According to Wikipedia, Endowment Effect is a theory when people value the things that they have higher than the things that they don't have. It is direct opposite of standard economy theory when willingness to pay should equal to willingness to accept. To put it simpler, let's say that you have 5 pearls which you bought for 100 dollars each on five years ago. In the next five years however, its price has rise to 500 dollars each. The question is, what will you do to the pearls? Endowment effects is the things that make you keep the pearls because you thought that the pearls are worth more than 500 dollars each. In other words, you have put higher value to your pearls than what they should be.
George Lowenstein and Daniel Kahneman from "Explaining the Endowment Effect" said that endowment effect could be caused by disappointment that may occurred when we trade our assets with other assets, or the affection you have on your assets. For example, no matter what happen to your hometown football team, you will cheer on them or even bet for them. If it happen on your investment policy, it is called endowment effect.
Then what's the connection with investment world? In investment context, endowment effect could have high contribution in deciding your investment plans. Those who have endowment effect will stay still on their investment plan no matter what. The important thing is, the effect will destroy the balance between your investment goals and your investment instrument. For example, you are a young people with high stress tolerance, bravery, and supported with high income, some would say that stock market is the one for you. However, since you are already familiar with debenture, which relatively more secured than stock and lower repayment rate, you still choose debenture as your investment instrument and lose your chance to gain more from stock market. The point is, go way back into your investment goal and analyze the potential and risk tolerance of yourself before deciding your investment instrument. Knowledge about instrument is not a good reason to quit because it could be gain anywhere and if you are serious about your investment plan, you have to take your time to study thoroughly about many option available for you.
Tuesday, June 15, 2010
Saturday, June 12, 2010
Overconfidence is Bad in Investment
The world is currently focused on South Africa as they host 2010 World Cup. Speaking about World Cup, most of us football fans should remember the day Ahn Jung Hwan destroyed Italian's dream in 2002 World Cup final-phase. That is one of many surprises that happened during the competition. The moral of the story is, shit happens. Overconfident could cause unhealthy effect when things went wrong.
Psychologist said that overconfidence could make someone give exaggerate value of their limited knowledge and ability, underestimating all risk, and believe that they could control any event that may occur. In investment, overconfidence is often discussed, especially on beginner. To make thing easy, take a look at this example. You are a beginner in investment and does not really understand about your ability and knowledge, but suddenly you gain a load of profit. The event make you think that the success is a manifestation of your expertise in investment. So any decision you've done later is made out of your unproven confidence. This is an overconfidence in investment.
Psychologist also said that most people become overconfident if they have an early success in any activities of their choice. Then, when those people have more information about their activity, they will get way over their own head. In psychology, this mental state is called Illusion of Knowledge. Too many information does not always mean that your decision will get better. The trick is how to pick only the right and essential information to support your decision in investment. Here is the example, when playing with dice, each of the number of the dice have the same 1/6 chance. However after the fifth throw the number that comes out is always 4. If you have this information, What number will you choose next? Illusion of Knowledge will make people choose 4 as they have came out fifth time before. What you should understand here is, no matter what, the numbers of the dice have the same change of 1/6, so it does not matter if you choose any other numbers.
As an investor, you have access on many information, including historical data (prices, yields, and transaction volume) and real time data utilizing technology like internet. For expert investor, this data is very helping. In contrast, beginner often do not know very much about interpretation about these information and most of the times, as they have access of these information, they feel so secured about their decision the same way as the dice example above.
Lesson that we all should take from the illustration above is investment is not as easy as flipping your hand. Gaining information is not sufficient as we have to extract the right analysis from the information to support our decision. Overconfidence could make us ignore the accurateness of the information and overestimating our ability in analyze it. This will lead to the wrong decision and wrong decision means loss in investment.
Psychologist said that overconfidence could make someone give exaggerate value of their limited knowledge and ability, underestimating all risk, and believe that they could control any event that may occur. In investment, overconfidence is often discussed, especially on beginner. To make thing easy, take a look at this example. You are a beginner in investment and does not really understand about your ability and knowledge, but suddenly you gain a load of profit. The event make you think that the success is a manifestation of your expertise in investment. So any decision you've done later is made out of your unproven confidence. This is an overconfidence in investment.
Psychologist also said that most people become overconfident if they have an early success in any activities of their choice. Then, when those people have more information about their activity, they will get way over their own head. In psychology, this mental state is called Illusion of Knowledge. Too many information does not always mean that your decision will get better. The trick is how to pick only the right and essential information to support your decision in investment. Here is the example, when playing with dice, each of the number of the dice have the same 1/6 chance. However after the fifth throw the number that comes out is always 4. If you have this information, What number will you choose next? Illusion of Knowledge will make people choose 4 as they have came out fifth time before. What you should understand here is, no matter what, the numbers of the dice have the same change of 1/6, so it does not matter if you choose any other numbers.
As an investor, you have access on many information, including historical data (prices, yields, and transaction volume) and real time data utilizing technology like internet. For expert investor, this data is very helping. In contrast, beginner often do not know very much about interpretation about these information and most of the times, as they have access of these information, they feel so secured about their decision the same way as the dice example above.
Lesson that we all should take from the illustration above is investment is not as easy as flipping your hand. Gaining information is not sufficient as we have to extract the right analysis from the information to support our decision. Overconfidence could make us ignore the accurateness of the information and overestimating our ability in analyze it. This will lead to the wrong decision and wrong decision means loss in investment.
Sunday, June 6, 2010
Lesson from The Beardstown Ladies
Anyone familiar with the investment world should remember The Beardstown Ladies, an investment club that made the member to become a celebrity. The club members are 14 female with an average age of 70. They have become famous for their statement of investment gains with the earnings yield of 23.4% per year for 10 years whereas the DJIA only holds 12.1% growth during the same period. In short, these women claimed that they can reap the benefits two times the performance of the stock market and most mutual fund shares in the U.S. during this period.
However, after an audit from Price Waterhouse published, their popularity drop to zero. Price Waterhouse report that their investment gain was only 9.1% per year, far below the 23.4% myth. So the actual profit earned by these ladies is still below the average performance of the stock market. Where did they go wrong? apparently, these women were miscalculating their routine deposit as a profit. As an supplement, NAIC (National Association of Investor Corporation) done a survey on 166 investment club all accross America. The result were surprising, most of investment club performance is lower than most mutual fund shares in the U.S. by 60-70%.
But one should learn from the success story of Klondike Investment Club of Buffalo. Having 18 members, all of their investment decision is based on rational analysis and deep research, not based on emotions or issues on certain company's stock. The important thing to learn is, even if an investment club is founded to learn about investment and gain benefits from it, decision made inside the club should be made on research and good intuition. Collectivity on a club is extremely useful to determine which one is the best option. Don't be too cocky if you are already a member of an investment club as you don't want the Beardstown Ladies' mistake to become yours.
However, after an audit from Price Waterhouse published, their popularity drop to zero. Price Waterhouse report that their investment gain was only 9.1% per year, far below the 23.4% myth. So the actual profit earned by these ladies is still below the average performance of the stock market. Where did they go wrong? apparently, these women were miscalculating their routine deposit as a profit. As an supplement, NAIC (National Association of Investor Corporation) done a survey on 166 investment club all accross America. The result were surprising, most of investment club performance is lower than most mutual fund shares in the U.S. by 60-70%.
But one should learn from the success story of Klondike Investment Club of Buffalo. Having 18 members, all of their investment decision is based on rational analysis and deep research, not based on emotions or issues on certain company's stock. The important thing to learn is, even if an investment club is founded to learn about investment and gain benefits from it, decision made inside the club should be made on research and good intuition. Collectivity on a club is extremely useful to determine which one is the best option. Don't be too cocky if you are already a member of an investment club as you don't want the Beardstown Ladies' mistake to become yours.
Tuesday, June 1, 2010
FAQ and Tips about Financial Planning Service
What is a Financial Planner?
Financial planner is a consultant, specialized in planning your monetary flow including investment protection, savings, pensions, education, taxation, or even legacy.
Do I need one?
Depends. Basically, people have three choice in managing their money. First is to do nothing about their money. People in this category is too busy to care about how their money spent. the dangerous thing about this type is loss potential is always big and we should remember that retirement is always come to everybody. Second, is planning financial condition by ourself. To do this, we should learn various topics about financial and practice. Though it will take some times, the benefits is good. The knowledge on financial is also useful in considering and evaluating the options given from a financial planner. Third, is to rent a financial planner to help in our monetary decision. Do not forget that the service offered is not free. Fees that you must pay is various depending on what service will you take. Some have hourly rate while others ask for commission on every successful investment that you have made.
Tips on getting a financial planner
1. Do all of your financial plan yourself before getting a financial planner. Some might be too busy to do this but try to do it at least one year to have the big picture on your financial condition and potential. By doing this you will be much smarter in considering any options your planner have for you.
2. Realize that there are a potent conflict of interest between financial planner whose income is based on commission on their sales rate, compromising the objectivity of their advices. You should be very careful when choosing your personal financial planner, at least choose the bonafide firm and check their certificate before picking one.
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