What’s In The Book?
The Financialist • Issue 86 • April 2005
BY BRETT SIMPSON
"It was the best of times; it was the worst of times." This article is not a Tale of Two Cities, but rather a tale of two numbers and their effect on investor behavior.
The two main characters in our tale of finance are Book Value and Market Value. Usually side by side, they appear, begging our scrutiny, teasing our emotions and testing our logic with compulsive frequency. Delivered with regulatory efficiency, our statement holds up both values to speak their tale of fortune, or lack thereof. Both speak eloquently, finding our most vulnerable investor weaknesses of fear, insecurity or greed. Through these cracks in investor logic, financial decision-making starts to falter. Investors often frame their current decisions based on their perception of what book and market value mean. When this happens, financial decisions become short term, emotional, and reactive, removed from the proper context of a consistent process and a long term strategy. Each of us has the tendency to drift in our risk tolerance, our conviction, or our trust, to differing degrees. Usually the result is lost economic value and with it, loss of time to reclaim it.
My objective here is to create self awareness of these behaviors. With this recognition and a better understanding of reported values, our behavior will be more confident and more consistent. With peace of mind, good habits can be created and kept.
Market Value
Let’s look at Market Value (MV) first. This value contains both "the best of times" and "the worst of times" totaled together. All past gains and past losses, both realized and unrealized, in addition to the original investment are included within the MV. The MV is an estimate of what the investment is worth at the close of trading hours (Eastern Time) on the statement date. MV is always an estimate only, because many investments trade on global markets after Canadian hours close, thereby changing in value 24 hours per day. MV does not include any relevant future costs of sale. For both of these reasons, the value may be different when the underlying security is actually sold.
Realized and unrealized gains and losses are an important concept requiring clarification before moving on. When an investment has appreciated from the purchase price, it has gained value; when it has depreciated, it has lost value. This gain or loss is "unrealized" until the asset is sold (or deemed to be sold through a change in ownership). When the asset is disposed of, the change in value becomes "realized". This distinction is important for tax purposes. "Realized" changes in value are reported for the current tax year, while "unrealized" are not.
Book Value
Let’s turn to our second character of this tale: Book Value (BV). BV contains the "best of times" but not the "worst of times". This is because BV accumulates gains, but rarely decreases from losses. Book Value contains a total of what was invested (net of withdrawals) plus all realized gains reported and distributed for tax purposes. BV also contains realized gains triggered on transfers of ownership, like "inkind" contributions to an RRSP.
Over longer periods of time, BV increases, approaching Market Value through gradual portfolio changes in asset mix, rebalancing, (e.g. proceeds of sale of one asset are added to the BV of the new asset being purchased) or tax planning. However, when Market Value declines during a market downturn, BV will not decrease. MV may even decrease below BV. This scenario occurred with investor portfolios across the industry in the three year downturn to start this century, and it will be repeated from time to time. How do investors tend to respond?
Think of a house as an example. Changes to its MV are estimates and are "unrealized" until the property is sold or ownership transferred. Some financial investments contain a group of assets over which a professional manager has discretion to buy and sell. Asset sales will realize some gains or losses, while others remain deferred and unrealized. The realized changes are internalized in MV ups and downs, and they are indistinguishable from unrealized changes within the total.
MV is the most relevant value to our financial freedom, and as such deserves most of our attention. When MV rises, we feel good about our progress and by extension, our process and strategy. This leads to a greater willingness to continue good habits, make systematic transactions and to take reasonable risks of short term capital reduction. In moderation, these feelings can be a good thing, but past rapid rises in MV have led to greed and euphoria. Some forget their strategy in the midst of "a sure thing". Such hindsight in a short-term trend creates overconfidence in the future. Emotion continues to overcome logic until a correction occurs, and then reason prevails again.
There have been three 26-year bull market cycles in the last 100 years: the "Roaring 1920’s", the "Nifty Fifty of the 1960’s", and the "Technology Boom of the 1990’s". Each was characterized by a euphoric peak, a spectacular crash, and then a period of consolidation inundated with fear and insecurity. There have been similar boom and bust cycles in real estate, commodities (oil, silver, gold), and economic regions (USA, Japan, Emerging Markets). Many cycles have happened more than once in our lifetime.
The common ingredient to all of these cycles is human behavior. When MV falls, we tend to question our beliefs, our strategy, and naturally, our trust. Small percentage changes in large asset values can translate into seemingly significant dollar changes. Elation over increases quickly turns to insecurity and risk aversion over drops. According to Dr. Daniel Kahneman, (the 2002 Nobel Prize winner in Economics for his research in this area), people hate losing 2.5 times as much as they like winning. As a result, they tend to put too much emphasis on short term reductions in Market Value, leading to excessive risk aversion and lost opportunities for gain. Kahneman concluded that organizations exhibited a lack of emotional variance in investing due to their long term perspectives and systematic processes. This gave organizations a significant advantage over individuals who react to short term losses and drift with emotion.
As investors, we erroneously believe Book Value represents the dollar amount of what we have contributed to each asset. When BV exceeds MV, we (often wrongly) assume that we have gained nothing. As Dr. Kahneman’s research shows, we "frame" our future investment decisions in this faulty context. Assuming our strategy is not working and a change must be made. Do-it-yourselfers react, and professional investment organizations reap the benefits. Awareness and understanding are two defenses against our own human nature to "frame" decisions with the most recent context and emotionally extrapolate the trends we believe are obvious. A Financial Advisor is paid to be a voice of reason and perspective beyond the din of MV, BV, television, newsprint or magazine distractions.
Use your RGF advisor to provide strategic financial leadership and a process to manage behavior. Good processes make good habits, and good advisors help you keep them.