Wise Money Decisions

Of all the skills that our government leaders should have, a basic understanding of economics is high on the list.  Too often I see politicians say or do things that betray basic misunderstandings of how the world works.

Here’s the latest example. From this AP Yahoo article about the Greek debt crisis, we have the Swedish finance minister Andres Borg saying:

“We now see herd behaviors in the markets that are really pack behaviors, wolf pack behaviors,” he said. If unchecked, “they will tear the weaker countries apart. So it is very important that we now make progress.” 

Does Mr. Borg really believe that Greece’s problems are a result of investors knowingly banding together to bring Greece down?   Really?  

Could decades of Greek financial and social mismanagement have something to do with it?

Borg’s misunderstanding is, alas, a common one.  My sense is that most people (politicians and non-politicians, and even some economists) don’t appreciate the “information aggregation” aspect of markets.  Market prices are a source of information that can help us understand what’s going on in the world. Market prices are the messenger.

For example, when the cost of milk goes up, something is causing it.  It may be a result of bad weather, mad cow disease, increased government regulation, higher consumption, or other factors.  The higher price is an effect, not a cause.  It is a message that something is going on, not necessarily that there are sinister forces conspiring to increase the price of milk (which could be a cause, but should not be the de facto explanation for any price whose level we think is too high).  If government believes that something should be done to lower the price, it should begin from the premise that the high price is telling us something.  It should figure out what that something is.

If the price of assets with Greek exposure is going down, the right conclusion to draw is that their value is low, not that speculators have banded together to punish Greece by selling assets at artificially low prices. 

By the way, if Mr. Borg’s explanation is correct, then these unidentified speculators have found a great way to lose lots and lots of money. After all they are selling at below fair price.  I only hope Mr. Borg is smart enough to take advantage of this supposed fire sale by dumping his entire net worth into Greek government bonds.

Fortunately there is another European finance minister that seems to have a better understanding:

“I’m against putting all the blame on speculation,” said Austrian Finance Minister Josef Proell. “Speculation is only successful against countries that have mismanaged their finances for years.” 

Update: Over at Seeking Alpha, Kid Dynamite offers another explanation for Greece’s problems.

Here is a sobering article about the growing size of government via Yahoo Finance.

If you are interested in asset allocation, or investing in general, you should check out Wall Street Journal’s graphs showing the correlation of various asset classes with the S&P500.

There are two graphs. 

The first shows a timeline from 1994-2009 showing the correlations over time.  The striking feature of the graph is the rise in correlation of just about every asset class with the S&P500.  For equities, it’s been increasing for several years.  For bonds, it’s a more recent rise (although notice that bonds were even more highly correlated with the S&P500 in the mid-1990’s).

The second graph shows similar data, except aggregated from 1973 to 2009. It also shows the correlation of each asset class with the S&P500 for 2008.  The point of the graph is the correlations became more extreme in 2008, either more positive (most asset classes) or more negative (short-term treasuries and TIPS).

The conclusion is that most asset classes become more correlated during a crisis, reducing the benefits of diversification.

Unfortunately I can only read the first 3 paragraphs of the attached WSJ article because I don’t have a subscription.  It seems to conclude that asset allocation as a strategy is not effective because the correlations rise during a crisis. 

I suppose there’s some truth to it if you only invest during crises.  But do you know anyone that only invests during crises?

On the other hand if you plan to invest long-term, the relevant data is the long-term correlation (the grey bar on the graph) and not the 2008 correlation (the blue bar).  I’m in the market long-term.  I don’t care if the blue bar rises during a crisis. It’s temporary.

And there’s one more salient point.  A well-thought-out asset allocation strategy, coupled with low fees/expenses and a strategic tax approach, is the only way to beat the market in the long-term that is : 1) Easily accessible to most investors, and 2) Legal. 

If you abandon an asset allocation strategy, you’re left with the problem of figuring out a better strategy. 

A few other points worth noticing on the second graph, going from right to left:

• The “U.S. Stock Market” to the right only shows a 0.64 correlation with the S&P500.  I would have expected something in the 0.90’s given that the S&P500 is often considered “the market.”  Not sure if their data is bad, or if there’s some other reason for the discrepancy.
• Hedge funds have a 0.35 correlation.  This shouldn’t be news to anyone, but hedge funds are not really for “hedging.”  There are half a dozen asset classes on the graph with correlations closer to zero, all of which would be better hedges.
• The emerging market stocks correlation is shockingly high at 0.99.  I would have expected much lower. 
• European stocks correlation is shockingly low at 0.05.  I would have expected much higher, perhaps in the 0.80’s.
• Junk bonds are essentially uncorrelated to the market, making them a good hedge against general market risk.

There is an interesting clip from “reason.tv” on the frontpage of the Utah Taxpayers website.  Drew Carey proposes a private market solution to the public problem of heavy traffic in Los Angeles. 

Mr. Carey would like to see private companies build roads that would, in essence, compete with public roads.  Drivers could choose whether to take the public road for free and run the risk of heavy traffic, or take the private road without heavy traffic.  The private roads would make money through tolls.  No taxpayer dollars would be used. 

Here are my thoughts after watching the video.

On the one hand free roads are nice because they’re, well, free. On the other hand there are long wait times because everybody else wants to use them too.

Roads are no different than any other service. When there is no marginal cost imposed on the user, they get used beyond capacity.  The result is long wait times. With roads, we call it “traffic.”  With healthcare, we call it “Dr. Johnson has no appointments available until next June.”  It also happens with internet bandwidth.

It makes me wonder what it would be like if roads were privately owned and operated. What would we think?  We would complain at the nickel and diming as we drive down the freeway each day. It would be easy to think, “If only we had government-run roads, we wouldn’t have to pay all these tolls. Driving would be free. What a great world it would be.”

Well, we have that world, and it’s filled with gridlock and long commutes.

It’s also interesting to see the technological solution on the private road on highway 91 in Orange County.  There’s a scanner that tracks the vehicles that drive through the private road.  Depending on the time of day and the amount of traffic, the amount of the toll goes up and down, ranging anywhere from $1.50 to nearly $10.  The average toll is about $2.75 according to the video. 

What kind of people choose to pay the toll?   People that believe the time they save is worth more than the toll.  Each person makes the choice for himself/herself.

Are there lessons to be learned from the way we do roads that apply to other services? 

Take healthcare.   There is no shortage of people who think their lives would be better if we move to a government-run healthcare system.  Some of them are right.  Some people would benefit.  It would be free or very lost cost.  Everyone could go to the hospital anytime they need, for any reason.  What’s not to like?

Just make sure you book your flu vaccination appointment in April.  It may take 6 months to get in.