How GST is going to affect us and the country?

The task of the taxing authorities is to "so pluck the goose as to obtain the largest amount of feathers with the least amount of hissing." We the taxpayers, of course, are the geese.

Jean-Baptiste Colbert

The highlight of our Budget 2014 is the long anticipated introduction of the 6% GST or Goods and Services Tax. Under the current tax regime we pay 10 % sales tax (mainly manufacturing goods) and 6% service tax (mainly on F&B). To illustrate how the operations of a company in Malaysia will be impacted by the implementation of the GST we will use the following scenario. By April 2015, a company operating in Malaysia will have to have to pay tax to its supplier which is also known as input tax. When the company sells its end product to the consumers or other businesses, it will have to impose a tax known as output tax. To calculate how much tax to pay the authorities it will have to add up its output tax and minus the total input tax or,   

GST payable by the company = Total Output Tax – Total Input Tax

Why GST is implemented?

There are many reasons for the implementation such as:

1. To widen the tax base rather than relying on current corporate and personal income tax.
2. Our income tax level has reached its political limits currently hence our government will have to look at other alternatives.
3. Government Deficits has to be financed through an alternative source that will not increase our Government debt burden.   

To see why our tax base is very narrow I present to you below the chart for our country’s income distribution. Malaysia can be considered to have one of the worst income disparities in the world and certainly tops in Asia.  As can be seen form the chart below, the top 10% of the population controls 38.4% of our country’s wealth while the bottom 10% controls only 1.7%. I suppose this explains why only 10% of our population pays income tax!!

The second chart displays Malaysia being on top spot in Asia’s richest/poorest 10% disparity chart. This clearly shows that our tax limit has already been reached and further hike in taxes will surely infuriate the top 10% of the population. By now you should know who made up the top 10% which is none other than the cronies or the special interest group (UMNO) plus their relatives and friends. In order not to cause further resentment to this group the government had no choice but to find an alternative taxing method.   

Secondly, our Government is currently running a budget deficit to the tune of 4.5% to GDP as shown by the graph below. A Budget deficit is a situation where it spends more than it received. To finance its spending our Government needs to either raise money through money printing, taxes, royalties, levies and other sources or through borrowing. The problem is that currently our Government’s debt is at 53.1% to GDP and capped at 55%.

Since its Debt/GDP is nearing the ceiling, our Government will have limited options to raise funds other than increasing taxes or reducing subsidies. These measures will fall into the non-monetize or deficit financing category. As its name suggests Non-monetize does not increase our Government’s debt because it will not increase the existing money supply. The reason why non-monetize activities does not increase the money supply is because it mainly involves a shuffling of money. Or put it in layman’s term it is the shifting of money from the left pocket to the right.

To illustrate, we take an example from our petrol or sugar subsidy. When our Government reduces their subsidies, money will be transferred from the public to the Government coffers because the public is paying higher price for them. The existing money supply is the same but our Government now has a bigger share of it and hence money to spend. Similarly when our Government implement the GST it also resulted in the transfer of money from the public to the Government. Since the GST is proportionally taxed meaning everybody, including the 90% that didn’t pay taxes will also be affected. Hence by shifting money from the left pocket (public) to the right pocket (Government) our Government is expected to add about RM16 – RM20 Billion to its coffers.

What are the shortcomings?

As a result of the implementation of the GST, it is not going to be a smooth ride. There will be repercussions from it and I present them below.

1. A rise in corruption. Since every company is subjected to the authority’s scrutiny hence is obliged to keep an orderly and tedious account. They have to report all their incomes, expenditures and the amount of tax to the authorities. As empirical evidence emerged from European countries with experience with VAT, companies tend to over-inflate their expenditures and hence reduce their value added. Discrepancies are bound to happen and this will give an opportunity for the powers to be to abuse their power and hence corruption. In the end it helped flourishes a brand new industry and that is faking invoices.

2. Increase in disparity because GST will apply to everybody irrelevant of their income level and hence also known as the proportional tax system. So how is the GST going to affect the poor more? To illustrate, we have two individuals, A with an annual income of RM30,000 and B with an annual income of RM80,000.

In a Progressive Tax system A is paying a 5% tax or RM1,250 for his RM25,000 income and B is paying 20% tax or RM16,000 for his RM80,000 income. In this respect the poor man pays only RM1,250 for his taxes while his richer counterpart pays RM16,000 for his taxes.  

In a Proportional Tax system everyone pays the same rate or 15% tax in this case. A with an annual income of RM25,000 will be paying RM3,750 while B with an annual income of RM80,000 will be paying RM12,000.

So, obviously the poor man is going to have less (RM21,250) after the tax deduction whereas the wealthier man still has much left (RM68,000). Similarly, with the implementation of the proportional GST of 6%, who is going to pay more in monetary terms? Hence, will the low and middle income or the high income group suffer more?  

3. Risk of Recession or slowing down of the economy. This will be caused by the Crowding Out effect on the money supply. When our Government raise funds through non-monetize deficit financing activities such as cutting subsidies or broadening the tax receipts through GST, it will have the effect of Crowding Out or displace the consumer and private business credit. This is because our Government is soaking up the money from the economy, money that would otherwise be used by the consumer to spend and the business to invest. At the end of the day this could reduce both private consumer and business spending and thus will lead to lower economic activity and worsen the recession.   

Our Government should also know that by soaking up money from the existing money supply will lead to lower economic growth and hence might cause a recession. A recession means lower future tax revenue from both the private consumers and businesses. What is our Government going to do next when tax revenues collapse? Increase the GST from 6% to 10% and further rationalising of subsidies? Or further monetize its debts by increasing its borrowings by raising the Debt ceiling?  

4. Increase in prices. In understanding how taxes affect the prices of goods and services we must understand the two concepts of taxes. Firstly, we must know that taxes impacts the prices of goods and services in two ways namely tax incidence and tax impact. Tax impact refers to the initial point of the tax or the impact on a company or consumer. Tax incidence refers to the final resting place or the burden of the tax where it ended. As for GST the first impression is that it will be levied fairly to everybody since it is proportional. Thus it also gives the impression that the initial impact will be on the companies.

However companies are able to shift the tax burden backwards to the suppliers or forward to the consumers. In economics this is called the shifting thesis. How do they do it? To reduce the impact of GST, companies can shift the tax burden backwards by pressuring suppliers to reduce their prices by a couple of percentage. With the current slowing economic conditions, I am sure most suppliers are willing to oblige. Thus the initial impact of the GST has already been taken cared because of price reduction from suppliers. Another method to shift the tax burden is to cut wages. Since buying more machineries will have some tax advantage and hiring more people doesn’t give any tax advantage, employers can then threaten employees to accept lower wages or risk being fired. This is because the company can now afford to hire less workers by automating their production processes.

Now to shift the tax burden forward to the consumers by increasing the price by 6% or they can reduce the portion (as in F&B).

Hence, in the end the companies will be better off in two ways, first by paying 6% GST on the back end but receive price reduction from suppliers and second from reduced wages and hence more profit. On the front end consumers will be charged higher prices (6% GST) but a smaller portion may be served (as in F&B). The poor consumers will be hit by full brunt of the price increase because they cannot shift their tax burden either forward or backward.        

In wrapping up

At the end of the day it will certainly create two groups of people where one is the recipient while the other is the payer to the state coffer. The group that pays consist of the middle and lower class while the recipients are from the rich whose members include the politicians and their cronies, friends and relatives.

Moving forward I reckoned that the disparities between the rich and poor in Malaysia will be further widened. This is because by further rationalisation of subsidies followed by price increases, the lower and middle income group will be more affected due to their inability to absorb further increases in the cost of living.

How the extra funds be utilized?

Our next problem is what is our Government going to do with the extra funds? From records, I don’t think much can be expected because we are still going to pay for road tolls, education, expensive and inefficient public transport, expensive public utilities and communications. In other words there is no genuine effort to help us reduce our costs of living other than dolling out some money through the Bantuan Rakyat schemes. Again much of the funds will be spent on projects that will benefit their cronies.

It seems there is not much being done to strengthen our comparative advantages such as abundant natural resources and labour force, good weather and strategic location. Companies in the past have access to the abundance of cheap labour as it is one of our comparative advantages. However this has almost disappeared because they are now being replaced by cheap foreign labour. Without them many of the products manufactured locally will not be competitive in the Global Market space. We have in fact lost many firsts such as being the biggest tin, rubber and now palm oil producer to the rest of the world.

In view of past industrialization efforts, we are yet to produce any ‘Emerging market Multinationals’. A good benchmark on how successful and influential that a company command is getting listed in the Fortune 500 Global Companies. The Fortune 500 Global is the ranking of the top 500 companies around the world as measured by revenue. Throughout the years the only Malaysian company that consistently listed in the Fortune 500 is Petronas. The virtue on why Petronas is listed in the Fortune 500 Global is because it is a GLC or Government-Linked Company. Singapore has two corporations listed in the Fortune Global 500 and they are Flextronics and Wilmar International which is controlled by Malaysian tycoon Robert Kuok. The following is the ranking list of countries with the most Global 500 companies.

China was virtually unrepresented 15 years ago, today has 89 corporations listed and ranked second place. Similarly South Korea whose economy was devastated during the Asian Financial Crisis has 14 corporations listed and ranked 7th  in the world. Other Asian countries that have done pretty well are India, Taiwan and Singapore.

After more than 20 years of industrialization modelled after the Japanese during our ‘Look East’ policy, we have yet to achieve commendable results. Even with the financial and technical assistance provided by the various Government agencies such as MITI (modelled after Japan’s MITI), Sirim, EPU and others, we have yet to produce any world class companies. So, I reckon our Government owe us some explanations to the following questions:

1. How are we going to address our widening income disparity?
2. Are we doing anything to make our economy more sustainable?
3. Are we doing anything to address the current issue in our education system where science and mathematics are not given top priorities?     
4. What steps are we taking to enable us to move up the competitive ladder?
5. How about issues on equal opportunity and corruption?
6. Are we doing anything to capitalize on the Chinese and Indian diaspora to help us build our economy as what happened in China and India? China’s current achievement being the ‘World Manufacturing hub’ and India’s reputation being the ‘World Service Centre’ are made possible due to the contribution of their overseas Chinese and Indians.
7. When are we going to stop discriminating other races from holding top positions in GLCs and the Government? As Deng Xiaoping quoted “it doesn’t matter whether the cat is white or black as long as it catches the mice”
8. Why Malaysia as a resource rich country is doing worse than countries like Singapore, Hong Kong, Taiwan, and Switzerland that have no natural resources?
9. How about our Talent development? Any idea where are we heading in the next 10, 20 or 30 years from now?

As long as no efforts are taken to address the above fundamental problems, it will be a herculean task to take our economy to the next level to compete with the rest. Despite the many corridors and hubs that have been implemented, we have yet to attract many Global technology companies to invest and create a critical mass in our Research and Development. This is because we are under funding our research in physical sciences and thus lagged publications in these areas. Our politicians have yet given a thought on what Malaysia want to be in the next twenty to fifty years. Reason being our politicians haven’t “Get it” as those politicians in China and India. Many of their top officials are trained engineers and they ‘Get it’ because they understand the linkages between technology development to manufacturing, university and infrastructure Eco-system.     

How our Animal Spirits cause Stocks and Properties Boom Bust cycles?

I finally know what distinguishes man from the beast : financial worries.

Jules Renard, 1864-1910. French Novelist and playwright

There is one principle which a man must follow if he wishes to succeed, and that is to understand human nature.

Henry Ford, 1863-1947, Founder of Ford Motor Co.

If you look at the performance of various stock markets around the world it can be best described as a roller-coaster ride. The following is the chart for our KLCI as from December 2012. Notice how volatile is the price in the chart. It is of common belief that stock prices movements are as a result of changes in economic fundamentals such as interest rates, GDP growth, consumer confidence and corporate earnings. The movement of the market index like our FBMKLCI is a result from the individual actions of thousands of buyers and sellers at the end of each trading day. Hence it can also be deduce that the movement of the individual chart movement of interest rate, GDP growth, consumer confidence or corporate earnings should mimic the movement of FBMKLCI.  But what can be seen from below is that none of the individual charts movement mimics that of FBMKLCI.

Thus it can be deduced that changes in economic fundamentals does not fully explain the movement of stock prices. This is because stock prices vary too greatly. Instead the other part that causes changes in stock prices is due to human emotions. I shall present to you below a write-up on how human emotions or ‘animal spirit’ affects our decisions on investment.   

By the end of this article you should learn the following.

1. What is mental accounting and prospect theory and how they affect our decision making in investing and daily lives.
2. How bubbles and crash are formed?
3. How greed and fear contributed to the wild swings in stock and real estate prices?
4. Why stock prices tend to revert to the mean?
5. How to capitalize on human emotions?

What is Behavioral Economics? Unfortunately it is one of the newer fields in the study of economics that has been literally left in the freezer. It has been taught in colleges and universities for more than 40 years but has not attracted much public attention. Behavioral Economics or sometimes called Behavioral Finance is the multi-disciplinary study of psychology and economics. Or put it simply, it is the study on how our rational and irrational decision making influences the way we invest, spend, borrow or save money. In other words it is a study of how our inborn animal instinct affects our financial decisions. Thus, by understanding how our animal instinct affecting our decision process, it tends to help us avoid many of our irrational decision making such as the following.

1. Why people tend to buy at the highest and sell at the lowest in stock market and real estate investments?
2. Why people are more willing to charge a $1000 dinner on credit card than spending $500 cash on a dinner.
3. Why we tend to spend all the money given to us by way of gift, inheritance, a profit from the stock market or a win in the lottery?
4. Why are financial prices so volatile?
5. Why are we unwilling to spend $1000 to overhaul the old car given to us by a relative?

It is also unfortunate that a lot of people believed that the economic events such as a rise or fall in the GDP, inflation rate, stock and real estate market are due to technical factors or past government decisions affecting the economy through its macro and micro-economic policies.  

According to traditional economics theory that goes back to the days of Adam Smith where free market performs the best if it is left on its own, without intervention from the government. In a free market people will rationally use all available opportunities to produce goods and trade with each other. This will thus result in full employment because workers are willing to work for less than what they can demand for. Hence by this definition it also means that the economy will always achieve stability because people looking for a job will always be employed because they are willing to sacrifice for a lower wage.

However it is insufficient to solve modern day economic crisis like during the Great Depression where the height of the crisis the unemployment rate reached a high of 25%. It may helped solved the problem on why the balance 75% of the population is employed because they are willing to work for less than they can demand for. Similarly, it cannot explain why unemployment is high in the current Global Economic Crisis. The following info-graph from the World Economic Forum shows the youth unemployment throughout the world.

 

How Animal Spirits influence our decisions?

Hence it can be deduced that although free market capitalism may help to explain why people are employed but it may not be able to provide answers on why economies go into expansion and contraction. This is because other than making rational economic decisions people are also influenced by non-economic decision which is guided by their ‘animal spirits’.  This non-economic decision is influenced by changes in our thinking process such as confidence, envy, temptation, compulsiveness, fear, greed, peer pressure, addictions and illusions. Understanding how these psychological traits in influencing how people make decisions will enable us to find answers to the earlier questions above. The fact is that now more people are making decisions that are not rational, self-interest or consistent in order to get more return from their limited resource allocation such as money.

An example is well illustrated by our recent rise of 20 cents in the RON 95 petrol. People may think that they are acting rationally by queuing up in petrol stations to fill up their tanks. They reckoned that by filling up their tanks at the old price which saves some money and hence a rational thing to do. However they failed to realized that not only what they saved is pittance but also a waste of time queuing. The savings resulted from filling up their tanks are much lesser (less than $10) after deducting the fuel spent on waiting and travelling from their home to the gas stations. Before we delve further into the field of Behavioral Economics, I reckon it is best to explore how and where it began.

The origin of Behavioral Economics

Although there are many claimed they are the pioneers of Behavioral Economics but the most likely location for the beginning is at the Hebrew University in Jerusalem. In the late 1960s, two Israeli psychologists Amos Tversky and Daniel Kahneman are devising a method to motivate fighter pilots in training. The flight instructors who are taking a class in Hebrew University taught by the above psychologists found that when a pilot is praised for a good flight he tended to do worse on his next flight and similarly when a pilot is criticized for a bad flight he tend to perform better in his next flight. This led them to argue against the conventional wisdom that rewards is a better tool than punishment in motivating fighter pilots. How can this be?

One explanation offered by the psychologists is through the mathematical concept called ‘Statistical Regression’ or ‘Reverting to the Mean’. It can be best described with the following chart.

From the chart above you can see that the samples which are represented by the ‘O’ scattered around the Mean or Moving Average (Regression Line). As shown over time the ‘O’ will tend to revert back to the Mean which is represented by the Regression Line.

Similarly any flight performed by the pilot whether good or bad which can be represented by the ‘O’ in this case. Over time it tend to revert back to the mean which is also the pilot’s long rang average. Not understanding this, the instructors concluded that criticisms tend to improve the pilots performance and praise tend to degrade the pilots performance. Even in the sport of tennis, it is found that when a player had a bad forehand it will be followed by a better forehand and vice versa. The more he hit the closer will be his performance reverting to his average.

How Behavioral Economics affects our decision making?

The two pillars upon which Behavioral Economics are based on are the concept of Mental Accounting and the Prospect Theory. We shall begin with the concept on Mental Accounting first. What is Mental Accounting?

Mental Accounting

Mental accounting refers to a situation where we treat money differently depending on where it came from. To illustrate this concept we shall see how mental accounting affects a gambler. A gambler tends to gamble more when using casino chips than with cash. This is because less pain is inflicted on him as a result of his loss using casino chips than it does with cash. This is because he tends to place different value on the chips than cash.

Another example will be the different value people placed on earned income and gift income. We tend to spend the $50 given by our parents with less thought than the $50 that we earned from our job. This can help explain why people treat our Government’s BR1M as gift money and hence they will spend it without any thought. Similarly when those Felda smallholders received windfall payments from the listing of Felda Global Ventures spent their money as gift money. As a result many of them spend it on cars, motorbikes, houses and other non-income recurring investments instead of replanting their rubber trees which will provide sustainable future incomes.  

Probably the best example to illustrate how mental accounting caused havoc in our personal finance is the use of credit card. If you happen to visit an electrical shop and wanted to buy an oven that cost $200. Even if you have $400 in your pocket you will hesitate to pay by cash because it will instantly reduce your cash holding and hence buying power by half. Instead you don’t have problem charging it to your credit card because you tend to treat the money differently. By charging it to the credit card you not only don’t feel any loss of buying power but also the money spent seem cheapened or devalued because we don’t feel we are spending our dollars.  

Prospect Theory

The Prospect Theory deals with the way we arrive at a decision based on gains and losses of money and how it affects our attitude toward risk. Instead of assigning different value to money as in mental accounting we now assign different value to the loss and gain of money. Thus by understanding how people view losses and gains differently, it can help us figure out why people make bad decisions on investing and spending. The prospect theory can be divided into two concepts which are also known as the ‘loss aversion and sunk cost fallacy.’

Loss aversion refers to our feelings towards a loss. To illustrate the concept of loss aversion and how it affects our decision on investing we present you the following test done by Tversky and Kahneman.

Scenario 1.

You are given $1000 and asked to choose between two options. Option 1 is you are guaranteed $500 and option 2 you are to flip a coin. If it’s head then you will receive an additional $1000 and if it’s tail then you will get nothing more.

Scenario 2.

Again you are given $2000 and asked to choose between two options. Option 1 you are guaranteed to lose $500 and option 2 you are to flip a coin. If it’s head you will lose $1000 and if it’s tail then you will lose nothing.

Which option will you choose in Scenario 1 and 2? The result suggests that most people will choose Option 1 in Scenario 1 and Option 2 in Scenario 2. This is because when you choose the above it shows that you are only willing to take more risk when losses are avoided hence ‘loss aversion’.

How does loss aversion affect us in Investing?

Understanding the concept of loss aversion can be very useful in helping us to improve our decision in investing. For those who are very sensitive to losses it implants a loss-phobia in them. During market downturns they are the ones who will panic sell and tend to get out of the market too soon. Watching their stocks going down with the market is something that is too much to bear and hence what other way than selling to stop the pain. However by reacting too spontaneously, the investor might not be able to differentiate whether the market reaction is a profit taking or crash. If the market reaction is due to profit taking then the investor have made a wrong decision. Additionally he will be subjected to another round of pain by watching his stocks rising again.

Another effect of loss aversion is making us holding on to our bad investments for far too long. I am sure during your investing career you had come upon stocks that are underperforming or so-called dogs. Due to your attitude towards loss aversion you tend to hold on to them forever believing it will make a comeback one day. The problem is that most of the time it doesn’t.

So what we can deduce from the above is that investors tend to sell winners too quickly and kept losers too long. This is because according to the loss aversion concept, it is less painful to sell winners and keep losses. This led them to do the opposite the sound investment strategy of ‘letting your profits run and cutting your losses’. This situation is also known as the ‘disposition effect’ in economics.

Sunk Cost Fallacy

Sunk cost is a cost that has already been incurred and cannot be recovered like paying the deposit for a home or car. An example to illustrate how sunk cost affects our decision making is the research paper by Hal. R. Arkes and Cathering Blumer of Ohio University titled ‘The Psychology of Sunk Cost’ in 1985.

In this experiment three groups of people are paying different prices for their theatre tickets for the 1983 season. The first group paid full price for the tickets of $15. The second group paid $13 or a $2 discount while the last group paid $8 or a $7 discount. What they found at the end of the experiment is that those people who pay full price for their tickets attend more performances than those who received discounts. Hence this shows that the more people spend on their tickets the greater will be their sunk costs and hence willing to attend the performances more frequently.

In the world of stock investment, sunk cost fallacy can help explain why investors tend to throw good money after bad money. Take for example from above the more money we throw into the stock market the greater will be the sunk costs. Say for example if you bought Stock A at $5 about 3 months ago but since has been going down and now trading at $2. Being a rational investor you should be cutting losses but due to the sunk cost committed you tend to buy more to average down your cost. When you average down by buying more when the price goes down you tend to throw good money after bad. Averaging down is not a good strategy because you are buying a weak stock with bad fundamentals whose price tends to slide further down overtime.

Similarly in real estate investments, people tend to hold on to bad investments because large amount of sunk costs have committed such as paying a hefty deposit or installments for the past few years. Liquidating bad investments not only proved that we made a wrong decision but also the pain inflicted with taking a loss. Hence we tend to hang on to them as long as we can.

By now you should understand how the above psychological traps influence our decision in buying and selling of stocks and real estate. At the micro level all these buying and selling or churning of stocks or real estate will influence the daily price movements. Thus by understanding how greed and fear move prices in the micro level, we can use it to our advantage. We now turn our attention to the macro level where collective actions of many individuals affect the market price of both stocks and real estates. This brings us to the following questions.

Why Stock Prices so volatile?

To begin with let us look at the definition of how an asset is being priced. The value of any asset can be expressed as ‘the present value of expected future cash flows discounted at a rate commensurate with the perceived risk of the asset’. For stocks the expected future cash flow comes from the expected dividend stream derived from the stocks. Or it can be expressed with the following formula which is also known as Gordon formula or Gordon Stock-dividend-capital appreciation model.

Price = Da (1 + g)ª / (1+k)ª

Where,

Da = expected dividend in period a

G = expected growth rate in dividend

K  = investor’s required rate of return

It is not our intention to decipher the above formula in this article but a guideline to show you stock prices are partly determined by investor’s expectations. Below I present 3 different concepts on how ‘animal spirits’ within us influences stock market prices.  

Price-to-Price Feedback

A rational investor will always let his profits run in a bull market while cut his losses during a bear market. When every investor reacted to the same manner where they all buy when the market is rising and sell when the market is declining eventually it will have a tremendous effect on the final price. This is because when everyone reacts in the same manner it will create a feedback effect into the changes in the prices in one direction. In other words buying begets buying and selling begets selling.

What happens next is that when buying begets buying it will help create a bubble where it will burst because the buying will be exhausted eventually. Similarly when selling begets selling the market will crash because there is not enough demand to absorb the selling. This phenomenon is also known as ‘price-to-price feedback’.

Price-to-earnings feedback

The other source of feedback that affects the prices of both the stock and real estate market is the price-to-earnings-to-price feedback. As you see when the market is going up people will consume more because they reckons that their gains (although paper gains) have make them richer and thus less tendency to save. The effect of increased consumption that is resulted from an increased in asset price is known as the ‘wealth effect on consumption.’  

When the stock market increase in value it gives an indication that the economy is doing well and thus encourage companies to expand their plants by hiring more people and buy more machineries. Not only the companies are seeing the encouraging signs, the confidence in individuals will be boosted. As a result of the so-called increased in ‘Consumer Confidence’, people tend to spend more because of their positive expectation on the economy in the future. This in turn will boost corporate earnings and thus will encourage their stock prices to go up.

This increased in consumer confidence will again feedback into the economy and will further encourage more people to spend and thus further boost confidence. But a lot of people cannot rationalize whether this boom is everlasting. They cannot rationalize that the increased earnings in companies which were brought about by their increased consumption might be a temporary manifestation of the rise in the stock prices. Eventually a bubble will be formed and will burst because this fallacy cannot go on forever because eventually the law of diminishing returns will apply to consumption.  

Price-to-leverage feedback

The Price-to-leverage feedback refers to how the effects of leverage can cause a rise in the asset prices. How much leverage is often determined by the so-called Collateral Ratio. The collateral ratio is the amount of money banks lend to people as a percentage of the value of assets that are pledged. Naturally during a rising market the collateral ratio will rise because the value of the assets whether stocks or real estate rises. Again this price-to-leverage feedback will eventually feeds back into the economy. This is because people can now buy more shares as a result of the increased margin value of their shares. Similarly, in the real estate market people can now buy their second home for speculation because banks are now willing to lend more based on the increased value of their properties. Hence this leverage feedback loop will further push the home prices upwards. Again this speculative frenzy will have to come to an end which nobody knows exactly when. But those that are going to be wiped out are definitely the greedy ones and the late comers.

How about the Real Estate?

Real estate prices can also be as volatile as stock prices as shown in the past. The current upward trend in real estate prices rest on the premise of land, population and economic growth story. Real estate has always been a good choice for investment not only for shelter but also for capital gain. Coupled with the belief that limited land supplies and population growth, it further convinces the people that real estate prices can only go up.

To explain why property prices in the vicinity of Kuala Lumpur especially in the Golden Triangle can maintain at a very level is partly due to the ‘Green Belt effect.’ The land area within the vicinity of Kuala Lumpur is very limited and there is no effort to increase the land supply by extending the city limit to surrounding areas. Thus it will create a shortage of land within its vicinity which results not only in the steep rise in the price of land but also rentals. Since the price of land is so expensive and limited supply coupled with an increasing population, the only way to develop is upwards and hence contributed to the recent mushrooming of condominiums around the KLCC area. Hence with the mindset that land is a scarce resource and there is always a demand, it has somehow made the idea of ‘real estate as a good investment’ cast in stone.   

The feedback loops such as price-to-price, price-to-GDP-price and price-to-leverage-price as we have seen in stock prices also operates in the real estate market. When real estate prices start to go up, bankers are more willing to lend and thus people are borrowing more money to buy more expensive or even second or third home for speculation purposes. As word gets around that money can be easily made from real estate. Thus the price-to-price feedback will eventually leads to the price-to-leverage feedback which will propel home prices higher and higher. Finally this endless loop of feedbacks will propel the real estate market to bubble level which eventually will burst.

Wrapping Up

In wrapping up, I reckon by now you should realized that it is the human emotion or animal spirits within us that is partly responsible for driving up the prices of all asset classes. It is our fear and greed that really drives us to make irrational decisions in either investments or anything regarding our daily lives.

Thus by understanding the weakness of others we can capitalize on it by making more rational decisions. For example one of the strategies that hedge funds employed is the Global Macro strategy. For global macro strategy to work, hedge fund managers first have to look at the big picture or larger trends in the global market space. Once a trend or an imbalance in an economy is detected the funds will then position itself into that particular country. Knowing that over-reaction in stock prices offers tremendous opportunity to make money. They then make bets opposite the direction of the market. This is because they know that market extremes tend to revert back to the mean or their long term average. Thus the hedge fund managers will then bet on either long/short positions.

Similarly for folks like us, we can make better decisions after knowing how mental accounting and prospect theory affects our decision making. The next time before you charge it on your credit card think about the 18% interest rates the bank charges on your card. If you have money given to you either as inheritance or gift, treat is as if it is ‘earned money’. Try training yourself to wait for a while before spending the money or put it into fixed deposits. Then it should prevent you from spending it like grandma‘s money. In making stock market decisions try not to relate it to previous losses as it will affect your decision due to your loss aversion mindset.   

Policy makers who are sharp and cunning can also make use of the sunk cost fallacy to their own advantage. To avoid future objections from NGOs or the public in controversial projects, they first try to spend as much money as they could so that the sunk cost fallacy will protect them. By the time the public wakes up to challenge or demonstrate against the project, millions of dollars have already been spent. Thus no one in the right mind is going to prevent the project from going on. One such project is the Lynas Advanced Materials Plant (LAMP) in Malaysia. Now that the plant is ready and the license has already been issued, there isn’t much the public can do about it other than signing anti-Lynas petitions and demonstrations.  

On the other hand Policy makers can incorporate animal spirits into their macro and micro-economic policies which can help them cushion the effects of a financial meltdown. By designing policies that will dampen euphoria during extreme bullish market conditions or instill confidence during market crashes will not only help ease the impact of a financial crisis but also make our economy more sustainable.