Tuesday, May 31, 2011

The Needs of the Many

" Logic clearly dictates that the needs of the many outweigh the needs of the few"

-Spock, Star Trek II, The Wrath of Khan

In 1968, Science Magazine published an article by Professor Garrett Hardin entitled The Tragedy of the Commons.  Despite the fact that Dr. Hardin was a biologist, his words have been very influential in the field of economics.  One of the classic ideals of capitalism, as defined by Adam Smith in The Wealth of Nations is that individuals acting in their own self-interest will end up benefiting society as a whole as if they were being led by "an invisible hand" (in other words, "greed is good").  The "invisible hand" theory has been used by those who want to minimize government regularions to justify their position.  By their reckoning, there is no need to regulate commerce when people acting in their own self-interest will end up acting in the public interest.

Hardin's "tragedy of the commons" provides a counterpoint to the "invisible hand" theory.  In his artcile, Hardin describes a scenario that was first described in 1833 by William Forster Lloyd.  His scenario harkens back to colonial times when there existed a "commons":  a central area owned by nobody where farmers were free to graze their cattle.  If each farmer acted purely in their own self-interest, they would ask themselves what the cost is to them to add an additional animal to his herd.  On the plus side, the farmer would get 100% of the profits from the sale of the additional animal.  On the other hand, the commons would suffer from the overgrazing caused by that additional beast.  However, that additional cost would be shared among all of the farmers in the town.  Therefore, each farmer would decide that it is in their best interest to add another animal to their herd.  After all, they share the cost but get all of the benefit.

Each farmer, making these individual decisions to maximize their own gain, would naturally seek to maximize their own individual herd.  However, if every farmer does that, the commons eventually would be reduced to ruin due to extreme overgrazing.  No individual farmer would seek to reduce their herd for the good of society as this goes against his own self-interest.  Each farmer would have to individually decide to sacrifice some profits for the good of the community.  However, we have seen time and again that this does not work.  Somebody must step in to prevent individual self-interest from destroying common property.  That "body" usually is the government.

Dr. Hardin gives several examples of "commons" in our modern world, and how we cope with their overuse:

1. Parking:

In popular urban areas, parking often is at a premium.  Usually there is a limit to the number of parking spaces available in a given area.  If people were free to park where they wished for an unlimited amount of time without cost, there would be very little free parking.  To cope with this, cities have instituted parking meters which allow people to pay to park for limited durations of time.  If people park longer, then they get a parking ticket and have to pay a substantial fine.  By imposing a cost on parking, it is now in people's self-interest to limit their parking.

2. Air Pollution:

The air we breathe is the ultimate commons.  It is a vast resource that we use on a daily basis without any cost.  Companies can also make use of the air.  Consider the manufacturing plant which needs to expel waste into the air.  It is in the self-interest of a company to belch chemicals into the air in order to make their product.  One company making this choice individually probably isn't going to affect air quality.  However, if you get thousands of companies making this choice, you end up with smog as thick as pea soup.  In order to prevent this, governments have imposed various taxes and regulations which make it expensive to pollute.  In that way, it is no longer in a company's self-interet to overuse the atmosphere.

3. Fishing restrictions:

Each individual fisherman obviously would want to catch as many fish as possible.  Since each fish means additional profits, the more fish you catch, the more profits you make.  However, there is a limit to the number of fish available in the ocean.  Some need to remain uncaught so that they make be allowed to reproduce and replenish the supply of fish.  If every fisherman acted in their own self-interest, eventually fish would disappear due to overfishing.  Therefore, the government imposes restrictions on fishing:  licenses, limits, fines, etc.  This forces fisherman to limit their catch.

Some may say that these regulations are coersion.  After all, each restriction is a limit on people's freedoms.  Who wants the government telling them where they can fish, where they can park, etc.  However, Dr. Hardin points out that individual freedom must be balanced by what is good for society as a whole.  Unlike what the "invisible hand" theory states, maximizing individual gains does not maximize societal gains. 

Interestingly, if you read Dr. Hardin's article carefully, you will see that his discussion of the tragedy of the commons is used to argue in favor of some unspecified sort of population controls.  His contention is that we need to "[relinquish] the freedom to breed, and very soon."  Obviously, it goes to show that we can't go too far in the direction of maximizing societial good either.  As with all things, there needs to be moderation.

Friday, May 27, 2011

The Worst Baseball Contract Ever?

Baseball fans and non-baseball fans alike probably aware of the relationship between uber-swindler Bernie Madoff and New York Mets owner Fred Wilpon.  This week's Sports Illustrated has an interesting article (Fred Wilpon Pays the Price, May 30, 2011) that sheds light on their relationship and the effect that it has had on the Mets.  By all accounts, the Mets are bleeding money left and right, and because of the impending lawsuit against Mr. Wilpon, they are unable to reinvest money in the team.  One aspect of the relationship which I was previously unaware was the role Madoff played in the contracts given to the Mets' players.  In particular, it talks about how Madoff may have influenced the contract of Bobby Bonilla.

In 1992, Bobby Bonilla was signed by the Mets to a contract which, at the time, was considered to be very extravegant.  Unfortunately, the Mets of the 90's were not all that great.  Bonilla's production on the field fell off during that time, and he became the whipping boy for agrieved fans.  In 2000, the Mets decided to part ways with the productive slugger.  In order to terminate his contract, the Mets had to pay his salary of $5.9 million for that year.  However, the Mets approached Bonilla with a deal.  Instead of getting $5.9 million in 2000, the Mets offered to pay him approximately $1.2 million a year for 25 years, starting in 2011.  Under this new payment structure, Bonilla was going to get $29.8 million altogether.  Why did the Mets agree to this? 

Bernie Madoff.

According to the SI article, the Mets were investing much of their operational money with Madoff.  Rather than putting their "day-to-day" cash in the bank where it earned a small rate of interest, they invested with Madoff and earned 10% to 12% - much more than they could with any bank.  The Mets figured that they could invest that $5.9 million with Madoff and earn enough on that money to pay Bonilla and still pocket a sizeable profit.

According to my calculations, even earning only 10% (the low end of Madoff's promises), the Mets would be able to pay off Bonilla's contract and still end up with close to $60 million by 2035.  That is about a 7% return on investment (i.e. if you invested $5.9 million in year 1 and you earned 7% a year, you'd end up with about $60 million).

Here is what the Mets were hoping would happen when they restructured Bonilla's contract (all numbers in millions):

YearStaring BalanceEarningsWithdrawalsEnding Balance
2000$5.90 $0.59 $- $6.49
2001$6.49 $0.65 $- $7.14
2002$7.14 $0.71 $- $7.85
2003$7.85 $0.79 $- $8.64
2004$8.64 $0.86 $- $9.50
2005$9.50 $0.95 $- $10.45
2006$10.45 $1.05 $- $11.50
2007$11.50 $1.15 $- $12.65
2008$12.65 $1.26 $- $13.91
2009$13.91 $1.39 $- $15.30
2010$15.30 $1.53 $- $16.83
2011$16.83 $1.68 $1.20 $17.32
2012$17.32 $1.73 $1.20 $17.85
2013$17.85 $1.78 $1.20 $18.43
2014$18.43 $1.84 $1.20 $19.08
2015$19.08 $1.91 $1.20 $19.78
2016$19.78 $1.98 $1.20 $20.56
2017$20.56 $2.06 $1.20 $21.42
2018$21.42 $2.14 $1.20 $22.36
2019$22.36 $2.24 $1.20 $23.40
2020$23.40 $2.34 $1.20 $24.54
2021$24.54 $2.45 $1.20 $25.79
2022$25.79 $2.58 $1.20 $27.17
2023$27.17 $2.72 $1.20 $28.69
2024$28.69 $2.87 $1.20 $30.35
2025$30.35 $3.04 $1.20 $32.19
2026$32.19 $3.22 $1.20 $34.21
2027$34.21 $3.42 $1.20 $36.43
2028$36.43 $3.64 $1.20 $38.87
2029$38.87 $3.89 $1.20 $41.56
2030$41.56 $4.16 $1.20 $44.52
2031$44.52 $4.45 $1.20 $47.77
2032$47.77 $4.78 $1.20 $51.35
2033$51.35 $5.13 $1.20 $55.28
2034$55.28 $5.53 $1.20 $59.61

Of course, it didn't quite work out the way the Mets would have hoped.  The money they had invested with Madoff is gone, they can't earn a guaranteed 10% any more, and they are still on the hook for the $29.8 million they owe to Bonilla over the next 25 years.

Worst contract ever!

Monday, May 23, 2011

Five Things I Learned From Watching The Apprentice

This Sunday was the season finale of the television series The Celebrity Apprentice.  For those who may not have seen the show, it is hosted by real estate mogul turned television star turned self-promoter Donald J. Trump.  On the show, Trump puts sixteen semi-celebrities through a series a business-oriented tasks involving significant product placement, pressure, and stylized drama.  At the end of each episode, Mr. Trump eliminates the weakest competitor with his trademark catch phrase "you're fired".  Despite its pretensions, I happen to find the show quite interesting (I won't give the ending away except to say that I disagreed with his choice of winner this season).  In addition to having certain train wreck I-want-to-look-away-but-I-can't qualities (Gary Busey), the show does provide some lessons on how to be a successful businessperson.  Here are some of my takeaways from the show:

1. Know your team:

One aspect of the show is that each week, each team chooses a "project manager".  The PM takes on the role of CEO for the week.  He or she is put in charge of the task assigned to the team.  The winning team's PM receives a cash award for his or her charity (even though some of the celebrities probably need the money for themselves [Richard Hatch] the point of the show is the raise money for charity).  The losing team's PM is usually the prime candidate for a good firing.  Thus, it is important for the PM to be able to control and direct the rest of the team so that they can be victorious.

One of the biggest mistake that players make is to become the PM the first week of the show.  During the first week, nobody knows anybody else, what they are good at (or not good at), what their skills are (or aren't).  This makes it very difficult for the PM to delegate tasks properly.  You don't who to assign the to do a graphic design because you don't know who is good at graphic design at that stage of the game.  A good PM knows his team's strengths ane weaknesses and assigns tasks accordingly.  The PM that first week is in the dark, however, on who can do what, and it often ends in disaster (i.e. Dionne Warwick doing her best snail impression on the cash register).

2. Know your boss:

If you are going to succeed in your business, invariably you will need to get into the good graces of your boss.  In the case of Celebrity Apprentice, your judge/boss is Donald Trump.  Obviously you need to know and understand what Mr. Trump values and what he dislikes.  For instance, if you are the sister of Michael Jackson, you know that you can do no wrong because Mr. Trump isn't going to denigrate you for fear of alienating your famous family.  Therefore, as incompetent as you might be, you will be allowed to come back onto the show after being fired regardless of actual merits.

3. Remember your oxygen tasks:

Oxygen isn't something that you need to survive.  Without oxygen, you die - plain and simple.  However, oxygen in and of itself isn't going to enhance your life beyond just keeping you alive.  An oxygen task is the same thing.  Doing it isn't going to cause you to impress Mr. Trump and win; however, not doing it is going to cause you to lose.  You need to remember to do these basic things like completing your task on time, making sure to put the company's URL on the advertising material, greeting Mr. Trump and the executives when they arrive at your event (although that last one can be overlooked by Mr. Trump if he really, REALLY wants you to win).  The point here is that you need to make sure you do all of the basics in order to not lose.

4. Don't accept responsibility:

It seems like if you screw up on Celebrity Apprentice, falling on the sword is the equivalent of "giving up" in Mr. Trump's mind.  When a losing PM goes into the board room and accepts responsibility for the loss, Mr. Trump is likely to interpret that as a resignation and you will end up on the elevator down to the lobby.  Of course, this is the complete opposite of what you should do in the real world.  Most normal people respect those who admit their failures and embrace defeat.  Most normal people don't respect those who try to "pass the buck" to others when something goes wrong.  Of course, on Celebrity Apprentice, passing the buck is interpreted as "being a fighter" and "showing desire".

5. It's not what you know; it's who you know:

One aspect of Celebrity Apprentice is the "fundraising task".  This is a task where the winning team is the one who raises the most money.  This usually involves the celebrities calling in favors from the rich friends.  Those with the richest friends tend to do better than those who don't.  In fact, those who don't have connections and can't raise any money end up getting fired on those tasks.  Therefore, it helps to have a deep Rolodex filled with deep-pocketed friends.

I am glad that Mr. Trump decided not to run for President.  That way, I know that he will be back next season to teach us all more lessons from the business world!

Thursday, May 19, 2011

Invest Like the President

This week, President Obama posted his 2010 disclosure form on the White House web site.  This form provides some insight into how he and his wife manage their money.  So how is the President doing?  From what I can tell, he seems to be doing okay.  For the most part, he seems to be pretty good in handling his financial affairs (better than most).  However, there are a couple of areas where he has room for improvement.

1. Obama maintains a healthy emergency fund:

According to his disclosure form, he has a checking account with between $250,000 and $500,000 in it (he only has to disclose ranges - not exact amounts).  Considering that the President earns $400,000 a year, his rainy day fund represents 7.5 to 15 months salary.  That is more than the three to six months that most financial planners recommend.  Considering that he may be unemployed come January 2013, it is probably wise to have a little bit more tucked away.

2. Obama is an index fund investor:

Obama has around $250,000 of his retirement money in the Vanguard 500 Index Fund.  He benefits from the diversity that the fund offers through its investment in the 500 biggest U.S. Corporations.  In addition, he pays very little in the way of expenses because he is investing in a passive index fund.  However, since that fund is weighted towards large U.S. companies, he probably could stand to add a small company index fund and an international fund to the mix.  Of course, it may not be politically feasible to invest in foreign corporations, even through a mutual fund, so that may explain his lack of non-U.S. exposure.  I can just picture Bill O'Reilly ranting about how Obama is a traitor because he has money in an emerging markets fund.

3. Obama is a big bond investor:

Bonds make up the bulk of his investment portfolio.  He has several million dollars in various U.S. Treasury Bills and Notes.  I suppose it is good to know that the national debt is being financed in small part by the President himself.  However, should interest rates rise in the future, having so much money in bonds could hurt him.  The saving grace is that Treasury Bills are relatively short in duration (less than one year) so once they mature, he can always roll the money over into higher interest T-Bills.  Notes, on the other hand, can be up to 10 years in length, which means he has locked in his interest rate for a lot longer. 

4. Obama is saving for his kids' college:

Obama has $100,000 to $250,000 in each of his kids' 529 Savings Accounts.  It appears as if the money is invested in a target date fund that is linked to his childrens' ages.  As the children get older, the money shifts from risky investments to less risky ones.  Target date funds provide a good way to construct a set-it-and-forget-it portfolio, so this is a pretty good move as well.

5. Obama is quite an entrepeneur:

By far Obama's biggest source of income is in the form of book royalities.  He gets several million dollars in royalty payments combines from his various books.  Obama is one of the lucky ones in that he actually makes quite a bit from writing.  Bloggers like me earn nowhere near that amount.  I guess the lesson here is that writing is profitable if you have an existing brand; if not, better stick to something else.

6. Obama is debt-free:

Under liabilities, Obama lists absolutely nothing:  no underwater mortgage, no student loans, no credit card debt.  Of course, it helps that you can live in a quarter of a billion dollar home at the taxpayer's expense.  Still, if you can forgo debt, you are way ahead of the game.

Overall, Obama seems to be doing pretty well with how he handles his money.  Hopefully he can be as wise with the taxpayers' money as he is with his own.

Friday, May 13, 2011

Society of Actuaries: Improving Retirement Security

How are Americans doing when it comes to retirement?  What can people do to improve their retirement security?  Those questions are tackled in a recent article in The Actuary entitled Improving Retirement Security.  The article is a summary of research in the area of retirement security, and it contains many prescriptions for how we can better secure our futures.

One of the bigget challenges that we face is the fact that retirement is in our own hands.  In theory, most of our retirement income comes from what are known as Defined Contribution (DC) plans.  These are plans where the amount you contribute to the plan is known, but the amount you will get out of the plan in the future is undetermined - think 401(k) or IRA.  Contrast this with the Defined Benefit (DB) plans of the past where amount of money you received in retirement was known in advance.  In a DC environment, there are many pitfalls faced by participants.  Some of the big ones are:

- Not saving enough.
- Poor investment strategy.
- Cashing out funds for non-retirement purposes.
- Using retirement money too quickly.

Overcoming these pitfalls is very difficult for many.  It should come as no surprise that people are not saving enough for retirement.  The article quotes a study by benefits consultant Hewitt Associates of participants in large employer plans which concludes that only 20% of people are on track to save enough for retirement by age 65.  This is probably higher than the total population as it only includes people who work at large corporations which tend to offer better plans than those offered at smaller companies.

What is the solution?

The article offers various suggestions for employers.  First, they can encourage savings through the use of auto-enrollment and automatically increases in contributions.  This will allow people who are not natural savers to increase their savings without having to do anything.  Many companies already are doing this (mine does), and it makes sure that the default choice is "save" rather than "not save".  Obviously people can opt-out, but this requires taking an extra step.

Second, they recommend improvements to investment options.  They model several different portfolios and used stochastic modeling to determine the likely outcomes from investing in these portfolios.  The so-called "safe" investments (stable value fund, TIPS only) had the worst outcome.  The median replacement ratio (the % of salary could be replaced in retirement from savings) was the lowest for these two options.  Meanwhile, the target date fund options replaced the most.  Interestingly, the more diversified the portfolio, the better the outcome (no surprises there).

Third, they recommend recasting fund balances in terms of the probability of replacing X% of income in retirement.  This also makes a lot of sense.  If you see a balance of $100,000 in your 401(k), you might think that you are on track.  After all, that could seem like a lot of money.  However, if instead your statement said that you have a 5% chance of replacing 80% of your income in retirement, you might be more motivated to increase your savings.

Fourth, they offer suggestions to get people to think of their retirement account as a retirement account and not a emergency fund to be drained before retirement.  To this end, they offer suggestions on how fund design could be changed to encourage loans rather than withdrawals by making loans more portable.  Currently, if you leave your job, you must repay any loan against your 401(k) otherwise the loan is treated as a withdrawal.  By making it portable from job to job, people would be more likely to repay their loan.  They also suggest improving education to get people to think about the impact of even a small hardship withdrawal.  As we know, a small amount can grow to a big amount over time, so a small withdrawal now can have a big impact come retirement.

My takeaway from the article is that our current environment puts the onus on individuals to save for their own retirement.  Defined Benefit pensions have gone the way of the Passenger Pigeon.  Certainly, there are changes the employers and our government can make to improve retirement security.  However, at the end of the day, it is up to individuals to educate themselves and take charge of their own fate.

Monday, May 2, 2011

Altucher: Market Going to 20,000, But Don't Buy Stocks?!

If you are a loyal reader of this site, you know my feelings regarding stock ownership:

- Historically, people who keep their money in the stock market will make money in the long run.

- Trying to predict the short term movements of the stock market is a prediction sure to go wrong (even for the experts).

- If you are going to invest in the stock market, you should be a passive buy-and-holder of stock index funds, since picking individual stocks is folly.

Recently, I came across an article by investor and blogger James Altucher where he gives his take on stock market investing.  His words are thought-provoking, wise, but ultimately wrong for most (at least in my opinion).  Here is his take:

- He is bullish on the stock market in general.  In fact, he says that the Dow Jones Industrial Average will hit 20,000 over the next few years.  However

- He doesn't think people should invest in the stock market ("you might as well flush [your money] down the toilet").

Here are his reasons in a nutshell (I am paraphrasing, but you can read his original article if you want his actual words):

1. You're not that good at it:  People buy high and sell low.

2. Competition:  There are professional investors out there who are ruthless.

3. Competition II:  There are professional investors who have much better information and research than you do.

4. Competition III:  Pretty much same as #3.

5. It's mostly a scam:  There are Enron's out there who are putting out false information about their company.

6. True wealth only comes if you make all the wrong decisions and get lucky:  Consider Bill Gates and Warren Buffet.  They did the wrong thing by not diversifying and never selling.  However, the one stock that they did own hit it big.

7. The best investors make 10% - 15%:  That's not a good enough return given the volatilty of the stock market.

8. Competition IV:  Companies with million dollar budgets make billions through high speed computerized trading.  How can the average person compete with that?

9. Daytrading stinks:  You can't make money at daytrading.

10. Stocks are boring:  Most companies make money in such mundane, boring ways that researching them is a chore.

His conclusion is that you are better off taking your money and investing in your own business venture by starting a company.  He thinks that this is a better path to wealth.

It seems to me that most of these reasons also are reasons to follow my advice and buy-and-hold passive index funds!

I totally agree with his points about competition ( numbers 2, 3, 4, and 8).  Most individual investors are at a significant disadvantage when it comes to picking individual stocks.  The big time investors have access to better information, better technology, and better brainpower than you do.  However, my conclusion is that you shouldn't pick individual stocks; you should diversify and buy them all.

In order to avoid the Enron's of the world (number 5), you need to diversify. Companies go out of business all the time, so if you own a piece of all of them, a single company's demise isn't going to affect you.

I agree that Bill Gates and Warren Buffet are exceptional cases (number 6). For the rest of us mortals, that sort of wealth isn't our goal. The goal of most is to accumulate a sizable nest egg for retirement, for our children, or whatever. Therefore, I would not use them as an example for the rest of us. Besides, even though Buffet may have made his money through one stock (Berkshire Hathaway), that one company owns dozens of other companies, so Buffet didn't just put all of his eggs in one basket.
If the best investors are making only 10% - 15% in stocks (number 7), that is still pretty darn good for most people.  Historically, the stock market makes about 8% per year over the long run.  For most people, that sort of return will earn them a comfortable net egg.

I agree with his statement that daytrading stinks (number 9).  Again, this is another argument for passive index investing.

Researching most stocks is boring indeed (number 10).  If you are a passive index investor, you don't have to worry about pouring over income statements and balance sheets that would make an accountant slit his wrists.

Note that I did not address number 1.  In my opinion, psychology is one of the biggests (if not the single biggest) barrier to investing success.  This barrier exists for index investing as well as investing in individual stocks.  The ups and downs of the stock market cause many people to buy at the wrong time and sell at the wrong time.  Doing that can cost you thousands.  However, that is not a reason not to invest in the stock market.  That is a reason to educate yourself so you have the mental fortitude to weather the storms in the knowledge that every storm will pass and the stock market will go up again (just as it did after the latest financial crisis).

Finally, I do agree with him that investing in yourself and becoming an entrepeneur is one route to financial success.  However, that route requires a certain mental makeup to be able to take that leap and to stick with it.  If he feels that most people don't have the intestinal fortitude to be a stock investor, then it is surprising that he should recommend being your own boss instead.  Working for yourself requires an order of magnitude more strength of will than being a index investor!

As you can see, Mr. Altucher's article provides ample food for thought (which is good); however, I ultimately have to disagree with his final conclusions.