FINANCIAL NOTEBOOK Q&A with CMMB Securities

Q.   A few times in this column you have mentioned “psychological accounting”. Can you explain that term?

Gail, Diego Martin

A: 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 $20,000 on a deposit and an outstanding bank loan of $15,000 when asked the question about the value of his savings in some cases may say it is $15,000, when it is really $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 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 savings 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.

Q.  I understand the difference between an asset and a liability, but what is an illiquid asset and should I have them in my portfolio?

Radhica, Chaguanas

A: 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. The most liquid asset in the local market is a Government of Trinidad & Tobago Treasury Bill due to the fact that there are primary dealers (commercial banks), which are always willing to buy and sell these securities. The Bills can also be bought and sold at the Central Bank of Trinidad and Tobago. A Money Market Account is also a liquid asset in that the funds can be withdrawn at anytime. However, there are some assets, which cannot be easily withdrawn. An example is a fixed deposit which is locked in for a period of time and which cannot be withdrawn before maturity without incurring significant penalties.

Another example is real estate. The size of the transaction is usually relatively significant and the transactional necessities of transferring, searching etc, could sometimes prove lengthy and 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. So, 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.

Q.   I have some US currency in a money market account. But I’m worried.  The US conflict with Iraq is causing the US stock market to slip and interest rates are low. Should I get rid of my US and convert it to TT dollar investments?

Russell, San Fernando

A: You should not convert your US into TT. Firstly, your funds are in a money market fund so that the fact that the US stock market is slipping does not impact you. On money market funds your principal is protected and secured against the bonds in the fund. Secondly, as regards interest rates in the United States being low or going down further this has more of an impact on you as the interest rate on the money market fund does tend to float with interest rates in the United States.

However, due to peculiarities in our local economy, the degree of movement is not very significant. This is because financial institutions in TT are always willing to pay up for US dollars given the temporary shortages, which occur from time to time. Thirdly, interest rates on TT and US dollars are almost at the same level in TT even though interest rates on US dollars should be much lower given the relative strength of that currency. Therefore an investor holding US dollars is in a win-win situation. As the purchasing power of his funds is protected in a strong currency and at the same time is earning an interest rate close to that of the equivalent TT investment, whereas normally the rates on US would be much lower than those on TT.

Questions can be sent to:
Po Box 1830,
Wrightson Road, Port-of-Spain.
Email: cmmbsecurities@mycmmb.com