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Resetting the asset test deeming rate thresholds

20 September 2017

The deeming thresholds will be reset to $30,000 for singles and $50,000 for couples from 20 September 2017 (for both pensioners and allowees). Current thresholds are $46,600 for singles, $77,400 for couples and $38,700 for members of allowee couples.

 

GEM Capital Comment

This measure effectively increases the amount of assessable income from deemed financial investments.

The proposal will impact the social security entitlements of income test affected pensioners and allowees. Additionally, older people subject to income tested residential aged care or home care fees may also be affected.

This measure will also impact holders of account based pensions which are impacted by the recent legislative change to deem account based pensions from 1 January 2015. 

Changes to the Commonwealth Seniors Health Card (CSHC)

The Government has announced a number of changes to the Commonwealth Seniors Health Card (CSHC). The CSHC allows self-funded retirees to gain access to medicines listed on the Pharmaceuticals Benefits Scheme at a concessional rate as well as other concessions.

 

To be eligible, a person must have an adjusted taxable income (ATI) of:

  •   $50,000 (singles)

  •   $80,000 (couples, combined), or

  •   $100,000 (couples, combined, for couples separated by illness or respite care)

    The proposed changes include:

  •   Annual indexation of the income thresholds to Consumer Price Index from September 2014.

  •   Account based pensions (ABP) that are subject to deeming will be included in the CSHC income test from 1 January 2015. Grandfathering applies to holders of a CSHC on 1 January 2015 with an ABP commenced prior to that date.

  •   Holders of the CSHC will cease to receive the Seniors Supplement beyond the June 2014 quarter. The Seniors Supplement is currently $876.20 p.a. (singles or couples separated due to illness) or $660.40 (couples, each). CSHC holders will still receive the Clean Energy Supplement.

  •  

 

GEM Capital Comment

The inclusion of deemed income on account based pensions in the assessment of income to determine eligibility to the CSHC will have a significant impact on a number of self- funded retirees.

Under the proposed change, based on the current deeming rates and thresholds and assuming no other income, a new applicant will not qualify for a CSHC if their ABP exceeds $1,448,543 (singles) or $2,318,886 (couple, combined).

However, these changes will not only impact self-funded retirees with large ABP balances, but also those with lower ABP balances who have other Adjusted Taxable Income such as income from untaxed Government schemes or foreign pensions.

The proposed change has a number of implications for holders of account based pensions. The grandfathering provision essentially “locks” clients into their existing ABP provider as any change after 1 January 2015 will see the new ABP deemed for CSHC purposes. 

Age pension age to increase to 70 by 2035

 

The Budget confirmed the Treasurer’s earlier announcement that the age pension age will increase to age 70 by the year 2035. This means that those born on or after 1 January 1966 (currently 48 years of age or younger) will have to wait until they are 70 before they are eligible for the age pension.

While the current pension age for both men and women is 65, it has been legislated that from 1 July 2017, the qualifying age for Age Pension will increase from 65 years to 65.5 years for both men and women. The qualifying age will then rise by six months every two years, reaching 67 by 1 July 2023. See table below. 

 

Date of birth

Qualifying age at

Commencing from

1 July 1952 to 31 December 1953

65.5

1 July 2017

1 January 1954 to 30 June 1955

66

1 July 2019

1 July 1955 to 31 December 1956

66.5

1 July 2021

From 1 January 1957

67

1 July 2023

 

The changes proposed in the Budget will continue the propose increase in the pension age as follows:

Date of birth

Qualifying age at

Commencing from

1 July 1958 to 31 December 1959

67.5

1 July 2025

1 January 1960 to 30 June 1961

68

1 July 2027

1 July 1961 to 31 December 1962

68.5

1 July 2029

1 January 1963 to 30 June 1964

69

1 July 2031

1 July 1964 to 31 December 1965

69.5

1 July 2033

1 January 1966 onwards

70

1 July 2035

 

GEM Capital Comment

Whilst the policy intention is to encourage people to continue working until age 70, the reality is many people will be unable to continue working. This means there will likely be a gap between when someone retires and when they qualify for the age pension.

How much additional superannuation will be required to fund this gap? A person who is currently 48 (born 1 January 1966) who wishes to retire at age 65, will require approximately $96,432 to generate the equivalent of the maximum age pension currently $21,912 p.a. (for singles) to fund the five-year gap. For members of a couple, they require approximately $72,689 each to fund the five year gap.

This is a substantial amount to accumulate over the next 16 1⁄2 years. To close this gap, a 48 year old today will need to make additional pre-tax contributions of approx. $5,232 p.a. (for singles) or $3,943 p.a. (for members of a couple) every year for the next 16 1⁄2 years.

Assumptions:

Figures are shown in today’s dollars; rate of inflation of 3% p.a. Centrelink rates for the period between 20 March 2014 and 30 June 2014. Pensions are indexed at 3.0% p.a. An account based pension is to be commenced at age 65 with rate of return of 7% p.a. Contributions tax of 15%, rate of return on investment in accumulation phase is 6.0% p.a. net of taxes and fees. Super contributions will increase by 3.5% p.a. 

 

 

 

Wednesday, 12 March 2014 08:25

Aussies should be investing overseas now

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Investment specialist Douglas Isles, from Platinum Asset Management talks with Peter Switzer on Sky Business News about the reasons why Australian investors should think about investing outside of Australia.

 

Douglas offers his views on which markets look attractive, the $AUD and much more.

 

 

Media

Tuesday, 04 March 2014 14:20

Warren Buffet's - 5 Investing Don'ts

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Warren Buffet, attributed as one of the best investors of the 20th century and one of the world's wealthiest people recently gave an interview to CBNC.  During this interview, 5 specific things NOT TO DO came from the discussion.  Warren Buffet's net worth is estimated to be around US$60bn at the time of writing this blog.

 

1. Don’t let world events affect your investing decisions.

Even if the Oracle of Omaha said he knew a big war was unavoidable, “I will still be buying stock ... The one thing you can be sure of is if we went into some very major war, the value of money would go down,” CNBC reported him as saying on its web site.

“The last thing you want to do is hold money during a war. You might want to own a farm, you might want to own an apartment house, you might want to own securities. During World War II the stock market advanced. The stock market is going to advance over time.”

 

2. Don’t feel bad when stocks go down

Even as global markets began to gyrate because of the Russian military build-up in the CRimean region of neighbouring Ukraine, the 83-year-old head of Berkshire Hathaway said: “When I got up this morning I actually looked at a stock on the computer, on the trades in London, that we’re buying and it’s down and I felt good ... We were buying it on Friday and it’s cheaper this morning and that’s good news.” Asked if he would buy more, he replied: “Absolutely.”

 

3. Don’t think you have to be an expert to profit from stocks

“The stock market just offers you so many opportunities, thousands and thousands of different businesses. You don’t have to be an expert on every one of them. You don’t need to be an expert on 10 percent of them even. You just have to have some conviction that either a given company, or a group of companies ... are likely to make more money five or 10 or 20 years from now than they’re earning now. And that is not a difficult decision to come to,” CNBC reported Buffett as saying.

 

4. Don’t go for the quick profit

When Buffett, whose fortune was estimated in December to be worth about $US59.1 billion ($66.2 billion), was asked if activist investors were acting in the best interest of targeted companies and their shareholders, he replied: “Generally speaking, they are interested in making a quick profit and there’s no law against making quick profits. But our whole attitude in our own business and what we like to see with the businesses we own stock in is we want to run them for the people who are going to stay in rather than the people who are going to get out. At any given time, you can make more money, usually, selling the company. ... The answer isn’t to sell the company. The answer is to keep running the company well. ... I could do certain things to jiggle up the price of Berkshire in the short run. It would not be good for the company over five or 10 years.”

 

5. Don’t put your money into bitcoins for the long run.

When Buffett was asked about the latest craze of investing in the virtual currency Bitcoin, he was quick to reply: “It’s not a currency. It does not meet the test of a currency. I wouldn’t be surprised if it’s not around in 10 or 20 years. ... It’s been a speculative – a very speculative – kind of Buck Rogers-type thing, and people buy and sell them because they hope they go up or down just like they did with tulip bulbs a long time ago.”

 

Thursday, 20 February 2014 08:10

Chinese Credit Boom - will it go BOOM?

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The rate of Chinese debt growth, particularly in the corporate sector and local government sector is now at a level that is drawing attention from ratings agencies to infamous investors like George Soros.

The chart below shows credit levels compared to GDP, and the rate of growth of credit (lending) in 5 countries at various points in time that represent 5 years that preceded a credit crisis.  (Obviously Chinese credit crisis has not yet happened).

 

 

 

 

 

 

 

 

 

 

 

This chart shows similarities between China's level of debt and growth in debt in the past 5 years with the US and UK most recently and Japan and Korea in the 1990's.  What followed in each of these scenarios was recession.

This growth in lending has largely funded Fixed Asset Investment, which is defined as capital expenditure of large items, such as roads, power stations, buildings.

If the rate of lending were to slow significantly, this would more than likely disrupt the level of fixed asset investment in China.

What does this have to do with Australia?  Everything.

Australia currently exports vast quantities of commodities such as iron ore to China that is required for their Fixed Asset Investment program.  A lower level of fixed asset investment would more than likely result in China importing lower quantities of some of Australia's major exports.

The chart below shows that China is now Australia's major export partner.  It used to be said that if the US sneezed, Australia would catch a cold.  Investors must now consider what happens to Australia if China sneezes.

 

 

 

 

Australia has enjoyed a decade of prosperity on the back of a China construction boom, which is now cooling.  Many investments have profited from this.  The challenge for investors now is to ensure that their investment strategy now is not anchored in the past.

 

DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.

 

 

Thursday, 20 February 2014 07:51

RBA Minutes - rates on hold for now

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BillEvans_small_headshot_WIBIQThe minutes of the February 4 RBA Board Meeting confirmed that the Bank now has a neutral bias and has desisted from further talking down the AUD. On interest rates: "the most prudent course would likely be a period of stability in interest rates". Whereas in the December Board minutes the AUD was described as "uncomfortably high" the language used early in 2013 has been restored with "the exchange rates has also depreciated further since the December meeting. If sustained, a lower exchange rate would be expansionary for economic activity and would assist in achieving balanced growth of the economy". Of course that fall has not been sustained with the AUD around US 91c at the time of the December Board meeting falling to US 88c at the time of the February Board meeting but now having rebounded to around US 90.50c, only slightly below the "uncomfortable level" at the time of the December Board meeting.

Commentary around the domestic economy is generally upbeat. Consumption, dwelling investment, business conditions and exports are described as being "more positive". In fact the minutes note that "survey measures suggested that business conditions had improved noticeably in recent months, to be above average levels". Of course the labour market was still described as weak but this was partially dismissed by describing the labour market as a lagging variable. Consistent with that theme, and, in line with the view around spending, the minutes note that the forward looking indicators of labour demand had shown signs of stabilising although were described as "consistent with only moderate growth of employment". There appears to be little consideration in this analysis of the feedback effects from a weak labour market to household confidence and incomes. Indeed the Bank expects that the rise in house prices will boost spending leading to falls in the savings rate.

The unexpected increase in inflation clearly played an important role in discussions. Four different explanations were given for this lift with interestingly the first one mentioned being "an element of noise that occurs in economic data". Other explanations related to: the faster than normal pass through from the lower exchange rate: "a slower than expected pass through from weak wages growth"; and finally the possibility that there was less spare capacity in the economy enabling retailers or wholesalers to increase their margins. The Bank concludes that it was not possible at this stage to distinguish these explanations and it was likely that some combination of these four explanations was at work.

A number of vulnerable remarks appear in these minutes. Firstly, the 3% decline in consumer sentiment back to average levels made the comment "consumer sentiment had recorded a modest decline around the end of 2013" somewhat out of date. A more disturbing issue was around the Bank's forecast for growth of Australia's trading partners which is expected to increase to be above average in 2014. It would be our view that with Chinese growth likely to decelerate this growth outlook seems overly optimistic.

Conclusion

There are no significant surprises in these minutes. If the Bank had decided to continue talking down the AUD possibly with less strident language than "uncomfortably high" then it is likely to have been covered in the Governor's statement accompanying the decision two weeks ago. With no lead from the Governor it was not surprising that the language around the AUD has reverted back that period in 2013 when there was no explicit effort to talk down the AUD. The Governor also made it clear that policy had been moved to a neutral stance and these minutes confirm that view. There are a number of behavioural assumptions in the minutes. Firstly it is assumed that the labour market will lag economic growth with feedback effects from employment to incomes and confidence tending to be overlooked. It is therefore assumed that the rise in house prices will prompt a marked lift in consumer spending through the wealth effect and therefore a reduction in the savings rate. We tend to be more sceptical around that dynamic given the ongoing attitude of households since the Reserve Bank started to cut rates in November 2011. However we do accept the explanation that the unexpected lift in the inflation rate most likely shows some noise; a faster than expected response to the fall in the currency and a slower response to soft wages growth. With the AUD now stabilising and wages growth remaining soft the wages story is likely to be the dominant driver of inflation through 2014.

Our forecast that the RBA will need to cut rates further in the second half of 2014 clearly hinges on the likely outlook, at that time, for growth in 2015 . Factors that will impact on that outlook will include the ongoing downturn in mining; fiscal consolidation; the impact of a fall in the terms of trade; and two important macro dynamics which the Bank appears to be understating. These are the direct feedback effects on confidence and incomes of the weak labour market and ongoing caution amongst business and consumers.

Bill Evans - Chief Economist - Westpac Banking Corp

DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.

Saturday, 15 February 2014 05:47

US Recovery - It's real!

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There continues to be much skepticism among the general public about the recovery of the US economy.

In this article, we provide a series of charts that show that the US recovery is very real.

Further evidence can be seen in the US share market.  During the most recent company reporting season we saw 68% of companies in the S & P 500 beating earnings expectations.

US Labour Market recovery

The next chart shows the average monthly employment growth - note that a number of 200,000 new jobs is required to lower the unemployment rate.

US Employment GrowthThe US Housing market has a multiplier effect throughout the economy both in terms of employment as well as consumer spending.  Activity and prices have most certainly turned as can be seen in the chart below.

US Housing Market RecoveryThe US Budget position has dramatically improved as economic activity has turned.

US Budget PositionUS energy sufficiencyUS Corporates are also in good shape - earnings have beaten expectations and their balance sheets are in good shape.

US Corporates in good shape

 

DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.

 

 

Monday, 03 February 2014 01:23

Emerging Market Risks - How Serious?

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Key pointsWorld Peace

- Concerns about emerging countries on the back of various political problems and trade imbalances that leave them vulnerable as the Fed slows down its monetary stimulus appear to have triggered a correction in share markets.

- However, while it makes sense to be cautious about emerging market shares generally, a re-run of the 1997-98 Asian crisis is unlikely and emerging markets are unlikely to pose a major threat to global economic recovery.

Introduction

The past week has seen renewed concerns about the emerging world reflecting a combination of political problems in several countries including Turkey and the Ukraine, a currency devaluation in Argentina and ongoing concerns about Chinese growth. Such concerns also reflect the impact of the Fed slowing its monetary stimulus at a time when parts of the emerging world are vulnerable.

This has seen falls in emerging market shares and currencies. Moreover, fears about exposure to the emerging world and a possible threat to global growth have seen share markets in advanced countries fall nearly 4% over the last week. Concern has returned that we may see a re-run of the 1997-98 “Asian-emerging markets crisis”.

Our assessment remains that another “Asian-emerging markets crisis” is unlikely. However, it is even clearer that the secular cycle has now turned against emerging market shares (EMs) relative to developed markets (DMs).

The 1997-98 Asian/emerging market crisis

Economic history reminds us repeatedly about the prevalence of cycles – both short term and long term. Asian and emerging countries and shares are not immune having gone in and out of favour several times over the last few decades. In the mid 1990s there was much talk of an “Asian miracle”. Growth was thought to be assured by high savings and investment rates, strong export growth and a shift in labour from rural areas to cities. However, as is often the case during good times, excesses set in including a growing reliance on foreign capital, current account deficits, excessive debt levels and over-valued fixed exchange rates. Eventually foreign investors had doubts. In mid-1997 Thailand experienced capital outflows that became a torrent and triggered a collapse in its fixed currency, which then led investors to search for countries with similar vulnerabilities (so-called “Asian contagion”) which led to the crisis spreading across the emerging world ultimately contributing to Russia’s debt default of 1998 that briefly dragged down developed market shares in August 1998.

In the 2000s, Asian and emerging countries mostly got their act together thanks to a range of productivity enhancing reforms, less reliance on foreign capital, low and floating exchange rates and high foreign exchange reserves and this along with the industrialisation of China and a related surge in commodity prices (which benefited South American countries and Russia) saw their growth rates improve. The enhanced perception of emerging countries and a secular slump in the traditional advanced economies of the US, Europe and Japan at the same time saw them once more come into favour amongst investors.

This reached a crescendo after the global financial crisis with talk of a “new normal” of poor growth in advanced countries and their rounds of quantitative easing encouraging capital flows to the “stronger” emerging markets leading in fact to talk of “currency wars” as EM currencies rose. The surge in the value of Asian currencies versus the $US over the last decade as a result of strong capital inflows can be seen in the next chart. Recent weakness has only reversed a small portion of the rally from Asian crisis lows, but emerging market currencies generally have been a lot weaker, having been in a down trend since 2011 (just like the $A!).

image1

Back to the future?

Has Asia and the emerging world just gone full circle such that it’s now standing on the precipice once more? Several factors are driving current worries:

  • Fed tapering has led to fears of a reversal in the money flow to the emerging world that may have come from quantitative easing. Transitions in Fed monetary policy often have implications beyond the US, eg the Mexican crisis when the Fed moved to tighten in 1994.
  • This has occurred at a time when the flow of news in developed countries – the US, Europe and Japan - has continued to improve.
  • Some emerging countries face political problems – the Ukraine, Turkey, Argentina and Thailand.
  • Several emerging countries, notably Brazil, India and Indonesia, used the capital inflows that occurred as a result of quantitative easing in the US to finance budget and current account deficits.
  • Slower growth in China has taken its toll on the emerging world generally by putting downwards pressure on commodity prices and dragging on the demand for imports from the Asian region.
  • More fundamentally, the boom years of the last decade allowed several emerging countries to go easy on necessary structural reforms. Poor infrastructure, excessive regulation and restrictive labour laws are key problems. The end result has been inflation and trade imbalances and reduced potential growth rates.

The end result has been for investors to start rethinking the outlook for emerging countries with flows heading back to the advanced countries. The problem for emerging countries in raising their interest rates to support their currencies – as has occurred in several including Brazil, India and Indonesia – is that it further serves to slow economic growth making the investment outlook in such countries even less enticing.

Put simply, there is no easy way out for countries with current account deficits when foreign investors start to withdraw their capital. In the short term domestic spending must fall, interest rates must rise and exchange rates fall to bring this about. The only way to sustained stronger long term growth is to reform their economies, but that takes time.

Still not 1997, but the risks have increased

The next table compares the state of current account deficits & inflation today with the situation before the 1997-98 crisis.

Not as vulnerable as in 1997

  Current account, %GDP FX reserves, $USbn Inflation rate, %
  1996 Now 1997 Now 1996 Now
Indonesia -3.2 -3.9 17 99 7.9 8.4
Thailand -7.9 -1.6 27 167 5.9 2.2
India -1.6 -3.1 20 295 9.0 9.9
Korea -4.4 4.6 20 345 5.1 1.1
Taiwan 3.9 10.0 84 421 3.1 0.3
Malaysia -4.4 5.0 15 136 3.5 2.9
Singapore 13.8 18.5 73 272 1.1 2.6
HK 3.9 2.3 93 309 5.9 4.3
China 0.9 1.9 140 3726 8.3 2.5
Brazil -2.7 -3.7 58 376 9.6 5.9
Russia 2.8 2.3 25 524 21.8 6.4

Source: IMF, Bloomberg, AMP Capital

The overall position of emerging countries remains stronger today. Current account balances are generally in better shape, central banks have much higher foreign exchange reserves, exchange rates are floating rather than fixed and not as high as they were before the Asian crisis and inflation is lower. Having mostly floating rather than fixed exchange rates is a big distinction today because, as IMF research has confirmed, floating exchange rates are less prone to crises than fixed: they create less economic distortions and don't need to be defended from speculative attacks.

image2

Source: IMF, AMP Capital

However, several countries are vulnerable, particularly Brazil, India and Indonesia where current accounts have moved heavily into deficit indicating a now heavy reliance on foreign capital inflows. See the previous chart.
Other emerging markets that are vulnerable thanks to current account deficits and hence a reliance on foreign capital inflows are the Ukraine, Turkey, South Africa and Chile.
By contrast China, South Korea, Taiwan and Russia with large current account surpluses are far less vulnerable.

While we don’t see a re-run of the Asian-emerging market crisis or a sharp collapse in emerging market growth the risks have clearly increased particularly for countries that now have large current account deficits. Emerging market growth generally is likely to be softer in the years ahead than what we got used to last decade.

Implications for investors

There are several implications for investors:
First, while emerging market shares are relatively cheap (with forward price to earnings multiples of around 10 times compared to 14 times for global shares) it’s too early to strategically reweight towards them. Notwithstanding likely bounces in relative performance along the way, the secular underperformance by emerging market shares relative to developed market shares could have a fair way to go yet, particularly given the extent of outperformance last decade.

image3

Second, investors in emerging markets should focus on current account surplus countries as these are less vulnerable to foreign capital flows, eg China and Korea. And in any case Chinese shares are amongst the cheapest in the emerging world.
Thirdly, emerging markets are unlikely to pose a severe threat to growth in advanced countries. Yes the emerging market share of world GDP is now just over 50% compared to around 35% in the mid-1990s, but more fundamentally a sharp slump in emerging market growth is unlikely given the stronger position of many emerging countries today compared to that prior to the Asian-Emerging Market crisis.
Fourthly, emerging market worries appear to have provided the trigger for a correction in advanced country share markets that high levels of investor sentiment had left them vulnerable to. But once investor sentiment falls back to more normal levels the rally in shares is likely to resume.

Finally, while a recession in emerging market countries is unlikely, slower growth than seen over the last decade will act as a bit of a constraint on commodity demand, providing another reason why the broad trend in the Australian dollar will likely remain down. Ultimately I still see the $A heading down to $US0.80.

Dr Shane Oliver

Head of Investment Strategy and Chief Economist AMP Capital

 

DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.

 

Friday, 24 January 2014 20:41

Common Investor Mistakes from Human Bias - Part One

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DohInsideEfficient investment market theory states that as all investors have access to exactly the same information at the same time, there are many well resourced participants, therefore it is impossible for investors to do better than the market.

Efficient market theory would work it if weren't for one thing - there is human involvement in the investment making decision progress and humans are hard wired differently and have many different personal biases and traps.

 

Here were begin examining some common investor short comings in a bid to help you reduce the number of mistakes made as an investor.

1. Confirmation Bias - as intelligent people we believe that we make decisions based on researching facts and analysing information.  We tend to suffer from Confirmation Bias where a decision is made and then information is sought from sources that support our pre-conceived ideas.

 

2. Loss Aversion - Humans are highly loss averse.  Studies have been done that show people are two and a half times more sensitive to loss than they are to gain.  Suppose you had a choice where you can accept a sure $500 or you can face 50-50 odds that you will either win $1,000 or nothing at all.  What would you do?

Or suppose that you are in the unfortunate situation where you have lost $500.  However instead of accepting this loss, you can face 50-50 odds that you either lose $1,000 or you lose nothing.  How would you react?  In a study more than half the students in this situation would take the chance of losing $1,000 instead of accepting a sure loss of $500. Phychologists emphasise that although people generally behave conservatively when it comes to risk, they are much more willing to take risks when they think they might be able to avert a loss.

 

3. Framing - is a cognitive characteristic in which people tend to reach conclusions based on the 'framework' within which a situation was presented.

This behaviour can result in making poor choices such as selling winning investments rather than realising  a loss on a poor investment.

For example consider a community preparing for the outbreak of an unusual disease which is expected to kill 600 people.

Question

A) If Program A is adopted, 200 people will be saved

B) If Program B is adopted, there is a 33% chance that 600 people will be saved, and 67% chance that no people will be saved.

Which Program would you choose?

Results from a conference where this was asked showed that 72% of respondents would choose Program A, despite the fact that the outcome of both Programs are the same.

 

4. Anchoring - the use of irrelevant information as a reference for evaluating or estimating some unknown value or information.  When anchoring, people base decisions or estimates on events or values known to them, even though these facts may have no bearing on the actual event or value.

In the context of investing, investors will tend to hang on to losing investments by waiting for the investment to break even at a the price at which it was purchased.  Thus, they anchor the value of their investment to the value it once had, and instead of selling it to realise the loss, they take on greater risk by holding it in the hope it will go back up to its purchase price.

 

5. Over-reaction and Availability Bias - One consequence of having emotion in the stock market is the overreaction toward new information. According to market efficiency, new information should more or less be reflected instantly in a security's price. For example, good news should raise a business' share price accordingly, and that gain in share price should not decline if no new information has been released since.

Reality, however, tends to contradict this theory. Oftentimes, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time.

Winners and Losers - example


In 1985, behavioral finance academics Werner De Bondt and Richard Thaler released a study in the Journal of Finance called "Does the Market Overreact?" In this study, the two examined returns on the New York Stock Exchange for a three-year period. From these stocks, they separated the best 35 performing stocks into a "winners portfolio" and the worst 35 performing stocks were then added to a "losers portfolio". De Bondt and Thaler then tracked each portfolio's performance against a representative market index for three years.

Surprisingly, it was found that the losers portfolio consistently beat the market index, while the winners portfolio consistently underperformed. In total, the cumulative difference between the two portfolios was almost 25% during the three-year time span. In other words, it appears that the original "winners" would become "losers", and vice versa.

 

Investing is both a science and an art.  Keeping controls of ones emotions plays a large part in the outcome.

"Individuals who cannot master their emotions are ill-suited to profit from the investment process"

"The investors chief problem, and even his worst enemy - is likely to be himself"

"To achieve satisfactory investment results is easier than most people realise, to achieve superior results is harder than it looks"

Benjamin Graham (attributed to teaching Warren Buffett)