Lesson 21 of 25 · 7 min
Optimism about the drawdown, and the one that arrives
A tolerance stated in percent is a forecast about a future emotional state, and the threshold may arrive several points before it.
Affective forecasting is the prediction of one's own future reactions. It is systematically poor in both directions, and the specific failure here is that predictions are made in a calm state about a state that will not be calm.
A stated tolerance also has a shape problem. An imagined 30 percent decline is a single object: a number, arrived at, sat through. A real one is a sequence of months, each of which ends without resolution, several of which are partial recoveries that later fail. The imagined version is endured once and the real version is endured continuously.
Under a pledge there is a harder constraint, which is that a tolerance may never be tested at all. Collateral of $1,910,000 carries a balance of $1,040,000 against a 70 percent threshold. The trigger value is $1,040,000 ÷ 0.70 = $1,485,714, and headroom is ($1,910,000 − $1,485,714) ÷ $1,910,000 = 22.2 percent. The stated tolerance is 30 percent. The threshold is reached 7.8 points before the tolerance is.
Carry it to the 30 percent point anyway and the collateral is $1,910,000 × 0.70 = $1,337,000. The threshold requires $1,485,714, so the shortfall is $148,714 of collateral, or a repayment of $1,040,000 − (0.70 × $1,337,000) = $104,100 in cash. The decline the borrower expected to sit through is a decline in which sitting is no longer one of the available actions.
A tolerance describes what a person will do. A threshold describes what a person will be permitted to do. The second one is written down and the first one is not.
Key terms
- Affective forecasting
- Predicting how one will feel and behave in a future state. Done in the present state, which is rarely the same one.
- Stated tolerance
- The decline a borrower expects to be able to hold through. A prediction about conduct, with no standing in any agreement.
- Path dependence
- The property that the route to a price matters as well as the price. A 30 percent fall over fourteen months is a different experience from the same fall in a week.
Worked example
A 30 percent tolerance against a 22.2 percent cushion
Collateral $1,910,000, balance $1,040,000, maintenance threshold 70% of market value.
- Trigger value
- $1,485,714
- Headroom
- 22.2%
- Gap between the tolerance and the threshold
- 7.8 points
- Collateral after a 30 percent decline
- $1,337,000
- Collateral shortfall at that point
- $148,714
- Cash repayment that cures it
- $104,100
$1,040,000 ÷ 0.70.
($1,910,000 − $1,485,714) ÷ $1,910,000.
30% − 22.2%.
$1,910,000 × 0.70.
$1,485,714 − $1,337,000.
$1,040,000 − (0.70 × $1,337,000).
The tolerance was 30 percent and the position stopped being the borrower's own decision at 22.2 percent. The last 7.8 points belong to someone else.
Check yourself
A borrower with $1,910,000 of collateral and a $1,040,000 balance at a 70 percent threshold expects to sit through a 30 percent decline. What actually happens at 30 percent?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.