It’s a funny thing, when you think about it, that if you owned a stock in the market and the value went up 50%, and then went down 50%, that it wouldn’t end up at what it started.

Another way to look at it, is if you owned something worth 100 and it lost 50%, it’d be worth 50. To get back to being worth 100 you’d then need a 100% gain. 

Asymmetry of returns

With the castles in the air approach a thing is worth what others will pay for it. If you can sell it to someone for twice the price then it’s worth that. You’ll often see this in bubbles (dot com, tulip, bitcoin…). It was described by John Maynard Keynes using the analogy of a beauty contest where you have to select the prettiest faces out of 100, and the prize goes to the selection closest to the group as a whole. Whether or not they’re actually pretty doesn’t matter if you can guess which faces others think are pretty. If you can predict what the crowd will do, then you can get their first and make a profit.

The firm foundations approach on the other hand is about finding solid reasons for assessing value based on analysis of the fundamentals of an asset, a firm anchor, it’s intrinsic value. If you can value something through this approach then a good bet is simply if the current asking price is less than the intrinsic value. The market will eventually correct for it and you’ll make money.

See A Random Walk Down Wall Street, by Burton Malkiel for more.

Approaches to asset valuation: Castles in the air and firm foundations

I work at Nutmeg and it’s one of the benefits we offer as standard whose importance is least understood. Perhaps this goes a little way to explaining it. It’s essentially about maintaining your risk exposure at the level you originally chose even as markets move and your different assets perform either well or badly.

Rebalancing your portfolio

I could never remember which was which and here is the way to remember it: when bulls attack they swipe up, and when bears attack they swipe down — just like their respective markets.

Bull market, bear market

Dividing up money in your head. Nutmeg, where I work, is, among other things, designed to help out with this.

PS
It’s been a long absence. A new child, moving house and all sorts of fun has happened. I’ll try to keep at it at a more leisurely pace. Thanks again for following.

Mental accounting

Turns out there are a lot of ways not to say the market is down and your investments have lost value. Try also: quieter or choppy.

Euphemisms for losing money

Your preference for risk - a psychological measure that changes slowly throughout our lifetime except for sudden shifts with big life events (eg losing a family member, having a baby).

Your capacity for loss - a situational factor that depends on your circumstances and, say, the context of the money you are taking a risk with. For example, if money is an unexpected bonus or gift, then you probably have a greater capacity for its loss, than if you earned it.

Both aspects are important. For example, some people are naturally daredevils on the ski-slopes, but even they may slow down a little when they have a family depending on them.

Core components of risk

We usually only see the winners. The losers tend to disappear from the record. Which is why all the fund managers in the papers seem to be giving great returns, or starting the next Whatsapp or Instagram seems like such a sure fire way to get rich. We don’t see all the funds, apps and entrepreneurs who never made it.

Survivorship bias

Hindsight bias, Loss aversion and Recency bias. Parents in particular frustratingly seem to suffer from hindsight bias where everything becomes blindingly obvious as soon as a child has dropped the glass/fallen over/bumped into someone. Though ‘careful’ is not so useful after the fact.

Sneaky cognitive biases: hindsight bias, loss aversion, recency bias

Zone of Possible Agreement

The cost of doing nothing

ISAs are like buckets

Extending my building block metaphor into Tetris.

A portfolio can reduce your overall risk

Individual investments, assembled together, make a portfolio, that is greater than the sum of it’s parts.

Investments are like building blocks

Your ISA allowance is one-way

ISAs are like wrappers

Rather than putting all your money into the market at once, by feeding your money in by installments you can reduce your overall risk, as the impact of big market movements is lessened.

Sketchplanations tagged with investing