A Lesson in Finance

Since I live in the US and I presume most of my readership is in the US, I will confine this essay to the US equity markets, but the concepts can be applied globally. The US Stock Market has historically returned about 11-12%. Investing about $30K today will yield $3MM in 40 years, but this ignores inflation, which has averaged 3% historically. Inflation erodes the purchasing power of the $3 MM. So, when analyzing investment returns, we control for this up front so that everyone is talking about the same thing: the real value of the investment. If we subtract the 3% from the historic returns of the stock market and we get a ballpark estimate of the real annual return of somewhere between 8 and 9%. Given the inflation devil, we can count on the market to return 8% real, over the long term.

The "Time Value of Money" concept means that a dollar today is worth more than it is tomorrow. So, let's analyze a $30,000 investment in the stock market over 40 years at 8%. If we invest $30,000, today, and sit on it for 40 years with an 8% real rate of return, compounded annually, we will have $651, 735.64, assuming no taxes and no transaction costs. Another way of saying it is that in 40 years, $651,735 will be equivalent to $30,000, today, given these parameters. Or, the $3MM at 12% in 40 years will have the purchasing power of $651,735 in today's dollars.

Now let's look at what we would need to do to have $3,000,000 in the future. In order for us to have $3 million, in an 8% interest rate environment, we would need to invest $138,092.80, today, assuming that you meet the market in your return over the course of the investment. The 8% is the mean and there are deviations around that mean. The standard deviation, in finance, is how we measure risk. That is to say, you won't earn 8% every year; there will be deviations around this long term average return. However, for those who invest for the long-haul, they will find that more often than not they will hit their annual 8% real return target in a diversified portfolio.

There are two kinds of risk about which we must worry, when investing: systematic and unsystematic. Systematic risk refers to the risk associated with the market; it is the risk that you face due to changes in the overall market. We cannot control this piece. Then there is the unsystematic risk component, which is something that we can control.

The best way to eliminate unsystematic risk and ensure that you meet the market is to invest in an Index Fund, which is a fund that includes all of the market. There is no unsystematic risk and one does not face the huge transaction costs that one would face were they to buy one of each stock in the market. If you want to match the market, then invest in an index fund.

On the other hand, if you think that you can beat the market by engineering a sophisticated portfolio, then you would decrease the systematic piece of your risk and increase the unsystematic piece. This would increase your risk, but you would also have a potential to beat the market and the risk can be managed through diversification. For unsystematic risk, the way we deal with it is to diversify across different sectors of the market, such as energy/utilities, airlines, telecommunications, etc.

This strategy is a hedge such that if one sector falls vis-a-vis the market, another will rise to a certain degree with respect to the market and depending on their relative risk levels and the weights in your portfolio, the movements will offset each other.
Depending on your risk appetite, we could also include some T-Bills to help you manage your portfolio risks, given a certain appetite for risk. We use T-Bills, or what we call "riskless securities", because they are backed by the US Government, which has never missed an interest payment since it has been in business. I could start talking about Betas - a measure of a stock's relative risk vis-a-vis the market, but it would only complicate this analysis and it might confuse you.

In terms of any portfolio, the key is diversification to minimize risk and maximize exposure to the market such that you optimize your portfolio, given your risk appetite. The best strategy to construct a portfolio that meets or beats the market (75% of the Mutual Funds out there don't do beat this benchmark), while minimizing the portfolio's exposure to risk. A good strategy for a young person would be to buy an Index Fund in a Roth IRA (i.e. with after tax $$), which meets the market return, but also bears the market risks. To further minimize an investor's risk, one would divert some of their nest egg away from the Index Fund and into bonds and some international holdings.

As we near retirement, we will want to gear down the aggressive capital appreciation strategy of our youth and allocate this capital into more conservative investments such as bonds. As a matter of fact, young people should have bonds in their portfolios, anyway. This serves as an effective means to insulate our portfolios against market variations, or systematic risk. Young people should probably allocate 10-20% of their nest egg toward bonds and another 10% to international holdings. If I were constructing a portfolio, I would probably have 10% in a Bond Fund, 10% in an International Fund, and 80% in an Index fund.

There all kinds of different kinds of bonds that people can buy and interest rate games that speculators can play. I could go into these, but it would make this post very long. It is too long to get into in one post and there is a difference between investing and speculation. Speculation is like gambling; one should only engage in it, if they can afford to lose the cash.

The key is to invest for the long term and be diligent about investing on a consistent basis. Ultimately, your long term return depends on how much risk you assume; the market rewards those who assume risk in their portfolios. Your job is just to minimize your exposure to it. The theory teaches us that the more risk you are willing to take, the more reward you can expect. That is not to say that there won't be bumps along the way. It just means that over the longer term, when things average out, you will be compensated for the added risk you assumed, given that you took appropriate measures to manage the risk in your portfolio.

The Inmates are Running the Asylum...

Mankind's constant state of warfare, or constant posturing thereto has perplexed the finest minds to have ever graced this planet. Why do we, as the richest country in the world, continue to wage war. It would be one thing, if we were merely protecting ourselves, but we go out looking for wars.

One answer might be that we have created a cancer within our society called the Military-Industrial Complex, which demands to be fed. Soon we will be a new Prussia. We won't be a state with a military, but rather a military with a state. "Jawohl mein Fuehrer! Sieg Heil!"

In liberal democracies, the military is supposed to be subordinate to civilian-rule. That is, we are supposed to be a state with a military, not a military with a state. I fear that it is too late to change the tide. We needed to listen for when the military starts complaining of civilian leadership that has no military background running the military, and how bad that is for the military. It sounds a little like a birdie saying "Coup? Coup?"

Here is a rule of thumb: Never trust a military officer, when they say something that leads to the conclusion we need a new high-tech, obscenely expensive and very profitable weapons system. They are in bed with the corporate interests.

On Innovation

Innovation is stifled in two ways: poor communication culture and grade inflation. Economics is the study of incentives and both grade inflation and poor communication are products of perverse incentives. As we will see, in the course of this discussion, perverse incentives can take many forms and yield some interesting results.

Companies run more efficiently when executives cooperate with each other; instead of merely trying to protect their turf and keep from getting “beat up” in meetings. I am a consultant and at my last client, there was no incentive for one department to talk to the other, because they just wanted to protect their turf. In organizations that lack a free and open communication culture, where executives keep things secret at the top, innovation is stifled. People don't want to take risks as they are afraid of being punished or what I term "thrown under the bus." Thus, the whole enterprise suffers.

We can take the metaphor of a house in which the CEO is the patriarch and the departmental heads are the children. If a lamp is broken, people start protecting their terf, instead of together to figure out how to fix the problem (i.e. sharing info), the result is a modus operandi of constant crisis. Things are constantly operated in "crisis mode" and the goal of each chief is to put out fires so that their ass doesn't get burnt.

Naturally, in this reactive management style, there is no management of anything except crises. It is better for executives to manage things proactively, as things run more efficiently. The challenge that I see is how to convert an organization that is reacting to crises to one that proactively addresses issues in which cross-functional specialists collaborate on how to fix core business problems. This would have the result of increasing innovation, allowing people to take calculated risks, and more operational efficiency.

If the variable pay of executives were tied to how well they communicated with other departments (although evaluating this would be the challenge, given its subjective nature), then the incentive would exist for departments to collaborate and a firm could move from a reactive management style to one that is proactive. Communication is the key to planning. Companies are built off of information and when information stops flowing, progress is stifled. Companies don't plan correctly and this is why they hire consultants to come in and tell them they are stupid.

The command and control concept comes from how the military runs. Management Science wasn't even a discipline prior to WW-2, when the US military needed to optimize its logistics for the war. In general, fragmentation of your troops, units, and divisions is bad news. In military operations, one needs central planning of the war so as to maximize the efficiency by effective resource allocation across the battles.

We can see the results of misallocation of resources as far back as the Civil War. During the Civil War, the regiments of the South were fragmented. Soldiers thought of themselves first as Virginians and second as members of the Confederacy. There was very little central planning. However, this weakness in their operations was offset by the Southern man's “will to fight”; if you see your house burnt down by a Yankee, you don't care about anything except killing Yankees. In the North, the soldiers really didn't care about the war as much as the Southerner. To them, it was just a steady paycheck.

The Civil War wasn't about slavery. Only the elite, which constituted 15% of Southerners (i.e. the landed upper-class) could even afford to own slaves. Of the other 85% of Southerners, who couldn't even afford to own a slave, a good portion of them didn't agree with the practice.

The fact is that the war was about states’ rights. When you boil that down, you can see a clash of two economies: agriculture and industrial. Each had its own set of values and priorities, which determined their position on what was "morally right." After the Civil War, states lost their rights and we became more federal; power became concentrated in the Federal Government.

One could plausibly argue that slaves were healthier as slaves, than when they were free because the plantation owner had an incentive to keep them healthy. There the pesky economics goes again, rearing its ugly head. Sharecropping was just another iteration of slavery, but people had the illusion of freedom. Slavery was destined to die off, though; the rest of the world was already moving in that direction.

Ultimately, the Civil War settled a dispute over the Constitution. The South really lost the war in the definitive Battle of Gettysburg, when Lee told one of his top officers (i.e. Pickett) to take a hill on which the Union was positioned. It was a gross waste of resources, because "Pickett’s Charge" cost Lee 15,000 men over the course of two battles. If I could go back in time just once, I would go to Lee that day and whisper in his ear "never try to take a hill from a downward position; you are at a disadvantage."

Another stifling factor for innovation and a primary cause of the housing boom has been grade inflation. You may raise your eyebrows at this thought, but just hear me out. There is a correlation. I believe the housing boom has been fed by two factors: excess global liquidity and diminished confidence in capital markets.

We can expect interest rates across the board to increase over the near term to address the excess liquidity and equilibrate capital demand with supply. The reason that there is excess capital is because people are putting their eggs in tangible assets and staying away from equity investments. They were burned in the Internet bubble of the early 00's and so they are staying away from equity investments. This fear is feeding the current housing bubble. People are moving their nest egg into real estate, which has historically returned 5% per year, adjusted for inflation.

This is part of the problem in 3rd world countries, where people lack confidence in capital markets. So, they buy something tangible such as land. However, land alone is unproductive. So, you have capital being invested in land, but not being made available for the capital markets, because there is a problem of transparency.

This problem stifles innovation, because people with ideas need capital to invest in R & D, which then causes the overall quality of life for the market in question to improve. This is what we mean, when we talk of "dead capital" in the 3rd world. Capital assets should be generating income; they should be put to use bringing the ideas on which capitalism is based to life through investment in R & D.

We in the US have our own problems with capital markets. In the US, people have lost confidence in capital markets as a suitable place for their nest egg. We can thank the accounting scandals for this. Why did we have the accounting scandals? I posit that the CPA's don't know how to audit anymore. Thus, they weren’t smelling rats, when they should have. This goes to grade and test score inflation. People are passing the CPA exam, who should not be, because they lack the necessary auditing skills to hold companies accountable to their financial statements, which is the primary information that investors use to base their decisions.

Now why do we have grade and test score inflation, you scratch your noggin? I posit that the reason these menaces exist is two pronged: a shift in the approach to education and the nature of the education business. The philosophy of education has transformed from one where an average grade was a "C" to one where the grades are inflated. There have been more perfect scores on the SAT in recent years than at any other time in history. Now, either we can give props to Darwin insofar as we are witnessing natural selection at work and our gene pool is flushing out the idiots, while keeping the geniuses, or the test itself is getting easier. There has been a shift in the approach to education. The education system has been moving toward enhancing student self-esteem. However, I think there is a larger problem at play.

When companies hire newly minted graduates, they hire those with the most A's. Businesses view schools that produce many students with high grades as providing a quality product. So, they have an incentive to “shop” there for skilled labor. In this context, the school has an incentive to inflate grades so that its graduates get top jobs or go to top graduate schools, which it can subsequently advertise to prospective students as the return that they will earn for choosing their school. The machine feeds off of itself.