Question: Can you explain that term "psychological accounting?"
Answer: Psychological or mental accounting is the process by which individuals develop a system of mentally separating their money into different categories. The most common example of this is the case with savings and bank loans. Individuals view their savings separately from their bank loans, when they should really be viewed together in determining the individual’s net worth. For example an individual with EC$20,000 on a deposit and an outstanding bank loan of EC$15,000 when asked the question about the value of his savings in some cases may say it is ECS$15,000, when it is really EC$5,000.
The reason for this misconception is that in the mind of the individual there are two mental accounts, a savings account and a bank loan account. He does not see the two as integrated and fungible (intermingled). This may be harmful if the individual keeps funds in savings at the expense of not paying off debt, which usually commands a much higher interest rate than bank accounts. Nevertheless, there could be cases for keeping savings even though there may be outstanding loan balances. An example of this may be the need to keep an emergency fund in case of contingencies.
Question: I understand the difference between an asset and a liability, but what is an illiquid asset and should I have them in my portfolio?
Answer: An asset’s liquidity is defined as the ease with which that asset can be liquidated at a price, which reflects the fair value of that asset. A savings account is also a liquid asset in that the funds can be withdrawn at anytime. However, there are some assets, which cannot be easily withdrawn. An example is a fixed deposit which is locked in for one year and which cannot be withdrawn before maturity without incurring significant penalties. Another example is real estate due to the fact that the size of the transaction is usually relatively significant and the transactional necessities of transferring, searching etc could sometimes prove bureaucratic.
Nevertheless, the returns on real estate could be quite significant over time despite its illiquidity. However, if there is a forced sale the price fetched could be below fair value. Therefore, one should only invest funds in relatively illiquid assets, which one would not need in the near future, as premature sale may be at prices lower than which would normally occur. Therefore investing in illiquid assets, which generate higher returns, may sometimes be a necessity but it should only be with the long-term part of a portfolio.
Question: What are the benefits and risks associated with owning bonds?
Answer: The benefits associated with owning bonds both corporate or government are mainly coupon payments and the receipt of the principal amount at maturity. Coupon payments are periodic interest payments that the company is obligated to pay whether it performs poorly or not. The principal amount is simply the original amount invested which is usually repaid on the maturity date. The benefits of owning bonds There are two main types of risk associated with bonds.
These are default or credit risk and interest rate risk. Although a rare occurrence there is the risk that the company or government may be for some reason unable or unwilling to make its interest rate payments or final payment. It should be noted, however, that companies and governments rarely default on bonds, making this form of investment considerably safer than others. Secondly, interest rate risk occurs when fluctuations in the market interest rate causes movements in the value of the bonds.