Familiarity Bias vs. Ambiguity Effect

Or otherwise known as reliance on old-fashioned financial institutions and outdated economic structures.  Partly, it is due to habit; partly, because of our concerns about liquidity; and partly, because we think that it is always risky to experiment with new things where we might lack information (“ambiguity”).

We seem to want to persist in using the tried financial technology that was used by our grandparents—Savings & Fixed Deposits—even though there may be memories of major economic dislocations in your grandparents’ times.

Strangely, we are very happy to adopt the newest smart phones, the latest kind of computers or automotive technology.  We do see rapid progress in those areas.  But progress in financial technology and how we invest our hard earned cash is another matter altogether.

Familiarity-Known-Not-Unknown

As a risk-averse investor we might tend to put our money into “safe” investments such as government bonds and bank deposits, as opposed to more volatile investments such as stocks and funds.

Even though the stock market is statistically the most likely one to provide a significantly higher return over time, we might prefer the “safe” investment in which the return is known, instead of the less predictable stock market in which the return is not known.

Let’s make it less ambiguous with an illustration in Hindu-Arabic numerals?

Let’s look at how the different investment classes would have fared over the last 5 years in Singapore (where I live).

(updated as of 31 Oct 2016)

A) For a 12 months FD (not really very liquid!), you would have “earned” 0.3% interest per year.

B) For a conservative Short Term Singapore Bond Unit Trust (Nikko AM Shenton Short Term Bond), you would have “earned” 2.6% interest per year.

C) For an automated low cost participation in the stock market via the Straits Times Index ETF (Exchange Traded Fund), you would have earned 4.3% per year (including re-invested Dividends).

But the above returns are just in paper money.  As we cannot live from paper alone, we need to convert that money into food, goods, accommodation, transportation, and so on.  Unfortunately, these items are getting more expensive over time.  In Singapore, the Consumer Price Inflation (= delayed taxation) came out at averagely 2.5% per year over the last 5 years.

Never forget to take that silent killer of savings, capital, and economic growth into account!

Inflation of 3% per year – for example -, though barely noticed but persisting for twenty years, cuts the value of your savings almost in half.

What would that mean for a hypothetical 10,000 SGD investment made in October 2011?

A) Your Fixed Deposit would now be worth 8,922 SGD (in purchasing power adjusted dollars).

B) Your Short Term Bonds would still be worth 10,022 SGD.  Not really what you have hoped for.

C) Your STI ETF would now be worth 10,904 SGD.

So if you are happy letting your hard-earned money laze around and shrivel in the tropical sun (also called burning cash), stick with your old fashioned Fixed Deposits or Bonds.

However, if you are determined to let your money work harder for you, but do not wish to spend your precious time in selecting individual stocks to invest in, you’d better get yourself informed about investments in Exchange Traded Funds (which actually is much easier than it sounds, provided you ask your banker the right questions and don’t let him lure you into high commission (for him only) unit trusts).

And yes, some of you might think about putting your money into Gold.  Not a bad choice right now as Gold is the “purest form of money” available and is not contaminated by the current fiat paper system.  Just for completeness sake, a 10,000 SGD investment into physical gold back in October 2011 would have shrunk to 6,678 SGD by now.  Yes, the last 5 years were lousy for gold bugs despite the nice appreciating since beginning of 2016.  Gold as a hedge against the fallout from unsustainable monetary policies is certainly a long-term decision requiring some conviction.

 

“Inflation is when you pay 15 dollars for the 10 dollar-haircut you used to get for 5 dollars when you had hair.” — Sam Ewing, comedian

Warren Buffet advised the trustee of his will: “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund (= Exchange Traded Fund).  I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions or individuals—who employ high-fee managers.”

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