Marginal Revolution University
Published on 23 Aug 2016On average, even professional money managers don’t beat the market. To show you why, here’s a scenario to consider:
Say we advise you to invest in companies serving the aging US population. Since the percentage of elderly will rise over the coming decades, it makes sense to invest now in products and services that the elderly might need. Sounds logical, right? Wrong.
See, the aging of the US population isn’t a secret. It’s public information. Now, say you acted on the information and did buy stock as we advised. The current price of that stock already reflects information known to the market. Thus, it’s hard to systematically outperform the market, given that everyone else tends to have the same information you do. This is also the main idea behind the efficient market hypothesis.
According to the efficient market hypothesis, the prices of traded assets already reflect all publicly available information.
With information available to buyers and sellers alike, no one has any sustainable advantage over anyone else. This is why even the pros tend not to beat the market. And that aside, even if news did pop up to change the price of an asset, it would be at random and would likely be reflected in the asset price almost immediately. So there’s no reliable way to forecast performance.
As proof of that, take the Challenger space shuttle crash of January 28, 1986. Within minutes of the crash, the news hit the Dow Jones wire service. The stock prices of the major contractors who helped build the shuttle fell immediately. Keep in mind: that was in the 80s. At today’s pace, new information can change stock prices within seconds. This is why stock tips often end up obsolete.
So to sum up — it’s hard to beat the market. You have to accept that.
Still, how should you invest? That’s what we’ll discuss in the next video.
November 25, 2017
Can You Beat the Market?
November 9, 2017
How Expert Are Expert Stock Pickers?
Marginal Revolution University
Published on 16 Aug 2016In this first video in our Personal Finance section of Macroeconomics — and also our new course on Money Skills — we’ll begin to lay out some smart rules for investing.
Today, we’ll tackle Rule 1 — ignore the expert stock pickers.
What’s the basis of that rule? Well, in his 1973 book, A Random Walk Down Wall Street, economist Burton Malkiel made a controversial claim. He claimed that a blindfolded monkey, throwing darts at the financial pages, could select a basket of stocks that would do just as well as a set chosen by the pros.
One of Malkiel’s later students, the journalist John Stossel, set out to test that claim. Stossel did throw darts at the financial pages. The darts landed on 30 companies. Turns out, Malkiel did have it right — the randomly-selected stocks did better than professionally-picked ones.
The point here is, random picking roughly gives you as good results, as trusting the pros. Consider — in most years from 1963-2008, the S&P 500 Index outperformed most of the managed mutual funds. And in a different study, researchers took the top 25% best-performing funds. Two years later, less than 4% of the original set remained in the top quarter. Five years later? Only 1% stuck around.
Basically — past performance doesn’t guarantee future results. Chance often tends to win out.
To show you what we mean, take a hypothetical set of 1000 experts making market predictions. Let those predictions be based on a coin toss. Experts who land heads will say the market will surge this year. Those who land tails say the opposite. At the end of the experiment’s first year, 500 of the 1000 experts will have been right, solely by chance. Now, say the remaining 500 toss again. At the end of the second year, 250 experts will have been right, again by chance. Continue with this logic, and by the end of the fifth year, roughly 32 of the 1000 will have been right, five years running.
Perhaps these 32 will be hailed as geniuses, but remember, they only came about through a coin toss.
So, what’s to conclude from this? Two things.
First, luck and chance matter. In some cases, it can be hard to differentiate luck from skill, as proven by the “genius” 32. Second, no need to spend big bucks on a money manager. After all, the studies prove that random picking often works just as well as professional management.
That said, what if you did have market information? What if you knew something about certain stocks, that made you think they’d do well? Could you beat the market then? That’s what we’ll answer in our next video, when we tackle the efficient market hypothesis. Stay tuned!
September 30, 2017
Office Hours: The Bond Market
Marginal Revolution University
Published on 19 Jul 2016In Intro to the Bond Market, you learned the basics about bonds and how they differ from stocks. But what if you’re investing and you’ve got a few possible companies to choose from? How would you evaluate which bond is likely to be the best investment for you?
Let’s look at an example from our bond market practice questions:
Suppose you’d like to invest in a company and you’ve narrowed your choice down to three firms: Company A is offering a zero-coupon bond with a face value of $1000 to be repaid in 1 year for $963. Company B has the same face value and maturity date but sells for $871. And company C also has the same face value and maturity but sells for $985. In which would you rather invest?
If some of the terms have you scratching your head, don’t worry! Go ahead and start this Office Hours video. Mary Clare Peate from the MRU team will cover the jargon and give you the tools you need to master the problem on your own.
September 20, 2017
Intro to the Bond Market
Published on 12 Jul 2016
Most borrowers borrow through banks. But established and reputable institutions can also borrow from a different intermediary: the bond market. That’s the topic of this video. We’ll discuss what a bond is, what it does, how it’s rated, and what those ratings ultimately mean.
First, though: what’s a bond? It’s essentially an IOU. A bond details who owes what, and when debt repayment will be made. Unlike stocks, bond ownership doesn’t mean owning part of a firm. It simply means being owed a specific sum, which will be paid back at a promised time. Some bonds also entitle holders to “coupon payments,” which are regular installments paid out on a schedule.
Now — what does a bond do? Like stocks, bonds help raise money. Companies and governments issue bonds to finance new ventures. The ROI from these ventures, can then be used to repay bond holders. Speaking of repayments, borrowing through the bond market may mean better terms than borrowing from banks. This is especially the case for highly-rated bonds.
But what determines a bond’s rating?
Bond ratings are issued by agencies like Standard and Poor’s. A rating reflects the default risk of the institution issuing a bond. “Default risk” is the risk that a bond issuer may be unable to make payments when they come due. The higher the issuer’s default risk, the lower the rating of a bond. A lower rating means lenders will demand higher interest before providing money. For lenders, higher ratings mean a safer investment. And for borrowers (the bond issuers), a higher rating means paying a lower interest on debt.
That said, there are other nuances to the bond market—things like the “crowding out” effect, as well as the effect of collateral on a bond’s interest rate. These are things we’ll leave you to discover in the video. Happy learning!
August 23, 2017
Intro to Stock Markets
Published on 5 Jul 2016
Today, we’ll examine a new kind of financial intermediary: stock markets.
As an individual, you participate in the stock market when you buy a company’s shares. This turns you into a part-owner, entitled to some of the company’s profits. Sometimes, profits are paid out directly via dividends. Other times, profits are reinvested for company growth. In this case, you benefit by seeing the value of your shares rise in tandem with this growth.
Still, the buying and selling of stock doesn’t actually create any new investment. Buying and selling only transfers ownership between stockholders. What actually creates investment is when a company offers stock to the public for the first time (known as an Initial Public Offering or IPO), which is when it issues new shares to raise money for key ventures.
This process of turning savings into investment is what makes the stock market an intermediary.
A key caveat, though — buying stock essentially means betting on a company. As with all gambles, sometimes it pays off, sometimes, it doesn’t. For you as a saver, this means some of your stocks will win, and others, not so much.
This volatility makes stock markets more risky than banks. Bank savers typically don’t have to worry about fluctuations in the value of their deposits.
As for the entrepreneurial side, the stock market is a key institution encouraging new businesses. For a founder, the payoff typically comes during the IPO. An IPO allows founders to sell some of their ownership (in a now more-valuable company) so they can diversify their own holdings.
Next time, we’ll look at the third kind of intermediary: bond markets.
July 15, 2017
Office Hours: The Solow Model: Investments vs. Ideas
Published on 7 Jun 2016
Ideas are a major factor in economic growth. But so are saving and investing. If you were given the choice between living in an inventive (more ideas) or a thrifty (more savings) country, which would you choose?
The Solow model of economic growth, which we recently covered in Principles of Macroeconomics, can help you make the choice. In this Office Hours video, Mary Clare Peate will use our simplified version of the Solow model to show you an easy way to work out each country’s economic prospects, and then compare them to see where you’d rather be.
February 28, 2017
Outbreak of World War 1 – A Banker’s Perspective I THE GREAT WAR Special
Published on 27 Feb 2017
The classic narrative of the outbreak of World War 1 is that everyone saw it coming and was awaiting it with patriotic fervor. But studying the people that profited most from a war, the bankers, that idea is definitely challenged.
February 24, 2017
Well it is the twenty-first century after all…
Hey guys! I just bought marijuana for the very first time!
A thousand shares of a legal marijuana grower called Aphria, Inc. I am so conflicted — I don’t know whether I should feel counter-cultural or conformist…
I sold my last remaining Blackberry shares to cover most of the cost of the purchase, which (given Blackberry’s shrinking technological niche) was a bit of a relief.
Legal notice: Nothing in the above post should be considered in any way to be professional financial investment advice.
December 12, 2016
Refuting Piketty’s call for revolution, again
Tim Worstall points out that Thomas Piketty has mis-diagnosed the “problem” of rising capital:
The report shows that there were 13 OECD countries in which assets in funded pensions represented more than 50% of GDP in 2015, up from 10 in the early 2000s. Over the same period, the number of OECD countries where assets in funded private pension arrangements represent more than 100% of GDP increased from 4 to 7 countries.
We’re living longer lives these days, we’re working for fewer decades of them and thus people are rationally saving for their expected golden years. Thus capital as a percentage of GDP rises – not to produce inheritances, but to produces incomes in retirement. And rises by potentially at least more than 100% of GDP.
We can’t see that this is a problem and we most certainly cannot see that this is an argument for greater taxation of capital. Quite the reverse in fact, people saving for their old age should be encouraged, not specifically taxed.
So much for the most recent French call for revolution then, eh?
November 24, 2016
QotD: Black hats and white hats
When considering the major failures of recent American governance – the 2008-09 financial crisis, the catastrophe that is U.S. policy in the Mideast – the one thing that any honest-minded person must conclude is: Nobody meant for things to turn out this way. It is impossible to make precise predictions about the effects of government policy; that is the nature of systems characterized by high levels of complexity. It’s one thing to predict that it’ll be colder during the winter, but another thing to predict down to the millimeter how much snow will fall on a particular acre in rural Maine on the third Wednesday in February, which is really what we expect from our public policy.
Classic cowboy movies, in contrast, are not complex at all: The good guys wear white hats, the bad guys wear black hats, all hats remain firmly affixed to all heads at all times, and that’s that. You can pretty much always predict how an old Western is going to turn out.
But that isn’t how the real world works.
On Tuesday, I had a conversation about Elizabeth Warren and Wall Street, pointing out that the popular version of that story – Senator Warren vs. Wall Street – is so oversimplified as to be not merely useless but misleading. The reality is that there are people working on Wall Street who dislike Senator Warren – investors and bankers, mainly – and people who adore her – notably Wall Street lawyers, who are reliable donors to her campaign and to those of other Democrats. My naïve interlocutor said: “Hopefully, it’s the lawyers that fight against Wall Street,” as though there were such a thing, as though there weren’t nice progressive lawyers in Manhattan who jokingly refer to their yachts as the SS Dodd-Frank.
Spend any time writing about this sort of thing and you’ll hear angry and panicked denunciations of derivatives-trading from people who pretty clearly do not know what a derivative is, just as you’ll hear paeans to Glass-Steagall sung by people who don’t understand the difference between a commercial bank and an investment bank, who don’t know how Goldman-Sachs makes its money or what it is that Standard & Poor’s does.
But they’re quite sure they know who is wearing the black hats.
Kevin Williamson, “Black Hats and White Hats”, National Review, 2015-04-15.
September 15, 2015
Tyler Cowen’s primer on Chinese economics
At Marginal Revolution Tyler Cowen pulls together the key economic points you need to know to understand what is happening in China’s economic downturn:
1. You can’t invest 45-50 percent of your GDP very well forever. It’s amazing how long China’s run has been, but it is over. The quality of their marginal investments is now low and that means their growth rate will be much lower too. The low hanging fruit is gone, at least for the time being. They might later on resurrect some new low-hanging fruit through institutional reform, we’ll see if they end up stuck in the middle income trap but right now they are at a sharp discontinuity.
2. There is no simple way to switch to a “consumption-driven” economy without the growth rate both falling and staying permanently lower. Structural reforms are absolutely called for, but in this context they represent a surrender to a lower rate of growth and thus they are especially difficult to pull off in a politically sustainable manner.
3. The Chinese have been growing at ten percent or nearly ten percent for about thirty-five years. More than a generation of Chinese is used to treating the risk premium as if they don’t have to worry about it. I shudder to think what economic and also political decisions have been made on that basis.
4. The Chinese economic response to the dwindling of their low-hanging fruit is sharp rather than smooth because there is a sudden revision of expectations, as people realize the risk premium isn’t zero after all. And seeing the others see that causes the new set of beliefs to spread pretty quickly. That is a very painful process for a macroeconomy, and it is not well captured by simple AD-AS analysis, although of course it has implications for both AD and AS.
5. I would not so quickly infer that the Chinese government is stupid when it comes to economics. It is true their actions do not correspond to what professional economists would recommend. But they are painted into a very unpleasant corner and have lots of interest groups to feed. Their observed response is possibly explained by some kind of public choice-constrained, nested game, internal conflict-driven seventh-best response. They were smart a few years ago, and they are still smart now. That doesn’t mean they will end up doing a good job.
6. Avoid mood affiliation! You can be a pessimist about the Chinese recession now without being a) a pessimist about China in the longer run, or b) a pessimist about Chinese political stability. Those are separate albeit related questions, and you are not forced to have the same mood response to all of them.
May 25, 2015
QotD: Deflation
Deflation occurs when there is not enough currency in circulation to meet the needs of the economy. Here again, the classical definition focuses on falling prices rather than an insufficient currency stock, but deflation is primarily a monetary phenomenon.
It is the economic version of anemia: too little blood is reaching the body. Each unit of the currency goes up in value relative to the goods and services available, but because the stock of currency isn’t growing fast enough, it starves the economy of investment capital. There isn’t enough money to build out existing business, to create new ones, or to hire new workers. (This is in part what happened during the Great Depression of the 1930’s.) Inventories shrink, but new goods aren’t being produced due to the lack of investment capital. Eventually the economy grinds to a halt as production withers away.
Specie currencies are more prone to deflation than fiat currencies for the simple reason that fiat currencies are not based on scarce (and thus valuable) resources like gold, silver, or what have you. There’s only so much gold and silver to go around, and sometimes the supply of bullion can be interrupted for long periods. (Sometimes this is even done deliberately by rival nations or speculators.) Also, because the value of gold and silver is set outside the control of government or authority issuing the currency, it limits the kinds of monetary policy the sovereign can conduct, especially during times of crisis.
Monty, “Inflation, Deflation, and Monetary Policy”, Ace of Spades HQ, 2014-07-11.
May 13, 2015
QotD: Mono-culture banking
One of the factors in the financial crisis of 2007-2009 that is mentioned too infrequently is the role of banking capital sufficiency standards and exactly how they were written. Folks have said that capital requirements were somehow deregulated or reduced. But in fact the intention had been to tighten them with the Basle II standards and US equivalents. The problem was not some notional deregulation, but in exactly how the regulation was written.
In effect, capital sufficiency standards declared that mortgage-backed securities and government bonds were “risk-free” in the sense that they were counted 100% of their book value in assessing capital sufficiency. Most other sorts of financial instruments and assets had to be discounted in making these calculations. This created a land rush by banks for mortgage-backed securities, since they tended to have better returns than government bonds and still counted as 100% safe.
Without the regulation, one might imagine banks to have a risk-reward tradeoff in a portfolio of more and less risky assets. But the capital standards created a new decision rule: find the highest returning assets that could still count for 100%. They also helped create what in biology we might call a mono-culture. One might expect banks to have varied investment choices and favorites, such that a problem in one class of asset would affect some but not all banks. Regulations helped create a mono-culture where all banks had essentially the same portfolio stuffed with the same one or two types of assets. When just one class of asset sank, the whole industry went into the tank,
Well, we found out that mortgage-backed securities were not in fact risk-free, and many banks and other financial institutions found they had a huge hole blown in their capital.
Warren Meyer, “When Regulation Makes Things Worse — Banking Edition”, Coyote Blog, 2014-07-07.
January 30, 2015
What can Plato’s Cave tell us about basic economics?
Over at Ace of Spades H.Q., Monty takes us back to Philosophy 101 to show the economic version of Plato’s famous story:
If you had occasion to take a Philosophy 101 course in college, you may remember the allegory of Plato’s cave. Plato meant it as a discussion of what “reality” is — whether it is an absolute thing, and whether humans can experience “reality” in its totality or if we are limited only to what we can experience and measure. The idea is that what we can sense and measure is only a subset of a larger reality that we cannot perceive directly.
I’ve long thought that this allegory works quite well for economics in many ways, especially as it pertains to concepts of money and wealth.
Take a dollar out out of your pocket and look at it. What is it? It’s many things, actually: it is money, so it must be a store of wealth, a unit of account, and a medium of exchange; it is a manufactured good, intended by its manufacturer to be used as currency; it is a work of engravers’ art; it is a complex piece of technology (especially modern bills with the various anti-counterfeiting countermeasures); it is a carrier for the oils, dirt, and germs of the people who have handled it; and so on.
You can think of money as a special kind of battery, only instead of storing electricity, it stores up economic value which can be expended at a later time. And just as a battery can store energy but not create it, money can store value but not create it.
It turns out that this dollar bill is a pretty complex object, all things considered. And yet it isn’t a “real” thing in the sense Plato was speaking of. Whatever else it may be, a dollar is not in itself valuable; it is rather a signifier of a real thing we cannot see directly. A unit of money — whether a dollar, a franc, a pound, or a quatloo — is only “real” insofar as it signifies some existing value in the economy. (We can think of some value as being latent as opposed to realized, as it often is with investments. We invest in expectation of value being created and providing some kind of return on the investment. No value appears spontaneously out of the void. The invested capital is based on already-existing assets; a return is only realized if the endeavor creates additional value. Interest income or dividends don’t just magically materialize — interest income is your share of the value added and payment for the time-value of the money you invested. Nothing comes from nothing, as Parmenides reminds us.)
That dollar you hold in your hand is the shadow cast by something of value in the world of real things.*
[…]
* One way in which the Plato’s Cave allegory doesn’t work well in the monetary sense is when considering an essential property of money: fungibility. For money to be money, it must be fungible — that is, a dollar bill is exactly like any other dollar bill in terms of how it behaves in a monetary sense. I can buy a candy bar with any dollar, not just one specific dollar. The Plato’s Cave allegory draws a 1-to-1 linkage between the “real” object we cannot perceive and the shadow we can perceive, but with money it is more like a probabilistic wavefront that only collapses when you spend the dollar.
This means that, in the economic sense, our “shadow” of a real world good or service is not a particular dollar but any dollar.
January 16, 2015
QotD: The impact of lower oil prices
When oil prices are high there is a rush of investment into oil based enterprises from multi-nationals to frackers. No bad thing but there is always a real danger of over investment leading to the exploitation of very marginal resources. A lower oil price will strand some of that investment and, just as importantly, postpone a great deal of it. Which frees up investment for other, potentially more useful, purposes.
The second thing which happens is that governments become addicted to the joys of relatively painless oil royalties. This looks like revenue but, because it is drawn from a diminishing resource, is actually a rather dangerous drawing down of capital. A lot of oil “revenue” is seen as general revenue and is spent on non-capital expenditures. With a booming oil sector governments are tempted to think the exaggerated revenues are available for general expenses and will continue to be. Which means that government budgets are set based on a purely extractive draw down of a province’s or nation’s capital. This is a poor idea.
Not to take anything away from the bright guys who are fracking and mining their way to oil fortunes, the reality is that extracting oil does not leave much in the way of useful, secondary industry, much less innovation. Which, in turn, means that when the oil is no longer profitable to extract there is no residual, non-oil, economy left behind. If a government spends the oil revenue as it comes in, or worse uses it to secure loans, when the oil revenue dries up there is nothing to cover the spending or the debt.
[…]
The golden lining of additional pressures on nasty states like Russia, Iran and Venezuela is likely not as significant as the prevention of malinvestment and governmental squander. In time, as various emerging economies continue to grow, demand will drive the price of oil upwards again. With luck investors and governments will not make the same mistakes twice.
(One unalloyed good arising from the collapse of the price of oil is that so called clean energy renewables like wind and solar look even sillier with their present technology. I suspect wind will always make zero economic sense; I have more hope for photo voltaic solar as new materials promise significantly higher efficiency. And those same materials in a different configuration promise radical gains in battery efficiency for that daily occurrence known as darkness. Again, a low oil price will dampen the insane over investment in these marginal technologies.)
Jay Currie, “Oil Wars”, Jay Currie, 2014-01-03
