Thursday, July 05, 2007

Economically-minded behaviors, Part 2

Smart Money magazine recently ran an article with the tagline “Emotions and poor judgment lead a lot of smart people to make dumb financial moves. Given my interests in psychology and economics, I thought this a perfect opportunity to review a few insights about money and behavior through the scope of this article.

1. Saving with the right hand, spending with the left. Are you one of those people who fixate on the price of a new automobile, but don’t monitor your routine shopping habits, such as groceries and entertainment? Do you think that it is a rational—or even acceptable—decision to have a savings account with a 5 percent rate of return, while you still pay much more than that for your credit card interest rate? How about the IRS: Do you set your tax withholdings in a given year so that you receive a high return at the end of the year?

The article duly points out a few more logical methods for dealing with the above scenarios. For instance, the average credit card debt of an American is about $1800; an amount that most households have in savings to pay off. Paying it off increases the rate of return on the money remaining in savings by reducing the strain placed on it from other parts of your cash flows. How about the tax withholding situation? Why don’t you instead set it more accordingly—so the IRS does not get so much of your earnings—and you invest it in an account that earns you money throughout the year; instead of offering the government an interest-free loan, you can make that money work for you. Controlling your financial present and future is a lot about making every dollar “scream:” That is, the harder you make your money work for you, and the less you use it to consume now, the more you will have to consume later. Radio talk show host Dave Ramsey has a saying that he fondly recites on his radio program: Today, live like no one else, so later, you can live like no one else.

2. And 5…Playing it too safe,” and “Throwing good money after bad. People don’t like losing. As I’ve mentioned before, “people are more displeased by a loss than they are over a comparable gain: In America, at least, we typically need to offset an unexpected loss by a gain of 2.5 times that loss. This loss aversion, obviously, extends to money. An example cited in the article is of the classic fuel-purchasing “penny pincher:” Driving miles out of their way to save as many cents per gallon when, in fact, the fuel consumption and the wear and tear on the person’s vehicle will cost about 6 times the amount that the person is saving. Individual investors, also, have the same attitude towards averting loss whereas they will be more apt to sell a winning stock than a losing one. The “sunk cost” bias tells us that we tend to feel that we’ve passed the “point of no return” and feel that cutting one’s losses would be a waste of resources—time, money, and otherwise. In fact, decisions about future investments should be made based on future possibilities and not biased by recent investments within the scope of the current scenario.

3. Looking into a cloudy crystal ball. While more than two thirds of Americans have life insurance, those in the 35 to 64 years old age bracket are six times more likely to be injured to such a degree that they would miss an extended amount of work—than they are to die. The upshot? Less than one third of us have disability coverage. People base their prediction of the frequency of an event or the proportion within a population based on how easily an example can be brought to mind—in other words, we tend to take “short cuts” to the conclusion that we want to draw with the information that is available to us, relying easily on images and experiences that come to mind more quickly than more logical alternatives. The article duly points out, via the words of University of Chicago researcher Cass Sunstein, a phenomenon known as “probability neglect:” “We tend to ask what’s the worst—or best—that could happen. Instead, we should be asking what’s likely to happen.”

4. Living in the moment.People like to procrastinate. Watching your favorite television program (or any television program at all, for that matter) instead of cleaning the garage or the attic is often more appealing and offers a more immediate reward than the alternatives. Instead of looking at the non-linear benefit or the delayed costs and rewards, people tend to look at the immediacy of them instead.

Letting your ego get in the way. Overconfident investors tend to have good experience and think they are skilled, while in reality luck may play a larger factor than skill. Because it is easiest to think about, focus, and analyze ourselves and our ability we will tend to take a shortcut back to ourselves and our own abilities and skills. Confidence is good; and a healthy dose of overconfidence (despite the definition and connotations otherwise) is good: Without it, we wouldn’t have a propensity to strive for what’s better, what’s next. An unhealthy amount of confidence when dealing with the stock market, it is pointed out in the article, trend towards high risk investments, overtrading, and under-diversification, and, ultimately, smaller rewards over the long term. Investing for all but the die-hard day trader, is like making a burger in that you get the fundamental essence of what you want and continue to play with it less, only moving it such that it doesn’t get burned, taking it off the grill when it’s ready to eat.

7. Following the crowd. Just because everyone else is doing it means that you should, too, right? The Bandwagon effect, or following the herd, is essentially the observation that people often do or believe things because many other people do or believe the same. Funny enough, a Yale study entitled “Dumb Money” by researchers Owen Lamont and Andrea Frazzini pointed out that poor sentiment was actually indicative of good future returns in both stocks and funds: Those who bought and held S&P 500 index after Black Monday have made eight times their investment; on the other side of the coin the more popular investments have been shown to underperform. The company that developed the ever-popular iPod and iPhone, Apple, has skyrocketed in the last year or so: Stock that I started monitoring at $117.98 is now worth 106.88 percent more than the price I began monitoring at. Some industry experts, however, have predicted that after the buzz of the iPhone wears off, the stock may finally start to deflate—if not plummet. Time will tell if these predictions are correct, however.

Out of town

I'll be out of town tomorrow, but I'll be posting Friday's blog entry today.

Have a great weekend, everyone, and be safe about it.

Economically-minded behaviors, Part 1

I’ve mentioned before that personal finance is more about a person’s behaviors than it is a function of their ability with crunching numbers. Taking this to its logical conclusion, a corollary would become that emotions and poor judgment lead a lot of people, exceptionally bright or not, to make, simply put, dumb financial moves. Historically, psychology has played an integral role in economics. For example, when Adam Smith wrote The Theory of Moral Sentiments it includedthe ethical, philosophical, psychological and methodological underpinnings to Smith's later works, including The Wealth of Nations (1776), A Treatise on Public Opulence (1764) (first published in 1937), Essays on Philosophical Subjects (1795), and Lectures on Justice, Police, Revenue, and Arms (1763) (first published in 1896).

Hersh Shefrin, in his 2002 work “Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing,” listed three main themes for behavioral economics:

· Heuristics: Using “rules of thumb” that are, at best, approximated, instead of strict rational analyses, people tend to make bad decisions.

· Framing: The context of the problem or the way it is presented to the decision maker will often affect his or her action; which can result in a bad decision.

· Market inefficiencies: Examples such as mis-pricings, return anomalies, and non-rational decision-making can explained observed market outcomes that are contrary to otherwise rational expectations of market dynamics.

College macroeconomics courses teach a concept of “utility,” a fundamental concept in neoclassical economics which depicts perceived value in a good or service. Prospect theory, as part of behavioral economics, describes decision processes as consisting of two stages: Editing and evaluation. Editing consists of possible outcomes of the decision are ordered following some heuristic. Specifically, people decide which outcomes they see as basically identical, setting a reference point and consider lower outcomes as losses and larger as gains. In the evaluation phase, people behave as if they would compute a value, or utility, based on the potential outcomes and their respective probabilities, and then choose the alternative having a higher utility.

Keep in mind, however, while all this theory is good for a foundation of understanding the basis for the mistakes—and successes—we will inevitably have when it comes to our finances, note that these models can fail to predict outcomes in real world contexts for one reason or another. As in the science of profiling, establishing patterns and trends are keys in determining if a particular model will accurately predict a desired outcome. On the other side of the token, it is argued that while behavioral insights can be used to update economic and financial theories that we’ve come to rely upon, they also offer greater depth into these two disciplines: Not only reaching the same (correct) predictions as traditional models, but also correctly predicting outcomes where traditional models have failed in the past.

Wednesday, July 04, 2007

The World’s Affluent

By standardized accounts, in order to be considered a “millionaire,” you must have more than one million dollars not counting their primary residence or private collections of objects such as art, antiques or coins. This can, however, include cash, equities, bonds, funds, or other real assets. How many of these High Net Worth Individuals (HNWIs) are there out there? How about their bigger, wealthier brother, the Ultra High Net Worth Individuals (UHNWIs) around the world?

Financial services group Capgemini and U.S. investment bank Merrill Lynch recently conducted a study about the slowing global economy and a consolidating and increasingly wealthy class of “super-rich” individuals around the world. Their findings shed some interesting light on the evolving face of wealth across the globe.

· The financial assets owned by the group totaled 37.2 trillion dollars (27.7 trillion Euros)

· Financial assets owned by this group increased by 11.4 percent from 2005

· Singapore, India, Indonesia and Russia produced the greatest number of new millionaires in this category

Why did this group grow so much, with the cumulative wealth of their combined whole increasing at such a strong magnitude? Increased production the world over increased real GDP and market capitalization rates drove and accelerated this growth through 2006.

· UHNWIs also increased their standing in recent years:

  • Increased by 11.3 percent in 2006
  • Global population of this extremely affluent group now estimated at 94,970 people
  • UHNWIs now account for 1.43 percent of the global population
  • Assets of Ultra-HNWIs increased by 16.8 percent compared with 2005

So, where does all their money go?

  • More than 25 percent of investments were in private jets, sports teams, yachts or race horses
  • Art investments accounted for 20 percent of the HNWIs’ investments
  • The remainder went into fine wine and jewelry, and alternative investments such as real estate

What to expect in the future? The report indicates that the collective fortune of the HNWI population is forecast to hit 51.6 trillion dollars in 2011, compared with 37.2 trillion in 2006.

Tuesday, July 03, 2007

…With the Blood of Patriots

The day was quickly ending that evening when ships outside Baltimore Harbor started bombarding the American Fort McHenry. It was sundown on September 13, 1814 when the British started bombarding the fort and the lights in Baltimore went out. Shells burst over the Fort for 25 solid hours: It was the only illumination in the entire area, allowing the flag to be seen by all—and that it was still standing through the night.

An American attorney and poet could be found on one of the British ships in the harbor along with a military officer, Colonel John Stuart Skinner. The two were meeting for a prisoner exchange with two British Flag Officers and a British General for the release of one Dr. William Beanes. Because they had knowledge of British military unit locations and strengths, they were not allowed to return to Baltimore that evening. Instead, the aforementioned attorney found himself without anything else to do but watch the bombardment of the beloved Fort at the mouth of Baltimore Harbor. Inspired, he penned the poem “The Defense of Fort McHenry,” using the rhythm of the piece “To Anacreon in Heaven.”

The man was Francis Scott Key and the song that resulted from his words would become the American National Anthem in the early 20TH century: The Star-Spangled Banner.”

Years earlier, at the conception of the American Union, the thought of revolting against the British Empire was only supported by less than 1 in 3 people, even though the colonists were being taxed without proper representation within the British Parliament. The beginning of the Revolutionary Era is recognized as being 1763, with a declaration of the independence of the 13 colonies being posed 13 years later. It wasn’t until 1783, however, that Britain recognized the independence of the United States of America and hostilities between the two nations—at least until the War of 1812—ceased.

The right thing is rarely the easiest, or even the quickest in coming. Change brings destruction, often obliterating one paradigm to be replaced with another. This paradigm change may be brought about by the sweat and tears of a few or the blood of many patriots. On this day, the birthday of the United States of America, reflect on the values of your freedom, regardless of where in the world you find yourself or under whichever flag you choose to fly—for the ideals that formed our nation are also those that make many other nations and peoples great. It has been said that those who forget history are doomed to repeat it. On this day, remember the ideals that bind us all together and the blood that has been shed by the patriots that have been willing to fight for those ideals.

Dollars and Sense

Financial success does not happen overnight; money is not something to be had instantly. Rather, financial success is the manifestation of a specific behavior set.

Once upon a time there was a boy born in the Midwest; for the purposes of this story, we’ll simply call him W. A bookworm with a natural ability in math, he went to work at his father’s brokerage in 1941. During his first year working there, W purchased a couple shares of stock, just for kicks. Purchasing them for a bit more than $38, he sold them for $40, not making much money from them: The Cities Services stock would soar to $200 months later. In 1944, at the age of 14, he started installing pinball machines in barber shops. Earning $1,400 from the deal, he purchased 40 acres of land and rented it to tenant farmers. A good student, his love of being an entrepreneur came before his desire to attend college. By the time he graduated high school at the age of 16, he had done so in the top 20 of his class and had saved nearly $5,000. His father coaxed him into attending university; yielding to his advice and matriculating at the Wharton School for three years and transferring in the last year. In 1951 he would earn his Masters degree in Economics. By 1956, he founded his first investment partnership with $100 out of his own pocket (and several thousand from multiple limited partners, family and friends). Spending much time learning, from multiple sources, the art of investing, he would run his investment partnership from his bedroom making an excess of 30% compounded returns in a market (1956 to 1969) when 7%-11% is the norm.

In 1962 W would start purchasing shares of a failing textile company, leaving his partnerships to operate it full-time in 1969. Turning it into a holding company, he began purchasing other companies with an emphasis in insurance concerns due to their large cash reserves that they must keep. Over the years, W fashioned himself a “capital allocator,” putting significant sums of money into high-value companies and keeping existing management.

How does such a man perceive his wealth?

I don't have a problem with guilt about money. The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing. I don't do that though. I don't use very many of those claim checks. There's nothing material I want very much. And I'm going to give virtually all of those claim checks to charity when my wife and I die.

The man? Warren E. Buffet, worth $52.4 billion as of 2007.

What can his rise to power tell the rest of us in the rise to ours?

1. Wealth-building decisions are long-term ones. Studies have shown that wealthy people made decisions for the long-term; usually doing a cost-benefit analysis for a 20-year period. Those on the opposite end of the wealth spectrum, on the other hand, make decisions for the short-term, “what will make me happy now?” In fact, you are more apt to make your own million than to inherit it from someone else: 86 percent of millionaires are first generation; the money is not inherited. Your wealth is the sum total of your decisions to date.

2. Wealth relates more to behaviors and less to number crunching. Think that there is something special about the affluent, like getting an inheritance or maybe that you have “bad luck” over other people? Research has found that wealth disparity couldn’t be explained by income—differences by income only accounted for a 5 percent dispersion. Furthermore the researchers noticed that “’chance events’—inheritances, medical bills, marital status, number of children— explained about 4% of the dispersion.

3. Don’t spend more than you earn. This is a simple axiom: If your net income is negative over a long enough period of time, no matter what your financial goals are, you will not be able to achieve them.

4. Pay off debts. The less debts you have, the more your cash flow will increase. Your income is the most powerful wealth-building tool that you have, and the less strain it has to provide for you, the more ability you will have to become financially successful.

5. Have a clear plan laid out—financial and otherwise. Dream big, but fashion it with rationality. If you plan to be a millionaire in 5 years and you’re currently making $30,000 per year…something drastic will need to happen to get to where you want to be.

6. Find opportunities and learn how exploit them. Success is when opportunity meets preparation. This means everything from being able to spot something that could be profitable in the stock market to knowing when to make a move at your job that could be advantageous to you.

7. Persevere. History is riddled with stories of the greats that kept on doing something “just a bit longer” than everyone else. Their determination and purpose to achieve their desired result allowed them to achieve their goal, which often led to financial success of some fashion.

8. Invest in yourself. If your income is your most valuable wealth-building tool, you are the reason that your income is such a valuable tool. Investing in yourself means sharpening and expanding your skill set through self-directed study and formal education. It also means doing those things to enhance the positive aspects of your life and minimize—or get rid of—the negatives.

9. Help others achieve. Success begets success. Helping others achieve not only helps them, it also helps you: Mentoring offers a different perspective that many people don’t realize and, therefore, don’t care to tap into. Humans are a creature that relies on community; we each have a symbiotic relationship with one another in the sense that what comes around goes around. Just s your success relies on the choices of other people; the success of other people will rely on the choices which you make.

10. Become an entrepreneur. Take an attorney, for example: With about 10 years experience, they have a median salary of about $100,000; considering a conservative 2,000 billable hours each year (for about 2,800 hours worked) at $250 per hour that the client is being charged, you are only realizing 20 percent of the business you are bringing into your law firm. All “blue sky value” aside, you could still make more doing that—albeit with more work—than the alternative of working for someone else. In the greater scheme of things where the affluent are separated from the economically (behaviorally) disadvantaged, having employees that earn you money is what sets the financially successful apart from the rest.

Lastly, think of earning money in this fashion: Split the day into 24 hours and divide your daily earnings by 24. How much money are you making per hour? If you’re working at McDonalds, chances are that you are making, what, about $3 per hour? If you’re the lawyer above, you’re earning significantly more than that. Determine ways to be creative and raise that “hourly earnings” rate that you have.

Money is almost entirely about the decisions that we make from day to day about tomorrow. To repeat something I mentioned earlier: Your wealth is the sum total of your decisions to date.

Ode to the iPhone

Every now and then, as usual readers can attest, I like to slip current events into the blog.

This is one of those times. Funny stuff!

Monday, July 02, 2007

Quote: The Appreciated Staff

"An underappreciated employee is an unhappy employee. An unhappy employee is an unproductive employee. When your staff knows they are valued, they will value the company."

Thanks go out to Jennifer for the quote. Thanks, Jen!

The Value of Money

Money: It’s the root of all evil, right? Not necessarily. Actually, the original quote from The Bible (King James Version) comes from 1 Timothy 6:10—“For the love of money is the root of all evil.” Money, finances, and all which they entail intermittently come up in conversation. Prior to discussing money as a quantitative entity, let’s look at it from a qualitative perspective.

I have seen, over the course of my years, so many people who have seen examples of people whom they do not want to become, exhibiting traits which they do not care to exhibit. For every person who is financially successful, a person can point out an example of someone who they’d ridicule for their actions—because of their wealth. Using this fear as a crutch, they limit themselves from seeking true financial success—often for very irrational reasons.

A culture has developed in this country—something that has been around the world for longer—steeped in the tradition that the various people in their various income classes throughout society have been dealt an unfair hand. Politicians with agendas have long engrained into people of the inequality of income and that it should be re-distributed among the different economic classes of individuals: Transfer payments derived from taxes on the affluent become welfare payments for the poor. Sure, there is a time and place for everything, but when the public is constantly being told that one person’s success over another’s complacency is unfair and that one should be punished to subsidize the other, a perception becomes commonplace amongst people that money can be a bad thing.

I’m a die-hard free enterprise capitalist at heart: In a generally unregulated economy (other than central banks and select industries) that each person is free to lawfully pursue making a dollar either by selling his or her labors to another in return for a salary or hourly wage or going into business and producing and/or selling a product or service to someone willing to purchase it, we are all free to earn as much for as much work and/or innovation which we are willing to put into something. Left and right there are examples of people becoming successful either way, even if you choose to work for someone else. Some statistics from show:

· In 1999, average annual earnings ranged from $18,900 for high school dropouts to $25,900 for high school graduates, $45,400 for college graduates and $99,300 for the holders of professional degrees (medical doctors, dentists, veterinarians and lawyers).

· Over a work life, earnings for a worker with a bachelor's degree compared with one who had just a high school diploma increase by about $1 million.

Additionally, there are fluctuations within degree field & occupation (courtesy of the Royal Society of Chemists):

The average earnings premium of having a degree relative to those with 2 or more A Levels was approximately £129,000 [about $257,500 USD]. The figure represents the difference in lifetime earnings after tax. Graduates in chemistry or physics on average earn well above this value, with a £185,000 - £190,000 [$370,000 to $380,000 USD] premium above those with no degree…Year-on-year statistics show that these subject differentials start to become apparent in the mid-career years: it is beyond the age of 30 that chemists and physicists start to pull away from their contemporaries in their earning power…For any graduate, the average rate of return is about 12% per annum but rises to 15% per annum for chemistry graduates. Psychology graduates will enjoy only a 10% rate of return.

Regardless of how much working for someone else will gain you, the hallmark of the great American economy is the stalwart of entrepreneurism fueled with a hefty amount of innovativeness, is the best path to financial success and affluence, even if it can be the most difficult.

At any rate, people often equate money with power. People also tend to equate money—in a financial inequity sense—with greed.

Power: Possessing or exercising power or influence or authority” or “possession of the qualities (especially mental qualities) required to do something or get something done.

Greed: excessive desire to acquire or possess more (especially more material wealth) than one needs or deserves,” or, more generally, “avarice.”

Paul Johnson, British journalist, historian, and author, recently wrote a column published in Forbes Magazine entitled “Greed is Safer Than Power-Seeking” in which he begins, beautifully, by stating:

Able, industrious, imaginative and creative people— the top 5% of mankind—divide into two broad categories: those who make money and those who make trouble.

The stage is certainly set for a tour de force comparing and contrasting a potential effect on an individual with wealth versus one with simple enthusiasm, zeal, and an agenda. It is striking that the hugely wicked are quite innocent of avarice,” Johnson writes, showing that tyrants and dictators such as Adolf Hitler, Joseph Stalin, and Mao Zedong weren’t oriented towards the accumulation of wealth; rather, they were obsessed with the accumulation of power. In people that you and I come across each day, he goes on to categorize groups of individuals which exemplify “troublemaking” through their activities. Among them: Attorneys who are concerned more with their interpretation of justice and fairness than an enriched society; Politicians who exist solely to translate their agendas into legislation; and the self-proclaimed environmentalists who, “buoyed by a sense of mission and high-principled idealism that often make them a little careless about the accuracy of their assertions,” have helped push the world into a shortage of energy supply by zealously convincing anyone they can that alternative sources such as atomic energy should not be pursued.

Oddly enough, he closes his column with the thought that “Of course, we need troublemakers,” in the sense that they have, historically, been the impetus for societal changes in civilizations throughout history. Whereas greed—the excessive desire to acquire wealth—can be a bad thing—the net result can always be reflected through the character of the individual in the sense that money only fuels the flames of character traits, be them good, bad, or ugly.

I once worked with a staff sergeant in the South Dakota Army National Guard who had the saying: Money is like oxygen—the more you have, the easier it is to breathe. Try this thought on for size: Money, wealth, does not accomplish things—people do. Money is a tool for accomplishing those things which the individual wants done; in doing so, it accentuates character traits that are already present in the individual: If you are predisposed to be greedy and love to acquire “things,” money will only make it worse; if you are predisposed to not like a certain race of people and believe that your land is home to a “master race,” then chances are that wealth will only fuel your need for power, manifesting itself as genocide and a world war.

If you have a predisposition, however, of trying to benefit humankind, no amount of riches will stand in your way of filling the shoes of purpose, desire, and motivation to accomplish something. However, with wealth as a tool, you might be able to accomplish great things.

Monkey Mondays: The Endangered Monkey

Scientists find endangered monkey in Vietnam!

It's a grey-shanked douc. Funny name, serious monkey.

The picture to the left is a red-shanked douc, courtesy