3-6-3 Rule: The banking industry of the 1950s, 1960s, and 1970s is often described as operating according to a 3-6-3 rule: Bankers gathered deposits at 3 percent, lent them at 6 percent, and were on the golf course by 3 o’clock in the afternoon. This refers to massive level rate arbitrage similar to the small time balance transfer arbitrage that we consumers are able to play on the banks. The bank ‘wins’ through pure economies of scale.
Adjustable-Rate Mortgage - Also known as an ARM. The interest rate you pay on an ARM is indexed to the interest rates determined by the federal government. After an initial period of time (often 5 years), the interest rate on your mortgage is automaticall reduced/increased based on the interest rate relative to when you took out the mortgage. This has caused quite a few problems for maky home owners as interest rates have recently been increasing. Isn’t taking the chance that your payments will go up while hoping they will go down gambling?
Anchoring: The tendency to rely too heavily, or anchor, on readily available information. Basically, if googling up the effect of interest rates on the economy, don’t go with the conclusion from the first article that pops up on google…do your research.
Bandwagon effect: The tendency to believe things because many other people believe them. A fancy term for peer pressure and one of the most interesting economic concepts out there. Why did the I-pod succeed? Because it is a great product. Why did people start voting for John Kerry? Because he was the most likely one to beat Bush.
Compounding Interest : When you have money in an investment account that is earning interest (via dividends or capital gains) that interest will also accumulate it’s own interest over time. Compounding interest is one of the most powerful methods of producing massive returns over time.
Core Position : A stock or other security that you purchase with the full intent of NEVER selling it. Essentially, this is a stock that you plan on carrying until retirement. Ideal core positions are companies such as Johnson and Johnson, Altria, or General Electric due to the fact that they are well established companies whose sales aren’t constant and reliable and provide a healthy dividend to take advantage of compounding interest.
Critical Mass : The level you need to reach in order for a portfolio, bank account, or other financial instrument to become self sustaining after all withdrawals and taxes have been applied. A self sustaining retirement account would generate enough income via dividends and capital appreciation to have the account value NEVER decrease in value after all withdrawals for living expenses and taxes had been subtracted from the account.
Disposition effect: The tendency for people to lock in gains and ride losses. If you were on two sports teams, one that won on a regular basis and another that lost almost every game, which one would you play for if you were only taking into account the chances of you winning? Add to your gainers and cut the dead weight.
Fixed rate mortgage: Also known as a FRM. The interest rate on the your mortgage remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or “float” as in ARMs. Fixed rate mortgages are a tried and true instrument for acquiring a home within given payment parameters.
Initial Public Offering (IPO) : An initial public offering is when a privately held company allows common shares to be sold on a public stock exchange. ‘Going public’ allows a private investor to own a piece of the company. This is generally done so that the company can raise money either to pay off existing debts or to expand their company. This process is facilitated by one or more financial institutions that underwrite the loan; this means that they give the comapny in question a certain amount of capital in order to be the one who can facillitate the sale of the security in question.
Law of small numbers: Also refered to as hasty generalization,fallacy of insufficient statistics, fallacy of insufficient sample, fallacy of the lonely fact, leaping to a conclusion, hasty induction, unrepresentative sample and secundum quid this is a logical fallacy of faulty generalization by reaching an inductive generalization based on insufficient evidence. Just because you love one song on a music album doesn’t mean that you will love ALL (or even most) of the music on the CD. Just because Enron and Worldcom shareholders lost most of their money doesn’t mean all shareholders of all companies will lose money.
Loss aversion: The tendency for people to have a strong preference for avoiding losses over acquiring gains. This brings to mind the phrase that “people are more afraid of the potential downside than the potential upside. If you are playing a defensive game, you won’t lose…but how can you win?
Margin: In finance, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty. You are borrowing against what you already own to purchase more. If you can’t pay back the margin, you can lose the margin securities as well as the collateral.
Negatively Amortizing Loan: Also known as NegAm, this is a method in which the borrower pays back less than the full amount of interest owed to the lender each month. This can often cause payment shock as the minimum payment each month increases due to the relative increasing value of a loan. (since you aren’t even making payments equal to the interest accrued each month) The payments continue to increase until one can make larger payments.
Outcome bias: The tendency to judge a decision by its outcome rather than by the quality of the decision at the time it was made. To avoid the influence of outcome bias, one should evaluate a decision by ignoring information collected after the fact and focusing on what the right answer is, or was at the time the decision was made. Jonathan Baron and John C. Hershey’s research article should provide you with a lot of information!
Recency bias: Also knows as chronological snobbery, this is the tendency to weigh recent data or experience more than earlier data or experience. Logic : You argue that A implies B. A implies B is an old argument, dating back to the times when people also believed C. C is clearly false. Therefore, A does not imply B. This is not logical.
Sunk Cost: Costs that have already been incurred and which cannot be recovered to any significant degree. Once you’ve incurred a sunk cost, you can’t get it back. A sunk cost should play little or none into your decision making process as it is irrelevant. The concept of allowing a sunk cost to influence your decision is often known as Post-Decision Dissonance. There is a great website fully explaining this theory.
Sunk costs effect: The tendency to treat money that already has been committed or spent as more valuable than money that may be spent in the future
Additional information:
Curtis Faith Blog
Investopedia.com Dictionary: you can sign up to have a term delivered to your e-mail every day…a great way to get to know financial lingo!
