About Endowment Effect

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.

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.

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.

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.

Investment Tips: Cash Reserve

How Much Cash You are Holding?

Some people would consider investing is the same thing as saving in the bank, but in reality, some financial expert would treat it differently. Savings account is focused on short term goal, therefore, it relatively more fluid, meaning you could gain your cash at anytime. Investment on the other hand is illiquid. While both are using financial assets, you spend some money now with expectation of profit in the future, savings always in cash form, you could take it anytime through your ATM or any other way. Investment refers to assets ownership in a long period, in simplest term, you cannot turn it into cash at any time soon. Regardless of the difference between both, the important thing to be noted is in a long time period, investment have more potential to give more profit than savings. Therefore, too much savings will diminish your assets potential to their minimum values.


But why we should hold cash? At least there are considerations why we should hold cash. First, we need constant cash flow for everyday expenses such as transportation, utilities (electricity, water, etc), and other needs. Second, we need cash to handle emergency like hospital fee, car accident, or any other things that not fit in our flow prediction. So how much cash reserve should we hold to handle emergency situations?

Experts recommends that everybody should hold cash reserve at least six to twelve time from our routine expenses per month but it doesn't mean that we should follow it blindly. People have different type of income and cash reserve should meet that requirement to live better and without worries. Here are things that should be considered to determine the amount of cash reserves.

• Your income type, how often you gain money have impact on how much cash reserve that you should have. If you have irregular income, or your money is based on commission, you should add more money to your cash reserve as a precaution if your income reach its lowest point.

• How risky is your job? More risk means you need more cash reserve. Insurance claims takes time and you want your family to live on without worries when accident happened.

• How healthy are you? People with congenital disease or acute potential like heart disease should have more cash reserve. It does not mean that we defies God but having health disorder have a high risk to reduce our ability to gain money in the future.

• Fourth, ability to borrow money have direct impact on your cash reserve. High access to borrow money mean more flexible cash reserve.

• Fifth is income source. If you are the sole income source of your family, you want to put more into your cash reserve to handle emergency. But if you and your wife have the ability to make money, your cash reserves should be more flexible because the chance both of you losing the income at the same time is smaller.

Sun Tzu said, "If you know the enemy and know yourself, your victory will not stand in doubt." You should know yourself, your ability to make money, and the risk that might hold you down in the future. This article is just a reminder, not a strict guideline to follow. In the end, the main focus is to make sure you are financially secure by having enough cash to live and maximize your potential in investment.

Where Does My Money Go?

Analyzing Where Did We Lost Track of Our Money

"Spending less than you earn," an old proverb which remind us to make our live a better one. Spending more than you could make will ends in load of debts. Life needs a careful judgment and that should apply to money management too. With every penny you’ve made you consider carefully on how will you spend, save, or invest your money.

Remember in my previous article about the question that will always pop up when you don’t make a good planning for your money. But we cannot fully blame ourself because in the information eras, ways to spend our money is easier than ever. Just take a look at ATM, credit cards, or E-commerce and paypal which made our money much easier to spend. The worst thing is, when your money is gone and debt start to take over, it is then you realized that you have spend more than you could afford. The following factors can make a person overspend, just to be a reflection before the you do stupid things that may cause your financial condition to get worse.

First is the credit card. How many do you have? Having credit card(s) make you want to buy things that you thought you’re going to afford. Of course, if you paid the bill plus interest with no delay, it won’t be that much of a problem. But still, regardless of your ability to pay debt, sooner or later credit card will push you to live outside of your limit.

Second is the habit of buying goods on credit. Dream of having one particularly awesome car sometime forced us to buy it on credit. Okay the interest looks low and they offer good insurance term but behind those, our future income is blocked to pay the debts.

Third, being a pushover sometimes made us forget to save money. For example, do you have the ability to say, "Let’s find a cheaper place to eat." When your friend planned to go to a fancy restaurant for lunch?

Fourth is the habit of making shopping as needs. Some would consider shopping as a stress cure after a full day of hard work. This will make you buy something that you don’t need. Even worse, some women and men are actually addicted to shop.

Fifth is ignoring your financial goals when shopping. Have you delay your vanity purchases when you remember about your retirement? Some of us would think that they will be much time later to save money, don’t ever do that, it will become regret later.

Sixth, for those who already have a family of their own, maybe they won’t hesitate to spend money for their children. Be aware though, love does not equal to money. Although we do feel really happy when our children said, "Thank you, papa," or,"Thank you, mama", their future is written in how much we can provide for their needs, like education.

Seventh, remember that money, while fulfilling your needs, cannot buy happiness. Try to remember,when is the time you are feeling most happy, I dare to say that no one will answer it is the time that they buy their new car, especially on credit.

It is not what you make, it is what you keep. Less savings mean less money in the future. A penny saved is a penny earn. Plan your financial flow and your future will be a bright one.

Basic of Financial Mathematics

Simple Financial Mathematics Tutorial

Time is money; it is actually more than a saying. It is a rule in investment. Time is identical to money and as time flows, money value also increase provide you don’t keep it under your bed. Yes my friend, interest is the things that will make your money grow. Two grands from today obviously more valuable than two grands from ten years in the future, then how will we make our two grand worthwhile? The easiest option is to save your money in a bank. With the knowledge of financial mathematics, you could understand how interests grow your money and could plan your future better. Here are the basic concepts of financial mathematics that you should know.

Future Value Concept

Present value of our money today could be transferred to the equal value in the future. Formula to calculate future value from our investment based on their interest is:

FV = PV * (1 + r)^N

r is the interest rate and N is time period. PV and FV are present value and future value respectively.

Example 1: Let’s take an example of 10% interest per year. If we save two grands today, how much our balance will be on the next year?

FV = PV * (1 + r)^N
FV = 2000 * (1 + 10%)¹ = US$ 2200

Not to tempting huh? Then let’s foresee our balance in ten years

FV = 2200 * (1+10%)¹⁰ = US$ 5187.48

Present Value Concept

Present value concept used to transfers future value to present value. In other word, present value concept used to count how much money we should have now if we want to complete a future payment.

The formula for Present Value is inverted from Future Value formula:

PV = FV/ (1 + r)^N


Example 2: Given an interest rate of 10%, How much will I need as starters to have that US$ 100000 house on the next ten years?

PV = 100000/ (1 + 10%)¹⁰
PV = US$ 38555

The amount of money that we should have now to buy our dream house in the future is

US$ 38555.

Future Value of Annuity

Annuity as a continuous fixed cash flow during certain period. Value that will come from annuities is the real sum of money after few periods from now.

Example 3: if you save ten grands per year for twenty years, how much will you gain after the given time?
For short, the formula to count your future money after years of saving is:

FVA = {A * [(1 + r)ⁿ - 1] / r}

A is annuity, r is the interest rate and n is the given period. So if you save ten grands every years, after 20 years your money will be

{10000 * [(1 + 0.1)²⁰ - 1] / 0.1} = US$ 572,749.99,

That is a lot of money my friend, 20 years of regular savings definitely worth it.

Present Value of Annuity

Present value of annuity is a direct inverse from future value of annuity. PVA is useful to calculate different cash flow in your finance to decide which one is better.
PVA can also be considered how the amount you must invest today at a specific interest rate so that when you withdraw an equal amount each period, the original principal and all accumulated interest will be completely exhausted at the end of the annuity.

Example 4: given 10% interest rate compounded annually, how much should we save today if we want to withdraw $5,000 from our account every year for 10 years?
Formula for present value of annuity is:

PVA = A * {1 – [1 / (1 + r)ⁿ ]} / r

The right answer for the example is
A = 5000
r = 10% = 0.1
n = 10
PVA = 5000 * {1 – [1 / (1 + 0.1)¹⁰]} / 0.1
PVA = $30,723