Nov 282016
 

The Sunk Cost Trap

We all try to make rational decisions based on the future value of objects, investments and experiences. But the truth is that our decisions can sometimes be tainted by the emotional investments we have put into them over time. The more we are invested in something, the harder it becomes to abandon it. This is known as the sunk cost fallacy.

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It’s what a lot of gamblers do. They throw good money after bad, thinking they can turn their luck around. But it usually doesn’t work out for them. Whenever we buy stocks there’s a chance that our investments will drop in the future because the business has fundamentally changed. This is especially true for tech companies like Nortel or Nokia. Both companies fell from grace for different reasons. When investments don’t work out some investors pull out, while others continue to hold on hoping their shares will bounce back some day. Knowing which is the wiser decision can make all the difference.

In dilemmas such as this, it’s best to consider the current circumstances and opportunities. And then make a decision based on forward looking expectations. 🙂 By estimating the economic consequences of holding or selling an investment at the present time we can eliminate our emotional biases accumulated from the past.

Similarly in economics and business, a sunk cost is a cost that has already been incurred and cannot be recovered. Some business owners will mistakenly refuse to mark down their older inventory because they don’t want to sell it for less than what they paid for themselves. But the original cost of the goods is now a sunk cost, which means the money has already been paid and is irrelevant to making present decisions. Instead of focusing on selling the inventory at a loss, they should think about the opportunities cost and the best alternative strategy going forward. 😉

Some people even double down on their investments or ideologies when faced with evidence that goes against their previous actions or beliefs. This can be very self destructive if they don’t realize what they’re doing.

Sunk cost applies to many other aspects of society as well. For example, some unhappy couples feel like they’re stuck in a bad situation because they’ve already invested so much time into their relationships. But if they’ve already tried and can’t make things work then similar to investing, maybe it’s better to cut their losses and bail. As the comedian Louis CK once said, “One day one of your friends is gonna get divorced. Don’t go ‘Oh, I’m sorry!’…No good marriage has ever ended in divorce. If your friend got divorced, it means things were bad. And now, they’re better.” 😀

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Random Useless Fact:

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Nov 242016
 

Comparing Finances

Money is like a lot like religion or politics; everyone has a passionate opinion about their own personal finances, but it’s not always easy to talk openly about it without social consequences. For example, the company I work for discourages open discussions about compensation and benefits. This makes sense from a corporate point of view because of the loss aversion theory. Psychologists and behavioral economists have found that we tend to feel loss about twice as intensely as we experience gain.

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We can imagine how this will play out if two employees were to find out that one of them was making more than the other. The worker making less would feel twice as bad about his job as the other worker would feel good. So this would lower the overall morale in the workplace and create negative sentiment towards management. 🙁 Furthermore, some people have a cognitive bias known as the Dunning-Kruger effect where they think they’re more competent than they really are, which could lead to misunderstandings.

This is why income, net worth, and other topics related to personal finance are often seen as taboo. We are told to not compare ourselves with others. But pretending to live in a bubble can alienate us from the rest of the world and become self destructive over time. In reality it can be very advantageous to compare our income, investments, and expenses to everyone else around us. Here are some reasons why comparing personal finances is useful.

  1. You can get the best deals. You compare employee benefits when choosing whom to work for. You compare prices when shopping. You compare company profits when choosing which stocks to buy. So by knowing what your co-workers are earning you’ll get a better grasp of what your labor is worth. By knowing how much your friends spend on cars you’ll have a better idea of where to find the best car deals for yourself.
  2. You can see the big picture. By comparing your finances with others, you will be able to determine for sure if things are really expensive, or you’re just poor. 😛
  3. You can improve your own finances. By comparing your financial progress to others you will be able to learn from different people over time. You will know who’s really good at budgeting, and who is the most successful at investing. You can then apply newly learned practices to your own life.

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Nov 172016
 

Asset Allocation

Many investors use a common rule of thumb to help with their asset allocation. They simply hold a percentage of stocks equal to 100 minus their age, and put the remaining amount in fixed income assets. So for a typical 30 year old millennial, 70% of his portfolio would be in equities, and the rest (30%) would be comprised of bonds and other relatively safe investments. Determining stock allocation based on age is an effective strategy to gradually reduce one’s investment risk over time. 🙂

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But this 100 minus age guideline is starting to become outdated because people are living longer, and bond yields are at historical lows. So we can modify the rule to be more suitable for the current times. For example, we can increase the baseline to use 110 minus our age. Those who have a higher risk tolerance than average can even go with 120 minus their age. Also, men have an average life expectancy of 80 years old in this country, while women can expect to live to 84. Since women live about 4 years longer than men on average, they would probably have higher costs in retirement than men. This means ladies have an incentive to be a little more aggressive with their asset allocation, especially during their working years compared to guys, assuming all other factors being equal. 🙂

Keep in mind that this guide to asset allocation speaks only to financial assets within a liquid portfolio. It’s also important to consider real estate, geographical diversification, taxation, idiosyncratic circumstances, and other factors when building a balanced portfolio. The 100 minus your age rule isn’t right for everyone, but it’s a good place to start for those who are just starting out to invest. 😀

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Random Useless Fact:

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Nov 032016
 

Motivational speaker Tony Robbins interviewed self-made billionaire Ray Dalio for his book, Money; Master the Game. Ray heads the largest hedge fund in the world, Bridgewater Associates, which has over $150 billion in assets under management.

The All Weather Portfolio

According to Ray, “there is one thing we can see with absolute certainty: every investment has an ideal environment in which it flourishes. In other words, there’s a season for everything.” The four seasons he refers to are the following.

  1. Inflation
  2. Deflation
  3. Rising economic growth
  4. Declining economic growth

He suggests that these 4 economic environments will ultimately affect whether an asset’s price will increase or decrease. So for example, bonds should outperform in a deflationary period. Ray elaborates by saying we should have 25% of our risk spread out evenly across all 4 economic seasons. This is why he calls this investment approach “All Weather.” There are 4 seasons in the financial world and nobody knows for sure which one is coming next. So the idea is to keep a balanced portfolio that will not only make us money, but also help protect us against any surprises in the markets. Here are some assets we can allocate to each of the four categories, and keep in mind it’s possible for two of these conditions to overlap.

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This is an interesting strategy. I’ve always had a bullish bias towards investing. In other words, my investment decisions are based on the idea that financial markets tend to increase with economic growth over the very long run, so I don’t try to short anything. But Ray’s approach suggests that it’s possible to make money even in environments of economic decline and deflation that doesn’t involve timing the markets.

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Oct 062016
 

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Why It’s So Easy to Overspend

We are all tempted by instant gratification to some extent. And thanks to poorly implemented public policies it’s now easier than ever to live beyond our means. When we run out of savings, we can simply use credit to continue buying what we want. At least that’s what I usually do. 😉

Once upon a time people had to work almost constantly to prepare, track, hunt, build, forage, and gather resources so they would have enough food to survive the winter. But now the average American only works 34 hours per week, according to the OECD. That’s 20% of their available time. In other words, people spend 134 hours each week sleeping, eating, and doing leisurely activities that don’t involve getting paid for labour. That’s a lot of time to kill.

We have so much free time on our hands we often have trouble deciding what to do with it. Businesses use this opportunity to target our wallets, which leads us to buy things we don’t really need.

The Advantage of Distraction

In order to prevent impulse purchases we simply need to distract ourselves and do something else with our time and attention. 🙂 The best way to do this is to find free or cheap hobbies that can take up a lot of time. For example, if we are already preoccupied with reading the latest Harry Potter book, then we are less likely to think about shopping. To put it another way, we spend money when we’re bored or have nothing better to do. This is why many workaholics tend to be frugal. They’re so busy with work, they literally don’t have the time to enjoy all the money they’re making, lol.

I recently came across this Reddit thread about affordable hobbies that anyone can do. I will share the top activities mentioned in the thread and add some of my own ideas. We sometimes overspend because we don’t have the willpower to walk away from something we want. But hobbies such as the ones below can distract us so we won’t even get the chance to think about shopping in the first place, and therefore, save money. 🙂

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