The Dangers of Excess Frugality – Budgeting and Balanced Living

"Virtue, then, is a state of character concerned with choice, lying in a mean… Now it is a mean between two vices, that which depends on excess and that which depends on defect; and again it is a mean because the vices respectively fall short of or exceed what is right in both passions and actions, while virtue both finds and chooses that which is intermediate." Aristotle, Nicomachean Ethics.

A Zen Garden

The dangers of excess frugality – The slippery slope of budgeting

The first steps in budgeting are usually a real eye opener. For the first time income and expanse are laid bare before our eyes more often than not resulting in surprise and disbelief as to the proportion of expense relative to income, the volume of different expenses and usually the inadequacy of income.

A little later on the potential hits. As with any new endeavor a significant portion of the benefit can be taken advantage on early on. Potential savings and sources of money leaks are easily identified and several quick and significant measures can be taken to materially improve the family's financials.

Newly discovered personal finance enthusiasm usually leads, then, to further interest and reading which in turn leads to discovering the power of finance and compound interest. The affects of saving early are empowering and goals are set to allocate a more significant portion of the budget to saving.

Frugality often follows. Each expenditure is carefully weighted and considered against the future alternative benefit which, when compounded over time, amounts to hefty sums. Considerations such as "This $1,000 vacation has an alternative cost of $1,800 in 10 years using a 6% interest rate" are not uncommon.

Retirement planning takes up more and more of one's time as a result. Thoughts of early retirement are fascinating with seemingly small sacrifices made on the way. Slowly but surely present time is replaced with imagery of retiring at 40.

Without noticing money becomes the object rather than the means. "I only need so and so much more and I'm settled". The present soon is sacrificed for the future.

Sacrificing the present for the future

The real danger of the slippery slope presented is sacrificing the present for the future. The American public as a whole is in no real danger of this happening and the future has already been sacrificing several times over on the altar of consumption. Still, many personal finance enthusiasts quickly find themselves torn apart when it comes to spending money.

Frugality, in its moderate form, is probably a good trait. However, any excess (or deficiency), as Aristotle had so eloquently put, lead us away from virtue. Virtue or sense, in this case as well as others, lies in the middle.

Excess frugality will usually results in forgetting our original goals altogether, abandoning them to the accumulation of wealth with no real purpose. The inheritance will surely benefit the next generation but our lives are ours to live, not to pass on (again, reasonably).

The problem with sacrificing the presence for the future is the unavoidable frustration. Any extreme behavior takes its toll on the person as well on the surroundings. Being happy in such circumstances isn't easy.

I should note I obviously do not suggest sacrificing the future for the present. I am only recommending a more balanced approach.

How to achieve Balance?

Balance will be represented, in this case, by the ratio of saving to consumption. In economics permanent income suggests a person wishes to average out his or her income over one's lifetime in such a way as to not consume to much in the present or, on the other hand, consume too little (by saving too much – There is such a thing).

The rule of thumb suggests middle class households should consume 75% of their income. The rest will serve as either an emergency fund for non-expected expanses and big planned expanses (which can be expected as I've elaborated on in Budgeting for unexpected expenses) or as long term savings (equally weighted).

If you're consuming less than 60% of your income or over 85% than an evaluation of income vs. expense is in order. Some circumstantial aspects obviously exist as dual income families with no kids would present higher levels of savings while others may present less available funds for savings.

Still, the rule of thumb serves as an indicator that something may be off. In higher income levels the ratio of saving out of income is obviously higher while in lower income levels saving money is something one can only dream of.

To some the idea of spending when you can save may sound careless. I argue the good mental health and happiness include the satisfaction of everyday needs. Stoic willpower may enable one to retire early but what of the years past? Usually the best years in life.

The illusion of having compounding interest working for you

There's a reason why the 30's are considered the consumption era in one's life. Investing in education, raising a family, buying a house and other significant financial obligations put a damper on any attempt to really save for the long run.

True enough, saving throughout 20's and 30's will result in compounding interest working for us but who of us has managed to save significantly without sacrificing our present? Amassing a considerable amount of money requires many concessions, maybe too many.

The illusion of saving early is frustrating since saving at such an age is extremely difficult. For one's good mental health savings should be balanced with consumption. The 40's and 50's are considered periods of wealth accumulation and will serve the purpose of amassing wealth as well (considering you are not intent on retiring at 40 – another illusion of you ask me).

A more balanced life and balanced goals will help achieve inner peace and acceptance that money is truly a means and not an end. This takes work and time. I suppose on cannot escape the slippery slope I've presented but understanding the need for balance early on will save considerable frustration and contribute to early happiness.

Related posts:

• Personal Finance Management: Budget vs. Net Worth
• Shortcuts to Early Retirement – Absurd Frugal Thinking or Common Financial Sense?
• Making Investment Decisions Together Helps Avoid Common Investment Mistakes
• How I Saved $2,000 by Being Creative and What Else Did I Discover
• How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?
• Outsourcing Our Chores - Do We Overvalue Our Spare Time?

Blame the Models? Take a Good Look in the Mirror

Is financial modeling to blame for the recent crisis? As always the fault does not lie with the tool but rather with the user. When was the last time you took a look at the validity of Net Present Value or Option Pricing?

The recent, or ongoing, financial crisis has been attributed, amongst other things, to over reliance on quantitative financial models which replaced good business judgment instead of supporting it.

The reason behind the failure of models wasn't simply poor modeling, for the most part. The main reason was poor business and risk management processes which placed blind faith in the models.

In this post I begin to explore the reasons why financial modeling increased the severity of the recent crisis and more importantly, what are the lessons we can implement to our personal finances?

The need for Financial Modeling

With the development of computing power advanced mathematical models enabled the creation of complex new financial instruments and professions such as financial engineering. Mathematicians and statisticians found their way to investment banks and hedge funds due to the increased demand and profitability of these endeavors.

These financial instruments included, for the most part, new underlying assets, that require complex financial models to model their pricing and behavior. Financial models which sadly broke during the recent crisis.

That is not to say that financial engineering and the use of models have been proven unsuitable for the financial markets. Much on the contrary, financial engineering and complex financial instruments help, in many cases, to increase the level of perfection in the market and ease the transfer of undesirable risks from one party to the other.

Models as a Representation of Reality

A Model, by its definition, is a representation of reality. Economics, for example, as any 1^st year student knows is based on very simple models of production, supply, demand and price. The strength and importance of these models is their ability to explain economic behavior even under very simplistic assumptions.

Think of the prisoner's dilemma in game theory or Nash's equilibrium which are very simple models that won their authors Noble Prizes. The beauty of the model is its ability to represent reality with a very limited framework.

As modeling advances assumptions are slowly removed creating more and more complex models which require a better understanding of the mathematic complexity. The reason is simple, the more "free" parameters the model needs to explain the higher the complexity.

Naturally, when dealing with financial instruments and their fair value pricing, models need to explain as much of the price as possible to adequately represent the fair value of the instrument. As such, models have grown quite complex as room for assumptions is very small.

What went wrong?

Before we get too judgmental let's consider the simple, commonly used model of Net Present Value. Net present value is a model used to determine how much a certain stream of cash flows is worth today – or, the present value of the cash flow.

Net Present Value is commonly used to determine the economic sense behind undertaking certain projects and investments. All those in the finance profession, as well as personal finance enthusiasts have probably tried to determine the net present value of a certain undertaking. The problem starts when you dig deeper into the model.

Most people are not aware Net Present Value assumes the following due to the very central role of the cost of capital in the model (further reading on NPV is available here):

• The existence of an efficient financial market – In order to price correctly an efficient financial market is required. NPV cannot be turned into value in the present if an IPO cannot be performed or valuated correctly.
  
  
• Access to financial markets– Without access to an efficient financial market the entrepreneur, again, cannot transform NPV to value in the present.
  
  
• The existence of diversified investors – Adequate pricing of the cost of capital can only be performed by ignoring the specific risk of the investment. A diversified investor, in finance, sees only the market risk when investing (the reason being a diversified portfolio will stay diversified even after investing in this particular project, for example).

When was the last time the Net Present Value calculation you had performed met these requirements? My guess is never.

The model is a helpful tool but the underlying assumptions and limitation cannot be ignored.

The reason behind why many of the financial models broke has to do with the assumption of liquidity and volume in the markets. Pricing models are built to price instruments under a normal market environment, as part of the normal course of business. When stressed scenarios occur the assumptions behind the models cease to exist and the model breaks.

• Black and Scholes model very commonly used for option pricing assumes normal distribution of returns (Not true, obviously).
  
  
• The CAPM Model (Capital asset pricing) which is a corner stone in asset allocation is based, again, on normal distribution of returns but also assumes, amongst others, the following highly debatable assumptions: Perfect availability of information, No taxes or transaction costs and a market portfolio which includes all types of assets (!).

With no liquidity in the markets strange phenomenon start to take place, phenomenon which cannot be analyzed through modeling but rather through good judgment and independent thinking.

The Importance of an Adequate Process

The role of an adequate risk management process cannot be overstated. Financial modeling is a tool, nothing more (and nothing less).

Like any tool the one who uses it needs to understand its capabilities and its limitations. Model limitations are inherent as they are, and only can be, a representation of reality.

Financial modeling will not go away. The need is too strong. What does need to happen is the implementation of robust risk management processes which will continue to remind what are the assumptions and limitation of the models and what the proposed mitigations against these limitations are.

The wisdom of the ancient Greek philosopher Socrates is a fitting quote: "I know that I know nothing" he said, not because he knew nothing because he didn't claim perfect knowledge. A humble state of mind is a very good start.

Related Posts:

• Is Present Value - Value in the Present? The Economic sense behind Net Present Value
• Diversification is Dead. Long live Diversification
• What is the Recommended Investment Strategy for Household Investors?
• Capitalism with Social Equality: A Powerful Though Experiment Demonstrates Our Moral Obligations
• Psychology tricks and increased spending – The Case of Expensive Wines
• The Big Mac Index – Applying Simple Economic Common Sense
• Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?

Dow Hits 13 Month High on Decision to Keep Aid Flowing to the World Economy

My fundemental reasons for concern

As several of my last posts indicate I have whole heartedly adopted Dollar Cost Averaging as my investment strategy. The reasons have been discussed in length a few posts ago.

Today I thought about liquidating some of the investments I've made in the past 6 months due to the negative vibe in the market encouraged by leading economists and investment gurus such as Noriel Roubini, George Soros and Bill Gross who all attribute a certain bubbly taint in the markets.

Good thing I didn’t. I might, though, tomorrow.

The reason that kept me from selling today was my attempt at disciplined investing and self restraint. Still, my fear of a near drop in stock prices only grew today. The reasons for my fears are:

The low interest rate environment as a catalyst to bubbles – Low interest rate drives investors wild. Risk appetite is gradually growing seeking alternative means of generating returns slowly yet surely forgetting the risks involved. In a 0.25% interest rate environment an 8% return reflects a 7.75% (!) risk premium. We must not forget that.

Many stocks have regain past losses and some are close to 2007 levels than ever before – There is no sign the economic growth is stable enough for the long term to justify such a prices level.

The markets are running on the government expense fuel – Bank earnings and growth is generated mainly through increase government expense with no signs of private sector backing or growth. How long can governments keep this up?

Fear of stagflation is real – Stagflation, the situation in which both inflation and economic stagnation are present is more and more a reality with each passing day. Price levels are bound to rise eventually due the huge amount of money being dumped on the markets by the government. Eventually the weak dollar may get weaker while the economy hasn't regained in full (again, very dependent on government expense).

Technical analysis points to diminishing volume of trade in recent stock price increase – The trade volume does not support the trend. This is cause for concern from a technical analysis perspective. Just look at the trade volume today.

The markets rejoice as government aid continues. This is a risky game. Any market position, whether short or long is a risky wager. I'm seriously thinking of adapting my strategy for the short term. Tomorrow I plan on restarting my dollar cost averaging after realizing some of the gains I had made during the past 6 months.

Related Posts:

• Dollar Cost Averaging – Practical Lessons From Recent Experience
• What is the Recommended Investment Strategy for Household Investors?
• How Should Households Invest? Sharing My Asset Allocation
• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out

Diversification is Dead. Long live Diversification

Don’t give up on diversification through asset allocation just yet

A short introduction to asset allocation and diversification

Assets allocation is said to be the optimal investment method for household investors. As household investors we lack both the time and knowledge to handpick assets and build and maintain a long term investment portfolio on our own. Unless you have a significant enough portfolio brokers and financial consultants will also professionally manage your portfolio through one asset allocation or another.

Asset allocation relies on diversification and the benefits it presents. If finance diversification is aimed to lower the specific risks of an investment and capture only the market risk, which cannot be eliminated. Specific risks are the risks associated with a single investment and include the risk the company we invested in will lose a major client, for example, or lose their successful CEO.

Diversifying is aimed to maximize the return with a given level of risk. The math behind this model is based on the correlation between the assets we invest in and this is one of the ways portfolios are built.

The bad news

If you’ve managed such a diversified and allocated portfolio over the past couple of years you must have noticed diversification didn’t quite work, to say the least. Each and every portfolio crashed and burned, regardless of the asset allocation (unless you went short on the market).

All major stock indices, commodities, oil and almost every asset that comes to mind plummeted. Diversification over assets, geographies and currencies hasn’t saved our portfolios from significant losses.

Some hoped that the emerging markets will be strong enough and independent enough to balance out the devastating impact of the recent crisis. Another economic motor would have created two semi-correlated financial drivers which might have offset some of the damages. It appears that it is too early to nominate China (and the European Union) as the next economic powers that be.

The reasons may be abundant but it seems that with globalization came increased correlation between assets and swept our precious diversification away. What are we to do now? How can household investors invest in such a turbulent market atmosphere?

Well, aside from increasing the risk free asset portion of the portfolio (such as deposits and government bonds) I believe there are also good news to be had.

The good news

First and foremost what crashed and burned together would probably rise back together. As such, anything we’ll put our hands and money on will probably generate decent returns on the upcoming investment horizon.

Some of us remember the good times back at 2005-2007 where all the assets generated decent returns and stock picking was never as needless.

Moreover, on the geo-political side of things, the increased co-dependence between our countries’ economies will hopefully lead to increased cooperation and mutual consideration of our impacts on one another.

How should households invest?

I’ve tried answering this question in my previous posts. I’m still a big supporter of good asset allocation. As I’ve written before good asset allocation includes allocation of investments over time not just over assets. Time allocation or dollar cost averaging helps us smooth the behavior of our portfolio by constantly averaging the buying price of shares and bonds.

I believe that other markets will emerge as economic engines of growth and will hopefully serve the world economy alongside the USA.

Related Posts:

• What is the Recommended Investment Strategy for Household Investors?
• How Should Households Invest? Sharing My Asset Allocation
• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out
• Know your Portfolio - Three Simple Charts Can Make a World of Difference
• Diversifying your risk in the stock market
• Key psychological factors in stock market success
• Tips for young investors
• Comparing Bonds Vs. Stock as an investment

What is the Recommended Investment Strategy for Household Investors?

I've promised to update you, my readers, on my investment decisions. I've decided.

After months of deliberation I've finally decided on getting my feet wet again and bought some stocks on Monday. As readers of The Personal Financier know I am a big fan of investment vehicles that track certain indices such as index funds or ETF's so I've decided on gradually increasing my exposure to the markets via these financial instruments.

Needless to say I have a gift for timing the market, the other way around. Since my recent purchase leading indicators, such as the S&P500 had shed over 5%. That was rather expected as the markets rallied these past couple of months.

In this post I'll share my personal considerations behind my recent decision to increase exposure to stocks. If I breakdown my decision into three main lines of consideration they would be:

• My considerations regarding my desired investment style.
  
  
• My considerations regarding the market environment.
  
  
• My decision to use index funds and ETF's and invest gradually using dollar cost averaging (Investing a certain sum each period).
  

My considerations regarding my desired investment style

So why did I decide to reinvest in stocks again? The reasons behind my newly discovered enthusiasm about the markets and why I decided on gradually increasing my exposure to stocks has a lot to do with what I consider a desired or suitable investment style for me and many other household investors (in my opinion, of course).

During the past couple of years I've been fortunate enough (ironically) to not have to worry about my savings and investments as I had none. I'd bought an apartment and literally invested my funds there releasing me of my need to consider alternative investments. Luckily enough the apartment I had bought has yet to suffer the impact of the housing crisis.

Now, two years later I've managed to save up a sum which necessitates more serious consideration regarding where to invest it and how to both preserve it and grow it, if possible.
Naturally, the state of the markets was enough cause of concern for me to seriously consider my investment plans. Losing my hard earned money is not an option.

The more I thought of it I understood I was failing to obey my view on investments, a view that I had learned after paying "tuition" in investment losses in my early investment years.

#1 I decided sitting on the fence won't get me far
I find out I was literally sitting on the fence. Avoiding decision allowed me to remain unscathed during the recent plummet but I did not earn anything either. I've written a post titled "Who Dares Wins" but failed to follow it.

There is no need to take huge risks for huge profits, just thought out risk for a better chance of meeting my personal financial goals.
Sitting on the fence is not a solution to anything. It's a very easy way out. Usually when I avoid deciding I know something is wrong. So I decided to slowly climb down from the fence.

It does feel much better to have decided and to have the feeling of taking a path and having a purpose. My savings were idling in a short term deposit which barely covers the bank's fees with the low interest rate environment. I had to do something and feel like I'm doing something.

#2 I was guilty of timing the market
I just can't help it. I don't think many can. I always try and time the market. Since one does not usually keep objective score of one's efforts of timing the market we never know whether we are any good at it. I most certainly am not.

No one thought the market would rally 50% after Citi's March earning release. Missing out on such a rally is very costly in terms of investment. And now, having raced 50% up the more probable scenario is a downward technical correction in prices… and then? Timing the market almost never works so I've decide to stop and just invest a portion at a time thus averaging these corrections out and enjoying the long trend in prices which will hopefully be a bullish one.

#3 I finally remembered I am a long term investor
It took some time but I've finally remembered I'm actually a long term investor. I think it's hard on humans to invest for the long term. We are programmed to be impatient and impatience is a bane for investors.

I think the birth of my baby boy had something to do with it. I've decided on treating my investments as his. An 18 year investment term should be enough to be considered long term (some may argue).

My considerations regarding the market environment

In my recent posts I've written about a correction in prices which is probable to follow the recent rally. I had thought the stress tests will give enough reason for sophisticated investors to realize profits and change the trend. This hasn't happed, yet. Markets have shed 5% but this can be considered only profit taking on an uptrend.

I still believe a correction is in order but since I've decided on quitting my market timing efforts I've decided to ignore this belief. This is actually a great relief. No one seems to really know what's going on anyway.

It certainly wasn't short-term considerations regarding the economy which got me to reinvest. There seem to be fundamental reasons to believe the global economy will get better in the near future (2-3 years).

#1 Very low interest rate environment leaves little choice
There is money out there looking for reasonable returns. With interest rates this low this money has little choice of investment and will turn, eventually, to the stock market. Interest rates on deposits are so ridicules many investors will find it very hard to accept.

This low interest rate environment will hopefully serve to set the markets back in motion with cheaper credit more motivation to capitalize on this opportunity.

There are risks to such a low interest rate environment, together with increasing influx of money into the markets. Inflation will follow and will have to be controlled but hopefully we'll be on a correct course by then.

#2 Risk appetite seems to be returning to the markets
One of the effects of the recent crisis has been a dramatic impact on risk appetite. When risks seem to be that high no return is justifiable. Risk appetite is perhaps the most important thing for the stock market which is, in essence, a risk-return tradeoff.

Recently there seems to have been a shift in trend and the risk appetite is reappearing. The public's share in the stock markets is increasing through institutional investors and, hopefully, it won't be long before the mass market will find stocks appealing again.

#3 Cyclicality
As my market timing days are over I am better equipped to use one of the characteristics of financial markets in my advantage. Cyclicality is a common trait of financial markets. Though it never seems so in times of prosperity or times of depressions, the tide will turn and the markets will change.

Keeping a presence in the market is vital for long term success and profiting of cyclicality.

My decision to use index funds and dollar cost averaging

My considerations should be clear by now in light of my investment style and market beliefs.

#1 Beating the market is as hard as timing it
Chances are you or the institutional investor you've chosen though a fund or IRA cannot beat the market. For this reason buying the market is the way to go. Fees and commissions paid are often unjustified and hurt portfolio performance with no real abnormal returns over the market.

Index funds are cheap in fees, are simple to follow I believe serve best the needs of household investors.

#2 Dollar cost averaging is a good way to gradually increase exposure
Uncertainty rules the markets, especially today. I would be very nervous had I invested my entire savings in one period. The market is still very fickle and dangerous. Naturally the risk – return equations dictates that averaging investments over time will yield lower returns, and it does, but it is important for sleeping at night.

Dollar cost averaging enables me to remain content even when markets correct themselves downwards. I'll just buy more, cheaply. When markets are bullish again I'll profit on the average investment.

I believe the outlines I've described to be the optimal solution for independent household investors under the current market conditions. I am not recommending anything to anyone. I'm simply describing my strategy as I've promised to do in the past.

I would not like to expose the size of my investments but rather the portion. I've invested 10% of my portfolio in stocks (US Index) and will continue to do so on a monthly basis.

I will update my readers on how my portfolio progresses. By next week I will hopefully have finalized my planned asset allocation and will share it as well.

Related Posts:

• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out
• Know your Portfolio - Three Simple Charts Can Make a World of Difference
• Stock recommendations from analysts or brokerage houses: How valuable are they?
• Diversifying your risk in the stock market
• Key psychological factors in stock market success
• Tips for young investors
• Comparing Bonds Vs. Stock as an investment
  

Image by: misw

On Causality and Correlation in Economics

Causality is perhaps the most fundamental element of empirical evidence available to economists. However, it is also the source of many misconceptions due to its elusive nature.

There are some things we take for granted. The relationship between cause and effect is so deeply rooted in us we sometimes forget they are merely a result of a clever induction made through observation on the repetitive nature of the two.

Causality is a fundamental corner stone to any empirical science. In economics causality is the basis for models and theories observed ranging from basic supply and demand curves to the most sophisticated economic models around.

The social science of Economics is more formal than other social sciences in the sense it includes theoretical models which are not directly dependent on correlations but rather on assumptions of maximization of utility at their basis. Nevertheless, at the end, utility maximization and its behavioral associations are bound to end include causality as a central assumptions of the coherency of nature.

More intricate relationships between various economic indicators such as interest rates, inflation, expectations, government spending, private consumption and many others are based on observations on different correlations between these parameters over time.

The problem of induction

David Hume is a famous Scottish philosopher known for its strict empiricism (A theory in philosophy which asserts all knowledge arises from experience rather than innate ideas and reason). The following may clear up this issue of the sources of knowledge a bit more.

David Hume, being the strict empiricist that he was, pointed out the problem with the logical problem embedded within the inductions we make based on experience. To put it simply, any attempt at proving our inductions to be correct will ultimately be based on induction itself and therefore cannot be constituted a logical reasoning. The argument would look something like:

• Every time I've dropped an object it fell to the ground
  
  
• Hidden statement: Nature is coherent/consistent or "that which has been is that which will be".
  
  
• Therefore, when dropped, all objects fall to the ground.

To justify my hidden statement I must turn to the same statement assuming that if nature has been consistent so far it will continue to be.

In Hume's eyes there is no logical justification to assume the sun will rise tomorrow simply because it had done so in the past.

Needless to say induction is crucial to science and the problem of induction presented by Hume has received great attention from philosophers ever since. Karl Popper, a famous philosopher of science (among others) suggested a clever way out of this problem by stating science will advance through efforts of disproving existing theories thus strengthening the correct ones and correcting the false ones. For example, the argument that all swans are white is correct until a black swan will be spotted.

Causality and Correlation

David Hume also took a swing at Causality or Causation following his treatment of induction. Hume stays committed to his reasoning all the way to the skeptic conclusion which is unavoidable according to which causality as a concept has no meaning as we cannot conceive the connection between cause and effect in any means available to us (I will explain shortly).

"…It appears that, in single instances of the operation of bodies, we never can, by our utmost scrutiny, discover anything but one event following another, without being able to comprehend any force or power by which the cause operates, or any connection between it and its supposed effect… All events seem entirely loose and separate. One event follows another; but we never can observe any tie between them. They seemed conjoined, but never connected. And as we can have no idea of anything which never appeared to our outward sense or inward sentiment, the necessary conclusion seems to be that we have no idea of connections or force at all, and that these words are absolutely without meaning, when employed either in philosophical reasoning or common life".

Trying to explain cause and effect in terms of experience is bound to lead us to Hume's reasoning. The connection between cause and effect can be described as either proximity in time, proximity in space, an obligatory connection or any combination of these. Still there will always be examples of events which answer to all these criteria and are not cause and effect. Hume gives us the example of the rooster that believes he bring out the sun with his cry every morning.

In order to lead our lives we all assume causality exists and will hopefully continue to govern our structured world. Many false theories however, are the result of assuming causality where only correlation exists. In economics and other social sciences the risk of erring in this way are very significant.

From the explanation above and the rooster example the difference between correlation and causality should be clear by now. The fact two phenomenon display certain similarities in their behavior, either in time, space or a connection does not mean they are, indeed, cause and effect. They may be simply correlated.

Correlation

Correlation is an important statistical figure which indicates the strength and direction of a relationship between two phenomenon or variables. For example, the price of wheat and bread are correlated. Putting the philosophical discussion aside, we believe these prices are correlated because the price of wheat serves as a cause for the price of bread. However, the prices of bread may be correlated with the daily yield on the Iranian government bond. There is no justification to assume causality here.

No less dangerous is assuming, perhaps, that the prices of bread influence the price of wheat. Getting the direction of the correlation wrong is a very easy mistake. Especially when we are researching variables we don't know much about.

Rudi Giuliani's fight against crime

A good example of the problems with assuming causality and using correlation is that of the significant decrease in crime in New York in the 1990's. The crime rate in New York had dropped significantly seemingly due to Mayor Giuliani's strict zero tolerance policy and the "broken window" thesis.

Researches today argue as to the real cause behind the decrease in crime rates in 1990's NY. Apparently some researches today claim Giuliani's success had merely been coincidental and that crime rates all over the country were dropping due to the economic growth in the 1990's and the decrease in the relative share of certain age-groups in the population. Several cities across the US have shown even more dramatic decrease in crime rates whit out Giuliani's fight against crime.

In their fascinating book Freakonomics (which is a must for any economics enthusiast) Steven Levitt and Stephen Dubner are presenting a very unconventional approach to economics and have presented a theory correlating legalization of abortions in America with the famous decrease in crime presented above. According to Levitt and Dubner the legalization of abortions has led to fewer unwanted births and to a decrease of the number of youths in the population exactly in the 1990's which in turn led to less crime and Giuliani's credit for the fight.
Although I agree with Giuliani's "broken window" thesis there is no real way to know what the cause behind the effect was.

This example serves to show how difficult and confusing it can be to prove causality between two variables and to incorporate that into any successful theory.

Conclusion

As always, all theories, especially when it comes to the social sciences need to be taken with a grain, or a whole bag, of salt. Adopting a skeptic attitude towards surprising findings will quickly sharpen your instincts and ability to tell reasonable from fantasy.

Understanding the problems with induction and causality and also the difference between correlation and causality is, perhaps, one of the most important aspects in leading a rational life. It will also help you quickly turn the page on that recent study which shows the amazing relationship between children who ate peanut butter sandwiches and their success in business later in life.

Related posts:

• Challenging Happiness – Exploring the Irony of Human Nature
• Capitalism with Social Equality: A Powerful Though Experiment Demonstrates Our Moral Obligations
• The Little Savings That Could
• On the Psychological Effects of Ownership and Overpricing
• Outsourcing Our Chores - Do We Overvalue Our Spare Time?

Image by: Dawnzy58

The Japanese Banking Crisis of the 1990's: Are We Facing a Similar Stagnation?

What can we learn from the 1990's Japanese banking crisis and the long slump in the Japanese stock market? Are we facing a similar scenario?

Price levels in stock markets worldwide are increasingly becoming attractive with each day brining yet another slump. The time of the long term investors has come. Still, a relentless doubt lingers on – Does this crisis represent an unorthodox change in the economy? Have the markets set into a recession which might take more than the usual 1-3 years to recover from?

The readers of The Personal Financier are familiar with my favorite example I often use when demonstrating why long term investing in stock is not risk free, as the odds suggest. That example is of the Japanese market which hasn't really recovered from the banking crisis it had experienced in the end of the 80's and early 90's.

The Japanese stock market, represented by the NIKKEI225 index has slumped from a level of almost 40,000 points in 1990 to 7,000 in 2003, a level which the Japanese market is currently revisiting in this crisis. The market hasn't shown any real recovery and has touched the 18,000 points level briefly in 2007.

The Japanese stock market is the stuff of nightmares for all long term investors and demonstrates the significance of geographical diversification.

The big question is: are we witnessing the Japanese banking crisis all over again in the US and western economies? Will the market slump for decades before showing signs of recovery?

The intuitive answer would be: no. No crisis is like another. Still, as I'm constantly considering buying into these levels of stock prices I thought a comparison of the two will prove interesting.

The Japanese Banking Crisis of the 1990's: Sources and Lessons

In January 2000 the IMF (International Monetary Fund) published a paper titled "The Japanese Banking Crisis of the 1990's: Sources and Lessons" which examined the characteristics of the crisis. Hopefully this paper would be able to shed some light onto our current situation.

The paper traces the roots of the crisis to accelerated deregulation and deepening of capital markets without an appropriate adjustment in the regulatory framework as well as to weak corporate governance and regulatory forbearance. Sound very familiar doesn't it?

The favoring economic conditions of the late 1980's Japan which included above-trend economic growth and near-zero inflation resulted in a considerably lower risk premium for the country and a marked upward adjustment to growth expectations which in turn boosted asset prices and fueled rapid credit expansion during the period. Still familiar…

Those who forget history are bound to repeat it. The exponential growth in the derivatives market along with a weak, passive and partial regulatory framework played a major part in the current crisis as well. Weak corporate governance as demonstrated in weak risk management and lack of internal controls proved fatal again.

The foresight of the IMF paper is rather remarkable: "The Japanese banking crisis serves as a warning that such a crisis can befall a seemingly robust and relatively sophisticated financial system".

The question regarding the unusual length of the crisis is answered to some extent
According to the IMF's paper weak corporate governance and regulatory forbearance stifled any incentive for meaningful restructuring of banks as well as their corporate borrowers.

Forbearance and restricting of bad loans – The structure of the banking system in Japan is different an important to understand as it contributed to the length of the crisis. Main banks in Japan act as quasi-insider monitor of the borrowing firm and as a mediator when borrowers fall into stress. This is advantageous as the monitoring costs are lower due to scale advantages of information on borrowers. Unfortunately, these main banks were reluctant to admit they had failed in identifying bad loans and began restructuring them, including the unpaid interest in yet another credit given.

By restricting non-viable loans banks actually increased the amount of problematic credit issued in the market. The end is obvious.

Capital Base - To salvage their deteriorating capital base banks issue more subordinated debt in higher returns to institutional investors thus further increasing the exposure to bad loans throughout the market (always suspect high returns). Furthermore, banks looked to tap unrealized capital gains to increase capital base, thus selling their stock and bond holdings and real-estate.

Weak corporate governance – The ownership structure and the board of directors' composition created little in the way of motivation for sound corporate governance. Owners had been dependent on the credit issued by banks and the boards of directors were comprised of former employees which were expected to hand over the board sit to other employees at the end of every term as a sort of bonus for the years worked at the bank.

Bank management was not under pressure to maximize profitability and returns and the absence of the necessary checks and balances meant no incentive for proper restricting or dealing with problems.

Regulatory weakness and forbearance – It is argued that the strategy of the government, postponing in dealing with the problems, actually raised the fiscal cost of the final resolution of the banks.

The authorities did very little in the way of arresting the decline in the conditions of the banking systems up to 1995. Regulators feared public panic in light of the strong measures needed to salvage the banks which grew in light of the lack of insurance on deposits.

Again, the IMF paper is amazingly insightful: "By giving rise to moral hazard problems, regulatory forbearance and "too big to fail" doctrines can lead to "gamble for resurrection" which often weakens financial institutions further".

Interest rates in Japan have been very low over the past decade and the economy is stagnant. Are we facing the same market conditions?

Conclusions for the current crisis

I felt calmer after reading the IMF paper and writing the aforementioned. It seems both crises have similar characteristics from a quick glance but a deeper examination proves the two are also different.

Regulators world-wide, I'd dare say under the leadership of Bernanke, seem of have learned and implemented the lessons in full. Lehman brothers was a mistake but no one could have foresaw it at the time (it was important to let Lehman fall from the moral hazard perspective on things). Government interventions are enormous and central banks are very attentive to the markets.
Furthermore, corporate governance may have played a part in this crisis but it was lack of adequate risk management and greed that were at the root of the current fall, not forbearance, which is somewhat comforting. Greed can be associated with economic cycles and will give way to prudential management every other cycle.

As far as restructuring and bad loans are concerned banks did delay some write-offs but we are also witnessing the biggest losses in the history of the world which surprisingly serve as a comfort.

The big questions of how much more financial waste is buried deep in balance sheets of financial institutions will remain unanswered but hopefully this crisis will be resolved in less than a decade.

Nationalization of banks, including the biggest two, may be very unpopular but it seems there isn't much choice in the matter and in that case earlier is better as the Japanese example illustrates.

The US market has defiantly had a lost decade as all major stock indices are revisiting levels they hadn't seen for 13 years. Still, perhaps this is an opportunity of a life-time. I, myself, am becoming more and more agitated and I do believe I will buy my way back in the markets in the near future. As I promised before I will update on my decision on this blog as it may be an interesting test case for the long-term.

Related Posts:

• Capitalism with Social Equality: A Powerful Though Experiment Demonstrates Our Moral Obligations
• The Big Mac Index – Applying Simple Economic Common Sense
• Is the Stock Market a Big Ponzi (Madoff) Scheme?
• Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?
• How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?
• How to Protect Your Money From Inflation
• On the Psychological Effects of Ownership and Overpricing

Capitalism with Social Equality: A Powerful Though Experiment Demonstrates Our Moral Obligations

An interesting thought experiment by American philosopher John Rawls demonstrates the morality of a more socialistic version of Capitalism

I've been writing here, at The Personal Financier, for over a year and a half now. My skepticism regarding Capitalism as the best economic system, or lesser evil, should be quite familiar to my regular readers. Still, when at times I offer a more socialistic approach in my posts the comments are not late to follow.

It seems our solid conviction in the morality of Capitalism is deeply rooted in us. While pure Capitalism or the more extreme free market variations might have taken a blow recently, our indisputable belief in unadulterated Capitalism remains unscathed, not without just cause.

Capitalism has proved to be a shining beacon in the darkness of earlier economic approaches and has allowed men and women to fully express their potential. Still, we cannot ignore the destructive side-effects our economic system has on social equality (or inequality) and the erosion of the middle class which is the foundation to any solid economy.

There is no need to elaborate on the destructive force of more extreme versions of capitalism as we are witnessing, first hand, the results of greed which "pure" or unregulated capitalism leads to. Obviously the human factor is to blame and not the system, but shouldn't systems be designed to contain our human flaws?

The intuitive appeal of a more socialistic approach

Imagine a disabled person, say blind or handicapped in some fashion. Would you agree that it is society's moral obligation to support such a person? I'm sure that by support the majority would agree that basic sustenance such as a decent roof over one's head, clothes, food and decent medical care are all very reasonable considering the financial capabilities of our western governments.

To take this discussion one step further, to a more risky area, we have to consider the following arguments which I believe to be true:
1. Not all individuals are created equal.
2. Not all individuals, even if are created equal, have equal opportunity.

The socialistic point of view I wish to discuss is such that will, accordingly:
1. Assure the basic needs of all human beings
2. Strive to create equal opportunity

Obviously I can hear the comments in my head already. Why should the lazy and careless live off my taxes? It is a bit more complicated than that but to put it very clearly and basically:
I believe the state of affair where several "freeloaders" enjoy basic sustenance on "our" expense is preferable to a state of affairs where the unfortunate, of which some are lazy and others have had it bad, are taken care off.

Don't get me wrong, I'm not advocating extreme equality and I believe the relationship between ability, effort and personal gain should be rewarded to make any sort of progress. I would, however, like to make sure the less fortunate are living with minimal dignity.

Before this discussion gets more complicated I'd like to present John Rawls Veil of Ignorance which I believe is a very powerful and intuitive thought experiment that contributes to this discussion greatly.

John Rawls' Veil of Ignorance

John Rawls was a contemporary American philosopher and a leading figure in moral and political philosophy. Much like Jean-Jacques Rousseau and Thomas Hobbes Rawls set out to discuss the "state of nature" or the hypothetical human condition prior to the foundation of the state and the state.

While Thomas Hobbes's state of nature is a savage war of every man against every man Rawls uses a thought experiment to demonstrate his concept of the state of nature.

Rawls suggests that at the state of nature it is reasonable to assume the talented and strong would be able to coerce others (the weak). To overcome this "evolutionary" problem Rawls sets up the "original position" and asks us to put ourselves behind a veil of ignorance which deprives us of any information regarding ourselves and others placing us all in an equal, conscious starting point for the discussion in the social contract which we are all interested in.

Rawls argues that the representative parties in the original position would select two principles of justice (as a result of the veil of ignorance regarding their actual positions):

1. Each citizen is guaranteed a fully adequate scheme of basic liberties, which is compatible with the same scheme of liberties for all others;

Even the most egotistical would like to assure their basic rights, unknowing what their actual position is (talented and strong or weak).

2. Social and economic inequalities must satisfy two conditions:

• to the greatest benefit of the least advantaged (maximin rule);
• attached to positions and offices open to all. The reason that the least well off member gets benefited is that it is assumed that under the veil of ignorance, under original position, people will be risk averse. This implies that everyone is afraid of being part of the poor members of society, so the social contract is constructed to help the least well off members (Wikipedia)

And sympathy is what we need…

Rawls thought experiment is powerful. It forces the thinker to consider himself in someone else's shoes and evokes sympathy. And as the song goes: …sympathy is what we need my friends …
I'm anxious to read your great comments.

Related Posts:

• Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?
• How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?
• No Salvation from Productivity Improvements: The Failed 35 Hour Work Week Experiment and Work-Life Balance Examined
• Valuation and Risk Measurement Models under Heavy Criticism – What Went Wrong?
• Coming To Terms with Never Getting Rich – A Look at the Pre-Requirements

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Is the Stock Market a Big Ponzi (Madoff) Scheme?

Looking into the notion of the western financial markets as a big pyramid scheme

I'm sure many of you are familiar with the tale of monkeys and villagers that cleverly demonstrates certain aspects of the stock market. Here's a short version for those of you who aren't.

Of moneys and pyramids

Once upon a time in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. The man bought thousands at $10 and as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20. This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each and the supply of monkeys became so little that it was an effort to even see a monkey, let alone catch it! The man now announced that he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him. In the absence of the man, the assistant told the villagers; “Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35 and when the man returns from the city, you can sell them to him for $50 each.” The villagers rounded up with all their savings and bought all the monkeys. Then they never saw the man nor his assistant, only monkeys everywhere!

At times such as the one we are experiencing now it is very tempting to claim the stock market and western market economics are all one big Ponzi scheme as Nassim Nicholas Taleb , the author of the black swan theory, recently did.

The western financial systems as Ponzi schemes

Mr. Taleb is a philosopher and a former derivatives trader, whose black swan theory deals, in a very insightful manner, with the affect powerful yet random occurrences may have in any field (a black swan as a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations).

The sub-prime crisis and the following credit crisis are huge black swans for that matter. Nassim Taleb enjoys the reputation of one of the few who foresaw the crisis.

According to Mr. Taleb, as was stated in a recent interview, the western financial society is based on a pyramid scheme, much like the Ponzi or Madoff schemes. We needn't take this statement to the letter but rather regard it as a notion to consider.

As many philosophers before him, I believe Mr. Taleb is offering a fresh perspective on an existing notion, in this case financial markets, which we should use to review our set ways of thinking.

In the headline I chose I asked whether the stock market is just a Ponzi scheme, a headline that wrongs Mr. Taleb's argument. The stock market is a means to an end: a tool to raise capital. Mr. Taleb "goes after" the western financial system that failed us.

The main argument is that investment banks and brokers usually risk other people's money and benefit on the upside only. This is a powerful argument with the results of which we can't really argue.

The tools of the trade are often complicated models which justify what they were built to justify while ignoring other important parameters. The already known end is usually a bubble busting, one size or the other. Models are simplifications of reality, that is their strength and weakness. Every model must be taken with a pile of salt.

By increasing the level of risk taken with other people's money bubbles are cyclical and are destined to explode eventually. Since the human mind is not very adept at dealing with risks objectively and is apparently very good displaying herd behavior the markets simply follow this cyclical pattern with investment bankers making a fortune every other 6 years or so.
The pyramid element is very strong. If you can either time the trend, or better yet create it, then you're one of the lucky few who put their money first. Chances are that like many other household investors, we'd be too late to really enjoy the party. What can we do? Simply be there, reserved yet present, through the good times and the rough.

Being aware is already a good starting point

There's no need to adopt a fatalistic approach to financial markets and keep all our money in ultra solid investments. Being aware of market dynamics and the structure of our "western" markets is important for financial survival and to taking advantage of the benefits they do offer.
We all enjoy the possibilities our financial markets offer. Our pensions, for example, are dependent on the market's performance. Even with bubbles bursting and crisis manifesting markets have displayed positive returns in the long term.

There is a solid basis and economic justification for the western financial markets and obviously claiming they are all a big pyramid scheme is too extreme. There is truth to the argument as I've discussed but there obviously so much more.

As the cycle continues regulation will be enforced more firmly, the fear will keep the markets at bay. Still, as the economy starts expanding again the perceived level of risk will decline again and the bubble will burst again.

Credit information by:

Related Posts:

• The Big Mac Index – Applying Simple Economic Common Sense
• Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?
• How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?
• How to Protect Your Money From Inflation
• On the Psychological Effects of Ownership and Overpricing

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The Wine Industry: A lesson in marketing

An interesting thought experiment: How would you value your wine collection should the labels wash away?

Yesterday I've had the pleasure of visiting a local boutique winery. The winemaker took us on a short tour through his winery explaining about the high quality of the local terroir, a French term used to denote the special characteristics the vineyard's geography has and its affect on the quality of wine produced.

We then followed to the barrel storage room where he proudly displayed his French oak barrels bought at $1,000 a barrel to give the wine that special flavor, we continued on to bottling and learned that the wine apparently goes into shock after being bottled for the first time which actually causes it to close up and lock in flavors and aroma.

The tour ended with a series of tastings, in the shop of course. They were pretty good wines, if at all possible to judge by my standards (me being wine ignorant).

Marketing to the Elite

If you've noted a sarcastic tone, you're right. I've always felt antagonism towards the wine industry and its elegant way of marketing to the so-called elite.

Many products have branded themselves as gourmet and luxury. This is a sought our niche for any product as the net profit is simply mind boggling. There's no better way to market something as sophisticated and gourmet as complicating it so much it takes whole courses to learn to differentiate between wines.

The fine palette and nose required to tell if a wine is truly good remind me of the H. C. Andersen's the Emperor's new suit where only the wise can see the emperor's fine clothes.
I have no idea if it's true or not but I heard the weird scoring system in tennis was invented in order to prevent the poor from keeping up with the game. Even more interesting, I once heard the French language had so many vowels inserted into words in order to keep the poor from learning to write. These maybe funny notions but the truth they hold is real enough.

Australian and Californian Wines as a Test Case

The French are fanatic about their wine traditions. Region, maker, grape and everything else are strictly monitored and old customs are preserved and followed to the latter.

The French were understandably upset when Australian and Californian wine makers began producing wine differently. They had wine age in huge tanks with chunks of barrels thrown in for the flavor, no less! Such a disgrace was unheard of.

Needless to say Australian and Californian wines are considered among the best in the world and keep winning blind tasting tests.

A Thought Experiment

The taste of wine, in my opinion, is tremendously affected by our psychology. Imagine the through experiment suggested in my introduction which comes from a play I heard about recently.

Imagine you had a wine cellar full of prized wines slowly aging and improving to perfection. When you have friends over you walk down together, choose a bottle, and drink it with a nice dinner. Like a proud parent you present your wine collection telling the story of each and every bottle. Now imagine a flood in your cellar removing all the labels from your bottles yet leaving the wine intact. Isn't that just horrible?

Much of the wine drinking experience comes from the bottle's shape, the label's elegance and prestige and your knowledge of the wine. That's simply how the human mind works. That is also why we're willing to pay so much for wine.

The thought of me buying something at x100 the cost of producing it simply irritates me. Thankfully there are great wine critics out there which see through the marketing ruse and agree that 90% of great wines can be purchased for under $30.

Credit Information @ credit-land.com

Related posts:

• Psychology tricks and increased spending – The Case of Expensive Wines
• The Big Mac Index – Applying Simple Economic Common Sense
• Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?
• How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?
• How to Protect Your Money From Inflation

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Citi in Trouble, Violent Market Swings and Staring at Stock Charts: My Thoughts

Citi won't be allowed to fall, we got accustomed to violent swings pretty fast and I admit it: I'm addicted to stock charts.


#1 Citi's troubles are a whole different ball game

During this crisis a lot of "unthinkables" occurred, changing our perspective on the financial markets and their institutions. I don't believe anyone dared dream both Bear Sterns and Lehman Brothers might go bankrupt nor Merrill Lynch sold.

Still, investment banks are one thing. Huge retail Banks are a whole other matter. Investment banks had the reputation of financial troublemakers, even though they were thought to be stable and profitable (which they were for quite a long time). Retail banking is one of the cornerstones of our economy.

Should Citi fall the ripples will surely tear through the global financial world faster than any shockwave. Banks worldwide have billions of dollars in exposures to Citi and its many activities, a staggering blow indeed.

That's why I'll risk saying Citi won't be allowed to fall (much like the automakers). I may be forced to eat my hat in the weeks to come but I'll take the chance. This obviously shouldn't motivate anyone to invest in Citi right now as we've seen how low bailed out stocks can go.


#2 Getting used to violent market swings

Oddly enough we've got accustomed to violent market swings quite fast. Only half a year ago shifts of 4% in any market index were reason for extreme fears, panic or hope (remember that 10% daily surge?).

Today, 4% shifts are hardly breaking news anymore and almost nothing will surprise investors. Volatility is immediately translated into risk and risk into premium which surely enough puts enormous pressure downwards on stock prices.

The first sign for household investors to slowly yet steadily make their way back into the market (in the fortunate case you've liquidated yourself) will be reduced volatility. Sure we might miss on the significant surge up (which will eventually present itself) but we will also avoid another bull trap like the ones only recently avoided.

Keep in mind an old market saying: Pigs get fat and hogs get slaughtered. Are we, with all the required reserve, hogs or pigs? Are we waiting on lower and lower levels before jumping back in? I'm starting to move restlessly in my seat.


#3 Staring at stock charts

I don't know about you but I've found myself staring a lot more in stock charts lately. There's something fascinating about the way they plummet downwards. I think it's the assumption some stocks will skyrocket back to previous levels and new highs.

Unimaginable daily drops catch my eye and I keep wandering back to the screens whenever I have 5 minutes to spare. I do believe I'm becoming an addict.

I'd like to take this opportunity to share a few carnivals from the past weeks, in gratitude to their hosts:

• Money Hacks Carnival #39 @ Moolanomy
• Carnival of Personal Finance #179 @ Money Ning
• Carnival Of Money Hawks @ MoneyHawk
• Carnival of Debt Reduction @ Simply Forties

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What Should I Do With My Money?

Turbulent times confuse household investors. I know I'm confused

An interesting and timely experiment was conducted by one of our local business papers. Trying to answer the eternal question of "what should I do with my money?" the paper set out to review what leading brokers, financial planners and money managers would recommend someone with a liquid saving of $50,000.

The question of what to do with our money is always present as money always has an alternative cost (and risk). Since money is a very flexible commodity we are often tempted to explore our options. At times of financial crisis this sort of behavior can be very risky.


What causes household investors to retreat back to the false safety of liquidity?

Not surprisingly, economic downturns cause the vast majority of household investors to retreat quickly, like frightened turtles, into liquid or short term bank deposits instead of exploring other more profitable ventures. I know I do.

I can testify, first hand, on the roots of this behavior:

#1 I worked very hard for this money. It'd be a shame to see it go to waste.

I feel my hard earned money shouldn't be carelessly spent while pursing the dream of fantastic returns. Each crisis is unique and carries surprises of its own. It is rather painful to see my money dwindling with each passing day as stock indices constantly search for new lows.
There are no guarantees in the markets. The Dow at 8,000 is not sacred and past indicators are never really relevant for the future. In the markets, very much like in wars, we are usually fighting the current crisis with the previous crisis' lessons.

I'd much rather sit this crisis out and join back in after a healthy spike in prices (although I'd probably be too scared as well).

#2 The need for a solid and healthy emergency fund has never been so relevant

It seems to me only the financially secure may have the luxury of making money out of this crisis. Personally, I've never been gladder to have my emergency fund as a comfy pillow to fall on should I need one.

Even though I've been able to save a bit more than I'd planned on in my emergency fund I sleep better knowing I've got two more months of living covered.

#3 I can't really commit myself to an appropriate investment term

Who really know when this crisis will end? Chances are we'll see a glimpse of financial hope during the second half of 2009 but who really knows? We can't afford to bet on averages with this crisis.

Furthermore, I've got too much going to really be able to commit to an appropriate investment term in stocks. As I've always written in the past, an investment term shorter than 5 years isn't suitable for a real long-term investment in stocks (preferably longer).

Again, only the financially secure seem to enjoy this luxury.

#4 I'm too greedy

Honestly, I may be just timing the market. I've recently written about a bull trap in the market that proved itself. Maybe next time it won't be a trap but the real deal. For now, I'm greedy.
Why did I call it the false safety of liquidity? As we all should know by now, liquidity is probably the worst long-term investment available. In the end, household investors lose big on their fears. But that doesn't mean those fears are unjust.


What did the brokers have to say?

First and foremost, keep in mind money managers make their living of our investments. As a result, it's always a good time to start a new portfolio.

Second, don't expect to find any answers. Brokers and money managers aren't smarter than us when it comes to timing the market or they would have retired long ago. What they are good at is maintenance.

The "professional" replies split into three distinct types:

1. If you have the discipline and financial depth to watch your portfolio shrink by 50% and wait it out than you can start thinking about buying stocks.

2. Go solid.

3. Some would say this is a good time to buy stock (A redundant and obvious tautology).

All the brokers stated the current price levels are low and seemingly attractive. Yet all of the brokers also stated that volatility and uncertainty are extremely high and that investors should be cautious. Bottom line: You decide, it's your money.

When you think about it brokers, analysts, planners and all other money professionals have no real motivation to be original. If they're original and they're wrong (say bet on a violent up trend when all is lost) they pay dearly. If they go with the herd and they're wrong no one can really blame them.

I do think professional money managers are important. They have the ability to maintain our portfolio and some do have a competitive advantage both in skill and knowledge. However, ultimately, it's up to us as investors to make the right choices, mainly Investment term and risk level.

Related Posts:

• Surprising (and Promising) Aspects of the Financial Crisis
• From a Financial Crisis to a Real Crisis: The Makings of a Greek Tragedy?
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• Extreme Risk Aversion Paradoxically Leads to Another Huge Risk
• How to Invest Wisely In a Bear Market?
• The Relation between Age and Portfolio Risk – Counter Intuitive Results

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Surprising (and Promising) Aspects of the Financial Crisis

What do Playboy Playmates have to do with a very interesting article in the NY Times regarding the impact of financial crisis?

Bloomberg reported yesterday that the number of visitors to the baseball hall of fame has reduced by 12%, on average. Fewer visitors and fewer donations find their way to the museum which is located in Cooperstown, 200 miles from New York City. The slump in visitors is naturally attributed to the current financial crisis.

Naturally, at times of economic hardship people almost immediately save on what they perceive as luxuries, the impact of which is quickly felt everywhere. Private consumption is one of the strongest economic forces there are and is necessary for real growth.

The Surprise

There are, however, more interesting aspects and phenomenon which manifest in times of economic hardship and financial crisis (with all due respect to Baseball of course). In a very interesting article titled "A Hemline Index, Updated", Tamar Lewin (NY Times) discusses the more surprising aspects of financial crisis and bad times in general as studied by various researchers. Here's a quick summary (I recommend reading the entire article for more interesting indicators):

• Looking at Billboard No. 1 songs from 1955 to 2003 for a study to be published in the journal Psychology of Music, prof. Pettijohn found that in uncertain times, people tend to prefer songs that are longer, slower, with more meaningful themes.
  
  

• Playboy magazine’s Playmate of the Year in bad times tended to have a more mature appearance — that is, to be older, heavier, taller and less curvy — than those selected when times were good.
  
  

• During a recession, laxatives go up, because people are under tremendous stress, and holding themselves back. During a boom, deodorant sales go up.
  

The Promise

I've tried researching more on the subject and found another, not so surprising, but rather promising aspect financial crisis.

There are winners to financial crisis as well. An interesting line of thought is presented by Andrew O'Connell for Harvard Business Publishing in this regard. Mr. O'Connell discusses the merits of what he calls Intergenerational transfer of wealth: "As housing prices fall, older generations of Americans are seeing significant amounts of their wealth evaporate, but the decline presents opportunities for younger people". Surprisingly enough, the fact that many homeowners are seeing their life savings evaporate (to put it rather drastically) is beneficial to the younger ones of us, who may now be able to afford actually becoming homeowners and seeing their net worth rise with their property by sitting out the housing slump.

Apparently in 1929, before the great depression, the social inequality in the US was at a peak. Financial crisis serve as stress relief in this regard as the rich get much less rich while the poor get a bit poorer. It's almost like the financial nature restores balance through systematic shocks.

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