How To Make Better Money Tradeoffs

How To Make Better Money Tradeoffs

“There are no solutions; there are only trade-offs.”

Thomas Sowell

There are tradeoffs in most aspects of our lives. We have a plethora of choices and cannot do everything we want to do. For every choice we make, opportunity costs requiring us to forego benefits for the option not selected. Opportunity costs are the loss of potential gains from other alternatives when making a choice.

Tradeoffs between time and money differ significantly based on age and lifestyle based on our unique set of values. With less time like Boomers as an older generation, you might place more importance on time while young people may favor money. That is not always the case.  Based on this global survey, those in the 20s and 30s tend to lean more time than money, valuing experiences over possessions than boomers, as seen in this infographic.

Each of us has to decide based on our characteristics and circumstances. Typical examples of trade-offs between time and money as we ponder our individual decisions, we:

  • Opt for a job requiring a long commute for a pay hike.
  • Have one income with mom or dad staying at home with the kids.
  • Go to a movie instead of working on an assignment due the next day.
  • Job security with the government or seeking a wealth opportunity with long hours and traveling.
  • Attend a community college initially, then transfer to a four-year college.
  • Work at home to spend more time with family.

Sure, we can try multitasking or combine activities when we face conflicting demands on us. However, there is often a price to pay when poor execution results.

Make Diligent Choices

Instead, we may inform ourselves by making diligent choices. How conscious are we when we make these decisions? For some decisions, make complex financial calculations as needed. On the other hand, there are times when we may not even be aware of having made a choice. Time, money, productivity, and health may act as alternative constraints, reflected in your priorities.

Time is a precious finite resource we often waste. Even if we have unlimited capital available, we just don’t have the time to spend it fruitfully. We want to enjoy our lives to the fullest, with health on our side. Without taking care of ourselves, time is short, and no amount of money may cure our illness. Since we have longer life expectancies, we need to support ourselves by fulfilling well thought out financial plans.

Typical Tradeoffs We Face:

 

Your Home: Buy or Rent

Owning versus renting your home is among the most common tradeoffs involving personal preferences, age factors, and your financial situation. Our family has rented and owned our home. After many years of ownership, we are renting a home in a lovely town, taking advantage of a great public school system.

If you seek to own a home, do you prefer stability, building equity, control over the home, and its responsibilities and tax benefits? Will you enjoy a sense of pride in ownership? These benefits come at a high cost based on a 20% down payment and mortgage loans for 80% of the home’s principal price, with interest rates strongly determined by your credit scores. The opportunity cost of owning your home may prevent you from saving for retirement and making other investments. Your home will not likely appreciate more than inflation.

The term of your loan can vary based on 15 years versus 30-year mortgages–another trade-off. The longer the loan, the lower your monthly payments. However, the 30-year mortgage raises your total costs compared to the 15-year loan.

Financial Implications For 30 Year versus 15 Year Mortgage

When comparing the different loan maturities on a $300,000 loan:

  • The APR will be higher for the 30-year mortgage than a 15 year one, all else being the same.
  • The monthly mortgage payments will be significantly higher for the 15-year mortgage, given the shorter period. If you can afford to pay the higher monthly amount, you are better off with the 15-year mortgage because you pay less in total interest.
  •  Assuming you have a 720 credit score, the total home price, including total interest paid and down payment, will be lower with a 15-year mortgage loan.
  • The 30-year mortgage is much higher because you are paying interest on your loan longer, so the total home price or principal is $375,000 plus $189,622, equalling $564,620.
  • If you opt for a 15 year mortgage, your total home price or principal  is $375,000 ($300,000 loan + $75,000 down payment of 20%) + $76,012 in total interest equals $451,012 for principal and interest.

On the other hand, renting provides flexibility and freedom. Your rent is usually more affordable than home costs, not having to deal with the home’s repair and maintenance, freeing you to use savings to make investments, and not have to worry about potential declining home values. The downside of renting your home has restrictions to do what you want to make your place more livable. Your landlord could decide to sell the property and require you to move. There is always the risk of having a bad landlord whose actions force you to pick up and leave.

My Take

The necessity of the tradeoffs of owning your home versus renting considers the tug between time and money differences.  When buying your home, you are making a long term commitment to the neighborhood, greater responsibilities in maintaining the property, insurance, and keeping up with monthly payments for some length of time. Alternatively, renting is usually a shorter-term commitment that may require future moves but with less responsibility and costs.

For families who want to control their home, buying is the way to go, especially if you can handle the shorter mortgage terms so you can pay off your debt sooner. Understand your long term goals for your family and financial priorities for your money. Don’t take on too big a house that you can’t afford. Renting is a great choice, especially if you don’t want the headaches of your own home. We compare advantages and disadvantages in our guide to owning and renting your home here.

A Car: Buy, Lease or Borrow

If owning your home is seen as the American dream, our culture has long embraced car ownership as a faithful supplement to our lifestyle. When seeking a car, you have a few alternatives. Do you want a new or used car, preferably certified pre-owned? Are you buying or leasing this car? If you are getting this car for personal rather than business use, the tradeoffs between buying the car with a loan or a lease are relatively straight forward. Assume you are getting a new car in a low-interest-rate environment and similar credit scores whether you are buying or leasing. About 30% of those getting a new car is leasing.

The Advantages And Disadvantages Of Leasing A Car:

There are lower upfront costs requiring a security deposit and usually the first month’s payment. Payments for registration and taxes are needed for leasing and buying the car. When leasing, you will make lower monthly payments for the lease term. Your credit score influences the amount, favoring those with very good to excellent scores.

The manufacturer’s warranty covers most if the leased car’s repairs.

Depending on your term, you are getting the latest technology available in safety, entertainment, and comfort. Those who lease can get a new car every 2-3 years.

There are mileage limits on the car though you may be able to negotiate a bit.

You don’t own the car at the end of your lease. Gap insurance is an optional add-on car insurance covering the difference between the amount owed on a vehicle and its actual cash value in the unforeseen event it is totaled or stolen. When returning the leased car, you may have to pay for excessive maintenance, wear and tear costs.

End of lease costs can be a bit shocking when returning the car. When we finished our lease recently, we were quite surprised at some of the hidden fees discussed when we initiated the lease. We incurred costs close to $1,000 to the lessor to reimburse them for taxes to the local municipality. These fees were relatively new to us, causing dismay. This lease was likely our final one.

Advantages and Disadvantages Of Buying A Car:

Higher upfront costs, including down payment and trade-in, if you have another car. Of course, the more the upfronts costs, the lower your monthly expenses.

Owning presents higher monthly costs than leasing, depending on term length. According to ValuePenguin, the national average of US auto loans is 4.37% in 60 months, though in recent years, buyers have increasingly extended their loan terms to 72 months, with 84 months gaining popularity. The longer the loan, the higher the total interest you are adding to the car’s cost. Experian has reported that new car buyers with the highest credit scores have average loans of 63 months versus those with the lowest scores taking out loans of 72 months.

As you own the car, there are no restrictions on mileage or what tires you want. While you can resell your vehicle, keep in mind that it is a depreciable asset that loses value in the early years and is impacted by mileage long term.

My Take:

The tradeoff on buying or leasing a car is similar to owning or renting your home. A third option to buying or leasing a new car is buying a certified used car. Depending on its age and mileage, it may have remaining time left on the manufacturer’s warranty. After purchasing and leasing cars for years, we recently chose this third option. We paid cash for a 4-year-old certified Subaru as a second car, given its strong reputation for longevity. We are tremendously happy with it.

Spending vs. Saving

This tradeoff’s concern is that it ignores the need to temper spending in favor of saving money. If you spend more than you earn, you either will be withdrawing from your savings and investment accounts or, worse, borrowing to pay for your purchases. On the other hand, if you spend less than you earn, you can better afford your living costs and enjoy life. Having money left over to build an emergency fund, save for retirement, and make investments provides you with more options over the long term.

Adopt an attitude that allows you to enjoy life but not be so costly that you can’t afford your bills. Avoid lifestyle inflation, which comes about when your earnings rise, and you increase your spending. The more you can delay spending and reduce impulse buying, the better your financial health. Many experiences are free, healthy, and worthwhile pursuits. Make room in your budget for a solid emergency fund, pay off your debts to manageable levels, and save for retirement.

Emergency Fund Vs. Debt Payoffs

You should be put savings aside for an emergency fund to cover at least six months of essential living costs. This habit will eliminate the stress of the unknown and reduce your need to abuse your credit card. Many people lack $1,000 in savings to pay for unforeseen costs like a job loss, an emergency surgery for a favored pet, or a damaged car. Having to pay for these costs often leads to higher debt, especially credit card debt with higher interest costs. Set small savings amounts aside earmarked specifically for an ample emergency fund and invest this money in a readily accessible liquid account.

Paralleling these savings, you need to pay your monthly student loans and your credit card bills. If you can’t pay your credit card balances in full, reduce your spending. It is easier said than done. However, committing to keeping debt at a manageable level is critical.

Saving For College Or Retirement: A Tough Choice

When faced with helping your children with their college funding or tapping your retirement money, it becomes a tough choice you don’t have to make. If you are in your 50s or more, you should not touch your retirement account. True, you want to avoid burdening your kids with student loans early in their lives. The average student loan is $31,172, a significant amount of debt to carry. However, they have the benefit of a longer-term horizon than you.

As a young couple, your earnings are rising through your 20s, 30s, and beyond. To avoid having to make a difficult choice, later on, save, and invest now. These are the years you should make your money work for your future. It may mean spending less now, so you have more money to address critical areas of your lives later consciously. These involve essential trade-offs.

Don’t ignore what you can do now to provide plenty of benefits to you and your family long term. Handling money allocation into key baskets for college funding, retirement, and investments early will improve your financial outlook.

Save For College Early Using A 529 Savings Plan

When you expect a child, put aside some money into a 529 Savings Plan or other plans you can read about here. You get tax benefits using pretax money invested in several options based on your preferences. The more money you can put into these funds, the greater likelihood of lower borrowing in your children’s college years. Most states have their plans and have a lot of investment choices. Prioritize saving early in your child’s life so that you don’t have to borrow from your retirement funds.

Retirement Savings In Your 20s

You should begin to save for retirement as soon as you enter the workforce, if not before. Most employers offer 401K retirement plans that make it easy to fund your account through your paychecks. Automating these payments is simple though it may require an opt-in process. Setting this up at work is among the first things you should do when you start your first job.

Many employers will contribute to your retirement account based on a pre-determined match formula. For example, if you save a targeted percentage of 6% of your paycheck to your company-sponsored retirement plan, they may add 50% of that amount or an additional 3% of the money to your account. Separately, you should also set up an IRA or a Roth IRA and focus on contributing up to the maximum amount allowed.

Saving for retirement in your 20s allows you to have a sizable nest egg with compounding returns when you are ready to move to the next stage of life. On the other hand, catching up to saving for retirement in your 50s, while possible, is very difficult. It may mean working longer or tapering down your lifestyle in your later years. The risk you have of waiting too long to accumulate retirement money is that of losing your job in your 50s or if, for health reasons, you no longer can work.

Facing these tradeoffs head-on and early in life create a lot of flexibility and freedom in your later years. Make your money and time work for you as productively as possible. It is easier to sacrifice some choices for the more significant wallet needed later on. Long term comfort in retirement is a worthwhile aim.

Final Thoughts

Making tradeoffs that consider time and money may be intuitive or involve financial calculations balanced with your financial priorities. Addressing many major decisions early in life may provide you with financial flexibility and the freedom to choose an array of lifestyle options. The more you delay thinking about your choices, the harder the trade-offs you have to make. Your 20s and 30s are golden times to tackle savings as your earnings rise. Avoid finding more things to spend on that don’t positively add to your comforts.

Thank you for reading! Please visit us at The Cents of Money to see other such posts and subscribe to our weekly newsletter.

What kind of tradeoffs have you been facing? Did your choices involve your lifestyle or career? We would love to hear from you!

 

 

 

 

 

 

How to Overcome Biases In Financial Situations

How to Overcome Biases In Financial Situations

We all have biases–cognitive and emotional– that may cloud our judgment when making day-to-day decisions, especially about our finances. We often depend on our intuition, but sometimes we are unaware of how our gut feeling may be faulty. 

These biases affect how we think, act, and make purchases against our better judgment. 

Learning how these biases work is a first step to guarding ourselves against becoming irrational when managing money when we want to save, be more rational shoppers, and invest.

What Are These Biases?

Biases are either cognitive or emotional that can lead us astray. They create behavioral patterns that may interfere with our financial goals. Our decision-making may be faulty when cognitive biases interfere. 

On the other hand, emotional biases are distortions in cognition, but emotional factors may lead to poor decisions. Emotional biases are ingrained in our brains and may be harder to overcome than cognitive biases. Marketers exploit these behavioral psychology traits to get us to spend more and buy impulsively.

Common Biases We Need To Overcome

 

1. Anchoring Bias

When shopping, anchoring, a cognitive bias occurs when we place a lot of value in the first information we get. We often rely on the listed price when we make price comparisons. For example, seeing priced T-shirts that cost $700 in one store and another one that is $200 will cause the latter shirt to look cheap. The higher cost is your anchor price. Retailers often use a higher list price for coats on “sale” at $1,000 with a 75% markdown to $250. Now, that coat’s a bargain, but it may not necessarily be so.

“I am not paying the retail price!”

I often shop with a friend, Sue. She will never pay the full or retail price for anything. As a result, Sue feels great walking out of a store, her hands full of marked-down items by various percentages.

The problem is that many retailers know that jacking up their list price to an unrealistic level with a beaming sale price will get shoppers’ attention and play to their beliefs that they got a bargain. It may not be so. Do your research and know the merchant’s sales strategies as well as the quality you are getting. Getting false deals is a real let-down.

Bob’s Furniture Store has a different strategy. There are no sales or ability to negotiate a lower price for their furniture. The list price is what you pay, period. We recently looked at several furniture stores before we ended up buying our children’s furniture there. While other merchants used anchor strategies, their marked down prices were either the same or higher, often for less quality.

Anchoring comes into play in various ways, such as negotiating your salary, a car loan, or getting a savings account. On the latter, you may get a higher annual percentage yield (APY) on your savings account than other banks, but it may charge higher fees. Know all of the specifics of the deal and compare it to other offerings to increase your savviness.

2. Choice Supportive Bias

Sometimes referred to as buyer’s remorse after making a particular purchase, choice supportive bias helps us to justify that discomfort we may feel postpurchase. Sometimes this is called cognitive dissonance. Ever experience regrets after making an expensive purchase? I have had that feeling which is sometimes akin to guilt or doubt about the decision. We want to convince ourselves we made the right choice. Increasingly, marketers recognize this tendency and work hard to provide postpurchase customer service by welcoming you to that merchant and asking if you need any help with the product.

Choice supportive bias changes what we remember about our decision. We distort our memories about our choices, ascribing more positive traits to justify our selection better. In a selective distortion 2000 study by Mathers, Shafir, and Johnson in 2000, the participants chose two job candidates. Each candidate had positive and negative attributes. Later, the subjects remembered their preferred candidate’s better aspects. 

Rather than twist our thoughts around, we should make better choices in the first place. Evaluate your alternatives and review return policies before making your final decision. This way, you maintain your control over buying decisions. We can reduce our spending by becoming better shoppers.

3. Confirmation Bias

“I never allow myself to hold an opinion on anything that I don’t know the other side’s argument better than they do.”       Charlie Munger

If choice supportive bias is selective distortion, confirmation bias is about selective attention. People will remember information selectively, interpreting data to support their existing beliefs, even if the evidence is ambiguous. We tend to agree with people who seem to conform to our ideas. Alternatively, we are dismissive of new information even if that provides evidence that is wrong but accurate. Sometimes we skim or not read all of an article or report.

I sometimes see my students do this in their term papers. For example, when looking to support their views, I will see only one part of the argument presented rather than writing about the opposite point of view they are encouraged to know. News from social media often reinforces one side of a debate. That tendency is pervasive and used to protect our egos from thinking we may be wrong.

This bias may hurt our abilities when making financial decisions. For example, if you are truly open to deciding between renting or buying your home, you should want to know both sides of each decision. There are pros and cons to every decision we make. Confirmation bias works when we may have a preference. We may only focus on the relevant information for your choice. However, you should always do research and know both sides of an argument.

Talluria Study On Dots

Talluria et al. study highlighted a confirmation bias based on experiments that seek consistency across different stimuli. In this case, the researchers asked the participants to view two successive movies featuring a cloud of small dots moving on a white computer screen. They reported on the direction of the moving dots after the first movie. They did the same, that is, report on the path of the dots after the second movie.

The Talluria et al. study proved that people would hold the same confirmation bias even if they are making choices (i.e., dot pathways) that are far less consequential than financial decisions. 

4. “Bandwagon” Effect

The majority of us fall for the bandwagon effect whether we consciously know it or not. The bandwagon effect (or jumping on the bandwagon) occurs when people mimic other people’s buying choices. For marketers, this phenomenon, when triggered, can propel the popularity of a certain product or service into a grand slam.

This psychological trait influences consumer behavior even when the product has features we don’t need. Think about those who bought 4K TVs when most broadcasts and hardware didn’t support those resolutions. Even today, people will stand in line (especially if it is a long one) for the latest iPhone release to buy the latest dual-camera offering. Are they better than the single-camera? People will also switch to a winning candidate than sticking with their choice. Groupthink happens in fashion, music, politics, and restaurants. Social media amplifies this cognitive bias.

When IPOs Are “Hot” And Sometimes Not

This happens a lot in the financial markets, incredibly when pricing the initial public offerings (IPOs). On their first day of trading, these stocks average 20% rises or higher. Beyond Meat, which makes vegetarian burgers and sausages began trading at $25 a share, ending the day at $65.75. This was among the most significant first-day pops of recent IPOs. This stock continued its rise months afterward.

However, many stocks ultimately flop after the first day’s rise, such as Blue Apron and Snap. Investors clamored for Facebook’s IPO, which immediately rose after it began trading. However, it fell back to its IPO price of $38 at the day’s close and had dropped below $18 in a few months. Yet, investors who aren’t able to buy at the IPO price may flock into the market, jumping on the exciting bandwagon after the new stocks begin trading, only to be disappointed later on. Warren Buffett, among the best investors of all time and a proud contrarian, says, “Be fearful when others are greedy and greedy when others are fearful.

5. Framing Effect

We often make decisions influenced by the presentation of information. Is the glass half-full or half-empty? Risky situations use framing. For example, when characterizing a rescue mission, saving 90 out of 100 people sounds better than losing ten people out of 100 people. When seeing sales signs, people are attracted to bigger percentages (25% as compared to 1%) as significant savings. For example, a lamp that sells for $40 has a 25% discount or $10 off. It might be worth the ten minutes drive to the store. On the other hand, if a $1,000 couch is marked down $10 or a 1% discount, we may consider this worth the trip.

Amos Twersky and Daniel Kahneman did a lot of research on framing risk. People generally avoid risk when presenting a positive frame. In their 1981 study, when presented positively, treatment A was chosen by 72% of people affected by a deadly disease. When presented negatively, only 22% of people selected it.

6. Ostrich Effect

Ever want to avoid bad news? You start to distract yourself with nonsense work, putting your head in the sand like an ostrich. I have done this more times than I would like to admit. It sometimes occurs when you are holding stock and you ignore bad news a company has released like missing their earnings target. Rather than sell the stock, I may delay making a decision. This is a form of selective attention. We may be missing information that proves to be an opportunity.

Coined by Galai & Sade in their 2006 study, the  ostrich effect means “avoidance of apparently risky financial situations by pretending it doesn’t exist.” Karlsson, Lowenstein & Seppi in their 2009 Scandinavian study, found that investors checked their investment portfolio’s value 50% to 80% less in weak markets. While we don’t want to know negative news, it could be beneficial. However, investment experts point out that imperfect markets could be huge buying opportunities. For those who were fully invested in the market, it could be good news to pick up beaten-down stocks if fundamentals are alright.

Avoiding what we need to do may cause us to miss deadlines such as opting in our company’s sponsored retirement plan or dealing with credit card debt getting to dangerous levels. Avoidance is somewhat akin to being a procrastinator as an easier path over making decisions in the short term. Longer-term, matters get worse with inaction. Be proactive over significant decisions in your financial life.

7. Overconfidence Bias Aka Dunning-Kruger Effect

Ever sit next to someone at a holiday gathering when that someone is spouting about a topic, holding everyone’s attention, and speaking confidently? You may admire that person for their intelligence at first. Later, you may realize that it is not so. This bias is when people believe they are smarter and more capable but they do not have the self-awareness to recognize it. They hold overly favorable views of themselves.

In the early days of attending law school, I noticed sometimes with envy that there were a few students who raised their hands constantly answering questions with zest. However, the professors didn’t seem too enthusiastic about their explanations. Over the next few months, these same students I thought were among the brightest quit law school, apparently flunking out.

In a Dunning & Kruger study testing humor, grammar, and logic, participants scored in the 12th percentile but estimated that they were in the 62nd percentile, overinflating their skills. They found that those with overconfidence aren’t necessarily embarrassed to learn differently because they hold strong views.

Overconfidence can get in the way of digging deeper into a topic whether at work or at school. You may truly believe that you know a lot in a certain area but your boss isn’t impressed and wants a full report on his or her desk.

Know What You Don’t Know

To combat this tendency, know what you don’t know. Exhaustively researching a critical subject doesn’t mean reading some articles online. Social media provides snippets of information and may convince you to see a lot. Dig deeper and explore beyond the superficial layers that you first. It takes more energy but it may get you to a better draft.

As a professor, I experience this often with some students. When searching for corroborative articles to support their thesis, they may say, “I looked everywhere and only found this one article.” They were sure they sifted through all the relevant articles. When they visit me in my office, we will search together using a number of different keywords. Over a relatively short period, we have gathered some more meaningful reports for their project after checking more ways.

8. Endowment Effect Aka Status Quo Bias

What you own or use is “the devil you know.” This bias refers to our preference for the current state of affairs. Making changes can be difficult. Data shows that switching jobs at the right time can be a smart move if it helps to maximize income. Yet, many of us resist even exploring the opportunity because of the switching costs like having to work with different bosses, co-workers, benefits, and systems we don’t yet know.

Status quo bias arises when we consider going to a different doctor, brand, or hair salon even if they charge better prices. We may even hold onto to a “losing” stock rather than sell it because we are continually expecting a turnaround that may never come. Status quo is similar to loss-aversion bias which says that what you own is more valuable.

 Wine Values That Appreciate

Kahneman et al write in a 1991 study about a gentleman known to have gotten several good Bordeaux wine bottles at low prices. The gentleman learned that the wine much appreciated from its $10 cost per bottle. It would fetch $200 at auction. Although enjoying this wine on occasion, this man would neither sell at auction nor buy at $200. This pattern reflects the fact that people often demand much more to give up an object than they would be willing to pay for it. According to our status quo bias, it suits us to hold onto this object we value, be it land, wine, or jewelry rather than part with it.

Sometimes, we may stay too long in a far more risky portfolio we bought when we were younger and without children. While it was appropriate then, reconsideration of your current lifestyle now is essential. Speaking to a financial advisor at different stages of your life may help you to realize that you should be modifying your investments. Your children may be approaching college years as you should be thinking about your retirement planning. Diversification and risk allocation should be reviewed by you annually and conformed to your life stage and appetite for risk.

Automate Where Possible

Overcome this inertia by planning. If you recognize that you have this tendency of paralysis and not making changes, automate your bill payments and automatically enroll in the retirement plan at work if this is available. Consider target rate funds when investing. These funds automatically reallocate your investments based on changes in your age and risk tolerance. When you start a new business, plan for an exit strategy if things don’t work out rather than losing money if success is not in sight.

Klontz Study On Personal Savings

In a recent study called The Sentimental Savings Study, Dr. Brad Klontz used financial psychology to increase personal savings. The study compared financial psychology sessions and financial educations sessions.

There were 102 subjects who participated in three stages: pre-session, post-session, and a follow-up. After the session, the group that received the financial psychology session showed statistically significant increases in their readiness to save, confidence in their financial abilities, and satisfaction. At their 3rd week follow-up, the financial psychology group reported a 73% increase in their savings versus a 22% increase for the other group. As Dr. Klontz proved, those who tend towards status quo bias, need a nudge to automate payments to enhance savings opportunities directly from paychecks.

9. Present Bias And Procrastination

This bias values the present when we are planning for the future. We procrastinate rather than thinking ahead to our detriment. It affects our health, including our financial well-being. If we favor the present, we won’t delay gratification. Instant gratification suggests that some of us shop impulsively, ringing up unreasonable bills and saving less than we should.  Stephan Meier’s study in 2010 found present-bias minded individuals are more likely to borrow and accumulate higher balances on credit cards.

10. Sunk Cost Fallacy

The feeling of throwing good money after bad arises in many investment situations. A sunk cost is a cost that has already been spent and permanently gone. You don’t have it in your budget.  If you are running a business, there are certain fixed costs, like salaries you have to pay. If you are renting your apartment, it is your monthly bill for the benefit of living there for time of the lease.

Examples of Sunk Cost Fallacy

Sunk cost fallacy is a negative mindset when you are honoring the sunk costs you already invested. For example, you bought paint buckets for your home. After painting a part of your living room, you realize that you hate it. However, you spent a lot of money thus far so you may as well use it.  This is probably not a good idea. You can return the unused cans and start over rather than be miserable. The cans already used are sunk costs, but the fallacy is when you go forward with the paint you don’t like anyway.

I sometimes stay too long with a book I am not enjoying. Other than losing time, it doesn’t feel like too much of a mistake especially if I find redeeming values at the story’s end. On the other hand, holding onto a stock well after it has become clear that the company’s best days are long gone is an example of sunk cost fallacy. Use the long-term capital loss to reduce your tax bill instead.

Don’t Make Bad Decisions Worse

Continuing to pursue an option that no longer makes sense is a waste of your time and money. Buying tickets to a show you are no longer interested in may not be the best way to spend valuable time. Consider giving them to a friend who may enjoy the show or at least the gesture. Time is more valuable than money especially when it is limited.

A common way to experience sunk cost fallacy is investing money into a home that is too small for your growing family. If you love the house, it may be worthwhile to get estimates and consider expansion. On the other hand, if you are continuously are putting money into your home to fix it to your liking (and it’s becoming The Money Pit), it may time to search for a new home.

Recognize that small losses will become bigger losses if you continue to spend or invest money you are no longer supporting. By continuing down the road, you are making a bad decision worse. Learn how to cut losses and consider that amount in the past.

11. The Halo Effect

Ever find yourself prone to first impressions even in the face of adverse news. Many of us consider those early beliefs important, whether it is visiting a new store or website or buying a new brand. Marketers know this and tell their companies that they have to get things right the first time a potential customer sees the new product.

Tesla’s Elon Musk counts on that first impression although his recent flawed presentation of the futuristic Cybertruck when the windows broke reasonably quickly despite being touted as bulletproof. It may yet be a hit as Tesla and Musk have that halo effect that many CEOs envy. Early buying of the truck seems promising.

12. Denomination Effect

This bias refers to currency and our penchant to hold onto bills with big dollar amounts such as $100 rather than spending it. In the Journal of Consumer Research in December 2009, Priya Raghubir & Joydeep Srivastava found that consumers like spending smaller denominated bills ($20) while holding onto to larger denominations they received as a means to control spending. The lower spending power of the lower denominated bill was preferable.

Final Thoughts

As humans, we have biases that create blind spots in our lives. Recognizing biases often impacted by biases is a big part of the battle. We can outsmart these tendencies.

Many biases are promoted by marketers using behavioral psychology to call our attention to what they want us to see. Instead, take back control of your thoughts and decisions. Be proactive, make plans to counter these biases whether it spending more rationally, knowing the specifics of a deal, and automating retirement savings and investments for your financial future.

Thank you for reading!

Did you recognize any biases you have? How do you overcome these tendencies to get more done than you would prefer? We would love to hear from you! Please subscribe to our blog and find more articles like this.

 

How To Talk To Your Kids About Money

How To Talk To Your Kids About Money

“Poor or rich, money is good to have.”

Leah Eliash Kaufman, my grandmother

I worked in my parents’ housewares store after school, weekends, and summers. From the age of 12 until I got my first full-time job after completing college, I helped out my parents. It was a family obligation, and I was not paid but got a wealth of knowledge running an up and down business.

Mom and Dad did share their values about money. My mom was mostly frugal, particularly when we had difficult times. My friends came from modest means as well, but they always seemed to have more than me. They had the latest toys, trendy clothing, a new bicycle, and a new car later. We rarely went on vacation because the store was open six (and sometimes seven) days a week.

Memorable Lessons Passed On

While I didn’t have a ton of material things, my parents did pass on life lessons about the importance of education, working hard, and giving back to the community. They also encouraged me to set up a bank savings account, invest in stocks, pay more with cash than borrow, and quickly pay off debt. 

My mom was never able to go to high school though she wanted to be a lawyer. Circumstances prevented her from moving ahead. She was so savvy about money, investing, and running an ultimately successful business.

Are We Rich?

As a mom, I feel her influence, especially with my kids, now in their teens. When they were younger, one or both accompanied me to the college finance classes I taught. That opened the door for my husband and me to have some early discussions about money with them.

I always asked my mother when I was a young child, and my kids have asked us, “Are we rich?”

According to Charles Schwab’s 2019 Modern Wealth Survey of Americans ages 21-75, you are wealthy if your net worth is $2.27 million.

However, the amount varied by generation:

Gen Z         $1.49 million

Millennials  $1.94 million

Gen X         $2.53 million

Boomer       $2.63 million

Those surveyed said that 72% based their definition of wealth on how they live, and 28% considered wealth on the dollar amount.

The average US household’s net worth is $692,000, skewed because the super-rich pull up the number. A more realistic number is the net worth of the median US household, which is $97,300.

The truth is the majority of Americans need help in better managing money with these statistics:

  • Only 38% have an emergency fund
  • 59%  live paycheck-to-paycheck
  • 44% carry a credit card balance at medium to high teens interest rates
  • On average, we spend almost $500 per month on nonessentials

For these reasons, we, as parents, have an essential role in fostering our children’s attitudes and adopting good financial habits.

Here are 10 Ways To Talk To Your Kids About Money:

 

1. Start to teach them early.

Conversations with your teens about anything sensitive can be awkward, especially about money. According to a 2018 T. Rowe Price survey, 66% of parents are reluctant to discuss money matters with their children. Only 21% of the kids recall their parents speaking about money at least once a week.

Speaking to children about finances takes some of the mystique out of money for them at an early age. It is more comfortable for parents to talk about savings, giving them a head start in math. Explain how the bank holds money for people and explain how it lends money. This will begin a conversation about financial literacy, leading to developing money management skills.

I did take my kids at a too-early age to an ATM to take out money.  My daughter, Alex, got too excited and wanted to try pushing buttons to get some money. She also gave $10 to a friend in her pre-K class for being her friend. It was her tooth fairy money. Luckily, his mom tipped me off. We talked to her about how that money goes into the bank to grow into more money.

2. Wants versus Needs

As they got older, my kids became accustomed to asking for and expecting everything.

It is tough to teach “needs” and “wants” when your 8-year-old says that he needs a smartphone. His friends had one for a long time. We began to set money limits by giving money for after school for the whole week. They learn something about allocating more money for the days they have plans with friends.

Spending money is a neglected topic for many. When kids see us spending money on big-ticket items like a 65″ TV screen, I usually share my thoughts with them with examples. 

We took a vacation with the kids, and when I was eyeing a decorative bowl,  my son Tyler was upset with me for buying something and not limiting myself. He asked me, “if I needed it?” I thought about the bowl and realized I had one just like it. I passed on the bowl and let him know he helped me make the right decision.

Teach your children to shop wisely and not to be impulsive about spending. Emphasize need, quality, and price.

3. The Dangers of Credit Cards Versus Debit Cards

Having credit cards are a big responsibility for everyone. Credit card debt is toxic to all to carry large balances. Parents should speak to kids about the difficulty of mounting debt if you don’t pay your credit card balance fully. Parents are having their children become authorized users on their cards at an early age. Many banks do not restrict age, allowing a 10-year-old who may not be truly ready to have one.

Parents should use this opportunity to allow their children to learn to take care of cards by getting debit cards. Reasonable spending limits can encourage to make choices. Parents should talk to kids about what to use the cards for and when to use cash. A debit card is an excellent way for your kids to acclimate themselves to using a card with care. 

Related post: A Guide To Your Child’s Credit Report: Pros And Cons

4. Financial Education For Your Family

The T. Rowe Price study found the effectiveness of financial education in the home or school were both falling short.

Most young adults who received some financial education in school are more likely to have a budget, emergency fund, be good with money, and have a retirement account. However, 34% said that their parents have more influence than schools on financial habits. 78% of young adults who received financial education had it in the 12th grade or later.

Encourage your children’s active participation in family matters that concern them. For example, they can make their case about the allowance they will receive, participate in family budgets for items you are shopping for like school supplies, clothes, and vacations.

Parents should enlighten their kids regarding their attitudes about money management. These are essential skills. For example, discuss getting another car. They can discuss why they may prefer to buy a new or used car outright versus taking a loan or leasing a vehicle.

Saving Money

If your goal is saving money, give your children reasons why buying a used car is better. A new car depreciates about 20% on average as soon as you drive it, plus most new cars lose some value in the first year. Along with these savings, you may pay less for sales tax, insurance, and registration fees.

Parents are in the best position to model responsible behavior about money. Once kids make some money on their own, parents should require their kids to save for their car when they begin to drive.

Still, the problem may go beyond parents’ reluctance to discuss money matters. Parents may be lacking in some areas of financial literacy themselves. It is a good idea to learn about money and to invest together as a family. I often talk to my kids about a favorite stock I own and why I still like it. They ask for updates at times.

5. Be Honest With Your Mistakes

We all wish we did everything well. The truth is that we make mistakes. We want our children to do better than us in education, making money, and managing money. If you have made money mistakes, whether it was taking on too much debt and paying it off or not having enough liquidity at times, share that with your kids.

We bought a lot of art and antiques at probably peak prices before we had kids. Frankly, I developed the bug to buy 18th-century Federal furniture and other collectibles, but it doesn’t contribute to retirement savings.

6. (Kiddie) Roth IRA

My mistake in buying antiques, although beautiful, is that antiques are less liquid than other assets when you want to raise money. This realization does allow me to discuss retirement savings with my Generation Z kids. Studies show that this generation is more aware of the need to set up IRA accounts early. Teenagers can contribute to a Roth IRA up to the amount they make from eligible employment.

If my son Tyler earned $2,000 as a camp counselor or at the movie theater, he can invest all or part of the $2,000. If kids invest all of it, parents can’t contribute up to the current maximum of $6,500 in 2021. Contributions to Roth IRA is limited to Tyler’s earned income of $2,000. If your teen is under 18 years, typically the age of majority, they are minors, and a parent has to serve as a custodian.

While it would be great for your teenager to contribute as much as possible to a retirement savings account, even a portion of their earnings would be a great start. The lesson for them is the growth of their contribution is tax-free and will benefit from compounding returns over the decades.

7. Investing In 529 Plan

As parents, you should set up 529 savings accounts for your children’s college education as early as possible. Your children may not even be walking or talking yet, but that shouldn’t stop you from beginning to save for your children’s future with tax-deferred dollars.

It is way too early to know if they will go to college. However, getting an early jump may allow you and your children to reduce the need to take on debt. If you haven’t opened an account yet, involve your children when you open the account and explain it to them. It is good to know that saving early may reduce the need for student debt later on.

8. Showy Social Media…Keeping Up With The Jones

Our kids are growing up with smartphones. They are continually interacting with their friends, reading about restaurants and vacations they have gone on, shopping for trendy clothes, shoes, and bags. They are exposed to many different lifestyles at a much earlier age than we as parents have been.

It is “Keeping Up With The Joneses” on steroids. Social media has led to many conversations after we recognized our kids looking a little crushed at times. They would point out that their friends were getting more things than they were.

An Example

Our son, Tyler, was on X-Box playing Fortnite with his friends all the time. Most of the kids were buying “skins” which are costly (up to $20 per skin), an expensive endeavor if you splurge for 60 skins.

We didn’t want to have to pay for this unnecessary game expense on an ongoing basis. We had to sit down with our son to explain that every family has different resources and spending patterns.  Some families make more, and some families make less. He gave us good feedback.

Weeks later, his group of friends moved on to another game.

9. Share Family Values versus Sharing Your Salaries

Discussing salaries are a complicated topic, requiring thought. Most families are uncomfortable discussing money in general, and even more so sharing their salaries. About 30% of families do not earn a regular paycheck. Besides, what does that figure tell your children? Often, it is an abstract number. Salary is different than your take-home pay because of the taxes you are required to pay.

Some say that revealing your salary is an essential part of educating your children about finances. It may help your children by being open and build trust in your relationship. Explaining how your take-home pay relates to your household expenditures could help your kids make your budget more transparent.

 A Better Life Lesson

Others say that salaries are personal information and children do tend to share everything. How do you explain your salary differences, or do you have to do so? 

There are many variables to discuss money without necessarily sharing your specific earnings or net worth. They prefer to know what you do for a living, do you like your job, and you will always have one.

It is better to share what you value, such as your family, friends, how you live, spirituality, and your beliefs. Learn what they value as well.

10. Charitable Giving

“To whom much is given, much shall be required.” KJV

It is never too early to involve your kids in giving to important causes to the family. It is a way to talk to your kids and find what their interests are. They can put aside some small amount and physically drop it in a box at a local shopping center or send a check. The point is to have them recognize they have social responsibilities larger than themselves.

Final Thoughts

Communicating openly and clearly with your children about money will help them grow more financially confident. It will strengthen their bond with you and earn their trust about financial literacy, a topic you don’t generally talk about with others. Their increased comfort with you will help them with important money management decisions they will need to make, such as college, career, buying an apartment or home.

Related Post: Why You Need An Emergency Fund (And How To Invest It)

What is your experience in speaking to your children about money? What works and doesn’t work? We would like to hear from you!

 

 

 

 

 

 

 

 

 

How Gratitude Can Lead To Better Finances

How Gratitude Can Lead To Better Finances

“Gratitude is not only the greatest of all virtues but the parent of all others.”            

Cicero

You probably don’t need Cicero to tell you that we feel better expressing our thanks to those we love. Telling our families and friends how much we care feels good for both parties. Both givers and receivers of gratitude can serve up a host of advantages that can help us lead more prosperous lives.

Why not be grateful every day? Gratitude studies suggest these benefits:

  • Healthier mental and physical well-being;
  • Our happiness increases;
  • Reduces stress, anger, and other negative emotions;
  • Generates positive chemical reactions in our brains; and
  • It enhances coping mechanisms.

All of these advantages are free AND can lead to better social relationships at work, school, with family and friends. Expressing gratitude is a win-win for us. It can help better deal with our careers and our finances.

How Gratitude Can Lead To Better Finances

 

 Boosts Motivation And Strengthens Our Social Relationships

We spend much of our waking hours working with others in teams, as employees, managers, and clients. Thanking someone for a job well done motivates us. We are getting high ratings on reviews from those we serve, and that feels great.

Gratitude is like a moral barometer. Getting a few words of appreciation from your boss when working on a challenging assignment provides a boost and energy. According to a 2001 study, gratitude is on par with empathy, agreeableness, guilt, and shame. Beneficiaries of gratitude are motivated, behave more prosocial, and are valuable to your team.

When managing others, you want everyone to be equally devoted and contribute to the team’s good, especially for the client. As an employee, you want your peers to share their ideas and efforts. Collaboration is a major part of the future workplace. Both the leader and employees need to be in sync. As the saying goes, you can catch more flies with honey than you do with vinegar. These researchers found experiencing gratitude fosters social behavior for both beneficiaries and benefactors, improving our interpersonal lives.

Increases Patience, Decreases Instant Gratification

Those who are thankful may have more incredible willpower and can delay instant gratification. Delaying gratification is a substantial benefit when it comes to shopping and impulse buying. In a study led by Prof. David DeSteno, a psychologist at Northeastern University, randomly assigned participants went to one of three conditions of which they wrote about a past event that made them: 1) grateful, 2) happy, or 3) neutral.

 Participants had to pick between getting $63 now versus $85 in three months to measure impatience in this study. Those who wrote on experiences that made them feel happy or neutral favored the immediate payout of $63. On the other hand, those who were grateful opted for the higher amount of $85, delaying gratification. The damage is done to our wallets because we are impatient, wanting instant gratification. That can be expensive.

A high percentage of us shop impulsively. Overspending or spending beyond our means leads to higher borrowing, usually on credit cards, which command high-interest costs on unpaid balances.

In a creditcards.com poll:

  • 5 of 6 Americans admit to impulse buying, spending $100 or more.
  • 84% of poll respondents made impulse buys, and 77% did so in three months.
  • 79% made spontaneous purchases in the store, with only 6% buying on their mobile phones.

 

Alternative To Materialism And Envy

Gratitude is negatively associated with envy and materialism. Materialism is a persistent emphasis on lower-order needs of material comfort and physical safety. Those values are in contrast to higher orders like self-expression and quality of life. As gratitude involves wanting what one has rather than having what one wants, instilling a sense of gratitude may help people appreciate the moment’s gifts. That is, free yourself from past regrets and worry about future anxieties. It is a better place to be. With gratitude comes the realization that happiness is not contingent upon materialistic happenings in one’s life. Rather, it is because we are part of caring networks of giving and receiving.

Being grateful is a more frugal pick over being materialistic. We may want expensive homes, luxury cars, and exotic vacations. These things make us feel more prosperous in front of our friends and family as a measure of our success.

Hedonic Treadmill

When we buy a new car, we usually get a boost of energy and happiness that is short-lived. This temporary boost is called a hedonic treadmill or adaption theory. As such, there is a tendency for people to get a quick buzz after their purchase and then quickly return to a stable level of happiness. Buying major things are habitual for some. The enjoyable moment is fleeting (though the bills are not). Spending to be happy often leads to lifestyle inflation which can be costly. Better financial habits can be learned even from millionaires.

One of my favorite books, The Millionaire Next Door, explores the different financial paths of two different kinds of millionaires. In one group are the frugal millionaires. They allocate their time and money efficiently to build wealth. The more typical millionaires concern themselves with the display of their social status but are financially more vulnerable. The book is based on studies from the 1990s and remains relevant today.

Count Your Blessings And Be Happy

Reflect on your present blessings, on which every mand has many, not on your past misfortunes, of which all men have some.”    Charles Dickens

We feel good when we are grateful and we function better with others. We live more prosperous lives, not solely based on money but as fulfilled beings. Grateful people have more resources–psychological, social, and spiritual–that can be drawn on in times of need.

A 2013 survey confirms earlier studies and broadens the demographics finding:

  • Americans are a grateful bunch.
  • Women are more grateful than men. (I knew that!)
  • Age is not much of a factor in gratitude as gender is.
  • While “your current job” received the lowest score from those surveyed, that is, people are not so grateful for their jobs, those earning over $150,000 are. Good to know!

Gratitude has a seemingly endless list of physical, psychological, and emotional benefits that help us live better every day. According to many studies, we have better immune systems, lower blood pressure, sleep better, have less stress, have greater self-worth, are more productive, experience joy and pleasure. Dr. Robert Emmons has pointed to a 25% increase in our happiness levels. Let’s be grateful for that!

Grateful Expressions Boost Our Brains 

Regularly expressing gratitude changes the molecular structure of our brains, A study led by Zahn using functional MRIs to measure the brain activity of participants imagining their own actions toward another person, experiencing different emotions either conformed (eg. gratitude or pride) or were counter to a social value (eg. anger or guilt). They found that gratitude can boost areas of the brain, releasing dopamine, a chemical that plays a positive role in many daily behaviors such as motivation, movement, and energy. I’ll take that dopamine now!

Promotes Generosity

Studies suggest that there is a neural connection between gratitude and altruism. Culturally, we admire people who give to others selflessly. Appreciation from others may lead us to offer more as part of our moral barometer to take great action. Hearing someone being grateful to us may encourage us to feel more generous. When we are beneficiary of kind words, we feel more optimistic, less stressed, and feel good in general.

Giving to others doesn’t always mean charitable donations, although that is meaningful giving. It could also mean volunteering in a soup kitchen, reading a book to a child or an older person in a hospital or rehab center. Paying it forward to others in any way you can has its rewards.

Being Grateful Is Good For Our Career

We are more productive at work, enjoy better relationships with our coworkers, and are more confident in asking for raises. Gratitude cultivates better decision making and improves engagement with others. More sleep and less stress allow thinking more clearly. We are motivated and energetic in our workplaces and better reach our potential.

Being Grateful Leads To Financial Goal Achievement

The same advantages we gain at work can help us deal with our personal lives’ financial situations. We can better handle money management issues head-on rather than delay payments. Procrastination is among the worst traits to have when dealing with money, especially when carrying burdensome debts. Instead, be proactive with your financial situation and make changes when necessary. Postponing bill payments adds late fees, higher interest costs, and negatively impacts your credit scores.

To better achieve our short term and long term financial goals, we need better habits.

Here is a list of ten “must do’s” to strengthen your financial position:

  1. Establish an emergency fund of at least six months of your living expenses in case of unforeseen events.
  2. Automate payments to avoid late fees.
  3. Pay your credit card balances in full, not just the minimum.
  4. Monitor your credit reports to find errors, and find ways to improve your FICO score. A higher score will help when you can have financial flexibility when needed.
  5. Save for retirement through tax-advantaged employer-sponsored benefits. Separately open up an IRA (preferably a Roth IRA) for more retirement savings.
  6. Set up a 529 savings plan as early as possible for your newborn. You will benefit from more years to invest; compound interest on interest will help you avoid borrowing later on for your children’s college tuition.
  7. Spend within your means to lessen or eliminate your borrowing needs.
  8. Don’t be impulsive when shopping. Retailers encourage us to spend, so counter those tendencies by buying what you need and value.
  9. Pay your income taxes on time and avoid unnecessary penalties. Why pay the government more than you owe?
  10. Earn more by being productive at work, making better decisions, and improving social relationships.

How To Practice Gratitude More

Be thankful for what you have; you’ll end up having more. If you concentrate on what you don’t have, you will never, ever have enough.” Oprah

  1. Simply smile at what you have in terms of family, friends, a job or a career you enjoy.
  2. Send old fashioned “thank you” notes to those whom you are grateful to or for having in your life.
  3. Keep up a gratitude journal to save those great moments.
  4. Practice saying and thinking about gratefulness in a meaningful way.  Exercising your ability to switch gears to counting your blessings rather than focusing on obligations often works for me. With two teenagers, it can be challenging to have some quiet moments for yourself. However, I find it can work for the good.
  5. Sometimes, losing a loved one makes you more grateful. It may run counter to the most challenging experiences. My mother lost her whole immediate family and extended family except for my Uncle before 20. Yet, she was always grateful for her life and that of her brother. It gave her the chance to have her own family.
  6. Having a traumatic experience often makes us grateful. I recently finished and enjoyed I Am I Am I Am, a memoir by Maggie O’Farrell. She had 17 brushes with death. Towards the end of the book, she is talking to a guy about her experiences. He said to her, “How unlucky for you,” to which she emphatically answered, “No, I was quite lucky,” and goes on to express her gratitude which ultimately made her stronger among other emotions.

Final Thoughts

Practicing gratitude is an inexpensive way to feel physically and mentally healthy. Try to have daily doses of gratitude which may help to reduce strains at work and home. It may produce better benefits than spending money impulsively, leading to big bills and higher borrowing costs. There are many reasons in your life to be grateful. Give yourself time to appreciate what you have as often as you can. Express your feelings to others. The perks are worth it.

Do you write in a gratitude journal? Have you been told you are appreciated or have you said it to others? You can make someone’s day better and remove some stress, add some motivation and energy to someone’s day, or helped them to resolve a lingering problem. 

Thank you for reading our blog. You are appreciated!

 

 

 

 

 

 

Working On The Street: Wall Street Jargon Explained

Working On The Street: Wall Street Jargon Explained

I worked on the street. It’s true!

For years, I told my college students and colleagues what I had done for a living before I taught business courses. They would exclaim, “Wow! I never knew anyone who did that!” or “What was that like?” “That’s tough, man!”

A True Story

The first time it happened, I was surprised. I realized, with a delay, the students were replying to another universe until Ron approached me. Ron was a disheveled-looking student I had noticed sitting in the back. Walking toward me, he said, “Professor, that took a lot of guts to share your background with us. I, too, live in the park most nights.” 

Suddenly I was aware I was taking it for granted that they understood “the street” as a common phrase for Wall Street. No, I was not “a lady of the night” but had been an equity analyst on Wall Street. This student had awakened me not only to a misinterpretation I was conveying but his plight living on the streets. With the school’s help, I was able to get him some support, but that story is for another day.

Language can be confusing. Those who have worked on idiosyncratic Wall Street recognize a different language and culture that permeates the business. Each area–research, sales, trading, investment banking, and money management— has its jargon that can be interchangeable. For those who want to work on Wall Street or simply want to know the basics of investing, this post is for you. Invest as early as possible. Use small increments of money at first just to get started..

Wall Street Jargon That Can Be Confounding:

Sellside/ Buyside

When I began my first Wall Street job, I had a lot to learn. As a newbie sell-side junior analyst, I was unfamiliar with a lot of jargon and felt stumped in others’ conversations. I had one particular experience that gave me a lot of personal grief and embarrassment.

It was a conversation with one of my peers, Amy, when she introduced herself. Amy asked me where I had previously worked and shared that she had come from the buy-side. I had come internally to join equity research from the “back office,” that is, the non-revenue producing part of the term.

When Amy said she came from the buyside, I had no idea what she was talking about nor what side I was on. I felt like I was in a war zone for a moment. In my early 20s, I used to turn bright red and never be able to hide it. Immediately, I marched into my boss with my beet-red light bulb face to ask him to explain. He patiently drew a lot of pencil diagrams. We were on the sell-side working for a brokerage/investment banking firm.

As a sell-side analyst, I covered the telecommunications services industry. I evaluated relevant stocks within that sector, published research reports, and made Buy/Sell/Hold recommendations.

The telecom industry was undergoing dramatic deregulation changes, facing new competition, entering the cable, internet, and video markets. I was marketing my research ideas to the buy-side analysts (did their own research) and portfolio managers, that is, institutional investors who were buying equities in my sector.

Long/Short Or Go Long/Go Short

Long/Short refers to what kind of security positions you have in shares. Investors who have “long” Apple shares expect that the stock will rise in value in the future. Short-selling or shorting is a more complex term. A short position is the opposite of a long position. It refers to the borrowing of shares by an investor and immediately sells them, hoping he or she can purchase them later at a lower price for a profit.

Short Interest

Short Interest is a gauge reflecting the number of shares sold short but not yet covered. Investors track them as a percentage or a number. An extremely high short interest for a certain stock may indicate negative market sentiment or high pessimism for that stock.

Short Squeeze

A short squeeze may occur when there is a rapid rise in stock. That happens due to a lack of supply accompanied by an excess demand for that stock. Stock prices rise when unexpected good news or better than expected earnings.

Overly negative sentiment about the company spurs short interest in the company’s shares. Short sellers get caught racing to cover their short position in the stock. Short covering happens to controversial or cult-like stocks like Tesla rise very quickly. Some investors didn’t believe Elon Musk or analysts’ bullish stance and shorted the stock. Then they got squeezed when the Tesla shares rose due to higher revenues than expected. 

GameStop Example

GameStop, a company with uninspiring fundamentals, is a recent example of short squeezes. Influenced by  r/WallStreetBets, there was excessive buying of this stock for no apparent reason other than seeming to want to impact short-sellers. Short squeezes resulted to cover high level of short-selling by hedge funds, among others.

As a result, GameStop (and other stocks) soared in this frenzy, before coming back down to more appropriate prices. Many young investors were caught, owning GameStop shares at these irrational levels, and potentially losing money.

Bull Market And Bear Market

We had a long bull market, or a rising market without a bear market threat until March 2020. The pandemic effects on our economy and the market came swiftly. The bear market arrived, but for only a few weeks.  For it to be a bull or bear market, the rise or fall has to be 20% or more. The term “bear market” came from the early 18th century.  Daniel Defoe said: “Thus every dissembler, every false friend, every secret cheat, every bear-skin jobber, has a cloven foot.” The bear market was first popularized when there was a huge market crash known as The South Sea Bubble of 1720.

There is more to the history of the origination of bulls and bears here. Envision these animals’ movement: bears swipe their paws downward while bull horns rise.

And The Pigs

“Bulls make money, bears make money, pigs get slaughtered,” a saying often recited by investors, portfolio managers, and traders alike. This old Wall Street saying warns investors against excessive greed. If you have a nice profit in your investment, it is a good idea to sell all or a portion to “ring the register.” No stock or investment continues to rise without abatement. A good strategy is to sell part of your position after your security has generated a 20%-25% return.

Taking Profits Off The Table/ Frothy Market

These terms are not synonymous but gradations. Taking money off the table or profit-taking are terms that indicated you sold your shares. Trimming some stocks is a smart move when you have made 20%-25% profits. You do not want to be too greedy. On the other hand, a frothy market is akin to a bubbly glass of beer leaking on the top. These are times when the market has been rising unsustainably.

Irrational Exuberance

As Federal Reserve Chairman, Alan Greenspan, in a late 1996 speech, referred to the risk of irrational exuberance associated with “unduly escalated asset values.”  Asset price inflation occurs when the S& P 500 index carries a price-to-earnings ratio well above its historical range.

Market Correction

A correction usually refers to a 10%  or higher decline of any security or the market. It may occur when the stocks have been rising without many drops and need some kind of pause. Corrections may happen over weeks or months. This produces buying opportunities in the long run. Historically, there have been more corrections than bear markets. Since November 1974 there have been 22 market corrections but only four bear markets according to Schwab Center For Financial Research.

Headline Risk

Sometimes markets seem impervious to bad news and continue to climb. Those are great days but seem too rare. More often, one or more negative financial news stories can provide an overhang to the financial markets, a certain sector (e.g., energy), or particular stock (e.g., Tesla).

Headline risk is news that may affect the price of stocks. Examples of this in past markets are US-China trade talks, Mideast conflict potential, Fed action, coronavirus. or Boeing 737 Max safety issues.

Black Swans

A black swan event comes as a surprise (can be negative or positive) that has a major effect impact on potentially ground shifting magnitude. The term is an ancient saying that relied on black swans not existing in contrast to white swans. However, Dutch explorers were reportedly the first to see black swans in Western Australia in the late 1600s.

Nassim Nicholas Taleb wrote of its theory in his book, “The Black Swan: The Impact of the Highly Improbable.” He argued black swan events have three characteristics:

  • Unpredictable;
  • Massive impact; and,
  • After the fact, an explanation is concocted that makes the event appear less random.

Some examples of black swan events are the rise of the personal computer, the Internet, September 11, 2001, World War I, and the financial crisis.

Bubbles

The most famous bubble is the Dutch tulip mania of the 1630s. It’s considered to be the first speculative one. It occurred during the Dutch Golden age when tulip bulbs were fashionable and had grown to extraordinary levels until their collapse.

A more recent well-known bubble was the US dot-com era in the 1990s until March 2000. Any company that had a “com” at the end of its name benefited from being associated with the hot Internet market. The company LDDS changed its name to Worldcom in the hopes that they would receive a higher valuation like the dotcom companies. The housing bubble is a more recent and familiar phenomenon. The higher pricing of housing financed by subprime mortgages caused the Great Recession.

When stocks rise without taking a pause, market participants fear their prices exceed reasonable valuations causing bubbles. Investors have growing concerns about cryptocurrency and SPACs  (special purpose acquisition companies) becoming bubbles. 

History Rhymes

There is an old saying that, “History doesn’t repeat itself, but it rhymes.” It is often credited to Mark Twain though there is no real proof that he said it. The saying (sometimes  “history rhymes”) comes up as people like to spot new bubbles or new patterns to point out that we have not learned our financial history lesson. Lately, I have been hearing there may be too much corporate debt taken on because of lower interest rates and that this be a bubble about to burst.

Following The Herd

A herd mentality is when investors follow what they believe other investors are buying without using their analysis. There is a danger in doing that as they may be purchased at higher prices at the end of that bullish cycle. This can be seen in stocks rise 20% on average after their initial public offering (IPO). Investors who didn’t participate in the IPO jump in to buy stocks after a big rise. In contrast to the herd instinct, investors often look for stocks with strong volumes as an indicator of increased institutional interest. I have used this strategy to a great degree to spot increased bullishness.

A Dog With Fleas

This saying points to some kind of defect in a company, for example, a business that has little to no growth or potential for any improvement. Most of the time, you can take a dog with fleas to a vet for treatment. Every investor wants to find a stock that has declined or has been “beaten to a pulp” undeservedly because its businesses are performing well. Sometimes it may mean that the shares are trading at a low valuation compared to their peer companies. Therefore, the shares could be “cheap,” “attractive,” or “value” or it may be like a dog with fleas.

An Improved Apple

One example of a dog with fleas was Apple a few years ago. Its growth had appeared to slow. Apple shares were trading at a low valuation despite having reliable businesses. However, no significant new products were being rolled out. Investors were lukewarm to Apple’s uninspiring new releases of its iPhones, iPads, and iMacs. Had it become a dog with fleas? 

The Apple Watch then gained popularity while the company transitioned to a service company from its lower-margin equipment roots and began its streaming business.  As a result, Apple shares have been performing well for a while.

Clearly, Apple is not a dog with fleas now.  On the other hand, dogs with fleas often refer to a company whose weak businesses may not be that apparent. The Boston Consulting Group (BCG) matrix recommends selling dogs as businesses with little potential for growth. Unfortunately for dogs, a lot of terms use them with negative sentiment.

Dogs Of The Dow

The Dow refers to  30 stocks of well-known large publicly companies, also known as “blue-chips”,  that compose the Dow Jones Industrial Average (DJIA).  An investment strategy popularized by Michael O’Higgins in 1991 was to buy the Dogs of the Dow, the 10 stocks which were part of the DJIA and had the highest dividend yields. The premise was investors could buy these high yielding but relatively safe stocks that had sold off. Many believe these stocks would rebound faster than the overall Dow.

Dividend Aristocrats

Another investor strategy is to buy stocks that are “Dividend Aristocrats.” A dividend aristocrat is a company that pays dividends consistently and raises its dividend relative to the size of its payouts to shareholders for at least 25 years consecutively.

Flight To Quality Or Safety

At times there may be several factors that converge on the markets, which add substantial risk. Stocks may decline if there are rising interest rates, a slowing economy, and reduced earnings estimates for the upcoming quarters. Investors may rotate out of specific sectors like tech growth stocks and flock to safer stocks with above-average yields. They may even rotate out of the equity markets and put money into Treasury securities. As the housing sector weakened leading up to the Great Recession, buyers sought refuge in these safer securities.

Widows and Orphans Stock

During times when there is an economic downturn, investors turn to safe harbors or “a flight to safety.” When a broker refers to buying “widows and orphans” stock for your portfolio it is usually for your protection against market volatility. Along with elderly people, widows and orphans refer to those most vulnerable in our society. These “vulnerables” require the preservation of capital associated with stocks like utilities with lower risk and lower return profiles.

Rising Tide Lifts All Boats

This term typically means that an improving economy will generally help most industries. Investors seeking shares in a specific industry, say energy or apparel, may see all such companies in the sector benefit from their industry’s fundamental strength. Often, some investors seek the best stock in the group, which may carry a premium valuation. On the other hand, value investors may look for those stocks in that particular industry trading at a discount hoping the valuation gap will narrow, thereby making a profit.

Bottom Fishing/Taken To The Woodshed

Going bottom fishing is often done by investors looking for bargains in stocks. Bad or unexpected news cause declines in share prices. It could be that the company reported earnings below expectations or apparent weakness in its business. The market–analysts, traders, investors–may have taken the company to the woodshed. That stock is now reflecting a cheap valuation because of its disappointment in the market. When valuation reaches a depressed level, and its risk is now fairly reflected in its price, investors go bottom fishing for potential good value.

Priced For Perfection

When shares are at high valuations relative to their historic levels, some say they are “priced for perfection.”  It may be challenging to hold these stocks because investors may treat the shares harshly if there is any earnings disappointment.  Any disappointment in its earning report–revenues, margins, subscribers, earnings, or forecast–will be why the shares sell-off.

Catch A Falling Knife

The image of this term used to make me wince a bit. When you own a stock that seems to be falling day after the trading day, there is a tendency to think that those shares must be reaching the bottom. If so, it could help you to reduce your cost of those shares by dollar-averaging. However, catching a falling knife refers to a stock that has its own downward trajectory, and investors should exercise some patience.

In 2017-2018, GE shares, historically considered a blue-chip stock part of the Dow Jones index, became such a stock. It was an absolute wreck, and its shares were in a downward spiral. Many analysts who covered this stock essentially said, “Don’t touch,” which caused GE to fall further. Sometimes, these falling knives may become bargains or even beautiful swans but it often takes major management changes and aggressive restructuring, which appears to be happening for GE.

Dead Cat Bounce

We have to give cats their due after using dogs, swans, pigs, and fish. After a long downward decline in the market or certain shares, a dead cat bounce occurs when there is temporary upward movement until the decline resumes.

Pound The Table/Back Up The Truck

Analysts on the sell-side must back up their recommendations or any changes they make to their earnings model, price targets, and earnings results. If a company reported better than expected numbers, the analyst would speak to their salesforce at the morning meeting, aggressively recommending a “Buy” on the stock. This event is “pounding the table” or telling others “to back up the truck” to load stock. Having a lot of confidence in a stock or sector often is mixed with the fear of being wrong as analysts undeniably are.

Among the more intimidating experiences analysts face is when you have to address this same audience with disappointing news in one of your stocks. That often feels like going in front of a firing squad. If you were downgrading your stock to “Sell,” this was an awkward conversation if they had recently bought the shares from your firm. The salespeople had the difficult task of explaining to their clients why their analyst’s perspective had changed.

 

Final Thoughts

Every industry has its bewildering lingo. When investing on your own and doing your own analysis, running into Wall Street jargon can be a distraction. This list of terms or sayings is only a small portion of words that belong in a larger glossary. I will add investment banking and equity analyst terms to make investing more manageable for you. I believe that everyone should be learning how to invest. Make use of a longer horizon, so you benefit from compounding returns for your retirement and investment accounts. For now, I hope this helps.

We have several related posts on Investing:

Guide For Investing Beginners

Diversifying Your Portfolio

How Stock Markets Games Can Teach Investing

 

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