Naked Economics:

Chapter 7 Financial Markets

Real Life Economics
 Grapefruit and ice cream diet
 Crazy, yet smart group of people believed and
tried it
 Was reminded of the grapefruit and ice cream
diet when talking to his neighbor about his
new stock investing scheme: studying charts
for shapes that would signal where the
market would go
 Doctor/university faculty, yet what he was
doing was venturing far from science
 For personal finance, people will toss good
sense aside
 The true rules of investment: discipline, self-
sacrifice, steady accumulation with some
setbacks
 This chapter is about what our basic
understanding about markets can tell us
about investing in the financial markets
 An investment strategy must follow the rules
of economics
 Financial markets are complex: stocks, bonds,
options, futures, options on futures, interest rate
swaps, government strips, credit default swaps…
 You can buy futures tied to the average
temperature of LA
 You can trade in smog (the right to produce SO2)
 All transactions are to create value: both
buyer/seller believe they are better off
 Mutual funds, index funds, as well as instruments
so complex that Wall Street executives didn’t
understand their products in 2008
Financial Markets cater to 4 simple
needs
#1 RAISING CAPITAL
 In modern life, we borrow to pay tuition, buy
homes, build plants, equipment, and launch
new businesses
 Companies can sell equities, or an ownership
stake and claim on future profits
 Companies can issue bonds
 Individuals, firms, governments need capital
to do things today that they could not
otherwise afford; the financial markets
provide it to them…at a price
 Modern economies need credit
 Even $50 or $100 can be a powerful tool for fighting
poverty
 Opportunity International has provided 325,000 low
or non-collateral loans in 24 developing countries
 Average loan is $195; for example, Esther Gelabuzi, a
widow with 6 children from Uganda set up a clinic –
has since delivered 1400 babies charging $6-$14
 OI has created 430,000 jobs; repayment rate is 96%
 Grameen Bank in Bangladesh – Muhammad Yunus;
winner of Nobel Peace Prize in 2006
#2 STORING, PROTECTING, AND MAKING
PROFITABLE USE OF EXCESS CAPITAL
 The Sultan of Brunei made billions in oil revenue
in the 1970s
 What should he have done with it? Hid it in the
mattress?
 It’s difficult to store, people would likely steal it,
and inflation would eat away at its value
 Financial markets can protect from theft and
inflation
 Financial markets can put excess capital to
productive use
 r = rental rate of money
 Harvard has $25B endowment as rainy
day money; hires 200+ people to manage
it, investing in bonds, stocks, venture
capital; putting into hands of people who
can use it productively
 1995-2005 – 16% return (lost 30% of its
value during the 2008 financial crisis)
 Financial markets can smooth income over
our lifetime; we don’t have to spend it at
the same time we earn it
 Neither a borrower nor a lender be (but
we will likely be)
 We can “manage the harvest”; spend
income we haven’t yet earned now, or earn
income now and spend it later; more
flexibility
#3 INSURING AGAINST RISK
 Life is risky: financial ruin can result from natural
disaster, illness or disability, fraud or theft
 We try to minimize risk: health, auto, life
insurance; it’s about averages, but you’re worried
you might lose more than average
 Pirates? 266 acts of piracy in 2005…marine
insurance
 Suicide bomber in 2002: insurance co. paid 70M
 FILA should have bought “win insurance” for Kim
Clijsters in 2009 U.S. Open; 40:1 long shot
 Futures locks a sale price for a commodity;
both producers and consumers fear future
price fluctuations
 Corn farmers know what price they’ll get
before they plant
 Airlines buy futures on jet fuel

 Fast food restaurants – beef, pork bellies

 Starbucks - coffee
 Catastrophe bonds; insurance companies minimize
risk by issuing these bonds
 High interest, but if disaster occurs, investors may
receive nothing; forfeiting the entire principal
 United Services Automobile Association issued cat
bonds tied to hurricane damage; 1 – 1.5B damage,
investors lose a fraction of their principal; over 1.5B
damage, investors lose all; relatively little damage,
investors receive 12%
 2006 World Cup insured against terrorism: 260M
cancellation bonds
 An advantage to cat bonds is that they are not
correlated to financial markets
 You can diversify with financial markets;
putting your eggs in different baskets
 $1000 in a mutual fund, you are investing in
500 companies. That would cost too much in
fees to buy individual companies
 You can invest in big and small companies,
long-term and short-term bonds,
international stocks and bonds, junk bonds
and real estate; some do well, some do poorly
 Credit Default Swaps
 Like lending money to your brother-in-
law, and buying insurance; if he doesn’t
pay, you’ll receive your money anyway. If
he does pay, you’re out the purchase price
of the insurance
#4 SPECULATION
 You buy futures to mitigate risk; or bet on the
rise or fall of future prices
 You buy bonds to help companies raise
capital; or you can bet on the rise or fall of
interest rates
 You can invest in companies with the
intention to share in future profits; or you
can buy at 10am and sell for a profit at 2pm
 What’s wrong with credit default swaps? –
anyone can get in on the action; if your
brother-in-law defaults, the losses can be
magnified 1000 times
 In the events leading up to the crisis, buying
and selling CDS; maybe they didn’t do their
homework, maybe they didn’t care and were
earning bonuses for buying CDSs
 AIG had sold insurance, basically
guaranteeing a lot of debt that went bad
 It was like “picking up nickels in front of a
steamroller”: small profits for some years, but
horribly disastrous in another
 AIG sold underpriced insurance on complex,
poorly understood securities
 Las Vegas is a zero-sum game: you won’t win, the
house has better odds; it’s entertainment!
 Wall Street is a positive sum game – things are
built, companies launched, risk managed
 But, not all are winners; dot com companies, real
estate bubble, and the Wall Street meltdown
 Financial markets are designed to allocate money
to where it can earn a high return
 Hopefully not to some corrupt government official,
or some “entrepreneur” who is the king’s friend
 Government can mess up the financial markets by
imposing burdensome taxes, regulation, diverting
funds to pet projects, refusing to allow creative
destruction to take place
 Or, government can minimize fraud, force
transparency, create and enforce a regulatory
framework, provided public goods to lower the
cost of doing business
 Teachable moments in the financial crisis:
regulatory system needs work
 The challenge is to continue allocating
capital and mitigating risk while curtailing
excesses (stupid bets that the rest of us
must clean up)
 How does one get rich in the markets?
 “Are you rich enough?”
 Real estate example: 3 storey single family
brownstone house; price range is 450k to 600k
 If one is listed at 250k, you buy it and turn around
and sell it for 500k
 Is the story true? No
1. Who’s the moron selling it?
2. Why didn’t the real estate agent buy it?
3. There are several smart investors who would have
bought it
 Everyone wants to maximize their utility; no
one is going to leave 250k sitting on the table
 Hot stocks?
 Someone has to sell it for you to buy it
 Maybe you know more? But the traders at
Goldman Sachs and Fidelity are not buying it?
What’s wrong here?
 Do you know something that no one else
knows? (that’s illegal)
 Analysts study the stocks: report on
management, future products, the industry,
the competition; but that is no guarantee that
you will earn an above-average return
 EVERYONE ELSE HAS THE SAME
INFORMATION
 The efficient markets theory: asset prices
reflect all available information
 It’s difficult to choose stocks that will
outperform consistently
 Picking stocks is like picking checkout lines at the
grocery market
 http://www.youtube.com/watch?v=LIPdI0ego3Q
 Most professional stock pickers don’t meet the market
average
 Everyone tries to pick the fastest line; sometimes right,
sometimes wrong
 Unexpected occurrences like the surprise price check,
or the restating of income for Microstrategy in 2000
wherein the stock price dropped 62% in one day
 Even large and well-established firms: Enron, or
Lehman Brothers
 Proponents of EMT advise picking a line and staying
there; if equities are priced efficiently, throwing darts
is a good strategy
 Malkiel says to throw a wet towel; index funds buy and
hold a predetermined basket of stocks. They are
cheaper to manage
 Morningstar says slightly fewer than half of US actively
managed mutual funds beat the S&P 500 index
 66% beat it over the last 5 years
 45% beat it over the last 20 years: a monkey throwing
a wet towel beat 55% of professional money managers!
 Economists and the 100$ bill
 EMT is not popular on Wall Street
 Housing market and stock market have not
behaved logically
 Individual humans are flawed: prone to herd-
like behavior, are too confident in our own
abilities, place too much weight on past
trends when predicting the future
 Individuals get it wrong; overreacting to good
and bad news: markets get it wrong; bubbles
and busts
 Neuroeconomics has discovered those people with
damage to emotional part of the brain are better
investors: took more risks when potential payoffs were
high and got less emotional when they made losses
 Robert Schiller challenged EMT with the book
Irrational Exuberance; it argued the stock market was
overvalued, and later he argued there was a housing
bubble
 Thaler made a mutual fund that would take advantage
of human imperfections; has made 4.5% since its
inception compared to S&P500’s 2.3%
 Markets may be occasionally irrational, but
the free lunch is not available to too long
 Like a checkout line, if a mutual fund starts
doing well, then others will copy the strategy,
making it less effective
 With supercomputers and special expertise,
you may find price anomalies, but without,
it’s best to simply buy an index fund
 Indexing is a good starting point
 SAVE, INVEST, REPEAT
 Compound interest; Einstein quote
 Save early, save often, pay off your credit cards

 TAKE RISK, EARN REWARD

 Riskier investments must offer higher expected return in
order to attract capital
 Riskier portfolio, higher return, on average
 1945-1997 – bonds earned 5.8%, stocks earned 12.9%
 Stock portfolio lost 26.5% in its worst year, bond portfolio
never lost more than 5%
 Stocks had negative annual returns 8 times, bonds only once
 Risk is rewarded, but you need tolerance for it
 Mother-in-law earns 3% always
 Harvard and Yale endowments take risk,
make high returns; risk also in investing in
ILLIQUID assets
 Aggressive investing occasionally pays the
price
 Also, Harvard and Yale endowments have
theoretically infinite investment horizons, so
different strategies for those investing for
retirement or college
 DIVERSIFY
 Flip a coin: quadruple return tails, total loss heads
 Now bring in many coins, same parameters; 5
worthless, 5 quadruple value; 100% return
 Now, buy several index funds from around the
world
 Make sure they are independent; non-correlated
 Bundling mortgages seemed like they were all
independent in terms of default risk. Normally
true, but when a real estate bubble pops, many
lose jobs and those clever securities become “toxic
assets”
 INVESTING FOR THE LONG RUN
 Casinos love it when someone wins big; it’s a
long run game; the odds are stacked in their
favor
 Where will the Dow be tomorrow? –don’t
know
 Where will the Dow be next year? –maybe
higher than today
 Where will the Dow be in 25 years? –
significantly higher than today; reasonably
certain
 An investment advisor promises a 20-40%
return?
1. It must be risky

2. Your investor has found an unusual

opportunity
3. He/she is incompetent and/or dishonest

Too often, it’s 3.

 Conclusion: Two Certainties
1. Like the past, in the future, financial
markets will be needed to raise capital or
to mitigate risk.
2. Americans will not have become thin and
healthy by eating grapefruit and ice cream