Laddering is a term in finance used in different contexts. You might have heard it in connection with retirement planning, where it refers to reducing interest rate and reinvestment risk of the investor. It is also used in the security underwriting market to describe a practice of offering privilege to insider traders at the expense of general investors. If you are an investor understanding the concept of laddering is essential to you.
However, laddering is also a theory applied widely in market research. It analyses the rationale behind the decision making and tries to find information which otherwise is hard to access. So, let’s look at what is laddering under different circumstances?
Use Of Laddering In Retirement Planning
laddering has several usages. One of them is retirement planning, where it refers to an investment technique. Laddering involves buying several investment tools of the same nature, with different maturity. When one bond in the investment portfolio matures, the money gets reinvested to the next available option.
Why is it done? This practice helps minimise reinvestment risk by transferring the amount to the nearest bond. Similarly, investors can evade the impact of the reducing interest rate by shifting their investment to the next higher return investment option.
Let’s try to understand laddering with the help of an example.
Let’s say you have accumulated Rs 800,000 from different investment, and now, at the age of 55, you transfer Rs 500,000 to secured investment avenues like bonds. Laddering helps in reducing reinvestment risks at lower interest bonds. With the laddering technique, your portfolio will look like below.
Rs 100,000 in a bond maturating in 1 year
Rs 100,000 in a bond maturating in 2 years
Rs 100,000 in a bond maturating in 3 years
Rs 100,000 in a bond maturating in 4 years
Rs 100,000 in a bond maturating in 5 years
Laddering involves investing in the same type of investment options (in this case, bonds) at the same time, with different maturity.
When the first bond matures, you take the money out to reinvest in the five-year bond. This way, you are exposed to only one year of interest-rate risk at a given time. In comparison to a lump-sum investment in a five-year bond, laddering helped in reducing reinvested risk exposure. It helps you receive more consistent return over a long time even if the interest rate fluctuates.
However, laddering also associated with an illegal practice in security underwriting. It refers to underwriters writing undervalue shares to a group of investors before an IPO offering if those investors agree to purchase shares at a premium value post-IPO launch. This way, insider traders get a market advantage against general investors.
Laddering Technique Of Understanding Business Decisions
Now, let’s come to the discussion of the laddering technique as an interview method. It is associated with the study of what influences the buying decision of investors. A common argument is that the conventional method of questioning is very shallow and doesn’t provide with an in-depth understanding of what influences buying decision among investors. In contrary to that, laddering method investigates beyond the initial fiding with a more structured set of questions.
With the laddering approach, analysts try to get the nuggets of information that play a critical role.
The Means End Chain Theory
The theory proposes that decision making depends on the hierarchy of perception at different levels of conscious consideration and interaction between the investor and the goods/service. The different stages of Means End Chain theory are Attributes, Consequences, and Values.
The conventional method is good at identifying attributes but falls short in determining consequences. Laddering encourages self-analysis to identify the reason behind the behaviour or decision. Like a ladder, you move from understanding attributes to consequences and eventually, the values to get a complete picture by asking a set of questions to its participants.
Laddering is an interview technique used in semi-structured interviews to measure the level of abstraction (high or low) in structured decision making.
The laddering technique produces a comprehensive idea – it asks a different set of questions, structured to give clear, in-depth understanding behind investment decision.
The laddering questionnaire includes the following questions.
- Why did you select the product or service?
- Why is this product good or bad so that you’ll buy or not buy it?
- Why is it essential for your business?
The above questions gradually move towards deeper understanding like one climb up in a ladder. The first question tries to identify the most valuable attributes of the product or service that drove the buying decision. The second question moves to more core value or the consequences involved in decision making. The third question tries to derive the underlying motivation or value that the decision generates for the investor.
The importance of the laddering technique is to identify the actual motivation behind a decision by individually interviewing each participant.
Limitation Of The Laddering Technique
Because it is simple to use and understand, the laddering technique is widely used. But while it is popular, it is not free from limitations.
- The process is lengthy, and the idea of asking a long set of question to all participants may sound tedious. Hence, you must explain the process before beginning the survey.
- The next challenge you may face is the answers becoming vague and overlapping as you move to more complex questions
- The system is more effective in active decision making and less in hypothetical decision scenarios. People with real experience are better able to answer the questions in the laddering technique
- Challenges may come in recording response as well. And hence, preparation is needed before conducting the survey
As we see, laddering can mean to quite a few things in the financial world. Knowing the context to which it is applying is, therefore, crucial
When used for interviewing, laddering technique reveals critical nuggets of information related to a business decision by stretching the potential of the analysis beyond attributes, to consequences and values. But the process is cumbersome and may become vague without clear sight. To boost the results, you may consider merging the study with detailed mapping of the decision unit and process.