don’t worry about how it ‘looks’, rather judge your investment approach by its results.

Throw it away

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 7 May 2016.

One of the interesting things I have learnt about children, since becoming a parent, is that they hate throwing anything way. It’s most obvious when I ask one of the kids to throw something in the bin for me. They’ll firstly give me a strange sideways glance, as if they can’t believe what they’ve just heard. Then they’ll walk ever so slowly over to the bin and peer inside, presumably checking to see if they can make out the fires of hell far below. Then the offending rubbish is held over the bin, carefully pinched between thumb and forefinger, before it’s dropped into the darkness, followed by another wary look into the bin, just in case the act of dropping the rubbish had started an inexplicable sequence of events that was going to culminate in a spectacular explosion. This very lengthy process can take a long time when someone has dropped a bag of sultanas on the floor.

Another rubbish related behavioural trait, is an apparent inability to distinguish between what’s rubbish and what’s not. An empty box for example, no matter its origin, is most definitely not rubbish. It’s an impromptu and mobile treasure chest, regardless of whether it initially held beer, nappies, shoes or coffee. Any empty container really, if it’s not shoved into the bin quickly enough, gets claimed by one of the children and pressed into storage duties. Obviously hoarding is a trait which we develop at a young age and which some people never really let go of.

When it comes to investing however, there’s no place for hoarding or for not wanting to throw anything into the trash. No matter how diligent is your investment selection process, at some stage you are going to end up owning some investment garbage. Now if you were a five year old, you’d be tempted to hang on to that garbage for the rest of your life, but as an adult you need to be more discerning. Some companies or investments are simply never going to make it back, from an investment perspective, and need to be let go. It’s not an easy task however, with a substantial body of research showing that investors hate to realise their losses, preferring to hang on in the faint hope of an improvement, an approach which typically leads to lower returns. Just as Jack and Kate don’t need all those empty cereal boxes stashed under their beds, do you need to keep the rubbish in your portfolio?

5 Investment rules

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 23 April 2016.

Recent years have seen a veritable flood of self-help books about making money, whether it’s through property speculation or stock market investing. They tend to have catchy titles like “The Property Gazillionaire: How I went from 1 to 20,000 Properties in Six Months!” or “Get Rich, Stay Rich: The Money-Making Guide for Impatient People”. I’m sure the books make for great reading, however I’m always a little curious as to why you would sell the apparent secret to untold wealth for just $12.99, but perhaps I’m simply being too cynical. Nevertheless, in the spirit of all this wonderful advice-giving, let me give you some free advice; it’s almost all you need to know when it comes to your finances. Here are the rules, in no particular order:

1. If it sounds too good to be true, it really is.

Everyone knows this one, yet it’s probably the most frequently ignored law of investing. When the rest of the world thinks 5% is a good return, how likely is it that someone else has stumbled upon a way to make 25%? With no risk? Exactly.

2. If you can’t understand it, don’t do it.

Or at the very least keep asking questions until you can understand it. Many investment losses can be avoided if you are fully aware of and understand the risks involved. If you don’t know the risks, don’t part with your money.

3. There are no shortcuts (that don’t come with the risk of losing everything).

Making money in a hurry requires a level of luck only experienced by lottery winners. Slow and steady accumulation of wealth may not sound very exciting, but it’s one of the few options open to you if you don’t have rich parents or a knack for picking lottery numbers.

4. Fear of missing out (FOMO) can be hazardous to your wealth.

Everyone wants to invest in gold after the gold price has gone up, buy property as the market reaches its peak or sell their shares just as the stock market bottoms. Falling victim to FOMO results in you joining the herd and unfortunately history has shown that the herd is often wrong.

5. Don’t put all your eggs into one basket.

Again, everyone knows this one, yet it’s sad how many times you hear of a hard-working retiree who lost it all because they had all their money in one investment, be it a managed fund or individual company. “Diversify or despair” should be the motto of every investor.

Not as exciting as building a property empire in 6 months, but these rules actually work (and best of all, they’re free!).

The cooking genius

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 9 April 2016.

As I write this, tonight’s TV fare is another reality television cooking show. It’s the usual format – a bunch of ordinary Australians from across the country, who are handy in the kitchen and dream of making it big in the cooking or restaurant industry. The usual approach to chef stardom, of getting a job as a lowly-paid pot-washer and working your way to head chef over the next thirty years, has made way for the glory of instant celebrity and a published cookbook. Unfortunately it seems as though the competitors each successive year haven’t noticed a nasty trend in reality television – if the first winner of the show, in series one, made it to D-grade celebrity-dom, the current crop of winners are going to struggle to make it out of Z-grade at best. For example, who can remember the winners of Masterchef or Australian Idol from six years ago?

Watching the show, what struck me was the confidence that every contestant had in their own abilities. No shrinking violets here, it’s all ‘We’re gonna smash the competition’ or ‘So and So may be good, but we’ve got the skills to take it home’. Perhaps it’s the editing or maybe it’s only because of encouragement by the producers, but it’s as though each contestant truly believes they are blessed with exceptional cooking skills. The tendency to be over-confident in one’s abilities is not restricted to reality television cooking shows however, unfortunately most of us are prone to over-confidence. One study in the United States found that 88% of Americans thought that they were better than average drivers, clearly an impossible position. In proof that over-confidence was not based on nationality, the same study found that 77% of drivers in Sweden similarly believed they were better than average drivers. Similar studies have found that in almost every endeavour, we tend to think that we are better than we really are.

The perils of over-confidence when it comes to investing are many. Overconfidence often manifests itself in excessive trading – if you truly believe you know what you are doing, you’re likely to (erroneously) want to keep on doing it. Buy, sell, buy, sell and generally lower your overall long term returns. The illusion of control and desire to master the market are also traits born from over-confidence. Again, such an approach is unlikely to result in the long term returns you expect (or hope) to make. Avoiding the trap of overconfidence is difficult, generally experience is the best antidote. But when you’re a good home cook on the fast-track to culinary stardom, taking time to gain experience is as undesirable as mistaking the salt for the sugar in the crème brulee.

What you want to hear

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 26 March 2016.

If you know someone who has a particularly strong political view, you may have noticed how this influences the newspapers or magazines they read and which television channels they watch. It’s a generalisation of course, but if they were somewhat conservative they might prefer to read The Daily Telegraph or The Australian, and get their TV news from Sky News. If their political views leaned to the left however, they probably prefer to watch the ABC and read The Sydney Morning Herald. That’s not to accuse the various media outlets of deliberate bias, it’s simply an acknowledgement of the fact that most news sources tend to attract readers or viewers of a particular political viewpoint.

This propensity of ours to seek out sources of information which corroborate and reinforce our views and opinions has a name – confirmation bias. If we hold a particular view, we feel more comfortable reading articles or watching television shows which broadly support our opinions. It’s as though we draw comfort from the thought that we’re not alone; we’re happy that there are others that feel the same way we do. While it’s arguable whether the presence of confirmation bias is a good or bad thing when it comes to politics, confirmation bias should be avoided when it comes to your investments. The danger with confirmation bias is the selective thinking which clouds your judgement. You may own shares in a company which you believe has great prospects so you decide to do a little research, perhaps reading the company’s marketing material and financial reports, or listening to a recorded interview with the CEO. You might even jump onto an online forum where fellow shareholders discuss the latest news and developments emanating from the company, all heartily agreeing with one another about what a great investment they had purchased.

Can you see the danger? All you’ve done is look for evidence which confirms your already-held view of the company and you’ve made no effort to seek out information which contradicts your views. This is a perfect example of confirmation bias. Proper due diligence should include an active effort to find information which challenges your views and opinions – it helps you to question your own position more forcefully. It doesn’t mean your opinion is wrong; you just want to make sure you have considered every angle. Not that it’s going to help much when it comes to politics, as said by John Kenneth Galbraith, “Politics is the art of choosing between the disastrous and the unpalatable.”