Friday, February 29, 2008

Thoughts on Income

How does one make money in this world? Who is best at it? Are the wealthiest the most intelligent? The hardest workers? The most determined?

I will argue that the wealthiest people are those that serve the greatest number to the greatest extent. Intelligence, work ethic, and determination certainly contribute to this ability, but these are traits rather than an essence. In fact, in my experience many highly intelligent people choose not to make a great deal of money since this service requires a sacrifice of their time towards nurturing their intellect, which may be a greater motivational force, marginally, than increased income. Although, most, if not all, would choose greater income than less, tradeoffs exist in the allocation of time towards intellectually stimulating endeavors and thrifty endeavors.

Take the case of an individual sitting on the sidelines and observing the economy. He then decides that he too would like to enter the game and create personal income. How would he create income, or make a profit?

In the most general terms, he has to provide a product that is “better” than some current product. Better is a relative term of course. There are two general characteristics of goodness in the economic sense: cost and quality. The “better” product is that product (or service) which provides the higher quality to cost ratio. This ratio, however, is unique for each individual. For both components may be different for each individual. It may cost more to provide a product for individuals in different geographic locations. But even if we assume the cost of providing the good are equal for all individuals, each ratio will still be unique.
Measures of quality differ based on unique personal preferences. Furthermore, the distributions of subjective quality for certain goods vary.

[As an aside I have to talk about willingness to pay. Willingness to pay is equal to an assessment of quality of items. An individual’s differences in willingness to pay represent his/her preferences in goods. However, it is not correct to compare willingness to pay across individuals for purposes of comparison of subjective value. Since some possess greater wealth, their absolute willingness to pay in nominal terms may be much greater than a poorer person’s nominal willingness to pay who may in fact value the item more. Therefore, a correct representation of willingness to pay will be willingness to pay as a percentage of wealth (wtp%w). This distinction is necessary only for my discussion of different “desires” for similar goods.]

For example, take a washing machine vs. a piece of modern art. If you were able to plot a population of individuals’ assessments of the quality (wtp%w) of these two items I suspect you would find the distribution to be much tighter for a washing machine than a piece of modern art. (In fact I suspect the range for the modern art piece would be a one extreme highly positive and at the other highly negative, essentially trash.) Therefore, the value in a good varies with subjective assessment.

Ok, once we know what to make, who shall we target? Two general groups look promising: masses and niches.

Masses are the dominant force to getting rich. If a profit margin is fixed, the only way to earn more wealth is to provide your product to more people. The masses approach is the one observed in TV commercials, mass marketing schemes, and generally anything to do with mass media. In being an approach that sells to a huge number and variety of people, mass campaigns try to appeal to common characteristics. These common characteristics often appeal to generally superficial qualities. Beauty is constant theme of mass marketing. It is easy to grow frustrated with the shallowness of advertisements based purely on sex appeal. But, sex appeal is a trait common to all human beings and, therefore, it shouldn’t be surprising that marketers are relentless plug sexual themes.

In general campaigns to the masses tend to ignores individualism and focus on collectively human themes. The larger the audience the more a company can be expected to engage in this type of activity.

But there is another driver of profit: individual interests. Rather than increasing the customer base, servicers to niche groups try to increase profit margin. Certainly there exists a tradeoff between advertising to unique interests and to large numbers. There is value in providing goods for unique interests taking advantage of higher willingness’s to pay due to increased desirability. As transactions costs decrease, an increasing number of niche groups will be provided to on profitable terms. The internet is a great facilitator towards desires of niches. Therefore, the niche influence (profit margin influence) places greater emphasis on individuality and customization. Future improvements in technology can only be expected to increase the amount of unique interests provided for.
The reason I have gone through discussion is that I think many people, especially thoughtful people, are disgusted with mass commercialism and its inherent superficiality. And what’s more, if you’re an intelligent, curious person seeking to pursue your intellectual desires often you’re left with few alternatives to both satisfy your curiosities and provide income. When this marriage happens it is a beautiful thing. I often think of engineers and scientists pursuing new creations. But even a great engineering achievement does not promise commercial success without mass-desirability. The value of the creation is in many ways unique to the creator and his peers.

As a strong advocate of individualism, I am also frustrated with difficulty in monetarizing my unique desires and ideas. Career paths can seem limited since creating income can reduce or eliminate time spent on personal interests. The internet and similar technologies provide hope, however, by connecting those with weird, wacky, and unique interests. Business in the future will increasingly segregate consumers. As transactions costs fall, entrepreneurs will seek to further differentiate their product.

Thursday, February 28, 2008

Go To The Mirror!

Here's a goodnight post. A bit shitty on the quality.

Check on the heels on Daltrey

Friday, February 22, 2008

My Defense of Investing

As a student of both economics and finance, I generally hang out in the econ world (in the blogworld) more that the finance world. However, I try to keep abreast of financial matters. I hold, generally, a long-term view towards investment themes. Economists often harshly criticize the investors (often investors in mutual funds). They use the “efficient market hypothesis” to accuse those that dabble in managed investments to be cavemen. These are men that are so foolish as to shed any notion of reason and science and spend a career trying to beat the market. And those, that are lucky enough to succeed (for given a large sample size, there are bound to be a select few who come out wildly on top) have the shameless ignorance and arrogance to proclaim their methods to be of skill rather than luck. Many studies, which show mutual funds are about as likely to beat the market as throwing darts at the WSJ, showcase this disdain.

My comments will express my great displeasure with any notion of a “super” efficient market hypothesis as well as give a general defense of the investing profession (no matter how barbaric these men might seem). There are many areas of finance, but I will concentrate on investing, specifically active management (versus say indexing). I will conclude that active investing is indeed a viable industry just like any other and that it holds great value for society, which is shown in the vast profits that some claim.

The efficient market hypothesis in its most extreme goes a bit like this. “All information is instantly factored into the markets through the great knowledge of the masses. Stock prices reflect current expectations of future profitability based on aggregate information across the entire world up to this second. Picking stocks, therefore, is a fool’s game because no one can know any more than anyone else. Game over—INDEX.” Now, I will come right out and say it. This is about the stupidest thing that I have ever been taught. I don’t think anyone who teaches it takes it that seriously, but I’m sure some do. I guess it’s more or less taught to make a point—to understand the underlying logic to much of portfolio theory (or underlying rationalizations).
But why the hell do we choose the stock market and assume it is perfectly efficient? Why not everything else? Where are the efficiency theories for making cars, or planting corn, or teaching at universities, or writing books, or any other activity that creates economic value? For example, we could reason, all the information for the market for making cars is known by all instantly. Therefore, no one has an advantage. No one has a better idea of what will make a better car in the future. The market just works by random guess, some happen to work, some don’t.

Well why the fuck does anyone get out of bed in the morning then? If no one can ever find advantage over anyone else, let’s just shut it down. Why should I waste the effort, when the effort doesn’t matter, and I will be just as likely to make a billion as to lose everything (actually much more likely to lose everything, since I don’t have near a billion to start with).

Oh but the stock market is the exception. Because SOOO many people are interested in it, and SOOO many people have their retirement futures involved it in, and SOOO many people make SOOO much money in it (never mind that this last statement is self-defeating). Therefore, this is the one place where we play God and know everything. The worst part of the theory isn’t the absurd proposition that everyone knows everything instantly. I think that I can reason around this a bit. The people that matter the most know a lot, and with the acceleration in the speed of communications know more and more every day. And these people have enough money that they can put the odds back in shape, by placing huge bets. And there are enough of them around the world to do it very quickly. So in the end, this thing sort of works out as if everyone has all the information instantly. I can follow this and see some sense in it. The real stupidity comes in when you take this to the next step. One reasons, if everyone has exactly the same information (all current information), then everyone will share identical expectations.

Expectations are what stocks are priced on. Sure everyone has the information, but everyone uses the information differently. Thus each individual may represent unique expectations given equal information. Resulting stock prices are the aggregation of these millions of unique expectations. And these aggregations hold great wisdom. Some look to this type of emergent intelligence to be much greater than the sum of its parts. No single human could compete with such a depth of information. And quite frankly, this is true. So once again, what are we doing? Are we simply slaves to the master of market, fueled by the ignorant bliss than an individual’s opinion matters?

It depends on what you are talking about. No lone soul could match the depth of the worldwide market’s knowledge, but individuals or groups of individuals can specialize. An investor can focus her knowledge on a relevant niche of expertise. And maybe this is why markets are so smart in the first place. In every little niche available there are experts that analyze their niche every day. They know it inside and out. The true experts are a small group of individuals. These people, it would stand to reason, have varying opinions, but with their equal depth of knowledge may have less variance of opinion than a larger group of, say, investors as a whole. When these experts see the scales tipping out of control they mobilize their capital and try to take advantage of it. But even within these expert groups some might be very good and smart and others not so good and stupid. The stupid ones could match the smart ones bets and keep the value distorted for long periods of time, until the stupid ones are knocked out. But you’ll notice that this cycle favors the smart ones and keeps increasing their pies, which leads to more accurately valued stocks. But smart ones don’t always stay smart, you must remember.

The greater point is this. Investing is fundamentally just like any other business. A new investor is analogous to the entrepreneur. The entrepreneur looks at a market and sees an investment that is under or over-valued and tries to correct it. People often call entrepreneurs crazy, saying: “There are already huge corporations with really smart people that have been studying this for years. They know way more than you. They know everything to know about this business. How could you do better than them?” Well like anything there are always tradeoffs. Sometimes when you are too close to a business or market you can exhibit tunnel vision. Giants are often blindsided by wild entrepreneurs with a new approach to tickling the customer. And how does this relate to investing?

The investor can specialize. Focus his efforts. Create new ways to invest. Look for different things to invest in. Or do the same thing that is already done but just better. The information barriers to entry diminish with the increasing speed and quality of communication. The real barrier to entry in investing is capital. But some investors are able to turn a little into a lot. Especially since when you have just a little you can focus it on a portfolio of your best ideas.
So this has been a broad, perhaps unscientific, defense of the investing profession. Investing is by no means easy. There is fierce competition. But with specialization, intelligence, and a logical approach some will achieve success—and not just for luck. The freedom a hedge fund manager often enjoys allows for the best structure to compete in investing. (But you need serious capital to start up one of these, not to mention reputation).

The real question is: are active managers successful enough to reward the extra fees versus indexing? How costly is it to choose the correct active manager? I think for the typical average Joe is indexing a good bet. But for with more expertise and wealth, you'd be a fool not to put a bit of your portfolio in a hedge fund or funds. That being said everyone has different circumstances and goals that may require different investments.

Thursday, February 14, 2008

Brown Sugar

Got another good one. The youtube archives of the rolling stones is fantastic.


Since I couldn't find my favorite Keith song, here is another sweet Stones performance for your pleasure:

I think this is 1966

Time Constraints

I recently read an article by Kevin Kelly that seems to have relevance to my previous post "Perpetual Welfare and the Value of a Life". Here is the link:

I really respect Kevin Kelly and am currently sifting through one of his books Out of Control.

The point Kelly raises is that humans are bound by time. We don't have enough time to let evolutionary, bottom-up processes run their course. These evolutionary algorimths have a remarkable ability to find workable solutions to problems (maybe optimal but I don't want to go there). However, this process works over biological time. A human life is much too short to bear the fruits of the evolutionary process, therefore, some shortcuts and editing need take place.

The connection to welfare programs is the following. Sure, if we let the economy run with little or no regulation, no redistribution programs, and well-defined rights (such as property) the proper incentives should be in place. And eventually would expect a beautifully adaptive outcome to the incentives. But maybe we are working on different time scales here. Waiting for the "long run" does little good to current human populations.

So maybe a redistribution is necessary on some levels. For the poorest people may die without such distributions. Although, I really don't know. In the US it may be less dramatic. But nevertheless, those who are the result of poor luck in the lottery of birth will be subject to severe risks in comparison to those born wealthy. A system of no redistributions would provide the correct incentives and allow consequences for negative economic behavior to be fully felt. Also with no expectations of future redistributions individuals would be required to plan for the future. The economic pie would grow more quickly and diversely; wealth creating choices would be fully rewarded, wealth destroying choices fully punished. But to reach these optimal future conditions, significant current pain may be felt. Indeed, the current generation may be dead before we can fully grasp the benefits of such pure incentives.

I value the current generation more than future generations. Our lives seem to be more important than those that will come after us, perhaps due in part to the uncertainty of their eventual existence. And why should our society suffer for future society's benefit? Or more properly stated, why should some individuals' lives suffer in order to bring happiness to unknown and uncertain future individuals' lives? Its not just that the people are unknown, but on some level it is unknown and uncertain whether they will ever be born.

Usually, current and future generation's interests coincide. Pursuing wealth creation helps us now and creates a better world for future generations to be born into. But in this hypothetical case, current generation's interests suffer for greater future wealth creation.

However, the term "current generation's interests" is very misleading. It is really millions of individuals with unique interests. All these individuals are of different ages. None are really in the same "generation", where generation means that they share common interests. Therefore, it seems I am agruing out of a sense of justice more than anything. Just as I don't deserve to be born into luxury, other's don't deserve to be born into poverty.

Therefore, some level of redistribution seems valuable. Our human society would be better in the long-run if no redistribution exists, but an individual's life should not be sacrificed for future lives. In some ways there may need to be some accounting for the distributions in the lottery of birth.

That being said, intentions are different from effects. One may have the good intention to correct this unfair distribution, but the effects of trying to solve the problem may only worsen it. The specific methods should be subject to empirical testing. Specifically, public vs. private methods of redistribution remain debatable. Private alternatives may hold greater utility.

Thursday, February 7, 2008

New Tax Scheme

As a sequel to my discussion of differential tax rates previously, I have devised a new taxing scheme. This taxing model has the advantages of simplicity and the removal of distortionary taxation effects. In other words, individuals’ decisions will not be influenced by tax rates (save the effect of choosing more leisure relative to work which all taxation will ensure).

In order to participate in society an individual must have money. In order to have money he must have income. Let’s assume all individuals work and, therefore, provide their income. Once the individual has provided himself with income, he has two options: spend or save—consume or invest. The function of these two options is exactly the same. In one case, he buys a coke and expects some utility (return) from the asset (in this case immediately). In the next case, he buys a stock and expects some utility (return) from the asset (greater quantities of the money in the future). But notice those are his only two real choices. Although, he can put it in a drawer, in which case the government has no claim to it.

The choices are essentially the same. Therefore, the taxation measures should be the same and the tax rates should be the same. There is no need to tax income (unless you are worried about money being spent in other countries, but that is trivial). Let’s just tax the only two things income can be used for: consumption or investment. And let’s tax them at the same rates at the same time. You want to buy a coke, pay 20% tax. You want to buy a stock—20% tax. The bank wants to buy your money (by your opening up a checking account)—20% tax (on the bank). Buy a boat—20% tax. Buy money (take out a loan)—20% tax. Up front, right in front of you. Wow, would this put the tax accountants in a tiffy. You wouldn’t be taxed when you received your investment income, because well, it is income remember.

Many will argue that this tax is not progressive—the poor have to pay the same percentage as the rich. It’s true. But the relevant question is: would the poor pay more or less tax than with the current system? Their income tax would be removed. The sales tax on goods may be set higher. The effect is uncertain, but the poor could be accommodated. Food stamps and no taxation on investments if you can prove your income is below a certain level. (This would be a hassle though, but don’t worry, there’s another route.)

I have never really been convinced that a progressive tax level is particularly valuable. Rich folks will still pay a huge percentage of the tax return. Also, they will be incentivized to spend more (on stocks or cokes). The government can do their re-distributions just as before (which of course are distortionary as well). If you want to retain the effects of a progressive tax structure, just give more benefits to the poor. It’s not how much money you make, but what you can afford with how much money you make. Collect evenly and distribute unevenly, the effects are exactly the same.

I’m not going to get into the cheating issue, which many cite as a criticism of greater sales tax levels. “There will become a black market to evade the sales tax. We will need a force to suppress it.” I think the IRS handles this already, and their job will probably be a bit easier with no income statements to mull over.

Tuesday, February 5, 2008

Perpetual Welfare and the Value of a Life

What if the implementation of welfare programs perpetuates more welfare programs? In other words, do welfare programs have some positive feedback effect inducing further creation?

The reasoning is pretty simple. Let’s assume that welfare programs help the poor very slightly in the short term, but hurt the poor to a greater extent in the long term. Poor are made a little better off, but they don’t have as strong an incentive to work, to learn, to innovate, to create, to problem solve, etc. These stronger incentives will lead the poor to a more prosperous future in the long run than the handout program.

To simplify this model, I’ll make another assumption: the short run will be defined as the current adult’s life who receives the handout. The long term will be defined as the poor adult’s children and all the future children’s children.

Ok, the current generation is made a bit better off with the handout. The children are made relatively worse off with the weak incentives. They also get a handout (later), but are left in much the same place as their parents. The political party that generally favors these sorts of handouts will keep receiving votes from the poor group. It is only human nature to want more and the benefits are to the current generation (the self interest). Therefore, the poor keep voting for welfare programs that damn their children to future poverty.

The parents of the poor may care for their children and want them to become wealthy. But since they lack education (have imperfect information), they remain unaware that their voting is perpetuating the problem. Once again the government handout creates less of an incentive to learn (and poor people are relatively less educated than non-poor form the start).

You are left with the current generation perpetually depressing wealth of future generations.

This argument is so clean and simple it bothers me. The assumptions are too basic and need some more sophistication. Maybe there is a kernel of truth to it though.

An area where such a discussion will invariably lead is the value of life. How can we choose between a life today and a life tomorrow? There seems to be some justification for welfare programs along these lines. By an unlucky draw in the lottery of birth one man was made so poor that he received no education or money and will surely die before the age of 20. Let him die and he won’t bear another son into the same situation to perpetuate the problem. But how can I justify letting him die when the cause is almost surely pure chance. Are all human lives counted the same? Should we discount future human life?

These are questions I must ponder.