Personal Finance for Everyday Challenges [1 ed.] 1527573869, 9781527573864

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Personal Finance for Everyday Challenges

Personal Finance for Everyday Challenges: Toward Financial Fortitude By

H. Nejat Seyhun

Personal Finance for Everyday Challenges: Toward Financial Fortitude By H. Nejat Seyhun This book first published 2022 Cambridge Scholars Publishing Lady Stephenson Library, Newcastle upon Tyne, NE6 2PA, UK British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Copyright © 2022 by H. Nejat Seyhun All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. ISBN (10): 1-5275-7386-9 ISBN (13): 978-1-5275-7386-4

Dedicated to Kent Seyhun

TABLE OF CONTENTS

Disclaimer ................................................................................................... ix Prologue ...................................................................................................... x Acknowledgments .................................................................................... xiv Chapter 1 .................................................................................................... 1 Why Finance? Chapter 2 .................................................................................................. 11 What Finance Teaches Us Chapter 3 .................................................................................................. 41 Understanding Risk Chapter 4 .................................................................................................. 70 Making Value-Creating Investments Chapter 5 .................................................................................................. 91 Is College a Good Investment for You? Chapter 6 ................................................................................................ 113 Dealing with Retirement Risk: The Road to Financial Security Chapter 7 ................................................................................................ 143 Dealing with Investment Risk in Stock and Bond Markets Chapter 8 ................................................................................................ 178 Understanding Incentives Chapter 9 ................................................................................................ 221 Real-World Applications of Incentives

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Chapter 10 .............................................................................................. 251 Understanding Informational Asymmetries Chapter 11 .............................................................................................. 314 Creating Flexibility in Our Everyday Lives Chapter 12 .............................................................................................. 350 Understanding Flexibility in the Workplace Chapter 13 .............................................................................................. 379 Understanding Debt Chapter 14 .............................................................................................. 412 Using Informative Price Signals to Avoid Scams Chapter 15 .............................................................................................. 450 Putting it All Together

DISCLAIMER

This book is filled with facts and research findings. However, our opinions, suggestions and advice are based on our own circumstances. They are merely meant to be suggestive, and should not be construed as specific investment advice for a specific person at a specific time. There are no guarantees that applying the advice in this book will achieve your desired result for you, given your circumstances. Alongside our employers, and the publisher, we specifically disclaim any responsibility for any loss incurred as a consequence of any of the advice, ideas or suggestions that are contained in this book. In addition to facts and up-to-date original research, this book contains a lot of opinions, suggestions, and advice. A lot of this opinion is based on past events, or our judgment of possible future developments. However, every reader is unique and different. Every reader will face his or her own special situations. History may or may not repeat itself. Life does not provide guarantees that a particular day will be sunny, calm, and perfect for skiing. The same goes for investing, career, family, health, and life advice.

PROLOGUE

Sow a thought and you reap an action; sow an act and you reap a habit; sow a habit and you reap a character; sow a character and you reap a destiny.” —Ralph Waldo Emerson

This is a book about the most important decisions of our lives. We face dozens of decisions every day. Many of them are not particularly significant, but some can fundamentally change the course of our lives; where to go to college or graduate school, what field to study, or what career to pursue. We also face important personal decisions, such how to save and spend, where to look for information, whose advice to take or reject, who to befriend, and who to confide in. In some cases, these decisions are difficult or impossible to reverse. How can we make the best decisions for our families and ourselves? How can we look back at the course of our lives and conclude that the major decisions we made were sound? How can we avoid repeating the same mistakes? We argue here that we have a powerful set of frameworks and ideas available to us that will help us assess our choices before the fact and help us to make the best decisions possible. The roots of these ideas have been evolving for hundreds of years, yet the key themes we discuss here are relatively new in the arc of human knowledge. They are the principles of finance – that is, how we make decisions of a financial nature, and allocate our dollars and other financial assets to achieve the best possible outcomes in the face of uncertainty. In the course of this book, we provide you with a framework and basic intuition for these ideas. We help you acquire what we call Basic Financial Literacy. We do this without advanced mathematics, computers, calculators, or visualization software. We develop these ideas in clear, plain English to make them accessible for you.

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We further argue that this essential knowledge can help us assess the social and financial challenges of life, filled with its assorted complexity, payoffs, risk, and uncertainty. The most important question in finance is how to make the best decisions in the face of that risk and uncertainty. This provides the foundation that supports the other components of financial thinking, including its logic, framework, and tools. The ideas of finance also help us understand concepts such as incentives, flexibility, and the value of information. We can successfully apply these principles to our everyday, non-financial decisions. Finance helps us make sound investments, including an investment of our most valuable asset – our human capital. The essential ideas of finance are very powerful indeed. We argue that Basic Financial Literacy is needed to understand the social world around us, including our jobs, family life, and general wellbeing. The ideas of finance apply to all aspects of life. This book is the culmination of decades of writing, reading, thinking, and teaching in finance. Before one ever writes a book, one must assess whether one can say something new. In the case of this book, the new idea we present is the close connection between everyday life and finance. Our many students over the years have found these ideas useful, and we hope you will react in the same way. Generally, there are three types of books on finance: self-help books, academic textbooks, and personal finance books. Self-help books tend to be filled with facts and numbers. They address a wide range of issues, including financial issues, career building, marriage, and self-confidence. There are also many academic finance textbooks. These require a background in economics, statistics, and accounting. Finally, there are many personal finance books. These tend to offer checklists of ‘do this’ and ‘avoid that’. Their recommendations are often overly general and simplistic. One problem for readers is that these types of books do not relate to each other. Self-help books tend to be practical, but they ignore the essential principles in economics and finance that readers need. Academic finance textbooks require extensive prior understanding, are largely inaccessible to non-academics, and are often devoid of real-life advice or applicability. Personal finance books, moreover, tend to follow an ad-hoc, aphorismbased approach. Unfortunately, without understanding the underlying key

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concepts, aphorisms can be misleading. Many recommendations in these types of books are not based on any unified framework, and their advice may be inappropriate given your circumstances. Despite the plethora of these books, none of them has systematically explored the intersection between life and finance. At least, not the way we do it here. As we see it, there are two main challenges that need to be overcome. First, we need to start with life’s most important questions and conundrums, and then address them with the tools of finance. Second, we need to distill the essential findings and concepts in finance that matter. We need to do this, moreover, without the technical language of economics, accounting, mathematics, and statistics, without equations, and without software. Another challenge of this approach is to combine the formal discipline of finance with psychology, philosophy, and personal finance – and to do so in way that is integrated, unified, theoretically sound, and consistent with what we observe in the financial market and other sectors. To make these concepts as accessible as possible, we have omitted certain technical topics, but we believe that the resulting clarity and intuition more than compensate for omission of these technical details. This book should be useful to professors, students, and general readers. Professors of finance and economics will find a rich set of examples and everyday applications of important financial ideas. These examples will enrich classroom discussions by broadening the useful applications of financial ideas. Discussing everyday applications of finance will also make finance more relevant and useful to students. Students will find it helpful because it is concrete and does not assume prior knowledge of finance, making it also suitable for classes in personal finance. If you adopt these ideas early in your life, you will then have numerous opportunities to put them into practice, and you have the potential to improve your overall wellbeing. This book should also be very useful to those who are just starting out in life. This is because we are not offering any get-rich-quick solutions in this book. Instead, we are providing guidance, and a ‘road map’ that will add up over a lifetime. High school and college students have their entire lives ahead of them. They start with a clean slate. By making the right decisions, starting immediately, they can reap huge benefits over their lifetimes and

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achieve spectacular results. Similarly, serious mistakes made in the lateteen years are the most costly mistakes. They will affect a person’s entire life. This is the right time to get on the right path. Similarly, the twenty and thirty-something crowd will typically find themselves at different crossroads in life. While college may be well behind them, they still have major life-changing decisions to face. There is the marriage-and-kids path, there is the graduate-school path, there is intensive-career-path, and then again, there is the play-video-games-anddo-not-worry-about-tomorrow path. The late twenties and early-thirties are probably the last chance most people get to make sure that they are on the right path if they want to make better decisions and achieve better results. Nevertheless, the book can be highly useful to the over-forty group as well. Parents and grandparents should also find it useful to help set the course for their children and grandchildren. Those who are of more advanced years, may find themselves saying, ‘I wish I had done things differently’. Nevertheless, it is never too late to start making the right decisions. We hope you find the book enjoyable and informative. Above all, we hope you find it useful for the next big decision in your life. Given that life is not a destination but a journey, we hope it also makes your journey more fun along the way.

ACKNOWLEDGMENTS

I am grateful to many colleagues, past students, and friends, for reading, discussing, and commenting on this book. Others have contributed in meaningful ways, in that they allowed us to use their life experiences as valuable lessons that were included in this book. I am especially grateful to Jonathan Seyhun, Charles Fishkin, Steve Verhoff and Victoria Barry who read the entire manuscript and offered numerous comments and criticisms. I thank Amanda Millar for her diligent work through the printing process. In addition, I thank Ugur Altun, Burcu Avci, John and Antigoni Psarouthakis, Ali Seyhun and Mujgan von Burg for valuable discussions.

CHAPTER 1 WHY FINANCE?

“Capitalism was the only system in history where wealth was not acquired by looting, but by production, not by force, but by trade, the only system that stood for man's right to his own mind, to his work, to his life, to his happiness, to himself”. —Ayn Rand, Capitalism: The Unknown Ideal

What is Finance? Many people would be surprised to hear that that the key concepts of finance have something tangible to offer us in our daily lives. Some think that finance and capitalism are part of the problem, not part of the solution. Some people even believe that finance and capitalism are manifestations of injustice and unfairness, or that money is corrupting. Others think that finance is relevant only for financial specialists. Many think it is too complicated, that it is something to be avoided, or that it uses a specialized language that is daunting to those who are not finance professionals or professors. A financial education is time consuming and expensive. To make money, you need lots of money to begin with.1 Finance is only for millionaires or billionaires.

1

President Trump famously said, “It has not been easy for me. And you know I started off in Brooklyn, my father gave me a small loan of a million dollars.” The New York Times claims that ‘small’ loan figure as north of $400 million. See, https://www.nytimes.com/interactive/2018/10/02/us/politics/donald-trump-taxschemes-fred-trump.html?mtrref=t.co&auth=login-email and https://www.washingtonpost.com/news/fact-checker/wp/2016/03/03/trumpsfalse-claim-he-built-his-empire-with-a-small-loan-from-hisfather/?noredirect=on&utm_term=.1dfd294e3e6d

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Some think investing is risky, akin to gambling. Similarly, they think the stock market is a casino and investing is nothing but playing roulette; that it is best to avoid investments just as it is best to avoid the roulette wheel. Others think that finance is not relevant to them. Their financial and social lives are separate. Their most essential financial activity is managing their checking account or buying their home. Retirement is something to worry about later. Social life is about finding love and happiness, while finance is solely about money. As the expression goes, we all know that money does not buy happiness. We will show they are more connected than you think. Others point to the Global Financial Crisis as one more example of how the ideas of economics and finance have failed to avoid financial disasters and have further given rise to huge inequality and a financial system that benefits only a few at the expense of the many. We hope to persuade you that these concerns are unduly simple, and are based on misconceptions on the part of those who have not had exposure (or at least not enough exposure) to the key themes of finance. People can disagree about public policy in finance and economics but still make use of its powerful ideas which explain how the world works. We hope to strip away these misconceptions and focus on how we can improve our own lives. We hope to be able to persuade you that finance can inform the challenges we face in our personal and professional lives. We argue that finance offers a rigorous, alternative, and better way of thinking about the world. The key concepts of finance have powerful explanatory properties. They help us observe and interpret the information we receive. They help us sort through a wide range of complex questions. What investments will bring us the greatest value of the long term? How do we determine the value of assets when we do not know about prices of similar assets? How do we make choices when you know the odds? How do we make choices when we do not know the odds or even the outcomes? How much should we invest in a particular project, program, or factory? If we can answer these questions, we can answer many others that are not related to money, financial assets, or financial decisions. These include our most important life decisions, those that relate to education, careers, and other essential choices. If used thoughtfully, they have the potential to enhance the quality of most aspects of our everyday lives.

Why Finance?

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Finance will not solve all of life’s problems. Instead, it teaches us to avoid reliance on erroneous predictions or emotions. It offers a formal framework, hard numbers, and approaches, to make optimal decisions. Instead of being persuaded by conflicting opinions we hear in the news media, or read on the internet, finance tells us how to take the initiative to manage important issues in our lives, and to follow a consistent strategy.

Can financial literacy help? To explore how finance can ultimately help us, we first need to recognize our starting point. So the next logical question is where are we now, financially, socially, and with our lives in general? Where is a typical middleclass American family these days? Do we actually need finance, or are we so well off that it will not make any difference? Alternatively, is this just a pipe dream? Are we so badly off that attaining financial literacy and financial security is just about impossible? Can we get to financial security from where we are? To explore these issues, let us just reflect on the current conditions for today’s typical, middle-class Americans, who are employed. Many middle-class Americans live in suburban houses with lawns and trees. Many of them have college degrees; they have desirable jobs with good salaries, retirement savings plans, paid sick time and paid vacation time. They drive to work in nice cars. They have a safe work environment. They have access to medical care.2 In fact, they have a higher standard of living than most other inhabitants of this earth do. However, the middle class faces many challenges. Compared with the rest of the world, we appear to have an abundance of comfort, and affluence. Yet the promise of a good life, once called ‘the American dream’, is becoming more elusive. For many, the American dream is now a restless night. For some, it is a nightmare. Some parts of our high current standard of living are based on borrowed money. Middle-class Americans are burdened with obligations like no one else in the world. They carry a lot of debt. According to a Federal Reserve study, the average debt-to-income ratio (meaning the amount of debt 2 https://money.cnn.com/infographic/economy/what-is-middle-class-anyway/ index.html

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someone has as a proportion of their income) has risen to about 1.0 in 2018 from about 0.6 in the 1980s.3 This is about a 60 percent increase in debt relative to income in a generation. We are borrowing money to keep up our current standard of living. This can only come at the expense of our future. Most Americans do not have job security. In fact, they have less job security now than they did fifty years ago.4 Many Americans work parttime. Data from the General Social Survey (GSS) suggests that such parttime and contingent workers comprised 35.3 percent of employed workers in 2006, and 40.4 percent in 2010.5 Most Americans can be laid off with no warning. They can even be laid off within six months of their retirement.6 The lack of job security causes stress and eventual health problems. For better or for worse, family structures have changed. About 38 percent of children live with a single parent, or with no parent.7 Americans are less able to support a family on a single income than they used to be. In most middle-class households, both partners work; they need to, in order to cover their expenses.8 Middle-aged Americans need to provide for their aging parents, as well as for their increasingly dependent children. They have 30-year mortgage payments, 84-month car payments, life-long student loan payments, and

3 See, https://www.federalreserve.gov/econres/notes/feds-notes/household-debtto-income-ratios-in-the-enhanced-financial-accounts-20180109.htm 4 Some 63% of Americans say there is less job security for workers now than there was 20 to 30 years ago. See, http://www.pewsocialtrends.org/2016/10/06/thestate-of-american-jobs/ Also, see https://www.gao.gov/assets/670/669899.pdf 5 See, https://www.forbes.com/sites/elainepofeldt/2015/05/25/shocker-40-ofworkers-now-have-contingent-jobs-says-u-s-government/ 6 Two million of the 25 million working-age Americans over 55 and close to retirement have lost their jobs. See, The New York Times, “Laid Off, with Retirement Almost in Sight, January 6, 2012. Also see, https://www.wsj.com/articles/even-abooming-job-market-cant-fill-retirement-shortfall-for-older-workers11545326195?mod=djemRTE_h 7 See, http://www.pewsocialtrends.org/2015/12/17/1-the-american-family-today/ 8 https://www.ey.com/us/en/about-us/our-people-and-culture/ey-studyhighlights-dual-career-dynamics-in-the-us#.XDycJlxKjIU

Why Finance?

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endless credit card payments, all totalling trillions of dollars.9 Their financial obligations are plenty. College education in the US is growing increasingly expensive. About 45 million Americans carry student debt, totaling about $1.5 trillion, which exceeds all other forms of personal debt.10 This debt burden falls directly on young students and their families. Only about 10 percent of students receive half of their tuition payments from their family, and fewer than 1 in 10 students had the majority of their college expenses paid for by their parents.11 Furthermore, the cost of college has increased much faster than inflation. From the late 1980s until now, the cost of an undergraduate degree has risen by 213 percent at public schools, and 129 percent at private schools, when adjusted for inflation.12 In contrast to the rest of the world, many Americans are personally and significantly burdened with their own university education costs. There is no universal, free, healthcare in the US. In stark contrast to the rest of world, the current generation of Americans are burdened with their own, their parents’ and their children’s medical costs. 13 Insurance is hard to get unless one is receiving health insurance through employment. Many worry about pre-existing conditions that may or may not be covered under their health insurance plans.14 About 60 percent of Americans who declare bankruptcy cite medical expenses as an important contributor.15 Unlike the rest of the world, Americans need to personally plan and provide for their own retirements. Defined-benefit retirement plans, a type of guaranteed pension, have mostly disappeared in the US. Many 9

https://www.ey.com/us/en/about-us/our-people-and-culture/ey-studyhighlights-dual-career-dynamics-in-the-us#.XDycJlxKjIU 10 See https://studentloanhero.com/featured/millennials-have-better-worse-thangenerations-past/ 11 See, https://lendedu.com/news/race-gender-paying-for-college/ 12 https://www.businessinsider.com/why-is-college-so-expensive-2018-4 13 See, https://www.wsj.com/articles/i-was-hoping-to-be-retired-the-cost-ofsupporting-parents-and-adult-children-1542381023 14 Affordable Care Act (ACA), which forbids deny insurance based on pre-existing conditions is under pressure from the Trump administration. See, https://www.commonwealthfund.org/blog/2018/lawsuit-ACA-preexistingcondition-protections-where-you-live 15 http://www.pnhp.org/docs/AJPHBankruptcy2019.pdf

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Americans typically get nothing from their employers when they retire. In 1979, 28 percent of private-sector workers had participated in definedbenefit retirement plans, but by 2014, just 2 percent did, according to the Employee Benefit Research Institute, a nonprofit research organization. By contrast, 7 percent of private-sector workers participated in definedcontribution plans in 1979, but by 2014, a full 34 percent did.16 Now they have to plan, save, and manage the retirement risks on their own. Unfortunately, most Americans do not have the tools to deal with retirement challenges. Many Americans think they have good health insurance, until they get sick and the insurance company denies coverage for new treatment or expensive medications.17 Prior to the Affordable Care Act (ACA), if they had a pre-existing condition, the chance of obtaining medical insurance was drastically lower.18 If someone is laid off and misses a mortgage payment for whatever reason, their whole picture of affluence can unravel and their entire lives can be turned upside down.19 Most of all, Americans lack what we commonly refer to as ‘peace of mind’. They are feeling high levels of stress. It is not surprising. Unfortunately, many Americans also live one paycheck away from disaster, since they do not have an emergency savings fund. In 2017, a full 29 percent of Americans said that, they simply could not have covered a $400 unexpected expense without borrowing money.20 Many Americans work at the pleasure of their boss. This means they do not have a formal written employment contract, and they can be fired at will. Consequently, Americans worry about losing their jobs. Many have 16

See, https://www.theatlantic.com/business/archive/2018/02/pensions-safetynet-california/553970/ 17 See, https://www.theatlantic.com/business/archive/2017/06/medicalbills/530679/ 18 https://www.hhs.gov/healthcare/about-the-aca/pre-existing-conditions/index. html 19 Even without an emergency, a full 22% of the Americans run out of money every month and do not pay their credit card, rent, mortgage or utility bills at least partially in a given month. See, Board of Governors of the Federal Reserve System, May 2018, “Report on the Economic Well-Being of US Households in 2017,” p22. 20 See, Board of Governors of the Federal Reserve System, May 2018, “Report on the Economic Well-Being of US Households in 2017,” p21.

Why Finance?

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effectively become the modern-day equivalent of indentured servants to their employers and bosses.21 Many of them cannot refuse completely unreasonable requests from their employers, or potential employers, even during their evenings, weekends, and vacations, simply because they worry about the consequences of saying no.22 The global pandemic of 2020 has further exacerbated these fissures in Americans’ lives. Millions have lost their jobs, and they are completely dependent on government support for their basic needs, such as food and shelter. With government support absent, we could now be experiencing the greatest depression in our history. What happens if we do not manage our personal assets? Although there is a vast financial services industry that is presumably devoted to helping people acquire assets and build wealth, we do not find that most Americans are financially secure. In fact, in spite of living in one of the most developed, most powerful countries in the world, where the median household income in 2017 was $61,300,23 many Americans live paycheck to paycheck, and hardly have any financial savings or wealth. Many who were once part of the stable American middle class must now work tomorrow to make it to the next day. And when they do not work for a day, they cannot function. The security of their world has become eroded and they can even descend into homelessness.24 Can we do better? Yes, we believe so. We argue that Basic Financial Literacy has the potential to improve lives. People do not have to live

21

See, https://www.nytimes.com/2014/05/17/your-money/uncertainty-aboutjobs-has-a-ripple-effect.html 22 The recent Me-Too scandals and tragedies have shown us some of the extreme forms of abuse some young women silently endured in the past, because they worried about their job security or about landing a small opportunity controlled by men. In one of these, Bill Cosby has been accused by 60 women of rape, sexual assault or sexual misconduct. 23 https://www.census.gov/library/stories/2018/09/highest-median-householdincome-on-record.html 24 According to the US Department of Housing, there were over 500,000 homeless people in the US in 2018. See, https://files.hudexchange.info/resources/documents/2018-AHAR-Part-1.pdf

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paycheck to paycheck, regardless of their circumstances. So, what is Basic Financial Literacy?

Tools of finance Finance is mainly concerned with how we can create value in the face of risk. Finance shows us what value is, how to measure it, how to create it, and how to avoid destroying it. If we do not even know what value is, we cannot possibly create value. If we understand finance, we can make better decisions in the face of risk and uncertainty. We will illustrate how finance can help us understand, build, and manage all our assets over our lifetimes.25 This includes our most important asset – our human capital, which refers to our totality of skills, expertise, education, and business networks. Finance not only offers a value-based framework, but also the data and relevant inputs to make smart, valueincreasing decisions regarding all our assets, including our human capital.26 Consider again, our human capital. We are best positioned to refine this asset when we are young. Our brains are still pliable, and we are free from the encumbrances of responsibility that might heavily impact on our time. While it is not ideal to refine this asset later in adulthood, it is never too late.27 Thus, our goal is to spend the early part of our lives rapidly building our human capital. Subsequently, as we work, we convert our human capital into physical and financial assets. In retirement, we draw down on these physical and financial assets as our human capital dwindles. What better tool than finance to manage our most important asset? We have said that finance may be used to manage risky assets. Hence, it follows naturally, that finance should be very useful in managing our human capital. This should not be surprising or controversial. What is the

25 Franco Modigliani was awarded the Nobel Prize in economics in 1985 for his work life-cycle consumption decisions. 26 Gary Becker was awarded the Nobel Prize in economics in 1992 for his work on human capital. 27 See, https://www.forbes.com/sites/nextavenue/2018/07/01/going-back-tocollege-after-50-the-new-normal/#45b644ab31ff

Why Finance?

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alternative to finance? There is no other effective alternative. Should we instead use our intuition to manage our assets? Our view is ‘no’. Finance helps us make rational, emotion-free, and well-informed decisions. Consequently, it can be used to understand and plan our careers, whether in business, medicine, engineering, law, education, public policy, or other fields. Furthermore, finance can also help us enhance our understanding of our friends and family, given that life is full of uncertainty. Here, in lieu of finance, we would typically use our social skills to manage our daily lives. From the perspective of finance, our social skills are no different from our technical skills, such as our understanding of math, writing, statistics, sciences, art and culture, or computer programming. What matters is how they affect our human capital. Certainly, our interactions with friends and family have a great deal of potential impact on our human capital, both positively and negatively. Experts carry a lot of weight in the public policy domain. We trust monetary policy decisions to appointed experts. These decisions include the raising and lowering of the federal funds rate, which affects interest rates. Experts are called upon to comment on foreign policy approaches. Experts interpret scientific progress on issues like the global pandemic of 2020 and climate change for the rest of us. We urge caution about blindly trusting experts. This can give rise to what we call information asymmetries and moral hazard problems.28 We explore these themes later in the book. We will explore how we can make better decisions about our health, our happiness, our friends, the schools we go to and what we study, and how we manage our personal savings and investments. In this book, we argue that we can do better in our everyday lives, significantly better in fact, by using the tools of financial economics. To begin, we will briefly and intuitively discuss how the ideas in finance are used. We will then talk about how these concepts can be applied to our everyday lives. The most important concepts in finance include value and

28 Oliver Hart and Bengt Holmstrom received the Nobel Prize in economics in 2016 for their work on moral hazard and incomplete contracts.

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value-creation, making wealth-increasing investment decisions, understanding resiliency, how information affects prices, incentives, agency costs, risk and risk management, and informational asymmetries. We will review these issues in the next chapter.

CHAPTER 2 WHAT FINANCE TEACHES US

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” —Attributed to Albert Einstein

The Basic Overview Our goal in this book is to make finance accessible to readers who do not have a background in finance. The key concepts in finance teach us how to make the best investment decisions in response to the various risks. One of the most important ideas in finance is that corporations must create wealth for their shareholders. This is, in fact, the job of the managers. Managers must find opportunities where a good or service can be created at a lower cost than the price the good or service commands in the marketplace. Managers must take into account a variety of risks, as well as the cost of capital or the rate of return that the shareholders require. The timing of cash flows must be taken into account. If the managers are able to create wealth for their shareholders, then stock prices generally increase. If they do not, then stock prices fall. Managers themselves are rewarded if they can increase stock prices. They can lose their compensation as well as their jobs if stock prices decline under their leadership. Finance can help us assess risky investment decisions at a personal level. The same ideas that help corporations create wealth are also useful for us. We have seven simple guidelines for you: 1- Learn about risks. 2- Understand your own risk tolerance.

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Chapter 2

3- Take risks at your maximum tolerance, especially when you are young. Finance tells us that without taking risks, there are no rewards. 4- Diversify your investments. As the expression goes, “Do not put all your eggs in one basket” (or even a few). 5- Pay attention to fees, expenses, and other costs that may not be readily visible. 6- Do not attempt to predict the future – even the smartest individuals cannot do that. 7- Manage your debts. Avoid taking on excessive debt, and make your payments when they are due. Risk. Risk means uncertainty. It means we can lose as well as gain, depending on how the future unfolds. To begin with, we need to understand what drives these risks, how big they, are and what their consequences are. We will take a deeper look into risk in the next chapter. Risk Tolerance. This idea refers to your ability to withstand a loss without changing your investments or risk level. Suppose your investments declined by 10 percent. If this is within your risk tolerance, you will continue to invest as before. Your loss, however, may be outside your tolerance if you start panicking, losing sleep, or worrying about what is likely to happen in the future, and switch to a saving account or risk-free investments. This means this investment is not for you. It is crucial that you understand how much loss you can withstand without losing sleep. Risk at Appropriate Times. Even with riskier investments, you can protect yourself against how much you can lose. Hence, one way to manage your risk tolerance is to invest in two separate baskets, one for short-term needs and another for long-term needs. Short-term needs refer to monies you will need over the short term for things such as living expenses, taxes, rent or mortgage payments, college tuition, and unexpected expenditure. These investments should be liquid and very low risk. A good place to invest these funds is in US Treasuries (bills, notes and bonds), and highly rated corporate bonds. Treasury bills are short-term in nature (less than one year to maturity), free from default and price risk, and typically referred to as cash. US Treasury notes and bonds have a longer term to maturity. Although they are also virtually free from default risk, they will fluctuate in price in

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response to economic conditions (typically going up in price when the economy slows, and interest rates fall). You should be able to access these at any time without worrying about the state of the economy or market returns. The rest of your savings should be invested for your long-term needs, specifically, retirement. Since you will not need to access these funds for decades, what happens tomorrow, next year, or next ten years is irrelevant here. All you should care about is how much you expect to have at the time of the retirement. With these funds, you should be able to take the maximum risk that you can tolerate. In subsequent chapters, we explore the idea that risk-free investments do not help you build wealth. You might, in fact, be losing money. This is fine in the short term when you care primarily about having access and liquidity (the ability to raise cash at low transaction costs) at all times. Returns are not as important. To see why you need to take risks, consider the financial landscape in 2020. Suppose you invested in Treasury bills (short-term risk-free assets of US Government debt) yielding 0.25 percent a year. Suppose you paid 25 percent in taxes, which leaves you less than 0.2 percent after taxes. Suppose also, that inflation is 2 percent a year. Then, you are losing 1.8 percent in real terms29 every year. This is still fine, because these risk-free investments give you liquidity and access to your savings. This is not an isolated hypothetical example. At the time of writing, the yield, even on ten-year US Treasury notes, is less than 1 percent per year. The nominal yields on many international government bonds are lower, with many in negative territory. For your long-term investments, losing 1.8 percent every year in real terms is not appropriate. You are definitely not going to build wealth for your retirement this way. The only way to build wealth in the long run is to take a lot of risks. Only by taking the maximum risk you can tolerate can you

29 Real means net of inflation. In this example, 0.2 percent is the nominal after-tax return and -1.8 percent is the real, after tax, return. Positive real returns measure whether we are increasing our purchasing power by making a given investment.

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hope to build wealth for your retirement. This is why we recommend the stock market as the place for your long-term investments. Suppose that you followed this advice and saved in two separate baskets. One is in safe assets for your short-term needs. This includes Treasuries, corporate bonds and possibly some REITs (real-estate investment trusts). The other basket is placed in the stock market for your long-term retirement needs (such as Standard and Poor’s 500 Index). At this point, suppose that the stock market drops by 50 percent. This should neither scare you nor cause any panic. Your short-term investments will not be affected since they are in safe assets. Hence, by definition, your short-term assets will hold their value. In fact, if you invested in long-term Treasuries, you might even find that your short-term assets are positively impacted, since there can be a negative relation between stock market and long-term Treasuries in times of panic, as we will demonstrate later. Your long-term assets will decline by 50 percent, but again there is no need to panic. You still have decades to retirement. In fact, you should view this decline with some cheer (especially if you are young) since it will give you an opportunity to pick up long-term investments at a cheap price. You make be taking too much risk if you are panicking and you are tempted to switch your long-term assets to a safer investment. You need to trim your risk-exposure, but you should wait for a more opportune time to do this. Selling your risky, long-term assets at the bottom is just about the worst thing you can do. Diversification means spreading our investments across hundreds, if not thousands, of separate individual investments. Finance tells us that diversification does not affect or reduce returns, it only reduces risks. Diversification is unambiguously beneficial to the average investor. Consequently, we should diversify as much as possible. We will show you how to do this later in the book. Fees, Expenses and other Costs. These fees are typically expressed as a percentage of your entire investment portfolio (and not your returns). If the fees are 2 percent, and you invested $100,000, then you are paying $2,000 a year for the privilege of having your money managed, regardless of your returns. Fees may seem small, but in fact, we will show you even a

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fee as small as 2 percent of your assets per year can eat into 80 percent of your portfolio in the long run. Consequently, we need to minimize the fees and expenses. Predicting the Future. Effective investing should not depend on forecasting the future. Investing is not about predicting whether a given stock, or the overall market, is likely to go up or down. Investment is about taking the right level of risk. Debt. Debts must be managed very carefully. Debt should not be used to increase your current consumption. Doing so can only mean that you will have to cut our future consumption by even a bigger amount. Debt is only appropriate to make long-term investments such as home and car purchases and possibly a college education. If you are accumulating credit card debt for daily living expenses or vacations, this will destroy your wealth and future standard of living, as we will show you later. Although finance may seem difficult, these seven concise guidelines will shape our goal of reaching financial security. In fact, most of the time, these basic financial literacy guidelines will be sufficient to guide us to the right approach. We will discuss these ideas in more detail in Chapter 3, and subsequent chapters.

Understanding the financial markets Financial markets, including the stock and bond markets, appear as esoteric, irrelevant, inventions to most people, a place where certain people buy and sell strange things. Most people do not understand the products that are bought and sold, or the workings of the markets. Furthermore, there are many misconceptions about these markets. Many think that the stock market is akin to a casino and should be avoided at all costs. Other people think that understanding financial markets needs to be left to financial specialists. Irrespective of what we do for a living, we should have a basic understanding of the stock market. Financial markets allow us to buy and sell risk and allocate resources across time. Financial markets are absolutely essential to any modern economy. Without well-functioning capital markets, modern economies would cease to function.

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Understanding the stock market and other capital markets at the most fundamental level is also important for everyone to make basic long-term investment decisions for their own retirement. Finance gives us important insights into how the financial market works and how risk is priced. Without a basic and up-to-date understanding of financial markets, it is not possible to manage any of our assets in an efficient way, including our human capital. Finance also tells us that the surest way to build wealth in the long run is to save and invest in the financial assets. Furthermore, finance tells us to start investing early and keep funds invested for years and decades. This is a simple, easily understandable, idea. We will expand on this theme later in the book. To achieve the diversification goals we discussed earlier, a useful strategy is to buy a well-diversified passive index fund, such as Standard and Poor’s 500 index (S&P 500). This index keeps track of the large and prominent public firms in the US. Hence, it is well diversified. The market value represented by the S&P 500 index is about $27 trillion, as of October 2020.30 Figure 2.1 illustrates the performance of the S&P 500 index (with dividends reinvested) during the period of 1975-2017. Although there are many ups and downs, the general trend of the stock market is typically up, thus providing a good place for long-term investment. In order to be able to earn these returns, any investor would have had to endure substantial market declines, especially around the periods of 2000-2002 and 20072009. During the calendar years 2001 and 2002, the S&P 500 index declined by more than 30 percent. During the calendar year 2008, the S&P 500 index fell by more than 35 percent. While not shown on the graph, during the global pandemic of 2020, the stock market again fell about 35 percent from February to the third week of March. In return for bearing these risks, the stock market provided marvelous rewards. Overall, the S&P index with reinvested dividends has increased 130-fold over the past 43 years. One dollar invested in 1975 has grown to 30 See, https://ycharts.com/indicators/sp_500_market_cap#:~:text=S%26P%20500%20M arket%20Cap%20is,S%26P%20500%20Earnings

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over $132 by the end of 2017. The stock market is an awesome wealthgeneration machine. Although this does not guarantee any future performance, the stock market has historically provided substantial rewards for taking risks.

Figure 2.1- Standard and Poor's 500 (Withdividends), 1975-2017

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We use the stock market to create long-term wealth, and Treasuries to control risk, since low risk assets do not create wealth. Consider the rewards of investing in risk free or low risk assets next. Figure 2.2 illustrates the performance of low-risk assets, such as T-Bills and T-Bonds. Treasury Bills (T-Bills) are basically short-term US Government obligations. T-Bills’ owners essentially lend short-term money (less than one year) to the US Government. T-Bills are arguably free from default risk, liquidity risk, and price risk. Similarly, Treasury Bonds (T-Bonds) are long-term (more than 10 years in maturity) US Government obligations. T-Bonds’ owners lend money long-term to the US Government. Again, this is also virtually free from default risk, although, as interest rates fluctuate, so does the price of T-Bonds, in the opposite direction. Figure 2.2 shows that one dollar invested in T-Bills has grown in 43 years to about $6.80, while one dollar invested in T-Bonds grew to $19.24 Comparing Figures 2.1 and 2.2 illustrates that there is a strong relation between risk and return. Common stocks (the S&P 500 Index) are among the most risky investments, and certainly much riskier than T-Bills and T-

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Bonds. Commensurate with their high risk, common stocks have also provided the highest returns. During the 43 years from 1975 to 2017, the returns on the S&P have averaged about 12 percent per year. The second risky asset is T-Bonds. These are free from default risk, but contain the risk of price fluctuations in the short-term. The average annual return in T-bonds has averaged 7.1 percent during the same 43 years. In contrast, the T-Bills, which are the least risky asset group, have averaged a return of 4.5 percent during the same time period. The lesson here, is that one must take risk to receive compensation. Lowrisk assets have lower returns. Higher risk assets have higher returns. Although high risk does not guarantee high future returns, low risk does guarantee low future returns. 20

Figure 2.2: T-Bills and T-Bonds, 1975-2017 15

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Next, consider the historical performance of various asset groups. This illustrates that invested money grows exponentially. Using the power of exponential growth, most people should then be able to save enough for their financial security, and for their retirement by the time they reach the age of 65, assuming that they have been investing consistently over the

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course of their careers. The stock market offers the chance to increase each dollar of investment by more than 100-fold over a lifetime. The exponential growth comes from the power of compounding, which is just repeated multiplication.31 “Those who understand it [power of compounding], earn it. Those who don’t, pay it”. Hence, the simple idea of building wealth for financial security must be understood and put to good use. We will discuss these ideas in more detail soon. Understanding the power of compounding is the first step to building financial security. We also need to talk about the specifics of saving and investing. In this book, we will show you how to harness this power of compounding into a powerful ally to build wealth. Alternatively, if you ignore these ideas, you can make this powerful tool work against you. We will show you how to avoid such mistakes. There are other important reasons why we want to understand the stock market as well as other public securities markets. These markets tell us what kind of investment returns we can earn on our own without much education, preparation, expertise, or active participation. This is the case even if we are not going to work in finance, or do not have a detailed understanding of finance. The overall returns of the markets provide us with what we describe as a benchmark. If we invest in funds that mimic the market portfolio, we can earn the benchmark market returns. Such funds are known as index funds or ‘passive’ funds. If, however, we invest in portfolios that diverge from the market portfolio, again we need to compare their returns to the benchmark, since we can earn benchmark market returns with little or no effort on our part. These select funds are known as actively managed funds. We will examine these issues in more depth in Chapters 4 and 5.

The role of prices Take another basic idea from finance and economics. Market prices are informative. Suppose you are very hungry and grab some fast food for lunch. Your hamburger costs $1. What do you make of this? One thing you 31 Albert Einstein reportedly said, “Compound interest is the eighth wonder of the world.” He should know.

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can conclude is that the cost of ingredients in your hamburger is probably less than 30 cents. The price tells us something about what is, and what is not, in that hamburger. While high prices do not guarantee high quality, low prices are likely to indicate lack of quality ingredients. Similarly, publicly traded asset prices provide valuable signals. In fact, the concept of market efficiency states that price of an asset or a commodity encapsulates and reflects all publicly available information.32 Conditioned on these competitively prices, it is hard to beat the market. This general idea should also be intuitive. Consider, for example, the price of oil. When the economy strengthens, businesses expand, and they need greater amounts of energy. The ensuing higher demand for oil increases its price. When the economy weakens, the converse happens. The reduced demand for oil decreases its price. Thus, price reflects the changes in aggregate demand. There is a positive correlation between oil prices and the state of the economy. Changes in price also guide economic activity. In a growing, stronger economy, higher demand leads to higher oil price increases and increased production becomes more profitable. To increase profits, everyone invests in exploration and development to produce more oil. Thus, higher demand signals higher price, which then signals higher production. When the economy slackens, lack of demand will decrease oil prices and lower production. Consider Figure 2.3. It shows the relationship between the Dow-Jones Industrial Average and oil prices. There is generally a positive comovement between these two series. When people expect the economy to improve, oil prices increase due to greater expected demand for oil. The expectations of an improving economy also increase stock prices, holding all else constant, as measured by the Dow-Jones Industrial Average. Similarly, when people expect the economy to contract, oil prices decrease, due to the expected lower demand for oil. This also decreases stock prices. During the global pandemic, and the resulting economic

32 Eugene F. Fama (along with Lars Hansen and Robert Shiller) received the Nobel Prize in economics in 2013 for his work on market efficiency.

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collapse, short-term oil prices, in fact, turned negative.33 Even though many other factors can affect oil prices, as well as the Dow-Jones, one can visually detect the positive co-movements between these two series. Figure 2.3: Dow Jones and Oil prices, 2014-2019

Dow-Jones

Oil Oil prices are a signal for the direction of the economy, whether it is strengthening or weakening. Accordingly, these valuable signals help us plan our lives.34 Oil producers look at the price of oil and determine whether they need to increase or decrease production to increase their profits. Oil consumers look at oil prices and do similar calculations. Hence, oil prices also provide us with valuable signals about global economic activity. Oil producers and oil consumers do not need to talk to each other. They just need to monitor prices. Thus, without receiving any

33

https://www.bbc.com/news/business-52350082#:~:text=The%20price%20of% 20US%20oil,world%20have%20kept%20people%20inside. 34 See, Friedrich Hayek (1945). "The Use of Knowledge in Society" . The American Economic Review. 35 (4): 519–530.

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orders from any organization or any government, both oil producers and oil consumers know what to do. They take their cues from oil prices. Thus, as is the case with oil prices, we are constantly being sent signals in the prices of all goods, services, commodities, real estate and stocks, and bonds. These signals inform us about the state of the economy, value of commodities, and profitable and unprofitable business opportunities. The goal is to disentangle these signals (from what we call ‘noise’) and learn from these prices and price movements. Finance tells us how the prices are formed, and what factors can, and do, affect price. Finance, moreover, helps us understand what purpose these prices serve. We observe prices every day. However, without additional guidance, we may not draw the appropriate conclusions. Later in the book, we will provide a more in-depth discussion of the potential interpretations of the various price signals we receive in our daily lives.

Resiliency Other important concepts in finance relate to resiliency, insurance, and guarantees. Resiliency provides us with the ability to withstand adversity by providing alternative avenues of action. The recent global pandemic showed all of us just how valuable flexibility and resiliency can be in our everyday lives. Insurance can help reduce or eliminate risk. One way to develop resiliency is by creating flexibility. Guarantees also provide protection against adverse outcomes. There is a formal construct in finance that encapsulates all these concepts – it is called an option. What is an option? An option gives the holder the right to buy or sell something at a fixed price (called the exercise price) during a fixed length of time (the life of the option) in return for paying an upfront premium. Thus, buying an option gives the holder a right to buy or sell, but not an obligation. The seller of the option has the opposite situation; they are undertaking an obligation to honor this contract, in return for receiving an upfront

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payment, called a premium. For a market in options to exist, your need both buyers and sellers simultaneously.35 Using sophisticated mathematical pricing models from finance, corporations and financial specialists can understand and determine the price of traded options, executive compensation options, or so called ‘strategic options’.36 Options are an important topic in investments, corporate finance, compensation, and risk management. Options can also provide financial flexibility (the ability to select from among various choices). We can also think of financial flexibility or insurance contracts as options. Finance has also developed a sophisticated option pricing formula, called the Black-Scholes formula.37 The BlackScholes formula can be used to price, not just traded options, but also financial flexibility. These ideas are important tools that are useful for corporations to make better financial and investment decisions. The BlackScholes model not only prices options, but it also tells us what factors affect the value of the options, how much they affect the value of options, and what factors do not matter at all. Be assured that we are not going to derive the Black-Scholes model here. Instead, we will only discuss its intuitive implications to our everyday lives. We will illustrate that financial flexibility and insurance are relevant to our everyday lives. Consider the ability of being able to work remotely from home. During the recent pandemic, this flexibility afforded many people a reduced risk of contracting COVID, and important peace of mind. The different activities we engage in during a day can create flexibility: we interact with others, invest, drive to work, buy an airline ticket, book a hotel, buy home or car insurance, or even make a simple promise to our

35 Chicago Board Options Exchange (CBOE) is an example of options markets. Chicago Mercantile Exchange (CME) also trades many options. 36 Strategic options refer to flexibility in our everyday lives. We will devote a chapter to this topic later in the book. 37 Myron Scholes and Bob Merton received the Nobel Prize in economics in 1997 for the contributions to the options pricing formula, since Fisher Black passed away in 1995.

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boss. In doing these activities, we are creating, giving away, receiving, or buying and selling flexibility, without even being aware of it. The most important applications of flexibility occur in our personal lives when we interact with colleagues, business associates, and friends. In these exchanges, we can help others, and build relationships which give us options to ask for return favors. How do we build these relationships? We need to empathize and be aware of others’ needs. We can offer them genuine support and good advice. We make sure we listen and sympathize. When they ask for advice, we do not hold back information useful to our friends and associates. These actions build flexibility. Alternatively, we can hide valuable information and offer superficial interactions. We receive without reciprocating. We can destroy these relationships and lose our flexibility through insensitive comments, snobbery, selfish behavior, or failure to follow through to express gratitude for any favors. We will discuss these ideas extensively in the book. Sometimes, we are explicitly dealing with options or flexibility. For instance, we are offered insurance or warranty products when we pay with a credit card, purchase a house or an airplane ticket, or buy a durable household appliance with a repair warranty. A warranty is another name for insurance; it is an option. What is a cancellable hotel reservation? It is a hotel reservation with an option to cancel it. Thus, you are paying for two things; one is a hotel room, the other is the option to cancel the reservation. What is a cancellable airline ticket? Again, it is an airline ticket with an option to cancel it. Thus, you are paying for two things; one is an airline ticket and the other is the flexibility. We can determine the value of these offers using the options pricing approach. Is it a good idea to purchase a cancellable ticket? How about travel insurance? How about a washing machine that comes with a repair warranty? In what situations should we purchase travel insurance or life insurance? Our objective in this book is to make you more aware of these options, or this flexibility, and help you decide what actions to take. What, then, is flexibility in our everyday lives, and how does it help us manage risk? Consider the following situation. It is early morning in Michigan. It is mid-November. We wake up and look out of the window.

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What we see is that there is steady, heavy, snow. It looks like a winter wonderland outside. Nice. We like the winter wonderland. Then, we then remember that it is actually Monday, not Sunday, and we have to go to work that morning. The next thought that comes to mind is that our 12-year old car, with its old tires, may not make it to work without getting stuck in this much snow. We are beginning to feel stress already, and we are not even out of bed yet. Is this a finance problem or a life problem? At first glance, it seems that this is a life problem, and it has nothing to do with finance. Finance thinking here is useful. Yes, we do have an old car, and we do have an obligation to go to work that Monday morning, but we do not have an obligation to drive our 12-year old car in deep snow. Instead, we have an option to drive. There is no reason to confuse the obligation to go to work, with the obligation to drive. On this snowy day, we can choose not to exercise our option to drive. Instead, we can simply call a rideshare car from Uber or Lyft. Yes, we will pay an extra $10 to go to work, but we will potentially avoid any risk of getting stuck in the snow. Similarly, we may have an option to take public transportation to work. Presumably, most people can identify with this simple everyday example. Notice how we took an everyday situation and described it in terms of financial concepts. More explicitly now, we can think of the $10 as the cost of insurance against the risks and costs of potentially getting stuck in snow or having an accident. Notice, we are not saying that we will definitely call a cab every day it snows. We just recognize that we have alternatives. This will help us relax and enjoy our morning coffee as we slowly wake up and get ready for the day. This is how we can make finance work for us. By thinking explicitly about the risks and costs of getting stuck in the snow, against the $10 ‘insurance premium’, we can make a more intelligent decision about our morning commute. Knowing our various choices also helps us accept the reality of our situations. Here is another example dealing with risk. You arrive at your hotel in a new city around midnight. You had thought you made reservations, but when you check your email, you discover a problem. Apparently, the credit card company rejected the charge, and the hotel reversed the reservation. You feel angry and upset. You blame the credit card company. How can they make a mistake on a simple hotel charge?

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Nevertheless, you still have a problem to solve. Although you do like to think of yourself as the adventurous type, you do not want to sleep outside. You also do not want to be overcharged by the hotel for a lastminute reservation. What do you do? Do you walk in and explain the situation to the hotel clerk? Do you hope he or she will help you, even though your shelter for the night depends on his or her kindness? Again, this does not sound like a finance problem, but it is. You can certainly walk into the front desk and explain your situation. You can beg, scream, or just blame the credit card company. However, this may not be the best approach. You will need to prove that you did everything you could, in good faith, to make reservations. Even if you are able to convince the clerk, he or she may simply not have the discretion to change the hotel’s rules. The finance approach tells us that you should not walk in. Instead, you should call the front desk from your cell phone while waiting outside and ask them if they are running any specials tonight. Walking up to the front desk would signal that you are impatient, you are out of options, and you will probably take any room at whatever the cost. A perceptive hotel clerk would surely try to upsell to a desperate customer. If you call instead, you are signaling that you have options and that you are price sensitive.38 Understanding the role of flexibility in dealing with risk is important. We need to build flexibility into important decisions in our lives, such as marriage and our career choices. If it is available, we need to purchase flexibility at the right price. If it is available, we need to offer and sell flexibility at the right price. If our options are well positioned, we need to exercise them and take advantage of the benefits of flexibility when the risks are realized. We will discuss these ideas extensively in this book.

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New apps that allow consumers to reserve last minute hotel rooms give users access to a market where there are multiple sellers (hotels) that are looking to fill rooms, as opposed to the market with only one seller in this hypothetical scenario. The result of this is that consumers have more flexibility and more options; all the more reason not to walk in.

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Finance and scammers Another source of risk comes from those who seek to exploit us. Many Americans suffer at the hands of scammers. The Federal Trade Commission estimates that telephone frauds alone have cost Americans about $1 billion in 2017.39 A few examples are debt collection, identity theft, and romance, financial, and imposter scams. Both the very young and the very old are special targets of scammers. Here we use another idea from finance – namely market efficiency – to analyze and detect scams. A corollary of this concept of market efficiency is that ‘there are no free lunches’. Market efficiency tells us that if something is cheap, it must have some unattractive feature. If something is expensive, it must have some attractive features that everyone wants. Consider the following situation. We often receive free offers in the mail. There are, presumably, free vacations, free dinners, and free cocktail parties.40 There seem to be great opportunities in penny stocks, South American gold mines, or rare silver coins. We may have won sweepstakes, or lotteries, or we may find we are the lucky 1,000th customer. What should we do about these offers? Is it ever possible to find a good deal here? The answer is no. The concept of ‘no free lunch’ is that there must be an even bigger benefit to the solicitor, and thus a hidden cost to us. No rational person will offer free dinners to numerous total strangers with no expectations of payback. The cost must be there, but perhaps it is hidden. We do not know how or when the cost will be revealed. However, we do know there must be a cost. Thus, one simple solution is to just ignore these offers. Just throw away the junk mail. Do not write or call back. In efficient markets, there cannot ever be any great deals of this sort. Stated differently, if something seems too good to be true, then it is too good to be true.

39

See, https://www.ftc.gov/policy/reports/policy-reports/commission-staff-reports/ consumer-sentinel-network-data-book-2017/main 40 Or emails from handsome Nigerian princes asking us to transfer some money for them.

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A similar idea applies to phone solicitations. If a total stranger makes a demand, or offers you a great deal on the phone, you will need to be skeptical. After all, this so-called great deal requires you to confirm your identity and provide your credit card information. You could be exposing yourself to an identity theft. It is much better to just hang up, do your own research (including the contact information) and then call vendors on your own. This applies to demanding phone calls from so-called ‘local police department’, the ‘IRS’ and ‘FBI’ agents, as well. Consider the following situation. If a total stranger promises you 100 percent return in one year with no risk, most reasonable people will immediately become suspicious and will not be interested at all. They will not want to know any details about this ‘deal’. Instead, they will simply shake their head and walk away. This offer is simply too good to be true. While 100 percent return with no risk must obviously be fraudulent, some other schemes may not be as obvious. What about 10.5 percent return in one year with little or no risk?41 How about 9.5 percent a year with no risk? What about 4.3 percent with no risk? Could this be a real opportunity? With some of these examples, we have to be more careful. For decades, Bernie Madoff was able to fool well-educated, sophisticated investors into giving him billions of dollars to invest, because he did not make it so obviously ‘too good to be true’. Although he reported earning about 10.5 percent per year, he also created a few down months. Nevertheless, he appeared to be offering reasonably good returns, given the little risk his returns contained. This small sleight of hand was sufficient to fool most investors. We will provide extensive technical analysis of Bernie Madoff’s fraud later in the book. So how do we judge some of these fraudulent investments? Finance gives us important insights. We will want to compare the promised return to the one-year, risk-free government bonds, which are yielding, say, 2.1 percent

41 Bernie Madoff who was convicted of running the biggest Ponzi scheme of all time,

was typically providing his investors with an average of about 10.5 percent per year return with very little risk. See, “Mr. Madoff ’s Amazing Returns: An analysis of the Split Strike Conversion Strategy” by Carole Bernard and Phelim Boyle, University of Waterloo and Wilfrid Laurier University working paper.

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a year. In this case, any so-called guaranteed promised return above 2.1 percent is either risky or fraudulent. That is it. This idea has no exceptions. Notice that the reverse is not true. If you are offered a ‘guaranteed’ investment of exactly 2.1 percent, you still may not be receiving a good deal. It may still be risky, and the 2.1 percent just represents an upper limit on the investment. In short, any promised so-called ‘guaranteed’ rate of return above 2.1 percent is simply too good to be true, but you can also end up with a lower return. In addition, if there is risk, then it becomes a bit more difficult to judge. We will talk extensively about the Madoff’s Ponzi scheme Iater in the book. This will help us understand why some financial fraud succeeds. Consider another simple, intuitive, perspective. Even if someone (say Bernie Madoff) were to discover such a great scheme, why would he or she share it with you, instead of exploiting it exclusively for themselves? Contrary to a common belief, you do not need to start out with money to make money. Consider someone that starts with $10,000 and earns a socalled guaranteed 100 percent per year. In ten years, they will have more than ten million dollars. In just twenty years, they will have more than ten billion dollars.42 Why does someone with ten billion dollars need our money? You can see that a claim of earning 100 percent per year really is ridiculous. Bernie Madoff made more modest claims. He claimed that he earned about 10.5 percent per year with minimal risk.43 At this rate, any investment would about double in value every seven years. However, a little reflection reveals that this cannot be a genuine opportunity either. A 10.5 percent return with extremely low levels of risk cannot be true. This is why: suppose that Bernie Madoff started with one million dollars and borrowed four million dollars, at say 3 percent based on his low-risk, brilliant strategy, he would have more than quintupled his equity after 7 years. Continuing this way, he should also have been able to grow his

42

The formula is 2n, where n is the number years invested. This is between December 1990 and October 2008. We will show these results later in the book. 43

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personal wealth to well over $600 million after only 28 years.44 Why was Bernie Madoff still getting equity money from investors through the feeder funds after all these years? He should have been borrowing on his own, and managing just his own money. 45 You should never even be tempted into getting involved in schemes that promise not only high returns, but also modest but steady (or even guaranteed) returns. Finance clearly tells us that such a scheme can only be either misleading or fraudulent. Remember the simple and powerful idea of ‘no free lunch’. It will help us form realistic expectations as to what it takes to achieve financial security and avoid getting involved in any Madoff-types of Ponzi scheme. In spite of its simplicity, many financial experts themselves did not appreciate the power of this simple financial principle. Prior to the Global Financial Crisis of 2008, banks took risky mortgage loans and bundled them into securities, called Mortgage-Backed-Securities (MBS), and sold these to the investing public. Rating agencies such as Moody’s and S&P, in turn, gave about 90 percent of these securities a rating of AAA, which is the lowest risk category, even though the underlying mortgages were quite risky.46 Yet, these securities could only be sold at a sufficiently low price, which gave them a significantly higher yield than other AAA-rated corporate bonds and riskfree government bonds.47 Presumably, we have a conundrum here. AAArated MBS have a higher rate of return than AAA-rated corporate bonds.

44 We are using the Rule of 72 here. Investments double in approximately 72/r years,

where r is the rate of return. At 10.5 percent per year, $5 million becomes $10.1 million after 7 years. His debt to the bank on the $4 million borrowed is $4.92 million with interest. This leaves $5.1 million equity, which is more than quintuple the initial money invested. 45 Apparently, there were many who smelled a rat with Madoff scheme. These people thought Madoff was making money by illegally front-running orders through the Madoff market-making arm, and thus it was okay to invest with Madoff. 46 https://www.nber.org/digest/aug18/w24509.shtml 47 See “Wall Street and the Financial Crisis: The Role of Credit Rating Agencies”, https://www.govinfo.gov/content/pkg/CHRG-111shrg57321/html/CHRG111shrg57321.htm

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Should we all dump our corporate bonds and replace them with higher yielding MBS? What is the lesson here? Our no-free-lunch principle suggests only one possible answer. If something is too good to be true, then it is just too good to be true. In this case, there is only one conclusion possible: these MBS’s must be more risky than AAArated corporate bonds. That is it. There can be no free lunch. Subsequent history affirmed this point. In fact, a full 91 percent of the AAArated sub-prime Residential-Mortgage-Backed-Securities (RMBS) issued in 2007, and 93 percent of the sub-prime RMBS issued in 2006, were downgraded to junk status.48 A full 97 percent of the Option Adjustable Rate Mortgage Backed Securities issued in 2006 and 2007 were downgraded to junk.49 If the financial experts had sufficiently applied this simple lesson of finance, they would not have recommended that their clients replace their corporate bonds with MBS. Instead, they would have acknowledged the higher risk, and asked whether the higher yield was sufficient to offset its higher risk. Remember, in efficient markets, you get what you pay for.

Finance and incentives Finance has other simple yet powerful ideas to offer us – that is, people respond to incentives. In all business and social settings, you want to understand the incentives and motivations of the people you are dealing with. Finance starts with the proposition that people want to enhance their own payoffs. Consequently, people can look at the same set of data and come to different, or even opposite, conclusions regarding what this information means. One reason people can disagree as to what the information means, is because they have different incentives about different outcomes. Incentives have to do with the payoffs that individuals receive in different outcomes. People care mostly about their own payoffs – namely, what can 48

See https://www.govinfo.gov/content/pkg/CHRG-111shrg57321/html/CHRG111shrg57321.htm at 244. 49 https://www.govinfo.gov/content/pkg/CHRG-111shrg57321/html/CHRG-111 shrg57321.htm

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make a difference in their lives, regardless of what the outcome of a particular situation is. Understanding people‘s incentives can help us better understand why people advocate certain positions or prefer certain outcomes. Consider the example of managerial incentives. A typical managerial employment contract specifies how the manager is compensated under different circumstances or different outcomes. In this case, the outcome refers to the profitability of the firms. Suppose a manager is compensated by straight salary, regardless of profitability. In this case, the manager receives salary compensation if the firm survives; there is no salary compensation if the firm files for bankruptcy and disappears. However, shareholders care about firm profitability, or the outcome, in this case. For managers, they care about their own payoff, which depends on whether they are employed, and thus receive salary compensation. Given this payoff structure, managers will have incentives to help reach outcomes where they continue to receive positive payoffs. Thus, in this situation, the manager has incentives to ensure that the firm comfortably survives, but no more. The managers will not care about whether the firm prospers and becomes extremely profitable, since there is no further upside payoff for the manager. This is especially true if prosperity for the shareholders requires that the managers put in a lot more costly effort. Finance states that everyone is motivated by his or her incentives or their own payoff structures. This is true in corporations, governments, social interactions within social networks, and within family. To understand why people behave in certain ways, we need to understand the incentives they face. Finance assumes that people care about their own payoffs and so they try to figure out what they would need to do to optimize their payoffs. A finance perspective provides us with a better sense of what steps people will take, what positions they will advocate, and what outcomes they would like to see. In this sense, understanding finance will help us better understand our everyday social interactions. We explore these issues further in Chapter 8.

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Finance and risk management We mentioned earlier that we need to understand risk and our risktolerance. In this context, risk means the likelihood of a bad outcome. In a risky situation, we can lose our investment. The company can go bankrupt. Managers can lose their jobs. Finance tells us how to make decisions amid risk. Finance tells us how to understand, measure, manage, control, and possibly eliminate, risk. Finance tells us explicitly that there are multiple approaches to dealing with risk. The first approach is to avoid the risk. If something seems too risky, you simply step out of the way of the high-risk situation. This is a good way to avoid sustaining a loss. As we mentioned earlier, we can always eliminate our risk by investing in risk-free securities. For our long-term investments, however, we need to take on the maximum amount of risk we can tolerate. Here it is important to understand how much compensation we get for bearing risk. This is what a market is designed to do. Markets constantly assess and value different kinds of risk. It is extremely useful to know the price of risk (or the rewards for taking risks). If the market reward for bearing risk is high, we can choose to buy or bear risky investments. If the market reward for bearing risk is low, we can choose to sell (or avoid) risky investments. Thus, we bear only those risks where the reward to risk ratio is sufficiently high. Another approach to risk is to insure against a loss. For certain types of risk, the potential negative outcomes may be so negative that we wish not to bear these risks at all. One way to deal with this situation is to protect against the worst set of outcomes – this is also known as ‘selling the left tail’.50 What are the important risks we face in our daily lives? One of them is the risk of death. It is a subject we often avoid, but we do need to address it. Finance offers a framework to do so. Usually, we cannot sell this risk, although there were historical exceptions. During the American Civil War, for instance, a draft was instituted when volunteers did not suffice to fill the army’s combat needs. However, not everyone was subject to the draft. 50 Outcomes that are the very worst of all possible outcomes are called ‘left-tail’ outcomes. It is a reference to the extreme left side of the distribution.

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Married men were not drafted while there were still available unmarried men not serving in the army. So, one possibility was to get married to avoid the draft. Another possibility was that one could hire a substitute or pay a fee and avoid the draft.51 How else do we manage the risk of death? Obviously, we can choose professions that do not expose us to a high risk of death at work. There is usually an extra wage (wage premium) associated with high- risk jobs. By giving up this risk-premium, we can take safer jobs and reduce the risk of death.52 Another approach to deal with cost of death is to buy life insurance. What type of life insurance is best for us? How much do we need? When should we buy it? When should we cancel it? We will discuss these ideas later in the book. Then, we have the risk of major illness or disability that can prevent us from earning a living. We can obviously buy health insurance and disability insurance against this risk. Also, how do we protect our health? How do we approach these challenges? Another major risk we face involves our jobs. Some jobs present high-risk, high-payoff characteristics. One example is show business, where winners take all, and the rest work as wait staff biding their time. Many of us face the risk of losing our jobs and spending extensive time and effort in finding a new job. New college graduates may find it easier to find a new job, especially if they are willing to relocate. After a certain age, it may be difficult for most people to find a new job. There is no way to insure 51 See for instance, https://www.warhistoryonline.com/history/14-great-militarymavericks.html 52 Arnould and Nichols (1983) estimate that the value of reducing risk at work by 0.001 is about $200,000. See, Richard J. Arnould and Len M. Nichols (1983) “WageRisk Premiums and Workers’ Compensation: A Refinement of Estimates of Compensating Wage Differential” Journal of Political Economy 91, 332-340. Some of the most dangerous jobs in America include logging, construction, fishing, airplane pilots, farmers, and metal workers. See, https://www.bls.gov/opub/hom/cfoi/home.htm and https://www.bls.gov/charts/census-of-fatal-occupational-injuries/number-andrate-of-fatal-work-injuries-by-industry.htm

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against this risk factor. How do we assess and manage this risk? Obviously, our career choices and our savings can help. Another major risk is loss of wealth. We run the risk of having our most important assets such as our house, car and retirement savings lose their value. How do we assess and manage these risks? We have additional risk factors such as major disruptions in our lives such as marriage, divorce, having kids, dealing with our parents’ health, and money problems. Then there is the cost of college education for our children. What do we do about these? Finance can help with all of these risk factors in our lives. Finance tells us that certain investments are better than others given the risks of our particular employment. For instance, if our job security is low, we need to cut back on the risk of our investments. We can also use finance to help us protect the value of our major investments. Finance can help us with the inherent risks in marriage, divorce, and children. We will discuss these ideas at length in this book.

Informational Asymmetries Another basic idea from finance is informational asymmetries. If acquiring information is costly, then not everyone will be equally informed. Some people come by information naturally and, as a result, they will be better informed than others. Others have to spend time and resources to become informed. We call this informational asymmetry.53 Informational asymmetries govern most of our transactions in real life. Sellers typically know more about their products than buyers do. Buyers tend to be less informed, but smart buyers also know that they are less informed. They know that they can spend resources and become informed. Less informed does not mean stupid. What happens when there are significant informational asymmetries between different actors? When information is costly, we can never be fully informed, since it is too costly to become so. This situation is typical. Suppose that you hear about a wizard stock market investor named Bernie Madoff. However, you 53 George Akerlof, Michael Spence and Joseph Stiglitz received the Nobel Prize in economics in 2001 for their work on information asymmetry.

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cannot find any information as to how Mr. Madoff makes money. You find out that he uses some strategy called ‘split-strike conversion’, which is supposed to represent a low-risk, low return strategy. You are puzzled as to how a strategy designed to reduce both risk and return can result in such high returns with little risk. Furthermore, no one knows how this strategy works either. What do you do? To deal with informational asymmetries, we will introduce a powerful framework called the Bayes Rule. Using the Bayes Rule, we will be able to analyze, update our beliefs and learn from the words and actions of opposing players. The Bayes Rule is the basis of rational, scientific, realworld learning. Our first lesson is that we need to be a smart buyer, since we are almost always making decisions that involve less than perfect information and risk. Quite possibly, we may never learn how someone like Madoff makes money. Consequently, we need to make a decision even if we do not find out Madoff’s secret. The bigger the information asymmetry, as in the Madoff example above, the more cautious we should be. Again, the Bayes Rule will be very useful here. The second lesson involves the relationship between the group that has the knowledge (the informed group) and the group that does not (the uninformed group). When the informed group takes an action, it will reveal some of their information to the uninformed group. If there is a transaction between these two groups, the transaction price will be affected by the action of the informed group. Using the Bayes Rule, we will again be able to learn and update our beliefs from the actions of others. Consider the following situation. Suppose you buy a new car. As you drive out of the dealership, you realize that you do not like a particular feature, say the operation of the windshield wiper blades. You decide you want to sell the car. You think this will be easy to do, since the car barely has 50 miles on the odometer. You think you will just sell it back, at, or close to, the original purchase price. However, you are shocked when you realize you are out by a whole 9 percent of the value of the car.54 This is because the moment you want to sell the car, you send out a negative signal. Others 54 See, https://www.edmunds.com/car-buying/how-fast-does-my-new-car-losevalue-infographic.html

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will think that you may be interested in selling the car because there is something wrong with it, perhaps very subtly so. The discount in price necessary to sell the car is another example of the information cost. You are sending out a more negative signal if you want to sell the car after only a few weeks or months rather than after a few years. If you have driven the car for, say, three or four years, the information asymmetry is less important. Many people sell these cars because it is time to buy a newer model. But, if you have only driven the car a few weeks, it is hard to explain away your decisions as anything other than the fact that there is something wrong with the car. Third, asymmetric information sometimes impairs the full functioning of markets. This is true for insurance markets, financial markets, and markets for everyday goods and services. Suppose that you own a business, and you decide that you want to borrow money from the bank. The fact that you contact the bank and you need to borrow money sends a negative signal. The bank immediately infers that your financial situation is weaker, since you are in need of the bank’s money. The situation is different if the bank contacts you to inquire whether you need a loan. If you appear too desperate, you are sending a stronger negative signal. As a consequence, the bank may simply deny you a loan regardless of what interest rate you may be willing to pay. One of your tasks is to convince the bank that you are not in a desperate financial situation. If this bank does not provide funding, you can get it elsewhere at a reasonable cost. Hence, understanding how informational asymmetries work will help you understand your various options. Another way we address informational asymmetries in our everyday interactions is to use what we might describe as mental short cuts, as a substitute for gathering more information. These short cuts may be based on our intuition. We also need to understand that these short cuts can give rise to errors, but have the potential to be effective if they are appropriately used by an expert who understands their value and their limitations. Finance gives us some lessons for dealing with informational asymmetries. It asks us to question the foundational basis of what we think we know. It illustrates the critical issues that need to be resolved. It also raises our awareness of potential errors. We may not know what we think we know.

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Another benefit of being aware of informational costs is that we can ask people not just what they know, but also how they came to know it. Again, exploring the bases of people’s convictions will help us distinguish whether the so-called truth has at least some logical or empirical evidence supporting it. We will discuss these issues at length in this book.

Managing Debt Debt represents a promise to pay back an amount borrowed with interest. Another name for debt is leverage. Borrowers receive money upfront, with a promise to pay it back over time, with interest. The borrowers honor their promise and pay it back when they experience good outcomes. If they experience particularly bad outcomes, they may default. Hence, debt confers risk. Finance deals extensively with debt. This includes the amount of debt, the mix of debt, the types of debt and risks associated with debt management. Another important issue in debt management is how we pay back the debt. We can pay in equal instalments, as in a typical mortgage, we can pay back only the interest amount, or we can make a lump sum payment at maturity. All of these details create different payoff structures and risks for the borrowers and lenders. Corporations borrow all the time to expand their existing operations, pay for new projects, or simply to increase their profits. They can borrow from the banks (loans), or from the public for short-term (bills), medium-term (notes) or long-term (bonds). Later in the book, we explore the consequences of borrowing and leveraging. Is debt always good for corporations? Does debt always increase profits? The answer is, it depends. Sometimes it does, and sometimes it does not. Some corporations prosper as a result of borrowing, while others are forced into bankruptcy. Finance provides a lot of guidance in managing the risks associated with debt. What lessons should we learn from corporate debt management for our personal lives? Most of us borrow on our personal account. We also have to manage the risks of debt in our daily lives. We have to borrow to buy a house, a car, and to go to college. All of us use credit cards. How do we judge if personal debt is good or not? Should we borrow to go to college? How much should

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we borrow? What form of borrowing should we use? What are the risks, benefits, and costs of borrowing? The lessons of corporate finance are directly applicable in our daily lives. Debt can either create or destroy wealth. We will learn that, sometimes, it is good to borrow, and at other times, it is a bad idea to borrow. We know that some investments definitely require borrowing. In the US, we simply do not save enough money to buy a house or a new car with cash. Similarly, most people have not saved enough to pay for college from existing savings. Hence, it is necessary to finance our investment, such as obtaining a college degree, buying a house or an apartment, by borrowing. The same is the case for purchasing a new vehicle. The use of credit card debt is another way to borrow. An important, related, concept is credit and credit scores. Various creditreporting agencies such as Experian, Equifax, and TransUnion, maintain credit histories and calculate credit scores for individuals. If we have a low credit score, we may be precluded from borrowing. Even when we are able to borrow, the interest cost may be more expensive, or even prohibitive, for those people with a low credit score. How do we build credit to qualify for these loans? How do we manage our credit scores? We will discuss these issues further. We will also learn that the advisability of debt depends on particular individual circumstances. Borrowing to buy one house may be a good idea, while borrowing to buy another, different, house may be a bad idea. Similarly, it might be a good idea to borrow to go to one college, and a bad idea to borrow to go to another college. However, we must remember that, just because we are able to borrow does not mean we should. In general, banks will be eager to lend us (especially at sky-high interest rates) more than we are willing to borrow. Consider that the banks and credit card companies will be happy to give us a $20,000 line of credit with a 20 percent annual interest rate even if we make only $15,000 a year. Should we take all the credit we can get? Why or why not? Is there a conflict of interest, or do the banks have our best interests in mind? How do we deal with this conflict? Do the banks lend to us even when it is not in our best interest to borrow and spend, or borrow to invest? What are these circumstances? Where do we stop borrowing?

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How much is too much? We will discuss these ideas extensively in the book. We pause here, and reflect on what we have said. Most people think that finance is best left for the financial specialists, while other disciplines can address our everyday lives and needs. Consequently, financial economics, or basic financial math, is not universally taught either in high schools or college. In this book, we hope to change your mind about finance and economics, and convince you that you can personally benefit from a better understanding of finance. We welcome you on your journey through the ideas of finance. Next, we start with a deeper understanding of risk.

CHAPTER 3 UNDERSTANDING RISK

“There are risks and costs to action. But they are far less than the longrange risks of comfortable inaction”. —John F. Kennedy

What is Risk? Risk is a fundamental concept in finance – and all of life. We simply cannot understand finance without understanding risk.55 Similarly, in real-life, we simply cannot function without understanding and adjusting for risk. What do we mean by risk? Is there a difference between what we mean by risk in everyday life, and what finance tells us about what risk? We first take a systematic look at how we understand, adjust for, and manage risk. The basic definition of risk is the potential exposure to an outcome that is not known. We often think of risk as consisting of adverse outcomes, such as a new situation, a loss, or a danger.56 The more likely the adverse outcome, the bigger the risk. The bigger the exposure, the bigger the risk. Note that we are contemplating the potential for risk before it occurs, rather than looking back afterwards. Distinguishing between the possibility of a negative outcome and the realization of that outcome is important. Adverse outcomes may, or may not, be realized. Even if an adverse

55 Economists William Sharpe, Harry Markowitz and Merton Miller received the Nobel Prize in economics in 1990 for their work on risk models used in investments. 56 We could get more detailed and discuss upside and downside risk, knowable and unknowable risks, tail risks and risks where outcomes themselves are not known. For our purposes in this book, we will keep it simple at this point and define risk as an umbrella measure covering uncertainty, ambiguity and likelihood of loss. We will discuss these issues in more detail later in the book.

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outcome is not realized, if the exposure or the possibility has increased, then risk has increased. What is an adverse outcome? Anything that can make us unhappy is an adverse outcome. This can include loss of life, property, wealth, freedom, or just loss of happiness. As our intuition would suggest, there are multiple channels of risk. In life, we can think of the loss of life, health, marriage, and loved ones. Risk can include social rejection, loss of respect, and isolation. In finance, risk can refer to the possibility of a wide variety of outcomes, including bankruptcy, losing some of our assets, our inability to access our assets, or our inability to engage in certain choices. In the most part, the concepts of risk in finance and risk in life are similar. They both refer to the possibility of losing what we value. It is helpful to think of risk as being comprised of two components. One is the likelihood that an adverse event will occur. The other is the magnitude of the consequences. Hence, we can also think of risk as the probability multiplied by the magnitude of extreme adverse outcomes. As the unknown increases, risk increases. One example of these extreme outcomes in finance is bankruptcy or insolvency. Insolvency can occur when the cumulative losses on our investments eat into our assets such that the value of our assets falls below our obligations and our equity position becomes zero or even negative. When our assets get close to becoming insufficient to pay off our debts, then we may default on our promises and the creditors can take over the assets. This is the risk of bankruptcy. Next, we start with basic financial lessons on how to understand and deal with risk. As we go through each finance lesson, we also apply these ideas to the real world. You will see a high degree of correspondence between finance lessons and real-world lessons in this chapter.

Measuring and adjusting for risk of loss Suppose we are considering an investment. We would want to know the potential upside and downside risks. With public companies, we can get a

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good idea by looking at historical price or return data which is readily available. Earlier, we saw that one component of risk is the probability of good and bad outcomes. In the stock market, one way to measure this risk is by examining the likelihood of price increases and price declines. To illustrate the concept of risk, we examine the day-to-day returns to one individual stock, namely, Bank of America’s publicly traded stock (Ticker BAC).

3.1: Bank of America Stock Returns 0.08000 0.06000 0.04000 0.02000 0.00000 18/09/2014 06/04/2015 23/10/2015 10/05/2016 26/11/2016 14/06/2017 31/12/2017 19/07/2018 04/02/2019 -0.02000 -0.04000 -0.06000 -0.08000 -0.10000

Five-year daily returns for BAC from January 28 2014 to January 25 2019 are shown in Figure 3.1. The daily returns are slightly positive, averaging 0.058 percent per day. A stock’s return on a given day is just the amount of increase or decrease in the stock’s price on that day, divided by the price on the previous day (the return is the most common and quick way to discuss a stock’s performance). However, there are also a lot of up and down days, indicating significant risk to owning BAC. Of the 1,257 trading days, BAC returns are negative (prices declined) on 597 days. This is about 47 percent of the days. The rest, or 53 percent of the time, the returns are positive. Hence, on a given day, the BAC stock price is slightly more likely to go up than it is to go down. When BAC goes up, it averages 1.167 percent. When BAC declines, it averages 1.167 percent. Once again, the fact that the owner of BAC stock can experience

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a significant loss as often as a significant gain indicates a large amount of risk. One way to adjust for the risk of the stock is to compute average returns. To compute average returns, we multiply the probability that BAC declines with the average returns when it declines (the bad outcome) and the probability that it increases with the average returns when it increases (the good outcome). Thus, the average return to BAC equals 0.47 times -1.167 percent + 0.53 times 1.167 percent, or 0.058 percent. The average return computed this way exactly equals the average return over the entire five years, telling us that our math is correct. To summarize, risk can tell us the likelihood of good and bad outcomes. We need to pay attention to both good and bad outcomes, as well as their likelihoods, instead of focusing exclusively on either the good or bad outcomes themselves. We also need to adjust for risk by computing average or expected returns, which means multiplying each outcome with the probability of that outcome and adding up across all possible outcomes. The expected return gives us what we need to know and pay attention to: In the long run, the owner of BACs can expect returns close to the average.

Measuring and adjusting for correlation risk A second concept of risk in finance is the correlation risk. A situation is more risky if it is correlated with other adverse events. Similarly, a stock is more risky if its return is more highly correlated with the overall state of the economy, or the return on the market. This means that the stock gains even more value when the economy, or the market is up, and the stock loses even more value when the economy is down. Why is this bad? Why does correlation matter? It matters because the fluctuations in the value of a given stock hurt us more when the rest of our portfolio loses value. This is what positive correlation means. The market falls when the economy goes into a recession. When this happens, many people lose their jobs. This is what ‘the market is down’ means. Hence, if we own BAC, negative fluctuations in the value of the stock make us even poorer. If the BAC stock is positively correlated with the market, this hurts us even more, because our other assets will make us even poorer still.

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In everyday life, this has a name. It is called ‘getting kicked when you are down’ and, indeed, it can hurt. Hence, the presence of positive correlation means that a negative outcome (getting kicked) is more likely to occur together with other negative outcomes (being down). This positive correlation makes the single action, in this case holding BAC, more risky and less desirable. If there is less correlation, no correlation or even negative correlation, then there is less risk, no risk, and even protection against risk. Hence, we would consider a stock less risky if it is less highly correlated with the market. This means that the stock gains less value when the market is up, and the stock loses less value when the market is down. Consequently, this less risky stock hurts us less when the rest of our assets lose value. No correlation means no risk. Short-term US government bonds are considered virtually risk-free, since they are guaranteed by the government and investors have confidence that the US government will not default on its debt. Hence, there is no correlation between what the government bond pays and the state of the rest of the economy. Consequently, we would consider the government bonds to be risk-free. A negative correlation means protection against risk. Many investors are attracted to gold, even though gold does not produce income. What makes gold an attractive investment is its potential negative correlation with overall business conditions. If the economy falls apart, gold would (should) maintain, or could even increase, its value. Hence, it is this presumed negative correlation that makes gold an especially attractive investment vehicle for some people. Using statistical tools, we can measure correlations. In this book, we will take a more informal approach and use graphs to measure correlations. As the barometer of overall business conditions, we use the market index measured by the return on Standard and Poor’s 500 Index, which represents a value-weighted average of the stocks of the 500 large public companies in the US. Suppose that we want to know the correlation risk of Bank of America’s stock (BAC). To calculate this, we need to know how strongly BAC is correlated with the market’s return. Figure 3.2 illustrates the returns to BAC against Standard and Poor’s 500 Index returns, which is a proxy for the

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market index in the US, over the same five-year period, from January 28 2014 to January 25 2019. The return on BAC is shown on the vertical axis, while the return on Standard and Poor’s 500 Index is shown on the horizontal axis. Each data point shows the realization of the return to both BAC stock and the S&P 500 on a given date. As is illustrated, most data points fall in positively sloped directions. A positive slope means a positive correlation between BAC stock and the market. The solid line shows the line of best fit for the scatter diagram. First, we see the dispersion in BAC returns. Once again, there is a lot of risk on a day-to-day basis. There have been some days when BAC lost more than 7 percent in one day. Hence, this dispersion, especially in the lower half, tells us that the BAC stock is relatively risky. The graph also shows a strong positive relation between BAC returns and the market returns. A positive relation means that BAC stock and the overall stock market tend to go in the same direction, more often than not. In fact, the slope of the line of best fit is 1.32. This just means that when the market rises by 1 percent, BAC stock rises by 1.32 percent, on average. When the market falls by 1 percent, BAC stock falls by 1.32 percent, on average. Hence, the positive slope means that bigger losses on BAC stock are more likely to occur when the overall market is down. We say that BAC stock is risky because it is highly positively correlated with the market. When the market goes up, BAC goes up even more. When the market declines, BAC declines even more than the market. The fact that when the market is down and we lose money on the rest of our assets, BAC also declines, makes BAC stock even more risky than the average stock. The slope of the line of best fit is called the beta of the stock. In this case, the beta of BAC is 1.32. Betas greater than one represent greater-thanaverage risk stocks. Beta measures that are less than one represent lessthan-average risk stocks.

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Figure 3.2: Bank of America correlation with 0.1 market 0.08 0.06

BAC's Return

0.04 0.02 0 -0.02 -0.04 -0.06 -0.08 -0.1

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

S&P 500 Return

Measuring risk in real life Finance measures and real-world measures of risk are, in fact, similar. Fluctuations are important. Both the probability and severity of losses are important. Correlation is important. Betas are important. Tail risk is important. Let us give some real-world examples of risk and management of risk. Think of insurance. Why do we value home insurance, even though on average we expect to lose money? We are happy to lose money on insurance because it reduces our tail risks, which refer to rare events with catastrophic outcomes. Hence, we value home insurance, not because we expect to make a profit, but because it reduces the correlation between our wealth and the value of our house. This is similar to the gold example earlier. When our house maintains its value (it does not burn down), we pay an insurance premium. When our house is burned to the ground (and we face the risk of being homeless), we receive money from the insurance company. Thus, cash flows from the insurance contract are negatively correlated with the value of our house,

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and they eliminate a tail risk. This provides a safeguard against a catastrophic event. Similarly, we can think about the likelihood of losing our job as a potential risk. We would also consider it more risky if this likelihood increases when the likelihood of other adverse events in our lives increases, such as when our house loses its value or when we fall ill. Like the finance example, if we think there is a positive relationship between the loss of our job and other adverse events, then we can say there is a positive correlation between the assets (our job, house, etc.). This positive correlation makes our jobs riskier. In real life, we may not explicitly think of risk as a positive correlation; nevertheless, we see upon deeper reflection that correlation is an important part of risk. In fact, the expression ‘kicking someone when they are down’ refers to a positive correlation between adverse events. Getting kicked when you are down is obviously worse than getting kicked when you are standing strong. Thus, whether we think in these terms or not, correlation plays an important role in our personal and professional lives, including our marriages and relationships with our friends and family. Consider an example from marriage: Think of the traditional American wedding vow: “I, Bob, take thee, Janet, to be my wedded wife, to have and to hold, from this day forward, for better, for worse, for richer, for poorer, in sickness and in health, to love and to cherish, till death do us part, according to God's holy ordinance; and thereto I pledge thee my faith". What exactly does this wedding vow mean? This vow is saying that one’s love and devotion to one’s spouse is going to be uncorrelated with one’s condition in life. Thus, there is an appreciation for uncorrelated affection and love. Uncorrelated love is valued more than correlated love. Who would want a spouse who loves and cherishes them in wealth but not in poverty? Who would want a spouse who loves and cherishes them when they are young and healthy, but not in old age, or when ill? The traditional wedding vow is, in fact, promising to be a zero-beta spouse. Again, zero-beta means uncorrelated with life’s fortunes. And we think a zero-beta spouse is much better than a positive beta-spouse.

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We can also think of the beta of our friends and relatives. Do you want positive-beta friends or zero-beta friends? How about relatives? What happens when someone wins a lottery? Suddenly, they would have a lot of long-lost friends and relatives. What should we call these people? They would be positive-beta friends and relatives, for sure. Just like we want to limit our financial exposure to high beta stocks (as we will explain), it is best to keep your distance from your high-beta friends. Can we measure the beta of our friends? The answer is, absolutely, yes. Like anything else, a friendship has its vicissitudes. This is normal. This is part of all friendships. Thinking about correlation forces us to answer the following question in our personal lives. We may have a great, wonderful, mutually beneficial, relationship with a friend. However, this is not sufficient. We also need to think what is likely to happen if we experience a misfortune. Will our friend be there for us? Worse, will he or she turn into an enemy? If so, then this is a high-beta friendship, and certainly not as valuable as a zero-beta friendship. You should seriously think about ending such relations, no matter how good they are today. Some of us think risk is the same as uncertainty or fluctuation. This is true to some extent. If our relationship with our friend is highly volatile, this would make it riskier. However, we can do better and measure betas or correlations. To measure the beta of a friend or future spouse, what we need to do is to think of a thought experiment where we measure whether our ups and downs are correlated with the payoffs our friends get from us. To measure the beta of your friends, try to imagine what would happen if you were to make a reasonable request (like reading a draft of a chapter of a book you are writing), or if you were to ask for career advice, if you suddenly lose your job or social standing. Again, you would want the help to arise out of friendship, as opposed to some implicit quid-pro-quo bargain. Now, you would measure how nice they are to you. If they are zero-beta friends (which is what you want), they should continue to be nice to you and help you out. If they are positive-beta friends, they will stop being nice, now that you need something from them. This is how you can measure the beta of your friends.

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A positive beta relationship can manifest itself in another way. If some people want something from you, they will approach you with all smiles – they will suddenly become very nice to you. Once again, this part is understandable. After all, they want you to do them a favor. Suppose you did help them out. The critical issue now is how they behave after they get what they want. If they become cold after the favor is completed, once again, you know you have a positive-beta friend. Do negative beta friends or relationships exist? The answer is yes, but they are not as common. We can potentially think of certain family members having negative betas. They will provide resources and generosity to us when we are in need, and when we are happy and thriving, they are content to sit back and lovingly wait, ready to swoop in at a moment’s notice should our fortunes suddenly turn south.

Dealing with Risk in Real Life There are six basic ways to deal with risk: 1- Avoid high risk; 2- Insist on explicit legal protections; 3- Diversify; 4- Keep the risk, but require compensation for taking it on; 5-Purchase insurance; and 6-Divest. Consider the case of Bernie Madoff. He stole tens of billions from his investors. Using simple finance tools, can we avoid becoming prey to this? Finance tells us that the most important risk element in business dealings with other people is the risk that arises from the character of that person. Finance tells us that if a potential business associate, client, or customer, does not pass the character or trust test, we should simply not deal with them. Notice that finance does not say if the potential business partner is low IQ, cash-poor, or lacking in advanced degrees, do not deal with them. Instead, first, a potential business associate must be trustworthy. The same caveat applies in life. If any friend, business associate, co-worker, or a potential romantic partner, does not pass the character or trust test, you need to dump them too. If you cannot be near 100 percent sure that they are honest, you dump them. It is that simple. Following this rule will save you a lot of grief later.

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One characteristic of honest people is that they are open and transparent. They have nothing to hide. Bernie Madoff failed this simple test. He was extremely secretive. He never even publicly acknowledged that he was raising money from his investors, since he was not even registered as an investment advisor.57 This is a serious red flag when it comes to honesty. In business, the first and the most effective way to deal with extreme risk is to avoid high levels of risk or catastrophic events. Simply step out of the way. This is the most basic lesson of finance. The same lesson also applies in banking. In fact, the most basic way banks deal with extremely risky borrowers is by denying credit. This is called credit rationing. This concept of trust-comes-first means denying credit to (refusing to do business with or refusing any kind of interaction) a potential high-risk situation. If someone wants to do business with you, but you are not 100 percent satisfied that they pass the trust test, you should not consider dealing with them. You do not need to inquire any further. It is not possible to compensate for lack of character no matter how good everything else looks. Suppose you work for a bank and the bank is contacted by a potential new borrower. Assume that the probability that this is a fraudulent borrower is high. What is the appropriate response here? Can you demand a higher interest rate to offset this risk? How about a higher amount of collateral? Can you ever make an acceptable rate of return if you lend to this borrower? The answer is no. In fact, there is nothing you or the bank can do to earn a profit from a fraudulent borrower. Suppose that the bank wants to lend to a fraudulent customer at a high interest rate. How will the borrower respond? The borrower will simply agree to the high rate. If the borrower does not intend to pay the bank back anyway, promising to pay a high interest rate is not a costly promise to make. Suppose instead, the bank demands collateral in the form other assets. This particular borrower will, again, agree to it. There have been many cases with fraudulent borrowers that the same assets have been pledged

57 https://www.forbes.com/2009/01/27/bernard-madoff-sec-business-wall-street _0127_regulators.html#13d7d33b5c28

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as collateral to multiple creditors, leaving banks holding the bag when they try to collect on the collateral after the creditor defaults.58 The bank can demand frequent audits. Would this work? The answer is still no. Audits happen after the funds are provided. Thus, this is not much of a deterrent on fraudulent borrowers either. An audit only discovers fraud after the fraud is committed. By that time, it is too late already. Once the borrower has absconded with the bank’s money, the audit is totally useless. The key theme is that no matter what the bank requests, the potentially fraudulent borrower will say “Yes, I agree to it”, and still cheat the bank. Hence, if the borrower is likely fraudulent, none of these measures will help. The borrower will not be deterred by a high promised interest rate, no matter how much you demand it. Similarly, the borrower will not be deterred by the amount of collateral or the frequency of auditing. The borrower is simply interested in taking the bank’s money and running with it. No amount of precautions can help the bank. The only thing the bank can do is to say, “Thanks for your interest, but no thanks. We simply cannot, and will not, lend money to you”.59

Avoiding High Risk Situations in Real Life The same principle holds in real life. You cannot deal with risky and fraudulent types in the real world. You cannot deal with unknown outcomes or catastrophic events. When the situation is too risky, the only thing you can do, and you should do, is to step out of the way. People play games. There are many games you just cannot win. Just because you cannot win a particular game does not mean you should lose

58 See, https://casetext.com/case/grede-v-bank-of-ny-mellon-corp-in-re-sentinelmgmt-grp-inc 59 How do you measure someone’s trustworthiness? It is not easy, since someone who is dishonest will not lie 100 percent of the time, so it may be hard to tell from their public track record. One subtle way – you could ask them their opinion on some clever but less-than-ethical types. If they approve, you may want to reevaluate your relationship.

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either.60 You simply need to step out of the risky and fraudulent games that you know you cannot win. Suppose you believe that a friend or a business associate abused your trust. What do you do? Should you give them a second chance? If the failure occurred due to an inadvertent mistake, you might give them a second chance. If the failure occurred due to willful and premediated fraud, then there is a character flaw, and you should avoid this person. The dictum, ‘fool me once shame on you, fool me twice shame on me’, applies here. Consider the following examples. Suppose you are interested in buying a sandwich shop. You talk to the owner, Jerry, and he seems to be a nice guy. After much communication back and forth, negotiations progress and you ask Jerry for copies of his tax returns. Jerry says that unfortunately he is not good at keeping records, they are kind of messy, and that they would not be particularly useful to you. What should you do? Is this a problem for you? Should you go ahead with the transaction, but offer a lower price? The answer is no. This is not a problem for you, and you should not go ahead. You need to say, “Thanks Jerry, but no records, no deal”. That is it. Just walk away. Now, it becomes a problem for Jerry. By simply walking away, you avoid getting into a situation where you cannot even assess the risks. You might think this is obvious. Who would ever invest without financials? As obvious as this simple rule is, many sophisticated investors did not practice it. In fact, Theranos founder, Elizabeth Holmes, raised $700 million from sophisticated, private investors without ever producing audited financials.61 Suppose you have an apartment to rent. How do you deal with all kinds of applicants who may be interested in renting your apartment? As we discussed before, you can demand to see their credit history and credit

60 John Nash (along with John Harsanyi and Reinhard Selten) was awarded the Nobel

Prize in economics in 1994 for his work on non-co-operative games. 61 https://www.marketwatch.com/story/the-investors-duped-by-the-theranosfraud-never-asked-for-one-important-thing-2018-03-19

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score. If they refuse, or if you are not fully satisfied, you can say no. This is the easiest way of dealing with undesirable or unknown levels of risk. You are new in a city and you are looking to make friends. Within a few weeks, you meet a lot of new people. What is the best way to deal with all these new acquaintances? The best way to deal with this indeterminable level of risk is to avoid getting into any serious romantic or business relations with the people you have just met. You need time to get to know them to determine the risks. There is no need to rush in the face of high risks. How do you know if someone is highly risky, or possibly fraudulent? Businesses use credit scores or FICO scores to get some idea.62 In real life, you can never be sure. Our point, however, is not that you should avoid the situations where you know for sure that this person or this situation is too risky. This is obviously true. However, you should also avoid situations where this could be true. If you are not 100 percent comfortable that someone’s character is commendable, simply end the relation or refuse to engage in the first place. After all, this is how sophisticated banks and lenders do it. We can give many examples of this type in the real world. When the consequences of risks are catastrophic, or simply indeterminable, the best way to deal with them is to avoid them altogether. Take something as simple as crossing the street. This is something we do all the time. While the probability is small, being hit by a car is a catastrophic event. This is an example of tail risk. Statistics show that more and more people are distracted with their music and smartphones these days, and pedestrian deaths in the US in 2018 hit 6,227, which is a 28-year high.63 We would make the argument that in this case, it is difficult to properly calculate the level of risk involved. Then, what is the answer? Simply make a resolution never to jaywalk especially while you are talking on the phone or listening to music. This is likely to reduce your risk significantly.

62

We will discuss FICO scores in more detail later in the book. See, https://www.cnbc.com/2019/02/28/pedestrian-deaths-hit-a-28-year-highand-big-vehicles-and-smartphones-are-to-blame.html 63

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Many of us have been told by our mothers to avoid risky situations. We do not escalate verbal arguments with strangers. It is better to walk away and calm down first. We do not engage opposing drivers in traffic who are enraged at us.64 We simply drive away. These are examples of avoiding tail risk. There is an important difference between legal drugs (such as alcohol and tobacco) and illegal drugs (such as heroin and fentanyl). With legal drugs, the risks are well-known and acceptable to some. With illegal drugs, the risks are not even quantifiable. The very first tablet a person ingests may be tainted, leading to an unacceptable tail risk (death). Consider additional everyday examples. This admonition applies even more when dealing with total strangers who advertise online. Suppose you saw a car advertised online that looks interesting. You would like to testdrive this car. You call the owner, and he invites you to come over to his house and look at the car. What should you do? This is a new, indeterminable, and potentially high-risk situation. It may be perfectly fine, and then again it may not be fine. Finance tells us that, at the very least, you need to be cautious. The simplest thing you can do is to meet this person in a public place with many people around. Even better, bring a couple of friends with you to help you look the car over. According to finance, the best clue to a person’s character is his or her past behavior. If someone you have met has been willfully dishonest or unethical, with anyone or anything, in any way or shape in the past, you should avoid them. If a person is systematically cheating on his taxes, you should avoid them. If this person invites you to cheat on the insurance company, you should avoid them. If a person is cheating his employer, you should avoid them. If this person cheated his clients in the past, you should avoid them.65 This is the method utilized by finance. Suppose that you want to know whether someone you just met would make a potentially good spouse for you. How do you evaluate this person? 64

https://www.cnn.com/2019/09/10/health/road-rage-survival-tips-wellness/ index.html 65 Many investors thought that Madoff was generating extra returns in his investment fund by front-running his market-making customers. This simple rule would dictate that they avoid Madoff.

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The answer is to look in their past. If this person did not show up for her wedding after all the arrangements have been made, she presents tail risk. You should probably take a pass here. We can apply this idea to another setting as well. Suppose you are thinking of buying a house. If you find out that this house sits upon a major earthquake fault line, it is probably a good idea to move on, regardless of the price. This house has tail risk. Thus, the first lesson of finance regarding excessive or indeterminable risk is to avoid it. Such risk is unmanageable. This simple lesson will go a long way in managing your risks. In a way, this lesson from finance is not much different from what our parents taught us all along - to simply avoid high risk situations.

Insist on legal protection Finance also tells us that a good way to manage acceptable levels of risk is to insist on legal protections, such as collateral, to reduce risk. Collateral is an asset that the borrower legally pledges to the bank in case the borrower is not able to honor some of his promises. The collateral legally protects the creditor when things go south. The value of the collateral must be large enough, and maintain its value in most situations, to cover the borrower’s obligations. Thus, collateral protects against risk following a failure. In finance, when we make promises, we put down collateral (money or a deposit) to demonstrate that we intend to honor our promises. For instance, suppose you borrow and sell someone else’s stock. This is called short-selling. Here, you also make a promise to return these shares later on. In this case, the broker will not only not give you the proceeds of the short-sale, but he will also require that you put up margin money (a deposit) to ensure that you will honor your promise. This deposit (collateral) ensures that you will return the shares, even if the stock rises in the future and it becomes more costly for you to do so. In real life, the equivalent of collateral is earnest money. If you hire someone to do some work for you, they will ask for a partial, upfront payment before they start the job. This upfront payment serves as a (partial) guarantee that you will honor your obligations. Furthermore, by

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always asking for regular, partial, upfront payments, the contractor can completely eliminate the risk of non-payment. If you want to buy a house, you sign a purchase agreement that will call for earnest money. If the purchaser violates the purchase agreement in any way, he will forfeit the earnest money. Hence, the earnest money serves to guarantee that the purchaser intends to follow through on their legal promise. Similarly, in real life, you can demand protection in the form of upfront contributions in your personal and business dealings. When a person is proposed to, they expect an engagement ring in exchange for saying yes. You can think of the engagement ring as serving as upfront collateral that the proposer intends to honor their promise. The more expensive it is, relative to one’s earnings, the stronger the message of upfront commitment it demonstrates. If the proposer changes his mind about the marriage, he forfeits the engagement ring. If the proposed changes their mind, they are expected to surrender the engagement ring. Similarly, you can ask your friends, romantic partner, or your business associates, to do something for you that is at least moderately costly. For instance, before you get serious, you can ask your girlfriend or boyfriend to help you clean your apartment when you move. If she or he baulks, then you are getting a strong message about a lack of true commitment. If they do not come through with this simple act of commitment at this stage, they will probably not come through when you need them later in the relationship either. It is better to find this out at the beginning than later on, when your financial interests are all comingled.

Insist on explicit, written, legally-enforceable protection Another way to control acceptable levels of risk is to insist on written legal protection. In a business loan, this is called a covenant. You sign these documents when you borrow money from a bank to buy a house. The bank will not take a verbal agreement or a handshake here. It demands written, legally enforceable, protection. Similarly, when you rent a house, you sign a renter’s agreement or a lease contract. This document specifies your rights and obligations, as well as those of the proprietor. Having a written document leaves no doubts as to

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one’s legal rights and obligations. This document protects both the property owner as well as the tenant. It is generally advisable to write down your understanding of the commercial terms of a business transaction.66 If someone wants to borrow money from you, even if this person is a relative, you should formally document all the arrangements and then have everyone date and sign the relevant agreements. It is best to discover any misunderstandings and clarify them at this stage, before money exchanges hands. Once the loan is made, you cannot go back and insist on a written document. Similarly, if you intend to go into a business arrangement, it is also a good idea to write everything down and have everyone sign it. This is your partnership agreement. This document should not just specify what is going to take place under current conditions, but it should anticipate changes in future conditions, and specify what will take place in these changed circumstances. Just going through such a partnership agreement document will make you more aware of potential risks, and give you an opportunity to address these risks in advance of making the commitment. In many high-level positions, the employer and the employee enter into an employment contract that sets out the terms of employment. Noncompetition agreements, or arbitrator agreements, are also examples of this type of employment contract. These contracts specify not just the rights and responsibilities of both the employee and the employer under current conditions, they also specify under what conditions the employer can terminate the contract. However, in all these contracts, some portion of the terms may not be enforceable. These terms are instead trumped by legal precedent, even when made explicit in the contract.67 One of the biggest legal commitments we make in our lives comes in a marriage. Unfortunately, the marriage certificate we sign is not the same as the one we sign in a bank’s office, or when we buy a house. Unlike a loan agreement, your rights and responsibilities are not fully disclosed to you at 66 Oliver Hart and Bengt Holmstrom received the Nobel Prize in economics in 2016 for their work on moral hazard and incomplete contracts. 67 For example, in Vermont, one of the most renter friendly states, a proprietor must provide at least 48 hours’ notice before entering a rental property. The tenant has this right regardless of if, say, the lease contract explicitly states that the proprietor can drop in for breakfast if he smells bacon sizzling through the open window.

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the time you sign the marriage certificate. You discover them along the way. A greater proportion of the rights and obligations of a marriage contract are stipulated by legal precedent than in the other types of contracts mentioned. The best way to protect yourself against the potential economic risks relating to a divorce is for the parties to enter into a prenuptial agreement. For this, you will need the assistance of a lawyer specializing in family law. A full-blown treatment of prenuptial agreement is, again, beyond the scope of this book. While no one wants to think about a divorce at the time of the marriage, it is a fact that about half of marriages end in divorce.68 In some European countries, this rate is much higher.69 Given this high risk, couples should consider whether it is appropriate for them to enter into a prenuptial agreement. Such agreements can set forth, not just financial arrangements if the marriage breaks down, but also children’s rights, custody issues and visitation issues. If these issues become contentious when there is no marriage, they will become impossible to sort out after the marriage breaks down.

Diversify You have worked hard all your life and saved one million dollars for your retirement. What should you watch out for? Is there still a risk of losing everything with one wrong move? Another important insight from finance is to diversify to reduce risk. Diversification can eliminate tail risks. It will protect against catastrophic outcomes. As we will see, risk is a relative concept. A stock or any other asset does not possess some absolute risk. Whether it is risky, and the degree to which it is risky, depends on the rest of the assets that the particular stock is held

68

See, https://www.apa.org/topics/divorce/ https://www.statista.com/statistics/612207/divorce-rates-in-european-countriesper-100-marriages/ 69

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with. A given asset may be considered risky in one context, but not in another well-diversified portfolio. To diversify means that we hold lots of different kinds of assets, instead of putting all our wealth in a single type of asset. We need to diversity across industry, asset class, and geographic location. Allocating our investment across 100 banks is not considered effective diversification, since all of it is still in the same industry. When we diversify, we rely on the fact that asset returns are not perfectly positively correlated. This means that the loss of value when one asset goes down can be offset by the gain in the value of another asset that we hold. Thus, the degree of diversification depends on the degree of correlation. This less-than-perfect positive correlation allows us to offset some losses against some of the gains and thus to reduce risk. In everyday terms, this is called not putting all of one’s eggs in one basket. To explore this idea further, look at Table 3.1. Here, instead of putting all our money into one stock, we now have two stocks, a bank stock and a collection agency stock. They are both risky. The bank stock does well in business expansion (boom) and returns +30 percent, but does not do well in recessions (bust) and returns -10 percent. In contrast, the collection agency stock does well in recessions since they get lots of business, and returns +30 percent, but does not do well in business expansions since most people pay their bills and returns -10 percent. Table 3.1: Risk and diversification Boom 50% probability

Bust 50% probability

A. Bank Stock

30%

-10%

B. Collection Agency Invest $50 in Bank and $50 in Collection Agency

-10%

30%

$10 or +10%

$10 or +10%

Table 3.1, above, also shows the probabilities of boom and bust. Each is represented as being 50 percent likely for convenience. Based on these numbers, we can compute expected returns to each stock across the

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business cycle. There is a 50 percent likelihood of earning 30 percent and 50 percent likelihood of earning -10 percent for both stocks. We now use the fundamental risk adjustment we learned above, and compute expected return. Thus, our expected return for each stock is 10 percent70 across the complete business cycle. Based on these characterizations, both stocks are risky. In either stock, you earn an average of 10 percent, but with risk. You can either gain 30 percent or lose 10 percent. Now let us see what happens when we diversify. Suppose we have $100 to invest. Instead of putting all our money in either the bank stock or the collection agency stock, we are going put $50 in bank stock and $50 in collection stock. If the economy expands next year, our $50 invested in ownership of the bank will earn +30 percent, or $15. Our $50 in collection agency stock will lose 10 percent, or earn -$5. Our expected earnings will be $10 (=$15 - $5) or 10 percent of our initial investment of $100. If the economy contracts next year, our $50 in the bank will earn -10 percent, or -$5. Our $50 in collection agency stock will earn +30 percent, or +$15. Our expected earnings will again be $10 (=$15 - $5) or 10 percent of our initial investment of $100. Both stocks held individually are risky. But we are not going to put all our money in one of these stocks. Instead, we diversify (spread our investment) across two risky stocks. Now, our overall portfolio always earns $10 or 10 percent. Whether the business is expanding or contracting, we expect to earn 10 percent. Hence, our overall portfolio has no exposure to business conditions. It is risk-free. Our example illustrates that risk is not additive. You can invest in two risky stocks, yet your portfolio may have much less risk than the individual stocks in that portfolio. Your portfolio may even be risk-free (as shown by the example above). Consider our example in more detail. How did we eliminate all risk by diversifying? The trick here was that we made up an example where risks 70

The math is as follows: 10% = 50% * 30% + 50%*(-10%) = 15% - 5%

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were negatively correlated across the two assets. With negative correlation we were able to eliminate all risk. Thus, the lesson from finance is that while uncertainty is part of the risk, so is correlation. Bigger uncertainty gives you bigger risk. Bigger positive correlation also gives you bigger risk. Zero correlation or negative correlation eliminates or reduces risk. The example shows that diversification is an important tool to deal with risk. It is very cheap and very effective. This is perhaps the only time we get something for nothing. By diversification, we did not lose any of our expected return. Each stock had an expected return of 10 percent. Our portfolio also has an expected return of 10 percent. Hence, expected returns were exactly preserved. What we lost, is risk. Our portfolio no longer fluctuates across the business cycle. It always gives 10 percent whether the economy is expanding or contracting. Diversification becomes especially important as we approach retirement age, and we do not want to risk everything on a single investment. This lesson from finance states that you should diversify your risky assets as much as you can. This means not investing in one individual stock or starting a new and unfamiliar business at age 65. This means investing in as many stocks as possible, the upper limit of which is what we call the market portfolio. To do even better, you can diversify your assets across the globe. We said earlier that diversification in the stock market is very cheap. There are many mutual funds that allow investors to achieve diversification, even global diversification, at little cost. A good example is Vanguard Group, Inc.,71 which has pioneered non-profit, low-cost, passive index investing. The annual expense ratio for Vanguard’s 500 Index Admiral Shares is only 0.04 percent.72 By simply buying the fund, your portfolio will closely track the returns of Standard and Poor’s 500 index, which is a broadly diversified index of large US stocks. Thus, you can invest $10,000 in this fund and pay only $4 in expenses per year.

71

See, https://investor.vanguard.com/corporate-portal/ See, https://investor.vanguard.com/mutual-funds/list#/mutual-funds/assetclass/month-end-returns 72

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Diversification across time and assets also reduces the likelihood of a loss. In Figure 3.1, we saw that the likelihood of a day-to-day loss in BAC stock is 47 percent. In the next chapter, we will see that a well-diversified portfolio of 500 stocks (called the S&P 500 Index) only declines in about 27 percent of the years on an annual basis. Hence, using diversification across time and many stocks, we can cut the likelihood of a wealth loss by almost half. We can apply these lessons to everyday life. Diversification in life is also important. Your happiness or your livelihood should not depend on a single business, person, or a single company. You should cultivate many friends and acquire different skills that can be useful in different industries or different companies, and spread your savings over many assets. Take the case of Elizabeth who started her own business at age 55. After working at the World Bank on a high salary, Elizabeth followed her passion and started an art gallery inspired by African art.73 Unfortunately, when the store failed, it wiped out a big chunk of Elizabeth’s retirement savings. Putting much of her accumulated wealth late in life into a single asset created a tail risk for Elizabeth, putting her on a financial cliff edge late in life. What could Elizabeth have done better? The concept of diversification applies here. One possibility is to take on enough partners to limit her investment in the store (and her maximum loss) to, say, no more than 20 percent of her savings, an amount that would not jeopardize her retirement plans. Ted Turner’s experience is another famous example of the value of diversification. After he sold his cable channels (CNN, TBS, TNT) to Time Warner, Turner kept his wealth invested in Time Warner stock. Following Time Warner’s merger with AOL in January 2000, the stock price collapsed by more than 95 percent from the highs of $170 in 1999 to the lows of $5 in 2002, and in the process, wiping out about $8 billion of Turner’s

73 https://www.pbs.org/newshour/show/55-unemployed-faking-normal-onewomans-story-barely-scraping

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wealth.74 This risk could have been easily avoided by investing the proceeds of the sale of the cable business in a well-diversified portfolio. Second, we need to think about correlations. We make two great friends who are sisters. This is not considered diversification. If we lose one friend, the other friend is also likely to go away. If a given adverse event is more likely when other bad things can occur in our lives (positive correlation), then that would be a bigger risk than otherwise. Should you worry about your job? How likely is it that you will lose your job? Is this likelihood related to global economic conditions? The beta of your company can inform you about these risks. Suppose you work for General Motors. You can look up its beta in yahoo.com/finance. GM’s beta is given as 1.21 over the past three years.75 This means GM has above-average systematic risk. The higher the beta, the higher the risk. Suppose global competition were to put GM in a financial bind. It is possible that GM would start laying off people. You may be one of those laid off. The higher the company beta, the more exposure you have to global economic cycles. Consider another example. Suppose you have been living in a onecompany town, and you work for that company. You have a good job, a nice house, and a good retirement plan. You figure you are well set. However, given that you live in a one-company town tells us that your employment and house values will be highly correlated. You can see where we are going with this. It is true that you are all set at this time, with employment, housing, and retirement, as long as the one company does well. If the company does not do well, it sets up a chain reaction that can simultaneously hit your salary, the value of your house, and the value of your retirement plans. You have too much correlation risk. Too much of your livelihood depends on the performance of this company. While we exaggerated here by pointing to a single-company town, similar risks are present if there are two or three dominant companies in your

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https://www.seattletimes.com/business/turner-turns-page-after-losing-billions/ https://finance.yahoo.com/quote/GM/key-statistics?p=GM&.tsrc=fin-srch

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town. When any one of them suffers, it will create a chain reaction of additional adverse events.76 Rochester, NY is a good example of this risk.77 How do you deal with these correlated risks? The answer is simple. You need to diversify as much as possible. For example, even if the company gives you discounted shares for your retirement plan, you need to sell these shares and transfer these funds to a globally diversified portfolio, as soon as the company allows you to sell them. Do not hold on to the shares of your employer in your retirement plan any longer than you must. What else can you do? Another precaution you can take is to buy the shares of competitors. If they outcompete your firm, you can still receive some protection. Alternatively, you can short-sell the shares of your employer if you are allowed to. We do not mean short sell as much as you can and bet against your company. However, by short-selling your employer's stock a little bit, you can offset some of the fluctuations in your compensation or bonus that depends on the company’s stock price.78 Is there anything else you can do? Suppose your spouse also works. You can reduce the risks for the family by making sure that your spouse does not work for the same company. This way, you can diversify family income. Any more precautions you can take? You can also choose not to buy a house in this town. If you already own a house, you can sell it, and rent instead. This way, if the company lays off people and housing prices suffer, you can actually benefit from this by renting more cheaply than before. Furthermore, you do not buy large tracks of land or invest in additional real-estate in the town. Finally, you can consider moving to a bigger town where your entire livelihood is not exposed to a single employer. The bottom line is that you want to reduce your exposure to the fortunes of this one company as much as possible by making small investments in 76

There are many examples of devastated towns after the only employer in town leaves. https://www.nytimes.com/2004/04/11/nyregion/all-nest-eggs-one-companybasket-corning-shows-risk-betting-fortune-employer.html. https://www.nytimes.com/2004/04/11/nyregion/all-nest-eggs-one-companybasket-corning-shows-risk-betting-fortune-employer.html 77 https://time.com/3810113/kodak-memory-city/ 78 Obviously, you need to find out whether your employer has any rules against this strategy.

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areas that will remain constant, or perhaps increase in value, when your company’s value decreases. The key to understanding and managing risk is to think of correlations. If you are a dual-career family but both of you work in the same firm or the same industry, then you are facing greater risks than otherwise. You are facing lower risks if your spouse works in an industry that is less exposed to recessions, such as movie theaters, liquor stores, or home healthcare services.

Keep the Risk but Require Compensation for Risk Another way to deal with risk is to require compensation to hold risky assets, with quantifiable and manageable risks. For instance, we showed earlier that BAC is riskier than the average stock. Similarly, common stocks are more risky than bonds. Consequently, we would require higher compensation to hold BAC or higher compensation to hold any common stocks than to hold government bonds. Finance further tells us that there is a linear relation between beta risk and required compensation (required return). Required return is the minimum return you require to engage in some risky activity or buy a risky asset. If the risk is doubled, then the required risk premium is doubled. If risk is halved, then the required risk premium is halved. This relationship can be measured. In the next chapter, we will see that a well-diversified portfolio of stocks averaged a return of 11.5 percent over the past 90 years, while the average return on risk-free government bonds was 5.2 percent. Thus, on average, stocks paid a premium of 6.3 percent per year as extra compensation for the extra risk.79 This is the extra compensation stocks offer for the fact that they are more risky than longterm government bonds. Since, by definition, the average stock has a beta of 1, this means that if a stock has the same risk as the overall market (beta=1), it should also offer a risk-premium of 6.3 percent. If the current risk-free rate is, say, 3 percent, adding the risk-premium would give us the current required rate of return 79 This is called the equity risk premium. See, Ross, Westerfield and Jaffe, Corporate Finance, 10th edition, Chapter 10.

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of 9.3 percent (6.3 percent risk premium added to the current risk-free rate of 3 percent). Why is this? The reason is simple. If a given stock is as risky as the market (beta=1), but it does not compensate as well as the market (risk premium of 6.3 percent), you would be better served by buying the market index (S&P 500) and getting the 6.3 percent premium on your own. You do not need to own risky individual assets if the compensation is insufficient. What if the risk is half as much (or beta = 0.5)? In this case, finance tells us that the risk-premium should be half as much or 3.1 percent. Adding this to the current risk-free rate, this stock should have a required return of 6.1 percent to be properly priced (3.1 percent risk premium plus 3 percent riskfree rate). What if the risk is twice as much (or beta = 2)? In this case, finance tells us that the risk-premium should be double or 12.6 percent. Adding this to the current risk-free rate, this stock should have a required return of 15.6 percent to be properly priced (12.6 percent risk premium plus 3 percent risk-free rate). Based on this discussion, what is the required rate of return on Bank of America stock? Remember BAC stock had a beta of 1.32. Consequently, the risk premium on BAC stock must be 8.1 percent (1.32 times 6.3 percent). If the current risk-free rate is 5 percent, this means the required rate of return on BAC stock is 13.1 percent. Since BAC stock is more risky than average stock, it must also have a higher required rate of return than the average stock. This simple algebra tells us what we need to know to compute required rates of return on all risky assets. Once we determine risk (beta), we multiply it by 6.3 percent, and add the current risk-free rate. This algebra has a name. It is called the Capital Asset Pricing Model (CAPM). Later, we will discuss an investment guide called the ROI approach. We will see that if an investment has a higher rate of return (ROI) than the required rate, then it is a good project and it should be accepted. If an investment has a lower rate of return (ROI) than the required rate, then it is a bad project, and it should be rejected. We can make this more precise: The investment rule states that if the project’s ROI is greater than the required rate of return, it is a good project. Otherwise, it is a bad project.

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Making sure that any risk asset we are considering buying has a ROI that is at least as high as the required rate of return we can get on our own in the stock market ensures that we get the right amount of compensation for bearing risk. Hence, the proper benchmark is the required rate of return, as we computed above. We compare ROI to the required rate of return to decide if a project should be accepted or rejected.

Buy Insurance Finance tells us that another way to reduce risk is to purchase insurance. We can do this in financial markets as well as in our everyday lives. In financial markets, call and put options serve as insurance contracts. We will see later that buying a call option insures against a price increase. Similarly, buying a put option insures against a price decrease. In life, buying life insurance, health insurance, and home-owners insurance policies, reduces the impact of major adverse events in our lives. We cannot prevent death, adverse weather, or illness, but we can make it less costly and less risky by purchasing insurance. We need life and health insurance when we are young, married, and raising a family. If we were to pass away or become disabled at this point in our lives, our dependents would be devastated. Life and health insurance will protect them when they are most vulnerable. As we get older and save for our future, we can cut back a bit on life insurance. One reason for this is the cost of insurance, which increases exponentially as we age. Another reason is that, hopefully, over time, we build our assets, thus obviating the need for insurance. Once we retire, and we have safely provided for ourselves and our dependents, we no longer need any life insurance.

Divest Another strategy dealing with risk is to divest and transfer. This strategy is particularly effective against the risk of lawsuits. While we may not be able to prevent lawsuits, we can reduce their impact by divesting our assets. Assume that you are a divorced person, you have already built your sizable nest egg, and now you are looking to get married again. One potential risk you face is the risk of a second divorce in the future. One way to deal with

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this risk is to transfer your assets into an irrevocable trust and name your children as the beneficiaries.80 This removes assets from your person into a trust and makes them unavailable to anyone else (including your future spouse) even in the case of a successful lawsuit against you. Another risk we need to deal with is wealth succession. A good strategy to deal with this risk is to transfer your assets into a revocable trust, naming yourself as the trustee and naming your children as the beneficiaries and successor trustees.81 The benefit of this revocable trust is that if you pass away suddenly, your heirs will avoid probate, which is a costly and timeconsuming process whereby a judge makes the ultimate decisions as to how to distribute your assets to your successors. In contrast, having a Will does not avoid probate. A Will is simply a set of instructions to the judge as to what your wishes are. With a Will, your heirs will still have to go through probate, and the judge may or may not follow your instructions. By setting a revocable trust, you completely eliminate the court’s involvement in your personal affairs.

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Be sure to consult with a competent lawyer when you do this. There are many other implications, such as local laws, taxation, and change of your circumstances that the lawyer can help you with. 81 Again, you will need the services of a competent lawyer to do this.

CHAPTER 4 MAKING VALUE-CREATING INVESTMENTS

“Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value”. —Warren Buffett

What is an Investment? Our goal here is to offer practical approaches to help you avoid disasters and increase the value of your most important investments, whether you are earning a college degree, selecting a career choice, buying a house, or starting a small business.82 We have sought to make these approaches accessible for people who are not finance specialists. At the outset, we want to contrast a wealth-increasing investment with a wealth-decreasing investment. A wealth-increasing investment can immediately be sold for a higher price than it cost to create it. A wealthdecreasing investment can only be sold for a lower price than it cost to create it. So, a fundamental rule is this: Take all wealth-increasing investments and reject all wealth-decreasing investments.83 If you follow this rule strictly, you can create maximum wealth. We begin with basic concepts. What is an investment? A new television set is a desirable asset, but not necessarily an investment. Some people also think a car, or a house, is an investment. Others consider jewelry or clothes as investments. What about college or a degree certificate? Are these

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things actually investments? If so, are they sound investments? What is the difference between buying something and investing in something? The key aspect of an investment can be concisely stated. You spend money today to acquire an asset (or a skill) that will likely provide incremental future earnings or cash inflows. Suppose we consider assets such as a car, house, clothes, jewelry, and education. Some of these might provide incremental future earnings. Then again, they can also be classified as consumption expenditures. We must examine whether these things will actually provide incremental earnings or future cash inflows. If the answer is yes, then they can be classified as investments. If the answer is no, then they are consumption expenditures. Just because people consider the purchase of an asset as an investment, that does not make it so Consider a car. If owning a car allows us to do our job better, then we can view it as an investment. A car can enable us to be more punctual and reliable in our job. That, in turn, can help us keep our job or earn more raises, enabling us to get a better job in the future. Some cars can be good investments, but others are not. For example, a $60,000 car is not a good investment for someone who earns $12-15 an hour. A reliable used car is a better investment. How about a house? Yes, a house can also be viewed as an investment. If we own a house, we do not have to pay rent to live in an apartment, and the value of our home may increase over time. Again, viewed from a purely financial perspective, a house can be viewed as an investment. Using this reasoning, it is more difficult to classify – at least for most of us – clothes or jewelry as investments. What exactly are the future cash inflows associated with jewelry? Expensive jewelry can make us appear more successful than we may be. This, in turn, may help us build a wider network of acquaintances, business associates, and friends who are impressed with this stuff. Using this network, we can increase our earning potential. So, is jewelry an investment? Yes, it is possible. Is this likely or realistic? You will need to interact with people who will be impressed by your expensive jewelry, and such people must be in a position to introduce you to business opportunities that you cannot obtain otherwise. For some, the

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answer may be yes. For most others, the answer is likely no. The likelihood is probably small for most people.

What is a Good Investment? Even if something can be viewed as an investment, it may not be a good investment. As stated earlier, finance tells us that we should accept good (value-increasing) investments and reject all bad (value-decreasing) investments. But what is a good investment? How can we determine this? We noted earlier that an asset is a sound investment if it can be sold at a higher price that it cost to create it. If not, then it is a bad investment. However, we need more detail to help us determine whether a particular investment is good or bad. One problem here is that there is no ready market for many investment assets, such as human capital. We will handle this issue later in this chapter.

The Payback Approach An important attribute of an investment is what is known as the payback period – that is, how long it takes to pay for the initial upfront outlay. A small payback period is good. The new project pays for itself relatively quickly with high cash flows. A long payback period is less desirable. To determine the payback, we first identify the after-tax cash flows from the investment and then see how long it takes us to recover our initial investment. Here is an example. Suppose that we are considering spending $500 on a food processor, a kitchen device that can perform multiple activities for preparing meals. We anticipate that we will use this appliance about once a month, saving about 15 minutes each time. We value our labor at $15 an hour on an after-tax basis ($22 an hour before tax). Is this a good investment? To answer this question, we can compute the payback period. We are anticipating an annual saving of three hours (a quarter of an hour per month, multiplied by 12 months). At $15 an hour, this amounts to about

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$45 in savings a year. At this rate, the payback period is more than 11 years ($500/$45). This is relatively long. It is quite possible that the food processor will become obsolete or break well before this time. In this example, a payback period enables us to estimate the value of the food processor. For us to consider something as a good investment, the payback period needs to be relatively short. A period of less than 5 years is usually considered fast. A period of more than 10 years is generally considered long. Sometimes the period is in the middle of the range, suggesting that we need to assess the specifics of the investment further. The larger the expenditure, the more important it is to assess the payback period. Consider the $60,000 car example again. Suppose that as a result of having a brand-new reliable car, we can increase our wages by $1 an hour after tax. Given about 2,000 working hours in a year, the annual benefit of the car works out to $2,000, giving it a payback period of 30 years. This is too long. Our car will not last that long. To keep payback under five years, we need to search for a car that costs less than $10,000.

The ROI Approach Another approach is called the return on investment, or ROI. If ROI is sufficiently high, the cash flows from the investment are high. We will consider this a good investment and accept it. If ROI is low, then the cash flows from the investment are low. We will consider this a bad investment and reject it. The ROI approach is preferable for larger investments. To compute ROI and judge whether a given investment is good or bad, we will need to think about several key factors: the initial investment, the risk of the investment, and the level of future cash flows for this investment. The initial investment is the amount we spend on the investment. If the investment takes place over a number of years, we typically value future investment amounts less than current amounts, and then add them up. However, to keep things as simple as possible for the purposes of this example, we just add these numbers up.

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The cash flow is the amount we receive each month. If we receive $2,000 a month, our cash flow is $2,000. The number of cash flows refers to how many months or years of future cash flows we receive. This analysis must further take into account the probability of the cash flows. In other words, are there circumstances that will affect the expected cash flows? Suppose that you have a job that pays $2,000 a month. You are thinking about attending a certificate program on the weekends to learn additional computer programming skills. This will enable you to look for a better job that uses your new skills.84 If you do get such a job, you expect to increase your salary by $1,000 a month to $3,000 a month. You also assess the likelihood of getting such a job as 80 percent. If the probability of obtaining a new job is high, then you are more likely to earn a good return on your investment. If, however, your probability of obtaining a new job is low, then you are less likely to earn a good return. In this case, we can consider the probability associated with finding a better job by multiplying the probability of getting a better job with the extra income we can make from the new job. The probability is 80 percent while the incremental income is $1,000. Hence, the product of 80 percent and $1,000 is $800. Thus, instead of using $1,000 as the benefit of the new job, we use $800. This adjustment takes into account the prospect of not getting a better job. Another name for this is expected payoff. Understanding this simple concept of probability is essential in making the right investment decisions. What matters is not cash flow associated with the most successful or the least successful outcome, but the expected cash flow. Expected cash flow is computed by multiplying a given cash flow with the probability of attaining it. Notice that the lower probability of employment makes the investment in education less attractive – it reduces the expected cash flows. Suppose that the probability of finding a better job is only 8 percent instead of 80 percent. However, if we do get such a job, we still expect to increase our salary by $1,000 a month. In this new example, we can take this lower 84

At the time of writing, there are a number of companies that offer ‘coding bootcamps’, consisting of three months (or less) of lessons, after which the student could potentially land a lucrative software engineering gig. See, https://www.nytimes.com/2017/08/24/technology/coding-boot-camps-close.html

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probability associated with finding a better job into account. We do so by multiplying the 8 percent probability of getting a better job with the $1,000 extra monthly income we can make. This is $80 – a significant reduction in the benefit of the new job. The lower probability (higher risk) has significantly reduced the expected cash flows. The expected payoff has fallen significantly. As this example suggests, a less likely or risky outcome does not necessarily disqualify an investment from being good. Similarly, a guaranteed outcome does not necessarily make it a good investment. We take probabilities into account by using the expected payoffs instead of actual payoffs. This provides us with a more accurate way to assess the desirability of an investment.

Opportunity Costs How should we think about risk-return relationship? How much should we be compensated to make good investment decisions? A useful approach is to compare the return from any investment (or ROI) with the return we could have made from other investments that are similar potential risks. In the case of our education example, suppose that the computer certificate program costs $10,000. Recall that the expected cash flows are $800 a month. We multiply this amount by 12 to find annual expected cash flows. This is $9,600 per year. This is before tax. Now assume that our tax rate is 25 percent. Our after-tax cash flow is $7,200. To compute ROI, we divide $7,200 by $10,000. In this case, the ROI is 72 percent per year. Next, we need to assess other possible options to invest this money. Instead of pursuing the computer programming certificate degree, we can invest in common stocks and bonds. Suppose that on average we can earn 12 percent or $1,200 a year on an after-tax basis from our stock market investment. This does not mean that we earn exactly $1,200 every year. This is an expectation based on what the stock market has done historically. The name for this 12 percent figure is the opportunity cost of education. If we decide to pursue the education, we lose the opportunity to make the stock market investment. We are nearly finished with our calculation. To determine if this is a good investment, we compare the after-tax ROI (72 percent) with the after-tax

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opportunity cost (12 percent). Since ROI is greater than the opportunity cost, we decide this is a good investment. We can also revisit the concept of payback period. We spend $10,000 upfront and receive an incremental after-tax cash flow of $7,200 per year. Thus, our payback is 1.5 years. This is a good investment. We can arrive at the same conclusion by comparing the cash flows. We expect to increase our salary by $7,200 a year on an after-tax basis. Our opportunity cost based on stock market investment is only $1,200 a year on an after-tax basis. This is what we could have earned if we did not pursue the education. That is why we call this the opportunity cost of the education. Putting these numbers together, we are ahead by $6,000 a year ($7,200 minus $1,200) for the foreseeable future. Based on this, we can again conclude that we can increase our wealth by going through with the certificate program. In this situation, the certificate program is a good investment. Next, keep all the numbers the same except the probability of finding a better job. If this probability is only 8 percent, then we expect to increase our (after-tax net) salary by only $80 per month. Our annual after-tax cash flows would now be $720 per year. Our opportunity cost is $1,200 a year. Our ROI is now 7.2 percent while the opportunity cost is still 12 percent. Since ROI is too low, this is a bad investment, and we should not pursue it. The payback is now 15 years. Again, this is too long. With a lower probability of employment, we would not want to pursue additional education. The expected benefits do not justify the expected costs. We can expect to sustain a loss of $480 a year. In this case, we cannot increase our wealth with the certificate program and therefore it is not a good investment based on its return potential. Another way of assessing the advisability of an investment is to compute the surplus dollar value it can be expected to create. We now have two tools, ROI and payback. We can use both of them together. Now reflect on what we have done. An important theme of this example is the importance of opportunity cost. It is an essential component of any

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investment decision. This requires that we be aware of the returns we can earn in financial markets. Another important lesson from this example is that a given investment – in this case pursuing a certificate program – can increase a person’s wealth if the ROI is high – recall our example where the probability of a better job is 80 percent. Concurrently, an investment can decrease a person’s wealth if the ROI is low – recall the situation where there is only an 8 percent probability of a better job. Consequently, the risk, and thus the value, of the investment can depend both on the project, as well as the person, undertaking the project. A project (such as obtaining a computer programming certificate) can make sense for one person and not for another. We discuss this further when we examine the advisability of college as a financial investment. Next, we expand on the concept of incremental cash flow. This is the extra cash flow that we would receive from the investment, that we would not receive otherwise. It is all the cash flows with the investment, minus all the cash flows without the investment. Return to our example involving the certificate program. Suppose that we complete the certificate program, but do not receive a better job offer. The skills we would acquire would also be useful in our current job. What is the expected incremental payoff? Use the same probabilities as before. Suppose there is an 80 percent of getting a better job with a $1,000 raise and 20 percent chance of not getting a better job. However, we can still increase our current earnings by $300 a month because of our expanded skills. What then is the expected incremental cash flow as a result of going through the certificate program? To answer this question, we multiply the probability with each outcome and then sum them. So as before, we multiply 80 percent with $1,000 ($800) and 20 percent with $300 ($60). We now add $800 with $60, to calculate the incremental expected before-tax cash flow of $860 per month. Thus, even though we may or may not get a better job, the incremental expected cash flow associated with the certificate program is higher, since the additional training makes us more valuable in our current job.

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There may still be additional incremental cash flows associated with the certificate program. One possibility is that these skills provide us with new opportunities that pay better and provide a higher quality of work. This is another incremental benefit of the certificate program. Alternatively, these skills may reduce the likelihood of losing your job.

Ignore sunk costs Consider another example of cash flows involving what we call sunk costs. Suppose that before we pursued a certificate in programming, we completed a certificate program in computer architecture one year earlier. This program cost $5,000. Unfortunately, this program did not lead to a job. Is the $5,000 investment relevant to our decision to pursue a second certificate program in computer architecture? The question is whether we should we add last year’s $5,000 cost to the $10,000 cost of the new certificate program. This, accordingly, would mean that our calculation would be based on a total investment of $15,000. What is our relevant investment in education? What do we mean by relevant? We might initially think that we are continually investing in our education and we need to justify a return on all our educational investments. The answer here is no. As we noted before, we need to consider incremental costs. The $5,000 has already been spent. Whether we go through the new program or not, we cannot recover the $5,000. Hence, we should only be concerned about the return on the incremental $10,000. If we consider $5,000 as part of the new investment, we would be understating the true return on the new $10,000 investment, and we may end up rejecting a good investment as a result. That would clearly be a mistake. There is a name for this concept. It is called ‘sunk cost’. The $5,000 has already been spent (i.e., sunk). If we require a return on the $5,000, then we have engaged in a common flaw in the sunk-cost fallacy. We should not be concerned with sunk costs. If we have spent money already and we cannot recover it, it is no longer relevant to a new and subsequent investment decision. We therefore need to ignore the $5,000 sunk costs.

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The sunk-cost fallacy has various applications in real life. Are you in a bad relationship or a bad marriage? Is it better to cut your losses or continue? Do you need to stick with a bad marriage or a bad relationship simply because you have put too many years into it in the past? To avoid the sunk-cost fallacy, we need to focus on the future, not the past. How many years we have put in already is irrelevant. If the future looks bleak, there is an argument to cut our losses and move forward (although there may be a number of other nuanced aspects of our situation to consider, such as the impact on children and other family members). There are other similar examples. You have started trading and lost $150. Should you continue in order to recoup your losses, or quit? The answer is to ignore the $150. If you think you can win going forward, you should continue. If you think this game is rigged and you are going to continue to lose in the in the future, you should quit. This is true whether you have lost $150 or $150,000 in the past. Suppose your new business is losing money. What should you do? Again, how much you lost in the past is irrelevant. If the business can make money in the future, you should continue. Otherwise, quit, regardless of what you have lost already.

Implementing ROI in the real world How do we implement these ideas in practice? “All’s good, this sounds doable, but where do I get these probabilities to estimate expected cash flows in the real world? How do I know in the real world whether my probability of landing a better job is 8 percent or 80 percent? How do I know that my salary will increase by $1,000, $2000, or zero?” Each of these questions has a good answer. We need these numbers to estimate incremental cash flows and implement our ROI approach. This why we ask two important questions: (i) what proportion of the graduates of the certificate program can find jobs requiring programming skills; and (ii) and what are their starting salaries. This is important information. If 80 - 90 percent of the graduates are finding jobs and the incremental monthly salary is $1,000, then we have a good chance of improving our situation.

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There are additional considerations. Are you a typical graduate? If you have an academic profile at least as good as, or even better than, the typical attendee, then our previous estimates are realistic and you can use them. If your background, experience and academic achievements are not as good as the typical attendee, then you need to determine these parameters for attendees who are more similar to you. This is an especially important question for you to try to answer. The sponsor of the certificate program should be able to discuss these issues with you. We discuss this in greater detail later. We cannot make a decision on whether we should pursue the certificate program without data on graduation rates and job placement. In this case, finance helps us determine what data we need and how to use it. Finance teaches us to consider effects that are incremental. Thus, the mere availability of the data is not sufficient to make a good decision. The applicable data have to be current, relevant, accurate, and free of bias. Consider relevance. We are not simply interested in the proportion of attendees obtaining jobs after graduation. Our aim is more specific. In our example, you already have a job, and you are pursuing the certificate degree part-time. Your goal is not just any job. Instead, you care about one that will enable you to use our newly acquired skills. Hence, you need to know the proportion of the students who obtain jobs that require programming skills. The data is not useful if the aggregate job employment numbers include graduates who take jobs in grocery stores, retail, or restaurants. This will obviously distort our analysis, leading us to make a decision based on incomplete or wrong data. This is not useful. That is why we need unbiased and accurate data. Furthermore, we need to know the most recent numbers. What the attendees did three, or five years ago may or may not, be relevant for us. The economic situation is continuously evolving. The job market conditions from three years ago may no longer be relevant today (think pre-pandemic versus post-pandemic). The sponsor may provide misleading placement data by averaging it over many years if the actual proportions are declining over time. You need the most recent placement numbers.

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Schools have an incentive to provide the most favorable placement statistics. School rankings depend on these numbers, and prospective students use these ranking statistics to decide if they should attend a given school. Nevertheless, while they are absolutely essential to making the right decision, these statistics must be carefully considered for their accuracy and relevance.85 A glaring example comes from US law schools. Almost all top-100 law schools in the US report employment statistics greater than 90 percent a short time after graduation, while, according to some, the truth may be closer to 45 percent.86 Apparently, some schools have added up all the graduates with a job to come up with these numbers, even if some of them are working in non-legal fields.87 In addition, they have not distinguished between temporary and permanent jobs. Some schools have even hired their own graduates, in temporary positions not requiring a law degree, to boost their employment statistics. Consequently, there have been dozens of class action lawsuits against law schools in the US for falsifying their employment figures.88 Meanwhile, the US government recently sued many for-profit universities for falsifying their employment data to obtain federal aid.89 As a smart consumer, you need to ask for relevant, current, and accurate, placement data. We now review here what we have learned. Finance provides us with both the framework and type of data needed to make a smart investment decision. If the incremental benefits of an investment (the return on investment) exceed the opportunity costs, then that is a value-increasing investment (positive economic value added) and it should be accepted. If the incremental benefits of investment (rate of return on the investment) are less than what we can earn elsewhere on a similar-risk alternative

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See http://www.jtexconsumerlaw.com/V15N3/V15N3_Professional.pdf See https://newrepublic.com/article/87251/law-school-employment-harvardyale-georgetown and http://www.nalp.org/uploads/NatlSummaryChartClassof09.pdf 87 https://lawjournalforsocialjustice.com/2011/12/14/the-true-law-school-scam/; and http://insidethelawschoolscam.blogspot.com/ 88 See http://nymag.com/news/features/law-schools-2012-3/ 89 See https://www.forbes.com/2010/08/01/higher-education-student-debtopinions-best-colleges-10-harkin.html#4570b0cd4122 86

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investment (our opportunity cost), then this is a value-reducing investment (negative economic value added) and the project should be rejected.90 We can earn our opportunity costs by buying individual stocks and bonds or, preferably, a fund that is based on a market index. Consider what the last 90 years of history tells us. Short-term risk-free investments (US Treasury Bills) have returned about 3.5 percent per year; long-term riskfree investments (US Treasury Bonds) have returned about 5.5 percent per year; and stock market investments have returned about 11.5 percent per year. Finally, publicly listed stocks of small firms, which are among the most risky investments, have returned about 17.5 percent per year. It is reasonable to use these historical average rates as estimates of our opportunity costs. We also refer to these as benchmark rates, or hurdle rates. For low-risk investments, we need to earn between 6 and 10 percent per year to qualify as a good investment. For investments of mid-level risk, similar to common stocks, we need to earn a minimum rate between 11 and 15 percent per year. For higher risk investments (such as stocks of smaller companies) we need to earn a minimum of 20 percent or higher. We want to compare the return on investment with the opportunity cost. For example, if we buy a house and earn 3 percent incremental rate of return per year by saving on rent, then this particular house purchase is not a good investment. Instead of buying a house, we can purchase common stocks and hope to do better. In this case, we would be better off investing in the stock market instead of buying a house. Alternatively, we can look into purchasing other (cheaper) houses that can qualify as a better investment.

Additional real world applications of the ROI approach Earlier we mentioned whether investment in housing is a good idea. We now explore this further.

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More specifically, the rate of return refers to the after-tax incremental cash flow generated by the investment divided by the cost of the investment. If the investment costs $1,000 and it generates an incremental cash flow of $100 per year, then the rate of return is 10% per year.

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Is buying a house always a good investment (as we are often led to believe)? What factors determine whether a house is a good investment or a bad investment? Many young couples are typically told to own their home and avoid wasting money on rent. With a house, you end up owning a physical building when the mortgage note is paid off. With renting, you do not own anything, and you do not have the potential for an asset to grow. We first assume that the house is bought and sold in a competitive market. This is a good assumption. After all, housing represents a type of auction where the highest bidder gets to buy the house. Information about any given house and comparable homes is readily and cheaply available. Hundreds of people are typically informed about any particular house, and they evaluate it along with information about other comparable properties. These conditions ensure that the selling price will fairly represent the market value of the house at the time of sale. Consequently, at the time of the purchase, the price of the house will be fairly and accurately determined. Holding all else constant, for most people, a house purchase cannot be an exceptionally good investment. In a competitive market, any positive attributes associated with a given house, over and above its competitors in the marketplace would go to the seller of the house, in terms of a higher price. This is because potential buyers compete with each other and would bid up the price to eliminate these potential rents. Similarly, a house purchase cannot be an exceptionally bad investment. Any negative attributes associated with the house would also be incorporated into the price. In other words, we can take the marketdetermined price of the house or an apartment as fair. Our ability to negotiate a better price (or finding so-called diamonds in the rough) is limited. The key issue for a potential purchaser is what kind of a house or apartment one should purchase, based on their specific situation. A house represents a mixture of an investment and consumption asset. Hence, tastes and preferences play a major role in housing choice. While the house price will appreciate over time, it will appreciate less than other pure investment assets. The average real rate of house price increase from 1940 to 2000 was about 2 percent per annum. Since 1980, the real rate of

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increase is about 1 percent. Since houses have also grown in size, about 1 percent per year over time, the real price increase is less than 1 percent per year.91 Consequently, one also needs to estimate one’s housing consumption needs carefully and ensure that housing consumption is in line with our budget. The business case for housing is similar to other investments. Once we have the purchase price, we need to think about the benefits of house ownership relative to renting. Suppose that an apartment has a price of $450,000. Is this a good investment? If we buy, we do not have to rent a similar apartment, for which we are currently paying $2,000 a month (after-tax). We also need to think about any incremental (additional) after-tax costs of house ownership such as real-estate taxes, insurance, and maintenance. Assume the extra costs add up to $450 a month. Now, we need to subtract this amount ($450) from the rental savings since these represent additional (incremental) costs of ownership. Putting these together, the net benefit of ownership is $1,550. Multiplying this by 12, the annual cash flows are $18,600. Based on an initial investment of $450,000, our ROI is 4.1 percent per year. Based on our numbers, the ROI is close to the risk-free rate that suggests that, from a financial perspective, this particular investment is not a good one. However, as we stated before, housing is both an investment and consumption choice. Hence, the purchase of this particular house is a consumption decision, and not an investment decision. We have simplified our analysis somewhat. Nevertheless, we have illustrated essential elements of a decision to buy or rent a home. For the typical homeowner, a house is generally a good investment. Whether the purchase is a good investment for us also depends on our own financial situation. The prevailing practice is that our housing expenses should be below 30 percent of our annual income.92

91

See, https://www.census.gov/hhes/www/housing/census/historic/values.html

92 See, for instance, https://www.investopedia.com/terms/t/twenty-eight-thirty-six-

rule.asp

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Recall that analysis of investment decisions needs to take into account incremental cash flows, as opposed to total cash flows. Suppose you are thinking about getting a Master’s degree. Currently, you earn $60,000 a year. With the Master’s degree, you can earn $80,000 per year. The incremental cash flow associated with the Master’s degree in this example is $20,000. This is the pre-tax increase in your salary that is directly attributable to the Master’s degree. We now apply our investment concepts to our main asset – ourselves (or our human capital). We can apply similar financial techniques to think about building and managing our human capital.

Managing our human capital Our single biggest asset is our human capital. This refers to the education, knowledge, experience, know-how, social network, and skills we acquire to provide for our livelihood throughout our lives. Our human capital determines our careers, compensation, and lifestyle. Over the course of our lives, we continually convert our human capital into physical and financial assets by saving and investing. When our human capital no longer generates income for us when we get old, we want to live off our acquired physical and financial assets. This is the plan. As we have discussed already, a good part of our human capital is genetics. This is the raw material we are born with. It includes our looks, height, intelligence, and natural traits. Some of us, for example, are good at mathematics and analytical thinking, while others are better at writing. Some of us are naturally outgoing, while others are more quiet and reserved. We cannot change some of these attributes after birth. So, we should focus on what we can do. Part of our human capital skill set includes formal education such as highschool, college, and post-graduate work, involving our understanding of science, mathematics, and language skills. We sometimes refer to these as hard skills. Again, these are needed for many careers. Alternatively, we can decide not to pursue college. Suppose that you decide to become a licensed landscaper. You start by attending a community college to learn the basic skills and then pursue apprenticeships. You may, at

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some point, want to start your own landscaping and snow removal company. With the money you save by not going to college, you can buy a bulldozer, rent an office, and go into the landscaping or snow removal business. Having a bulldozer and an office allows you to be more productive. These physical assets are also a component of your total assets. Part of our human capital skill set also includes our ability to express ourselves, get along with people, and form supporting relationships. Our productivity is based on where we live, the people we know, how we relate to others, who can provide us with useful information, and who we can trust. We sometimes refer to these as soft skills (in contrast to the hard skills discussed earlier). To succeed in life, we need to build and manage our overall human capital. We therefore need to acquire the requisite both hard and soft skills to be successful in our careers. How do we do this? Using what we know from finance, we also determine our beginning point and our end point, and we assess the tools we need from one point to the other. Where do we want to end up? What career is best for us? We need realworld data. We want to learn as much as we can about different potential careers. What can be helpful are conversations with parents and other family members as well as watching documentaries and reading magazines and newspapers. We also want to learn about the qualities needed to be successful in our chosen career. What set of skills are needed for a given career path? How much does it cost to acquire these skills? Will we be able to acquire these skills? Do we have the resources to acquire these skills? Next, we want to understand where we are. Who are we? What are our strengths and weaknesses? Will we enjoy practicing in this particular area? Is it possible to get there from where we are? Do we have the basic raw material, the support, and resources that we can build upon to arrive at our destination?

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If the answer to any of these questions is no, then we need to continue to search for other career paths. For instance, we may enjoy being a movie star, but we may not have the connections, talent, looks, or the personality, to make this a realistic choice. The analysis is similar for other possible career paths. You may enjoy becoming a professional basketball player, but this career is not realistic if you are of average height and cannot jump three feet from a standing position. We are not saying it is impossible, we are just saying that the likelihood is pretty small. Many young people are given the advice by college counselors to follow their dreams and ideals and pursue careers that they think they will love. They talk about art, history, poetry, dancing, and philosophy. This is partly guided by the Platonic ideal that pursuing beauty and perfection gives meaning to our lives.93 We get this. Nevertheless, we also have to be practical. Are there career opportunities for students who major in anthropology, sociology, or archeology? What are the employment statistics or salary numbers for art history majors? Will a major in art history, poetry, or dancing enable you to obtain a job to support yourself? Furthermore, you need to consider whether you need to borrow money to fund your education. We are not arguing against learning about art history or the liberal arts. We agree completely that studying art history or any kind of beauty and perfection will improve the quality of our lives. It will make our lives fuller, richer, more colorful, and more enjoyable. It teaches us to think in new and novel ways, and it prepares us for careers that will take different directions over time. It may prepare us well for graduate or professional school.

93 This sentiment was also shared by the founding fathers. John Adams, in a May 12 1780 letter to Abigail Adams: “I must study Politicks and War that my sons may have liberty to study Mathematicks and Philosophy. My sons ought to study Mathematicks and Philosophy, Geography, Natural History, Naval Architecture, Navigation, Commerce and Agriculture, in order to give their Children a right to study Painting, Poetry, Musick, Architecture, Statuary, Tapestry, and Porcelaine”. See, https://founders.archives.gov/documents/Adams/04-03-02-0258

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However, an important question is whether to it makes sense to major in a particular area to the exclusion of skills that have market value. This is a different question. Perhaps a compromise is for students to strike a balance – major in statistics, but minor in English. Major in finance but minor in music. Double major in computer science and Russian. Major in history or political science, but plan to go to professional school in law, public policy, public health, or business. Yes, we should seek find a career that we enjoy and is a good fit for our abilities. This is essential. However, most people look to their career for income to provide for their livelihoods. You want to understand the costs of maintaining a standard of living. Finance is useful here. We need to know about food, shelter, and transportation, as well as art and beauty, and we should inquire about the relevant numbers. The debate on the purpose and types of formal education is as old as civilization. There has always been a tension between learning across the spectrum of knowledge and learning ‘job ready’ skills. This debate goes all the way to Aristotle.94 On this point, John Locke, the English philosopher, argues in favor of Cartesian rationalism in support of manual trades, mathematics, medicine, and sciences (called natural philosophy during his time). As early as the 17th century, there was debate about the relative benefits of accounting, rhetoric, music, Latin, and philosophy.95

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For example, Aristotle argued that “the Good equals happiness equals excellent activity; that for an individual there are two kinds of excellent activity, one intellectual (e.g., doing geometry) and one moral (e.g., doing just actions); that therefore everyone who is capable of these types of excellent activity should acquire a knowledge of geometry and a disposition to be just; that a knowledge of geometry can be acquired by instruction and a disposition to be just by practice, by doing just actions; and that the young should be given instruction in geometry and practice in doing just actions”. See, https://education.stateuniversity.com/pages/2321/Philosophy-Education.html 95 In his publication Some Thoughts Concerning Education, published in 1693, John Locke writes regarding accounting: “Merchants’ accompts, tho’ a science not likely to help a gentleman to get an estate, yet possibly there is not any thing of more use and efficacy, to make him preserve the estate he has. ’Tis seldom observed, that he keeps an accompt of his income and expenses, and thereby has constantly under view the course of his domestick affairs, lets them run to ruin: and I doubt not but

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Consider another example of how we can incorporate reality into our decision making. Many high school basketball players dream about playing professional basketball. However, according to one estimate, only 3 out of 10,000 high-school basketball players are drafted into the National Basketball Association (NBA).96 Finance teaches us to adjust the outcomes we hope for by multiplying each of the outcomes by its probability. A typical (median) NBA professional basketball player makes $2.5 million a year.97 The average probability of making it to the NBA is only 3 in 10,000. Our expected salary (adjusted for the probability) is only about $750 a year or $60 a month. Using the methodology of finance, we focus on the expected incremental cash flows. This is only $750, and not $2.5 million a year. Surely, most high school basketball players can pursue other careers options that provide an expected career payoff higher than $750 a year. Alternatively, you may want to be an electrical engineer. If, however, you have had difficulty with math in high school, then this may not be the most achievable choice for you. Math in college is even more difficult, and the pace of the program is intense. You will be competing against top math students to get accepted into an engineering program. There must be congruence between your abilities, your resources, and the set of skills you want to acquire. Furthermore, the risks must be reasonable, obtainable, and manageable. Presumably, anyone can acquire a given set of skills with enough hard work. Nevertheless, it may not be the smartest decision to pursue a career just because we think we will like it. If your odds (probability) of earning a living by playing professional basketball are exceedingly small, then you need an alternative plan, whether coaching, teaching, construction management, or one of so many other choices. We

many a man gets behind-hand before he is aware, or runs farther on when he is once in, for want of this care, or the skill to do it. I would therefore advise all gentlemen to learn perfectly merchants’ accompts, and not to think it is a skill that belongs not to them, because it has received its name from, and has been chiefly practised by men of traffick”. 96 See https://www.livestrong.com/article/365997-what-percentage-of-highschool-players-make-it-to-the-nba/ 97 See, https://www.basketball-reference.com/contracts/players.html

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would argue that three-in-ten-thousand odds is not how you should manage your career choice. In life, most people use their emotions, such as fear, shame, pride, excitement, and happiness, to guide most of their decisions.98 People do not think logically using rates of return on investment. This is acceptable for small decisions such as restaurants, clothes, or even cars. However, a career choice is usually a once in a lifetime decision. Instead of relying entirely on our emotions and feelings to decide which career paths to follow, we can also rely on financial tools to understand potential choices better. Once we do so, we might still choose to major in French or Italian literature. Our key theme here, and throughout this book, is that finance teaches us how to create a framework, and determine the data we need to start managing our most important asset – namely our human capital. In the next chapter, we delve in more detail into this topic.

98 See, David Hume, http://www.earlymoderntexts.com/assets/pdfs/hume1739book1.pdf

CHAPTER 5 IS COLLEGE A GOOD INVESTMENT FOR YOU?

“The things taught in schools and colleges are not an education, but the means to an education.” —Ralph Waldo Emerson

Does college matter? Every year, the fall brings difficult choices for students and their families. Some choices are whether to attend college the following year, where to apply, and what preparations are needed for various careers. The beginning of adulthood has arrived, and with it, some of the most difficult decisions we will be asked to make – decisions that will influence the course of our lives in significant ways. Should we go to college? Should we remain in our home state or look across the country? What majors should we be considering, and what schools have them? What if we have to borrow money to fund our education? Should we instead begin with a job and attend a local community college? Yes, these are all difficult questions. We can seek advice from friends, counselors, family members, and others. The tools and concepts of finance also provide an essential perspective about college-related decisions. College is typically a great time in our lives. It gives us the means and freedom to discover ourselves, helps us explore different ideas, meet people, contemplate life, and sometimes it enables us to acquire skills that we can use in a first job. This growth occurs in an environment of great flexibility for many students (although many have busy schedules filled with courses, labs, study groups, part-time jobs, and student activities). College gives us the opportunity to interact with fellow students from diverse backgrounds and meet accomplished professors who can guide us as mentors. We can use our time in college to build a social network of likeminded colleagues and friends who can provide us with a lifetime of support. Overall, college helps us gradually grow into adulthood.

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However, the question we want to explore is not whether students enjoy their time on campus, or find it worthwhile. Most students do.99 Their reactions are even more positive if they receive scholarships that reduce some, or all their tuition costs. The question we want to explore is whether college is a good investment. There is intense debate and disagreement about the benefits of college education. Proponents have argued that the incremental increase in earnings of a college graduate over the course of a career is from $1 million to $3.4 million.100 They argue that a high proportion of college graduates should go to college and will benefit from it. Others disagree, noting the lack of rigorous academic standards, grade inflation, high drop-out rates, and large amounts of debt, that students incur to fund their educations. Some even argue that college education has seriously failed to provide a subset of students with any meaningful value.101 What is our view of this debate? Since this is an empirical question, our view is shaped by data. What do the data tell us? Can today’s students increase their lifetime of earnings by $1 million by majoring in business, nursing, accounting, or STEM subjects (Science, Technology, Engineering, and Math)? First, most of us agree that college will increase your earning power. However, this is not sufficient to make it a good investment. Finance tells us that it is possible to increase your earnings and still reduce your wealth (NPV negative project). One of the statistics often discussed is called the college premium. This the median hourly premium college graduates earn over high school graduates. A typical estimate given is around 70 – 80 percent. For instance,

99

https://www.oxford-royale.com/articles/7-ways-university-experience-better. html 100 https://cew.georgetown.edu/wp-content/uploads/Exec-Summary-web-B.pdf 101 https://nypost.com/2017/04/05/the-college-scam-how-boomers-betrayedmillennials/

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a Federal-Reserve study estimates the college premium to be a little over 80 percent in 2012.102 The college premium can, however, be misleading. It is an average, historical, number. It does not apply to every single college graduate. To obtain more relevant current estimates, we need more information, yet many of the variables we need are not observable. This increases the difficulty of our analysis. Here is one of the main difficulties: Finance teaches us that we need to estimate the differences in earnings of those who went to college versus what those same people would have earned had they not gone to college. The key statistic is not total cash flows from college but the incremental cash flows. We also need to hold all else constant. Finance further teaches us that we would need to know what a given person would have earned if that same person went to college, versus their earnings if that same person did not go to college. To repeat our point, we would need to focus on the same person, not compare across individuals. Yet, unfortunately, this key number is not observable! A person either goes to college or does not. We do not have both. Nor is it possible to do an experiment. We cannot have both alternatives side-by-side and compare them. We will never know what the college graduates would have earned had they not attended college. There are additional problems. We do know that college graduates earn more. The college premium tells us something. However, it does not necessarily imply that attending college causes a million dollars of extra wealth. Are there other possible explanations for the college premium? Does the premium come about because of what the college students actually learn in college? Is it because of their knowledge? Or is it because college attendees tend to be more talented than those who do not attend? Do these students who happened to attend college have better parental support and extra resources to succeed? What about differences in their 102

See, Figures 1-3 in https://www.clevelandfed.org/newsroom-and-events/ publications/economic-commentary/economic-commentary-archives/2012economic-commentaries/ec-201210-the-college-wage-premium.aspx

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nutrition or the quality of the health care they have received? Or is it because of the signaling value of the college degree? Perhaps. All of these are possible. One problem is the direction of causality. We call this selection bias. It is possible that the college graduates tend to earn more because they are smarter, and they have more of the skills to succeed amid the challenges of life. These people arguably would have earned more over their careers, even if their initial jobs were not what we might call professional or managerial roles, requiring a college degree. The so-called college premium will be overestimated if a greater proportion of smart people go to college. Consider the examples of Steve Jobs, Bill Gates, Mark Zuckerberg, and Larry Ellison. They are among the many highly successful people who either did not attend college, or left college to pursue their passions.103 College graduates as a group may earn high incomes, not because they all went to college, but because they are smart and resourceful. A college education is not necessary to start new business and acquire wealth. In fact, had Steve Jobs, Bill Gates, and others actually attended and graduated from college, presumably they would still earn high incomes, but we could be misattributing their success to their degree and college education. Highly talented individuals can earn high incomes whether or not they attend college. Our analysis is further complicated in yet another way. This is the challenge of comparing the group of college students graduating today versus the group that graduated in the prior generation. Over time, the fraction of high school students attending college has risen from around 10 percent to well over 40 percent.104 Thus, close to half of the population now attends college. Instead of being a very selective designation, a college degree is now common.

103

https://www.quora.com/How-is-it-that-college-dropouts-like-Steve-Jobs-BillGates-Mark-Zuckerberg-changed-the-world-so-much and http://money.com/money/5013563/15-super-successful-people-who-nevergraduated-college/ 104 https://nces.ed.gov/programs/coe/indicator_cpb.asp

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This fact is important in our analysis. To estimate the benefits of college, we need to not only look at the differences in starting salaries, but also differences in mid-career and late-career salaries. However, the mid- and late-career salary numbers are not observable for recent college graduates. The numbers that people use to estimate the college premium come from an earlier generation before the baby-boomers, when far fewer people attended college and attending college was much more exceptional. If more people attend college now or if the benefits of college education decline over time, we would again be overestimating the benefit of college education for the current generation. Consequently, we need to carefully compare the benefits of college twenty or thirty years ahead. Moreover, there are risks associated with pursuing a college education, such as dropping out due to academic or financial reasons, experiencing family-related stresses, and failure to obtain a job after graduation. We need to carefully think about each of these risks and take them into account. If we only observe the salaries of successful college graduates with jobs, we are not accurately assessing the benefits of college education for most entering students. There are other selection biases here. We need to also examine how many students start college, take on student debt, but never get a degree (in such case, also giving up the earnings they could have obtained if they were working). The college premium ignores these students. We also need to make comparisons between relevant statistics (the so called ‘apples-to-apples’ rule). If a high school student graduates in the bottom half of his class, then the median earnings of college graduates is not a meaningful measure for him. He will need to compare his potential earnings as a high school graduate with the earnings he can achieve from potential colleges and majors that will be available to him. For him, what can be earned by an economics major graduating from the University of Chicago or the Massachusetts Institute of Technology is irrelevant. Another issue is the time it takes to earn a college degree. To accurately estimate the benefits of college, we also need to estimate how long it will take to graduate. Most students attending colleges do not graduate in four years. In fact, only about 60 percent of the students graduate from four year-colleges within six years of starting. This rate falls to 21 percent at

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private, for-profit colleges.105 The longer it takes to graduate, the further the decline in the benefit of going to college. Similarly, the benefits of a college degree can fluctuate over time. Starting salaries for college students are highly dependent on the state of the economy when they graduate. Graduating in a recession year reduces wages by about 9 percent. These effects last about a decade.106 For example, if oil prices are high, the demand for petroleum engineers can rise. If oil prices are low, the demand for petroleum engineers can fall.107 Furthermore, these cycles do not last very long. We need to be careful not to forecast the mid-career and late-career earnings using the most recent numbers for the current graduates. This is especially the case when these numbers are much higher or much lower than the historical averages. Although our questions can be easy to formulate, the answers are not. We need to make estimates carefully, taking into account all the applicable aspects of the situation. Finally, we know that there cannot be one single answer that fits everyone. The benefits of college can depend on what everyone else does. If 99 percent of the population attended college, then the earnings of college graduates would decline, because there would be greater competition for positions. Furthermore, the selectivity associated with a college degree would decline. In this case, those seeking skilled trades would earn favorable wages and benefits relative to college graduates (and would not have had to forgo income). People, moreover, have different talents, temperaments, skills, and needs. Some can work in an office spending their days programming, but others 105

“The 6-year graduation rate for first-time, full-time undergraduate students who began seeking a Bachelor’s degree at 4-year degree-granting institutions in fall 2011, overall, was 60 percent. That is, by 2017 some 60 percent of students had completed a Bachelor’s degree at the same institution where they started in 2011. The 6-year graduation rate was 60 percent at public institutions, 66 percent at private nonprofit institutions, and 21 percent at private for-profit institutions”. See, https://nces.ed.gov/fastfacts/display.asp?id=40 106 https://www.nber.org/digest/nov06/w12159.html 107 http://insideenergy.org/2015/02/13/falling-oil-prices-leave-petroleumengineering-students-out-in-the-cold/

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may prefer working as landscapers, painters, carpenters, electricians, plumbers, and other skilled craftspeople. Not everyone can, or should, get a college education (but of course everyone should be literate and have a grasp of mathematical reasoning; otherwise, the costs of not being educated are significant).108 Many students (and their families) pay tens or hundreds of thousands of dollars in tuition and incur large amounts of student debt, yet drop out of college. If they do receive their degree, they may be unsuccessful in a search for a professional job. Some may become sandwich makers, bartenders, taxi drivers, or office clerks. For these people, attending college is a bad investment. There are, however, many professions where a college degree is an essential requirement. These include medicine, law, pharmacy, engineering, education, accounting, and finance. For these professions, the question becomes not whether college is a good investment or not, but rather the selection of a particular college and major. For many occupations, a college degree can serve as a valuable signaling device. Regardless of whether you learned immediately practical skills in college, your diploma tells the world that you have the right attitude and discipline to follow instructions, take dozens of courses, write term papers, complete complicated problem sets, and pass exams. Many employers may consider these skills essential. Between these two extremes, the answer is much more challenging: it depends. College is likely to be a good investment for some students and not a good investment for others. Furthermore, one particular college can be a good investment for one student but not another student. How can we analyze this issue for a particular person facing a particular set of circumstances? Once again, the concepts of finance are relevant. As we noted earlier in the book, we need to determine whether we are earning a good return on our investment. A good return means an increase over what we can earn elsewhere if we did not go to college. If the answer is yes, then that is a good investment. It does not, however, mean that it is 108

https://www.washingtonpost.com/news/answer-sheet/wp/2016/11/01/ hiding-in-plain-sight-the-adult-literacy-crisis/

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the best investment we can make. But at least we can say that it is a good investment. If the answer is no, then we are not getting a good return on our investment, and we should not make it. First, we need to determine the amount of our investment in a college degree. This includes tuition, books, and fees. Figure 5.1 shows tuition plus fees for public and private non-profit colleges from the 1971-72 academic year to the 2017-18 academic year.109 For private schools, tuition has increased by 216 percent in real terms during this period. For public schools, the rate of increase is 285 percent.

$40,000 $35,000 $30,000

Figure 5.1: Tuition+Fees, 2018 dollars Private Nonprofit Four-Year Public Four-Year

$25,000 $20,000 $15,000 $10,000 $5,000 71-72 73-74 75-76 77-78 79-80 81-82 83-84 85-86 87-88 89-90 91-92 93-94 95-96 97-98 99-00 01-02 03-04 05-06 07-08 09-10 11-12 13-14 15-16 17-18

$0

College is expensive and becoming more so every year. Suppose that the annual cost for tuition, books, and fees at a particular college is $15,000.110 While most students take five or six or more years to graduate, we will assume here that you will graduate in four years.111 Based on these estimates, our expected investment in a college degree is $60,000 (four 109

Source: Collegeboard.org For the 2020-21 academic year, the average on-campus tuition plus room and board for a 4-year public college is about $22,180 For private, non-profit colleges, the average tuition and room, board and fees is about $50,770. See, https://research.collegeboard.org/pdf/trends-college-pricing-student-aid-2020.pdf 111 See graduation statistics, https://nces.ed.gov/programs/coe/indicator_ctr.asp 110

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years of college at $15,000 a year). The calculation is obviously different if the time to graduate is longer. If the numbers you are considering are different from these, then use your own numbers. If you receive a partial scholarship, then use only your own out of-pocket costs. This is not meant to be a one-size-fits-all, comprehensive answer. Our goal is show you how to determine your own return on investment. At this step in our analysis, we do not attach a probability of not completing a degree, or not finding a job after graduation. These probabilities do matter, but we will address them later. For now, we do not consider the likelihood of dropping out, or not being able to find a job upon graduation. We also do not consider living expenses, such as room and board. Our reason is that we have to incur these expenses anyway, whether we attend college or not. We assume that the living expenses are the same whether one goes to college or starts working immediately after high school. This is for simplicity. With this assumption, we can ignore living expenses, since these expenses are not incremental. If you do go to college, you will not be able to work, get experience, or receive a salary. The issue here is whether you can immediately get a job and start earning a salary without additional vocational training. We assume here that you can. Our next step is to estimate your likely earnings with just a high school degree, and compare them to what you anticipate you could obtain with a with a college degree, in each case on an after-tax basis. For this purpose, you need accurate and timely numbers. We use estimates from the United States Department of Labor, Bureaus of Labor Statistics (BLS).112 Every year, the BLS publishes comprehensive, up-to-date, and accurate, wage numbers with details of location and growth rates, as well as the full distribution. Suppose that you like to work with animals. With a high school degree, you can get a job as an animal control worker who investigates the mistreatment of animals, controls dangerous animals, and looks after abandoned and unattended animals. You believe that this job would make 112

See, https://www.bls.gov/ooh/occupation-finder.htm

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you happy and fulfilled. In May 2017, the Bureau of Labor Statistics (BLS) lists the median pay for this job to be about $35,000, with average expectations of growth. In addition to the median pay, the BLS also provides 10th, 25th, 75th and 90th percentiles for this position. For the animal control position, these percentiles are given as $22,000, $28,000, $45,000, and $57,000.113 Hence, this additional data allows you to consider not just the median pay, but also the distribution of pay. In addition, the BLS provides estimates for various metropolitan and non-metropolitan locations (as well as a location quotient, indicating the relative concentration of that occupation in that location). For instance, if you plan to live and work in a smaller city, the pay you are likely to face may be the 25th percentile of the distribution, and you would earn $28,000 rather than the 50th percentile ($35,000), based on the location and location quotient for your chosen career. BLS also provides the likely number of positions for this career track. We can use this information to decide whether we are pursuing a narrow, niche, specialty career track, where employment opportunities are limited or not. If the employment opportunities are limited, we need to take this into account later, when we consider the probability of finding employment. Finally, the BLS also provides estimates for future salary growth. These categories include ‘much faster than average’, ‘faster than average’, ‘average’, ‘slower than average’, ‘little or no change’, and ‘decline’. These estimates are useful to get a handle on salary differences, not just at the entry-level stage but also in mid-career and late-career stages. We now continue with our college-education question. You are considering college for a better job, again working with animals. One career path you are exploring is being a zoologist. Again, you believe that this job would make you happy and fulfilled. This career path requires a Bachelor’s degree. The Bureau of Labor Statistics lists the median pay for this job to be about $62,300 in May 2017. Again, the growth rate is expected to be average.

113

https://www.bls.gov/oes/current/oes339011.htm

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In this case, college education is promising to increase your salary by 78 percent. This is the ratio of $62,300 to $35,000, or an increase of $27,300. Is this a good investment for you? Most people would probably think that, based on the 78 percent premium, college would be a great investment. These are the kind of numbers politicians tout when they are promising greater access to education. Multiplying $27,300 by 40 years of work-life gives a lifetime of the college premium that exceeds $1 million.114 Can we decide, based on the $1 million premium alone, that this is a good investment? The answer is no. We need to engage in additional finance-directed analysis and then decide. We need additional data before we can complete our analysis. One such number is the applicable tax rate, since the salary estimates given above are before taxes. What we care about is our after-tax earnings, since the government will take taxes before we receive our wages. We will simplify our analysis and use one rate. Since tax rates increase with earnings, using a single rate benefits the ‘choose college’ decision slightly. Assume that we would be paying roughly 25 percent tax in either case. An amount of $35,000 before taxes will be $26,250 after taxes. Similarly, $62,300 before taxes will be $46,725 after taxes. Again, the particular single tax rate we used is for illustrative purpose only. We now assess these various numbers. If we go to college and it takes four years to graduate, then we will lose four years of after-tax earnings as an animal control worker. This amount totals about $105,000.115 Adding this to a four-year tuition-fees-and-books estimate of $60,000, this brings our total investment in college to $165,000. By attending college, we get a 78 percent wage premium. This amounts to a before-tax increase of $27,300 per year after the fourth year.116 Given a $27,300 before-tax salary increase, the incremental after-tax earnings 114

See, https://www.clevelandfed.org/newsroom-and-events/publications/ economic-commentary/economic-commentary-archives/2012-economiccommentaries/ec-201210-the-college-wage-premium.aspx 115 4 years times 0.75, which is the after-tax salary, times $35,000 salary, equals $105,000. 116 The difference between $62,300 and $35,000 is $27,300, which is the before-tax increase in salary.

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from our college degree amounts to $20,500 per year after the fourth year.117 Thus, taxes reduce the benefits of college education. If we were to use an even higher tax rate, which corresponds to a higher tax rate on higher income, then the benefits of college would be further eroded. We now conclude our analysis. To obtain our rate of return on investment (ROI), we divide $20,500 by our total investment, which is $165,000.118 Hence, based on our investment of $165,000, we are earning 12.1 percent per year on our investment.119 Notice that 12.1 percent per year is significantly less than the initial 78 percent number. Does 12.1 percent return represent a good investment? We need a basis for comparison. Accordingly, we need to compare 12.1 percent to the return we could have earned if we did not get a zoology degree but invested in the stock market or started a landscaping business. Although it is hard to determine the return from landscaping (since we haven’t done the analysis), we can easily determine the stock market returns. We learned earlier that the average annual return in the stock market was approximately 11.5 percent. Before we can conclude our analysis, we need to make another adjustment. Our earnings are likely to grow at least at the rate of inflation, while our investment is fixed. Consequently, instead of using the historical average return in the stock market (called the nominal rate of return), we need to use an inflation-adjusted return, or how much the stock market returned over and above the inflation rate (called the real rate of return.) Estimating historical inflation to be about 3 percent, the real rate of return in the stock market has been around 8.5 percent.120 We will use this number as our benchmark.

117

Again, the difference between $62,300 and $35,000 is $27,300. Taking 75% of this for after-tax amount gives us $20,475. 118 This is computed as $75,000 + 5 times $26,250 (after-tax earnings with a high school degree). 119 There is some hand waving going on here since we are just adding after-tax earnings in different years. We are trying to focus on simplicity instead of precision. 120 8.5 percent = 11.5 percent minus 3 percent.

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Based on our findings, a college degree in zoology is a good investment. The incremental real rate of return of 12.1 percent is above what we can earn on our own in the stock market (8.5 percent). There is another adjustment required. There is a still bit of overestimation of the benefits of college, since the costs were paid in the first four years while the benefits started in year five. We ignored this time gap for the initial estimate. A rough adjustment for this gap would discount the benefits over the two-to-three-year average gap. Using a 10 percent annual discount rate, and applying a minimum 20 percent discount for a two-year gap121 to the benefits, gives us a 10 percent instead of 12.1 percent real return on our investment. This is still an acceptable rate of return on investment in college. Nonetheless, a 10 percent real return on investment (ROI) is well below the often-advertised 78 percent college wage-premium. What does this mean? This means that college is a good investment for those good students who choose a major with a high college-premium, graduate in four years, and find a good job immediately. In this specific example, more specifically, a zoology degree path is better than the animal control career path. Given the low risk of career earnings, this incremental rate of return falls in the acceptable zone as a reasonably good rate of return on investment. If these were the only two choices, and you think you will graduate in four years and get a job immediately, you should go to college and get a zoology degree. It is a good investment. Suppose you have other alternative career options that would be equally attractive from a lifestyle perspective. In this case, you can apply the same analysis, and compute and compare the return for your other equally attractive alternative career paths. After this you can choose the best career path, taking into account the different rates of return on your investment.

121

Adding the first four years of costs instead of discounting them leads to above 20% overstatement. Not discounting a year five cash flow leads to a 50% overstatement. Taking a ratio of these gives us a net overstatement of about 22%. Thus, a 20% discount is an approximate adjustment.

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Here we did not consider in our analysis any money you need to borrow for your education. In this example, the answer is the same whether you have saved the money already and do not need to borrow the money or whether you have to borrow it. Why is this? Why does debt not matter? What we are assessing here is the value of the investment. This is independent of how we pay for it. For this, our method of funding our investment – whether out-of-pocket or with debt – does not influence the calculation. Saving money does not mean that we cannot earn a return of return on that investment. That money is not free. It too has an opportunity cost. We could have invested this money in the stock market. In fact, we would obtain misleading answers if we incorporated debt into our analysis. Assume that we have saved half of the tuition fees and borrowed only the remaining amount. Then the return on the college investment would be overstated relative to the case where we had to borrow all of it. Instead, we need to evaluate the rate of return on the entire investment. We did not investigate savings with and without a college degree. The reason is, again, the same as the debt issue. This is automatically considered when we consider the differences in incremental salaries.

Managing the Risks of Investment in College There are many real-world risk factors that can reduce the value of a college education. In the example discussed above, we assumed that it only took exactly four years to graduate. We assumed that you obtained a zoologist position immediately after graduation. Similarly, we assumed that there was a zero probability of dropping out of school and zero probability of not securing a zoologist position after graduation. We also assumed that obtaining an animal control position did not require any training program. Hence, we ignored some of the real-world complications associated with the college investment.122

122

Some will point out that the future unemployment rate for college graduates is smaller. We agree. Since these differences are relatively small, we ignored this refinement. Besides, we concluded that a college degree beats out the animal

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Each of these represents an important risk factor. If we adjust for some of the college-related risks, then the return on college investment will change. The question is how much? Suppose we drop courses here and there or take a while to decide our major and thus it takes five years to graduate. Is college still a good investment? Using five years of attendance to earn a degree, your tuition investment grows to $75,000123 while the after-tax wage you forego climbs to $131,250 for a total of $206,250.124 The after-tax wage premium is still $20,500. Thus, your ROI now falls to 10 percent.125 Using a similar 30 percent time-gap discount, your net ROI is now 7 percent. This is below that 8.5 percent real return you can earn in the stock market. This seemingly minor adjustment reverses your decision, suggesting that attending college to get a zoologist degree is not better than getting an animal control position after high school. There is another useful perspective to consider. In 2019, Sallie Mae was charging between 4.7 percent and 11.3 percent for fixed rate student loans.126 Assuming an average rate of 7.5 percent to 8 percent, the ROI of 7 percent does not even cover the cost of the student loan. There is no compensation for the risk of the equity investment (foregone wages). Based on these numbers, college is no longer a good investment. So far, we still ignored the risks of delaying your job search, or the probability of dropping out of college altogether. If we add delays to your job search or some probability that you will drop out of school or some probability that you would not be able to secure a zoologist position and get a job in animal control, which you could have achieved with a high school diploma, the ROI will fall further. Next, we examine what happens to the return on your investment when you consider these real risks. Suppose, in addition to graduating in five years, we add a one-year delay before you secure a zoologist position after graduation. This increases your control position. Taking unemployment rate differentials into account will only add to the benefit of the college degree. 123 5 years times $15,000 a year in tuition. 124 $206,250 equals $75,000 plus $131,250. 125 10 percent = 20,500 divided by $206,250. 126 See, https://www.simpletuition.com/results?WT.mc_id=10328571

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investment by about $35,000 before-tax, or $26,250 after tax (as a result of the lost opportunity to earn a living in animal control for another year) to more than $232,500, and your rate of return on investment decreases to approximately 8.8 percent (or about 6 percent after the time-gap discount). A simple rule is to compare this rate of return to the interest cost of student loans, assumed to be 7.5 to 8 percent. In this case, a college education is again wealth-destroying. Suppose that, while you still ignore any delays in finding a job, you consider some probability that you drop out of college or some probability you will not be able to secure a zoologist position. In both of these cases, assume that you can get an animal-control position. We can assume that these probabilities add up to 40 percent.127 These risks would further reduce your rate of return on investment to about 5 percent (or about 4 percent after the time-gap discount). Once again, college would be a bad investment in this particular circumstance. You would be better off with a high school degree and a job. What are the important conclusions here? For some good students who choose their majors carefully, college is likely to be a good investment. It is important to choose a major with a large expected college premium (at least 80 percent), that you graduate in four years, and obtain a well-paying job that requires a college degree. Under these assumptions, college pays. For all others, college is not likely to be a good investment. If you chose a major that gives you a 40 percent college premium, then you are likely to destroy wealth. You will also be likely to destroy wealth if you graduate in the bottom half of your high school class (which in turn will make it more difficult to obtain a college degree and therefore a professional job).128

127

See graduation and drop-out statistics https://www.publicagenda.org/pages/with-their-whole-lives-ahead-of-themreality-2; http://media.collegeboard.com/digitalServices/pdf/professionals/fouryear-graduation-rates-for-four-year-colleges.pdf; and https://nces.ed.gov/programs/coe/indicator_ctr.asp. Looking at the specifics, the drop-out rate depends on college selectivity. For schools with open admissions, the drop-out rate averages close to 70 percent. For selective schools with admission rate less than 25 percent, the drop-out rate is about 12 percent. 128 and https://nces.ed.gov/programs/coe/indicator_ctr.asp

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Your outcomes would be improved if you took the animal control position immediately instead. Again, we can generalize from our findings: Consider a non-selective college (which has an open admissions policy) where only 31 percent of the students graduate within six years of enrollment.129 Assume that you would be a typical student at this college. The lower the graduation rate, the less likely it is that you will benefit from a Bachelor’s degree from that college.130 Analyzing these circumstances further, suppose that you are not admitted to your college of choice for a zoology degree, but instead you decide to enroll in a private, for-profit college. Unfortunately, the risk of dropping out from for-profit colleges is higher, possibly as high as 70 percent.131 Suppose we estimate the drop-out plus failure rate conservatively to be 60 percent.132 How do we assess this risk? We need to multiply your incremental aftertax salary increase by 0.4. This is because you only have a 40 percent chance of earning these salary increases.133 Hence, instead of using $20,475, we need to discount this for the additional risk of dropping out. To do this, we need to multiply $20,475 by 0.40, and use $8,190, instead.134

129

https://nces.ed.gov/fastfacts/display.asp?id=40 While the examples above give us useful information, we can do even better by looking at additional career options. Suppose that our likelihood of landing a zoologist position is low given the small number of new positions that open in this area, we might still benefit from college education if this makes a career, say, as a veterinarian, more likely in the future. Hence, we do need to keep the big picture in mind. 131 Graduation rates for private, for-profit colleges within 6 years of enrollment is less than 30% while graduation rates from selective colleges (admission rate less than 25%) is about 87%. See, https://nces.ed.gov/fastfacts/display.asp?id=40 132 A recent Senate Report shows that for a cohort group of about 600,000 students who enrolled in for-profit colleges in 2008-2009, 54% left without a certificate or a degree by mid-2010. Presumably, the drop-out rate would be much higher three or four years after enrollment. See, https://www.govinfo.gov/content/pkg/CPRT112SPRT74931/pdf/CPRT-112SPRT74931.pdf 133 We assume that we would get the animal control position if we cannot secure the zoologist position after college. 134 $8,190 equals 0.4 times $20,475. 130

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Taking the risk of dropping out of college into account, your return on investment now falls to about 4 percent even before time-gap discount.135 Our initial estimate of a 78 percent premium has degraded to a 4 percent return on investment (before time-gap discount). Based on purely a financial analysis, we can confidently conclude this particular private, forprofit college investment destroys wealth. As we have noted before, there is no one single, correct answer that is applicable to all students, all majors, and all colleges. The answer depends on the risks faced by individual students and their choice of college and major. An important determinate is the length of time it takes to obtain a professional job after graduation. College is a good investment for a specific set of students – those pursuing a major with a high collegepremium, who graduate in four years, and obtain a good job immediately. For most others, it is not likely to be a good investment. A key factor for our analysis is the current, accurate real-world probability of graduation and obtaining a job that requires a college degree. You can access the graduation statistics for most colleges from the National Center for Education Statistics.136 Another excellent source of detailed, up to date information is the college scorecard website maintained by the US Department of Education.137 Here you can find starting salaries, and graduation rates, as well as apprenticeship information. For instance, if you find out that the 6-year graduation rate from the college you are considering is only 21 percent, then going to that college is not likely to be a good investment. For a given student and a given college, we also have to consider the choices of possible majors. One major may be unacceptable for that student, while another major can be good. Similarly, the student may prefer the culture of one college, yet another choice may cost less. Furthermore, even for a given student, given school, and given major, the specific answers can change based on the state of the economy. Suppose you are considering a career in petroleum engineering. If oil prices are high when you graduate, then the demand for petroleum engineering can rise, 135

4% = 8,190 divided by 205,000. See, https://nces.ed.gov/collegenavigator/ 137 https://collegescorecard.ed.gov/ 136

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thereby increasing your salary and your rate of return on investment. If oil prices are low when you graduate, the demand for petroleum engineers can fall.138 If there is a high cyclical component to starting wages, you can average out the starting salaries going back five or six years, instead of using the most recent number. Since there is a four-to-five-year delay between starting college and getting a job, there is an additional risk of oil price fluctuations. Even if oil prices are high now, there is a risk that oil prices might tank by the time you are out looking for a job. Accordingly, your college investment is even more risky. Fluctuations in the overall business climate affect your starting job salary as well as the likelihood of finding a job. As we discussed earlier, we can also assess these risks. In this case, you should require a higher rate of return on your investment, something close to, or even above, the average return on the stock market, instead of the cost of a federally guaranteed loan rate, for instance. Sometimes, the decision about college is evident with even fewer calculations. Suppose that instead of a zoologist position, you are considering getting a social science research position, studying the environmental effects of the welfare of animals and their survival. This position also requires a Bachelor’s degree. The median pay for this job is given as $46,000.139 The college premium here is only 31 percent. Now, your after-tax incremental earnings are about $8,000 per year. Given this number, even if you ignore all the risks of delayed graduation, drop-outs, and failure to secure a job immediately, a major with a low college premium (31 percent premium) is not a good investment. It will take close to 20 years to recover your initial investment of $165,000 on an after-tax basis. Low-paying career paths can make sense only if your investment in college is low. Many majors with low college-premiums will never earn a good rate of return on their $165,000 college investment during their entire working lives. As we stated earlier, finance is a way of thinking that can help us make more informed choices. Even though a particular career path may have a 138

http://insideenergy.org/2015/02/13/falling-oil-prices-leave-petroleumengineering-students-out-in-the-cold/ 139 Bureau of Labor Statistics, https://www.bls.gov/oes/current/oes339011.htm

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promised wage-premium of 80 percent, we still need to carefully analyze the value of the investment. Following our systematic analysis and after taking important risks into account, we discovered that the true rate of return can fall below 3 – 4 percent. This is the difference between taking someone else’s word and doing our own analysis. Earlier, we stated that only about 60 percent of students graduate from four year-colleges within six years of starting. This means that 40 percent of the students take more than 6 years, or do not even graduate. Based on our analysis, we can state that attending college is likely to destroy wealth for about half the students that attend 4-year colleges. Furthermore, the graduation rate falls to 21 percent at private, for-profit, colleges.140 This means for about 80 percent of the students that attend private, for-profit, colleges, attending college probably destroys their wealth. We said that college education is more than ‘dollars in minus dollars out’. Some argue that attending college can help you create a better social network. Attending college can help you be a better learner and better consumer. College graduates may be healthier or live longer. In fact, some evidence suggests that college attendance is associated with lower mortality rates of between 15 and 19 percent. This is attributed to a reduction in deaths from cancer and heart disease, adding ten years to life expectancy.141 A college education may allow you to find a more suitable life partner. It may also make you more emotionally satisfied.142 One problem with some of these outsized claims is they are just correlations, not causations. In fact, the direction of causality may go in the opposite direction. Those who have the personality or resources to take care of their health may also be more likely to go to college. Nevertheless, 140

“The 6-year graduation rate for first-time, full-time undergraduate students who began seeking a Bachelor’s degree at 4-year degree-granting institutions in fall 2011, overall, was 60 percent. That is, by 2017 some 60 percent of students had completed a Bachelor’s degree at the same institution where they started in 2011. The 6-year graduation rate was 60 percent at public institutions, 66 percent at private nonprofit institutions, and 21 percent at private for-profit institutions.” See, https://nces.ed.gov/fastfacts/display.asp?id=40 141 https://www.brookings.edu/research/the-effect-of-college-education-onmortality/; and https://www.ncbi.nlm.nih.gov/pubmed/20370495 142 https://www.timeshighereducation.com/news/degrees-happiness-graduatesreport-higher-well-being

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these issues are real and important. We are not suggesting that you ignore these issues. In addition to the financial consideration, you still need to assess the qualitative issues, such as whether you would be happy with a particular career path in deciding whether or not you should attend college. Whether or not to attend college is too important a decision to leave to emotions. We can use the same analytical approach as before, and estimate a value for these additional qualitative and emotional benefits of college. Hence, using this same finance framework, we can also bring all the other considerations into our decision-making. Your family may strongly encourage – and even insist – that you attend college. If so, you are fortunate to have this support. You can still use finance to help inform your choice about which college to attend. Many students decide on their college choice by visiting the school, where they can talk to other students and admissions officers. This is useful information. They also see the monumental college buildings, perfectly groomed lawns, state-of-the art gyms, massive swimming pools and water slides, and excellent restaurants.143 Then they make their decisions, heavily influenced by what they saw and experienced. At this point, we need to urge some caution. How does a perfectly groomed lawn, stately building and entertaining playground help you with your education? They do not. The same is relevant to the other niceties. The reason the grounds are perfectly groomed is that the university administrators understand how students make their decisions. This is why they have invested in non-educational staff and state-of-the-art gyms, games rooms, and swimming pools.144 These things ‘sell’ colleges. However, here we are talking about a career. Instead of being swayed by non-educational related investments – like the gym, water slide, and rockclimbing wall – you should also carefully examine the financials. You can use the financial tools we discuss here to choose among the colleges and find the best one for you.

143

https://www.collegeconsensus.com/rankings/best-college-waterparks/ https://www.nytimes.com/2014/09/21/fashion/college-recreation-nowincludes-pool-parties-and-river-rides.html 144

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Using the financial tools we discussed so far, we can analyze the investment values represented by different majors. Suppose that, instead of setting your sights on a single career track, you have a menu of potential career opportunities. Using our financial tools, we can help determine the financial outcomes of each of your choices. Our financial tools are useful in other contexts as well. In addition to college choice, you can analyze whether you want to start our own carpentry company, buy a restaurant, or create an online retail business. There are many possibilities. We have gained some insight into how to make value-creating investments and how to avoid value-destroying investments.

CHAPTER 6 DEALING WITH RETIREMENT RISK: THE ROAD TO FINANCIAL SECURITY

“Money is a guarantee that we may have what we want in the future. Though we need nothing at the moment it ensures the possibility of satisfying a new desire when it arises.” —Aristotle

The three elements of financial success One of life’s biggest challenges is how we attain financial security when we reach the age when we can no longer work (or no longer want to work). Is it realistic for most people to expect to attain some degree of financial security? How does one achieve it? To acquire financial security, we focus on what we can control: our goals, methods, and decisions.145 This strategy involves adhering to a careful and persistent path over time. While any amount of luck always helps – and additional luck is always welcome – we can accomplish a huge amount with a careful plan. This takes time, but it is achievable with a steady job, a basic knowledge of finance, and a moderate amount of discipline.

145

Well, there is another factor, namely luck. While do not explicitly think about luck, luck is indeed very important. In fact, the less we think, plan, and organize, the more important luck becomes in our lives. With luck, we can win the lottery. With luck, we can marry into wealth. With luck, we can come into the world possessing innate good looks, big brains and exceptional physical and artistic talent. While some social skills are also required, innate good looks or personality can help tremendously with marrying into or associating with wealth. Using our exceptional innate talents, we can launch a successful career in business, high-paying sports, acting, or music.

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This approach requires three elements for success: first, saving; second, investing; and third, long-term thinking. This is not a quick fix. We must keep at it over time. The results can be marvelous for our financial security.

What are savings? To save, we must spend less than we earn. It is that simple. We must all save, since we cannot achieve financial freedom without doing so. It does not matter how much money we make. We can earn tens of millions of dollars per year and still go broke if we spend more than we make.146 Later in the book, we discuss approaches that you can consider to build wealth over the course of a lifetime. Intuitively, one of the requisite steps in this process is the steady accumulation and growth of savings. For savings, we may have learned some lessons from our parents. They may have advised us that “good things come to those who wait”. They may also have advised us to “take care of the pennies and the dollars will take care of themselves”. This is incredibly good advice. The essential path to financial security is to postpone unnecessary spending. This is the essence of savings. Notice, we are not advising you to avoid spending completely. We are suggesting that you postpone unnecessary spending. This, of course, is easy to say, but not easy to do. We realize that. There are two main approaches to accumulating savings. We call them the top-down, and bottom-up. Ultimately, you can adopt whichever method suits your personal situation. What matters is that you save. How you do so is your decision. In a top-down approach, you budget a percentage of your income for necessities, luxuries, and savings. You then stay within these guidelines. You might set, for instance, 20 percent of your earnings for savings from the very start. Then you allocate 60 percent for necessities and 20 percent for discretionary purchases. When we use the term necessity here, we 146

Some examples of bankrupt high-earning celebrities include boxer Mike Tyson who reportedly earned $400 million over his career, the rapper 50 Cent, MC Hammer, singer Marvin Gaye, and actor Burt Reynolds. See, https://www.businessinsider.com/rich-famous-celebrities-who-lost-all-theirmoney-2018-5

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mean food, shelter, health, and transportation. Notice, we did not say a four-bedroom apartment with a view of the park, eating out every day, and buying a new car every other year. We would classify those things as wants – things that would be nice to have; they are luxuries, not necessities. The savings are, then, the residual amounts that you do not spend. In a bottom-up approach, you justify every purchase. You question each decision carefully before you spend any money. Once again, you have a savings goal, but this one varies month-to-month. What you do not spend at the end of the month is what you save. You can save in several ways: via only top-down approach; via only a bottom-up approach; or you can combine the two. The bottom-up approach requires more effort, since each purchase, no matter how small, must be scrutinized and justified. We suggest that you consider a top-down approach. The first thing you do whenever you receive your paycheck is to set aside your savings. You should set this amount at not less than 20 percent of your after-tax earnings, preferably higher, especially if you are younger and just starting to build up your savings. Put this amount aside. Then budget for your necessities and let the rest go to your wants. Now, having saved and already provided for your necessities, you can spend the rest on what you want. Next, we turn to the nature of saving and why most Americans struggle with it.

Why is it so difficult to save? Americans do not save enough, particularly in comparison with residents of other countries. Based on OECD data, the US savings rate is about 5 percent; Germany, Switzerland, Norway, and Sweden average between 10 percent and 20 percent, and China averages close to 50 percent.147 How much of our income should we save? A reasonable amount to start is between 10 and 20 percent. In your early to mid-twenties, you should aim for a minimum of $5,000 savings per year (although this amount might not be feasible for everyone). If you are more ambitious, you can aim for savings of $10,000 per year, or 30 percent of your annual income, or an 147

See, https://data.oecd.org/natincome/saving-rate.htm

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even higher amount. Where will these savings come from? As we will see, they come from both small and large items. Big items are obvious targets, yet we do not often pay attention to small items. If we do spend on these small items every day, they can add up over time. Your savings should always go to tax-advantaged vehicles first, such as IRA and 401k plans. In this manner, you obtain a double benefit. Not only do you save, but you also reduce your tax liability. You should exhaust your tax-advantaged vehicles before you save in taxable accounts. We discuss this theme further later in the book. We illustrate later that these levels of savings, coupled with sound investment techniques, are sufficient to address most – if not all – of your future monetary needs for financial security. Next, we explore the nature of saving and spending. We all find it challenging to save. To understand why this is so, first we have to understand why we spend. To understand spending, we need to understand not just how much we spend, but also why we buy, what we buy, how we buy, how often we buy, where we buy, and when we buy. We will discuss each of these next. So why do we spend money? You might say just to live, but there are other (often hidden) reasons. Humans have some basic needs, which are typically easy to satisfy. In addition to these basic needs, we have many other wants and desires. Our basic needs – such as food, shelter, transportation, health,148 and security – can usually be met with a nominal amount of money. Our higher needs – such as love, respect, power, and acceptance – are not easily satisfied by just spending, no matter how much money we have. We can spend substantial amounts of money, yet we can still feel unloved, and

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Health insurance is a must for financial security since medical bills can be large and unexpected, causing financial difficulties for most people without insurance. According to a survey by the Kaiser Family Foundation, 9 percent of those surveyed say they have at some point declared personal bankruptcy because of medical bills. See, http://files.kff.org/attachment/Report-KFF-LA-Times-Survey-of-Adults-withEmployer-Sponsored-Health-Insurance

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even worse, unlovable. Spending money will not help us acquire love, respect, self-importance, and other important aspirations. Consider a simple and routine expenditure for many of us – namely the money we spend on coffee. We typically do not even think about this expense. It is just coffee. So, why do we buy it? How do we buy it? Where do we buy it? If our goal is to boost our alertness in the morning – a utilitarian benefit – we can accomplish this more cheaply and easily. We can purchase a nonbranded cup for about $1. We can learn to live without coffee, or we can make it ourselves for pennies a day. It only involves a little advance planning. There is no need to pay $4 per cup at a branded coffeehouse. If coffee is satisfying our occasional social needs to show off our branded cup while meeting with friends, this is a relatively low expense to absorb. If this is weekly, $4 a week will not affect our savings. Suppose, however, that we consume two or three branded cups a day at a coffeehouse. If we spend $4 per day on coffee, then we will spend $1,460 a year. If we drink two to three cups a day, at $10 to $12 per day, we will spend $3,600 to $4,400 a year. Earlier, we said that we should aim for a minimum of $5,000 savings per year. Thus, something as simple as a daily visit to a branded cafe could amount to 80 percent of the required minimum of $5,000 annual savings. Yes, that is a full 80 percent of our savings goal. The key theme here is this: We started with a simple expenditure like coffee and assessed the impact of these expenditures our long-term goals. Even if we can afford an expense ($4 a cup), we may choose to forgo it so that we can further support our long-term savings goals. Food is similar. Food can satisfy both a basic need and a social need to compete. We can meet our basic nutritional need by making and packing our own lunches and dinners. This is relatively inexpensive. If we prepare our own food, we can meet our basic needs for amounts in the range of $400 a month. Suppose we eat out regularly. Assume we eat fast food and pay $10 a meal three times a day, or $30. Most of us would be shocked to learn that this

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adds up to over $10,000 a year. Depending on how often we eat out, we can easily save thousands per year by preparing our own food. Eating, however, has an important social aspect. We can meet our friends or colleagues over breakfast, lunch, or dinner and exchange ideas, comment on politics and current events, or discuss our families. We have a choice of restaurants and menus that make our dining experiences enjoyable. Food also meets our psychological needs. It’s fun to eat out in welldecorated, upscale restaurants, where we are shown our own reserved space, waited on, and can order exactly what we want, how we want it (and even send it back if we don’t like how it is prepared). We feel good, even if only for an hour or two. Later, we can share our experiences on social media. These are important experiences. The question is whether they interfere with meeting our long-term goals. Assume that we spend $50 each time, twice a week, at upscale restaurants. This will amount to an extra $5,000 a year, equaling our minimum required annual savings. A key point we want to emphasize is that we need to be aware of how much money is spent on non-essential spending and the related impact on our ability to build retirement savings. If we carefully manage these expenses, we can meet our annual savings goals and ultimately, achieve financial independence. The social aspect of food can be enhanced by having friends over to our home to try different dishes, including foods from different cultures. Friends can also bring their own favorite dishes, which further enhances the social aspect of eating. Cooking with friends can save a huge amount of money and make for a very enjoyable evening. Next, consider transportation costs. There is a wide range of choices. New luxury cars can cost as much as hundreds of thousands of dollars, while low- to mid-level models can cost tens of thousands. Then there are the costs of a new model every year or two, fuel, insurance, after-market enhancements, and repairs. Transportation costs can easily become significant. Conversely, if we are comfortable cutting back on these expenses, we can easily meet our savings requirements. A good used car can cost $10,000 or

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less. Bus or train tickets can be had for a couple of hundred dollars a month. That is a significant amount of savings. Why do we spend on transportation? A utilitarian need is easy to understand. Depending on our budget, we can buy a new car, or a reliable used car, or take public transportation. The average annual cost of operating an average new car – including depreciation, maintenance, insurance, and fuel – is about nine thousand dollars a year.149 Alternatively, we can take public transportation at a much lower cost, especially if we live or work in a city. If we cannot take public transportation, a used car can cut transportation costs by at least 50 percent over a new car.150 Any one of these more economical choices can enable us to meet – or even exceed – our minimum annual savings goals. Next consider housing. Expense for housing can vary considerably based on the prestige of the property, desirability of neighborhood and location, amount of space, and degree of privacy. An apartment on Park Avenue in New York City – a highly prestigious address – can cost tens of millions.151 The cost of housing, as we know, is also particularly expensive in the suburbs of Boston, New York City, Washington DC, Los Angeles, and San Francisco. Who would not want a well-finished and spacious apartment or home? Yet is it a necessity to have a luxury home in the most prestigious location? If we are just starting out in our careers, we can rent a studio apartment, share multiple bedrooms with friends, or even live with our parents. In many cities, the average annual cost of a single bedroom apartment is well over ten thousand dollars.152 Sharing an apartment with one or more roommates can reduce housing costs at least 50 percent. These utilitarian choices can help us meet our long-term savings goals.

149

https://newsroom.aaa.com/auto/your-driving-costs/ See, for instance, https://cars.usnews.com/cars-trucks/new-cars-vs-used-cars 151 Just to name a few distinctive features, these homes include polished granite entrance floors and columns, peacock-decorated balconies, domed tops, and grand lobbies. 152 https://www.huffpost.com/entry/heres-what-an-average-apa_b_10346298 150

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We also need to think carefully about big expenditures. One item that stands out is the cost of a wedding, which can be over $30,000.153 Many families spend much more. We are led to believe that big, elaborate weddings should be expected, even for middle-class families. However, there are viable lower cost options. Once again, it is important to understand why we spend. If the point of the wedding is to celebrate our special moment with friends and family, we can find a way to do so within our budget. If we want to spend beyond this, we need to realize that this decision can have a permanent meaningful impact on our savings and financial flexibility. Suppose we avoided an elaborate reception costing $30,000. If we were to invest that same $30,000 in the stock market and earn as little as 6 percent per year, then we would have over $300,000 in our retirement account in 40 years.154 At 10 percent earnings per year, $30,000 today amounts to $1.4 million in retirement benefits that we would have in 40 years.155 This cost saving alone can provide us with an amount that is about the midpoint of what we need for a comfortable retirement. Even for those of us just starting out our careers, simple life-style choices can help save us well over twenty to twenty-five thousand dollars a year. This is more than sufficient to meet and exceed our savings requirement. These savings can directly go into an emergency fund, a house down payment, and retirement savings. What each of these examples share, is that they involve current restraints or inconveniences in return for much larger benefits in the future. There will be a time for extra consumption, but first we need to engage in shortterm discipline. Before we can spend, we need to earn, save, and invest. Short-term discipline also means making investment in our education or in our careers when we are young. This can require postponing marriage or children – of course, to the extent possible under our personal and medical circumstances – until our career or job situation is more stable than if were just starting our first jobs. Having the financial responsibility of a spouse or 153

See, https://www.businessinsider.com/average-wedding-cost-in-america-mostexpensive-2018-3 154 The math is $308,571 = 30,000 * (1.06)40 155 The math is $1,357,778 = 30,000 * (1.10)40

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children can make it more difficult to invest in our own human capital or our future. If you think having a new car or a large apartment is expensive, there are even bigger costs associated with having a family with children. A family, furthermore, involves a significant commitment of time for the care and support of children. Some obvious areas of unnecessary costs involve excess consumption of alcohol and cigarettes or the recreational abuse of drugs. A pack of cigarettes costs us between $6 and $13 in most cities.156 Many smokers spend over $2,500 a year on cigarettes (at $7 a pack), which is 50 percent of our minimum annual required savings. It can also have a huge positive impact on health.

How we are tempted into spending As we said earlier, we can have substantial needs. We want to have adequate nourishment, physical safety, health, and financial security. We also want to feel loved, respected, and accepted. These needs are not usually met with money alone. We cannot buy love, respect, or social acceptance. To be loved, we have to give love and deserve love. This requires patience, good communication, and some self-sacrifice. Love requires looking at life from the perspective of a spouse or other person you care about. Love, furthermore, means supporting a person’s own accomplishment and not comparing him or her to other people. Money also does not buy respect. To be respected, we have to take actions that involve difficult choices. Aristotle refers to this as being just and virtuous.157 To be respected, we have to work hard to achieve results. Respect has to be earned.

156

See, https://www.theawl.com/2017/07/what-a-pack-of-cigarettes-costs-inevery-state-3/ 157 See Nicomachaen Ethics, Aristotle, http://classics.mit.edu/Aristotle/nicomachaen.1.i.html

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To be accepted and admired we have to be beneficent.158 We have to help our friends, colleagues, and others in society. Many mistakenly believe that to be accepted, one has to be rich, famous, or powerful. Spending money itself will not make us rich, famous, or powerful. Nonetheless, we are bombarded with conflicting and confusing messages, especially from the media. Many commercial messages target these higher needs. We are shown images of the top 1 percent, rich, famous, and powerful people. They seem drive expensive cars, vacation in exclusive spots, and enjoy exclusive privileges. We are led to believe that we can feel rich, famous, and powerful if we spend money. Unfortunately, spending too much money will have the exact opposite effect. Messages we hear can also be confusing. Suppose you are shopping for a new car. The dealer shows you two cars. One car costs $25,000, financed over 50 months at 0 percent interest, with monthly payments of $500. The other car costs $35,000 financed over 100 months at 0 percent interest, with monthly payments of $350. Which car is more affordable for a given budget? Most people would say $350 a month is more affordable than $500 a month. But this reasoning in faulty. We provide a more detailed explanation later in this chapter. Our wants can seem substantial, especially when we feel we can afford it. Most of us want to look younger, smarter, thinner, wealthier, and more successful. However, we are only fooling ourselves if we think we can achieve these outcomes with frivolous purchases. We also worry that others are doing better than us. We look at our friends, neighbors, and colleagues. Their spending habits may make us feel envious and inferior. We may feel that additional spending is the only way to stop feeling inferior. Why do we feel this anxiety?159 In the US, we often view our compensation as a measure of our success, ability, and intelligence.160 We are led to believe that smart, hardworking people succeed and are well paid. A related part of this thinking is that people lack ambition if they do not earn 158

See Adam Smith, A Theory of Moral Sentiments, Gutenberg Publishers, 2011. Reproduced from the 6th edition, 1790. 159 See, Alain de Botton, Status Anxiety, 2005. 160 Alain de Botton, Status Anxiety, 2005

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a high salary. There is an expression, “If you are so smart, why aren’t you rich?” It is an unfortunate one, but nonetheless one we hear too often. How do people know how much money we make? Mostly they do not, since it is considered inappropriate to ask people this question. One signal they observe is how much people spend conspicuously. Here is a key theme. If we spend impulsively for emotional reasons, it will adversely affect our financial security. Impulsive spending is not going to make us younger, smarter, and more respected. People may seem rich, but may actually be destroying their wealth. Conspicuous luxury spending – for houses, cars, jewelry, clothes, and Botox shots – serves as an external sign of wealth. The same may be the case for luxury watches, SUVs, and vacations at exotic luxury resorts – the farther away, the better. To the extent these expenditures interfere with our longterm savings goals, they will hurt us to a meaningful extent.

Why does advertising work? Some advertising can work subtly to appeal to our emotions and vulnerabilities.161 It does not directly tell us what to do. If it did, we would likely reject the idea of purchasing items that are being promoted. Instead, most advertising shows, threatens, humors, cajoles, and tempts us.162 To exercise control over our spending, we need to be explicitly conscious about why we spend. We need to use the rational part of our brain. Most of us do not think explicitly about what triggers our purchases. As we discussed before, a utilitarian need is driven by our basic needs, such as food, water, warmth, shelter, rest, health, and transportation. Other socalled ‘higher’ psychological needs include love, respect, intimacy, acceptance, admiration, feelings of importance, and outlets for creativity. Advertising can sometimes seek to show us how we can fulfill our highest needs for love, respect, and acceptance. These are not usually realistic 161

https://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1319&context =articles 162 https://www.researchgate.net/publication/264341030_Mixing_emotions_The _use_of_humor_in_fear_advertising

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ways to achieve them. Advertisers understand our inner voices at least as well, or even better than we do. They seek to understand our inner desires, worries, fears, and insecurities.163 We must, however, recognize that our wants can be huge while our resources are finite. Arthur Schopenhauer reminds us of our challenge: “Striving for happiness is like an unquenchable thirst”.164 Mick Jagger put it more succinctly: “I can’t get no satisfaction”. Finance, however, appeals to our rational side, and teaches us to analyze the messages of advertising. Suppose we are interested in a luxurious dress that costs $400. Given its highly distinctive style, it will be out of fashion in one season. How many times can a person wear a new dress over the next three months? What is the benefit per wear? Does this limited use justify the expense? If the answer is that we can wear it only once or twice, then the cost per evening is between $200 and $400. We can then ask ourselves whether this kind of cost-benefit is compatible with our long-term savings requirements.

Where do we get our information? To be a smart consumer, we need to be informed. We need to acquire upto-date, accurate, and unbiased information about the products and services we consume. Most of us obtain this information from TV networks, radio, internet searches, and social media. While they seem free, they are really not. They are free in the sense that we do not pay them to use their services, but they can actually be expensive if we consider what that they can lead us to purchase. Modern technology, coupled with social media, is hugely increasing the power of advertising. Search engines and social media applications collect detailed personalized information from us.165 Social media enables 163 See, Sandra Moriarty, Nancy D. Mitchell, William D. Wells, Robert Crawford, Linda

Brennan, and Ruth Spence-Stone, Advertising: Principles and Practice, 2015, Pearson, pp131, 140. 164 https://digitalseance.files.wordpress.com/2010/07/32288747-schopenhauerthe-world-as-will-and-representation-v1.pdf 165 See, Facebook and Cambridge Analytics controversy,

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companies to know us better than any other organizations, and they can obtain insights about us that we may not even know about ourselves. Not only does a social media application know our basic demographic information – it also may know what we did today, yesterday, or ten years ago. It has perfect memory. It knows our tastes and dislikes. It knows about our musical, artistic, and political preferences. It also knows the characteristics and personal information of our friends. It even knows our exact whereabouts in real time. Over time, it will know an extraordinary amount of information about us. Even more, social media knows about our psychological ‘pain-points’ and it can manipulate them, intentionally or inadvertently. By pushing on them, social media may be able to encourage us to vote for certain candidates and go to certain locations.166 The information social media collects from us is becoming a substantial source of profit for corporations. Sophisticated artificial intelligence (AI) models have enabled the advertising industry to customize its messages to individuals that take into account individual profiles and tendencies. Using face and voice recognition technology, corporations are already able to follow us everywhere and at all times. They share this valuable information – subject to privacy restrictions – instantly around the globe, and they are

https://www.nytimes.com/2018/03/19/technology/facebook-cambridge-analyticaexplained.html 166 Interfering in other countries’ elections used to be a costly affair. Many times, it required years of planning, investment of hundreds of millions of dollars, and messy and deadly military interventions to overthrow governments. The list would have to be too long to be comprehensive, but regime changes in Panama, Honduras, Nicaragua, Mexico, Chile, Haiti, Japan, and Iran brought about by the United States are just a few examples. For a more comprehensive list, see, https://en.wikipedia.org/wiki/United_States_involvement_in_regime_change The United States Government was a pro at this. Not anymore. Now thanks to social media, a handful of trolls located anywhere in the world can plant false stories in the social media and manipulate elections in the world. The 2016 elections in United States was no exception. Such is the power of modern technology and social media. Facebook is credited (if that is the right word) with starting the Arab Spring revolution. See, https://www.nytimes.com/2012/02/19/books/review/how-an-egyptianrevolution-began-on-facebook.html

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able to direct their messages at us, and at all times. They already have the power to create instant needs and offer their services to fulfill those needs. Is any of this surprising? It should not be. Technology provides its users with enormous power and leverage. It can be used to manipulate and extract value from us. We ignore technology at our own cost. We anticipate that some of you will react negatively to what we have said. How can you tell us what to consume? People have free will. They decide voluntarily what to buy and consume. Who are we to tell them otherwise?167 What is the answer? As we have noted, finance teaches us that we need to set aside a proportion of our income for savings to help us in retirement. Excess spending that interferes with this goal is detrimental for our wellbeing. How we achieve this goal is up to us. Nevertheless, the top-down model we have proposed earlier in the chapter removes one level of required self-monitoring, making it a more convenient approach.

Resisting temptation To save, we need to manage temptation. One way is full avoidance. The other approach is to learn, understand, and exercise, reasonable restraint. Consider the avoidance approach with an example from Homer’s The Odyssey. Sirens – creatures who are half-bird, half woman – lured unsuspecting sailors by singing enticing songs to them.168 In response, the sailors turned their boats toward the sirens to hear them better, and they crashed on the rocks. The sailors were then devoured by the sirens.

167 Herman and Chomsky provide a model to explain the role of the media in shaping

public discourse on economic and political issues. See Manufacturing Consent: The Political Economy of the Mass Media by Edward S. Herman and Noam Chomsky, Pantheon Books, 1988. 168 "'Come here,' they sang, 'renowned Ulysses, honour to the Achaean name, and listen to our two voices. No one ever sailed past us without staying to hear the enchanting sweetness of our song- and he who listens will go on his way not only charmed, but wiser, for we know all the ills that the gods laid upon the Argives and Trojans before Troy, and can tell you everything that is going to happen over the whole world’.” Odysseus …

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To avoid the temptation of the sirens, Odysseus instructed the crew by to plug their ears with wax. He, on the other hand, listened to their beautiful songs. As a precaution, he had himself tied to the ship’s mast. This worked. He could not act on temptation and was not harmed. The sailors, on the other hand, stayed on course since they could not hear the songs. We can do the same in our everyday lives. As we will see throughout this book, finance teaches us that ‘there is no free lunch’. There is no free TV, search engine, or social media. Their ‘cost’ is the advertising we have to watch. The restraint approach is to turn off the siren song of commercials. This means plugging our ears, one way or another. One approach is to stop using the internet or TV. That’s it. The alternative approach is to understand the message of advertising and take steps to avoid being manipulated by it. Of course, when we turn off the music, we turn off both the advertising and the content. You may like the content. It allows us to be entertained, be social, and pass the time. No arguments here. If we need the TV to be entertained, then we are somewhat stuck. The best we can do is to reduce the time we spend watching it. Again, the most important issue is not the total elimination of TV, but rather, control of it. We need to appreciate the potential conflict of interest between us – the consumers – and the sponsors. Advertising should not be considered an unbiased source. With constant exposure, however, we may be misled into making purchases we otherwise would not have made. As we said before, the solution is not to eliminate TV. We can just cut our TV time. Instead of watching TV for four hours a day, we can cut it to half an hour, or fifteen minutes a day. We can turn off instant notifications on our phone. We can approach advertising or even so-called content with a skeptical eye.169

169

We can also attempt a ‘phone detox’ which, during the writing of this book, is getting some attention.

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How do We Become Smart Consumers How do we apply a healthy dose of skepticism in our daily lives? How can we practice restraint – what we also refer to as ‘smart consumption’? First, we can save, using the top-down approach. Every month, we remove our mandatory savings from the checking account and put it into savings accounts. By doing this at the start of the month, we do not wait to see if anything is left over at the end of the month to save. This also avoids temptation. If unspent money remains at the end of the month, we are free to spend it. We therefore determine what we can afford, not based on what we make, but on our disposable income after we save. This requires discipline and self-control. Another restraint is to use cash instead of credit cards. Cash imposes a binding restraint. We can only spend what we have in our wallet. If we do not have it, we cannot spend it. To enforce this restraint, we need to take a limited amount of cash with us. Each time we spend, we watch our wallet getting smaller. We physically experience the decrease in the amounts we can spend. This imposes an additional physical constraint on our impulses. A credit card is the opposite of cash. Credit cards demolish restraint and budget constraints. Credit cards allow us to spend not only everything we have, but also what we have not yet earned. Credit cards also allow us to spend on goods and services we cannot afford. If we cannot afford a $1,000 purchase with cash right now, then we also cannot therefore afford the $1,000 plus potential interest and penalties using a credit card that we will be required to pay next month. The solution is to remove the credit cards from our wallet or purse and carry a limited amount of cash. Our wants, which we thought of as urgent, will seem less so. Credit cards also come with various temptations to earn discounts, free airline miles, free dinners, and free hotel stays. Credit cards promise to give us cash-back rewards. We love the word free. Just the possibility of getting something for free is enticing enough. Before we get tempted with these offers, however, we need to think about whether, and how often, we actually earn these rewards, net of all the potential late fees, interest costs and penalties we incur if we do not pay the whole of the outstanding

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balance, in full and on time. If we do not, there is no need to pay attention to the so-called freebies. Another method of restraint is not to act on our every impulse as soon as we feel the urge. Once we think that we need something, we should not act on it immediately. Instead, we need to think about what exactly a new gadget will do, and how many times we actually needed it over the past year. Since we did not have it, what did we do instead? If the answer is not even once, this is good time to insert some restraint. We can estimate the value of the gadget to us, using the way of thinking we have learned from finance. Suppose that a kitchen gadget costs $250. We did not need it at all during the last year and now we think it would be nice to have. Suppose we think we would use it three or four times a year if we had it, and it would save us 15 minutes of labor each time. This means that we would save about one hour of labor a year. Assuming we value our leisure at $15 an hour after tax (or $22 before tax), this gadget will take more than 15 years to pay for itself. Will the gadget even last that long? This seems like an unsound purchase. This simple restraint rule will help us avoid impulse spending. Another important restraint is that we should not confuse need with affordability. Just because we can afford something, clearly does not mean we need it. Affording something and having a use for it are completely separate concepts. Consider the example of a car. Suppose we decided to buy a new car. We have some idea of what car we would like to have, but we are still open to other ideas, and we consult the car dealer. When we go to a new car dealer, the first question the dealer will ask us is our monthly budget for payments. The dealer wants to know what the maximum monthly payment we can afford for the new car is. To make it even more expensive for us, and more profitable for the dealer, the dealer offers us 84-month or even 96-month financing. The longer financing terms appear to make even more expensive cars more affordable. Consider two cars. Car A costs $20,000 financed at 0 percent interest rate for 48 months, while Car B costs $35,000 to be financed at 0 percent interest rate over 96 months. The monthly payments are $417 for Car A and $365 for Car B. Hence, stretching the financing terms appears to make

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the more expensive car even more affordable. However, the cost of a longer financing-term can mislead us about the true overall cost of one option versus another. What happens when we buy the most expensive car with payments based over 96-month financing? We are stuck for the next eight years with mandatory car payments. The most immediate result is that there will be little or no additional amount of funds left for any other purpose. The more expensive car (that looked affordable to us) will reduce our flexibility. There will be no funds left even for any emergency, let alone for long-term savings. The initial purchase price of the car is only one component of the cost. With a more expensive car, insurance costs will be higher. Repair costs may be higher. If it has a bigger engine, fuel costs will be higher. There is yet another hidden problem. What determines affordability is not the monthly payments, but also the real depreciation on the car. Our overall cost for the new car is the total of the monthly payments minus our equity in the car. Equity is defined as the market value of the car, minus remaining payments. When equity is negative, this creates a second hidden cost. To further illustrate this problem, we extend the terms of the loan beyond what is usual. Suppose that the dealer offered a 25-year, or 300-month financing for Car B. The monthly payments now go down to $117. Will this actually make the car more affordable? Clearly, the answer is no, since no car will last 25 years. This car, with 300month financing terms, will break down and become practically worthless after 10 years or so. At that point, we will need a new car, even though we still owe money on the old car due to the extended term of the financing. If the market value of the car is less than the remaining debt on the car, then you have a situation called negative equity. This amount will be added to the cost of the second car, and our monthly payments will rise. Hence, stretching the terms of the loan simply exacerbates the negative equity problem. We are consuming more car than we can afford, and the difference is building up as growing debt over time. To formally illustrate the problem of negative equity, we compare the resale value of the car against the remaining debt for 84-month financing.

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The typical real depreciation rate of a new car is 25 percent in the first year and about 16 percent per year thereafter.170 Figure 6.1 shows the resale value and remaining debt on a new car as a percent of the purchase price. The difference between these two lines is an additional cost of ownership, with white boxes as negative equity, and black boxes as positive equity. As is evident in Figure 6.1, the remaining debt is higher than the resale value of the car during the first five years of ownership, thus leaving the owner with negative equity. In fact, one has to keep the car a minimum of six years to end up with a positive equity. Alternatively stated, our car is depreciating faster than our payments. Hence, we are paying more for the car than the monthly payments in terms of lost resale value during the first five years of ownership. This is a hidden cost.

Figure 6.1: Resale value v. Remaining debt for a new car

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What happens if the owner sells this car in year 4 and buys a new car? The negative equity is also financed and added to the loan on the new car. Consequently, the total debt on the new car can exceed its market value the moment it is acquired. This way, negative equity grows with each cycle. As of 2019, about one in three car owners who traded their old cars in when buying a new car had an average negative equity of about $5,000 on

170

https://goodcalculators.com/car-depreciation-calculator/

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their cars.171 This ratio was less than one in five in 2009. Owners with negative equity are financing approximately $39,000 car loans (compared with $30,000), have higher monthly payments ($640 compared with $521), have longer loan terms (76 months compared with 68 months), and pay a much higher interest rate on their loans (7 percent compared with 5.3 percent) than car owners with positive equity in their cars.172 The lesson here is simple. Many of us are simply consuming too much expensive transportation. Many of us think we can afford these new and expensive cars because the bank is willing to provide financing. They are confusing affordability with desirability. Just because some people can get a big loan for a new car does not mean they should accept a big loan. Similar problems exist when we buy expensive houses with ‘teaser’ financing rates.173 Again, the initial cost is only part of the problem. We have to worry about mortgage payments, upkeep costs, and fluctuations in the value of the house. We miss the larger picture if we focus only on the monthly affordability or monthly mortgage payments. We need to think about optimal house size instead of the biggest house. How often do we use these extra rooms? Why do we need to maintain an impeccable living room where no family member is allowed to walk in and touch the furniture? How often do we use the guest bedrooms? How many bathrooms do we really need? How often do we entertain? When we think explicitly about these issues, the ideal house for us need not be the most expensive house we can afford. As before, we will lose our flexibility if we purchase the largest house we can afford. Furthermore, a bigger house requires higher annual real-estate taxes, insurance, and more daily upkeep. We have to furnish the extra

171

https://www.wsj.com/articles/a-45-000-loan-for-a-27-000-ride-moreborrowers-are-going-underwater-on-car-loans-11573295400?mod=hp_lead_pos1 172 https://www.wsj.com/articles/a-45-000-loan-for-a-27-000-ride-moreborrowers-are-going-underwater-on-car-loans-11573295400?mod=hp_lead_pos1 173 McMansions, as they are called, a monster house on a small lot.

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rooms, heat and cool them, and clean them. All of this costs even more money.174 Once again, if housing values fall, or interest rates rise, we would face the same negative-equity (or negative amortization) problem. We could owe more on the house than its market value. If we have any problems with making monthly payments, we cannot solve our problems by selling the house either. Many Americans experienced negative equity issues during the Global Financial Crisis. They owed more on their houses than the market value of the house. They had to sell their homes at a substantial loss or walk away from them, in many cases losing substantial savings.175 Consider a simple example to illustrate the affordability paradox. Suppose that you bought a house for $200,000 with no down payment. The interest rate is floating, set at a teaser rate of 1 percent during the first year. This makes the monthly payments $167 a month. However, this does not make the house necessarily affordable. If the floating interest is likely to jump to 5 percent the next year, monthly payments will also jump, five-fold, to $833. You have to ask yourself if you can afford $833 a month – not $167 a month. An example of a mortgage product with negative amortization is a reverse mortgage, which allows the homeowner to take out a mortgage initially and receive cash upfront or monthly, live in the house as long as they are alive, and not make any monthly interest payments on the loan. The homeowner is still responsible for paying property taxes and insurance premiums. At first glance, this may seem like a great product for many elderly people. The problem here, once again, is that there is ‘no free lunch’. The initial mortgage amount will be, at best, close to about half of the value of the equity in the house. Furthermore, this is a negative amortization loan, with the loan amount growing every year, since no interest payments are being 174

Another cost of a big house is that our family life could be adversely affected. In a big house, there is less family interaction. We won’t get to see our children as much, since they will be hiding in their own bedrooms watching their own television programs. How would we be able to spend precious quality time with them if they are not around? 175 See, http://www.nbcnews.com/id/21478416/ns/business-answer_desk/t/ which-worse-foreclosure-or-bankruptcy/#.XWP_x-hKhaQ

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made. These interest payments, and any monthly service fees, will be added to the initial loan amount, thus increasing the amount of the loan. If the home is not maintained, or taxes or insurance premiums are not paid, then the homeowner can end up defaulting on the loan. Whether a reverse mortgage is appropriate for a given person will depend on the particulars, such as the age of the person, the amount of equity in the house, the interest rate and fees, and whether the loan amount can exceed the market value of the house at the end. Banks and businesses make it easy for us to spend, but until, and unless, we control our spending habits, we cannot save. In our view, the most important idea in financial economics is that we can build large amounts of retirement wealth by simply saving, investing, and staying invested for a long time. You do not need to be a finance professor, hedge fund manager, or investment banker. To achieve a minimum level of financial security, you do not need to buy and sell the stock market at the most opportune time – a practice called timing the market – and you do not need to buy and sell individual stocks at the most opportune time – a practice called stock picking. Not only do you not need to be an expert on the stock market, but you don’t even need to understand the basics of how the companies work, how they make money, or how the stock market works. What you need to do is to save, invest, and stay fully invested for a long time. This is something any of us can do! To save money, we have to live, not at or above our means, but strictly below our means. The difference between what we earn and what we spend is our savings. Thus, to be able to save, we have to live strictly below our means, namely we have to spend less than what we take in. Only then is saving possible. This statement is true for everyone. There is no avoiding this dictum, even if someone makes five million dollars a year, or receives a large lump sum payout, such as professional athletes, celebrities, or lottery winners. Anyone who lives above their means will eventually exhaust all their assets as well as their borrowing capacity, and they will eventually be forced into bankruptcy. In fact, evidence shows that this is exactly what happens. The

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lottery winners in Florida had the same bankruptcy rates as the general public.176 Unfortunately, we do not seem to save well. In fact, our accumulated savings is abysmal. The median177 retirement savings level for Americans age 26-79 in 2010 is only $2,500.178 Basically, half of all adult Americans of all ages have just about zero in retirement savings. The median net worth of households age 26-79 is just $77,000 in 2010, which is, again, nowhere near sufficient to retire.179 Thus, most Americans struggle to save anything. Many Americans spend more than they earn. They are in debt. We will discuss the consequences of debt in more detail later in the book.

Where to Save Let us assume that you are ready to save. Now what? Where do you put your savings? You need to think of short-term and long-term goals. You also need to think about your taxes. Consider taxes first. You have choices between taxable and non-taxable accounts for your savings. For those of us who are working and paying taxes, we should always take advantage of the tax-deferred savings options first. If your employer offers 401(a), 401(k) or 403(b) plans, or a Supplemental Retirement Account (SRA), you should take full advantage of these. If your employer matches your contributions, you should make full contributions and ensure that your employer fully matches your contributions. Suppose that when you contribute $1,000 to your 401(k) plan, your employer matches this, dollar for dollar. This means that your $1,000 immediately becomes $2,000. This means that you are getting a 100 percent return on your investment the day you invest. No one can match 176

See, Hankins S., M. Hoekstra, and P. Skiba, “The ticket to easy street? The financial consequences of winning the lottery.” Hankins, Hoekstra and Skiba write: “In all, 1,934 Fantasy 5 winners were linked to a bankruptcy in the five years after winning. This match implies a one-year bankruptcy rate among lottery players of just over 1 percent, which is similar to the filing rate of 1.0 percent for all adults in Florida from 1993 through 2001.” 177 Median means 50 percentile. Half the observations are greater than the median while half are below it. 178 https://www.epi.org/publication/retirement-inequality-chartbook/ , Figure 12. 179 https://www.epi.org/publication/retirement-inequality-chartbook/, Figure 27.

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this kind of return, no matter where you invest. We must make full use of these opportunities. In addition to employer-matching plans, we should take full advantage of the availability of Individual Retirement Plans (IRA), or Keogh plans. The traditional IRA plans allow us to make contributions from pre-tax dollars. Any money we contribute is not taxed. However, our earnings will be taxed in retirement. If we expect our tax rates to decline over time, the traditional IRA is a better tool to use. Any money left to your heirs will typically escape all taxation by stepping up the basis of the investments.180 The upfront tax-deductibility is equivalent to getting a 30 percent return on investment as soon as you invest. Once again, it is impossible to match this return in any other way. There is also the Roth IRA. In this form of IRA, your contributions come from after-tax dollars, but your earnings are not taxed upon withdrawal. You can also access your savings prior to retirement, as long as you have had the Roth IRA for a minimum of five years.181 There is no tax benefit upfront, but your earnings will grow on a tax-free basis. If you expect your tax rates to increase over time, or you need to access your savings before retirement, the Roth IRA is a good vehicle to take advantage of changes in the tax rates. Keogh plans are similar to IRAs for self-employed people. These can be set up as defined contribution plans, with up to 25 percent of the annual compensation amount. Legal requirements are similar to those for IRA accounts. As we stated earlier, many corporations will match the contributions of their employees, dollar-for-dollar, up to some legal limits. This benefit should be used to the fullest extent. Suppose that you can save $7,000 a year in a 401(k) plan, and your employer provides dollar-for-dollar matching. Suppose that instead of saving this money for retirement, you decide not to contribute and you want to trade on your own instead. What 180

New tax rules require that all inherited IRA assets must be withdrawn within ten years by the heirs. See, https://www.forbes.com/sites/martinshenkman/2019/12/25/secure-act-new-irarules-change-your-estate-plan/#1512a99d710f 181 https://investor.vanguard.com/ira/roth-ira

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rate of return do you need to earn in order to make sure that you come out ahead? If you do not put the $7,000 in the 401(k), you will receive about $5,000 after taxes. If you had contributed, you would have had $14,000 in your 401(k) account, including your $7,000 and your employer’s matching contribution. In order to break even, you would then need to earn $9,000 or an after-tax rate of return of 180 percent in the first year.182 Furthermore, in all future years, you will need to earn at least 1.5 times that, in order to stay even, before paying taxes on your personal account as well as the foregone employer contribution, while the 401(k) continues without being taxed and receives matching employer contributions. Achieving these kinds of levels is just about impossible for most mortals. Even the most successful investors of all times, such as Warren Buffett or Peter Lynch, only achieved an annual return of 20 to 30 percent.183 One drawback with using tax-advantaged shelters (except Roth IRAs) is that you will not have access to our savings without a tax penalty, at least until you turn 59.5 years old.184 However, not accessing your retirement funds should be manageable, since this is strictly retirement saving. You need to make sure that you build up your emergency funds such that you will have other means to meet any emergency needs. You can also address this liquidity issue by keeping some portion of your savings in a Roth IRA. Suppose you followed the advice in this book, and postponed or eliminated wasteful consumption and saved instead. Now what? You need to invest. Yet most of us just do not know enough about low-cost approaches that generate income and growth in the long run. We will explain shortly. A lack of basic understanding about investments is surprisingly common, even among lottery winners, celebrities, and successful young professional

182

The break-even rate of return is ($14,000/ 5,000) -1 = 180 percent. Warren Buffett’s Berkshire Hathaway earned about 21% per year from 1965 to 2017, while Peter Lynch’s Magellan fund earned 29.2% per year from 1977 to 1990. See, https://www.cnbc.com/2018/05/05/warren-buffetts-three-best-investingtips-explained.html and https://www.investopedia.com/university/greatest/peterlynch.asp 184 In some circumstances, your employer may offer to loan some funds without triggering a tax penalty. 183

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athletes who suddenly come into large amounts of money.185 Some successful professional athletes and celebrities do invest, but many sustain huge losses on their investments. While the reasons for failure are varied, there are common themes. Many chase fraudulent, get-rich-quick schemes.186 Some get into bad investments. Some are taken advantage of by their friends, financial advisors, parents, or other family members.187 We can give hundreds of examples of poor investments. In the movie, Broke, Bernie Kosar tells his own story. Kosar played professional football for the Cleveland Browns and made $19 million. Yet, in spite of these vast sums earned, he ended up filing for bankruptcy. When he filed for bankruptcy, he had only $44 in his checking account. Apparently, his professional earnings were squandered in bad real estate and other investments. How can we prevent these problems? We need to have a very basic understanding of appropriate approaches to investing. We need to learn this ourselves. This should not be delegated to family, friends, or financial experts. Next, we focus on trading and two investment types – one where the investor is actively involved, and the other where a portfolio manager makes the investment decisions.

What about trading? People often confuse investment with trading. First, we explore the differences. Trading is buying and selling an asset for the short-term. In contrast, by ‘investment’, we mean buying and holding an asset for the long-term. An asset is something that will give us earnings in the future. 185

A Sports Illustrated article estimated that, within two years of leaving football, an astounding 78 percent of professional NFL players are either bankrupt or in financial distress over joblessness and divorce. See, https://www.si.com/vault/2009/03/23/105789480/how-and-why-athletes-gobroke 186 See, https://www.cnbc.com/2018/05/14/money-lessons-learned-from-proathletes-financial-fouls.html 187 See Bernie Kosar story in the movie “Broke.” Also see, https://bleacherreport.com/articles/1357277-bernie-kosar-former-qb-exposespitfalls-of-athletes-trusting-family-in-broke

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These could be illiquid assets, such as physical buildings and equipment that are not easy to sell in a short time period; or they can also be liquid assets such as stocks and government bonds. There may be long periods of losses, or zero earnings. Nevertheless, as we are going to maintain our investment approach until retirement, long-term means ten, fifteen, twenty, or even fifty years. Trading is different from investment. Trading has a short-term outlook, typically days, or a few months at the most. Trading involves buying and selling liquid assets, such as stocks, bonds, commodities, and other securities. Liquid means that the transaction costs of buying or selling the asset are small. These costs include commissions, taxes, mark-ups usually known as the bid-ask spread, and other trade-related costs. We buy something with the express purpose of selling later at what we hope is a higher price. Later could mean later in the day, next week, or next month. Nevertheless, we intend to hold the asset only while we are waiting for the price to go up to some previously determined target profit level. If the price goes down instead going up, we, again, sell once it reaches a predetermined loss level. Consider a simple example. Suppose that we buy a stock at $100 today and a month later, we sell it at $103. This is an example of successful trading. We made a $3 short-term capital gain on our trade. What do we need to do to trade successfully? Successful trading requires effort to select, monitor, buy, and sell the asset. Furthermore, these activities require timely access to information and trading platforms. We start with a trading strategy – called an investment thesis – that specifies why the asset is cheap at this time, and what factors will cause it to go up in price in the near term. Next, we need to do research to analyze and identify potential candidates for trading that fit our investment thesis. Specifically, we need to identify assets that are likely to increase in price in the near term. Since there may be a large number of assets that pass the filters, we need to further narrow our choices. We do this by obtaining more asset-specific information. All of this requires expertise about the underlying assets, knowledge about current market specifics, and investment in information, time, and labor. We also need to think about the fact that if we are correct in our analysis, why is it that the asset price has not already increased? Why is it that we

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are the only ones to notice this profit opportunity? What is holding other people back from jumping on this asset already? After purchasing the asset, we still need to monitor our investment continuously. We need to keep track of information flow and price movements. We need to keep track of new information about the underlying asset to determine whether our investment thesis is being fulfilled. We need to understand what caused the price movements and whether the reason we bought the asset in the first place is still valid. If the investment thesis is no longer valid, we would sell the asset regardless of current price. Successful trading also requires information, expertise, and discipline. Suppose that our investment thesis remains valid, but the asset price declines. A disciplined approach requires that we do not become emotional. A disciplined approach requires that we stick with our investment, or maybe even increase our exposure to the asset, since it is now even cheaper. Similarly, asset price may have increased a bit, but our investment thesis is no longer valid. In this case, a disciplined approach requires that we sell the asset. Hence, successful trading requires its own set of temperament, skills, and expertise, to analyze, identify, and trade securities. Successful trading requires investment of time and energy. It requires risk tolerance and discipline to execute the trading strategy without getting tangled up in one’s emotions. Most people do not possess these skills. Hence, successful trading is hard for most people. Consequently, trading is not appropriate for someone with a full-time job. Trading should be done by professional traders, not most of us. Next, we return to investments. Investing also involves buying and selling an asset, similar to trading. However, we do not need to identify whether the asset is currently cheap or expensive, or what is likely to happen in the short term. Instead, we focus on the long-term. In the long run – say ten, twenty, or forty years – these pricing considerations would be minor details. What matters is whether we are bearing sufficient risk, and whether we stay with our investment in the long run. We will explain this further.

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Participatory and directed investments We classify long-term investments into two broad categories: we describe them here as participatory investments and directed investments. (It may also be useful to describe them as ‘active’ versus ‘passive’ types of investment, although these terms have a well-developed meaning in investing that refers to whether an investment style follows a broad market index (passive) or whether a small subset of stocks are chosen (active)). As we use the terms here, what distinguishes participatory investments from directed investments is the level of involvement of the ultimate investor. In participatory investments, the investor is usually physically present, personally managing all aspects of the business. This requires time, money, and expertise. Examples of participatory long-term investments include startup companies, new retail shops, consulting firms, or restaurants. In contrast, directed investments include a savings account in a bank, stocks, bonds, mutual funds, exchange traded funds, and real-estate investment trusts (REITs). Someone else makes the investment decisions. Participatory investments are appealing choices if you have the time, money, experience, and expertise. It is not something you can do on a parttime basis while you hold a full-time job. Many people think that they can just hire a professional manager for their participatory investments. Suppose you do not have the time or the expertise to personally run these businesses. Instead, you intend to hire a professional manager. You then let the professional manager take care of the day-to-day running of the business. Would this work? The answer is maybe yes and maybe no. Consider a real-estate example. Suppose you purchased a rental apartment building for investment purposes. You then hire a real-estate management company. They will manage the business on a day-to-day basis, such as fixing any broken appliances, cleaning and maintaining the property, removing the snow in winter, mowing the lawn in summer, running background checks on potential renters, signing rental contracts, collecting rents in full and on time, evicting those who do not pay rent, preparing tax forms, paying taxes in full and on time, and doing everything else necessary

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to keep the renters coming and maintaining the property in good standing. Clearly this is time consuming. Furthermore, even if you hire a management company instead being personally involved, you still need to monitor the management company to make sure that they are complying with the management agreement. This means inspecting the management company’s reports and going over their financials. You need to make sure the management company is run by honest, competent, people. Otherwise, you cannot be sure that either the management company or one of their employees is not cheating you. Thus, participatory investments require time, effort, expense, expertise, experience, and the temperament to deal with people, solve problems, stay focused, and stay organized. If you do not have enough time or effort, you are going to fail. Even If you put in the time and effort, you still may fail if you do not have the right temperament to deal with subordinates or employees. If you offend good employees, they are not going to remain with you. If you are not a good judge of people, and you hire ineffective staff, your investment will suffer, or even fail. There is no substitute for any of these requirements. For most of us with full-time day jobs, it is not practical to develop a complete set of required skills or a detailed understanding of all the investment vehicles. As we discussed in the introduction, it is this complexity that intimidates people. However, we do not need to be participatory investors to build retirement savings. Earlier in this chapter, we discussed how lottery winners, celebrities, and professional athletes, fail in many of their investment attempts. One of the most common mistakes is that people attempt ill-suited participatory investments. Unfortunately, since they lack one or more of the requisite skillsets to properly manage either the managers or these investments, their attempts typically end up in failure. With directed investments, what we really need to know can be learned with relative ease. In this book, we recommend only directed investments for retirement savings for people with full-time day jobs. The simpler the better. The less the time it requires, the less the cost, the less the skill requirement, the better the investment.

CHAPTER 7 DEALING WITH INVESTMENT RISK IN STOCK AND BOND MARKETS

“Using volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” —Charlie Munger

The US stock and bond markets can seem quite daunting. So many choices, so many participants. The market swings (this is called volatility), sometimes wildly, and often without a clear explanation. There are so many funds and products to select from. Each analyst seems to recommend a different approach. How do you make sense of this if you do not have an MBA or a PhD in finance? How can the individual investor – who is not an expert – possibly compete with others who study the markets every day? These are valid questions. They are questions we begin to answer here in this chapter. You will not become an expert after reading one chapter or even one book, but you will have a better understanding of an approach that arises out of the historical analysis of stock and bond prices over a long period. Our key theme is that the stock and bond markets can offer a long term and sound approach to building retirement savings if you make the right choices at the outset of your career and over time. We offer you some thoughts about this. Before we explore these themes, we need some basic vocabulary. Anyone can start a business, such as a restaurant, or retail store, or if they work for themselves as a skilled laborer. In these cases, the business and the owner are considered the same. This is called a proprietorship. Your legal name and your business name are the same.

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If more than one individual starts a business, they will form a partnership and specify their agreement in a formal document called a partnership agreement, which specifies the rights and responsibilities of each partner. The partnerships are registered with the state. Both proprietorships and partnerships require your active participation. Being the owner also means being the manager. To be successful, you need to possess money, expertise, and experience, and invest your time and effort. A more formal business structure is a corporation which involves dozens, hundreds, or potentially even millions of owners. You become a part owner of a corporation when you buy its shares. In becoming the owner of a corporation, you delegate the management of the company to professional managers who are compensated in the form of a salary, bonus, and grants of shares. Corporations have more specific written agreements, such as articles of incorporation, by-laws, and policies. Corporations also have to register with their state. Corporations can be one of two types: public or private. In the US, a company is required to be a public company (listed and traded on an exchange) if it has more than 500 owners and $10 million or greater in assets. Public companies are required to provide investors and other market participants with specific information on a quarterly basis, including information on their assets, liabilities, revenues, and expenses. They must, on an annual basis, also provide details of their executive compensation. Their financial statements and other related disclosures must be submitted to the Securities and Exchange Commission (SEC), the federal agency charged with regulating the securities markets,188 and this information is subject to federal securities laws that require timely, accurate, and adequate, disclosure. The company’s financial statements must also be audited by a public accounting firm in accordance with generally accepted accounting principles (often referred to as GAAP). In contrast, private corporations are not required to provide public disclosure, although some do provide more limited disclosure, usually a statement of assets and liabilities (often known as a ‘balance sheet’). Private companies can only sell equity and debt to qualified investors on a private basis (where the equity is usually called private equity). A qualified 188

See Securities and Exchange Act of 1934: https://www.sec.gov/answers/aboutlawsshtml.html#secexact1934

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investor is required to have more than $200,000 in income for the last two years, and more than $1 million in investable wealth (excluding primary residency).189 Even if you are not able to comprehend and evaluate a public company’s disclosure documents, other sophisticated investors and analysts will be reading these public documents to learn as much as they can. They may decide to buy or sell their shares, and such decisions may have an impact of the price of such shares. As one of many investors, you benefit not only from the federal securities laws, and the related oversight of them by the SEC, but also from the effort and expertise of other investors. Their effort and information will be reflected in the price you pay to buy or sell shares. Private companies do not share this same level of transparency. Even if you are able to meet the requirements to qualify as a private investor, you need to understand the potential for gain or loss. This requires time, effort, expertise, and experience. You should proceed carefully, and seriously consider whether you can understand and tolerate the potential for loss.190 Public corporations raise capital by issuing shares of stock, also known as equity. To do so, they usually interact with an intermediary known as an investment bank, which buys the shares from the company and resells them to investors. For this service, the investment bank earns a fee. This is known as public underwriting. Bonds of publicly held companies are sold in a similar manner. What is a stock or a bond? How do they differ? What other forms of securities can you invest in? As we mentioned before, a share of stock of public company represents a proportional ownership claim in the company. When you buy its shares, you share in its prosperity on the same basis as other shareholders. You participate in its technology, innovation, patents, and other assets. If the company is successful, it will earn profits over a long period of time, and it

189

https://www.coindesk.com/sec-proposal-would-broaden-accredited-investordefinition 190 We can also make a no-free-lunch argument. If the private investment opportunity was truly worthwhile, shouldn’t you be the one that has to seek it out? Thus a healthy dose of skepticism is useful with private investments.

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will reinvest part of these profits back in the company; the remainder will be paid to investors in what is known as a dividend.191 Consider Microsoft, a uniquely American company known for its innovation and expertise in software and hardware. It has consistently been among the most valuable companies, based on the outstanding value of its shares. If you buy 100 shares of Microsoft stock, you own proportional ownership interest in Microsoft.192 You are able to vote for, and elect, the board of directors of the company, which is supposed to represent your interests and act on your behalf; the board also hires and fires the firm’s senior leadership, sets their compensation, approves or rejects major initiatives, and approves dividends.193 As owners you are entitled to receive the dividends that the company declares. (So, if in early 2020, Microsoft declared $2.04 as a share dividend, you will receive $204 per year as a result of your 100-share ownership interest).194

191

In other cases, companies buy back their stock. This is a complicated area of finance, and we don’t intend to explore it here other than to say that sometimes companies view the buyback of their own firm’s stock a more productive use of their capital than reinvesting in new or ongoing company projects. Finance professors and finance professionals have much to say about the pros and cons of stock buybacks. We need not go into that here. See for instance, https://www.wsj.com/articles/SB100014240529702038249045772138910356143 90 and https://www.wsj.com/articles/the-real-problem-with-stock-buybacks1530903118 192 The exact amount of ownership your shares give you depends on the number of shares that Microsoft has outstanding. If Microsoft had 1,000 shares outstanding, 100 of which are yours, then you are a 10% owner. As of mid-2019, Microsoft had about 7.7 billion shares outstanding. See, https://finance.yahoo.com/quote/MSFT/financials?p=MSFT 193 Sometimes, there may be competition for your vote. You may be asked to choose between two different directors, each of which has different strategies for the company. This competition results in different management teams being chosen to run the company. Hence, by your vote, you can help determine who the top management, and therefore what the strategy of the company, will be. 194 See, https://finance.yahoo.com/quote/MSFT?p=MSFT

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If you decide to sell your shares later and the price of Microsoft stock has increased over time, you can benefit from the price increase. This is called a capital gain. Almost anyone can participate in the stock market.195 A common practice is to open up an account with a brokerage company and send them money. You can easily make your purchases and sales online. There are many brokerage firms. Among the largest are Vanguard, Fidelity, and Schwab.196 You can also execute your order through a financial adviser, who may charge you a fee on the basis of the amounts you have invested. This form of passive investing is in contrast to participatory investing, which occurs when you own and run a small business. Passive investing also has another meaning, which involves investing in a market index as opposed to individual stocks. We will discuss later in this chapter. In the long run, stocks have provided their owners with higher rate of return than other asset classes. One reason for this is that U.S. companies have been consistently profitable, making productive use of people, technology, and physical resources. Some of this profit has been reinvested into the companies, enabling them to make even larger profits. As we previously noted, some of this profitability is also shared with owners in the form of dividends. By buying shares in a public company, you are participating as owners in the growth and prosperity of the US economy. However, stock prices are also relatively volatile on a day-to-day, or even on a year-to-year basis. Prices can fluctuate by as much as 20 percent or more on a given day. Some companies lose money. They pursue ineffective strategies, or they fail to innovate. Some go bankrupt. Consequently, it is important to understand the risks these investments can create and how

195

Investing in a stock market index is known as ‘passive investing’ in that your time and or expertise are not needed or required. Furthermore, you have limited liability since you are not personally responsible for each company that composes the index’s borrowing. The amount you can lose is limited to the amount you purchased. The amount you can gain has no upper limit. 196 Vanguard is a non-profit mutual as a low-cost brokerage firm. See, https://investor.vanguard.com/corporate-portal/. You can also check out Fidelity at https://www.fidelity.com/ and Schwab at https://www.schwab.com/

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these risks can be managed. We will discuss these concepts further in this chapter. Next, we briefly discuss fixed income investments. These include borrowings in the form of loans, mortgages, bills, notes, bonds, and commercial paper. These are obligations of the borrower to make repayments at maturity. Depending on the structure of the instrument, they usually also require periodic payments of interest. For example, when a company borrows money from a bank, it promises to pay back the amount it borrowed (i.e., the principal) as well as interest on the principal. If a company borrows money from investors in the form of public offerings of debt securities, it does so by issuing (selling) bonds or notes, or by selling short-term instruments, such as commercial paper. Thus, if you buy a corporate bond, you essentially lend money to that company. If a company sells you a bond, the corporation is borrowing money from you, with a legal promise to pay you back the amount it borrowed with interest. From an investor’s perspective, one significant difference between a loan and a bond is what we call liquidity – that is, the ability to buy or sell an asset easily and quickly at a fair price between a willing buyer and a willing seller. Generally, bonds are liquid, and loans much less so. Banks often hold on to the loans they make and collect principal and interest payments. Sometimes big banks will make large loans and sell the loans to different investors, including other banks and insurance companies. This is called a loan syndication. These sales and purchases are individually negotiated arrangements between the bank and sophisticated investors. If the borrower experiences difficulty in making payments on the loan, the bank (or the lead bank in the case of a loan syndication) negotiates with the borrower regarding the next steps, which may involve restructuring of the loan or an organized bankruptcy. In contrast, companies can also bypass the banks and raise money in the public securities markets directly by issuing (selling) bonds. The interests of the bondholders are represented by a trustee and governed by a document called an indenture. If the bondholder no longer wants to own the bond (i.e., loan money to the borrower), it can usually ‘step out’ of the relationship by selling the bond. This assumes that there are buyers available, which may not be the case under certain market conditions. This

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happened during the Global Financial Crisis. Selling a bond security is usually easier than selling a loan. That, however, depends on the size of the bond, the issuer, the specific terms of the security, and the willingness of dealers to buy and sell the securities. A bond or a loan is an obligation to make a specific payment, which is why these instruments are usually called fixed income instruments. The risk is different from owning stocks, in that a bond issuer has a legal obligation to pay you back. Consequently, the interest rate you will receive is relatively low. This aligns with what we would intuitively expect. There is not an upside for these fixed claims. The company (typically) does not increase the interest rate it pays when it earns more money. The outcome we expect is that the company honors its promise to pay back the amount of the loan with interest. If the company does not meet its obligations, the creditors (the holders of the bond or the people who lent the money) have a right to sue the company, force it to sell its assets, and pay back the principal and interest owed, to the extent of the funds available. The lenders get paid before the equity holders, who can lose the entire value of their shares. Anyone can purchase stocks, bonds, or notes sold on public exchanges. As we observed, the internet has hugely simplified the process of buying and selling financial instruments. We can do this with our laptop computers and even with our mobile phones. We now introduce and review one of the most essential concepts in finance. It is called compounding. It plays a huge role in long term investing. One of the beneficial features of compounding is that you let your money grow over time, assuming that you have properly invested for the long term.

The power of compounding The interest rate on a bank deposit illustrates how money grows over time. If the interest rate is 10 percent, it grows at 10 percent per year. The power of compounding tells us how money grows when invested over time. Suppose you put $100 in a bank at a 10 percent interest rate. This means that, at the end of year one, your money will earn 10 percent interest on the $100 you put in at the beginning of the year. That amount is $10 ($100 times 10 percent). Hence, at the end of one year, you will now have $110

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($100 in principal and $10 in interest) in your bank account. Your deposit has grown by 10 percent in one year. Suppose now, the 10 percent interest rate did not change and you left all your money in the bank for yet another year. Now your $110 will earn the 10 percent interest. This means that during the second year, you will earn $11 in interest (10 percent of $110). Added to your previous total of $110, your money will now grow to $121 at the end of two years. Suppose again the 10 percent interest rate did not change, and you left all your money in the bank for yet a third year. Now it is your $121 that will earn the 10 percent interest. This means that during the third year, you will earn $12.1 in interest. Added to your previous total of $121, your money will now grow to $133.10 at the end of three years. What is happening to your interest earned? Even though you did not put in any additional amount in the bank and the 10 percent interest rate did not change over three years, you earned $10 in interest in the first year, $11 in interest in the second year, and $12.10 in the third year. Your dollar amount of interest earned increased every year. Furthermore, the dollar interest earned is increasing exponentially. This is the power of compounding. You are earning interest on interest. This power will allow you to build wealth exponentially over time. Consider another example. Suppose that you are a new college graduate at age 22, earning $60,000 a year. You expect your salary to increase by 2 percent every year. You are careful about your expenditure, and you save a full quarter of your earnings for your long-term retirement plan. You do this for the next 28 years until age 50 and then you stop saving. Assume that you invest in a stock portfolio and, on average, you earn 6 percent annual real rate of return. Using simple arithmetic, we can compute your retirement savings. By the time you reach the age of 50, you will have accumulated approximately $1.3 million.197 197

Using only middle-school arithmetic, we can compute this amount. The first year of savings of $15,000 will grow by 6 percent to $15,900 at the end of year one (=15,000*1.06). Repeating this by multiplying by 1.06 for each year for 28 years, the first year’s savings will grow to $76k by age 50. We treat the other savings in subsequent years similarly. In the second year, for instance, we save $15,300, which

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This is just one example of how we can attain financial security. Having a portfolio of $1.3 million is sufficient for a minimum level of financial security. Even if you do not earn or save any further amounts, you do not have to work any longer. Furthermore, you can enjoy an income of about $50,000 per year from these savings (assuming a 4 percent draw down) as long as you are alive, without having to work one more day in your life. This amount of $50,000 per year is close to the median family household income in the US in 2018. How do you do it? First, you start saving as soon as you can, at age 22. Second, you save as much as possible, a full 25 percent. Third, you stay invested as long as possible. These are the three elements of a strategy for long-term financial security. Suppose that you are more disciplined in your approach. Instead of saving until age 50, suppose you save until age 60. In this case, your accumulated real wealth will grow to about $2.8 million by the retirement age of 60. Assuming the same 4 percent withdrawals, you can now enjoy an annual income of $110,000 per year as long as you live. In making these calculations, we assumed a savings rate of 25 percent. We also assumed a real rate of return of 6 percent per year on our investments over the next 28 years. Is this realistic? We explore this further in this chapter.

Capital Markets We now consider different investments in US public markets, including common stocks, Treasury bonds, and Treasury bills. To explore an investment in common stocks, we select the Standard and Poor’s 500 index. This index consists of the common stock of the 500 large firms that trade on US public exchanges. The amounts invested in each common stock are proportional to their market value, called the market

represents a 2 percent increase in our salary, which then grows by 6 percent every year to about $76k by age 50. By repeating this for every year for the next 28 years, we can compute our retirement wealth. Easy peasy.

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cap.198 Hence, larger firms get bigger weight than smaller firms. As of October 2020, the total market cap represented by the S&P 500 Index is around $27 trillion.199 This index is often used as a substitute for the entire US stock market. This is for several reasons. First, the index consists of well-known, highly liquid, large stocks. Second, the index is replicable. The additions and deletions to the Index are announced well in advance, with the exact date that the change will take place. This allows individual investors to buy and sell the stocks entering and exiting the index so that they can keep track of, and replicate, the index performance. Third, many mutual fund companies offer funds that replicate the index portfolios at a low cost. Consequently, you can buy the index as easily as buying a single stock. One such mutual fund company is Vanguard. Since about the year 2000, Vanguard has created a passive index fund based on the S&P 500 Index, called the 500 Index Admiral Shares mutual fund (symbol, VFIAX).200 This fund closely tracks the performance of the S&P 500 Index, and it has low expenses, which are reflected in a number called the expense ratio, which is just 0.04 percent, or $4 per $10,000 invested. Treasury Bills (T-Bills) are short-term US government borrowings. By buying T-Bills, you can lend to the US Government for maturities up to one year, and do so on a nearly risk-free basis, since the US Government has the legal authority to tax US persons in US dollars, and it can also legally print US dollars to honor its obligation. Treasury Notes (T-Notes) and Treasury Bonds (T-Bonds) represent longer term US Government borrowings. By buying T-Bonds, in effect, you can lend nearly risk-free to the US Government, for maturities between ten years and 30 years.

198

Market Cap is the sum of the values of all shares outstanding. If a firm has 100,000 shares outstanding and the stock price is $10, then it has a market cap of $1 million. 199 See, https://ycharts.com/indicators/sp_500_market_cap#:~:text=S%26P%20500%20M arket%20Cap%20is,S%26P%20500%20Earnings 200 See, https://investor.vanguard.com/mutual-funds/list#/mutual-funds/assetclass/month-end-returns

-50.0%

-30.0%

-10.0%

10.0%

30.0%

50.0%

70.0%

T-Bill returns

S&P 500 returns

T-Bond returns

Figure 7.1: Annual Returns to S&P 500 Index, T-Bonds and T-Bills

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Figure 7.1 shows the historically-realized annual returns for three different investment portfolios: (i) Treasury Bills; (ii) Treasury Bonds; and (iii) the Standard and Poor’s 500 (S&P 500) index from 1928 to 2017. 201 We used a longer time horizon for a comprehensive history of the average annual returns. Stock returns are, on average, positive, but volatile year to year. This volatility is another way to visualize the risk of investment in the stock market. The average annual return slightly exceeded 11.5 percent over the past 90 years. Over this time, stock returns exceeded +52 percent in 1954, and equaled about -44 percent in 1931. Hence, these high average annual returns come with significant risk. In 24 of the last 90 years (or 27 percent of the time, or every third or fourth year), stock prices have declined, year on year. T-Bonds offer lower risk and lower return than common stocks. T-Bond returns also show volatility, although to a lesser extent than common stocks. T-Bond returns have averaged 5.2 percent per year, with a maximum of 32.8 percent and a minimum of -11.1 percent. T-Bond returns have been negative in only 16 out of the 90 years (or 18 percent of the time). T-Bills offer even lower risk and lower return. On a year-to-year basis, TBill returns are very smooth. T-Bills have averaged 3.4 percent per year, with a maximum of 14.3 percent and a minimum of 0.03 percent. Nominal T-Bill returns have not been negative in the last 90 years. Next, we compare the returns from financial markets with some forms of gambling. One is the Mega Millions Lotto. This game costs $2 and the odds of winning are one in 302,575,350.202 Suppose that no one had the winning numbers for an extended period, and the jackpot grew to $90 million. What is the rate of return on playing this game, and how does it compare to the stock market? In Mega Millions, there may be multiple winners, in which case you have to share the winnings. Your winnings, moreover, are not paid immediately

201

The source data come from Professor Aswath Damodaran’s website. See, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html 202 See, https://www.calottery.com/play/draw-games/mega-millions/how-to-play

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but distributed over 30 years. If you want cash immediately, the payment is much less than the announced amount. Assume for convenience that you are the only winner, and the cash value is $50 million.203 You also owe tax on this amount, and assume that Federal and State taxes are about 40 percent. You will immediately receive about $30 million after tax. Since the odds of winning are less than one in 300 million, the expected payout is about $0.10.204 Thus, for each $2 you ‘invest’, you will receive no more than $0.10. This makes your rate of return not a positive return at all, but rather a loss of more than 95 percent. For each dollar you pay, you can expect to lose more than 95 cents. Some critics of the stock markets are right, in the sense that both investing and gambling are risky. However, the similarities end there. In the stock market you expect to earn 11.5 percent every year for bearing risk. In Mega Millions, you can expect to lose nearly all your investment! What if the jackpot has grown to an even larger amount? Does the Mega Millions become a good investment at this point? The answer does not change. Suppose the jackpot has grown to $2 billion for Mega Millions. Is it not a good deal now? The answer is still no. As the jackpot rises, so do the number of tickets sold, and the expected number of jackpot winners, which further reduces your expected earnings. Even with a $2 billion jackpot, the expected returns are still negative.205 Since the current jackpot record is $1.6 billion, Mega Millions does not make any financial sense, no matter how large the jackpot. This is true of all forms of gambling. Gambling is not a way to financial security. In fact, it is a sure path to wealth destruction. To build wealth, we need traditional, established methods.

203

The immediate cash payout rate is about 56 percent. See, https://www.washingtonpost.com/business/2018/10/20/mega-millions-jackpotreaches-record-billion-after-no-winner-latest-drawing/?noredirect=on 204 $30 million divided by 302 million odds. 205 For instance, suppose that the jackpot rose by a billion dollars in the last round and grew to $2 billion. This means more than 500 million new tickets are sold in the last round, which is more than 150% of all available combinations. This means that your expected after-tax payoff is $2 billion * 0.56 * 0.60 /(500M) =$1.33. For each dollar you spend, you are still losing about 33 cents.

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Generating income from stocks and bonds We now return to our three financial portfolios. Using the returns shown in Figure 7.1, we build three portfolios: (i) the S&P 500 index; (ii) US Treasury-Bonds; and (iii) US. Treasury-Bills. Figure 7.2 illustrates the wealth levels associated with these three portfolios with a $1,000 initial investment. Based on Figure 7.2, a one-time investment of $1,000 in the S&P 500 index in 1928 grew to about $4 million in 2017. Over the course of 90 years, this is, approximately, a 4,000-fold increase. In contrast, T-Bond investment grows 70-fold to about $73,000, and the T-bill investment grows 20-fold to about $20,000. Once again, the average annual return for the three portfolios over the past 90 years is as follows: 11.5 percent for the S&P 500 Index; 5.2 percent for T-Bonds; and 3.4 percent for T-Bills.206 These numbers illustrate several key themes. The first is that a moderate amount of year-to-year equity returns (around 10 percent) is more than sufficient to build wealth for the long term. Only annual returns of 11.5 percent are needed, if invested for a long time, to build up a 4,000-fold increase in our wealth. This should give us perspective. We do not need to earn 20, 30, or 50 percent per year to build wealth. On average, it is sufficient to earn returns in the range of 10 percent per year. The keys to long-term wealth building are time, discipline, and persistence, not high annual returns. The second key theme is that historical stock returns have been more than enough to provide retirement savings. In our earlier numerical examples, we used a 6 percent return. In contrast, actual historical stock market returns have been close to twice that amount. What is needed to achieve this excellent performance is discipline and persistence. Steady savings and investment in the stock market will provide adequate retirement savings.

206

See, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html

$1,000.00

$10,000.00

$100,000.00

$1,000,000.00

$10,000,000.00

T-Bills

S&P 500

T-Bonds

Figure 7.2: Wealth levels for $1,000 invested in S&P 500, TBonds or T-Bills in 1927

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$73K

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To achieve these returns, we do not have to be experts in the stock market. We merely bought an index fund based on the S&P 500 index. This is as easy as one phone call, or one online session. We did not have to watch any investment experts on television, read any investment books, select money managers, or invest any significant amount of time listening to investment programs. We did not have to hire a financial advisor. Instead, we bought a well-diversified, low-cost, index fund and held on to it for years. This is what is known as ‘passive investing’. The alternative approach – being more heavily weighted toward specific stocks or sectors – is called ‘active investing’. A third important theme is that we need to take certain thoughtful risks to build retirement savings. Common stocks are volatile. If we have the tolerance for additional risk, we could have bought a low-cost, passive index fund in small stocks. These are even more volatile (and provide higher returns) than the S&P 500 Index. We also kept invested in the stock market. We did not exit our investments in bad times, nor did we try to guess what would be the best time to buy or sell stocks. We did not worry about what the experts said about whether this was a good time or bad time to buy stocks. We kept invested in the stock market, both in good times and bad times. Furthermore, following Charlie Munger’s advice about risk,207 we ignored the day-to-day volatility and we kept invested in a volatile stock market, as opposed to low-risk savings accounts or low-risk bonds. Investing only in T-Bills, or T-Bonds (or a savings account in a bank) would not have served our purpose. Investing only in T-Bills increased our wealth only 20-fold. Investing only in T-Bonds increased our wealth only 70-fold. Without taking substantial volatility risks, we could not even hope to achieve the kinds of results which will help us build adequate retirement savings. What we are saying may seem paradoxical. On the one hand we talked about the volatility of the stock market. Yet, we concluded that everyone needs to invest in it. Are we contradicting ourselves here? The answer is no. The market is volatile, on a daily, weekly, or even on a yearly, basis. It is possible that the stock market can decline by 30 – 40 207

See the header quote for Chapter 5 for Charlie Munger’s advice.

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percent in a given year. The declines from intra-year peak to intra-year troughs can be much larger. If such a decline is going to scare you into pulling your money out, then you should not invest in the stock market. You should only invest an amount of money in the stock market such that you can withstand as much as a 50 percent or even bigger decline in a given year. Otherwise, invest less. A fourth important theme is that you need to start early and be persistent. It is not sufficient to invest only for two years or five years. Even fifteen years is not sufficient. You need to start as early as possible, as soon as you have a job. You do not want to wait until you reach the age of 50. You need to invest over your entire working life – a time period of thirty to forty years – to provide adequate retirement savings.

Risks in the stock market If you stay in the stock market for your entire lifetime, you can manage the risks (or volatility) of investing in the stock market. Yes, this might sound paradoxical, but it is still true. If you remain invested in the stock market over time, you can offset year-to-year volatility and earn a long-term, positive, expected return. To further illustrate this point, consider the following experiment. We start with a $5,000 investment. By choosing a random return from the 90-year historical record of returns, we simulated the performance of a one-year investment. If our investment fell below the initial investment, we noted this event as a loss. We then continued for a 40-year holding period, each year choosing a random rate of return and noting whether our portfolio fell below the initial investment of $5,000. We then repeated this experiment 10,000 times and computed the probabilities of a loss for different investment horizons, from one year to 40 years. Figure 7.3 illustrates our results. As you can see, the highest probability of a loss occurs for a one-year investment horizon. The probability of a loss in the stock market is about 27 percent after one year. If we invest for two years, the probability of loss declined to 22 percent. Why does the loss decline with a two-year investment? The reason is that the stock market is, on average, profitable. It generates approximately 11.5 percent return per year. The loss in a given year occurs with a low

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probability of 27 percent (in 24 out of 90 years). There is, therefore, about a 73 percent probability that a one-year investment will make money. During the second year, there are odds of approximately 3-1 that our portfolio will experience another positive return and make up at least some of the loss in the first year. Two consecutive years’ loss is even a smaller probability. This is why the probability of loss declines the longer we invest. At five years, the probability of loss further declined to 14 percent. As you can see, these are still rather high probabilities. There is substantial risk of loss when investing in the stock market. There is still a one in seven chance of losing some of the initial investment if we only invest for five years.

Figure 7.3: Probability of Losing Money in the Stock Market 0.3 0.25

RIsk

0.2 0.15 0.1 0.05 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 Risk

Suppose the investment horizons are longer. If you invest for 10 years, the probability of loss falls to 7 percent. At 20 years, it is a mere 2 percent. At around 26 years, the probability of loss falls under 1 percent, and becomes pretty much negligible beyond 30 years. As we can see from Figure 7.3, the risk is always persistent. It cannot completely disappear. Smart investing does not mean zero risk. Smart investing involves taking thoughtful risks. This is what the stock market enables.

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Another caveat is that here we assumed that the stock return distribution remains constant over time, and that the future will be similar to the past. This assumption may or may not hold. We also need to be cognizant of this fact and adjust our expectations. The key message here is that we can reduce and minimize the risk of losing money in the stock market by staying invested over the long term. The longer we invest, the lower the risk. Even if we experience a period of negative returns, the overall returns over time will remain favorable. This is the so-called ‘magic’ of the stock market, providing an average of 11.5 percent return per year. You might also object that our model is based upon only US data, or that past performance is no guarantee for the future. These objections are valid. The future is, by definition, unknown. As we said, we can never eliminate all risk. There are never any guarantees. What we are suggesting is the best approach we know based on the historical data. Long-term investment in the stock market is a thoughtful investment requiring riskmanagement. As for being US-centric, the available evidence suggests that these high returns in the stock market are not unique to the US. The rest of the world offers similar opportunities. For instance, Vanguard International Growth Fund (symbol VWIGX) has returned 10.33 percent per year between 1981 and 2018, net of expenses.208 We argued earlier that financial security is achieved with continual investing and taking acceptable levels of risk. The best way to reduce the risks to an acceptable level is with T-Bonds and T-Bills. Lower risk levels enable us to withstand the volatility in the stock market and remain invested whether the market rises or falls. This is the key to remaining invested for the long run.209

208

See, https://investor.vanguard.com/mutual-funds/list#/mutual-funds/assetclass/month-end-returns 209 Andrew Ang, now at BlackRock but formerly at Columbia University, makes the same point in relation to sovereign wealth funds in his excellent book. See, https://www.amazon.com/Asset-Management-Systematic-InvestingAssociation/dp/0199959323

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Managing Expenses Another critical issue in investments is the expenses and transaction fees that asset managers charge. Some actively managed funds – where the manager tries to pick winning stocks instead of trying to replicate a passive index – charge higher expenses, and other fees. Suppose that you paid just 2 percent in expense fees for an actively managed fund which otherwise had a similar performance as the S&P 500 Index. What would be the difference in return with a $1,000 investment? The results are shown in Figure 7.4. As compared to Figure 7.2, your investment of $1,000 would only grow to $738,000 after expenses, compared to $4 million with lower expenses. Even though the 2 percent expense ratio represents about 17 percent of your total annual returns, after 90 years, well over 80 percent of total stock market earnings are eaten away by a 2 percent annual expense ratio. This is why paying attention to expenses is essential. Even moderately small expenses can degrade the vast majority of your total earnings. You need to minimize expenses. It is useful to understand the performance of financial markets over the past 90 years, yet this does not tell us how much wealth we can realistically build by saving and investing in the stock market. This is the case for several reasons. First, the investment horizon for most people is not 90 years, but somewhere between 30 to 50 years. Consequently, we are going to focus on a 40-year investment horizon.

Figure 7.4: S&P 500 with 2% Expense Ratio

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$800,000 $600,000 $400,000 $200,000 $-

Wealth Level

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Risk of investments over time Figure 7.1 illustrates the historical path of stock prices, but it represents just one path. We need a better understanding of risk given significant year to year variation in returns, and thus a great deal of uncertainty about the future. To do so, we engage in the following hypothetical exercise. We assume that annual returns will vary, but the distribution of returns observed over the past 90 years will remain stable. Using the last 90 years of realized stock market returns, we randomly choose one of these 90 annual Standard & Poor’s 500 Index returns, and assign it to year one. We continue this way, until we have 40 years of randomly chosen stock returns. We then compute the wealth path for a strategy of investing $5,000 at the beginning of every year. We then repeat the procedure 10,000 times. This gives us 10,000 possible paths that the stock market investments could possibly take, based on historical distribution. Next, we order these 10,000 paths based on the final year wealth level. The lowest 40-year wealth level is given a rank of 1. The highest wealth level is given a rank of 10,000. Finally, we pick the bottom 2.5th percentile, or rank 250 as the lower wealth level, the 50th percentile or 5001st rank as the median wealth level, and the top 97.5th percentile or 9,750 rank as the upper wealth level. Figure 7.5 illustrates the entire 40 years of lower, median, and upper wealth-level paths. Figure 7.5 indicates that the median wealth level after 40 years of hypothetical investments is about $2.4 million. The 2.5th percentile, or the lower band, ends up around $391,000 while the upper band ends up around $15.2 million. The difference between the lower-bound and the upper-bound of the 95 percent confidence interval shows the extent of the risks. Based on our calculations, the top of the band is almost 40-fold higher than the bottom end of the band. The bottom line is, that there is significant risk in stock market investments even after 40 years. Our wealth levels can be as little as $391,000 after 40 years (with a 2.5 percent probability). The most likely scenario is the median wealth level. Here 40 years of investments of $5,000 a year are likely to give us a minimally comfortable retirement wealth level. Assuming a 2 percent inflation level, $2.4 million

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in our retirement portfolio is equivalent to about $1.1 million in real, purchasing power 40 years earlier. Assuming that we stay invested at 3 percent annual returns, we can spend $55,000 a year from this portfolio, over a 30-year retirement period, in real terms. The important message from this exercise is this: If we save and invest a manageable amount of $5,000 over 40 years, we will have a minimally comfortable amount of savings for retirement. This is the case if we save just 5,000 per year. Obviously, if we can save $10,000 a year or more, these values would all be more than doubled.

Some people may feel that the risks of investing in the stock market are still just too high. They cannot tolerate the volatility of the stock market. What else can we do? Do we need a financial advisor to help us select a more conservative portfolio? The answer is still no. We can still do it ourselves. Finance teaches us that, regardless of one’s risk aversion, everyone must invest in the same well-diversified portfolio that comes close to representing the entire market.210 Yes, this is correct. Regardless of how differently people feel about risk, there is only one appropriate portfolio for everyone. This is the market portfolio.

210

This is called the separation principle in finance.

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Contrary to what you hear on television, the way we manage and reduce risk is not by selecting lower-risk or defensive individual stocks. It is also not by timing the market, attempting to buy when the conditions are favorable or attempting to sell before the market declines. Instead, it is by investing a smaller proportion of our investment in the stock market and putting the rest in lower risk assets such as T-Bills and T-Bonds. Given this, we do not need a financial advisor to ‘pick’ so-called ‘good stocks’. The market portfolio is still the right investment option. We can still do this on our own. One particularly popular approach is to create a balanced portfolio. In this case, instead of putting 100 percent of our savings in the S&P 500 Index, we can spread it by allocating 60 percent of the weight into the S&P 500 Index, 30 percent weight in T-Bonds, and 10 percent weight in T-Bills. This balanced portfolio still achieves the same amount of diversification with less risk. We also want to maintain the balanced portfolio over time. To do this, after each year, we check the value of each of the positions in stocks, bonds, and bills. If the stock market has risen, and consequently, our position in common stocks is now 70 percent because of a good stock return last year, we should sell some of our investments in common stocks, reduce it back to 60 percent, and allocate the proceeds of the sales to TBonds and T-Bills. This is called ‘rebalancing’. The main idea of using a balanced portfolio is to reduce the risks of investment. Suppose you cannot tolerate the possibility of a 50 percent decline in the market in a given year. By investing only 60 percent of your funds in the stock market, you can reduce the bad case scenario from a decline of 50 percent to a more manageable decline of 30 percent. Obviously, there is no ‘free lunch’. By keeping only 60 percent of your investment in the stock market, you also give up part of the upside. When the market goes up 40 percent, your portfolio would only go up by 24 percent. Hence, a balanced portfolio removes the extreme values, both on the upside as well as on the downside. A balanced portfolio (or even a more conservative portfolio) might also be attractive to someone who has already built a large portfolio and is near retirement. In this case, caution can be valuable. By putting only 60 percent

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(or an even smaller amount) of their investment in the stock market, their retirement savings will still be robust even with a major market decline. If we maintain a balanced asset allocation, we sell stocks after a market increase and buy stocks after a market decline. In other words, we are ‘buying low and selling high’. This is the opposite of what panicky investors typically do, which is to buy high and sell low. Another advantage of a balanced portfolio is that when the economy declines, the stock market declines, and many people seek a safe haven by buying Treasuries, which increases their price and thus their returns. Thus, real shocks to the economy induce a negative relation between T-Bond returns and stock market returns. Hence, by including long-term Treasuries in our portfolio, we can get additional diversification benefit against economic recessions. The negative relationship between the stock market (S&P 500 returns) and the T-Bond returns, over the past 20 years, is shown in Figure 7.6.211 We explain this important point again. When the economy is growing and risk-appetite is strong, people sell out of safe assets (such as Treasury Bonds) and buy stocks. This puts further upside pressure on stock prices, causing them to rise. The selling out of Treasuries causes the prices of Treasury securities to fall, putting upward pressure on Treasury yields. The reverse happens when the economy is slowing down, and risk-appetite is weak. This can, in turn, cause money to flow out of the stock market (negative stock returns) and back into the bond market, creating upward pressure on bond prices and downward pressure on bond yields.

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This negative relation does not always hold in the past. In fact, if the shocks to interest rates come from inflation (or money supply), then higher inflation can cause both stock prices and bond prices to decline, thus inducing a positive relation between the two. See, Bob Barsky and Lutz Kilian, “Do we really know that oil caused the great stagflation? A Monetary alternative” https://www.nber.org/papers/w8389. Similarly, after Treasury Bond yields have declined significantly, or after they have become negative, the capacity for Treasury yields to decline further (or the price to increase) in bad economic times diminishes. This reduces the ability of Treasuries to hedge the risks of stock market investing. See, https://www.wsj.com/articles/theres-no-place-to-hide-anymore-when-thestock-market-plunges-11601717401?mod=searchresults&page=1&pos=5

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Figure 7.6: T-Bond Returns (vertical axis) versus S&P 500 Returns (horizontal axis) from 1998-2017

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Next, to replicate the performance of the balanced portfolio approach, we engage in a similar hypothetical investment strategy using the balanced portfolio weights instead of the 100 percent investments in Standard and Poor’s 500 Index. Figure 7.7 illustrates the resulting lower, median, and upper, wealth paths. A balanced portfolio reduces the upper and median wealth levels significantly, and increases the lower wealth levels modestly. Charlie Munger is right after all. Reducing year-to-year volatility risks is very costly. The wealth level corresponding to lower-level wealth has increased by $110,000 to around $500,000. The upper end has also shrunk from $15 million to $4.4 million. You should ask yourself whether it makes sense to give up $10.5 million upper wealth potential in return for $110,000 in lower wealth protection. This is an almost 100-to-1 payout. Viewed from this perspective, taking volatility risk would be well justified. For the balanced portfolio weights, the median wealth level has declined from $2.4 million to about $1.5 million. Remember, this $1.5 million occurs 40 years from now. Reducing year-to-year volatility also eliminates almost $1 million from the median outcome, and it is indeed costly. You can still retire on this money, but not as well.

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1 2 3 4 5 6 7 8 9 10111213141516171819202122232425262728293031323334353637383940

Figure 7.7: Upper, Median and Lower Bounds of $5,000 a year investment in Balanced portfolio with 60% in S&P 500, 10% in TBills, and 30% in T-Bonds

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In essence, our portfolio is somewhat less volatile, and it protects us against negative scenarios. If we want to further protect against year-toyear volatility or worst-case scenarios, we will need to move to even more diversified portfolios with lower levels of investments in US common stocks and higher levels of investments in real estate, corporate bonds, and government bonds. Figure 7.7 also illustrates the importance of taking risks, especially early in life. Becoming too conservative early in life to avoid short term volatility can impair our efforts to obtain financial security in retirement. If you want to be conservative, then do so after you have become financially secure. Suppose you feel that the risks (year-to-year volatility) or worst-case scenarios of the portfolio are still too high. What else can you do? There is nothing magical about 60-10-30 levels. You can cut your proportion invested in the stock market further. In Figure 7.8, we cut our stock market portion to 30 percent, with 10 percent in T-Bills and 60 percent in T-Bonds. Figure 7.8 demonstrates that a further cutback on the stock market (to 30 percent) does not benefit the worst-case scenario. The lower bound only improves only by about $30,000, while both the upper bound and the median wealth levels are again cut back sharply. The median wealth level now goes slightly below a million. You can opt for this ultra-conservative portfolio, but the question arises as to why you would do so. Once again, we come back to our basic investment principle. You need to take material volatility risks in the stock market in order to create long-term wealth. We have also investigated other weights. They reaffirm our strategy to take added risk, over the long run. If we were to increase our stock market investment to 80 percent, with 10 percent in T-Bonds and 10 percent in Tbills, we can still achieve better wealth levels while still cutting some of worst-case scenarios. For this portfolio, the lower, median, and upper, bound levels are $0.44 million, $2 million and $8 million.

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$0.99M

Figure 7.8: Upper, Median and Lower Bounds of $5,000 a year investment in with 30% in S&P, 10% in T-Bills and 60% in T-Bonds

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Thus, an 80 percent allocation in the stock market doubles the expected wealth levels at retirement, and doubles the upper bound without reducing the lower bound too much. Hence, we can create double the wealth without introducing too much additional risk. Having said this, you still need to be comfortable with your risk exposure. Taking too much risk will only cause more problems if you have to make adjustments as a result of significant market declines. Alternatively, instead of changing the proportion we allocate to the three asset classes, we could have added other investment asset classes such as real estate, commodities (such as gold), and foreign stocks and bonds. We have to take risks to build wealth in the long run. The best way to guard against worst-case scenarios is to increase your savings instead of cutting back on risk exposure. Instead of saving $5,000 a year throughout your working life, you can start out at $5,000 and increase your savings as your earning power increases. Given your increasing savings, you can now also increase your risk exposure. This strategy allows you to guard against worst-case outcomes, as well as position you to benefit from increased levels of exposure to the stock market.

Timing the market Returns in the stock market are not uniformly distributed over days. There are periods when the stock market can rise sharply as a result of increased risk appetite or strong economic performance. Similarly, there are periods when the stock market can fall sharply as a result of decreased risk appetite or weak economic performance. Consequently, there is no expectation of earning 10 percent of the returns if you stay in the market 10 percent of the time. Instead, the stock returns are highly skewed both to the left and to the right. Most of the big positive and big negative returns are realized over very few days. This idea has important implications. If you attempt to time the market, you will add to your risks by reducing diversification over time. Timing the market means trying to buy the market when it is cheap and selling the market when it is expensive. This outcome cannot be achieved, even by most professional investors.

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This theme can be further illustrated in Table 7.1, which shows the outcomes from the following experiment. Among 43 years of daily returns for the value-weighted market index from January 1 1975 to December 31 2017, we observed that there were exactly 10,847 trading days. We started by eliminating the best and worst 10 days, 20 days, and so on, until we eliminated the best and worst 110 days. We stopped at 110 days since that represents about 1 percent of the trading days in this period. The results are shown in Table 7.1. For the entire sample, the annual returns averaged 10.1 percent, which is similar to the 90-year annual holding period we examined earlier. A $1 investment in 1975 grew to $62.40 using the value-weighted market returns. When we eliminate the best days, the average returns and wealth levels decline. When we eliminate the worst days, the average returns and wealth levels increase. Table 7.1 illustrates a key point. When we eliminate the best 110 days, or just 1 percent of the outstanding days, all of the positive returns disappear. Hence, 1 percent of the trading days contain all the positive returns. The rest amounts to negative returns. Table 7.1: Missing Best and Worst Days in the Stock Market Time Period: January 1, 1975 to December 31, 2017

All Data Miss 10 days Miss 20 days Miss 30 days Miss 40 days Miss 50 days Miss 60 days Miss 110 days

Miss best days

Miss worst days

Number of days

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Wealth Level

10,847 10,837 10,827 10,817 10,807 10,797 10,787 10,737

10.12% 8.34% 7.17% 6.13% 5.17% 4.28% 3.44% -0.15%

$62.40 $30.37 $18.61 $11.85 $7.70 $5.01 $3.25 ($0.06)

10.12% 13.22% 15.15% 16.73% 18.06% 19.43% 20.50% 23.66%

$62.40 $207.55 $427.26 $762.90 $1,235.02 $2,015.31 $2,922.97 $8,494.33

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When we eliminate the worst days, returns jump. Our average returns more than double. The lesson in Table 7.1, however, is that it is important to stay invested in the stock market. We know already from earlier discussion that the longer we stay in the market, the more the risks decline. Trying to time the ups and downs of the market will increase the risk. For risk averse investors, the longer they stay invested, the lower are the risks, and the better off they will be.

When do you start investing Should you start thinking about investing for the future in your 20s, 30s, or 40s? What about the investment horizon? We argue strongly that you need to invest for your entire life. Assuming that you are just starting out and you are in your twenties, this corresponds to an investment horizon of about 40-years. What if you are already older; in your 30s or 40s? How much do you have to save to achieve about a $2.5 million in your retirement portfolio? Let us explore these issues next. First, to determine how much someone in their 30s needs to invest, we look at a 30-year investment horizon. These results are shown in Figure 7.9. To achieve the same level of retirement wealth, someone in their 30s will need to save a minimum of $15,000 a year. This is triple the amount a twenty-something needs to save. For many people, this is still doable, but this is a bigger mountain to climb than $5,000 a year. Now consider how much someone in their 40s needs to save. We now look at a twenty-year saving horizon before retirement. These results are shown in Figure 7.10. We now see that to achieve similar levels of retirement wealth, a typical 40-year-old will also have to triple the annual savings to $45,000, compared to a typical 30-something individual. Every decade someone waits to save, the minimum saving amount triples. Thus, it is best to start as early as possible, while you may be still in your twenties. Clearly, saving $45,000 per year is not realistic for most people. Many people make $45,000 or less per year. Therefore, you need to start saving for your retirement in your 20s. It is still doable, but much more difficult in your 30s. If you have already reached your 40s, and have not saved a dime yet, you are most likely not going to achieve financial security. You can nevertheless save as much as possible. This is still beneficial.

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Figure 7.9: Upper, Median and Lower Bounds of $15,000 investment per year in S&P 500 for 30 years

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We now summarize our key themes. Historical data indicates that the stock market has been a strong engine of wealth creation. However, this does not mean that the stock market is guaranteed to build wealth. No, we cannot say this. In fact, no one can say this about any investment. The best we can reliably say is that the stock market has created substantial amounts of wealth in the past. Consequently, unless something fundamental changes, we would expect the stock market to continue to generate wealth for us in the future. This is not guaranteed, but it is likely to be the case. Assuming that the distribution of the returns is to remain stable, we can help build a comfortable amount of retirement savings with a minimum of about 80 percent of our wealth invested in common stocks for a long time, say 40 years. Our key themes are as follows: A. You need to take risks. This means investing in stocks. Taking risks does not guarantee success, but not taking risks guarantees that your assets will not grow over time. If you keep your savings in a savings account, you are guaranteed not to build any wealth in the long run. If you put all your money in Treasury Bills, you will not even retain the purchasing power of your money. This much is guaranteed. B. The stock market is an excellent way of taking risks and getting paid for it. The average annual returns in the stock market have been about 11.5 percent per year over the past 90 years. This is a huge amount of return that is more than sufficient to build a comfortable retirement portfolio. If you are in your 20s, even saving as little as $400 a month or about $5,000 a year will help you build a retirement fund. You can do even better by saving and investing larger portions of your income in the stock market. By investing $10,000 to $15,000 a year, you are highly likely to end up with a multi-million-dollar retirement portfolio by the time retirement comes around. C. The stock market exposes you to significant volatility risk in the short term. You should not worry about short-term volatility. The best way to reduce these risks and make them manageable is to remain invested in the stock market for the long term. The longer you invest, the lower the risks.

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Hence, you need to plan for staying invested in the stock market for your entire career. D. There is no need to forecast the returns in the stock market before making an investment. There is no need to identify defensive or aggressive individual stocks for current market conditions. The best investment is a diversified, low-cost, index fund. E. You should not enter and exit the market with the goal of trying to time the peaks and troughs. You should not try to pick individual stocks. If market fluctuations make you uncomfortable, put a smaller portion of your investment in the stock market, and put the remainder in corporate or government bonds. F. For a young person starting out, a good investment ratio is at least 80 – 90 percent in the stock market. Early in life is the time to take as large a risk as you can. You can even invest in smaller stocks if you want to increase your exposure to high-risk, high-growth, stocks. As you get closer to retirement age, you can reduce this stock market portion to about 60 percent. G. If you wait until you are in your 30s to start saving, your minimum saving amount triples to $15,000. If you wait until you are in your 40s to save, your minimum savings amount triples again to $45,000. Hence, the earlier you start, the less you need to save to attain some degree of financial security.

CHAPTER 8 UNDERSTANDING INCENTIVES

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.”212 —Adam Smith

Understanding the system How do people in society relate to each other? Why is society organized as we observe it? Why do people act as they do? We can better understand the answers to these questions if we understand the role of incentives. This is an essential concept in finance, and it is explored in this chapter. Many of us have the mistaken belief that our social system is designed to help us succeed and prosper. By our social system, we mean all human interactions, spanning commercial, political, spiritual, and personal. We think the system has our best interests in mind. In practice, what occurs is much more nuanced. In finance, you have a fiduciary relationship with another person if you have their best interests in mind. Certainly, we think our family members will consider our best interests. This is usually the case. Similarly, we expect our friends and neighbors to have our best interests in mind. This is sometimes the case. Yet things are quite different in our interactions with those beyond our friends and family. For the most part, the system does not owe us anything. In fact, it does not owe us the truth, good health, jobs, nutritious food, a useful education, or good governance. This is why we are often disappointed

212

Adam Smith, The Wealth of Nations, 1776.

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in our relationships with friends, neighbors, schools, hospitals, government, financial institutions, manufacturers, and service providers. The problem is not so much with the ‘system’ but our expectations from it. Once we realize that society does not owe us anything, we bear greater responsibility to attain the best possible outcomes. If we want the truth, we personally need to uncover it. If we want good health, we need to maintain it. If we want nutritious food, we need to become informed about our choices. If we want an education that enhances our value in the labor market, we need to seek it – not wait for it, or let someone else make a decision for us. We expect many things from society and its institutions – accurate reporting by the news media; scientific discoveries that lead to new medicines; vigorous and honest investigation of crimes from law enforcement organizations; high quality healthcare; high quality schools, colleges, and graduate programs; politicians who think about what’s good for society; government that acts in the best interest of the people. When the outcomes fall far short, we are disappointed. Experts are not always considering our best interests. Without question, the police and prosecutors are experts in investigating and prosecuting crimes. Does this mean we should always rely exclusively on the police for crime investigation? The answer is clearly no. The police are not likely to be the best choice for investigating potential crimes committed by their own colleagues. They will be biased in favor of their colleagues. In fact, there is a name for this – it is called ‘professional courtesy’.213 While the police are experts in investigating crimes, they may not have the objectivity to discover the truth in investigating their own peers. Similarly, Boeing may have the highest level of expertise in certifying aircraft airworthiness. Does this mean they should certify their own airplanes? The answer, once again, is obviously no. This simple point escaped the Federal Aviation Administration (FAA) Following failures by both Boeing and the FAA, foreign aviation regulators announced that they

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See, https://news.vice.com/en_us/article/595kv3/police-crime-database

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would independently conduct their own certification reviews of Boeing’s future jets.214 Most of our relationships in society are not defined by formal agreements or contracts. Most of the time, they are based on implicit expectations and informal understandings. Some individuals and organizations will honor their implicit promises, while others will not. In contrast, formal agreements set forth the rights and obligations of contracting parties. If you buy a house with borrowed money, you are obligated to pay the lender the principal sum, and interest, each month. If you do not do so, the bank can undertake a legal process to have your home sold and apply the proceeds to the outstanding debt. These terms are set forth in the various legal documents you enter into when you buy a house. What is the difference between fiduciary and contractual relationships? In a fiduciary relationship, the other party is required to act in your best interest. This can happen in a well-functioning family. It can also happen with some social institutions such as healthcare and education. However, it is by no means usual or prevalent. Contractual relationships are defined by the rights and obligations that are set forth in a written contract between the parties. This may involve purchase prices, delivery requirements, and other commercial terms. The contract makes explicit what the parties are supposed to do. There is little emotion involved. It is usually quite clear. If, at a later point, the parties disagree, and they cannot resolve their differences, they can enter into litigation through the court system. Relationships between individuals and organizations are very complicated. To understand them better, the field of finance has developed a set of terms and concepts. They are, of course, relevant to financial transactions, but they are also applicable to the full range of interrelationships we see across the spectrum of human interaction. One such term is known as the principal-principal conflict. This is the case where our interests directly conflict with another party. Another related term is the principal-agent conflict. This refers to the relationship between

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See, https://www.wsj.com/articles/after-737-max-crisis-foreign-regulatorsraise-scrutiny-of-boeings-next-jet-11574870007?mod=hp_lead_pos1

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us and the people we hire. We need to deal with the inherent challenge that the people we hire maximize their own interests rather than ours. Another related concept is a payoff. It is something of value, whether cash or other consumption items. As we explore further below, payoffs can also include non-monetary rewards. The desire for payoffs does not mean everyone is selfish or only cares about cash. Many people are motivated by feelings of honor, chivalry, and a sense of duty. People can, moreover, act against their own perceived self-interests for a variety of reasons. Sometimes people simply do not understand what is in their best interest and mistakenly prefer outcomes where their own payoffs are reduced. Examples include smoking, addiction to drugs, or abuse of alcohol. Some who engage in these practices may not believe that they are as harmful as others have warned. People may even vote for political candidates who will reduce their wealth. Is this out of stupidity or ignorance? Not necessarily. These candidates may have other appealing characteristics, such as their likeability, religious affiliation, ethnic backgrounds, or socio-economic views. In this case, their payoff includes an emotional benefit they receive from electing someone who shares their qualities or their points of view. Many times, rewards other than money can make people feel good. Hence, some people care about the greater public good, and vote for candidates who will increase their personal taxes, because there are other benefits they hope to attain, such as accessible healthcare or a more just society. This happens when the voter is fully informed about the candidates’ policy positions. Some people even donate millions of dollars to the US Treasury to reduce the national debt.215 Other people choose virtuous, but low-paying, jobs to give back to society. They may be motivated by greater public good and donate their time freely to public causes, even though they can earn higher wages at other jobs. One example may be a person who – out of a sense

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See, https://www.treasurydirect.gov/govt/reports/pd/gift/gift.htm

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of duty – gives up a high-paying career to volunteer to serve in the Army during wartime on the front lines.216 Yet other people may be motivated by their own convictions – possibly shaped by their social, cultural, cognitive, or emotional factors.217 Finance has a term for these attitudes or ideas that a person takes as given. They are called ‘prior beliefs’. They may include experiences or values, such religious traditions, family upbringing, parental opinions, or social experiences. Once acquired, people tend to hold onto their beliefs, even in the presence of strong, contradictory data. This is known as confirmation bias.218 Strong prior beliefs can also mean strong preferences for certain favored outcomes. Some people are even willing to die so long as they believe they are defending their country, religious beliefs, or moral values. Consequently, these people will seek to bring about their preferred outcomes, regardless of personal payoffs to them. Thus, the point is not that everyone is selfish, or that they only care about dollar payoffs. The point is more general. People care about whatever they value. Hence, the same incentives are not universally applicable to any single person in any one instance or location. This is something we need to understand. We argue here in this chapter that we can better understand people’s behavior and actions if we focus on what motivates them. This is the case whether incentives are based on cash-payoffs, set beliefs, or prior ingrained doctrines. To understand how incentives work, we first need to understand different payoff structures. In this case, once again, payoff can mean cash payoffs,

216 For instance, NFL player for Arizona Cardinals, Pat Tillman, enlisted in the US army

in 2002, and in he was killed in action in Afghanistan in 2004. See, https://www.biography.com/people/pat-tillman-197041 217 Richard Thaler received the Nobel Prize in economics in 2017 for his work on behavioral economics. 218 https://www.newyorker.com/magazine/2017/02/27/why-facts-dont-changeour-minds

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or psychological payoffs based on prior beliefs. Here both of these concepts will be referred to as payoffs. People also respond to pain, and they will readily choose outcomes that will reduce it. This is how populations are controlled by dictators, autocrats, and repressive regimes. For the purposes of our argument, we assume that one person will not intentionally inflict pain on others. Consequently, we focus here only on rewards or payoffs. We can observe many payoff structures. Nevertheless, there are some common models. We review these next. We emphasize here that these are complicated concepts. They are not easy even for finance professionals and finance professors with many years of experience. Understanding these concepts may take more than just one reading. Go at your own pace, and do not worry if you feel you do not understand all the concepts we are discussing in one reading. We have included a number of examples as well as graphs. If you are finding the terminology hard, do not worry. Either keep reading, or take a break and come back to it. However, keep going. These are very important concepts that are applicable to your daily life, whether or not you invest in stocks or bonds.

Skin in the game First, there is what is called a linear, or one-for-one, payoff structure. Figure 8.1 shows such a linear payoff scheme. Here, an individual receives a positive payoff in favorable outcomes and a negative payoff in unfavorable outcomes. Furthermore, there is a one-for-one relationship between outcome and payoff. For our purposes here, outcome refers to the resolution of some realworld uncertainty. For instance, an outcome can be the state of the economy, such as economic growth, level of employment, wage growth, or the level of the US dollar in relation to another currency. Alternatively, an outcome can refer to a change in stock prices or the level of stock market indices. An outcome can also refer to the final score at the end of a basketball game, or the result that is obtained by tossing a coin 100 times. Hence, an outcome represents the resolution of a situation where there is uncertainty.

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Payoffs refer to the change in the value of one’s own wealth or one’s own portfolio as a result of the outcome. Payoffs can be how much we benefit if the stock market rises or falls, or how much we benefit if unemployment falls, or wages rise. The idea is that people care about their own payoffs upon the resolution of the outcomes.

Payoffs

Figure 8.1: Skin in the Game

Outcomes

Figure 8.1 illustrates the linear relation between outcome and payoffs. These payoffs typically arise when we have ownership, which gives us a stake in both the upside and downside outcomes. Suppose you have invested in the stock market. In this case, you would have a stake in the outcome of the market. A one-for-one linear payoff scheme means that you benefit proportionately when the market goes up or down. Your payoff increases 10 percent when the market rises 10 percent and your payoff decreases by 10 percent when the market decreases by 10 percent. If you buy a stock, you have a stake in the outcome of the stock market. You would face Figure 8.1. If the stock price goes up (outcome), you make a profit (payoff). If the stock price goes down, you incur a loss.

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This topic is explored by Nassim Nicholas Taleb in his book entitled Skin in the Game: Hidden Asymmetries in Daily Life. However, our approach differs from Taleb’s in certain respects. First, we take the payoffs as given and do not assign moral judgment to a particular payoff. Second, we argue that the most important consideration is not whether you have skin in the game but whether your payoff differs from that of your opponent. Third, we highlight examples where it can be unproductive to have too much, or too little of a skin-in-the-game payoff. There are many variations of this linear payoff type. One possibility is that one can receive greater than one-for-one payoffs. This means that the payoff is greater than one when the outcome is one. Similarly, the payoff is less than minus one when the outcome equals minus one. This is also known as leverage. The first lesson here is that people will have skin in their own games. Thus, to understand the opposing party’s incentives, you need to understand their game. Sometimes the players can affect the outcome; at other times they cannot. In the case of the stock market, for example, an investor in a portfolio based on a market index cannot affect the outcome.219 Hence, he cannot make the stock market rise. Nevertheless, his payoff structure means he prefers outcomes where the stock market rises. This is illustrated in Figure 8.1. In other cases, participants can affect the outcome by taking certain actions. One example is the portfolio manager of an actively managed fund, who can decide to buy or sell certain stocks in way that differs from owning a portfolio based only on an index.220 In this situation, the skin-inthe-game payoff scheme would typically encourage individuals to take actions to reach the most positive possible outcome. A person’s attitude toward risk is constant in Figure 8.1. Whether you are ahead or behind in the game, you feel the same about the risk. In general,

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Index portfolio refers to passively buying all the stocks in an index according to their weights in that index. 220 An actively managed fund refers to buying those stocks that are likely to increase in price.

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you would not want to increase or decrease the risk, depending on a partial realization of an outcome. To function in society, you need to understand and compare your payoffs to the opposing party’s payoff. If you are both facing the same payoff picture, then you have a full understanding of the kinds of actions you might want to take, and their consequences. You are not likely to be disappointed. If you are facing a different set of payoffs, then you need to be more cautious. If possible, you either try to align the payoffs of your opponent or you do not participate in the interaction in the first place. Suppose you work for a company. As an employee, what do you want? A typical list includes a safe working environment, nice colleagues, competitive pay, good healthcare, retirement benefits, vacation time, interesting challenges, and rewarding work. What does the company want from you? High performance at the lowest possible cost. The higher the pay, the lower the profits. There are two different, and potentially opposing, goals. This situation can create conflict. One way to address these problems is for the company to give the employees some skin in the shareholders’ game. The company can set up a profit-sharing plan that pays bonuses based on long-term cumulative profits. The company can fire underperforming employees. Here, the game refers to the profitability of the company. We benefit if our company is profitable, and we suffer if our company loses money. Now, with the bonus and dismissal plan, there is a better alignment of interest between shareholders and employees. It is not perfect, but it is much improved. In this case, our incentives would be similar in shape to Figure 8.1, although the slope may, or may not, be one-for-one. The idea here is that our collective actions affect the profitability of the company (the outcome). By giving us skin in their game, the company is encouraging the employees to work harder and help make the company more profitable. How well this scheme would work depends on the number of rewards and penalties, how much harder the employees can work, and how much they can affect the profitability of the company. By ensuring that both shareholders and managers have similar payoff structures, the agency problem is reduced.

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Consider another example. Suppose you are a manager. The company wants you to have skin in the shareholders’ game. Thus, in addition to salary, you also receive a cash bonus based on profitability of the firm. Suppose that each percentage increase in company profitability increases your bonus by 5 percent. Similarly, each percentage drop in company profitability decreases your bonus by 5 percent. In this example, there is still a linear relation between the outcome and payoff; however, the relation is five-to-one. Managers will receive 5 percent higher payoffs as the profitability of the firm increases by 1 percent. This is called a leveraged payoff. It is more effective in resolving divergence of interests between the managers and shareholders.221 Leveraged payoffs occur when part of the investment is financed with debt. We get to benefit more than one-for-one when a favorable outcome occurs. If an unfavorable outcome occurs, we are hurt more than one-forone. If a project is therefore financed with some debt, the managers will have an extra incentive to work hard. We discuss this in more detail later in the book. Consider an investment example. Suppose that you have $1,000 to invest. Now you borrow another $1,000 and invest a total of $2,000 in the stock market. In this situation, the market return represents the outcome, and your own equity return represents your own payoff. Suppose that the market rises by 1 percent the next day. This is the outcome. In this case, your $2,000 investment will go up by $20 (1 percent of invested amount). However, a $20 increase represents 2 percent of your own $1,000 equity. Thus, when the market rises by 1 percent (outcome), your payoff rises by 2 percent. Consequently, you now have a ‘bet’ on the market that has been enhanced by leverage. Your payoff is still linear in market return, but now it is greater than one for one. Once again, levered incentives will be especially effective in getting the agent to work harder and find best investment opportunities. However, if the market declines, the leverage exacerbates your losses. Alternatively, we can receive less than one-for-one payoffs. When the outcome is two, the payoff can be one. Similarly, when the outcome is 221

See, Michael Jensen, “Agency costs of free cash flow, corporate finance, and takeovers” American Economic Review, vol. 76, no. 2.

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minus two, the payoff can be minus one. These payoffs can arise when an investor allocates only a part of the investment to the given project, and the remainder is invested in a less risky (or risk-free) project. Another way to say this, is that the individual is not fully-invested – the individual does not ‘put all his eggs in one basket’. Less than one-for-one incentives will be less effective in solving agency problems. Consider various examples. In a good marriage or a well-functioning family, all family members should have linear payoff functions similar to Figure 8.1. The outcome here is family income. This situation arises since they share the collective positive and negative payoffs. This is a perfect example of the expression ‘all for one and one for all’. Unfortunately, even in a family, everyone might have a different game. To be a well-functioning and coherent family, every member must buy into the family game. Otherwise, everyone will have skin in only in their own game. If each spouse is playing a different game, this can create severe conflicts within the family. Suppose that parents value hard work and savings, while their young adult child lives at home and does not work, abuses drugs, and plays violent video games. This situation is full of potential conflicts. Family members do not share in each other’s values and choices. If you think such situations are unrealistic, we suggest you watch ‘Dr. Phil’ on TV. Sometimes, skin in the game can be unproductive. Suppose that a police officer shoots an unarmed teenager and other active police officers in the same department are chosen to investigate the incident. In this case, the investigating police have skin in the game, as opposed to being objective fact-finders. If they find culpability with their colleague (negative outcome), they themselves may face some costs or a backlash. Since they can affect the outcome of the investigation, holding all else constant, they will have incentives to find no culpability. To get at the objective truth, experts with absolutely no skin in the game will need to be chosen for the investigation. Imagine a situation where students grade each other’s final exams. Similar to the police investigating themselves, this is not likely to produce objective grades. These incentive problems exist with all self-regulating organizations.

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All upside on the right and no downside In the real world, many situations involve non-linear payoffs. One type of such payoff is shown in Figure 8.2. It looks like a hockey stick. Here the individual has all the upside on the positive side, and none of the downside. In these circumstances, the individual receives a substantial payoff if a favorable outcome occurs. On the other hand, the individual receives a limited loss, or no loss at all if an unfavorable outcome occurs. In Figure 8.2, the kink in the hockey stick is shown at the origin. This is for convenience only. In general, the kink can occur anywhere along the outcome line by shifting it left or right. The hockey stick can be shifted up and down. Furthermore, the slope of the hockey stick does not have to be one-for-one. It can be greater than, and/or less than, one-for-one. With a payoff structure such as Figure 8.2, the individual still cares about the outcome. Here the individual prefers outcomes where the payoff is positive. In Figure 8.2, this individual would prefer only positive outcomes. The more positive, the better. However, the individual is indifferent to the extent of the negative outcome. It does not matter whether the outcome is slightly negative or hugely negative. In either case, the individual receives a zero (or some fixed) payoff. As before, the individual may, or may not, be able to affect the outcome. For those who may be familiar with options, Figure 8.2 also refers to the payoff from a call option. A call option gives you the right (but not the obligation) to buy something (a stock) at a fixed price (called the exercise price). If the stock price increases above the exercise price, you buy it at the fixed price and receive a dollar-for-dollar payoff (the difference between actual price and the exercise price). If the price declines, you choose not to exercise your option, since you can now buy it cheaper in the stock market. Your payoff is zero. Figure 8.2 is a profile commonly associated with those who commit theft or fraud. They think they will obtain all the upside of good outcomes (meaning no detection or apprehension) and none of the downside of bad outcomes (meaning apprehension and conviction). Society can change this perspective by adding or increasing penalties for negative outcomes. These measures can include greater detection effort, fines, sanctions, and enforcement. For civil infractions, allowing for class-action lawsuits and

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strict liability for malpractice can serve as disciplining devices, even when the dollar amount of the infractions is small.

Payoffs

Figure 8.2: All Upside and No Downside

Outcomes

To understand incentives better, we need to compare and contrast our payoffs with those of the opposing parties. If our payoffs are similar, then there are likely to be few conflicts. If our payoffs differ significantly, conflicts may arise. The key to managing the relationship is to change the incentives and try to align the payoffs of the opposing party with our own. Suppose our payoff in a game is given by Figure 8.1, while the opposing party is looking at Figure 8.2. What issues arise here? First, there are no conflicts on the right side. We both want good outcomes. The problems and conflicts occur on the side where there are negative outcomes. We experience losses if a substantial negative outcome occurs, while the opposing party does not. Hence, our interests conflict on the downside. How should we manage this situation? We would want to take action to avoid the downside, where the opposing party will not care at all about the downside. The key to managing this situation is to get the opposing party to accept some negative payoffs in the case of negative outcomes. Consider an example. Suppose you are out of town, and you are considering two restaurants for dinner. One of them is a member of a chain, while the

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other is a local restaurant. They are both located near a highway exit. What are the incentives facing these restaurants? Which is likely to provide a better experience? The chain member is likely to be facing Figure 8.1, while the local is facing Figure 8.2. They both benefit if you patronize them, and you are happy with the outcome. However, if you are unhappy, you may be more likely to avoid the members of the same chain in other towns. If you are unhappy (outcome), the chain also faces negative payoffs. If you are unhappy with the local restaurant, it does not matter much to the local owner. You are not likely to come back to that restaurant anyway. In this case, your payoffs are better aligned with the chain member and you are likely to be happier with the chain. One important takeaway: It pays to frequent establishments that depend on repeat business (yours or other customers). Similarly, you can attempt to control the incentives of the opposing parties (contractors, repair people, co-authors) by signaling to them that you intend to conduct repeat business. The possibility of losing your future business gives them incentives to make you happy each time. Consider another example. Suppose you are the parent of an adolescent college student that you are financially supporting. You are a hard worker, but you struggle to motivate your child to do the same. Unfortunately, your adolescent has also started to skip classes as his social interests are expanding. If he gets good grades, you are happy for him, receiving emotional benefits from his success. Unfortunately, if he skips too many classes and fails the course, he needs to retake it, which means extra tuition payments for you. Your child is looking at Figure 8.2, while you are looking at Figure 8.1. Going back to Figure 8.2, here the outcome refers to your kid’s grades. Payoff refers to what the child receives. In this game, the child has all the upside and none of the downside. You can immediately see how these divergent interests will generate conflict. You would want your child to stop excessive socializing. He, on the other hand, will view the situation as a unique opportunity to enjoy his youth.

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You might want to change your child’s incentives. Instead of paying all the tuition as long as your child attends school, you can tell him that you will pay for four years of tuition. The additional years must be assumed by him. Once again, this admonition helps to align both of your interests. Consider additional examples. Figure 8.2 describes the situation of shareholders in a firm that has borrowed money, although here, shift the hockey stick slightly to the right. Here, outcome refers to the value of assets. The payoff refers to the common stock value. The kink in the graph, on the x-axis, is at the amount that the firm has borrowed. If the value of the assets exceeds the value of debt, then the managers can pay the debt off. The remainder belongs to the shareholders, which is shown on the right side. If the assets of the firm are worth less than the value of debt, the firm is insolvent. Since shareholders have limited liability, they simply walk away and get a zero payoff (the left side of the graph). The debtholders take over the firm. Figure 8.2 also describes the situation that can arise when the individual takes in money from investors, borrows additional money, and then invests that money. We previously referred to this as leverage, a strategy that is used by many hedge funds. The managers of the fund have significant upside with limited or zero downside. If the hedge fund invests successfully, the investors benefit. If the hedge fund invests poorly, the investors and creditors can experience significant negative outcomes. Managers only experience limited loss on the downside. If individuals face the payoff structure shown in Figure 8.2, they prefer taking additional risk, resulting in more extreme outcomes. Positive extreme outcomes benefit the individual dollar for dollar, while negative extreme outcomes do not hurt the individual because they value all negative outcomes equally (at zero). Whether the outcome is slightly negative or extremely negative, the payoff is still zero. Consider additional personal examples. Suppose you are married. Both you and your husband have good, steady, well-paying jobs. Now your husband wants to start his own business. This means that your payoff profile and your husband’s payoff profile have now diverged. Unfortunately for you, your husband has little or no expertise in creating a new venture. If he is successful, you both benefit. If he fails, you will need

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to support him. In all these cases, the payoff to your husband is similar to Figure 8.2, while you are looking at Figure 8.1. If the business venture succeeds, then the whole family benefits, and you are both happy. If the business venture continues to lose money, then you have to work even harder (maybe get a second job) to pay for your husband’s poor decisions. How do you manage this? One possibility is a prenuptial agreement. If you have one that states that all assets and liabilities belong solely to the party that owns them, your husband is likely to be more careful with his appetite for risk and entrepreneurial ambitions.

All upside on the left and no downside Another variation of this non-linear payoff type is the mirror image of Figure 8.2. This is shown in Figure 8.3. Here the player has all the upside on the left side and none on the right side. In these circumstances, the individual receives a positive payoff if a negative outcome occurs. There is little or no loss if a positive outcome occurs.222 For those who may be familiar with options, Figure 8.3 also refers to the payoff from a put option. A put option gives you the right (but not the obligation) to sell something (a stock) at a fixed price (the exercise price). If the stock price declines, you sell it at the (high) fixed price and receive a dollar-for-dollar payoff for the difference. If the price increases, you choose not to exercise your put option since you can now sell it at a higher price in the stock market. You throw away your put option and receive no payoff. In a payoff structure such as Figure 8.3, the individual still cares about the outcome. Specifically, the individual prefers negative outcomes. The more negative, the better. The individual does not prefer positive outcomes. Moreover, the individual is indifferent to how positive the outcome is. Whether the outcome is slightly positive or extremely positive does not

222 As before, Figure 8.3 shows the kink in the hockey stick at the origin. You can shift

it right to left and up and down. In general, the kink can occur anywhere along the outcome line. Furthermore, the slope of the hockey stick does not have to be onefor-one. If can be greater than, and/or less than, one-for-one. Again, the one-forone slope is for convenience only.

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matter. In either case, the individual receives a zero payoff. As before, the individual may or may not be able to affect the outcome. If individuals face the payoff structure shown in Figure 8.3, then they, again, want to take more risk, resulting in more extreme outcomes. Negative extreme outcomes benefit the individual dollar-for-dollar, while positive extreme outcomes do not hurt the individuals. Whether the outcome is slightly positive or extremely positive, the payoff is still zero.

Payoffs

Figure 8.3: All Upside and No Downside

Outcomes

A new important concept we introduce here is known as moral hazard. It refers to some hidden action that the individual would not normally engage in, without the incentive, in order to capture the positive payoff. This is illustrated in Figure 8.3. Suppose that you have a conniving brother-in-law. You need to be careful with him, but unfortunately, you trust him 100 percent. Suppose you give him your money to manage and ask him to open a brokerage account. To your utmost surprise, he just brings the signature page, saying that he has filled out all the rest of the forms himself and all you need to do is to sign this page. Is your conniving brother-in-law being nice to you? Maybe and maybe not. You are looking at Figure 8.1, while your brother-in-law could be looking at Figure 8.3. Your brother-in-law could benefit from a bad outcome at your expense.

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How can such a situation arise? Suppose your brother-in-law filled out the legal forms to open a joint account instead of a single account in your name only. If anything happens to you, your account now belongs to your brother-in-law. If nothing happens to you, and you are still alive, you hope you can exert enough pressure on him to turn the full account proceeds back to you. In general, it is difficult to reconcile the interests of someone facing a profile of Figure 8.3 versus someone facing a profile of Figure 8.1. You should not engage in this type of situation. Consider an example from the movie The Godfather. It is, of course, makebelieve entertainment and we do not suggest that the movie reflects the world. But since many people have seen the movie, it can serve as a useful example from the world of entertainment. In the movie, we observe various situations similar to Figure 8.3. For instance, the older brother, Fredo Corleone, gives specific information to a rival family that will result in Michael Corleone’s assassination.223 The outcome here is whether Michael lives or dies. Fredo must think that he is looking at Figure 8.3. If Michael is successfully assassinated (negative outcome), Fredo benefits. If Michael survives the assassination attempt (positive outcome), and no one finds out about Fredo’s betrayal, then Fredo gets a zero payoff. Michael Corleone, of course, is looking at Figure 8.1. He has skin in his own game of life and death. Clearly, the fact that Fredo is playing his own conflicted game inside the family has created a strong conflict of interest between Michael and Fredo Corleone. The next issue is why Fredo Corleone would get the impression that there would be no negative consequences if Michael survives the assassination attempt. The answer must be that Michael has given off signals of his own weakness and vulnerability to his brother. This vulnerability has prompted Fredo to conclude that he is looking at Figure 8.3. There is only positive payoff with no downside. This relation cannot be managed. Michael must cut off all contact with Fredo. Another lesson from this discussion is not to signal weakness 223

In the movie, when Michael confronts him, Fredo denies that the information he gave to a rival family would be used to hit Michael. However, such a denial would be expected under the circumstances.

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regardless of the true state of things. Signs of weakness can invite aggression from those people who are conflicted with you. Most perpetrators of crimes (frauds, robbery, or murder) believe that they are looking at Figure 8.3. In this case, let the negative outcome refer to the successful execution of the crime where the victim loses. The perpetrators have come to the belief that if the crime is successful, they would benefit and if the crime is unsuccessful, there is little or no downside for them. The best way to manage this is to avoid these people if at all possible. In addition, you can discourage these crimes by projecting strength. First, make the potential perpetrator believe that the crime is not likely to be successful. Second, the potential perpetrator should also believe that there would be a steep price to pay in an unsuccessful attempt. Had Fredo thought that there would be little to gain from a successful attempt and that Michael would exact revenge on him from an unsuccessful attempt, he would not have sold out his brother in the first place.224 Similar payoff structures can describe some large families. Suppose that one family member can start a false rumor about other family members and cause intense family conflicts. Not being a direct party to the conflict, the ‘rumormonger’ increases his or her prominence in the family as the ‘perfect’ one and receive positive payoffs as they get to benefit from resultant enmities among others. What is the best way to ward off these troublemakers? One step is to ostracize and avoid all contact with the rumormonger.225 Another step is to expose the rumormonger. If a family member misbehaves, make sure that the troublemaker is exposed and not rewarded, therefore preventing similar future problems.

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Economist Gary Becker won the Nobel Prize in Economics for his work on the incentives of criminal behavior. He theorized that criminals were rational actors and would respond to incentives just like everyone else. See https://www.chicagomaroon.com/2012/05/25/the-economics-of-crime-with-garybecker/ 225 In ancient Athens, the citizens could vote to expel someone (usually a prominent politician) for a period of up to ten years by writing his name on an ostraca, without any need for a trial. The highest vote getter once a year was then banned (ostracized).

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Typical insurance contracts have payoff structures shown in Figure 8.3. If a negative outcome occurs (the house burns down), the insurance provides a payoff. If a positive outcome occurs (the house does not burn down), then insurance does not pay. Typically, all insurance contracts have a payoff picture similar to Figure 8.3. In general, if the individuals can affect the outcomes, this payoff structure will encourage them to take excessively risky strategies to reach more and more negative outcomes with more positive payoffs. If the risky strategy works out, and negative outcomes are realized, then the individual benefits. If the risky strategy does not work out, the individual does not lose much, if at all. A related example of moral hazard can occur when the house is overinsured. In this case, the payoff from the insurance company exceeds the lost value from the house. This leads to moral hazard where the individual would not only wish the house to burn down, but he may also take active steps to make it happen. You might rightly think that the insurance company is aware of this risk. They are not going to insure the house for greater than its market value or replacement value. Nevertheless, individuals can be incentivized to engage in moral hazard and still try to cheat the insurance company. In addition to insuring the physical structure, they can also insure the contents of the house such as furniture, paintings, and jewelry. In this case, the individual faces a temptation to remove the insured contents to a secret location and then burn the physical structure and claim that the expensive furnishings have also burned down. Of course, such behavior is clearly illegal. Life insurance policies can be especially tempting to criminally-minded people. The beneficiary of the life insurance policy would face a payoff structure as in Figure 8.3. If the policyholder continues to live (positive outcome), then there is no payoff for the beneficiary. If the policyholder were to die, (negative outcome), the beneficiary collects on the insurance contract. It is all upside on the negative outcome and no downside on the positive outcome for the named beneficiary. Life insurance policies can tempt people into moral hazard. Unfortunately, the newspapers are full of these kinds of horror stories. It is always a good idea to examine people’s motivations or payoffs.

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Suppose you are newly married. It was love at first sight and you do not know your spouse closely. You saw this handsome male on the street. He asked you to marry him unexpectedly, and you said yes. Barely a week goes by and your new spouse asks you to take a $1 million life insurance policy on yourself and name him as the beneficiary. What should you think? You need to realize that the payoff structure facing your new husband looks similar to Figure 8.3, while you would be looking at Figure 8.1. Immediately you have two separate games in the same family, and this creates a potential conflict. If you continue to live (positive outcome), there is no payoff to your husband from the insurance contract. If you die suddenly (negative outcome), your husband gets a million dollars. It is all upside on the negative outcome and no downside on the positive outcome for your husband. Consider more closely the nature of the moral hazard here. As we know, life insurance is intended to replace income and living standards in case of death, and provide for those who are unable to provide for themselves. Presumably, in this example, the husband can provide for himself. Furthermore, if the availability of insurance makes someone better off than without insurance, then that creates a moral hazard risk. Moral hazard is surely tempting. Under these suspicious circumstances, you may want to speak with a lawyer about a divorce. If not, definitely refuse the life insurance. As discussed earlier, you should worry if your spouse can affect the outcome. This is particularly the case if your spouse takes an interest in risky activities, such as trekking along the Grand Canyon. If you think this is all hypothetical, unfortunately, there are real-world cases, where similar situations have resulted in the murder of unsuspecting spouses to collect the insurance money.226 As a general practice, you should be concerned if someone you trust has the payoff structure as shown in Figure 8.3 while you have skin in the game, facing the payoff structure shown in Figure 8.1. Anyone with these payoff structures can have a severe conflict of interest with their partner looking

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See, https://www.theguardian.com/world/2001/sep/27/andrewosborn

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at Figure 8.1. This is especially true if the trusted individual can affect the outcome of the game (e.g., the fictional character Fredo Corleone).

All downside on the left and no upside A fourth type of non-linear payoff is the situation where the individual has all the downside on the negative side and none of the upside. This payoff structure is shown in Figure 8.4. In these circumstances, the individual has obligations to honor a contract, which triggers when a negative outcome occurs. Typically, these individuals do not choose this strategy, but they are left holding the bag with the negative payoffs if the strategy chosen by someone else does not work out. For those who may be familiar with options, Figure 8.4 also refers to the payoff from a selling a put option. If you sell a put option, then you give the opposing party (buying the put) the right (but not the obligation) to sell something (a stock) to you at a fixed price. You have to honor this contract, which means you have the obligation to buy the stock at a fixed price. If the stock price goes down, the opposing party will sell it to you at the (high) fixed price and you are obligated to buy it. You can turn around and sell it in the market, but only for a lower price. This loss is your negative payoff. If the price increases, the opposing party chooses not to exercise the put option, since they can now sell the stock at a higher price in the stock market. The put option has no value and you receive a zero payoff. Up until the middle of the 19th century, it was considered acceptable to engage in a duel to restore one’s honor. In 1804, for example, US Treasury Secretary Alexander Hamilton was killed in a duel by the sitting Vice President Aaron Burr. Both parties faced a payoff, as illustrated in Figure 8.4. In one outcome, the individual walked away. In another outcome, the individual was killed. By the middle of the 19th century, as moral codes changed, duelling essentially stopped, thankfully so. Consider other examples. Recall your conniving brother-in-law – call him Jack. Suppose he is a banker. Jack appears to be knowledgeable about investments. Furthermore, you trust him, and you give him your savings and ask him to invest them for you. After all, who knows investments better than Jack?

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Payoffs

Figure 8.4: All Downside and No Upside

Outcomes

After Jack invests your money, you ask him what specific investments he has made, but Jack is quite confusing as to what he did with the money. Why can’t he just state how the money is invested? You start worrying whether your brother-in-law has taken your money. Unfortunately, you do not know what situation you are in. In this case, you could be looking at Figure 8.4, while Jack is looking at Figure 8.2. Jack could be gaining at your expense. Suppose that, without telling you, he invested your money in the stock market. If market subsequently goes down, he truthfully reports your market losses. You are unhappy, but you accept it. Stock markets do go down sometimes. You bear these losses. If the stock market does go up, Jack is likely to falsely report that he invested your money in risk-free government bonds with a low yield, rather than the stock market, which is what he actually did. This way, Jack can pocket the difference between the high-realized return on the stock market and the low yield on the government bonds. Thus, Jack keeps these stock market gains mostly for himself. You end up with a payoff diagram similar to Figure 8.4. How do you protect yourself from this game? It is best to avoid dealing with Jack, since you can never win with him. Instead, use a reputable asset management firm.

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If you feel obligated to deal with your brother-in-law (or father-in-law), then you need to take additional precautions. Before you give him any money, you need to insist on reviewing his investment plan. If it is too late for this step, then you need to know his investment decisions. With every passing day, you could be losing more money. Consider again the example of the entrepreneurial husband. He quit his regular job to start a new business. You are providing for the family. Unbeknownst to you, your husband is planning to leave you if the business thrives. If the business fails, you will be absorbing some of the losses. In this case, you are facing Figure 8.4. Furthermore, your husband has incentive to take as much risk as possible at your expense. Consider a situation where your underage son becomes interested in playing poker. When he wins, however, he spends all the money on parties. Now you do not really care whether he wins or not, since there is no benefit to you. If the child loses, however, you feel obligated to cover his losses. In this case, your payoff structure looks similar to Figure 8.4. The child decides to play the game and you are obligated to cover his losses. If he wins, there is no benefit or cost to you. Once again, if it is heads, your son wins; if it is tails, you lose. If you are facing Figure 8.4, how do you feel about risk? You would want to avoid it. You would not want your son to play poker for bigger pots. If he wins, there is no benefit to you. If he loses, you have to cover even bigger losses. The solution here, once again, is insisting that your son be responsible for his losses. In our life-insurance game, the life-insurance company also faces a payoff structure similar to Figure 8.4. If a negative outcome occurs and you die, the insurance company pays. If a positive outcome occurs and you live, the insurance company does not pay. One way the insurance company deals with this risk is to require a medical exam to ensure that you do not have a life-threatening illness at the time you purchase insurance. Consider other examples. Once again, in real life, we do not want our children to think that the message that we will always support them, no matter what, is always applicable (even if it is so). If they perceive that there is no downside for them, we are sending them a signal that they do not need to worry about negative payoffs associated with negative

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outcomes or the risk of the games they play. Heads, the children win; tails, we lose. In effect, our payoff structure would look like Figure 8.4. Instead, we should emphasize that there will be at least some negative consequence for them, similar to Figure 8.1. Typically, as we will learn later, Figure 8.4 suggests the presence of obligations. The negative payoff represents the payments to satisfy these obligations. Suppose you have joined the army. Now you face obligations. You have to fight and face the consequences when you are ordered into battle. Suppose you volunteered for combat service in Afghanistan. You then learn that you are being ordered into combat the next day. In this case, your upcoming payoff structure looks similar to Figure 8.4. If some negative outcome occurs (you get attacked), there is a big negative payoff for you – you lose your life or limbs. The best outcome is that nothing bad happens and you survive combat with your body and mind intact.227 There is no upside in this game. In general, when you have obligations, there is no upside to you. The best outcome is for your obligations to end. If individuals face the payoff structure shown in Figure 8.4, then they dislike risk. More risky strategies result in more extreme outcomes. Positive extreme outcomes do not benefit the individual. Negative extreme outcomes hurt the individuals. Whether the outcome is slightly positive or extremely positive, the payoff is still zero. However, more extreme negative outcomes hurt the individual much more. Consequently, the higher the risk, the worse off the individual is. As a result, the individual prefers less risk. What about the annual running of the bulls in Pamplona? What is the payoff structure? You can assess this one yourself.

All downside on the right and no upside Another variation of this payoff structure is shown in Figure 8.5. Once again, the individual has all the downside on the right and none of the upside on the left. Hence, this time, the negative payoffs occur on the positive outcome side. In these circumstances the individual has 227

The person may still feel good, in that he is serving his country.

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obligations to honor some agreement (a contract), which triggers when a positive outcome occurs. Typically, once again, these individuals do not choose the strategy, and they are left with the obligation to honor the contract when the positive outcome occurs. For those who may be familiar with options, Figure 8.5 also refers to the payoff from selling a call option. A call option gives the opposing (buying) party the right (but not the obligation) to buy something (a stock) from you at a fixed price. This means you have the obligation to honor this contract, which means you have the obligation to sell at the fixed price. If the price increases, the opposing party will want to buy the stock from you at the cheap fixed price. You need to go into the market, buy it at the high market price, and sell at the low fixed price. This loss is your negative payoff. If the price decreases, the opposing party will choose not to exercise his option, since he can now buy it cheaper in the stock market. He throws away his call option and you receive a zero payoff. If individuals face the payoff structure shown in Figure 8.5, then once again they dislike risk. More risky strategies result in more extreme outcomes. Negative extreme outcomes do not hurt the individuals. However, positive extreme outcomes hurt the individual. However, more extreme positive outcomes hurt the individual much more. Consequently, the higher the risk, the worse off the individual is. As a result, this individual would prefer less risk. We return to the example of the struggling son. Suppose that your son is currently self-sufficient, although he is not doing great. You tell him, “Why don’t you go to college? If you attend college, I’ll co-sign all the loans”. Once you make this proposition, your payoff is Figure 8.5. Suppose your son accepts the proposal and attends college. Then the longer he stays in school, the larger the loans become. If he does not attend, he is selfsufficient and there is no obligation to you. If you make such an unconditional offer, you son might just take you up and stay in school as long as he can. You have the upfront costs and none of the benefits. You are also encouraging him to go to as expensive a school as he can get into.

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Payoffs

Figure 8.5: All Downside and No Upside

Outcomes

Consider another example. Suppose you hire a house painter for the exterior of your home, and you decide to provide incentives for him to finish the assignment. You agree that he must complete the job in 30 days. If he finishes the job before 30 days, then he gets a bonus. Furthermore, the faster the job is finished, the bigger is the bonus. If the job is finished on or after 30 days, then there is no bonus. In this case, your payoff from the incentive contract would look like in Figure 8.5. If a positive outcome occurs (the job is finished quickly), then you pay. If a negative outcome occurs (the job is not finished quickly), then you do not pay. Obviously, you may be unpleasantly surprised if the job is finished too quickly. Suppose that the contractor hires a dozen college students and finishes the job in one week, instead of using an experienced painter over one month. In this case, you may suspect that the painter gave you the 30day estimate just to scare you into a type of incentive contract that you agreed to. Alternatively, the painter may cut additional corners on quality to finish the job as quickly as possible to earn the bonus. Thus, incentives may not always work to your advantage. This payoff scheme can be further illustrated with another example. Suppose that someone has stolen your identity. He then bets $1 million on the stock market with his own identity and uses your identity to open a

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brokerage account and take a $2 million ‘bear’ position on the US stock market.228 If the market happens to rise by 100 percent, he gains $1 million and you lose $2 million. He is happy, while you lose $2 million. If the market declines by 50 percent, he loses $0.5 million but you will make $1 million. However, in this case, he removes $1 million from your brokerage account to pay for his losses and still have an extra $0.5 million. So, he always wins. You, however, lose if the market rises, and do not gain if the market falls. The more the market rises, the more you lose. In this case, you are facing a payoff structure given in Figure 8.5.

Significant downside, limited upside Another payoff structure is the situation where the individual is exposed to significant downside. If the outcome is negative, the individual loses. Moreover, the individual has no upside, or only a limited upside. If the outcome is positive, the individual gains only a limited amount. This payoff structure is shown in Figure 8.6. Once again, the picture can be shifted up and down, or right, or left. These payoff structures occur when an individual, or a firm, lends money. Individuals with these payoffs do not fully participate in good outcomes, but suffer the negative payoffs if the borrower does not repay the loan. If a positive outcome occurs, the lender is repaid the loan amount plus interest. If a negative outcome occurs, the lender loses some, or most, of the amount of the loan. These incentives are discussed in detail when we discuss debt. Similar payoff structures occur if the manager works only on a fixed salary. If the business succeeds, the manager receives no additional benefit. If the business fails, the manager will lose his job.

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We explain later in this chapter how he takes a bearish position in the stock market. This is called shorting the market.

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Figure 8.6: Lots of Downside and Limited Upside

Outcomes

Suppose your payoff structure is described by Figure 8.1. Your agent – someone you hired on an hourly wage basis – has a payoff structure defined by Figure 8.6. What conflict would you expect? Neither of you want the downside, as you both lose. There is no conflict here. What about the upside? You would like as much of an upside as possible. Your agent, however, only has a limited interest in the upside. Once his payoff plateaus, he has no incentive to work additionally hard to reach even more positive outcomes. Thus, you have some conflict on the upside. Here, it makes sense to provide some incentives to reach more positive outcomes.

Negative skin in the game Another type of payoff is shown in Figure 8.7. Once again, this payoff structure is linear. However, this individual receives a positive payoff when the outcome is negative and a negative payoff when the outcome is positive. They do have skin in the game, but it is negative skin. The payoff can be one-to-one or a different ratio. In finance, these types of payoffs arise when people sell securities they borrow. Yes, this is correct. Outside of finance, it is not legal to sell something that belongs to someone else. It is theft. In the world of finance,

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you are allowed to sell a security that you don’t own, by borrowing it. This is not illegal. This is called short-selling, or shorting.

Payoffs

Figure 8.7: Negative Skin in the Game

Outcomes

How does shorting work? It is a complicated, and not often understood, area of finance. The basics are as follows. Suppose that you think the shares of General Motors will decline in price, but you do not own GM stock. You have enough conviction in your view that you are willing to risk some money in the stock market. You must first borrow GM shares from someone who holds them. Usually, a broker can arrange for this. You then sell the shares in the market. Suppose GM’s current stock price is $30. So, you borrow the shares and sell them for $30. You then have your proceeds from the sale. You also have to promise to return the shares sometime in the future. Hence, you cannot just walk away with the $30. You also need to put up some deposit (called margin) to demonstrate that you will honor your promise. But this deposit is your money, and it is returned to you when you deliver the shares sometime in the future. Suppose that the GM stock price falls to $25 and you decide to return the borrowed stock.229 In this case, you buy the GM share for $25 (using the

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This is called closing your short position.

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initial $30 proceeds) and return the share as promised. Now your position is known as closed. These two transactions have enabled you to make a $5 profit. You first sold at $30. Then later you bought at $25. You made $5 while GM shareholders lost $5. Your interests are the opposite of those of GM’s shareholders. Suppose instead, that GM had risen to $35. Again, you decide to close your short position. Now you buy a GM share for $35 and return it as promised. This time you have lost $5. You bought GM at $35 and sold at $30. GM shareholders, however, made $5. Your interests are again the opposite of GM’s shareholders. Why, again, would anyone want to short-sell a stock? The answer is that you expect the stock price of the share to decline. In this case, you sell before the price declines and buy after the price declines. You think the company’s prospects are poor and you are betting against the company. You have the payoff structure shown in Figure 8.7. So, if you expect the price of an asset to increase, you buy first and sell later. This is called a long position. If you expect the price of an asset to decline, you sell first and buy it back later. This is a short position. We return to the movie The Godfather. The mistake that Fredo Corleone made is that he thought he was looking at Figure 8.3 even though he was facing Figure 8.7. He thought that he would never be discovered as the betrayer even if Michael survived. What he did not realize is that Michael would go all out to discover the name of the betrayer, thereby bringing revenge upon his brother, Fredo. If two opposing parties are looking at Figures 8.1 and 8.7, they have irreconcilable differences. This relationship cannot be salvaged. The only thing to do, is to avoid or end these relations as soon as possible. With such conflicts, there cannot be any trust. Without trust, there cannot be any meaningful interaction. You never, ever, want to have two family members with such conflicting payoffs, where one looks at Figure 8.1, and the other looks at Figure 8.7, a situation which represents maximum conflict. They will oppose each other on every issue, every effort, and every outcome. In the example of the entrepreneurial husband, there is no way to reconcile these conflicts. If your husband wants to start a risky new business with your money, you

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may want to say no, and be prepared to leave the marriage. This relationship cannot be managed, since the husband will have a large appetite for risky investments using your money. Every family is, of course, different, but from our perspective it is advisable that family members avoid these kinds of opposing games in the first place. A similar conflict situation occurs in any kind of non-consensual relationships. These payoffs are illustrated in Figures 8.3 and 8.4. When one party in the relationship holds physical or economic power over the opposing party, their interests are diametrically in opposition. In this case, the strong party (Figure 8.3) ensures that negative outcomes are always realized, and they will always gain at the expense of the weaker party (Figure 8.4). Examples of these relationships are servitude, extortion, blackmail, and human trafficking. In many business contexts, we can observe negative-skin types of payoff. Whenever you compete for a business deal with others, you get opposite payoffs. Suppose two defense contractors are bidding for the same new weapons system. Their payoffs are opposed. When one wins, the other loses. They will have similar payoffs as in Figures 8.1 and 8.7. You and your insurance company mutually benefit from each other, until you file a large claim. Now your incentives are diametrically opposed. Negative skin represents the worst possible conflict. It is more common than it appears. Consider other examples. Normally, having a credit card benefits both you and the credit card company. Suppose, however, that you have fallen behind in payments and accumulated huge balances on your card. Now, the credit card company is worried about losing the money in the entire account. You receive annoying phone calls at work to make payment or face severe consequences. As we will explain, your interests and the credit card company’s interests are now in diametrical opposition. When you face someone whose interests are diametrically opposed to your own, they will not be looking out for your best interests. For instance, in the credit card example, you are not likely to get honest and objective answers to your questions from the credit card company. You may have

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questions about the statute of limitations on your debt,230 whether the credit card company is allowed to call you at work, or whether they can visit you at work and complain to your boss. These questions are best answered by a lawyer who represents you, not by the lender. In fact, you probably want to be skeptical about whatever you hear from the credit card company. They are likely to exaggerate their position, or their power over you. The credit card company simply wants to be paid as much of the outstanding balance with interest and penalties as possible. The more you pay, the better off they are. The less you pay, the worse off they are. If you have any questions about your debt, you should consider seeking answers from an independent source, not the lender. Doctors typically care for their patients. However, if a patient happens to suffer injury while under their care, the interests of the doctor and the patient now diverge diametrically. Your doctor is no longer the best source of medical advice. There is yet another reason for a payoff scheme as in Figure 8.7. It is the possibility that there are two individuals who dislike each other. Think of the classical example of the shepherd and the farmer. Their interests diverge in their occupations and ideas for land use. Think of any other example, including hate, bigotry, ethnic differences, religious beliefs, or political views. Each person wants the worst outcome for the opposing individual. Whatever the opposing individual wants, they want the opposite. As we discussed before, people may or may not be able to affect outcomes. Suppose you face Figure 8.1 and you engaged someone with the payoff structure in Figure 8.7 to do a task for you. You have just hired your enemy. You will probably not win in this game.

No skin in the game Another payoff structure for someone who has no skin in the game is shown in Figure 8.8. These people always get the same payoff, no matter 230

Statute of limitations for credit card debt falls under state laws and typically varies between 3 and 10 years. See, https://www.creditcards.com/credit-cardnews/credit-card-state-statute-limitations-1282.php

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the outcome. Thus, they do not care about the outcome. They have no skin in your game. Someone you hire by the job, and pay upfront and in full, typically has a payoff structure shown in Figure 8.8.

Payoffs

Figure 8.8: No Skin in the Game

Outcomes Suppose you are a salaried government employee with job security. You feel that both your salary and the terms of your employment are secure. You may feel (rightly or wrongly) that you have no skin in your employer’s game. In this case, you are looking at Figure 8.8. Suppose you are facing Figure 8.1 (skin) and you hired someone who is facing Figure 8.8 (no-skin). What should you look out for? How will their interest conflict with yours? First, the person (our agent) facing Figure 8.8 does not care at all about the outcome. In contrast, we lose with negative outcomes and gain with positive outcomes. Thus, our agent will not do anything to avoid negative outcomes, nor will they put in any effort to end up with positive outcomes. They also do not care about risk. An increase or decrease in the risk of the game has no implications for them. In many interactions, some opposing parties may be looking at Figure 8.8. They have no skin in our game. The solution here is to induce the opposing party to accept penalties for negative outcomes and receive rewards for

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positive outcomes. If you want some of your friends to be happy about your end-of-year bonus, you celebrate and treat your friends.

Limited downside, limited upside Another payoff structure is shown in Figure 8.9, which has a limited downside and limited upside. This is a common profile. It is similar to Figure 8.1, but with limits on both positive and negative payoffs. We call this limited skin in the game.231

Payoffs

Figure 8.9: Limited Skin, Limited Downside, Limited Upside

Outcomes Many real-world activities will have the limited-skin-game type of payoff. This describes many personal activities, such as small business deals, politics, or sports. If the outcome is positive, you win, but a limited amount. If the outcome is negative, you lose, but again, a limited amount. Close calls may also matter in real world. Take, for example, politics. If you lose

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In fact, Bernie Madoff, the fraudster, claimed that he was using a split-strike conversion strategy, which has a payoff structure shown in Figure 8.9.231 You can see that this is a low-risk, low return kind of game. The extreme ends, both on the left side and right side, are chopped off. Obviously, it would be very difficult to produce high returns from a real-world application of this strategy.

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a close election, you still have the opportunity to try again.232 Similarly, a close election win is not as good as a convincing one. Players in this game will have incentives to win the game. They will seek positive outcomes. Similarly, they will prefer avoiding negative outcomes. Accordingly, a limited skin in the game is similar to Figure 8.9. There is skin in the game, but it is less intense. Players may, or may not, be able affect outcomes in Figure 8.9 (limited skin). If they can affect the outcomes, they will work to end up on the positive side and they will work to avoid ending up on the negative side. The payoff structure shown in Figure 8.9 also affects the preferences for risk. If a player is substantially ahead in the game, then the risk does not benefit them. In fact, risk can only hurt them. Consequently, they will want to cut down, or eliminate, all risk. If the players are behind in this game, then the status-quo does not help them. In fact, the status quo hurts them. They will want to increase the risk. Risk gives them a chance to catch up. Hence, players’ preferences for risk depend on whether they are winning or losing. Here are some examples. The appropriate risk taken by a politician, a sports team, or a company, depends on where they stand. If they are ahead in the scoring, they will prefer safer strategies to ensure that they finish the game ahead. If somehow, they can eliminate all risk, they guarantee a win. If they are behind, they will have more tolerance for risk. Holding all else constant, they would now prefer riskier strategies to catch up. Consider the 1984 football game between Boston College and Miami. Only six seconds was left on the clock. Boston College was behind. The quarterback Doug Flutie – only 5-foot-9 inches in height – threw a 52-yard pass into the end zone facing the 30-mph wind. His receiver made a touchdown and Boston College won. Normally, such a pass would be 232

A recent example is Robert Francis (Beto) O’Rourke who lost the Senate election in Texas in 2018 but did better than expected against the incumbent Senator Ted Cruz. On March 14 2019, Mr. O’Rourke announced his candidacy for the Democratic nomination for the President of the United States in 2020. See, https://www.nytimes.com/2019/04/03/us/politics/beto-fundraising.html

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considered too risky and unwise. But with six seconds to go and trailing, Boston College used the optimal strategy.233 Similarly, a politician who is ahead in the polls would prefer staying above the fray, running a clean campaign, and focusing on political and economic issues only. If a politician is behind in the polls as the election date is approaching, then more risk is appropriate. This can include personal attacks on the opponent, the opponent’s marital life, and their shady business dealings. They do not care much whether the opponent will use the same strategy. The greater risk gives them a chance to catch up. If it does, they can win. If it does not, they have not lost much more. They were already expecting to lose the election. In fact, this strategy in politics has a name: It is called ‘October surprise’. The starkest sports example of this occurs in the game of ice hockey. If the team is down and the clock winds down to a minute or so, the trailing team pulls out the goalie and puts in an extra offensive player. Having no goalie is normally extremely risky, and what often happens is that the leading team will score from the far side of the ice, securing their win. If the extra offense works, and the trailing team scores a goal, the incentives change once again. Now they do not want the extra risk and thus the goalie comes right back in. If they do not score, no problems. The game would have been lost anyway. Many money managers can also face similar payoffs. How the money manager acts depends on whether he is ahead or behind, relative to competitors. If the manager is ahead of his competitors, then he may want to close the risky positions to avoid losses. If the manager is behind, he may increase his risky position.234 In this situation, the manager faces asymmetric payoffs. If the fund’s performance is up at year-end, the manager not only keeps his job, but may also earn a bonus. If the fund is down at year-end, the money manager is likely to experience liquidations, and the fund may even need to be shut

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https://www.complex.com/sports/2016/09/the-10-greastest-individualperformances-in-college-football-history/hail-flutie 234 Stephen Brown, William Goetzmann, and James Park, “Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry”, Journal of Finance 2002, 1869-86.

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down. Hence, the manager has a stake in how the year-end performance looks. If the manager can finish the year close to other funds, then the manager will keep his job. Typically, just being ahead of competitors is sufficient. There is no reason to take big risks if the manager is ahead. If the fund is still down at year-end, relative to competitors, and the money manager is going to see liquidations, the fund may even need to be shut down, causing the manager to lose his job. In this case, manager will likely follow riskier strategies to help save his job.235 An important theme from this discussion is that we need to understand the incentives, or the payoff structures of people or organizations, given their current situation. Consider a person facing a payoff structure as shown in Figure 8.1. This person will behave differently from a person facing the payoff structure given in Figure 8.9. In many cases, simply understanding the incentives of the actors may be sufficient to forecast their actions. Once again, suppose you hired an agent who faces Figure 8.9, while you face Figure 8.1. What do you expect to happen now? In this case, there is an alignment of interest between you and your agent. You both want positive outcomes, and you both want to avoid negative outcomes. However, your agent is not vested as much as you. Your agent is not going to put in as much effort as you would to avoid really bad outcomes, or to attain really good outcomes. Nevertheless, this is a situation where the conflicts of interests will be under reasonable control.

Other combinations We have seen a number of payoff structures here, but our list is not exhaustive. We can also have more complex structures, or various combinations of these structures, in different outcome zones. In one outcome zone, the payoff can be linearly increasing, and in another outcome zone, the payoff can be flat and then decreasing. In this case, we

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Franklin Edwards, 1999, “Hedge funds and the collapse of Long-Term Capital Management” The Journal of Economic Perspectives, 13, 2, 189-210.

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can focus on different incentives in different outcome zones using a similar logic. Alternatively, we can have combinations of these payoffs where the individual receives payoffs shown in two separate figures simultaneously. An interesting combination occurs when we combine the payoffs in Figures 8.2 and 8.3. This is shown in Figure 8.10. In this case, the individual wins big whether the outcome is positive or negative. Yes, this is possible. Furthermore, people looking at Figure 8.10 like risk. The more the better.

Payoffs

Figure 8.10: Win if down, win if up

Outcomes In finance, there is a name for this payoff structure. It is called a straddle. You can create it by buying a call and a put (with the same exercise price) on the same stock. If the stock price goes up, your call pays. If the stock price goes down, your put pays. Another name for this is buying volatility. As you can see, the holder of the straddle benefits from an increase in volatility or more extreme outcomes. Other structures such as strangles, strips, and straps, have similar payoffs.236 Similarly, option payoffs for butterflies and condors are also closely related to the straddle payoffs.

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Strangle is similar to a straddle, but the call exercise price is typically higher than the put exercise price. Strip is two puts and one call. Strap is two calls and one put.

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In his book with the same name, Nicholas Nassim Taleb calls these payoffs ‘antifragile’. Not only is one not hurt from negative outcomes, but one, in fact, benefits from negative outcomes. This is a win if down and a win if up. Consider examples of these complex payoffs. Suppose that some corporations give campaign contributions to both candidates running against each other.237 In this case, the donors will win no matter which candidate wins the election. Heads, they win. Tails, they win.238 Imagine an armed conflict by local combatants, A and B. A global superpower sells arms to both of them simultaneously. The outcome is chaos. A positive outcome means that chaos benefits party A. Similarly, a negative outcome means that chaos benefits party B. The zero outcome is peace. In this case, the superpower is not vested in the direction of the outcome but does not benefit from peace. The superpower also does not care whether chaos benefits party A or party B. However, the bigger the chaos, the more the superpower would win. Suppose you are a wealthy woman considering a marriage to a man of modest means. You need to ensure that your husband-to-be does not face a payoff similar to Figure 8.10. Such a situation can arise if you pool your assets. Once the assets are pooled, your future husband faces a different set of incentives. Later in the marriage, there are two outcomes: the marriage prospers (heads) or the marriage ends in divorce (tails). If heads come up, he wins; if tails come up, he wins again by sharing in your assets. You need to make sure your husband is not marrying you for your money. In addition, you need to be aware that your future husband is likely to push you into highly risky business ventures. Suppose you try to control these incentives after you get married by putting your husband on a strict budget. Will this work? The answer is no. Since now the right side is relatively flat and the left side is relatively steep,

237 See, https://link.springer.com/article/10.1057/s41309-018-0031-7 for a discussion of

strategic campaign contributions 238 For instance, Imaad Zuberi has given money to both Hillary Clinton and Donald Trump’s campaigns. See, https://www.opensecrets.org/news/2019/02/he-gave-totrump-inauguration-and-isin-sights-of-feds/

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your husband is now more likely to divorce you to capture the higher payoffs by claiming that you have created financial stress for him.239 Another interesting combination occurs by combining Figures 8.4 and 8.5 and shifting the picture a bit right. This is called the optimal range. This is shown in Figure 8.11. This is the inverse of Figure 8.10.240

Payoffs

Figure 8.11: Optimal Range

Outcomes

Suppose that a patient is receiving a painkiller. There is typically an optimal range of dosage. The outcome refers to the medicine dosage. The payoff is patients’ health. Too little medicine is bad since it is too low a dose to reduce the pain. Too much medicine is also bad, both for the person’s health (addiction) as well as the extra expense. It is important to find the optimal range for the medicine, as shown in Figure 8.11. Similarly, most of what we do in our personal lives has payoffs analogous to Figure 8.11. This includes work, family time, leisure, exercise, vitamins, and food. Some amount of work is optimal. Too little or too much is harmful. Some amount of leisure is optimal. Neither being overworked nor having nothing to do is optimal. How much sun exposure should we get? 239 240

The payoffs described here correspond to a strip, namely two puts and one call. This is also known as a short straddle or selling volatility.

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Too much sun exposure can cause skin damage, while too little can cause vitamin D deficiency. Hence, either too little or too much is harmful. This is the same for just about everything we do personally in our lives. The same logic applies to personal characteristics. The right amount of courage is optimal. Too little (cowardice) or too much (rashness) is harmful. You can continue the same reasoning with generosity, ambition, temperance, and so on. Figure 8.11 can also apply to most if not all government policies. Suppose the outcome is the tax rate. The payoff is the tax revenue collected. At zero tax rate, no taxes would be collected. Similarly, at a 100 percent tax rate, once again no tax revenue would be collected, since there is no point of working if the government taxes it all. An optimal tax rate would maximize social welfare.241 Suppose the outcome refers to interest rates. Keeping the interest rate too low or too high will be harmful to the economy. There is an optimal range. Think of any government policy, such as crime prevention. Doing nothing on crime is not optimal. Neither is draconian punishment. The optimal crime prevention policy is one that minimizes the costs of crime, or maximizes social welfare. Suppose the outcome refers to defense expenditures. What is the optimal defense policy? Too little defense spending will expose the country to attack. Too much defense spending can bankrupt the country. There is an optimal spend that depends on the marginal benefits and marginal costs of an extra dollar spent on defense. There are many other applications that resemble Figure 8.11 payoffs. Suppose you are a ski operator in Colorado. The outcome refers to the temperatures. The payoff refers to the earnings. If it is too cold, that is not good for business. People do not want to ski in extreme cold. If it is too warm, either the snow melts, or you have to incur expense to make snow. 241

The so-called Laffer curve captures the relation between tax rates and tax revenues. Arthur Laffer, "The Laffer Curve: Past, Present, and Future," Heritage Foundation Report No. 1765 (June 1, 2004). Tax theory indicates that optimal taxation should be based on maximizing social welfare: See for instance, https://pubs.aeaweb.org/doi/pdf/10.1257/jep.23.4.147

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There is an optimal range of temperature that will maximize the operator’s earnings. In this chapter, we covered a variety of payoff schemes based on incentives since people respond to incentives. This is a fundamental principle that is the foundation of finance (and economics). If we understand how people will respond under different circumstances, we better make sure that the ‘games’ we play will be fair to us. We expand on these ideas next.

CHAPTER 9 REAL-WORLD APPLICATIONS OF INCENTIVES

“It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”242 —Upton Sinclair.

Two-player games We now explore how incentives are relevant to our lives and our interactions with others. At the outset, we need to remember that each party in a business or personal relationship may have different incentives and motivations. It is important to understand where these align or differ. We are reminded of the famous expression, temet nosce, or ‘know thyself’. To protect our own interests, we must understand our own payoffs and the payoffs of others. We often need to hire skilled professionals such as interior designers, financial advisors, mechanics, stonemasons, electricians, plumbers, or carpenters, both for advice and actual work. Is the recommended work appropriate given the problem? How do we can trust this person? Does he or she have the experience we need? Will the person be able to perform the work and charge prices we can afford? Suppose, after a winter of heavy snowfall, your roof leaks. You need a roofer to both diagnose and fix the problem. You have heard that good roofers are hard to find. You are looking at Figure 8.11 (the optimal range) while the roofer is looking at Figure 8.1 (skin-in-the-game). The outcome refers to your expenditure on fixing this problem. You have two problems to solve here: One, what is the problem and what is the best way to address the problem? After all, you are not likely to climb 242

Upton Sinclair, I, Candidate for Governor: And How I Got Licked (1935), ISBN 0520-08198-6; reproduced University of California Press, 1994, p109.

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to the roof and see for yourself. Two, who can do this work for a fair price? If you hire one person to solve both problems, you will have various conflicts regarding the scale, scope, and cost of the job. You want to spend the optimal amount, while the contractor wants you to spend the maximum amount. How do you reconcile these different points of view? You must understand your own payoffs and recognize the conflict. You also need to acquire independent information from an objective source for the scale and scope of the job. One possible solution is to hire someone on an hourly basis, separately, for advice. This person will then have no skin in how the repair work is done. This same advice applies to interior decorators, financial advisors, and all the rest of the skilled professional work. Another approach is to break up the work into smaller pieces. You can work with one contractor on the first piece by telling him that if you are fully satisfied, he will get the second and subsequent pieces. The possibility of future work will keep the contractor disciplined. You also need to recognize that incentives can also change over time. You can shift from common interests to conflicting interests. An absence of conflict now does not mean it will be so in the future. This change can sometimes occur quickly. Suppose, for example, that you start a business with a partner you know and trust. You each bring complementary skills and qualities to the new venture. Both of you want this new venture to succeed. In this case, you have no conflicts; rather, you have common interests. Both of you are looking at Figure 8.1 (skin). Suppose, however, you and your partner lose your moral compass and engage in some questionable accounting practices and do not report cash revenues as income. After a while, both you and your partner are arrested and questioned by the police to determine whether a crime has been committed. Furthermore, the police offer each of you leniency if you provide evidence on any possibly illegal schemes. You are now in what is known as a classical prisoner’s dilemma. In this case, your payoff is the opposite of your partner’s; Figure 8.7 (negative skin). Here, outcome refers to your partner’s payoff. If you co-operate, you avoid a prison sentence (positive payoff) while your partner goes to prison

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(negative payoff). If your partner provides evidence of your illegal actions, you receive a negative payoff while your partner receives a positive payoff (avoids prison). Now you have diametrically conflicting interests. What is a key lesson here? You do not want to engage in any activities that you will regret later. You can create conflict even if there was none to begin with. Consider an example of a personal nature. What if your marriage ends unexpectedly? You have been married for 25 years and are totally devoted to your family. You work hard and do your best to support them. In your hearts, both you and your spouse have Figure 8.1 (skin). There is no conflict of any kind. You both want the best for the family unit and work toward the same common goal. One day, you go on an international business trip. Your wife drops you at the airport, kisses you goodbye, and tells you she looks forward seeing you again. When you return from your business trip, your house is empty of your wife’s personal possessions, your own personal papers have been scattered around the house, and you find a letter from a lawyer saying that your wife is divorcing you. What has happened to common interests now? These examples offer several lessons. First, choose your business partners and your spouse very carefully. This goes without saying. Second, people change over time, sometimes giving rise to interests that diverge. A business partnership or a marriage can break up, sometimes without much notice. Third, incentives can change over time such as diverging preferences. Fourth, break ups can have unexpected adverse economic consequences unless you agree at the outset what will happen in the event of a breakup. Even if you do have an agreement, things can get quite messy and complicated if the parties cannot agree over the consequences of a breakup. What is the key lesson here? Once again, it is to recognize that incentives can change over time. You need to recognize that nothing lasts forever. Consequently, you need to arrange your affairs so that a change of incentives will not impair your life. If you set up your marital relations upfront with an understanding that they can end up in divorce, and you agree on the written (and notarized) rules upfront (a prenuptial agreement), at

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least you will be prepared. You may still hate being divorced, but at least you will be prepared.

Principal confusion Often people enter into business or personal relationships without fully understanding the incentives of the involved parties. Instead of gathering information or formalizing an agreement with written contracts, they make assumptions. This can result in problems. As we stated, incentives shape the interactions between parties, whether those relationships are between two principals or between one principal and an agent. A principal is a person who appoints someone else, called an agent, to act on his or her behalf. Principals and agents often have conflicting interests. The costs arising from this conflict are called agency costs, or costs of conflicts of interest. We learned that two opposing principals have diametrically opposite incentives. One principal faces Figure 8.1 (skin) while the other faces Figure 8.7 (negative skin). If one gains, the other loses. We must understand these potential conflicts before they occur and, whenever possible, avoid them. Even sophisticated participants such as investment bankers do not manage these conflicts. An example occurred in 2007 in a transaction called ABACUS offered by the investment banking firm Goldman, Sachs & Co. (GS). According to the Securities and Exchange Commission Complaint243 against GS, John A. Paulson wanted to take a short position (e.g. Figure 8.7) against subprime residential mortgage-backed securities. To do so, he chose a package of mortgages that would likely fail in the near term. Paulson paid GS approximately $15 million to arrange a transaction where Paulson would take the short side of the risk – that is, he would benefit if the price of mortgage-backed securities declined. According to the SEC complaint, a potential German investor in the deal, IKB Deutsche Industriebank, had already indicated to GS that it would invest (take the long side, e.g. Figure 8.1) in real-estate deals that used an independent, third-party collateral manager. To structure the transaction, GS arranged for ACA Management (ACA), a reputable independent 243

https://www.sec.gov/litigation/complaints/2010/comp21489.pdf

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manager, to act as the collateral manager. GS also provided ACA with most of Paulson’s hand-chosen mortgages to be included in the collateral pool. GS, furthermore, told ACA that Paulson was taking a long position when he was actually going short (Figure 8.7 not Figure 8.1). Based on this structure, IKB invested $150 million while ABN AMRO invested $850 million in the deal (Figure 8.1), while ACA Capital provided $909 million of insurance for the deal. Paulson took the entire short side (Figure 8.7). The confusion about conflicts between the parties occurred when both ACA and IKB accepted GS’s representation that Paulson was taking long exposure. They assumed that Paulson was on the same side as IKB. They did not realize that Paulson was taking the short side as an opposing principal against IKB, even in the face of some evidence to the contrary.244 Within nine months after the deal closed in April 2007, 99 percent of the portfolio had been downgraded. Paulson made $1 billion in profit, but the other parties lost substantial amounts: $150 million for IKB, $850 million for ABN AMRO, and financial difficulties for ACA Capital.245 Later, Goldman paid $550 million to settle SEC’s charges and agreed not to commit intentional fraud in the future.246 There is an important lesson here: in any transaction you enter into, do your due-diligence, and understand who is ‘betting against’ you. To explore this idea a bit further, anytime someone brings a business proposition to you, you need to understand whether they are acting as a broker or a principal. If they are a principal, they are diametrically opposed to you. You should probably refuse many, if not most of these deals. If they are a broker, you can still work with them. You need to find out how they

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More on this later. See, https://www.sec.gov/litigation/complaints/2010/comp21489.pdf 246 “Though Goldman did not formally admit to the SEC’s allegations, it agreed to a judicial order barring it from committing intentional fraud in the future under federal securities laws.” “In addition, Goldman acknowledged that the marketing materials for Abacus “contained incomplete information” and that it was “a mistake” not to have disclosed Mr. Paulson’s role. As part of the agreement, the bank also said it “regrets that the marketing materials did not contain that disclosure”. See, https://www.nytimes.com/2010/07/16/business/16goldman.html and https://www.sec.gov/news/press/2010/2010-123.htm 245

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are getting paid. A flat fee suggests low conflict. A commission based on price indicates that they will push for a high price in any eventual deal. In another scene from the movie The Godfather, Michael Corleone’s longtime trusted lieutenant Sally Tessio says he is acting as an honest broker and brings a ‘peace’ proposition from the Barzini family. Michael suspects that Tessio has already betrayed him and joined the Barzini family. Wisely, Michael Corleone treats Tessio as an opposing principal and not an honest broker, and sets up a trap for him.

Agency costs and motivating managers Agency costs refer to the costs and challenges that principals incur – whether directly or indirectly – to get their agents to act in their interests. These costs are a function of human nature. Agents pursue their own interests. The principals can write contracts, cajole, bribe, and use a carrotand-stick approach. Yet the underlying conflict still remains. They are, however, subject to the costs and constraints that are imposed by the principals. To address this problem, principals seek to impose constraints on their agents. In doing so they incur costs. These costs will arise whenever you and your agent face different payoffs. If you were to face similar payoff structures, there are little or no agency costs. This is what you would expect in a well-functioning family. If all members of the family face off Figure 8.1 (skin), there are no significant agency costs. Everyone has the same incentive to seek positive outcomes and avoid negative outcomes. Similarly, suppose that two players have the same payoff as in Figure 8.2. This could be two doctors reviewing the medical records of a patient. Again, here there is no agency cost or conflict. They both want the same outcomes (for the patient to get better). As we have seen already, the maximum conflict occurs in an opposing principal-principal situation where one principal faces Figure 8.1 (skin) while the other faces Figure 8.7 (negative skin). Smaller conflict occurs when one principal faces, say, Figure 8.1 (skin) while the agent faces Figure 8.9 (limited upside, limited downside). As a result, the degree of conflict depends upon how the payoffs vary.

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Agency problems are common in a team setting, such as corporations, government, the army, or professional sports. When the costs of an action fall to the individual (all the downside and limited upside, or Figure 8.6) but the benefits go to the group (upside only, or Figure 8.2), or when the benefits accrue to the individual, but the costs are shared by the group, agency costs can lead to particularly dysfunctional outcomes. The famous fairy tale about who will ‘bell the cat’ is a vivid example of these agency costs.247 Consider professional sports. Suppose that the future earning potential of a professional player depends more on his individual statistics than on overall team performance. A self-centric player will then have an incentive to improve his own statistics, even if this occurs at the expense of the overall team. These players detract from team spirit and performance even if they are highly capable individually. Team owners and coaches have learned to avoid such players, or trade them to another team. Suppose there are two parties to a transaction, and one faces Figure 8.1 (skin) while the other faces Figure 8.11 (optimal range). There is agreement on the left side, or low outcomes. There are no conflicts here. The conflicts occur on the right side. One party would like to stop at some optimal point, while the opposing party would like as high an outcome as possible. In finance, agency costs can arise in many contexts. One, often cited, example is the large modern corporation, where there is a separation of ownership (shareholders) and control (managers). Shareholders are the principals; the managers are their agents. Shareholders hire the managers but do not become involved in the day-to-day running of the firm. This is the role of managers. This separation creates agency costs. A shareholder’s payoff structure looks similar to Figure 8.1 (skin). In this case, outcome refers to change in shareholder wealth. Thus, shareholders want the managers to pursue wealth-increasing projects and they are willing to face the consequences if a project does not succeed. They have skin in the game. What about their agents (managers)? A manager’s actions will depend on his or her payoff structures. Can managers have the same payoff structure as the shareholders? The answer is no. Managers do not generally have 247

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their wealth tied up in the firm, although some of their compensation may be in the form of stock or stock options, which we will discuss later. Consequently, they do not face the same payoff diagram. Without special incentives, managers have the payoff structure shown in Figure 8.6 (limited upside). The payoff represents the change in the wealth of the managers. If bad outcomes occur, the managers are likely to earn lower compensation and suffer damage to their reputations. Or worse, if the firm fails, managers will lose their jobs. Having been associated with a firm that went down, it may also become difficult for them to get another managerial position. Hence, there is little or no conflict on the negative outcome side. Consider what needs to happen for a company to do well. Managers need to work much harder and commit the firm to a particular strategy that they hope will pay off in the future. If the strategy works, wealth is created for shareholders, but the managers do not benefit. If it does not, managers can lose their jobs. Consider the situation facing Gini Rometty, who was appointed IBM’s CEO in 2012. She committed IBM to invest in IT consulting services, artificial intelligence, block chain, and quantum computing, and away from hardware. While some of these investments performed well, unfortunately, IBM was not able to gain significant foothold in the fastgrowing cloud-computing area, which hurt IBM’s performance. During Rometty’s eight-year tenure as CEO, IBM stock price declined by 25 percent while Microsoft was up 500 percent. She took risks, but they did not work out for IBM. She formally stepped down as CEO, effective from April 6 2020.248 Hence, managers suffer when the risks they take do not work out. In general, if managers are not given special incentives (they face Figure 8.6), they will have little incentive to work hard, or make risky bets. Hence, conflict arises on the positive outcome side. In other words, if managers have some downside exposure and limited upside benefit, they will not even want to make risky investments to benefit the shareholders.

248

See, Wall Street Journal, January 30 2020, “IBM’s Ginni Rometty Steps Down as CEO”.

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The above situations offer examples of agency costs. In these cases, the costs are opportunities foregone. Managers perform at levels below where their talent and capacity could take them. Moreover, managers achieve less than optimal results because they are hesitant to take the extra level of risk necessary to boost performance. These costs are difficult to avoid, given the differences in the incentives of shareholders and managers. To enable the managers to work harder, take risks, and solve the conflict on the positive outcome side, shareholders need to motivate the managers (their agents) to align their interests with principals. One way to do this is to offer profit-sharing contracts, bonuses, and stock options to the managers. Suppose a manager’s compensation is comprised only of stock options. An agents’ payoff scheme will be transformed from Figure 8.6 (limited upside) into Figure 8.1 (skin). Now managers also have significant upside, providing incentives for hard work and appropriate risk taking. As we have learned from the history of finance, however, more of a good thing is not always better. In many cases, too much skin can make matters much worse. Excessive incentive schemes may motivate managers to engage in deception, fraud or ‘cooking the books’. Shareholders must still be vigilant. Suppose that the shareholders created excessive incentives for the managers with a bonus plan based on earnings. Assume, moreover, that it is easier to increase short-term earnings by borrowing money instead of creating well-designed products for long-term prosperity. Managers will be incentivized to borrow too much money, exposing the firm to undue risk. Similar concerns arise if shareholders create excessive compensation plans tied to the firm’s stock price. This will motivate managers to cut expenses on necessary investments in information technology, risk management, compliance, and worker safety. This, in turn, will weaken the firm’s ability to detect fraud, protect its employees, or diversify for the future. Incentives have to be carefully designed. Too little, or too much, is not good.

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Conflicts in daily business Another nuanced issue relates to conflicts of interest. Suppose the CEO of a pharmaceutical company oversees the acquisition of a health insurance company, with the goal of making the combined firm an integrated provider of healthcare. Subsequent to the merger, the CEO is diagnosed with a rare form of cancer that will require multiple surgeries and radiation treatments. The treatment is very expensive. The CEO and the insurance company now have opposite payoffs. The CEO is facing a payoff structure as in Figure 8.1 (skin) while the insurance company is facing a payoff structure as in Figure 8.7 (negative skin). In this example, think of the outcome as the medical expenditure to diagnose and treat the CEO’s medical condition. If appropriate amounts are spent to diagnose and treat the CEO’s illness, he will have the opportunity to recover from his illness. The insurance company is worse off. Similarly, if he does not receive medically appropriate care, he will be worse off, but the insurance company will incur less expense. Another way to characterize this relationship is that the CEO and the insurance company have maximal conflicting interests as they relate to expenditures, although of course the insurance company wants to follow treatment guidelines that are generally standard. How do you address relationships that are conflicting? As a general matter, you want to understand the sources of conflict and take steps to avoid them, if possible. One example is to avoid buying health insurance from a company that incentivizes its employees to keep revenue robust and expenses low. The less the company pays for your healthcare, the more money it makes. The insurance company is looking at Figure 8.7c (negative skin) while the individual is looking at Figure 8.1 (skin). This is maximum conflict. The lesson here is that you do not want to buy health insurance from a for-profit insurance company that provides profit sharing arrangements for their claims adjusters. (As a matter of public policy, there is a compelling argument that incentive compensation in insurance companies should be prohibited by law). A similar set of concerns arises with life insurance or home insurance companies. Once you file a large claim, you and your insurance company

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are facing off against each other, as principals with diametrically conflicting sets of interests. As another example, suppose you hire a contractor to build an addition to your house. You and your contractor have agreed upon a price for the work. You pay the contractor a fixed amount, while the contractor is responsible for buying the materials, supplies, and hiring and paying subcontractors. In this case, both you and the contractor are now principals diametrically facing off against each other. You each gain at the expense of the other. Once the contractor is paid, you need to monitor him to make sure he completes the renovation with high levels of quality. The contractor now has incentives to do the job quickly, using low quality supplies. By cutting quality, he can save on his investment of time, and pay less for materials and labor, and thus make the difference (although the continuation of such practices, if it becomes public, may damage the contractor’s reputation). Another option is that you seek the contractor’s advice on subcontractors, but you choose and pay for supplies, and you pay the subcontractors directly. You still want the contractor to monitor the subcontractors to ensure high quality work. In this case, the contractor is working as your broker or agent. The incentives facing the contractor will differ under these two circumstances. In this case, the contractor has no incentives to cut back on quality. Instead, the contractor has incentives to overkill on quality and prolong the work, since he is getting paid by the hour. In general, whenever you work with others, you are facing two challenges. One is to acquire information about the scale and scope of the project. The other is to execute and monitor the work. You can combine these two tasks, or you can acquire them separately. Combining them is the more common practice. It is much easier and more convenient to use a contractor who will handle both the scale and scope of the project as well as the execution and monitoring. However, this situation will give rise to multiple principal-principal conflicts in this setting. Consequently, you are more exposed to the risk that the work may be lower quality and more expensive. Alternatively, you can become informed about the project’s scale and scope using information from objective third parties. Once you have this

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information, you can interview different subcontractors and choose the best price for a given level of quality that you have specified. You also need to monitor the work of the subcontractor yourself to ensure that quality specifications are met. This requires more work on your part, but you are likely to have higher quality and lower cost using this approach. Consider another example. Suppose you have a leaky roof, and you hire someone to fix it. Do you pay the contractor by the hour or by the job? Should you work on the basis of an informal understanding or a written contract? It is advisable to pay the contractor by the hour if you can easily observe whether the subcontractor is working effectively, and the job is well defined. This requires that you climb onto the roof, locate the leak, and determine whether the wood trellis supporting the roof is damaged. You also need to buy the appropriate materials. It is also important to ask the contractor how long it will take to finish the job and write the maximum payment into the contract. A fixed price arrangement is an appropriate choice if you do not have flexibility to observe whether the workers are working effectively, and the job is not well defined. A written contract would need to detail all aspects of the quality, timing, and payment schedule for the job. You also encounter agency costs in your everyday dealings. When you rent a car, you do not drive it in the same way as your own car. If there is no per-mile charge, you can put thousands of miles on that rental car over a weekend. You do not change the oil, wash the car, or avoid potholes. Why should you? It is not your car. Who pays for this extra wear and tear on the rental cars? Actually, you do. It is an agency cost to you. It is not practical for the rental agency to write contracts that can cover every contingency or monitor our behavior closely, so they estimate these average extra costs and include them in the rental price. You face similar incentives when you rent a house, tools, equipment, or machinery. The owner will anticipate the average wear from agency costs and charge the renter upfront for these costs. Given all this, does it still make sense to rent a car, for instance? The answer is yes, especially if you are worse than the average driver of the rental cars (temet nosce).

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Public-Policy Domain Our world is full of costs relating to conflicts of interest. Another good example is public policy domain, such as partisan politics. Politicians want our votes to get elected but they also care about the power and perks associated with the role. Most politicians do care about the voters, but only enough to get elected. Whether they get 90% of the votes or 60 percent of the votes does not matter. Initially, they promise whatever policies are needed in order to get the majority of the people to vote for them. These promises may be in the form of direct payments from the government, less regulation, free tuition, or lower taxes. The art of politics is to balance these conflicting interests. Politicians care not just about votes, but about payoffs in the form of power and perks. Their legislative track record will also be designed to look out for the interests of anyone who can provide them with large enough benefits in terms of campaign contributions, perks, and post-public service jobs, speaking engagements, and salaries. The agency costs associated with promises to the voters by elected politicians are well understood by the public. Politicians enjoy the benefits of elected office. Some ride in military jets, stay at expensive locations, dine, and entertain, all at the taxpayer’s expense. In sum, politicians have multiples masters to consider. They have their own self-interest, their voters’ interest, and their lobbyists’ interests. Their legislative loyalties will consider all three sources of payoffs, and trade off voters’ interests against special interest and their own interests. This results in the agency costs of democracy. These concerns about incentives are especially relevant for so-called experts since we do not observe – nor are we able to judge – the value of their work. Although most people believe that some experts (say politicians) mislead us, they put undue confidence in other experts – such as financial advisors, political scientists, doctors, lawyers, professors, and economists – to do the right thing all the time. Although these people typically have the requisite knowledge and expertise, and usually, they know the ‘truth’, they will not necessarily advocate that truth all the time, if doing so at certain times can impair the pursuit of their own interests.

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From a finance perspective, most experts typically have option-like payoffs shown in Figure 8.2. They have all the upside and very little, or none, of the downside from their advice or recommendations. Suppose a politician takes a controversial or extreme position on an issue and recommends drastic change, possibly military action (or embargoes, freezing of assets, or severe tax cuts). If a war is pursued, and it ends in victory, the politician receives the glory of the victory. For the politician, it mostly does not matter whether the war is the most efficient solution to the problem and how many people die on both sides. Politicians typically get very little or none of the downside payoffs from costly and drawn-out wars, since neither they nor their families usually serve in the military in wartime. Instead, casualties are sustained primarily by volunteers or conscripted masses.249 A good starting point toward understanding public policy is to think about how the experts are compensated or what their financial interests are. Take a climate-science expert. While the worsening climate creates mostly losers, it also benefits some. These experts’ incentives will be very different if they live in Buffalo, New York, versus Phoenix, Arizona. Northern cities like Seattle and Buffalo would probably benefit from rising temperatures, while southern cities like New Orleans or Phoenix would be hurt.250 As another example, think about interests of global players in the climate change debate. What are the interests of Canada, Greenland, or Siberia? What would happen to land values in these countries if there were one or two degrees rise in global temperatures? What about oil reserves under Arctic waters? If Arctic waters are opened up for oil exploration from a warming Earth, who will lay claim to that oil? Compare that with the interests of some cities in India, Indonesia, Colombia, Venezuela, Peru, Argentina, or Chile, which would be completely covered by about a 10-foot rise in ocean waters.251

249

Michael Gross explores the duty to die in the military: See, https://www.jstor.org/stable/40441500?seq=1#metadata_info_tab_contents 250 There would be winners and losers from climate change. For instance, Northwest USA is likely to benefit while Southeast is likely to lose from some climate change: https://www.rollingstone.com/politics/politics-news/welcome-to-the-age-ofclimate-migration-202221/ 251 https://www.climatecentral.org/news/us-with-10-feet-of-sea-level-rise-17428

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From a finance perspective, the simple answer is that the payoffs facing the politicians, or many corporations, are different from the payoffs facing society. To fully understand these issues we should expect that many people will benefit from dangerous and misguided policies, or policies that do not serve the public interest. What are the payoffs to the politicians, corporations, defense contractors, the tax-paying public, and the allvolunteer or salary-compensated military forces, under various policy choices? Politicians typically exaggerate internal and external threats to our national security.252 Rodger Payne of the University of Louisville writes: “Empirical research by scholars and journalists reveals that numerous American national security elites and policymakers have employed narratives that created a false or substantially distorted vision of reality about threats posed by potential US foes. Moreover, a large volume of empirical evidence produced by scholars and journalists suggests that security elites frequently employ dubious analogies, and exaggerate threats and US policy successes for reasons other than narrow national security interests”. Politicians also understate the costs and overstate the benefits of the policies they advocate. First, it is easier to deal with a false, perceived threat. False threats disappear magically on their own. The real threats are much more difficult, and they require significant sacrifices. One example is the US’s response to the 9-11 attacks. The George W. Bush administration convinced the American public that the US also had to attack Iraq after attacking Afghanistan.253 Remember that none of the 9-11 attackers were Iraqis,254 and Iraq did not pose a direct threat to American national interests or its national security.255 Looking back on the situation, it seems that some people in the Bush administration used the 9-11 attack as a pretext to accomplish what they had long wanted to achieve, namely

252

See, https://www.researchgate.net/publication/310426720_Thinking_the_ Unthinkable_About_National_Security_Narratives and http://web.isanet.org/Web/Conferences/ISSS%20Springfield%202015/Archive/29f a9a1e-68d3-490a-921a-56035cad8b31.pdf 253 https://www.pbs.org/wgbh/pages/frontline/shows/choice2004/bush/war. html 254 https://en.wikipedia.org/wiki/Hijackers_in_the_September_11_attacks 255 https://www.tandfonline.com/doi/full/10.1080/10669920701616443

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a regime change in Iraq.256 For the rest of us, the 9-11 attacks involved a lot more than direct costs in terms of lives lost and property damaged. It also gave rise to what was, arguably, a hurried response. Furthermore, President Bush told the American public that the cost of ousting Saddam Hussein from power was between $50 billion and $60 billion. This was done in 2002, during the time his administration was trying to gather support for the war.257 Just five years later, the Congressional Budget Office estimated the cost of the Iraqi war to be between $1 and $2 trillion dollars! As of 2017, a study by researchers at Brown University estimated the costs of Afghani and Iraqi wars at around $6 trillion and running!258 This cost only included the net cost to the US taxpayers. It does not include the damage to the economy and infrastructure, or the costs incurred by civilians in Iraq or Afghanistan in terms of life, health, and liberty, in current and future generations. It also does not include the cost to the psychological health of the US soldiers who served. To paraphrase the late senator from Illinois, Everett Dirksen, “six trillion dollars here and six trillion dollars there, pretty soon you are talking real money”. Why do we tolerate these politicians? The simple answer is that there are significant costs of becoming informed, and voters are not able determine whether elected or appointed officials are exaggerating the threats or telling the truth. We face the same agency cost as the mouse tasked to ‘bell the cat’. We would have to pay for all the costs of becoming informed, but society in general, benefits. How could a citizen determine whether the threats from Al Qaida or Saddam Hussein were real or exaggerated? How could a citizen determine whether government and elected officials distorted the truth about the threat posed by Iraq?259 Most people rationally choose to stay uninformed instead. Another challenge we experience with elected and public officials is the socalled ‘revolving door’. After they leave office, they can receive large

256

https://www.vox.com/2016/2/16/11022104/iraq-war-neoconservatives https://www.nytimes.com/2008/03/19/washington/19cost.html 258 See, https://watson.brown.edu/costsofwar/ and https://watson.brown.edu/costsofwar/files/cow/imce/papers/2018/Crawford_Cos ts%20of%20War%20Estimates%20Through%20FY2019.pdf 259 See James P. Pfiffner, 2004, “Did President Bush Mislead the Country in His Arguments for War with Iraq?” Presidential Studies Quarterly, 34, 1, 25-46. 257

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speaking fees, or offers of highly compensated employment from those affected by their legislation.260 The benefits can also distort government officials’ incentives in favor of special interest groups.261 The revolving door is another agency cost we pay to live in a democracy.

Financial Services Industry Next, consider the incentives facing the financial services industry. Suppose you have saved $20,000 and you want to invest it. Assume that you have no formal education in finance. What do you do? Where do you start? Most people cannot simply become financial experts. Investing money becomes a daunting task for most. Dealing with finance can be scary. The easiest approach is to seek out someone who seems like an expert.262 Suppose you decide to hire an independent financial advisor and ask him to help manage your money. Financial advisors can be paid by the hour, by percentage of assets, or with a fixed fee. Some may offer free consultation. First, you will need to know how your advisor charges for advice. If they say the advice is free, you should be especially worried. Second, you can also check the advisor’s background information on the SEC’s web site.263 Assume that you find a financial advisor who charges by the hour. What are the incentives facing this financial advisor? Based on our previous discussion, this financial advisor will generally not have a conflict with you regarding investment choices. However, hourly compensation also does not exactly align the financial advisor’s interest with yours. The payoff structure facing the financial advisor is similar to Figure 8.8 (no skin), assuming outcome denotes your investment payoff. The financial advisor

260

See, https://abcnews.go.com/Politics/washingtons-highest-lowest-speakingfees/story?id=24551590 261 There is a one to two-year restriction on taking private employment post government jobs. See, https://www.doi.gov/ethics/restrictions-on-post-government-employment 262 Charles Schwab, Fidelity, and Vanguard, offer some low-cost brokerage services. We recommend opening an account at a low-cost mutual fund. Vanguard and Fidelity are among our favorite mutual funds. 263 https://www.adviserinfo.sec.gov/

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has no skin in your investment game. Nevertheless, you may find yourself in long and drawn-out conversations with your financial advisor. Now assume that you are paying the financial advisor as a percentage of your assets. This could be as low as 0.25 percent for robo-advisors to 1 percent of the assets, or even more, for experienced advisors. If you have a small amount of assets, the percentage may be even higher. This form of payment has both advantages and disadvantages, but generally people seem to like it. Most importantly it eliminates some of the potential conflicts, such as unnecessary churning, since trading does not increase the advisor’s compensation. You also know how much you will be paying. On the other hand, the advisor may want to spend less time with you and will surely want to convince you to give him the rest of your assets. Another disadvantage is that this arrangement may be especially expensive for those with a small amount of assets, since the percent rate for smaller accounts will be higher. Suppose you chose a fee-for-service financial advisor. Suppose that you pay a flat, per-month fee that includes all services. This is a clear arrangement whereby you are aware of all the costs upfront. Your advisor will serve you well if he/she recommends low-cost diversified, passive indices for investment and provides help with financial planning such as understanding your risk tolerance, financial goals, building an emergency fund, minimization of taxes, saving for education, home purchase, and managing your debts.264 Suppose instead, you found another financial advisor who says that he will not charge you any fee at all. Could this really be free? The efficient markets hypothesis tells us that there can be ‘no free lunch’. There must be something missing. Nevertheless, many financial advisors working at brokerage firms may offer so called ‘free consultation services’. A financial advisor at a brokerage firm is actually wearing two hats, one as a salesperson for the firm, and the other as an advisor for you. What should a good financial advisor do? We would expect the financial advisor to go

264

Charles Schwab recently offered such a flat $30 per month fee-for-service plan: See, https://www.wsj.com/articles/you-pay-for-netflix-and-spotify-monthly-whatabout-financial-planning-11554478211?mod=hp_lead_pos8

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over the five investment guidelines we discussed in Chapter 2, and ask you about your risk tolerance, your short-term and long-term financial goals and needs, your current short-term and retirement savings, and your debt levels. The financial advisor should recommend a well-diversified investment portfolio at low cost. If you have expensive credit card debt to begin with, a good financial advisor should recommend that you forgo any investment at this time and simply pay off your expensive credit card debt with your $20,000. Notice that paying off your expensive debt will not bring any benefit to the financial advisor. Suppose instead, that your financial advisor recommends an (in-house) investment product. You ask for more details about this product and the financial advisor does not provide a clear answer. He says it has hundreds of different assets in it. You ask about his fees, and the financial advisor says that the advice is free. You ask about returns, and the financial advisor says you can get 10 percent return per year with minimal risk, but markets go up and down. He further urges you to trust him, just as his other clients have done. What should you do? Be skeptical and walk away! This financial advisor is not interested in helping you. In fact, most likely you are facing diametrically opposed principal-principal conflict here. He is helping himself and his firm at your expense. He is likely to get paid from his recommendations by the sponsors of investment products. These are inhouse brands created by brokerage firms, banks, and insurance companies. They will compensate the financial advisor for selling their funds. How can the provider of investment products afford to provide the financial advisor with a fee? Where does this money come from? The fee is actually paid by you, although it is not visible. The firm’s advisor has an incentive to select products that have higher hidden costs. These costs reduce your returns. The evidence shows that money managers who try to pick stocks do not beat passive indices. Hence, you are paying by earning less return. There is, therefore, a direct conflict between your interest and those of the financial advisor. The more payment the financial advisor gets, the less you earn. So, what sounds like the best solution may actually turn out to be the worst solution. A financial advisor that does not explicitly charge you for advice

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may be the most expensive of all the advisors. One simple solution to this problem is to ask questions about how the financial advisor gets paid. Ask whether he is a fiduciary. This will help eliminate some of the conflicts of interest. As an informed consumer, you can choose what is best for you, given your own particular needs. While the Labor Department under President Obama passed a rule requiring a fiduciary standard for financial advisors, it was overturned in a recent legislation signed by President Trump.265 Under current law, financial advisors are not subject to the fiduciary standard. Financial advisors are not legally obligated to look after the best interest of the investors. Nevertheless, there is no substitute for becoming informed about how the financial advisor is compensated. The above discussion illustrates that even good experts can provide bad advice. There is usually no question that the financial advisor is well informed about the underlying financial information. The problem here is typically not one of expertise, but one of incentives. As long as the incentives of the financial advisor are not aligned with the client’s, the client may not be served in the optimal way. If you are interested in the financial securities industry, the author Michael Lewis has many informative and entertaining books that detail its inner workings. In Flash Boys (2014), Lewis points out some of the potential conflicts between retail traders and various brokers. For instance, when an individual puts in a trade with a broker, the broker can sometimes sell the order to a third party for a rebate (called pay-for-order flow), who then executes the order slowly (sending it over copper wire to a distant exchange), while front-running the order using a fast fiber-optic network. In this case, both your broker and the third party can benefit at your expense. This is another simple example of a potential conflict.266 The cost per trade is quite low, about one-half of one hundredth of one percent, but they add up across all traders to about $5 billion a year.267 265

https://www.nytimes.com/2018/05/22/business/congress-passes-dodd-frankrollback-for-smaller-banks.html 266 See Michael Lewis, Flash Boys, A Wall Street Revolt, W.W. Norton & Company, 2014. 267 https://www.fca.org.uk/publications/occasional-papers/occasional-paper-no50-quantifying-high-frequency-trading-arms-race-new-methodology

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Investing is already complicated. We all need to simplify it in order to understand the risks and potential returns. In Chapters 2 to 4, we recommended that you eschew all active investment in individual stocks, bonds, derivatives, and complicated and proprietary, structured products. This level granular investment simply requires too much time and expertise, which is not necessary for typical retail investors. Instead, we recommended that you simply invest in a passive, low-cost index funded by well-known mutual fund companies.268 Now, not only do you eschew costly Wall Street advice, but you are also likely to outperform Wall Street products. As an additional benefit, you will not need to worry about potential conflicts of interest. This is because the fees are fixed, and there is no ability to create additional fees by churning (increased turnover) of the fund. 269

Conflicts of interest in monetary policy Monetary policy, namely the level of money supply and interest rates, is governed by the central banks. In the US, this is the Board of Governors of the Federal Reserve System, known also as the ‘Fed’. An important question is whether the Fed acts in the best interest of all citizens to run the monetary policy. Many critics of the Fed point out that it was either negligent, or complicit, in the financial crisis of 2008. These critics argue that one of the responsibilities of the Fed is to avoid financial crises. It needs to manage monetary policy to promote price stability and employment. Did the policies of the Fed truly serve these purposes? Who benefitted and who lost from the Fed’s monetary policy choices? We first explain the financial crisis of 2008-2009. Then, we will discuss the subsequent government solutions and the role of the Fed.

268 We like Vanguard since it is a non-profit corporation with minimal expense ratios. 269

https://www.cnbc.com/2019/01/17/its-easy-to-be-an-index-investor-like-jackbogle-heres-how-ton-do-it.html

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The administration of George W. Bush aggressively promoted home ownership as a solution to many social problems.270 The Bush administration stated: “The US homeownership rate reached a record 69.2 percent in the second quarter of 2004. The number of homeowners in the United States reached 73.4 million, the most ever. And for the first time, the majority of minority Americans own their own homes. The President set a goal to increase the number of minority homeowners by 5.5 million families by the end of the decade. Through his homeownership challenge, the President called on the private sector to help in this effort. More than two dozen companies and organizations have made commitments to increase minority homeownership - including pledges to provide “more than $1.1 trillion in mortgage purchases for minority homebuyers this decade”. This sounds like a laudable public policy goal. 271 To help with this effort, the Fed initiated a low-interest rate policy during 2001-2004. This brought the short-term interest rates from 6 percent down to 1 percent (Figure 9.1).272 These were the lowest levels of interest rates in the last 50 years. These extremely low levels had the desired effect of stimulating the demand for housing. Following this unprecedented period, rates were increased to about 5 percent. Unfortunately, instead of cooling the housing market, these rate hikes punctured the housing bubble and led to a broad financial crisis.

270

https://georgewbush-whitehouse.archives.gov/infocus/achievement/chap7. html 271 See, https://georgewbush-whitehouse.archives.gov/infocus/achievement/ chap7.html 272 Source: Federal Reserve Bank of St. Louis. See: https://fred.stlouisfed.org/series/FEDFUNDS

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Figure 9.1-Effective Federal Funds Rate 20.00 15.00 10.00 5.00 0.00

Alongside the Fed’s decision to lower the interest rates down to 1 percent by 2004, the Bush administration eliminated or eased the down payment requirements for house purchases on loans guaranteed by the Federal Housing Agency, Fannie Mae, and Freddie Mac, guarantors of home loans, thus further lowering the cost of, and encouraging, home ownership.273 Yet as interest rates went down and stayed down, another problem resulted – unprecedented speculative investments in homes.274 The government used other policy instruments to encourage home ownership. This included zero-down-payment loans, home-loan guarantees, and tax credits that encouraged home ownership.275 “The Administration proposed the zero-down payment initiative to allow the Federal Housing Administration to insure mortgages for first-time homebuyers without a 273 President Bush signed the $200 million-per-year American Dream Down Payment

Act which will help approximately 40,000 families each year with their down payments and closing costs. See, http://www.aei.org/wp-content/uploads/2012/04/-free-fall-how-governmentpolicies-brought-down-the-housing-market_113947314103.pdf 274 See, https://www.nber.org/papers/w14631.pdf 275 See, http://www.aei.org/wp-content/uploads/2012/04/-free-fall-howgovernment-policies-brought-down-the-housing-market_113947314103.pdf

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down payment. Projections indicate this could generate over 150,000 new homeowners in the first year alone. President Bush proposed a new Single Family Affordable Housing Tax Credit to increase the supply of affordable homes. The President proposed to more than double the funding for the Self-Help Homeownership Opportunity Program (SHOP), where government and non-profit organizations work closely together to increase homeownership opportunities. The President proposed $2.7 billion in USDA home loan guarantees to support rural homeownership and $1.1 billion in direct loans for low-income borrowers unable to secure a mortgage through a conventional lender. These loans were expected to provide 42,800 homeownership opportunities to rural families across America”.276 The administration also put pressure on federal agencies to extend government guarantees to an ever-increasing potential number of homeowners, further lowering mortgage interest rates.277 The Federal Reserve allowed various mortgage products with little or no interest payments or adjustable-rate payments for an initial period. Consequently, cheap mortgage loans became widely available even for those with no down payments and regardless of whether they could afford to pay back the debt. Banks made trillions of loans to people who did not have a demonstrable ability to pay them back. These loans were called ‘ninja loans’, or ‘no income, no job, no assets, no problem’. The banks would quickly sell these loans to other investors, removing the problem loans from their books.278 Many people ended up ‘owning’ homes, yet they could not even make the first couple of payments on their mortgages.279 All of this succeeded in raising the demand for housing as well as house prices.

276

See, https://georgewbush-whitehouse.archives.gov/infocus/achievement/ chap7.html 277 See, https://www.nytimes.com/2008/10/05/business/05fannie.html 278 See, https://www.forbes.com/sites/stevedenning/2011/11/22/5086/#3f7d808df92f 279 See, https://www.npr.org/templates/story/story.php?storyId=9855669

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Figure 9.2-Case-Shiller 20-City Composite Home Price Index 220 200 180 160 140 120 100

The House Price Index is shown in Figure 9.2.280 This index more than doubled from 2000 to 2006. The rise in interest rates and the slowing economy finally began to lower house prices in January 2007. It all came crashing down in 2008, with a further slowing down of the economy following the rise in interest rates. Housing prices collapsed by about 30 percent, property values fell below the amount of the mortgage debt, and homeowners ‘walked away’ from their homes, leaving them to the banks to foreclose on them and resell for what they could. Thousands of banks experienced financial difficulties when they lost money on these loans. The Federal Government had to inject trillions of dollars into the banks to save the economy from total collapse. The response to the financial crisis brings up interesting questions. Why did the Fed first create a bubble and then help burst it? Why did the Fed stand by while banks made trillions of dollars in ninja loans? Did the Fed think ninja loans would be repaid? Why did the rating agencies give AAA

280

Source: Federal Reserve Bank of St. Louis. See: https://fred.stlouisfed.org/series/SPCS20RNSA

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ratings281 to the securities backed by Ninja loans? Why was the Fed totally silent on the ratings of these ninja loans? Consider one of these questions. Did the Fed think that these ninja loans were legitimate or good for the economy? Whether it did, or it did not, the Fed failed here. Ninja loans contradict long-held financial principles of prudent lending. The Feds did not do what they were appointed to do. Why did the Fed act this way? We suspect that it is not a competence issue but rather one of incentives. Fed felt pressure from the politicians to look the other way while this terrible home-ownership bubble was building.282 Perhaps the Fed lost its objectivity and was not sufficiently skeptical. Perhaps they too wanted to believe that housing prices would continue to rise forever. The Fed, which is supposed to run monetary policy independently from political pressure, is subject to political pressure. If you think this only happened from 2001-to 2007, think again. Just recently, President Trump told the chairman of Federal Reserve, Jerome Powell, to stop raising the interest rates.283 Here is a small sample of what Trump tweeted about Powell: “I’m doing deals and I’m not being accommodated by the Fed. They’re making a mistake because I have a gut and my gut tells me more sometimes than anybody else’s brain can ever tell me”. I think the Fed right now is a much bigger problem than China. I think it’s I think it’s incorrect what they’re doing. I do not like what they’re doing. I

281 This is the highest rating, indicating extremely small likelihood of default, typically

much less than 1 percent. 282 The Bush Administration’s own website states: "This Administration will constantly strive to promote an ownership society in America. We want more people owning their own home. It is in our national interest that more people own their own home. After all, if you own your own home, you have a vital stake in the future of our country". - President George W. Bush, December 16 2003. See, https://georgewbush-whitehouse.archives.gov/infocus/achievement/chap7.html 283 https://www.marketwatch.com/story/trump-reportedly-irate-over-fed-interestrate-hike-mulls-ousting-powell-2018-12-22

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do not like the $50 billion. I do not like what they’re doing in terms of interest rates“. “They’re so tight. I think the Fed has gone crazy”.284 Finally, Powell relented and complied with Trump’s demands to lower the interest rates.285 Take the next question: Was it wise for the Fed to keep the real interest rates at zero or negative levels in 2000-2004 before the financial crisis, or again following the financial crisis, between 2009 and 2016? Who did this policy benefit? Who did it hurt? The biggest beneficiaries of the extremely low interest rates include builders, corporations that manufacture cars and consumer durables, borrowers, and the politicians currently in office. The lowering of the interest rates once again re-inflated house prices even above the 2006 peak (Figure 9.2). The low interest rates benefit the present at the expense of the future. In effect, they expropriate wealth from our children by encouraging over-borrowing. The losers are lenders such as the retirees who depend on the interest income on their savings. We can question other Fed policies during the financial crisis. Was putting trillions of taxpayer dollars into the bankrupt banks after the Global Financial Crisis of 2008 the best or only available solution, while the bankers paid themselves billions in bonuses?286 We have seen that some former Treasury officials who pleased their future employers obtained lucrative jobs with the banks they were regulating after they left office.287 What role did the payoff structures for the Federal Reserve officials, politicians, credit rating agencies, banks, and home-builders and home buyers play in the Great Recession of 2008?

284

https://www.bloomberg.com/news/articles/2018-12-17/all-the-trump-quoteson-powell-as-attacks-on-fed-intensify 285 https://www.forbes.com/sites/lisettevoytko/2019/07/31/fed-announcesinterest-rate-cut-first-since-2008/#2a7b2e11237d 286 See, https://www.nytimes.com/2009/07/31/business/31pay.html 287 https://www.oecd.org/corruption/integrity-forum/academicpapers/Wirsching.pdf

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Consider another Fed policy, which was to put trillions of taxpayers’ money into bankrupt banks and take the bad assets from the banks’ books. These bad assets are now on the Fed’s balance sheet. If they are eventually written off, the taxpayers will lose. Thus, if the policy works out, the Fed officials get the credit. If the policies do not work out, taxpayers pay. In general, the Fed is conflicted to some extent. Government officials including the Fed receive all the upside and none of the downside of the consequences of the policies they recommend. This is shown in Figure 8.2. If these policies work out, they are viewed as heroes. If the policies do not work out, they simply retire with a nice pension while taxpayers pay. We discuss these issues in more detail later in the book.

Incentives in the health industry Conflicts and severe incentive problems are especially acute in the healthcare industry. Many would say that Americans’ health is not the best it can be. We have a growing problem with excess weight and its various consequences. In the US, about 43 percent of adults, aged 40-59 are obese.288 Our life expectancy in the US has been falling for three years in a row.289 According to the CIA, the US ranks 43rd in the world in life expectancy behind Greece, Taiwan, and Israel.290 Between half and threequarters of Americans over the age of 45 have diabetes or pre-diabetes.291 An opioid epidemic in the US led to severe consequences (deaths of

288

https://www.cdc.gov/nchs/data/databriefs/db288.pdf https://www.smithsonianmag.com/smart-news/us-life-expectancy-drops-thirdyear-row-reflecting-rising-drug-overdose-suicide-rates-180970942/ 290 https://www.cia.gov/library/publications/the-world-factbook/rankorder/ 2102rank.html 291 As of 2015, the percentage of adult Americans (aged 18+) with diagnosed and undiagnosed diabetes is estimated as 12.2%, while the percentage with prediabetes is estimated as 33.9%, making a total of 46.1%. For those aged between 45 and 64, the total percentage is 50.8%, and for those aged 65+, the total percentage is 73.5%. See, Tables 1 and 3, separately for age groups, in http://www.diabetes.org/assets/pdfs/basics/cdc-statistics-report-2017.pdf 289

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despair).292 In 2017, about 47,000 people died from opioid abuse, most of them in their prime years.293 Clearly, we spend large amounts on healthcare, but we are not accessing or processing proper medical information. What roles do informational asymmetries and incentives play here? What is the motivation to solve these incentive problems by healthcare professionals, pharmaceutical firms, politicians, and patients? What is the connection between lack of retirement savings, daily stress, and deaths of despair? One way to characterize these potential conflicts in medicine is that patients are looking at Figure 8.11 (optimal range) while the pharmaceutical companies are looking at Figure 8.1 (skin). There is an optimal amount of a medicine from a patient’s perspective. In contrast, the pharmaceuticals companies would benefit from selling as much medicine as possible. These are not complicated problems to explain. Major, unfortunate outcomes are partly due to a lack of understanding the issues, and partly due to conflicted incentives. Do we get the right advice that is in our best interest? Understanding the simple idea of incentive compatibility, from finance, can help us avoid a lot of confusion, pain, and suffering. We cannot, of course, solve all these problems by using finance, but we obtain better insights if we understand the financial dimensions of incentives of all of the players involved. From a finance perspective, asymmetric information causes serious problems, while sunshine is the best disinfectant. Sunshine eliminates 292

https://www.brookings.edu/wp-content/uploads/2017/08/casetextsp17bpea. pdf 293 Anne Case and Angus Deaton, 2015, “Rising morbidity and mortality in midlife among white non-Hispanic Americans in the 21st Century”. Angus Deaton received the Nobel Prize in economics in 2015 for his work on poverty and welfare. Case and Deaton report that all-cause mortality for US whites aged 45-54 has increased from 380 per 100,000 in 1998 to 420 per 100,000 in 2013, resulting in a possible extra half a million deaths. This represents about a 10 percent increase in the death rate. Leading causes are drug and alcohol poisoning, suicides, chronic liver diseases, and diabetes. The increased mortality is concentrated mostly in those with high school education or less.

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information asymmetry and the advantage of the policy experts and elected politicians. Here are some commonsense suggestions. Require that all hospitals and doctors display all the payments they receive from pharmaceutical companies and medical device companies. Require doctors and hospitals disclose all labs, devices, and treatment where hospitals and doctors have financial interest. This will help better align the incentives of hospitals and doctors with the best interests of the patients.

Other applications Similar logic can be applied to other industries. Take financial advice. One requirement might be to insist that financial advisors display all payments they get from recommending different financial products. This will help investors better interpret the financial advisors’ recommendations, and eliminate the informational advantages of the financial advisors. Make sure that all elected officials disclose their tax returns. This would eliminate the informational advantages of the politicians. Since the politicians are working as our agents, we need to make sure that they are not too conflicted. By examining their tax returns, we would be in a better position to judge if their allegiance lies with the public interests or some special interest group. At the time of writing, even President Trump had not released his current tax returns. This does not set a good example. It seems that we have much to do. Require that senior governmental officials disclose additional information about their compensation when they leave office. We will discuss the informational asymmetries in more detail, next.

CHAPTER 10 UNDERSTANDING INFORMATIONAL ASYMMETRIES

“Enlightenment is man's emergence from his self-imposed immaturity. Immaturity is the inability to use one's understanding without guidance from another… If I have a book to serve as my understanding, a pastor to serve as my conscience, a physician to determine my diet for me, and so on, I need not exert myself at all. I need not think, if only I can pay: others will readily undertake the irksome work for me… He has even become fond of this state and for the time being is actually incapable of using his own understanding, for no one has ever allowed him to attempt it. Rules and formulas, those mechanical aids to the rational use, or rather misuse, of his natural gifts, are the shackles of a permanent immaturity”.294 —Immanuel Kant, What is Enlightenment 1784

What is informational asymmetry? In The Republic, Plato imagines a group of people living in caves. They are chained to a wall and cannot see the outside world. They can only watch the shadows that outsiders cast on the walls, and they try to interpret what the shadows mean. These shadows are their reality. This allegory has powerful implications for everyday life. In certain ways, we are like Plato’s imaginary cave dwellers. We interpret the world through the descriptions of others. We see the shadows, not the true forms. Most of us are not even interested in learning about the true forms, since they may be too uncomfortable to confront, or too costly or difficult to understand. Like the individuals in the cave, we too are challenged by an essential concept in finance, called informational asymmetries. This idea has required economists to rethink the very foundations of traditional ideas in economics. This new thinking is profound and useful.

294

http://www2.idehist.uu.se/distans/ilmh/Ren/idehist-enlighten-kant02.htm

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Finance teaches that it is costly to create or acquire information. Some of us come by information easily in the course of our daily activities. Others will have to spend resources to become informed. In these cases, some people will be better informed than others. This is informational asymmetry. Adam Smith and other classical economists assumed that information was uniformly equally available to everyone. Consider the relationships of parties with different interests – an employer and employee, home buyers and sellers, borrowers and lenders. What happens when there are significant informational asymmetries between these parties? The informed will attempt to exploit their informational advantage. The world is full of informational asymmetries. In nearly every interaction or transaction in life, we face informational asymmetries, whether in our workplace, in our homes, or when we buy or sell anything. Consider an example that is familiar to many of us. You receive a bill for $140 for a visit to a skin doctor for a recurring rash. You are surprised, since your insurance has previously covered your consultations. You call the doctor’s office and inquire. The representative explains that the office presented the charges to your insurance company, but unfortunately, the claim was rejected. You check all of the insurance information again, and confirm its accuracy. What should you do? Do you become so frustrated that you pay the outof-pocket expense? Both the healthcare provider and the insurance company know more about this situation than you do. To resolve this issue, you can take one of two steps: either write a personal check and cover the over-charge, or call the insurance company to determine the basis for the rejected claim. In this case, you call the insurance company. You learn that it has actually paid the bill, but the doctor’s office did not record the credit. You obtain the check number and share it with the medical practice, and the confusion is easily sorted out. The lesson here is that you resolved the issue by seeking your own information. Consider another familiar example. You want to buy a new car. What do you do? Typically, most people visit a car dealership, look at the car, see the list price of the car, and then try to negotiate down the list price. You

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expect that the offered price already includes a large profit margin, but you do not know how much. You try to gauge the profit by attempting to negotiate with the salesperson. However, one does not need the services of a salesperson to find out the level of discount that the car dealer offers. It is much better to seek out independent information about the dealer’s cost and actual transaction prices and then negotiate with the salesperson. This will, however, require additional effort.295 Another example of information asymmetry from the business world is the activity of corporate insiders who exploit their informational advantage in the stock market.296 Insiders are typically more informed than shareholders and other investors. They buy and sell shares based on their informational advantage. On average, insiders trade profitably, even though there are very strict criminal laws against insider trading.297 To understand insiders’ informational advantage, consider Table 10.1, which illustrates the abnormal profits of insiders when they buy and sell their own company’s shares during a range of periods, including one month, six months, and 12 months, after their transactions. This is based on more than four million insider transactions between 1975 and 2017.298 It is apparent that insiders have special information that benefits them, relative to other shareholders. They buy before stock price increases and sell before stock price declines. In doing so, they beat the market.

295

Many publications provide information about dealers’ costs and the distribution of actual transaction prices. See for instance, https://www.edmunds.com/ 296 See, Seyhun, H. Nejat, Investment Intelligence from Insider Trading, MIT Press 1998. 297 The way insiders can trade profitably is to avoid trading in situations that is likely to trigger an SEC investigation. These are typically earnings announcements, dividend announcements and merger and acquisitions. By trading outside of these events, insiders can typically avoid legal entanglements. 298 Since 2002, insiders’ transactions have to be reported to the SEC on Forms 3, 4, and 5 by the end of the second business day following the date of the transaction. This data is publicly available and used as the source of the data in Tables, below.

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Table 10.1: Insiders' Abnormal profits 1975-2017299

Number of Observations

Abnormal Profits after 30 days

Abnormal Profits after 5 months

Abnormal Profits after 12 months

Large Shareholders

623,603

1.00%

0.84%

-0.66%

Officers and Directors

2,515,039

0.78%

2.30%

3.97%

Top Executives

1,316,440

1.00%

2.85%

4.82%

All Trades

4,455,082

0.88%

0.0228

3.58%

Only the trading activity of large shareholders300 is not as well informed: They hardly make any profits when they trade. In contrast, officers and directors are able to make about 4 percent excess profit during the one year following their trades. Top executives trade even more profitably, making about 5 percent from their trades. Table 10.2 illustrates the profitability of insiders’ transactions grouped by the number of shares traded. Table 10.2 illustrates that insiders trade a greater number of shares when they have information that is more valuable. This is the case up to one million shares traded. When insiders trade 100 shares or fewer in a given month, their abnormal profit is about 1 percent. When insiders trade between 10,000 shares and one million shares, they can earn between 5 percent and 6 percent abnormal profit during the following 12 months. Hence, when insiders have more valuable information, they trade a greater number of shares. However, insiders do not appear to have an additional information advantage when they trade greater than one million shares. Consider the return of trades of more than one million shares -- the abnormal returns are approximately zero. This result suggests that insiders do worry about

299 300

Author’s calculations. Large shareholders own more than 10 percent of the equity of the company.

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regulatory concerns when they trade in amounts of shares that are more likely to be noticed. Table 10.2: Insiders' Abnormal profits, 1975-2017301

Number of Observations

Abnormal Profits after 30 days

Abnormal Profits after 6 months

Abnormal Profits after 12 months

203,962

-0.13%

1.97%

1.51%

1,577,177

0.61%

1.34%

1.64%

1,838,295

1.10%

3.11%

4.52%

729,143

1.14%

3.88%

5.77%

95,356

1.16%

3.80%

5.71%

11,149

0.25%

0.83%

0.01%

100 shares or less traded Between 1001,000 shares traded Between 1,00010,000 shares traded Between 10,000100,000 shares traded Between 100,0001,000,000 shares traded More than 1,000,000 shares traded

The evidence above suggests that corporate insiders know more about their own firms than any other market participants. They have been trading profitably against all other market participants for decades, despite the prohibition of insider trading under the securities laws. A further indication of the value of insider information is that other market participants follow and mimic the trading activity of insiders.

301

Author’s calculations.

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There is an important lesson here. If we think people are informed, we should watch their actions and give less emphasis to their words, which are merely what they say, not necessarily what they truly believe. In contrast, their actions are based on costs that they have incurred to acquire information, giving these actions greater credibility. As we can observe, outcomes change when one party has information that the other party does not. This is the topic we turn to next.

Consequences of information asymmetries The valuation of used cars further illustrates information asymmetries. Suppose George buys a new car for $40,000. Although the car was supposedly new, it had 46 miles on it on the dealer’s lot. George asks the dealer about this, and the dealer says that this is due to test-drives by potential buyers. This is fine with George. He likes the car and buys it. Over the next month, after driving for only another 150 miles, George does not like the acceleration on the car. He wants a livelier driving experience. He decides that he wants to sell the car to buy a different one. What price can George receive for this practically new car? He will lose about 10 percent of the car’s value.302 Why does a new car sell only at about 90 percent of its value? Is it the miles? A 10 percent discount seems high for 196 miles. In comparison, the car’s value was not affected by the 46 miles driven by the dealer. What explains this significant difference? The answer is informational asymmetries. We expect that a car on a dealer’s lot will have a small amount of mileage on it. We understand that potential customers will be test driving the car. The 46 miles provides us with no unfavorable information about the car. George’s situation is different. All potential buyers know and understand that George probably knows more about his own car than anyone else. George both drove the car, and decided to sell it afterwards. Potential

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George Akerlof (1971) and the lemons problem. See, https://www.carfax.com/blog/car-depreciation for the resale value of a one-monthold car.

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buyers do not know what George knows, but they do understand that George has an informational advantage over them. Consequently, when George decides to sell his car after only one month, with only 196 miles on it, he is signaling – rightly or wrongly – that he possesses unfavorable information about the car. When George tries to sell the car, people will assume that there must be – or at least there might be – something wrong with it. Rational but uninformed outsiders will correctly anticipate that George is likely to have negative information about the car. They will place greater value on what George does rather than what he says. They reflect their concerns into the price they are willing to pay for George’s car. The 10 percent discount reflects the expected value of this unfavorable information.

Learning using Bayes rule The idea that we can learn from the actions of others (selling a new car) is formalized by Bayes rule, which teaches us how to update our expectations after observing some data.303 Bayes rule starts with our prior beliefs and updates it using observed data. It is important that our prior beliefs be anchored on objective data, rather than our incentives, or our wishes and desires. The updated distribution is called the posterior distribution, given the data. As we generate more data, our old posterior becomes the new prior, and we keep updating it. First, let us introduce the idea of odds, which are just a common way to describe a ratio. If for example, there are 2 apples and 3 oranges in a basket, we can say that the ratio of apples to oranges in the basket is 2:3 (2 to 3). Were we to draw a fruit from the basket at random, the odds of drawing an apple are 0.66.304 In this way, you can see that odds represent the ratio of probabilities.

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https://www.greenteapress.com/thinkbayes/html/thinkbayes006.html#:~:text= The%20term%20on%20the%20right,data%2C%20than%20they%20were%20before. 304 0.66= 2 / 3.

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Here we are interested in the odds that the car is a lemon, given that George is selling it after 196 miles.305 Suppose that among all cars less than one year old, about 1 percent are lemons. This is our prior belief, or prior odds ratio.306 As stated earlier, we base our prior odds on the objective prevalence of lemons relative to good cars in use. Next, we want to understand how informative the data are, namely the fact that George is selling his car with less than 200 miles on it. Suppose, in general, that owners of new cars would be ten times more likely to sell if theirs was a lemon than if it was a good car. This ratio of odds is called the likelihood ratio (or Bayes factor). This is the observation we make based on historical data. The fact that the likelihood ratio is ten (instead of one) tells us that someone selling a practically new car is a very informative signal regarding the bad quality of the car. If the likelihood ratio had been one, then selling a practically new car would not be informative at all about the quality of the car. Bayes Rule tells us that the odds of it being a lemon, given that George is selling it, is the likelihood ratio times the prior odds. In our example, our posterior odds are equal to ten times, one percent, or ten percent.307 Using Bayes Rule, we revise our odds that George’s car is a lemon from about one percent (prior odds) to ten percent (posterior odds). Thus, as George attempts to sell his car, new information is disclosed to the market and the odds that it is a lemon rise tenfold. So, what will George do? He may decide that he can live with a 10 – 15 percent loss on sale. If the amount he receives from a particular potential buyer is equal to or [higher] than 90 percent of its original purchase price, George will still sell the car and benefit from his information advantage. If 305

Bayes Rule states that Odds (Lemon|Sale) = [Probability (Sale|Lemon) / Probability (Sale| Not Lemon)]* Odds(Lemon). In English, this can be translated to “the odds that the car is a lemon given the owner is trying to sell it is equal to the probability of selling a car given it is a lemon, divided by the probability of selling a car given it is not a lemon, all multiplied by the odds of the car being a lemon among all cars in use”. 306 Odds ratio refers to probability of a lemon divided by the probability of a good car among all cars in use. 307 More precisely, for every 110 cars for sale, 10 would be expected to be lemons while 100 are expected to be good cars. In this case, the odds ratio is 10 to 100 or ten percent.

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George has to sell the car for less than 80 percent of its original purchase price, then George will keep the car. There is no way to fully eliminate information costs, but there are steps that George can take to minimize these costs. One way would be to purchase a warranty. For instance, George can offer to take the car back, with no questions asked, within 24 to 48 hours of the sale. Again, suppose you are a potential buyer. You need to obtain your own information independent of what George says or does. You can take the car to an auto mechanic for evaluation, which will help you make a better decision on whether to buy the car. In real life, we learn from the actions of others, while we can also spend time and resources to generate our own information. This is true when we deal with new people, new companies, and new products and services. When you buy a so-called new car, it is really brand new? Even if it is brand new, could it be damaged and repaired? You need to find out. Do the dealers have to disclose any repairs? Sometimes yes, and sometimes no. Information asymmetries are everywhere. People change, products change, the world changes. Our reliable old familiar products may have changed over time, and we need additional investment in time and money to learn about them. There are also costs and limits to learning. We should not wait until we learn everything, since it is not possible to do so. Eventually, we will make decisions with incomplete information. Smart people will at least understand that there are many issues where ‘they know that they do not know’, and can live with this uncertainty. Once we introduce differing incentives in addition to informational asymmetries, things get even more complicated. This makes it difficult for us to learn from anyone, even from experts. We will take these ideas onestep at a time. Suppose you went out to a restaurant and had a nice meal. Later in the evening, you experience stomach cramps. Is this due to what you ate at the restaurant? It is hard to know. It could be. The restaurant would probably have a better idea if enough patrons complained about similar

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symptoms. This is an example of informational asymmetries in our everyday lives. Let us apply Bayesian inference here. How often do you normally get a stomach cramp (your priors)? If the answer is almost never, then the likelihood that you picked up a bug from a restaurant is much higher. We experience these situations all the time. At your next dental appointment, your dentist tells you that you need a filling. What do you do? Do you really a need a filling, or will your teeth heal by themselves after a while? Could the dentist be interested in earning extra income at your expense? It is hard to know. If you trust your dentist 100 percent, you will probably go ahead with a filling immediately. If this is the first time you have been told that you need a filling (strong priors about your good dental health), then you might want to get a second opinion. In this case, you should ask for the x-rays, take them to a new dentist, and get a second opinion. Why do we need to get a second opinion if we have a good history of dental health? The answer again comes from Bayes Rule. Bayes Rule tells us that our posterior odds are a product of new data (the dentist tells you that need fillings) and our prior odds (long history of good health). The posterior odds will be in between new data and our priors, depending on which is more informative or more precise. If our prior is very informative (long history of good dental health), then we would not change our posterior very much based on new data. It will still be close to our prior. In this case, we should question the so-called new data and get a second opinion instead. Let us use some numbers. Suppose our priors based on long history of good health are that the odds of fillings are 1-100 (assume that no dentist ever told us that we needed fillings until now). Suppose that over 90 percent of dentists are honest, and given a diagnosis, the likelihood of new filling is 10-1. In this case, our posterior is that the odds of a filling after a new diagnosis is still 10-100 (or only about ten percent). We should definitely get a second opinion. Finance teaches us that informed traders can profit when they possess asymmetric information. Finance also teaches us that sometimes, markets do not work in the ideal manner described in economics textbooks.

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Sometimes, prices will not be informative. Sometimes, prices will be too informative. It is not always the case that there is a positive relation between price and quality. Asymmetric information can cause markets to cease to function in an orderly manner. As the information signal becomes stronger, the likelihood of lemons in the resale market will increase. This, in turn will require bigger discounts as buyers try to price-protect themselves from lemons. Eventually, the market may break down entirely.308 Suppose that instead of a ten-fold increase, owners of lemons show 100fold increased propensity to sell their new cars. What happens now? What will the proportion of lemons in the resale market be? What will the discount be? Using Bayes rule, we can compute this easily. Our posterior odds ratio will now be one (100 times one percent). This means for each good car, there is one lemon, indicating that half of the cars in the resale market will now be lemons. Given that half of the cars are lemons, the discount will need to be at least 50 percent. With a minimum necessary discount of 50 percent, most potential ‘taste’ sellers are likely to be discouraged from selling their new cars. The remaining sellers will be selling for information reasons. This shift will further increase the propensity of ‘information’ sellers rather than ‘taste’ sellers in the pool of all sellers. Increasing the relative propensity to sell due to information will lead to a vicious circle where the market can break down entirely. Let us take the extreme case where all sellers precisely know the true value of their cars, and buyers have zero information. You want to purchase a used car. There are 101 cars for sale, with values ranging from $10,000 to $0, in $100 increments. Assume that the only reason the sellers offer their cars is to make a profit from their informational asymmetry. Initially, all you know is that the average car is worth about $5,000. How much would you offer for a given car? Suppose you offer $5,000. Would

308 See George Akerlof, “The Market for Lemons: Quality uncertainty and the Market

Mechanism” The Quarterly Journal of Economics, 84, 3, 488-500.

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this offer be accepted? Under what conditions would the seller accept this offer? Since the seller has a precise estimate of the value of the car, the seller would only accept a $5,000 offer if the true value was strictly less than $5,000, or between $100 and $4,900, with an average value of $2,500. The seller can either accept or reject your offer. If the seller rejects it, you infer that the car must be worth more than $5,000. If the seller agrees to this price, you infer that you must be overpaying (or paying twice the expected value) since the price is agreeable to the seller. This reasoning is relevant to any price you offer, even just $500. If the seller agrees to the price, you know you are paying too much. You should reject any offer that the seller agrees to in the first instance. Hence, any proposed trade will be disagreeable to either the buyer or the seller. The market will not function in an orderly way. Informational asymmetries are everywhere. You want to hire a nanny for your children. How do you find out if she will be a good match for your situation? Can you rely on a reference letter from the current employer? Usually not, since the nanny’s current employer might be conflicted. If her current employer wants to keep the nanny, then they have an incentive to prevent you from hiring her. If they no longer want the nanny, they have an incentive to provide a reference that is more favorable than justified by the quality of her work. Thus, a strategic bad letter may indicate a good nanny, while a strategic good letter may indicate a bad nanny. This means that a reference letter from the current employer is likely to be useless. You need to conduct your own assessment. One approach may be to hire her on an experimental basis and carefully observe her interactions with your family. This approach is not without its own drawbacks, either. We next apply these themes to financial markets. A useful example of the ABACUS transaction is described in Chapter 9.309 Each of the participants in the transaction had different levels of awareness and incentives. John A. Paulson was the short party, ACA the independent collateral manager, Goldman Sachs the broker, and IKB (and ABN Amro) was the investor, the long party. ACA was told that Paulson was going to buy the mortgage 309

All of the facts in this case are taken from the SEC Complaint. See, https://www.sec.gov/litigation/complaints/2010/comp21489.pdf

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securities (go long) by GS, even though Paulson was going to sell (go short). Yet, when choosing the collateral pool, Paulson rejected all the mortgages issued by Wells Fargo. ACA was puzzled about Paulson’s actions and asked about why he rejected all of Wells Fargo’s mortgages, since ACA assumed that the mortgages would be high quality. Although ACA had reservations, they acted on the basis of GS’s assurances that Paulson was a buyer.310 Let us analyze this situation from a Bayesian perspective. Based on their limited work, ACA should put a low weight on their prior belief that the pool is a random representation of all mortgages. After all, they did little or no due diligence of their own here. The data they observed however, namely, that Paulson rejected all of the Wells Fargo mortgages is a powerful signal that the pool is likely to be problematic. If they were to put a large weight on new data, their posterior inference would reject this deal. Thus, the rejection of Wells Fargo mortgages (actions) sent a very strong signal that was revealing some information about the true intention of Paulson, which was to sell. Nevertheless, ACA acted on GS’s words. As we know well, what people do is more important than what they say. Pay close attention to credible, strong information signals (actions not words). We return to this topic next. Another interesting example is the Theranos scandal. On March 14 2018, the SEC accused Theranos, Ramesh Balwani, and Elizabeth Holmes, of the fraudulent selling of securities. The SEC Complaint was later followed by a criminal indictment by the Department of Justice.311 According to the SEC Complaint, Theranos raised more than $700 million from 2013 to 2015, making false claims that it had successfully developed a proprietary equipment to conduct comprehensive blood tests based on a few drops of blood drawn from a fingertip. The results, they argued, were faster, cheaper, and more accurate than traditional blood testing labs.312 The scandal was mostly exposed by the grandson of a director of Theranos, Tyler Schultz, who worked at Theranos and observed his grandfather 310

See, https://www.sec.gov/litigation/complaints/2010/comp21489.pdf https://www.justice.gov/usao-ndca/pr/theranos-founder-and-former-chiefoperating-officer-charged-alleged-wire-fraud-schemes. As this book goes to press in 2021, the criminal trial was just getting underway. 312 https://www.sec.gov/litigation/complaints/2018/comp-pr2018-41-theranosholmes.pdf 311

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George Schultz still using the traditional lab tests instead of the finger prick method that Theranos claimed to have developed. This observable, strong signal made no sense to Tyler, causing him to question why Theranos was not using this revolutionary new procedure.313 The only conclusion he could draw (being a good Bayesian) was that there must be problems with the equipment Theranos had developed. Tyler Schultz suspected fraud, even though many sophisticated Theranos investors accepted the representations (words) by Elizabeth Holmes and Ramesh Balwani. The young Schultz exposed the scandal by paying attention to his grandfather’s actions (strong new data) and ignoring the words of Balwani and Holmes (weak priors). Let us apply Bayesian reasoning here. Suppose that young Tyler Schultz initially found the new technology reasonably credible, and assigned prior odds of it working as 2-1 in favor. Let us consider the factors going into the prior distribution here. We know that Elizabeth Holmes dropped out of college at age 19 to work on her start-up.314 A reasonable person would ask what Holmes learned in her freshman college chemistry class to be able to develop a revolutionary new technology that nobody else had come up with. This is a tall order. Given this fact, a prior odds ratio of 2-1 in favor of Holmes’ new technology is very generous. Next, young Tyler Schultz observes his grandfather getting the painful, traditional full blood draw from the arm, instead of a finger prick using the new technology. This is a negative signal. Let us assign a likelihood ratio of 1-2 against the proprietary technology with this observation. This means that, conditional on the new technology working, his grandfather should have about a 33 percent chance of a full blood draw instead of the finger prick. This is a reasonable assumption. Once young Tyler observes his grandfather getting the full blood work, his posterior odds ratio is revised to 2-2, or a 50 percent chance of working. After two full blood draws, the posterior is now revised to 2-4 against, or 313

https://abcnews.go.com/Nightline/video/theranos-whistleblower-2017deposition-holmes-lied-device-capabilities-60524143 314 https://www.businessinsider.com/theranos-founder-ceo-elizabeth-holmes-lifestory-bio-20184#:~:text=Elizabeth%20Holmes%20dropped%20out%20of,charged%20with%20%2 2massive%20fraud.%22

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33 percent chance of working. After five full blood draws, the posterior is now updated to 2-32 against, or only about 5 percent chance that the new technology is working. Hence, each time Tyler observes his grandfather getting a full blood work, he revises his posterior beliefs about the new technology. If he observes his grandfather get ten or more full blood draws in a row, as a good Bayesian, he would be convinced beyond a reasonable doubt that the new technology is simply a fraudulent claim. Notice that Tyler is able to come to this revised belief, even though he does not know anything about the underlying new technology itself.

Sometimes we cannot, or we should not, learn from data Bayes rule tells us that sometimes we cannot learn anything from the words or actions of others. If someone is a religious fundamentalist, they will be absolutely sure about their beliefs, whether something is true or not, or whether something does or does not exist, and they will assign a zero or infinity to their prior odds. In this case, no matter what new data says, their posterior will always equal to zero or infinity, since zero times anything is still zero. Similarly, infinity times anything is also still infinity. Thus, if someone’s prior odds are zero, then their posterior odds will always stay at zero. If their prior odds are infinity, then the posterior odds will always stay at infinity. Since these people never update their beliefs, they will not be able to learn or teach anything other than their prior beliefs. In this case, it is best not to argue with these people regarding their beliefs. Suppose that, instead of religious fundamentalism, we have strong social, cultural, or political convictions. For most of us, these strong prior convictions will help determine our prior beliefs. Consequently, our prior beliefs will be biased toward zero or infinity and away from objective data. This means that even if we use the Bayesian framework, our posterior beliefs will not properly reflect the data that we observe. Incentives are similar to social, cultural, and political convictions, in that they will also bias our priors in the direction of financial and social rewards. Consequently, even if we use a Bayesian framework, our considered opinions will be biased toward our incentives.

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Finally, all forms of cultural biases, nationalism, racism, misogyny, misandry, all work similarly. These people will form priors not based on objective data, but along with their ex-ante biases. Once again, they will not learn much from real-world data no matter how strong the data are. Another problem is that most of us do not use a Bayesian framework. Instead, we engage in everyday logical reasoning. At this point you might ask, what is the difference between Bayesian inference and everyday logical thinking? There are clear differences, and we will discuss these ideas next. Let us illustrate the difference between everyday logical thinking using Bayesian reasoning with an example. Suppose you read that Russians have undertaken a disinformation campaign against the US-based COVID vaccines.315 Suppose also that based on your political orientation, you believe the Russian government is a foe. Does this increase or decrease your confidence in US vaccines? For many, using everyday logic, this evidence would be clear proof that US vaccines must be effective, since the adversarial Russians have mounted a disinformation campaign against the American vaccines. However, this is not the correct answer. Now suppose, based on your political orientation, you believe that the Russian government is a good partner. How do you interpret the effectiveness of the American vaccine now? Most people would now conclude that the Russian government is engaged in a friendly educational campaign and we should all be wary of the vaccines. However, this is not the correct answer either. Let us now use Bayesian reasoning here. Bayesian inference asks us to consider both the hypothesis in question and the alternative hypothesis simultaneously. Aside from being an adversary, Russia is also a global competitor to the US. Certainly, if the American vaccines are effective, given their opposing financial incentives, Russians would be expected to mount a disinformation campaign against them, since Russians have a competing vaccine, Sputnik V. So far so good. Bayesian reasoning goes one more step, and asks about the alternative hypothesis, namely that if the 315

https://www.wsj.com/articles/russian-disinformation-campaign-aims-toundermine-confidence-in-pfizer-other-covid-19-vaccines-u-s-officials-say11615129200?mod=searchresults_pos3&page=1

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American vaccines were not effective, what would the Russians do? You might actually expect them to mount another public campaign against them. Again, this would not be disinformation, but rather an information campaign. Nevertheless, they would say exactly the same things about the vaccines. Thus, the evidence of a Russian campaign against American vaccines is equally likely whether the American vaccines are effective or ineffective. Using Bayesian reasoning, the likelihood ratio would in fact equal one. This means our posterior odds are exactly the same as our prior odds. Thus, there is nothing to learn from the Russian campaign and, based on Bayesian inference, you would best ignore the Russian campaign. The preceding discussion indicates that when a given party is conflicted, or has strong financial interest in the outcome, we cannot, or should not, attempt to learn anything from what they say or do. It is best to just ignore them. This reasoning also applies to TV networks, news outlets and other mainstream media sources. This logic applies to government-controlled media as well. Most, if not all, media sources have strong political convictions, which means they are conflicted with any data unfavorable to their priors. Consequently, it is best to ignore all news from strongly politically motivated sources.

Learning from other observable signals Suppose a firm wants to raise outside capital. As we discussed earlier, the firm’s managers know more about their company than we do. Although we are less informed, we are rational and analytical (as good Bayesians). Since it is illegal to mislead investors in financial markets, we can discern some information about the company based on what the firm says or does. A profitable firm earns sufficient money through its operations. If the firm is forced to go to outside capital markets for new funds, we have two possible negative signals: 1) The firm does not have sufficient internal funds and, 2) It is not sufficiently profitable to raise the funds from operations. Using Bayesian reasoning, let us ask about the alternative hypotheses. If the firm were profitable, what would it do? In this case, we would not expect the firm to raise capital, since it is costly to raise capital when it does not need it. Hence, we can be comfortable with the fact that the firm going for external capital does indeed send a negative signal.

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The next question you would ask is how, or in what form, the company plans to raise these funds. Does it intend to sell debt or sell equity? If the firm is selling equity, you should rationally expect that the managers might know more about the stock price than you do. If the managers expect the stock price is overvalued, then they will want the firm to issue stock before the price drops. Thus, we have another negative signal: If the firm wants to raise outside capital in the form of equity, this may be an additional signal that stock price is currently too high, and it will fall in the future. Take the alternative hypothesis. Suppose managers expected the stock price to increase. What would they do? How would they raise funds? Well, they would not want to sell equity at the current cheap price. Instead, they would prefer to borrow in the debt markets. Thus, the sale of equity capital sends an additional negative signal. If someone wants your equity investment, ask yourself a question. Under the alternative hypothesis that the company is doing well, why would it share its success with you? Why wouldn’t the company just use its internal sources or its future profits, or obtain a loan, or issue debt securities? Next, you would want to know why the firm needs new funds. Possible answers could include starting a new project, an enhancement of existing operations, or a reduction in debt. Each of these answers sends a different signal. Alternatively, the firm may also be silent on this issue. If the firm is seeking to raise external equity to take on a new project, doing so may not be a terribly negative signal. We begin with concluding that the firm does not have current resources, is not going to be sufficiently profitable going forward, and the intrinsic value of the equity is less than the price the company is currently trading at. However, against these three negative signals, we also learn that the firm has a new and promising project it hopes to fund. In this case, we still want to learn more about the project, but at least we get one possible positive signal in addition to our three negative signals.316

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The fact that the firm needs external capital is the first negative signal. This tells us that the firm is not likely to be profitable in the future. We also learn that the firm does not have sufficient internal funds for the expansion. This is the second negative signal. Third, the firm decides to raise equity instead of debt. This is also a negative signal.

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Suppose instead, that the firm will use the equity capital to fund current operations. In this case, the firm is sending a plethora of negative signals. For one, it does not have enough retained earnings; two, it is not going to be sufficiently profitable in the future; three, the equity may be overpriced; and four, the firm does not have any new ideas for projects. Furthermore, the firm does not have a plan to improve its profitability and, consequently, it needs outside equity capital just to keep going with its present course.317 Suppose the firm uses equity funding to reduce debt. The signal is even worse now. The firm does not have sufficient retained earnings; it is not sufficiently profitable; the equity may be overpriced; and the firm does not have new ideas for projects. As in the other case, the firm does not have a plan to improve its profitability. The firm also needs to reduce its debt burden, which is so onerous that it will do so with the external equity capital. As you can see, the seller is more informed. Yet, as the seller tries to exploit its information, it also reveals more of its asymmetric information through its words and deeds (similar to the resale car market). Once again, words are also relatively more credible in this context since it would be a violation of the securities laws for the company to make incomplete or misleading statements about its financial condition.318 A takeaway here is that if a company whose shares you own is trying to sell new equity to replace its debt, you should also sell your stock in the company. Consider some similarities to the Madoff scandal. Madoff claimed to achieve highly successful investment results (earning about 10.5 percent per year with little or no risk), yet he constantly needed and wanted outside money. These co-existing events are a contradiction. If Madoff needed outside money, then he could not have been that successful. This was an important signal. If a money manager claims to be highly successful but he needs new money, it is best to just walk away.

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We can hear what some of you are thinking. Why doesn’t the ABC firm announce that they want to take a good project with the proceeds of equity issue, and then after they get the funds, just retire debt instead? This would be illegal under securities laws in the US, since the original prospectus would be incomplete and misleading in this case. 318 Section 10b of the Securities and Exchange Act prohibits companies from selling securities using misleading or incomplete information.

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To form your own views, you need to ask your own questions and seek your own information. If you rely on others, as in Plato’s cave, you will be at a disadvantage.

Generate your own signals If the issue at hand is important to you, there is no substitute for generating your own data. Consider, again, the ABACUS transactions at Goldman Sachs (GS). Why did asymmetric information cause problems here? We are reminded of Immanuel Kant’s caution not to take the words of others as a substitute for our own investigation. And, as Plato reminds us in The Republic, we see reality differently if we only see the shadows rather than the real forms. Furthermore, these shadows may come from a play created for us, instead of true reality. The German investor IKB, and the Dutch bank ABN-AMRO could have generated more of their own information in spite of whatever they heard from GS. They could have specifically asked who was taking the short side of the transaction. The answer here would have been informative, since GS has to give a truthful answer. Alternatively, they could have asked about the details of the mortgage pool. They could have asked ACA how the pool was chosen, including whether there were any mortgages in the pool that ACA did not choose. Alternatively, they could have simply analyzed the mortgage pool themselves, just as Paulson did, and throw away mortgages they did not like. They could have asked whether any mortgages were already rejected from the pool. They could have asked how GS was compensated; in which case they would have learned that GS was being paid $15 million by Paulson. Apparently, they did not ask any of these questions. They based their decision to invest $1 billion entirely on what they inferred from what GS executives told them. They must have assumed that GS had their best interest in mind because IKB was already a client of GS. They paid a high price for their lack of inquiry. Asymmetric information can create subtle effects. What is the objective of a party with the information-advantage? Not to reveal their information. As a result, they will take into account whether their own actions may, or will, reveal their own unique information. Consequently, they will decide which action to take only after considering the potential reactions to each alternative.

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Assume, for example, that you are a senior executive at a publicly held company and you are in a position to be informed about its inner workings. Accordingly, people know that you have a valuable perspective, and they observe your actions for clues on the future direction of the stock price. You also realize that your actions may create signals. What happens under these circumstances? If you try to buy the stock based on favorable information, the price will rise suddenly, preventing you from exploiting your information. Consequently, you would have an interest in not acting openly on your information, and you might choose to sell publicly and push prices down first, before buying the stock secretly.319 Thus, if people can act strategically, shadows may not always be even minimally informative. A key theme here is that since their actions will reveal their private information (think of George trying to sell his practically new car), the informed parties will try to take alternative measures to protect their informational advantages. They may at times send signals that are deceptive. Consequently, the opposing party or parties will need to take explicit action to generate their own information, and not rely on the informed party for signals.

Application to College Education Consider an additional example of information asymmetry – that is, the relationship between the quality of a college and its tuition fees. Students do not find out about the benefits of education until after they leave school. By this time, it is too late to do anything about it. One guide to quality that people emphasize is the cost of tuition. The obvious question is whether more expensive schools are better. The answer is no. Using Bayesian reasoning, what do we expect low quality schools to do? Since parents or students cannot discern quality on their own and they rely on tuition, low quality schools will also raise their tuition fees. Thus, tuition rates do not need to reflect quality of education. It is important for the 319

See, Kose John and Ranga Narayanan, 1997, “Market Manipulation and the Role of Insider Trading Regulations”, Journal of Business, vol. 70, pp217-247.

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students to find out as much as they can about the school, including starting salaries for its graduates, types of jobs obtained, graduation rates, and the impressions of recent graduates and the parents of former students. We should not assume automatically that more expensive schools must be better; some schools can actually raise their tuition fees just to make themselves seem more elite.320 We are accustomed to think that higher priced items and more expensive services are of higher quality. This is usually true, since higher quality costs more, and thus it requires a higher price. However, this cannot always be true. Lower quality can also sell at a high price if people cannot tell the quality. If all we can observe is the price, there is nothing preventing lowquality vendors asking for higher prices. Students and their families may view more expensive schools as being superior. Many private schools pay more to their faculty and staff than the state universities or community colleges. They may – although not always – offer more student services relating to activities, student life, counseling, and career advising. They may have graduates who form a strong network for recruiting and promoting business relationships. (“We have thousands of alumni across the country, and once you come here you are one of us for life”). However, do high tuition fees mean a better education for a student? Should students select the most expensive school option? The answer is obviously no. College administrators know that many people think more highly of higher priced colleges. Given this knowledge, what will the college administrators do? They will, typically, raise tuition fees as much as the market will bear. In this case, once again, higher tuition will not signal higher quality. This problem is especially acute for private colleges that are run by forprofit companies, which set tuition fees to maximize profits – that is, set the price at the maximum the market will bear. In a number of cases, they accept students who are not necessarily well prepared for college, but

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One consequence is that the families of more affluent students effectively subsidize the cost of students who receive financial aid or other forms of scholarship. In other words, the schools raise the prices where the students may be less price sensitive so that they can offer lower cost tuition to students who are highly price sensitive.

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have family resources, or are able to borrow the money to fund their education. At colleges that are perceived as elite, there is a different dynamic. Using targeted advertising, they encourage many students to apply, especially targeting affluent families. However, they only admit a small number of students, making them seem even more desirable. Many applicants will be willing to pay higher tuition fees just to be admitted. Another confounding factor with the price of college education is the fact that students are not very sensitive to tuition. This is because the federal government makes student loans available to all students, without requiring a test of repayment ability.321 Thus, as far as the students are concerned, no matter how high the tuition fees are, they feel that they can always afford college. Suppose now, that the federal government increases student aid by 10 percent. What will the college administrators do? Well, they may simply raise the tuition fees, since the ability of students to pay has increased by 10 percent.322 According to the Bennett hypothesis, named after the Secretary of Education, William Bennett, universities take into account the federal funding available to students in setting their tuition rates.323 The academic research suggests that tuition goes up by about 60 cents for each $1 increase in in federal aid to students. The increase is even greater in forprofit colleges.324 Once again, there is not a positive relationship between tuition rates and the quality of the college. How can we determine which college, product, or service is better? As we have just discussed, we should be very careful not to generalize from price (or tuition) alone. In some cases, high prices may signal higher quality, but 321

https://studentaid.ed.gov/sa/eligibility/basic-criteria See, “Our Greedy Colleges”, New York Times, 1987, https://www.nytimes.com/1987/02/18/opinion/our-greedy-colleges.html and https://www.help.senate.gov/imo/media/for_profit_report/ExecutiveSummary.pdf, “The for-profit education companies examined rarely set tuition below available federal student aid”, 3. 323 For instance, https://www.jamesgmartin.center/2017/12/bennett-hypothesisstill-matter/ 324 https://www.jamesgmartin.center/2017/12/bennett-hypothesis-still-matter/ 322

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not always. When does a higher price signal higher quality, rather than higher cost? When are higher costs unrelated to a higher quality of the product itself, or even just higher profit margins? Students pay attention to the physical state of college campuses. They equate magnificent buildings with a magnificent education. In return, colleges are happy to oblige them with impressive buildings, well-kept lawns and gardens, water parks, rock climbing walls, and nice restaurants. They do this even if they cannot recruit the best professors. Yet, what does a water park add to the quality of education? Is the education of students improved when a college spends large amounts of money on advertising, recruiting, ground keeping, restaurants, and elaborate gymnasiums? Colleges engage in these practices because students use them to judge the quality of the education. What else can we do? We can focus on the real determinants of the quality of the education. We can focus on what proportion of revenues are spent on instructional faculty, faculty publications, and job placement. For instance, according to a government report, for-profit universities spent 22.7 percent of their revenue on marketing, advertising, and recruiting and admissions. They spent only 17.2 percent on instruction.325 In this case, such a college can have high tuition fees and high expenses, but not necessarily offer a high quality education. There is no substitute for generating your own data. Know how the colleges spend their income. What can we learn about a college that spends more money on recruiting than on instruction? There is not a lot of demand for this college. Either they are not getting enough students to begin with, or current students are leaving. There are available places. Consequently, the college has to spend extra money to fill them. This is a signal relating to the quality of a college. Once again, you should not assume that higher prices (tuition fees) alone mean higher quality. A recent report by the Senate Committee on Health, Education, Labor, and Pensions found Bachelor’s degree programs at forprofit universities also averaged fees which were 20 percent higher than the cost of analogous programs at flagship public universities; associate

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degree programs were, on average, four times the cost of degree programs at comparable community colleges. Concurrently, the costs of certificate programs similarly averaged four and a half times the cost of such programs at comparable community colleges.326 Once again, high price and high quality are not the same. Higher price is not necessarily associated with higher quality in this case.

Information signaling When information is costly, finance tells us to pay attention to credible signals. Let us explore what those signals are, what makes them credible, why they matter, and what we can and cannot learn from them. Assume that there are two types of students: high ability students (H), and low ability students (L). Also, assume that the students know their own type while the employers do not. Suppose that the costs of attending college are much higher for the L group. These costs include opportunity costs as well as psychological costs. If the difference in costs is large enough, then all L types would voluntarily choose not to go to college, while all H students would choose to go. We call this a separating equilibrium. A college diploma would serve as a signal of type in this situation. Those with a diploma would be viewed as H-type; those without diplomas would be viewed as L-types. The presence of a costly signal – a college diploma – would separate H-types from L-types. Signaling, if done properly, works. The key variable here is the difference in costs for H and L types. When the difference is just large enough, signaling is effective because it leads to a separation of H- and L-types. H types go to college, while L types do not. Costly actions become credible signals. Suppose the costs of going to college are minimal for both types. What happens then? In this case, everyone would attend college, and everyone would have a college diploma. We call this a pooling equilibrium. In this case, having a college diploma is not an effective signal. Furthermore, the salaries for college graduates would not be significantly differentiated 326

See, https://www.help.senate.gov/imo/media/for_profit_report/Executive Summary.pdf.

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between H and L types. Everyone would get the average salary. H-types cannot separate themselves from L-types. Signaling is not effective when costs are small. The takeaway lesson is that signaling works when it is costly to send a signal. Consider some applications of credible signaling in real world. You are going to a job interview. You need this job, and you want to impress the interviewer. How should you dress? We send signals in the way we look, including our choice of clothing, haircut, shoes, and accessories. We use these choices to tell others about us – our tastes and preferences, personality traits, and resources to spend on clothing. Research shows that, for example, luxury items express authority but diminish warmth. If the job requires authority, then you may help yourself. If the job requires empathy and understanding, you may damage your chances by wearing luxury goods.327 You can, however, make choices to send intentional messages that may differ from who you really are. If you think that others will form impressions of you from your clothing, you can make intentional selections to send distinct signals. Suppose, for example, that you have a first date and agree to meet at a restaurant. Your date has never seen you before, and you want to make a favorable impression. How should you dress? Suppose your date values signs of material success. In this case, expensive clothes will impress him/her. Suppose your date values education, personal warmth, and thoughtfulness. In this case, expensive clothes may make you seem overly concerned about appearances. You might make a more favorable impression with ‘smart casual’ wear. Suppose you are professionally and financially successful, but you definitely are not interested in dating someone who values career success and money above other traits. How should you dress now?

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See, Cannon, C., & Rucker, D. (2019). “The Dark Side of Luxury: Social Costs of Luxury Consumption” Personality and Social Psychology Bulletin, 45(5), 767-779.

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You can obtain information by dressing even more informally than you do normally, such as wearing jeans, a cotton sweater, white socks, and running shoes. If your date is not interested, it could be because of your informal appearance. But this should be perfectly acceptable for you. You do not want a relationship with someone who is more focused on appearance than who you are as a person. Consider again the job interview. Suppose you are interviewing for a banking job. How should you dress? You should send signals of sincerity, honesty, neutrality, and trust. Bankers should convey a sense of trust – that their customers can trust them with their money, or to raise capital. When you go to a banking job interview, you need to dress like a banker. You should dress formally – like the person who is likely to be interviewing you. As a rule, you dress to ‘look the part’. A doctor that looks like a banker does not instill confidence. Similarly, a banker should not dress like a doctor, plumber, electrician, carpenter, or a house painter. For skilled professionals, we should care not about how expensive their clothes are, but whether they can repair our homes in a reliable way at a fair price. What message do you send if you go to a banking interview and you do not dress like a banker? One possibility is that you do not know what a banker looks like. This is a negative signal. The interviewer will interpret this signal as a sign of your ignorance. Another possibility is that you know what a banker looks like, but you chose to dress like a college professor. In this case, you are also sending a signal that you do not care about the bank’s expectations from you. You are telling the interviewer that you want to follow your own norms. This again is a negative signal. The interviewer will interpret this signal as a sign of arrogance. In a typical banking position, arrogance is not an attractive attribute. The safest choice is to look like a good banker. Can you signal your intelligence, leadership skills, or other positive attributes with your clothes in the banking interview as well? The answer is you might, but you need to be careful. As we saw earlier, finance tells us that some signals (namely costly actions) are more credible than others (words) are. Why does a Rolex watch appeal to some people? If you are trying to appear affluent, a Rolex watch may send that signal. However, suppose that the person you are meeting does

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not make enough to afford a Rolex watch or perhaps the person wants to save money for their children’s college education, and has decided not to purchase a luxury watch. You may offend the person interviewing you by overdressing. This can send a negative impression that you are insensitive, or may be even that you are so well off that you do not need the job and it will not be a priority for you. The message is that you should send a signal that is appropriate. A related take-away is to avoid signals that send a negative message and favor signals that send a positive message. We are very familiar with the expression ‘talk is cheap’. Anyone can say anything they like. Hence, you should de-emphasize cheap, verbal signals. Typically, actions are more credible than words. Go back to ABACUS. IKB and ABN-AMRO invested based on words, and ignored the actions. It is relatively easy to look like a traditional banker – grey or blue suit, white shirt, ties or scarves with muted patterns, and conservative shoes. If most people can dress like this, then we should not try to discern from their clothing whether they would make a very good banker. What we may learn is that the interviewee understands the basic clothing preferences of most bankers. Consider the fashion style choices of Elizabeth Holmes of Theranos. She wore black turtlenecks just like Steve Jobs.328 Did this style choice give her credibility and make people think she might be like Steve Jobs? Who knows, but initially she was highly successful in raising hundreds of millions in funding. Nevertheless, we could think that her black turtleneck is a cheap signal that is best ignored. We know she is not Steve Jobs. What are costly signals? Costly signals are those that are hard or expensive to imitate. Actions are expensive. Education is expensive. An education at a major research university is even more expensive. A college diploma takes four years of hard work as well as foregone earnings and tuition fees. When these costs are sufficiently large, fewer people will want to get a college diploma, in which case getting one will signal useful information. This is why we value diplomas.

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https://www.esquire.com/style/mens-fashion/a26836670/elizabeth-holmessteve-jobs-black-turtleneck/

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Although our example contained only two types, the real world is obviously more complex. First, not every diploma is the same. The admissions standards for elite schools are much more difficult. Certain majors are more difficult to complete than others. Then there is the time spent attending college. Some students graduate in four years while others can take eight years. There will still be some signaling even if everyone attends college. The more common a diploma is, the less useful a signal it will be. Suppose it takes a student eight years to obtain a diploma in communication studies from a college that has highly flexible admissions standards, and not particularly rigorous course requirements. What signal does this send? Not the same signal as a diploma obtained in four years from a research university in Science, Technology, Engineering or Mathematics (STEM).

Why can’t we always learn from experts? Experts may be informed, but their incentives are not always aligned with the general public. They have their own social, cultural, and political convictions. They feel pressure to publish. They might also be on the industry payroll. This will affect what they will say or do. As we have shown earlier, if someone is conflicted or has a financial interest in the outcome, it is best to ignore everything they say, regardless of their expertise.329 Professor John P A Ioannidis asserts that most of the published medical research that doctors rely on is false.330 The idea is that the researchers 329

See, David H. Freedman 2010 Wrong: Why experts keep failing us-and how to know when not to trust them, Little, Brown and Company. 330 See, https://journals.plos.org/plosmedicine/article?id=10.1371/journal.pmed.0020124 &xid=17259,15700019,15700186,15700190,15700248. Ioannidis writes, “a research finding is less likely to be true when the studies conducted in a field are smaller; when effect sizes are smaller; when there is a greater number and lesser preselection of tested relationships; where there is greater flexibility in designs, definitions, outcomes, and analytical modes; when there is greater financial and other interest and prejudice; and when more teams are involved in a scientific field in chase of statistical significance. Simulations show that for most study designs and settings, it is more likely for a research claim to be false than true. Moreover, for many current scientific fields, claimed research findings may often be simply accurate measures of the prevailing bias”.

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control many degrees of freedom, and they can almost always hack their research results into statistically significant findings in directions that favor publication and financial and other benefits to them. As an example, consider scientific research articles. Are they credible? Should we change our behavior based on what we read? If a topic is an important issue for us, we need to obtain our own data. We need to not only critically evaluate the source of the information, but also seek other objective sources. In the process of doing so, we need to think about asymmetric information and conflicting incentives. Suppose you read an investigative report or an academic publication on the dangers of eating eggs. Is this objective, unbiased, and accurate? Is it credible? Can we trust this information? Can eating such traditional food be dangerous? The answer, of course, is that it depends. While people have been eating eggs for thousands of years, there is always the potential to discover new information that can provide us with insights about nutrition. If we are going to accept a change from longstanding nutritional practice, we will need exceptionally robust evidence. Using a Bayesian approach, this means that our priors regarding the dangers of eating eggs are that there is a very small probability of risk, and historical evidence is very strong. To change our minds, any new evidence has to be exceptionally strong in the opposite direction, persistent, and acquired over a very long period. Anything less should not meaningfully change our posterior. One important attribute of good evidence is that it be objective and free of bias. This requires that researchers do not have an incentive to support a particular outcome. In many cases, we may have to conduct our own research, rather than relying on others who may have a particular agenda or incentives to support a conclusion. To understand incentives better, we need to obtain our own information. We need to dig deeper into the research article and read it ourselves. We need to understand who conducted the research, and how the research was funded. Two important aspects of research are the objectivity of the investigator and the source of funding. Suppose the egg research is supported by the

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American Egg Board, an industry group. Not surprisingly, we would expect that the research will emphasize the nutritional benefits of eggs. Alternatively, suppose the research conducted by an institution with a nondescriptive name such as ‘Americans for Nutrition.’. The name of the organization may tell us something, but it is not, in itself, sufficient. We need to dig deeper. Who did the research? What if the researcher is a tenured professor at Northwestern University who has done extensive research on nutrition? Academic research is likely to be more objective than industry-funded research, although we have to still examine the methodology. Are eggs nutritionally sound or not? This question has been the subject of extensive research, and there are conflicting views.331 We can reasonably argue that we need exceptionally robust evidence to forgo eggs. This is a tall challenge, because it requires randomized control experiments involving food consumption over long periods. Consider the case of a Northwestern University professor who published an article in 2019, in a prestigious journal about the danger of eating two eggs a day.332 Is this article sufficient to change your mind about eating eggs? We cannot know with certainty. We should consider the article, since the research appeared in a journal that subjects articles to review by peers. This does not mean we should change our diets yet, but we will want to carefully examine the methodology of the research. Is the signal costly? Conducting typical academic research and publishing an article is costly and time consuming, with little monetary payoff. It is even more difficult and more costly to publish in prestigious academic journals. The more costly it is to imitate the signal, the more credible it should be. Since this article was published in a respected medical journal, it merits a careful examination of its methodology and conclusions (in this case, that cardiovascular disease risks increase with eating eggs). We should think about incentives, namely whether anyone benefits from this finding. Possible beneficiaries include the manufacturers of cholesterol 331

https://www.wsj.com/articles/the-great-egg-debate-are-they-healthy-or-not1528812769?mod=article_inline 332 https://jamanetwork.com/journals/jama/article-abstract/2728487?mod= article_inline

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lowering drugs, the makers of egg substitutes, and breakfast cereal producers. Accordingly, we will need to be alert to possible conflicts. Not all scientific articles are valuable. Many have low readership; many are cited only once or twice, or even never.333 Many are written with the primary purpose of obtaining academic tenure. Some articles are written by investigators who receive grants or consulting fees from organizations that will benefit from the research. This may reduce the credibility of the article’s conclusions. What about the journals themselves? Are the academic journals objective platforms? What are the incentives of academic journals? What about the organization that publishes the journal? Does it have a financial interest in the outcome of an article? Suppose an academic article analyzes whether a particular medicine is effective in treating a particular ailment. Is the academic journal indifferent to what the article finds? Typically, if the medicine were found to be effective, the manufacturer of the medicine would be expected to purchase thousands of reprints of this article, which is a big financial boon for the journal. The manufacturer might also advertise in the journal, next to the article. If the opposite result were found, there would be no such financial benefit to the journal. Hence, the academic journals are not exactly objective, independent, observers. They can have a financial stake in what the research concludes. What about explicit fraud in academic journals? We expect outright cheating to be rare with academic articles. An academic researcher also has more to lose by publishing an article using false, or ‘cooked’ data, since it would derail his or her career. Researchers spend decades building their research reputations, which they want to continue to advance. They depend on funding provided by an unbiased source, such as the government or a university. The rewards of publishing an article do not depend on whether the results are favorable or unfavorable for a particular outcome. Thus, for all of these reasons we should, and we do, put weight on scientific or academic articles.

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https://www.nature.com/articles/d41586-017-08404-0

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This does not mean that are no biases in science or academics. It is hard, if not impossible, to publish research that finds a zero effect. Suppose a researcher examined the health effects of eating two eggs a day and the results were inconclusive. This would be hard to publish. A researcher will not be satisfied with this conclusion, since he or she will have to secure research funding to survive and prosper. If researchers do not publish, they will eventually lose research funding and their academic positions. This is what is known as “publish-or-perish”. Consequently, academics will have incentives to over-promote their findings. One potential bias in academic articles is that a researcher has an incentive to make his or her findings appear more important than they may actually be. One subtle way to do this is to overstate the statistical significance of their findings (a practice called p-hacking). Consequently, we need to be alert to researchers who overstate the results of their research, even if the methodology is generally sound. What can we do to protect ourselves against bias in research? As stated earlier, we can start with ignoring all research, and using an observational approach. We should also ignore all research that is industry funded, or where the authors have a financial connection to the potential outcomes in research. Alternatively, if this is an important issue for us, we need to do our due diligence and generate our own data. Instead of relying on a summary of the article in a magazine or newspaper, we should read the original article and assess whether the data in the tables supports the conclusions. There is often a difference between the actual article and how it is portrayed by journalists and bloggers. We should also think about the author, his/her funding source, and any potential biases. Consider again the article mentioned above about eggs. After reading it, what do we learn about egg consumption? First, this is a meta-study of other published studies, involving over 29,000 participants. Given this large sample, even small changes in risk outcomes are likely to result in statistical significance (think p-hacking). The authors use a 5 percent significance test, which is relatively easy to achieve with such a large data set. Second, this is not a randomized control study that can establish cause-effect relations, but rather an observational study. Individuals are given a survey about their egg consumption at one point, and then they are observed over time.

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Consequently, the most we can conclude is that there is a possible association between egg consumption and adverse health outcomes. Observational studies do not establish a causal link. This is because participants in the study are not randomly chosen. In addition, people who say they eat eggs may be cooking the eggs with processed oils; they may also eat other processed foods such as sausages or bacon334 with their eggs; they may be drinking processed orange juice. Hence, it is difficult to control for these confounding effects. If an observational study does not explicitly explore certain questions, it cannot determine whether adverse health outcomes relate to the eggs, sausages, bacon, oils, or something else that is related to what these people eat while they also eat eggs. It is therefore difficult to discern definitive conclusions from any observational study. In fact, randomized control trials repeatedly fail to confirm the findings of observational studies.335 Third, at the beginning of the study, the participants in the original studies were given a single questionnaire about how many eggs they had eaten in the past (going back to 1985). They were then observed for a median of 17.5 years and up to 30 years later. The assumptions here are that participants remembered accurately what they ate each day in the past, and that their eating habits did not change over decades. These are both somewhat suspect assumptions. In addition to all of these problems, the findings of the study are modest: The study found that an additional consumption of 300mg of cholesterol (2 medium eggs per day) increased the adjusted risk of cardiovascular disease by 3.2 percent and of all causes of death by only 4.4 percent. These are tiny, tiny increases. Based on these findings, the authors concluded as follows: “Among US adults, higher consumption of dietary cholesterol or eggs was significantly associated with higher risk of incident cardio334

After reviewing more than 800 studies, The World Health Organization (WHO) says that eating too much processed meat, including hot dogs, ham, bacon, and sausage, causes cancer. See, https://www.cancer.org/latest-news/world-healthorganization-says-processed-meat-causes-cancer.html 335 See for instance, Omenn GS, Goodman GE, Thornquist MD, Balmes J, et al. “Effect of a combination of beta carotene and vitamin A on lung cancer and cardiovascular disease” New England Journal of Medicine 1996, 334, 1150-5 or Graziano JM, Glynn RJ, Cristen WJ et al. “Vitamins E and C in the prevention of prostate and total cancer in men” JAMA 2009, 301:52-62.

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vascular disease (CVD) and all-cause mortality in a dose-response manner”.336 It is our own view, however, that a 3 percent increase in risk is not compelling in light of the significant measurement errors we mentioned above for an observational study. We would only be worried if the hazard rate had at least doubled. For instance, evidence indicates that cigarette smoking increases cancer risk by 15 to 30-fold, or a thousand-fold higher than 3 percent.337 However, some of you might consider a 3 percent increase important, and curtail your own egg consumption. There are also other findings in the paper that give us reasons to be cautious about interpreting the results. Interestingly, the study finds that all-cause-mortality effects are, typically, as big, or even bigger than CVDmortality effects, suggesting that non-CVD mortality is as big, if not bigger than the CVD-mortality.338 Why would, say, the risk of having cancer or traffic accidents be related to eating some eggs decades ago? This raises

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https://jamanetwork.com/journals/jama/fullarticle/2728487?guestAccess Key=8c4cf1ef-5c3d-4c32-b157ba708f8c4b6f&utm_source=JAMA_Network&utm_medium=referral&utm_campai gn=ftm_links&utm_content=tfl&utm_term=031519 337 https://www.cdc.gov/cancer/lung/basic_info/risk_factors.htm#:~:text=At%20 least%2070%20are%20known,the%20risk%20of%20lung%20cancer. 338 See, eTable5, eTable6, eTable8, and eTable9 of the supplement. In fact, in eTable 14338 of the article, authors use subsamples and separate individual channels of CVD incidence and CVD-mortality from non-CVD mortality. In this case, the relation between egg consumption and coronary heart disease incidence disappears statistically, as does the relation between egg consumption and heart failure incidence. In addition, the relation between egg consumption and overall CVD mortality also disappears. In contrast, the relation between egg consumption and non-CVD mortality remains significant. https://cdn.jamanetwork.com/ama/content_public/journal/jama/937900/joi19001 9supp1_prod.pdf?Expires=2147483647&Signature=rnjEm2BwnR9St5hmQOtTgAFT DvwwCuirORvlnrIY582Wy~oZQgqUKSJNFDCzdW0~MJRqmShDx92w8EWXRFNOcXN nGkoQZAKrNq8t3ldLPVizb~ophZYmsxCLXXjPqgJFWckufT0tNxLAdTn6iuCE8xAZ8qYW6mMiKAGcq2QZdVe-sHkTxXZqZURSMPqTtPpNZRYccSHzVjRZrFvpAhiOhl5vA52BFChhMTZhHGrdDK01K4XWz UH94wQYTB~YA3F-EH8i5x1nLmu2XNCSoo~5zGvIIf~fosZrRNHFkYfYLf8KssJtU0tqxvGivQ6caxG4rRCTCTUhxB0S7fcp6dg__&Key-PairId=APKAIE5G5CRDK6RD3PGA

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the possibility that higher overall mortality outcomes could be due to some factors which were not controlled in the study. Next, consider the potential for conflicts of interest. The article discloses that some of the authors received payments from pharmaceutical companies that take the form of employment, research support, and honoraria, including some firms that sell cholesterol-lowering drugs.339 In our view, holding all else equal, this potential conflict also reduces the significance of the new information in the article for us. For us, funding matters. Research shows that the funding source can change a study’s findings. Take for instance, the potential relation between sugary drinks and obesity. Is there a connection between the two? Among the studies with no reported conflicts, 83 percent reported that sugary drinks were directly associated with obesity. Among the studies funded by the industry participants – including Coca-Cola, Pepsi-Cola, and the American Beverage Association came to an opposite conclusion – namely, 83 percent reported that there was insufficient evidence to draw a connection between sugary drinks and obesity.340 Potential conflicts over funding sources can, and do, affect so-called scientific conclusions. In additional to some of the weaknesses in the research which have already been discussed above, the current US dietary guidelines issued in 2015 do not restrict cholesterol intake to below 300mg per day. Furthermore, other studies come to the opposite conclusion and find no (or even a negative) relation between egg consumption and CVD-related mortality. For instance, a recent British Medical Journal (BMJ) article involving over three million participants found no relation between egg consumption and CVD or

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The article states the following: “Dr Wilkins reported receiving consulting fees from NGM Biopharmaceuticals (Modest). Dr Mentz reported receiving research support from Akros, Amgen, AstraZeneca, Bayer, GlaxoSmithKline, Gilead, Luitpold, Medtronic, Merck, Novartis, Otsuka, and ResMed; honoraria from Abbott, Amgen, AstraZeneca, Bayer, Janssen, Luitpold Pharmaceuticals, Medtronic, Merck, Novartis, and ResMed; and serving on an advisory board for Amgen, AstraZeneca, Luitpold, Merck, Novartis and Boehringer Ingelheim”. 340 See, https://well.blogs.nytimes.com/2014/01/03/are-sugary-drinks-fatteningdepends-who-you-ask/

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strokes. On the contrary, for diabetes patients in the BMJ study, the highest CVD incidence was found in the lowest egg consumption group.341 Now that you have reviewed the various egg studies in greater detail, you can assess the costs and benefits of egg consumption on your own. You can decide to curtail, or continue with, your egg consumption. Your own assessment based on your preferences or risk tolerance should be the main driver of your behavior. If we do not do our own investigation and generate our own data as we did here, it becomes very difficult to learn compelling facts about the real world. Consider another Bayesian insight. If someone (a researcher) is absolutely certain about a hypothesis, no amount of new data or evidence can ever change their mind. If someone gets paid to espouse a given view, no amount of new data will lead them to conclude for the opposite view. Consequently, we are going to be bombarded by conflicting findings about every issue, making us more confused than ever and dependent on others (as Kant observed more than 200 years ago). Although there is now increased awareness of the importance of incentives, we still have more to learn. We need to continue to read the original research and generate our own information.342 In particular, we need to learn about the funding of various research articles published.343 We need to understand and learn about authors’ incentives. Another type of medical research involves randomized control trials (RCTs) where the patients are randomly assigned to treatment or placebo groups, and health outcomes are measured over time. While RCT studies are more reliable than observational studies, they too can have problems. One problem is prescreening. If the entire pool of participants is first given the medicine to determine its side effects and all participants with adverse side effects (such as headaches or muscle pain that presage an adverse outcome), 341

https://www.ncbi.nlm.nih.gov/pubmed/23295181 You can review original medical research on https://www.ncbi.nlm.nih.gov/pubmed/. It currently contains more than 29 million citations (sometimes with full text content) for biomedical literature from MEDLINE, life-science journals and online books. 343 Funding information is now readily disclosed in published medical research. Again see, https://www.ncbi.nlm.nih.gov/pubmed/. 342

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are eliminated, then it is impossible to learn anything from the experiment. The resulting findings can be severely biased in favor of the treatment since the worst possible outcomes in the treatment group will no longer be observed. Another problem with RCTs is that many are funded by the industry. The industry sponsor can simply choose to end the experiment early if the results begin to go against them. This selection bias makes the published papers favor the treatment. Alternatively, the decision to publish at all may depend on the findings. Suppose the corporate sponsor decides only to publish the experiment if the results are favorable, and completely ignore it if the results are unfavorable. These selection biases mean that we can never learn anything from industry-sponsored research. Most, if not all, of the published research will always favor the industry point of view.344 To get a more objective view of the medical research, it would be a good idea to ignore all industry-funded studies as well as those where the authors receive financial inducements from the industry. Another recent personal anecdote is useful here. My friend Sophia recently became concerned about her heart health and sought advice from a cardiologist. Sophia is in good metabolic health, with good body mass index (BMI), normal blood pressure, and normal cholesterol levels; however, she did have a family history of heart disease. To her surprise, her cardiologist recommended that she immediately start taking statins. Her doctor said this was a slam dunk case. Since Sophia preferred a natural life-style approach first, she told her doctor that she was reluctant. However, she also told her doctor that she was willing to change her mind if she were convinced of the net benefits given her own unique situation. So, she asked her doctor for the most convincing academic studies on this topic. Her cardiologist sent her a 2009 meta-analysis study published in the British Medical Journal (BMJ) as the most convincing study in this area.345 This study had a sample size of over 70,000 consisting of elderly adults, 344

EU regulations that came into effect in 2004 require publication of all investigations of medicinal products regardless of outcome. See, https://www.ncbi.nlm.nih.gov/pmc/articles/PMC1974829/. For US regulations effective in 2017, see https://www.research.uci.edu/compliance/human-research-protections/ researchers/guidelines-for-registering-in-a-clinicaltrialsgov-registry.html 345 https://www.bmj.com/content/338/bmj.b2376

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who are overweight, with high blood pressure and metabolic markers, taking statins. The authors concluded “Statin therapy was associated with a significant risk reduction in all-cause mortality of 12 percent, in major coronary events of 30 percent, and in major cerebrovascular events of 19 percent. Moreover, statin use was not associated with an increased risk of cancer”. Sounded like a slam dunk indeed. Sophia then read the study carefully. First, she noticed that the metaanalysis study contained many studies that were sponsored by the industry. Second, of the three American co-authors, two of them had received over $500,000 in consulting income each from the same pharmaceutical companies that manufactured statins. These facts immediately sent a red flag regarding the objectivity of the paper. Third, the 12 percent reduction in all-cause mortality was referring to relative risk reduction, from 5.7 percent to 5.1 percent. Therefore, the absolute risk reduction was 0.6 percent. This means that if 1,000 people took statins for four years, 6 fewer deaths would occur in the treatment group, compared to the placebo group. Put alternatively, 167 people would have to take statins for four years to avoid one premature death. This seemed like a small benefit to her. Fourth, the statistical significance of the results in spite of the large sample size was borderline. The overall results were barely significant at 5 percent level, while the subsamples were not significant. So, if you asked the question whether women benefitted in a statistically significant manner, the answer was no. Neither did the men. Neither did those over 65. Neither did those under 65. Fifth, her doctor told her that once on the statins, she would have to take them for the foreseeable future. Unfortunately, none of these studies went further than four or five years. She had no idea of the long-term side effects of taking statins based on these studies. Given all this, and based on her own risk assessment and her own health outlook, Sophia told her cardiologist that she was not going a take a statin every day. Her doctor told her this was fine, saying, “We have to agree to disagree on this”. Nevertheless, Sophia made an appointment to see her cardiologist again the following year to follow up on her heart health.

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There is a positive development to report after all this discussion on experts and conflicts. In the securities markets, there is greater awareness of these potential conflicts due to differences in incentives. In 2002, the SEC mandated new rules that govern potential conflicts of interest by analysts.346 One consequence of the new rules is that analysts who discuss their opinions on radio or television are required to disclose whether they or their firm have ownership interests in the company, and whether the company is a client of their firm. These disclosures can help the investors interpret better any potential conflicts of interests or potential biases in analysts’ opinions.

Public Policy Public policy is rife with asymmetric information, political convictions, and conflicts of interest. Public policy issues are just too big and too complex to fully comprehend or make confident inferences about, from a scientific perspective. Moreover, the personal benefit to us is relatively small compared to the costs of obtaining information (negative externality). This is true for most real-world issues, such as trade wars, Brexit, climate change, privacy issues, governmental monetary and fiscal policies, or government involvement in health policy issues. As we have said before, it is impossible to conduct randomized control trials in public policy domain either. First, science is often of little everyday use here. Even the simplest knowledge based on original, careful research evolves very slowly over decades. Even after 10 or 20 years, there may be no scientific consensus about a particular conclusion. Science is painstakingly slow. In contrast, TV programs cannot wait that long. They present pundits expressing their opinions on every topic, 24/7. Furthermore, various socalled ‘expert’ opinions are expressed on many sides of these complex issues, not based on scientific bases, but based on their own political convictions or financial interests (words are cheap). The true motivation for these opinions cannot be science-based, since scientific development is too slow for public policy debates. Consequently, it is hard to learn anything substantive from any of these discussions.

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See, https://www.sec.gov/news/speech/spch559.htm

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Take the Iraqi war as an example. Was this war in the best interest of US taxpayers? Certainly, even ignoring extremely important humanitarian issues, the financial stakes were huge, in the billions or trillions of dollars. These financial incentives could influence what people will say about this issue. The correct answer to the question depends on whether Saddam Hussein posed a danger for US national security or the national interest. The true answer to this question is costly and very time-consuming, and is one the public is at a huge disadvantage to comprehend. However, we can think of incentives. If the US government were to go to war, arms manufacturers can sell billions of dollars of weaponry and ammunition to the US government. Construction companies will need to provide logistical assistance. The combat soldiers will need to eat, live, sleep, move around, and communicate. Some companies will meet these needs of the soldiers, earning billions of dollars. These incentives will affect what the hired pundits will say about this issue. If the US government does not go to war, the main beneficiaries would be the US soldiers and their families, US taxpayers, and the Iraqi people (who do not have a say in this matter). However, these people do not appear on TV as often as the other side, if at all. Hence, the incentives mostly pile up on the side of the pro-war group and their hired mouthpieces. Given the asymmetry of incentives, it is unrealistic to expect objective, unbiased, scientific arguments regarding the costs and benefits of the war. We can give many more examples. What are the likely consequences of the trade dispute with China? What about Brexit? Are we too late to do anything about climate change? These are all exceedingly difficult questions with no simple answers. Take climate change as an example. Billions of dollars are also at stake here. There are big winners and losers from climate change, or from increased climate control. Once again, it will take decades for science to establish clear-cut cause-and-effect relations. With so much at stake on both sides, it is reasonable to expect that there will be many objective articles and opinions expressed on this debate. Is there an actual change in climate? If so, is this dangerous? Financial incentives are huge here. If public opinion can be altered slightly against the dangers of climate change such that more people remain

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confused or undecided, it can make the difference of billions of dollars in profits to utilities, automobile manufacturers, oil producers, and coal mines. If public opinion can be altered slightly toward the dangers of climate change, it can make the difference of billions of dollars in profits to solar energy, wind energy, nuclear energy, and electric vehicle manufacturers. Doubts can be created at any point. Is climate change man-made, or is it a naturally occurring phenomenon? How costly is it to switch to sustainable sources? Or are the future climate change dangers over-exaggerated? Even when science points strongly in one direction, it is not that easy to tell for many people. Some sort of securities-type conflict disclosures would also be useful here. Sometimes it is easy to assess the incentives of an organization or individual. An article funded by a global energy company may support particular policy views on climate change or pollution. Yet despite obvious biases and clear incentives, corporations continue to fund research on environmental issues.347 Apparently, large companies find such research beneficial. Suppose that some research funded by BP and Exxon-Mobile finds that climate change is mostly man-made, and that hydrocarbons are responsible for the greenhouse effect.348 Is this research more credible than some university-funded research? Possibly, but not necessarily. Clearly, this conclusion seems to go against the best interests of BP and Exxon-Mobile. We still need to dig deeper. We need to keep in mind that public corporations are for-profit companies, with responsibilities for their shareholders. Before we jump with joy, we should probably read the article very carefully. It is possible that the article may point to the man-made hydrocarbons as the culprit, but the proposed potential solutions to the climate-change problem may still benefit current energy producers. For instance, the research article may conclude that the best solution to climate change is to cap-and-trade pollution rights and

347

See for instance, https://blog.ucsusa.org/elliott-negin/exxonmobil-still-fundingclimate-science-denier-groups 348 https://energyfactor.exxonmobil.com/perspectives/better-approach-climatechange/

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allocate a lot of the pollution rights to the existing oil producers.349 Of course, we should not be surprised by such a recommendation, given the funding source.

Professionals Similar to complex public policy issues, we need to be careful when dealing with professional experts in our everyday lives. Yes, highly educated and accomplished professional experts can in many situations, provide us with views that are subsequently determined to be incorrect. The incentives facing the lawyers, doctors, scientists, therapists, politicians, and other professionals are not necessarily the same as the ones we face. Furthermore, the objective value provided by these experts is difficult to evaluate, even after the fact. There are so many confounding factors that it is just about impossible to even second-guess these experts’ recommendations. Finance implores us to ask about asymmetric information, strong prior convictions, potential conflicts and incentives. What do the experts know? Can we observe their actions? Do they have conflicts of interest that make their advice biased? An important question we need to consider is whether the person is actually an expert in a particular subject. Someone may be a good heart surgeon, but this does not make him or her an expert on the brain. Someone may be a good actor and play a doctor on TV, but this does not mean we should rely on him for medical advice. Another important question is whether the incentives of the expert are aligned with our own interests. Suppose that we have hired a lawyer to help us with a legal matter. How can be confident that the lawyer is serving our best interest? Most people understand that some lawyers are usually paid by the hour. Under this fee structure, your lawyer will be paid, irrespective of whether you obtain a favorable outcome. The payoff structure facing these lawyers is similar to Figure 8.8. They have no skin in our game in the short term.

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https://issues.org/swift/

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Other lawyers may be paid only if you win the case. They can face payoff structures that are a mix of Figures 8.1 and 8.2. There is a big upside to them if they win the case, but they will absorb some costs if they lose. Suppose we have retained a lawyer on an hourly basis. Under this arrangement, a lawyer may not have an incentive to resolve the matter quickly (although the most thoughtful lawyers will take on matters where they believe they can obtain a favorable outcome for the client). On the other hand, a lawyer does have a long-term incentive to resolve a matter quickly and efficiently. Doing so will enable them to acquire a favorable reputation that will attract more clients over the long term. Nevertheless, finance tells us to pay attention to the hours to be spent on the case, and be ready to counteract. There may be times when a quick settlement is in both the interest of the lawyer and the client. There may be times when additional negotiation will be beneficial to us. It depends on the circumstances of a matter, as well as the lawyer’s judgment.

Medical care Medicine involves life and death issues. The stakes are high – the quality of our lives, and life itself, as well as the risks. Lives can be destroyed as a result of bad advice or inadvertent mistakes. In assessing your medical care – and that of your family – it is important to be informed. Information is hard to come by, and risks are large and sometimes unknown. Only you can make the decision regarding how much risk you are comfortable with. Consider an example that actually occurred to my friend, Leo. He was jogging outdoors and was bitten by a stray dog. He went to the emergency room and was first seen by doctor who was a medical resident in emergency room medicine. Following the examination, the resident observed that one treatment option was a series of rabies shots, although the resident described the treatment as a matter of clinical judgment as opposed to a necessity. The resident said he would discuss the treatment plan further with the senior emergency room physician in charge. After 30 minutes or so of waiting, a nurse hurriedly approached Leo and said, “There you are. I have been looking for you for 15 minutes”. She grabbed him by the arm and was about to administer an injection of medication. Leo hadn’t heard her use his name, so he stopped the nurse and asked,

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“Wait, what is the name of the person you are supposed to give the shot to?” The nurse replied, “Aren’t you Sebastian Albertson?” Realizing he was not, the nurse ran away with a shocked look on her face. Leo had narrowly avoided being the subject of a potential medical malpractice. In another actual case that happened to Leo, he visited his dentist and was told that he needed two new fillings. This was surprising since Leo had rarely needed fillings in the past (strong priors). After having one filling done, he regretted his decision and left. Later he asked the first dentist to send his dental x-rays to a new dentist and asked the second dentist which teeth actually needed fillings based on the x-rays. He was told that all the teeth looked good and that none needed fillings. Medical professionals, while well trained and careful, can make mistakes. They may not be fully informed on your particular disease, or they may have a clinical preference. They may even have conflicts. They may be motivated by reasons other than your health, whether avoidance of malpractice, cost, risk to their license, or not wanting to take career risks. Doctors may sometimes practice ‘defensive medicine’ and order tests that may not be necessary. When the stakes are high, our first task is to understand our health care professional better. Are there complaints against your doctor? Has your doctor been sued for malpractice?350 Does your doctor get significant monetary benefits from pharmaceutical companies or device manufacturers? All this can be learned quickly from public sources these days.351 This information will give you a better idea about your healthcare professionals. While most doctors put the health of their patients first and foremost, holding all else constant, we would also expect doctors to follow their employer’s guidelines. They can be terminated if they do otherwise. Similarly, doctors have to follow the instructions of their organizations. Your physician will be typically instructed to refer you to a doctor who is in the ‘network’ of your insurance plan, without necessarily considering the success rate of that network specialist. When these two objectives conflict, the primary care doctor will typically follow the institution’s rules. If the 350

See, https://administratorsinmedicine.org/AIM/Public/About_DocFinder.aspx You can find out about payments from https://projects.propublica.org/docdollars/ 351

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institution requires a referral from a primary care doctor for diagnostic test or a consultation with a specialist, then you will need to follow this process, even if you or the primary care physician disagree with it. Employers can also affect doctor’s incentives. Suppose that your primary care physician (PCP) works for a Health Maintenance Organization (HMO). In HMOs, your primary care physician must co-ordinate all your healthcare needs in line with HMO policies, and must refer you to HMO in-network specialists if the need arises. It does not matter whether the in-network specialist is the most knowledgeable in treating your issue. Suppose that you have joined an HMO. You have chosen a PCP. Then, you develop a severe headache, and you see your PCP. You want to be referred to a neurologist, but your PCP says that the referral is not required. He wants to wait and see if the condition will improve on its own. Is this medical advice in your best interest? It is hard to tell. It may or may not be. Suppose now that you learn that your HMO gives a year-end bonus to those PCPs with the lowest specialist referral rates.352 Now, you might suspect that there is a potential conflict of interest built into the HMO’s rules. You may want to get a second opinion in this case. Again, we are not suggesting that most physicians that work for HMOs will recommend less than absolutely appropriate care. No matter how well intentioned your doctor is, HMO rules may sometimes create a conflict of interest between you and your doctor. Suppose your PCP recommends a treatment, but the Medical Director of the HMO denies coverage. Furthermore, the Medical Director’s compensation depends on the HMO’s profitability.353 We need, therefore, to be aware of these potential conflicts of interest and be ready to counteract them. Similarly, many doctors and hospitals have received financial benefits from pharmaceutical and medical device companies. These payments amount to billions of dollars a year. From August 2013 to December 2016, payments by pharmaceutical and medical device companies to doctors and hospitals have exceeded $9 billion, paid to more than 900,000 doctors.354 352

See the movie Sicko for many of these types of real-world examples: https://vimeo.com/76646445 353 See, https://vimeo.com/76646445 354 https://projects.propublica.org/docdollars/

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This raises a question: Does this huge amount of money affect how medicine is practiced? To get a better idea of the potential conflicts that payments create, take a look at Figure 10.1 which shows the average payments received by US doctors. The average payment to all doctors is about $3,500, while the average payment to cardiology specialists is about $5,000. The median payment (not shown here) is negligible. This means that a minority of doctors are receiving large amounts, over $50,000 a year, which is substantial. Whether these large payments affect the medical advice given by these doctors is unknown. Figure 10.1: Payments to US doctors (lower line) and US cardiology specialists (higher line)355

The recent opioid epidemic is a particularly difficult example of the negative effects of incentives in medicine. This is certainly a complex situation that we do not want to oversimplify, but we can discern some useful insights if we carefully examine the relationships between the drug 355

See, https://openpaymentsdata.cms.gov/

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manufacturers and prescribers.356 It is clear that an important factor in the opioid epidemic was that the drug makers provided payments to some doctors to overprescribe opioid painkillers. After opioids were publicly blamed for the overdose epidemic, the manufacturers cut back on payments to the doctors. In 2016, opioid drug makers paid $15 million to doctors for speaking, consulting, and travel expenses. This was down from $23 million in 2015.357 Oklahoma is one of 37 states that sued Purdue Pharma and Johnson and Johnson, claiming that these companies promoted widespread opioid abuse. Recently, Purdue Pharma agreed to pay $270 million to resolve claims by the Oklahoma attorney general.358 Purdue Pharma still faces more than 1,600 opioid lawsuits, and has recently filed for bankruptcy.359 Its future is uncertain.360 Johnson and Johnson was ordered to pay $572 million in the Oklahoma case.361 In this situation, the different participants have different payoffs and motivations. The patients have a payoff structure that largely resembles in Figure 8.1 (outcome representing health), while some doctors, manufacturers, and distributers of opioids benefitted, no matter what the health outcome 356

See, for instance, https://www.nytimes.com/2019/01/07/health/baselga-sloankettering-astrazeneca.html?action=click&module=Latest&pgtype=Homepage. Also see: https://openpaymentsdata.cms.gov/. This page contains listing of payments from drug and medical device companies to medical doctors and teaching hospitals. You can also search payments received by individual physicians. 357 https://www.propublica.org/article/opioid-makers-blamed-for-overdoseepidemic-cut-back-on-marketing-payments-to-doctors 358 https://www.wsj.com/articles/purdue-reaches-270-million-settlement-withoklahoma-in-opioid-crisis-case-11553606534?mod=djemalertNEWS 359 https://www.statnews.com/2019/09/16/if-purdue-pharma-declaresbankruptcy-what-would-it-mean-for-lawsuits-against-the-opioid-manufacturer/ and https://www.reuters.com/article/us-purdue-pharma-investigations-opioids/us-states-seek-2-2-trillion-from-oxycontin-maker-purdue-pharma-filingsidUSKCN25D2EG 360 https://www.wsj.com/articles/purdue-reaches-270-million-settlement-withoklahoma-in-opioid-crisis-case-11553606534?mod=djemalertNEWS and https://www.wsj.com/articles/purdue-pharma-in-talks-to-resolve-opioid-casesthrough-bankruptcy-11566945535 361 See, https://www.cnn.com/2019/08/26/health/oklahoma-opioid-trial-verdictbn/index.html

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of the patients taking the medication. For the drug company, their payoff depended on the amount of medicine prescribed, without regard to whether the medication provided the intended health benefits, or whether the opioids led to serious addiction, even death from overdoses. The drug companies made money, obviously, if more patients took their drugs. Suppose that some doctors set up their own labs and clinics, and refer their patients there. This situation can give rise to conflicts of interest. According to a survey in the State of Florida, 45 percent of doctors have set up such joint ventures. These doctors may have an incentive to act in a manner that may not be in the patient’s best interest.362 How can you protect yourself against such practice? This is a difficult challenge. One possible approach is to obtain a second opinion. Consider another situation, which actually occurred to my colleague, NR. He had one of his teeth damaged because of so-called ‘deep-cleaning’. A subsequent periodontist recommended that the damaged tooth be extracted. He said it was not possible to save it. Not eager to lose his tooth, NR got a second opinion, and he was able to save the tooth with root canal treatment instead. It is essential that we are all willing to do our own due diligence. Collecting our own data, however, can be a challenge in technical fields such a science and medicine. Consider the situation of Doris Levering. Her husband Mark required liver surgery. It was supposed to be a standard, minimally invasive, procedure lasting two hours. The hours went by, but the surgery was still underway. Finally, after many hours, the surgeon came out, saying that there had been complications. Mark had extensive bleeding and lost three quarts of blood. He was finally taken to the intensive care unit. Later, Doris found out that a surgical device (a stapler) misfired, putting Mark into a coma. He required 22 minutes of CPR and emerged from the coma unable to walk or recognize his family members.363 Was this a case of malpractice or device malfunction? Doris did not know, but decided to do her own due diligence. She asked her primary care doctor, who then looked at the failure rate of this particular stapler in a 362

See, https://www.nytimes.com/1991/08/11/weekinreview/headliners-whendoctors-own-their-own-labs.html 363 See, https://www.miamiherald.com/news/health-care/article227210164.html

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registry maintained by the Food and Drug Agency (FDA). There were hardly any reports of past failures. The doctor she consulted concluded that that the problem was probably with the surgeon. Unfortunately, despite her best efforts, she has found it difficult to discern the factors that led to the poor outcome. It subsequently became known that the problem was not with the doctor, but with the device. In fact, the FDA’s record keeping was not accurate. Unfortunately, at the request of the device maker, the FDA did not disclose most of the malfunctions. Apparently, FDA was giving reporting exemptions to many medical device manufacturers, which kept the high failure rate out of the public domain. Consequently, over a fifteen-year period, more than one million device malfunctions occurred and were concealed from the public, residing in a separate database that was accessible only to the FDA.364 To get access this database, Doris needed to file a specific Freedom-of-Information Act (FOIA) request, instead. There is an important theme here. Costly information and informational asymmetries can prevent us from obtaining the best care we need, even when we do our best to obtain our own information. The key to receiving medical care that is the best for you, is to make your own informed choices about different approaches, and the potentials risks and benefits of each approach. Unfortunately, the medical profession can make this a challenge. If you have stable angina, for example, your symptoms may be reduced with Percutaneous Coronary Intervention (PCI), but this may not prevent future myocardial infarctions. According to one study, when patients were told about the lack of prognostic benefit of PCIs, the number electing to have the procedure decreased from 69.4 to 45.7 percent.365 Thus, even asking a simple question – namely, does the procedure I am about to undergo reduce or prevent future heart attacks – can result in significantly different therapy. What about psychotherapists? Again, most therapists focus on what they believe to be in the best interest of their patients. However, their model of practice is to be paid by the session, and therefore they want to have a 364 365

See, https://www.miamiherald.com/news/health-care/article227210164.html See, https://www.ncbi.nlm.nih.gov/pubmed/25156687

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busy practice. They do not get paid a fixed amount for treating their patient’s problems (which, of course, is a common model in medicine). Notwithstanding this potential for conflict, many therapists and patients have long term clinical relationships that help patients cope with behavioral health issues. Again, however, you need to be aware of the potential conflicts, and make careful decisions. How do we deal with informational asymmetries? The finance approach argues that we learn about incentives and payoff structures. This is costly and challenging. The best thing is to obtain our own data. Depending on what is at stake, this can still be worthwhile. One final note of caution. As we obtain our own data, we need to be careful in understanding what risk is, and interpreting the available evidence appropriately. Suppose that you are told contraceptive pills increase the risk of potentially life-threatening blood clots by 100 percent. What should you do? Should you stop taking the contraceptive pill based on this information alone? The answer is not necessarily. This statistic above tells us about relative risks, not absolute risks. Before you can make an informed decision, you should also learn about absolute risks, as well as the relative and absolute risks of side effects. Suppose now you learned that the risk of thrombosis increased from one in 7,000 to two in 7,000.366 How do we feel about the 100 percent increase in the risk of contraceptives now? The absolute risk is still small, even with a 100 percent relative increase. On the other hand, suppose the absolute risks were to increase from one in 100 to two in 100. Now this is more serious increase. Again, armed with this absolute risk information, you can make an informed decision.

Short-cuts versus data collection Unfortunately, instead of seeking our own data, most of us rely on shortcuts, rules of thumb, and simple filters. Becoming fully and perfectly informed is costly, time consuming, and not practical for most people. As Daniel Kahneman points out in his excellent book Thinking, Fast and Slow,367 we resort to our intuition. Kahneman writes: “A general ’law of 366 367

https://journals.sagepub.com/doi/10.1111/j.1539-6053.2008.00033.x See Kahneman, D., 2011, Thinking, Fast and Slow, Farrar, Straus and Giroux.

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least effort‘ applies to cognitive as well as physical exertion. The law asserts that if there are several ways of achieving the same goal, people will eventually gravitate to the least demanding course of action. In the economy of action, effort is a cost, and the acquisition of skill is driven by the balance of benefits and costs. Laziness is built deep into our nature”. Thus, instead of obtaining data, we often rely on our intuition. This, in turn, is typically based on our experiences and upbringing. If we do not have the relevant experience to rely upon, we also ask our family and friends for guidance. If we want to gather any information about medical matters, we often prefer bigger, older, and more reputable academic hospitals. We ask to see which medical school the doctors have graduated from. We ask our friends about their experiences at a particular hospital. These inquiries may be useful, but are of limited value. However, as we learned earlier, there is no substitute for gathering our own first-hand information, learning, and evaluating on our own regarding the payoffs facing the hospital or doctors. For the most part, however, people take what is readily available and do not ask any questions or gather any information. Many of us use simple approaches, typically based on our emotions, feelings, and prejudices. We give less emphasis to logic.368 Some people deal only with people from their own ethnic or socio-economic backgrounds. Others trust only those people from their own religion, or socialize only with people who are of the same race. Although these approaches may seem overly simple, we often use them. Judy was a college student at an elite Midwestern university, and she spent a summer in Austria while going to a German language school. Judy was of fair complexion, with blond hair and blue eyes. She was staying with an Austrian host family. Later in the summer she invited her boyfriend, Ahmet, a classmate, to come and stay with the host family, before they toured the country together (of course with the full approval of the host family). When Ahmet arrived at the host family’s door one late night in 368

See Kahneman, D., 2011, Thinking, Fast and Slow, Farrar, Straus and Giroux. Kahneman received the 2002 Nobel Prize in economics along with Vernon L. Smith. In Kahneman’s terminology, our first reaction to most situations is knee-jerk fast thinking based on intuition.

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Vienna, however, there was an unexpected reaction. The host mom looked at Ahmet (with his dark hair and darker skin tone) and slammed the front door in his face (without asking any questions) insisting that he would not be staying in their house (even though they had approved him earlier, face unseen). Apparently, the host family used simple and unfortunate shortcuts. A blond American female is trustworthy, while a male with dark hair and Mediterranean skin tone is suspicious, and a blond female should only associate with someone of similar ethnic background. Ahmet ended up in Vienna, at night, and needed to make other accommodation arrangements. What else do people do to solve the information asymmetry problem? Is there anything we can do to deal with these information costs, other than painstakingly collecting information about past experiences and payoff structures? Again, most of us use shortcuts. When we deal with people, we trust members of our particular church, synagogue, country club, golf club, or college where we graduated. The idea here is that these people are more trustworthy because they are more like us, and hopefully less likely to cheat us. Another approach, though again of limited value, is that we trust people who are introduced to us by our family and friends. We think that if our friends trust them, they must be trustworthy for us as well. Again, these are simple shortcuts that are likely to be of limited benefit. Clearly, these filters are overly simplistic solutions to complex problems, and they are not effective in most situations. Furthermore, the scammers understand the filters we use and they might simply pretend to graduate from our school, belong to our country club, or be a member of our own church.369 Scammers will befriend our friends and relatives first.370 They will use our own filters to gain our confidence. Using short-cuts blindly is dangerous. Insurance is another industry that is rife with asymmetric information. Suppose you evaluated five insurance companies and chose the one with

369 In the movie Catch Me if You Can by Steven Spielberg, the main character was based on the life of Frank Abagnale, who was able to con millions of dollars before his 19th birthday by posing as a pilot for Pan American World Airways. All he did to put his con into practice was to obtain a fake pilot ID and put on an airline pilot’s uniform. 370 Bernie Madoff’s scam was propagated mostly through the friends and family members of those who had already been conned by him.

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the lowest premiums for a given benefit. Is this a good choice? The answer is not obvious. It is not easy to judge if we are dealing with a reputable insurance company. Similarly, an insurance company is not sure if they are dealing with an honest client. Under an insurance policy, we keep paying premiums, and only years later, we make a claim. What if, after years of paying premiums, the insurance company refuses to cover a major illness we suffer? What if our house is totally flooded after a major hurricane and the insurance company claims we are not covered for this particular flood? What if the insurance company does not pay a death benefit? These are typical questions that we may confront. In addressing them, we are often at an informational disadvantage. Suppose that we buy homeowners’ insurance. It is not easy to tell whether we have made a made a good purchase based only on the premiums. If the premium is low, is that because the insurance company carefully chooses its policyholders and therefore experiences fewer losses, or is it because the insurance company contests most claims to reduce costs? If the former, then a low premium is a good sign; if the latter, it is a bad sign. However, the cost of the policy alone does not indicate one way or another. Similarly, if the premiums are high, is it because the insurance company is honorable and pays out on a majority of claims, or is it because they have done a poor job of pricing their risk and insures people in the higher-risk categories for the same premiums? Again, it is hard to tell based on the premium alone. Suppose we bought life insurance. We paid premiums for fifty years, but when we die and we are no longer around (to yell at the insurance company), the insurance company refuses to pay a death benefit to our family. This is hard to monitor. What can we do about this? What do we do in these types of real-world situations, where informational asymmetries are of paramount importance? A time-honored method is to deal with well-known company names when we need to buy insurance or other expensive goods and services. One reason we choose brands instead of generic names is to reduce these informational asymmetries. While any product or service can be defective or faulty, we expect a well-known brand name will stand behind their product or service and make it good,

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or repair or replace it if defective, at zero cost. If they do not, they simply have a lot more to lose in reputational capital than a no-name brand. Using a similar approach, we choose well-known brand names in education, airlines, restaurants, hotels, and banks. We conclude that the well-known names must have lower informational asymmetries.371 Businesses understand that we struggle with these informational asymmetries. They want to nudge us into believing that we have solved this problem. To help us along, banks may announce that they have been around since 1800s. They house their offices in stone buildings with large, stately columns. Why do they do this? The banks want us to associate the physical strength of the building with the financial strength of the bank’s balance sheet. They know that a bank in a stone building, with thick shiny marble columns seems more reliable and trustworthy. We face informational asymmetries everywhere: at work, in our personal lives, and within our families. How do we screen our potential good friends? How do we know what our kids do after school? The answer is we do not, and we cannot find out. We cannot spend significant amounts of time trying to overcome every informational asymmetry. When a decision is important, we need to select our priorities carefully and obtain our own data. This is another reason why companies advertise: We pay attention to their advertising. Sometimes, we confuse the messages of advertising with real information. Thus, we trust advertised brands better.372 Again, we are

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Some of the author’s friends made this mistake while traveling across New Zealand in a van. By choosing a local van rental company instead of a large (and slightly more expensive), international company, his friends were much less likely to have any legal or reputational protection when they returned the van. The international company has much more to lose from a reputational hit via a negative Yelp or Twitter post. In addition to this, the local company, knowing that the author’s friends aren’t likely to return to the country to sue them, can simply tell them to buzz off with little consequence. As expected, they ended up paying for a preexisting dent in their van. 372 See, https://adage.com/article/digital/5-key-takeaways-2019-edelman-brandtrust-survey/2178646

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using short cuts. Unfortunately, if everyone uses a short cut, then no one collects information or monitors these firms. We need to be careful here. Another way we try to reduce informational asymmetries is to ask for references from former teachers, employers, and business associates. What is the information content of these letters? What should we attempt to learn from recommendation letters or comfort letters? What incentives do the letter writers have to be honest and truthful? The letters do offer some useful, though limited, information. Typically, they will be more informative for what they do not say, rather than what they do say. We explore this issue later in another chapter. We can also demand or provide written, explicit, legally-enforceable, guarantees. When we borrow money to buy a house, we sign legallyenforceable contractual agreements relating to our obligations. One of these requirements is that the bank retains the title to the house. If we do not make timely payments, the bank has the right to foreclose on the house and sell it to satisfy the loan requirements. This is called a lien. Yet for credit card debt, there is no collateral. What do banks do to manage these risks? How can we manage these risks? These attempts also simply aim to reduce these informational asymmetries. We address these issues next. We would expect that the borrowers have better information than the lenders about their borrowing needs. How does this affect personal borrowing decisions? Suppose you have an idea for a new product or service, and go a bank to borrow money to start this business. This presents the bank with a number of problems to solve, since you know a lot more about your circumstances than the bank does. First, the bank needs to determine whether you are an honest person who intends to pay back the loan, or a crook out to steal the bank’s money. Next, if the business fails, the bank needs to consider whether they will be repaid. Then, the bank has to determine whether your idea will generate enough cash flow to make the promised principal and interest payments. The bank then needs to determine what conditions the legal contracts need to specify. This includes setting the interest rate sufficiently high to offset the likely defaults, and the costs of providing and administering the loan and ensuring that the loan is a profitable one for

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the bank. The legal contract needs to be written and signed in front of witnesses, and usually notarized. Finally, if the answers to all these questions are favorable, the bank needs to assess whether this is a good time to lend and/or whether the bank is interested in lending to a business such as yours at all. Even if everything is favorable, the bank may refuse the loan because it has a sufficient exposure to this type of business already, and it does not want to increase its exposure any further. The bank is not obliged to make a loan. If the bank finds that any one of these conditions fails, it can stop the process immediately. For instance, if the bank suspects that the loan applicant is not likely to be honest in his or her dealings with the bank, it can stop the process immediately and deny the loan request. If the borrower were to act dishonestly in the future, it does not matter what the promised interest rate is. It does not matter what the cash flow from the business is. A dishonest borrower does not intend to pay, and he/she will not be deterred by a high interest rate. The bank cannot trade of a bit of dishonesty against a higher promised payment. How does the bank know who is likely to be honest? In a world with costly information, it can never be sure, but it can generate its own data. It can start by examining the past. If someone has been dishonest in the past, there is a higher chance they will continue to be dishonest in the future. Any evidence of dishonesty in the past is sufficient to stop the process. The bank can review the credit score of the applicant. If the credit score is not sufficiently high, the bank will stop the process there. Suppose you have bought an apartment for investment purposes and you want to rent it out. What problems do you face, and what uncertainty or asymmetric information issues do you need to resolve? What data do you need to generate? This set of problems facing you is very similar to the one the bank needs to solve. The potential tenant knows a lot more about his/her individual situation than you do. To successfully complete the transaction, you need to become informed about the same set of issues and follow similar procedures as the bank. First, you need to determine whether the potential tenant is an honest person or a crook. How do you do this? Once again, you can also review the credit history and credit score of the tenant, and refuse to rent to those

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below a minimum cutoff score. These are probably somewhat nosy, but still unbiased and useful, indicators of integrity and honesty. Obviously, you will get a ‘sob story’ to accompany any low credit score, but you need to be resolute and refuse to rent your apartment to people with low credit scores, regardless of what story they tell you. You can also attempt to get an idea about honesty by asking for reference letters from current and previous property owners. What issues do you face here? This is not going to be as reliable as a credit history or a credit score. Obviously, if the current property owners want your potential tenant out of their apartment immediately, they may omit some relevant negative details in their reference letter, to get you to accept them immediately. Similarly, if the previous property owners do not want to get into potential litigation issues, they may also omit disparaging details. You and the current property owner are conflicted. The incentives you face are opposite to those facing the current property owner. As an astute reader, you need to be aware of these potential biases when evaluating reference letters. Reference letters are not as reliable as credit scores or credit history. You can ask other family members to co-sign the rental agreement. However, for this step to have any benefit, co-signers need to be high creditworthy individuals themselves. Otherwise, substituting one bad credit rating for another is not going to help. Hence, co-signature requirements are also not as reliable as credit scores or credit history. How do you evaluate whether the tenant will maintain the apartment in good order, and whether they will be able to pay the rent? Here, you are looking for a steady source of income that is high enough. Typically, you would require that their monthly income is at least three times the monthly rent amount. You can also require that the person be employed by a sufficiently reliable employer. To ensure that the tenant will keep the apartment in sufficiently good order, you would ask for a large enough security deposit. The bottom line is, that the process you would follow is remarkably similar to the one a bank would follow to decide to whom to lend.

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Suppose now that your cousin comes to you and wants to borrow $10,000 for a great new idea. What data do you need to obtain? Will your cousin be good for the loan? What do you say? Once again, you would need to follow exactly the same process as in the bank example. Generate your own data. Ask all the questions and put everything in writing. What is the credit history of your cousin? What is the credit score? Does your cousin have a steady and reliable source of income? Is the agreement in writing? Is the agreement notarized? If you take any short cuts and omit any steps, you may find yourself both out of money and out of a relative. Suppose you are single and decide to get married, or you have recently been divorced and have begun to date. In this case, your payoff structure from dating is similar to Figure 8.1. If you can find a genuine match, you will benefit. A negative outcome will cost you. What data do you need to obtain to help you making a thoughtful decision? Not surprisingly, you are again facing a similar set of issues as the bank. Honesty is especially important. First, you are trying to determine if the person you are dealing with is honest. How do you screen good apples from bad apples? How can you tell if someone is only interested in you for financial or superficial reasons? How can you tell if someone will stick with you in good times and bad, in sickness and in health, for richer, for poorer, before we experience bad times, bad health, or poverty?373 What is the credit history of this person? What is the credit score? Has this person held a steady job? In terms of the finance approach, you are looking for a person who also has a payoff structure the same as yours, namely, the one shown in Figure 8.1. What if the person you meet has a payoff structure as in Figure 8.2? This is a fair-weather partner. He or she is not interested in suffering with you in bad times. This person will stick with you in good times, and will abandon you if you experience negative outcomes. One way to find out would be to

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A traditional American wedding vow says: “I take thee to be my wedded husband/wife, to have and to hold, from this day forward, for better, for worse, for richer, for poorer, in sickness and in health, to love and to cherish, till death do us part, according to God's holy ordinance; and thereto I pledge thee my faith [or] pledge myself to you".

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pretend that you have zero savings. If the person loses interest, then you have avoided a big problem later. What about someone with a payoff structure as in Figure 8.3, all upward trends for negative outcomes? This is someone who can benefit from your misfortune. This would be a kind of person who would take advantage of you. Finance teaches us to learn about the payoff structure facing your potential matches. This requires asking specific questions to uncover what is important to this person. Find out what this person’s value system is. If all they talk about is money, then you have your answer. In general, we do not know what other people want. We also need to accept that we will never become fully informed. Even after living with a person for years, it may still be impossible to understand their true motivations. Being fully informed is definitely not the same as being fully uninformed. Just because we will never become perfectly informed does not mean that we should not try to learn what we can. Donald Rumsfeld374 famously said about evidence: “Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. However, there are also unknown unknowns — the ones we do not know we do not know. And if one looks throughout the history of our country and other free countries, it is the latter category that tends to include the difficult ones”. Rumsfeld is making an interesting reference here. Regarding uncertainty, Nobel Prize winning economist Lars Hansen points out that sometimes we do not know what the future realization of an event will be, but we know the model and the distribution. At least, we usually know the historical empirical distribution. For example, we do not know when an individual person will die, but we know the average life span of a group with certain characteristics. These are also referred to as insurable risks. Sometimes,

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Rumsfeld, who recently passed, was the Defense Secretary under President Bush from 2001 to 2006 and under President Ford 1975-1977.

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we know neither the future realization nor the distribution. Finally, we do not even know how to model the event.375 In addition to risk, our own beliefs about risk also matter. To help illustrate these ideas in more detail, we constructed a table (Table 10.3) that shows a two-way classification between our beliefs and what we actually know. The rows show our beliefs. The columns show the reality. Each cell shows the consequences of the intersection between our beliefs and reality. Table 10.3: What we think we know and what we do know Our belief

We think we know

Reality We do know

We do NOT know

Rational/deliberate and appropriate action

Ignorance/ overconfidence/errors of commission

Rational/deliberate and We think we do not Ignorance/underconfidence appropriate mitigative know / errors of omission action First, there are things we think we know, and we do know them. This is what Rumsfeld calls known-knowns. If we think we know something and we are correct, this lays the groundwork to take deliberate appropriate action in line with our beliefs. Knowing something correctly is not sufficient, but is a necessary condition for deliberate action. We may still lack time, money, willpower, or other resources to take deliberate action, but at least we have the basic knowledge. Then there are things we think we know, but we are mistaken. If we think we know something, but in reality, we are mistaken, this is a type of ignorance that can get us into big trouble. We can take action based on erroneous beliefs. We call this an error of commission, or overconfidence.

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Larsen calls the first type risk, the second, uncertainty, and the third, ambiguity. See, https://qz.com/1417105/lars-hansen-a-nobel-winning-economist-has-tips-fordealing-with-uncertainty/

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Another possibility is we do not think we know something, but in reality, we do. Rumsfeld does not mention this possibility. We also call this ignorance. This may be something we once knew and have now forgotten. If we have forgotten what we knew once, in this scenario, we will underact. We will make errors of omission. We call these errors of under-confidence. Finally, there are things we think we do not know, and in reality, we do not know. These are what Rumsfeld calls unknown-unknowns. Rumsfeld says that this scenario has gotten us into the greatest difficulties throughout our history. Here we need to be more careful. As long as we realize that we cannot know everything, we will leave room for error for all sorts of unknowns. Consequently, in our everyday lives, we can take measures to limit our exposure to unknown unknowns (think tail risk). For instance, by maintaining our flexibility (the topic of the next chapter), we can deal with unknownunknowns to some extent. Hence, as long as we are rational and realize our ignorance, we should not get into big trouble here. We agree with Rumsfeld that unknown-unknowns is the most difficult to deal with. However, it is not likely to be the most prevalent category. It is one thing to be ignorant and another to be irrational. If we do not know something, we can still think of potential realizations and take appropriate action, such as complete risk avoidance or insurance.376 When we discuss asymmetric information, we assume that people may be ignorant but still rational. They may not know something, but they should know that they do not know. For us, the big problem occurs with overconfidence. This is the stuff people think they know, but are actually wrong about. Since they think they know, they are not likely to show restraint and end up with errors of commission. What all of these situations have in common are degrees of informational asymmetries. How can we reduce some of these informational asymmetries? Knowing that we do not know everything is a good place to 376

Rumsfeld claimed that Saddam Hussein of Iraq was hiding weapons of mass destruction, including chemical and biological weapons, and referred to unknownunknowns to rationalize the invasion of Iraq. Thus, according to Rumsfeld, even if one were to believe that Saddam Hussein harbored unknown-unknowns, his preemptive invasion of Iraq was one way to deal with such a situation.

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start. Next, we need to do our own due diligence. Hopefully, at this point in this chapter, we all agree with Immanuel Kant that there is absolutely no substitute for generating our own data.

CHAPTER 11 CREATING FLEXIBILITY IN OUR EVERYDAY LIVES

“I am a man of fixed and unbending principles, the first of which is to be flexible at all times.” —Senator Everett McKinley Dirksen

What is flexibility? Flexibility is the freedom to choose our actions. Flexibility means that you are not fully dependent on a single outcome, or the decisions of one person or a few persons. Anything that creates choices increases our flexibility. Anything that reduces choices results in a loss of flexibility. Almost anything and everything we do can affect our flexibility. A commonly offered suggestion for young people is that we should embrace one choice or one path. Be a pianist, filmmaker, surgeon, chef, or finance professor. We should be ‘all in’ or ‘make a concentrated bet’. Yet, upon reflection, this approach may not result in the best outcome. The field of finance offers some insights about this issue. Having flexibility means you can choose to do something or not do something, in each case in accordance with your wishes. The opposite of having flexibility is being required to take a course of action. Many times, governments make choices for us. A government official may, for example, tell us where to live, what to do for a living, or what school we attend. This typically does not happen in the US, but it does in many countries. For instance, in many European countries – including Germany, Austria, and Switzerland – elementary school kids after the 4th grade are separated according to ‘academic ability’ and are required to attend one of three kinds of schools: Hauptschule, Realschule, or Gymnasium.

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Consequently, it becomes difficult to change course of one’s life-path after the age of ten.377 You would be disappointed if you wanted to attend Gymnasium but were not chosen to do so because your parents did not attend college. Choosing your own path is very important. Some consider it as important as life itself.378 Flexibility gives you the right and the option, but not the obligation, to pursue something. With this flexibility, you can choose what you think is your best course of action. This will make you better off. If someone else chooses for you, they may choose an action that is best for them. This course of action may not be the best course of action for you, but for the chooser. In fact, if the opposing party chooses, that will represent the worst outcome for you. So, do you want to choose actions that affect your life such as who you marry, where you work, where you live and where you go to school? In this chapter, we will discuss the issue of choice.

Creating Flexibility Typically, flexibility does not exist in a vacuum. You can either create flexibility or purchase flexibility from another party. Another approach is to maintain your flexibility by not undertaking obligations. Creating flexibility can involve up-front costs. To decide whether it is a good idea to create, purchase, and maintain, flexibility, we need to compare the value of flexibility to the cost. During the course of our lives, we make many important decisions without knowing the outcome. In most cases, we also do not control the outcome. How do we deal with it? One approach is to estimate the likelihood of future courses of outcomes and take what we believe are acceptable risks. A second approach is to buy insurance against risk. The third approach is to maintain our flexibility.

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Susanne Wiborg, argues that the root cause of the Germanic elitist system is due to weak social democracy: https://pdfs.semanticscholar.org/14fb/47d25af9d27c 0e52fa6fa57bb6389b0d4033.pdf 378 “Give me liberty or give me death” - Patrick Henry.

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Consider some examples. You want to meet a friend for dinner. What is the difference between saying “I’ll meet you there at 6:00” and “I can be there sometime between 6:00 and 6:30?” Obviously, the second response has added flexibility. You are giving yourself some minimum level of flexibility at zero cost. You are also giving your friend the same flexibility. Why make a commitment for a precise time if flexibility is available, literally, at no cost? The benefit of adding flexibility is not obvious at the time you agree to meet with your friend. The benefit may, or may not, be realized until later. Suppose that you intended to arrive on time, exactly at 6:00, for your dinner meeting, but you encountered heavy traffic and you can barely make it by 6:30. If you had promised to meet your friend exactly at 6:00, your friend could be upset while waiting for you. If you had promised a range of times between 6:00 and 6:30, you are still on time. Thus, in this case, our own initial promise created both expectations and some obligations. Notice this flexibility benefits both of you. If you friend arrives exactly at 6.00, she can bring something to read, knowing that you will be at the restaurant any time between 6:00 and 6:30. If you arrive early, you will not be upset while you wait for your friend. You were aware of this possibility from the beginning. This type of relationship occurs frequently in our workplace. Flexibility is the difference between committing to do something outright, versus committing to do something if certain conditions are met. Suppose your supervisor demands an outright commitment with the request: “I want the report on my desk at 9am”. You can reply in two ways; “Yes, sure, no problem”, or “Yes, I can deliver the report sometime in the morning, assuming that I can get hold of the underlying data on a timely basis”. The difference, again, is flexibility. Suppose you anticipate that not everything is under your own control, but instead certain events need to happen for you to be able finish your assignment. You can build contingencies and create flexibility without cost. For instance, in response to a request from your boss, you can say, “I’ll do my best, but this is a big job, I need to get hold of this particular data, and it could take two to three days to finish and audit properly”.

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You should make commitments carefully and thoughtfully. Depending on how future events unfold, these commitments can be costly to you. You need to weigh up the benefits of commitment, if there are any, against their costs. The first response to your supervisor makes an outright commitment, while the second and third responses provide you with flexibility. The next question is whether retaining flexibility has some cost. In other words, does making a commitment provide you with a benefit at the outset? If there is no cost to retaining flexibility, or there is no benefit from making a commitment, then the advisable action is to retain flexibility. Always try to maintain flexibility, even if you cannot see the benefit. In these examples, what would be the costs of commitment, or the benefits of retaining flexibility? Again, these two costs and benefits may be the same, without either of them taking on any particular value. Suppose that you finished the report by 9am. If you had a commitment to finish at 9am, you are just meeting your commitment. No better, no worse. You will actually look better if you specified that you would probably finish it before the day’s end but you still delivered it by 9am. As the expression goes, you ‘under-promised and over-delivered’. This is much better than overpromising and under-delivering. Alternatively, depending on how the future unfolds, there can be a significant difference between these two promises. Suppose that you did everything you could with the assignment, but you could not obtain a key piece of information. Without this key data, you work all night, but you do not complete your assignment by 9am. When you try to explain to your supervisor why the assignment is not complete, you may sound as though you are making excuses for your failure to meet a deadline. The difference between the first response and the others may be a night of work followed by an unproductive workday, versus a good night’s sleep, followed by a day of productive work. If these commitments, followed by a failure to deliver on a set time, turn into a pattern, then the first set of responses will create an impression of an unreliable employee who is always apologizing for his shortcomings, while the second or third set of responses will create an impression of a dependable employee who is

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always productive and who always delivers on his promises. Which impression would you rather build?

Break it up Another technique to create flexibility is to break up a big task into smaller tasks, observe your progress, and proceed on a similar course if you receive a favorable response. Suppose you are planning to travel to another city. You expect to stay there for a week, but you are not certain.379 It may take longer, or it may take less time, to finish your task. Faced with this uncertainty, you can make a hotel reservation for only two days, wait to see how things develop, and then make a separate reservation if necessary. By breaking up your big trip into multiple segments, you are building flexibility. If you finish your task in only two days, there is nothing to cancel. You are free to go with no obligations. Suppose that you want to continue your education. You should approach it in small steps. Instead of registering for an entire year or an entire semester, you can just register for a single class. Try it out. If you do well and find it beneficial, you can register for additional courses. Breaking it up allows you to assess your progress. If you do not find it beneficial, you only lose the tuition fee for a single class instead of a whole semester or a whole year. By breaking it up, you limit your obligations if things do not work out. This kind of flexibility can be valuable. Buying a house or buying a car can create long-term obligations. Renting a house or leasing a car creates smaller, shorter-term, obligations. If you enjoy living in the neighborhood you can always buy a house later. If you do not like it, it is much easier to leave a rented apartment than to sell a house. Buying a vacation house380 creates obligations. You now have to stay in the same place year after year. A short-term solution – such as staying in a hotel or renting a house – gives you flexibility. If the nearby beach is polluted five years later, you can vacation elsewhere the following year. 379

Suppose that you are, say, a professional tennis player flying to a new city for a tournament. If you lose in the early rounds (as you usually do), you will fly home immediately afterwards. But if you catch fire and make it to the finals, you will need to stay for the whole week. 380 Or worse, a timeshare.

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Similarly, getting married creates many long-term obligations. You can reduce the likelihood of a bad match by taking additional time to learn about your potential spouse and your respective long-term interests and goals for each other.

Create a savings cushion Another important way to build flexibility is to build an emergency savings fund that is easily and readily accessible. Depending on the uncertainty in our lives, this emergency fund should cover anywhere from six months to twelve months of living expenses. This is especially important if we have high levels of uncertainty in our lives. These emergency funds can be invested in risk-free securities with shortterm maturities, such as Treasury Bills. Another option is a savings account at a bank. The amount of the emergency fund should also be sufficient to cover life’s unexpected turns of events, such as an illness, a government shutdown, a broken appliance, auto repair, job layoff, or an unexpected hospital bill. With your emergency fund in place, you can have ‘peace of mind’ and attend to your professional and personal needs. If you lose your job, the emergency fund will act as a cushion while you search for another one. If your car breaks down, you can get it fixed or buy another one. If durable household items fail, you can use your emergency fund to replace them. Without an emergency fund, you may be forced to borrow, using expensive sources of credit.

Building Redundancies Building redundancies is another way to create flexibility. For example, we all have keys for our house, car, and office. Sometimes, we go to the expense of making spare keys and keeping them in a safe and convenient location. Sometimes we do not. Once we have the spares (redundancy), we have a backup we can rely on, no matter where, why, or when. We can continue with our lives. Suppose you have to travel to Chicago in January. Since there is a convenient train ride between Ann Arbor and Chicago, you park your car

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in Ann Arbor, travel on the train, and return that evening. As soon as you arrive back in Ann Arbor, you discover that you do not have your keys. You do not have either the car key or the house key. It is close to midnight and a rain-snow-sleet combination is coming down heavily. What do you do now? You realize this situation is going to be expensive. First, you need accommodation for the night. You make some phone calls, and you are able to make a last-minute reservation for a hotel (expensive). Your feel fortunate that there is not a home football game, when hotels in Ann Arbor are booked months in advance. You take a cab to a hotel, hire a locksmith to get into your house the next day, then get a spare key made for the house. You also need your car. Next, you have your car towed to the dealer and then get a spare car key made. Meanwhile, you take cabs between home and the office until everything is sorted out. This is a serious commitment of time, expense, and inconvenience. This is all avoided with a spare set of keys. Suppose you kept the spare set in your wallet or under a rock by your front porch. Losing your original set of keys simply means you open your wallet or turn over a rock and use the spare. That is it. To see if we should create spare keys, we compare the cost of having spares made with the potential benefit of avoiding all the obligations associated with losing our keys. If the probability of losing the original set is sufficiently high, or the obligations are sufficiently costly, we would opt for having a spare set made. This gives us the flexibility and helps us avoid the inconvenience and expense. Our lives are full of opportunities to create additional flexibility, with important up-front costs and consequences. Think of these situations as spare keys. Some of these keys open cars; others open careers, relationships, and new opportunities. There are many choices ahead.

What is an Obligation? Finance teaches us that the opposite of flexibility is obligation. If we do not have the flexibility of spare keys, we are obligated to get a hotel room, hire a locksmith, have the car towed, obtain a spare key for the car from the

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dealer, and pay for cab rides. Thus, flexibility and obligation are related concepts. Understanding flexibility helps us understand the obligations. How do you place a dollar value on flexibility? We can incorporate concepts from the trading and pricing of financial instruments called options. There are two types of financial options – calls and puts. These are fundamentally important concepts in finance. A call option is the right to buy something (the underlying asset) at a fixed price (the exercise or strike price) during a specified length of time (the life of the option). There are also two parties to each call transaction, the buyer and the seller. The buyer of the option has the right to buy something (the underlying asset) at a fixed price (the exercise or strike price) during a fixed length of time (the life of the option). The seller of the call option has the obligation to sell something (the underlying asset) at a fixed price (the exercise or strike price) during a fixed length of time (life of the option). The parties agree that the buyer will pay the seller an amount (called the option premium) in order to enter into the transaction. Now consider the sale of an option. Suppose you gave your neighbor the right to buy 1,000 General Motors (GM) shares from you at $40 a share, which is also the current stock price for GM, anytime over the next ten years. To obtain this right, your neighbor paid you a fee at the outset of $1,000. You have the obligation to fulfill this contract, which means you have an obligation to sell 1,000 GM shares at $40 a share at any time over the next ten years. How much better or worse off are you as a result of this transaction? One possible answer may be that you have earned $1,000. If your neighbor wants to exercise her right and buy GM shares from you today, you can buy the GM shares yourself at $40 (current market price) in the stock market and then satisfy your obligation to sell GM shares to your friend exactly at $40. You get $40 from your neighbor and you pay $40 in the marketplace, thereby keeping the $1,000 initial payment. Is this the correct answer? No. Remember that you are obligated to sell GM at $40 not just today, but anytime over the next ten years. How does this change the answer? The change is significant. Using finance concepts, we can compute this amount. Under reasonable assumptions, finance teaches us that the answer is approximately $18 per

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share, or $18,000.381 Hence, making this promise today will cost you $18,000. Since you did get paid $1,000 up-front, you are behind a net of $17,000. This is more than 42 percent of the value of the entire GM shares today. You are giving up almost half of the value of the underlying asset (GM shares) with this promised obligation. Why does the answer change so much when you go from, say, one day to ten years? The reason is that your neighbor will behave strategically. First, the stock price can move much more over the next ten years than in one day. Second, if the stock price falls below $40 over the next ten years, then your neighbor will simply ignore the option, and once again, you will realize a zero cash outflow. You neighbor has the right, but not the obligation. Consequently, she will not be interested in paying $40 a share when she can buy more cheaply in the market. She will just disregard her option. If instead, the GM stock price rises to say $100 after ten years, your neighbor will now turn to you and say you have to sell GM shares to her for $40 a share. Now you have to buy each share at $100 in the market and sell it to your neighbor at $40. Now you lose $60. These numbers begin to suggest why this transaction has substantial value. Over the next ten years, there are many possible stock price paths for GM shares. Some of them end up costing you zero (when GM is trading below $40). Others will cost you significant amounts (when GM is trading above $40). The average value today of all these possible paths for the option is estimated to be the $18 per share we calculated. This is the value determined by the Black-Scholes options pricing model. Now, some of you may think that you could just avoid this cost altogether by simply buying 1,000 GM shares today for $40 a share. This way, if and when the price goes to $100 a share, you can just give her the 1,000 shares already owned, thereby avoiding the necessity of having to buy the shares at $100 a share. You also pocket the $1,000 received up front. Is this correct?

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The right to buy something at a fixed price is called a call option. In this example, you have given your friend a call option. We can use Black-Scholes option pricing model with annual volatility of 35 percent, 1 percent dividend rate and 3 percent risk-free interest rate to compute the value of the call option that we have given away. This is where the $18 estimate comes from. See Hull.

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Unfortunately, this is still not correct. While this scenario avoids the obligation to pay $100 a share for GM later on, it can still end up costing you plenty. The problem is now on the downside. What would happen if after you purchase the shares, GM falls to $5 a share? Now your neighbor will simply walk away and you will be stuck with GM worth $5 a share. Thus, there is no escaping your obligation without costs. Now ask a related question. What exactly is the value today of the flexibility that you provided to your neighbor (or the obligation you entered into)? We know the answer without performing any calculations. It is also worth exactly $18 (minus the $1 per share she paid you). This is because flexibility and obligation are defined by the famous expression, ‘two sides of the same coin’. They have equal value. When you lose, your neighbor gains the exact same amount. If you lose $100, your neighbor gains $100. If you lose zero, your neighbor gains zero. On average, since you lose $17 on the day of promise, your neighbor gains exactly $17. This discussion gives us another important insight about rights and obligations. Before we make a commitment, we need to estimate the market value today. Consequently, if we do not get an upfront benefit equal to, or greater than, this value, then we should refuse to make the commitment. Similarly, when we are thinking about creating flexibility, we need to consider both the costs and benefits. In the spare keys example, the costs are minimal. The benefits are much larger. This is, therefore, an easy decision for most people. There are multiple lessons from this discussion. One key theme is that the promise you make results in a loss of flexibility and exposes you to potential future liability. Every time you make a promise, you are essentially agreeing to an obligation. Another important theme is that the exact size of the liability is not known on the promise date. It may end up being zero, or as high as $100,000, or even higher. If the price declines subsequently, you will end up losing nothing. If the price rises, you will lose. Nevertheless, we can estimate the value of this net liability to be about $17,000, on average, for the GM example.

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A related theme is the nature of the loss. This loss ($17,000) is not a cash outflow on the day you made the promise. In fact, that is when you received $1,000. Nevertheless, this loss is just as real. In the future, you could be forced to pay an amount which is equivalent to $17,000 net loss today. A final theme is that the economic loss does not happen when you actually make a payment to settle your obligation. The economic loss actually happens on the promise date. You need to think about the loss of flexibility when you make the promise (or enter into an obligation) and be sure to estimate the cost associated with your promise. After the promise (a commitment) is made, it is usually too late to do anything about it. Step back from these calculations and consider what they mean. Today, you entered into (or gave away) an obligation that seems to be minor. Yet, because your obligation is long-term, your commitment can seriously reduce your wealth. Thus, a finance perspective helps us properly focus on the right costs. The cost to you today is not zero, but actually $18,000, or almost half of the entire investment itself. This is offset by the $1,000 you receive at the outset of the transaction, yet still leaving you with a net loss of $17,000. To enter into such an obligation today, you must insist on getting a value equal to, or greater than, the obligation today, or more than $18,000. If you do not, then you should refuse to enter into such an obligation. Next, consider the implications of other kinds of flexibility and obligations. Now change the example. Suppose that our obligation only lasted one day. What is the cost to us now? Again, using the Black-Scholes model, we can compute the value of the option as only $0.29 per share, or a total of $290, or less than 1 percent of the value of the underlying asset. Hence, there is a strong relation between the length of our obligation and the cost of the obligation.

Public versus private investments The ideas we have been discussing are applicable to many aspects of work and life. In the previous chapter, for instance, we discussed investments in public and private companies. We advocated that unless we have the time and expertise to monitor private investments, we should only make investments in publicly owned companies. A key difference between public

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and private investment is flexibility. Public investing is flexible. Private investing is much less so. The equity shares of publicly held corporations generally trade on public exchanges. The daily trading volume is huge, relative to what an individual investor may want to buy and sell, usually resulting in liquidity to anyone interested in buying and selling. The transactions costs are minimal. If the corporation does not do well, or you change your mind for whatever reason, you can usually sell your shares quickly (and exit your investment). You decide to sell, and then either instruct your broker or execute trades online yourself. You receive your money in a few days. The transactions cost is small. You do not need the approval of anyone else. You do not need to wait.382 In contrast, when you make an investment in a privately held firm, your deal usually involves a formal agreement between you and the seller. For example, suppose you start a restaurant with a friend. You will usually enter into a written partnership agreement that will specify the rights and obligations of each of you. Suppose that you want to exit the partnership. In this case, you do not have the same flexibility to exit your investment as you would with an investment in a publicly held company. You need to value the restaurant, and you need to get your partner to purchase your interest. In this case, your flexibility is constrained. Typically, you do not have a right to exit your private investment at your request. The agreement you have signed determines how, if, and when, you get your investment back. Typically, the only way to exit your private investment is to have your partner buy back your share of the investment. You now need the approval and participation of your business partner to sell your interest. If your partner does not agree, you cannot take action. Under what conditions will you want to exit the restaurant business? The most likely answer is when the restaurant is losing money. If the restaurant is profitable, you usually want to maintain your investment.

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In finance we can represent the liquidity provided by public investments as a put option, which is the right to sell something. We will study put options more formally later in this chapter.

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Suppose that the restaurant is losing $10,000 a year. Because of other commitments – such as mortgage payments and kids’ school expenses – you cannot afford to keep reinvesting $10,000 every year. This is something that you never expected. Besides, you worry that this amount could rise in the future. You are running out of cash to keep putting back into the money-pit restaurant. You want to exit your investment. On the other hand, your partner has deeper pockets. He views the restaurant as a good long-term investment. He is therefore willing to keep investing for the long-term. He is aware, moreover, that, you want to exit the investment. This is the cost of losing your flexibility, even if your investment would have been valuable in the long run. Losing your flexibility can mean losing most, if not all, the value in your investment. In Chapter 3, we discussed how to make value-increasing investment decisions. We learned that a good investment is one with a higher rate of return on investment (ROI) than we can earn on our best alternative. However, this is only part of the story. Before you evaluate any investment as appropriate or not, you should also consider your need for flexibility. The restaurant business may at first seem to be a good investment based on its potential to produce positive returns relative to other alternatives. However, you also need to think about the cost of losing flexibility. This conclusion is not the same for your business partner. For him, this is an opportunity, since he always expected the business to lose money early on and build up over five years. For him, the current losses can even represent good news, if you are losing less money than the initial projections. Hence, the same business can have different values to different investors, depending on their expectations and flexibility. It may be an appropriate investment for your partner and not for you. Your business partner will think you are making a mistake and not taking advantage of a valuable business opportunity, but your interests have diverged, and he should find another more suitable partner. Flexibility can be immensely valuable. The loss of flexibility can be immensely costly. Often, we do not think about flexibility or options in a systematic way. Its value or its cost is not obvious until we experience something unusual (we lose our keys, or we need to put in $10,000 into a

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restaurant to keep it going). Most people underappreciate or completely ignore flexibility. The restaurant example is also relevant to other private investments. Consider an investment in a hedge fund, a privately offered investment that involves more risk than investing in a public company. The terms of the hedge fund investment agreement requires you to maintain your investment in the fund for seven years. You are ‘locked in’ and subject to what is known as a ‘lock up agreement’. If the fund is a fraudulent operation, you may lose some or all of your investment. Next, we explore flexibility in our social networks.

Flexibility and our Human Capital In Chapters 4 and 5, we argued that our biggest asset is our human capital, which refers to the education, knowledge, experience, know-how, connections, and skills, we acquire in order to provide for our livelihood and financial security. It also includes our colleagues, business associates, and the network of people we know. What is flexibility in this context? How does flexibility work? How does flexibility affect our human capital? What can we do to maintain our flexibility and increase the value of our human capital? As a young person, we usually do not think about the long-term implications of decisions we make aged eighteen. What young person thinks into the future for ten, twenty, or thirty years ahead? However, if we limit or lose our flexibility at this early stage, we may experience longterm adverse consequences. We can extend these ideas to bad habits. Many unhealthy habits are acquired at a young age. Young people often think that their bodies are indestructible and not affected by smoking, coronavirus, excess alcohol consumption, and drug abuse. Confronted by the coronavirus pandemic, many young people still chose to go to parties, cafes, bars, and beaches. In building and managing our careers, we need to separate emotion from rational decisions. Emotions are acceptable for decisions involving small sums, but your career is one of the most important decisions in your life.

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You need to live with the consequences of career decisions for decades, and you need to do your utmost to maintain and protect your flexibility. Yet people make emotional decisions regarding their careers. People resign if they become angry with their boss.383 They become emotional. They drink alcohol in excess at company parties. They reject or accept assignments based on emotional reasons. They decide to look for a new job if they are passed over for a promotion. We can decide which brand of coffee to buy based on our emotions, but not whether to resign a job. We should not make career decisions based on emotional considerations. We need to be calm and rational. A useful practice is to assess a new job situation for at least three months. During this time, you should gather all the relevant information and become informed about all costs and benefits of the career change. If you still think you are making the right decision three months later, you increase the probability that this is a logical decision, and not an emotional one. Flexibility also means that you do not have to react to every potential opportunity. You can be selective. While some opportunities may increase flexibility as well as provide extra dollars, for the most part, extra dollars come at the expense of flexibility. You need to weigh up these additional considerations. The same issues are relevant even in mid-life. Although a job that offers more money may seem attractive, it may be less so when you consider the significant overtime that will be required during evenings and weekends, which is the time you want to spend with your family. This can limit your flexibility. Alternatively, if this opportunity can possibly create options in new and highly attractive career paths, you may want to consider it seriously, even though it does not seem very attractive right now. Whenever possible, you should seek to preserve or add to your flexibility. When we are young, we tend to focus on the immediate present. Sometimes, however, youthful indulgence can have long-term consequences.

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https://www.monster.com/career-advice/article/keep-your-cool-heatedresignation

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Suppose you have been arrested for taking illegal drugs in the park with a friend. Unfortunately for you both, you live in a conservative state with harsh penalties for minor offenses like this one. You are handcuffed and booked, charged with multiple felony counts, and your family hires a lawyer to negotiate with the District Attorney, who offers you a deal to plead guilty to a single charge with no prison time.384 What do you do? While the possibility of one charge instead of multiple charges may sound appealing, finance tells us that you probably need to resist this offer and try to fight, even if it may be expensive to do so. Consider the life-long consequences. A single criminal arrest can harm a promising career.385 Whether you are convicted on a single felony charge or five charges, you will have a criminal record. Most employers will ask about a criminal record when you apply for a job.386 In fact, criminal record searches are used by over 90 percent of employers who conduct pre-hiring screenings. Like the banks and lenders, employers do not want to incur risk with an applicant with a criminal record when they can easily hire another applicant without one. The result of this is that they often will not even consider someone who has a criminal record, even though they could be turning down a good person who has made one bad mistake at one point in their life.387 Consider another example. Suppose you receive an early morning knock on your door from a local detective. He tells you that during the previous night there was a break-in at the nearby corner store. He asks if you would be willing to accompany him to the police station to talk about what you saw last night. You are clearly innocent, so should you try and be helpful and answer a few questions? Finance teaches us that liability occurs, not when a bad outcome is realized, but when flexibility is lost. Here, even though it is likely that you will not be accused and detained, there is a small possibility you might. Our 384

See, https://www.nolo.com/legal-encyclopedia/the-basics-plea-bargain.html See, https://www.wsj.com/articles/as-arrest-records-rise-americans-findconsequences-can-last-a-lifetime-1408415402 386 See, https://www.shrm.org/resourcesandtools/hr-topics/talent-acquisition/ pages/ban-the-box-criminal-history-job-applications.aspx 387 See, https://www.nytimes.com/2016/07/10/magazine/how-a-2-roadside-drugtest-sends-innocent-people-to-jail.html?_r=0 385

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situation becomes a liability as soon as we sit down to interview, since we can be detained on the spot. We cannot help our cause by volunteering to answer questions on our own. The best course of action is to thank the detective, but say you are busy and cannot join them. If you hear from them again, you will likely need a lawyer. There is nothing you can say or do that would help your case, it has only downside and no upside. Even if 95 percent of what you say helps your case, the police can build a criminal case around the 5 percent that does not help you. Consider the implications for your human capital. The human capital perspective teaches us to examine our actions and decisions based on the outcomes over a lifetime. Everything you do affects your human capital.

Social Networks One way to build flexibility in our personal and professional lives is by investing in a social network. We all have social networks comprised of family, friends, and business associates. These are meaningful relationships with people who we would call, or get together with, to discuss a problem, obtain information, or seek advice. These are people who we can trust and who will provide honest and useful information. These are the people whose life experiences will be beneficial to us. How do social networks work? They create options (and some costs or obligations) that can be highly valuable throughout our lives. Where do these options come from? These options are created from the advice, guidance, and information we receive from our social network. The obligation or cost is the reciprocity they expect from us. As strange as it sounds, we need to further define the word ‘friend’ in year 2021. What exactly is a friend? It is a concept that gives rise to confusion. Here, we are not talking about most of our ‘social media friends’. We are talking about real, meaningful, face-to-face friends, and business associates. Trust is a key element of friendship. If someone attempts to deceive, or use us, they are not a friend. If someone is only interested in getting information from us and does not reciprocate in-kind for whatever reason, they are not a friend.

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We continuously deal with people inside and outside our social network. Every day, we get many chances to help people, impress them, or ignore them. We may choose not to share information with them, and maybe even lie to them. In the process, we sometimes create good or negative impressions. We have a chance to grow our social network if we create favorable impressions. We can also reduce our social network if we ignore, insult, or lie to people we meet, either intentionally or inadvertently. Does this mean that we should never offend anyone? Not necessarily. From a strictly financial perspective, it is actually acceptable to offend people, as long as the expected benefits exceed the expected costs. In some professions, such as politics or corporate leadership, it is expected that you will strongly oppose certain points of view and ideas that you disagree with. In fact, in most cases, the stronger the opposition, the better. The idea is reflected in the common expression that ‘you cannot make an omelet without cracking eggs’. In this case, taking a strong position has a big benefit. People need to understand where you stand, what ideas you support, and what ideas you oppose, in order to vote for you or have confidence in you. In the process of promoting your own ideas and discrediting the ideas of others, you may offend some people. This is to be expected. What about discrediting or attacking people in your network? Unlike the previous examples, there are no obvious benefits to be had by discrediting or attacking people in your network, especially those who you have trusted in the past. If, for whatever reason, you do not trust them any longer, or someone has not reciprocated in kind when you needed them, you can drop them quietly from your network. There is no reason to insult them or publicly attack them. Unfortunately, too many people do gain from attacking others and promoting polarization. Living in harmony is not always an option. Wellknown examples are politicians, journalists, and television commentators. They think they can gain greater attention, recognition, and votes,388 by

388 In addition to politicians, many special interest groups may benefit from upheaval

and polarization. One simple example of this that gun sales go up after mass

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promoting discord among people with different religions, ethnicities, races, and socioeconomic status. For most of us, this is not what we want. Consider your job. Suppose you decide that you want to leave it. How do you seek help? Can your network create value for you? Do you ask members of your network to offer you a job? Do you promise ‘quid-proquos’ if you get a job offer from their firm? The answer is no. Insisting or demanding is not effective. So, can our networks be helpful to us? The answer is yes. What you can expect is not job offers, but leads, information, and guidance. So, you tell your friends, business associates, and past employers that you are conducting a job search, and you would appreciate any contacts, information, and leads. How could this pay off? Your initial request needs to make it clear that you are just looking for information, guidance, and leads. There is no pressure to follow up. You are not imposing on anyone. Intended this way, your request will not make anyone worse off. Everyone has an option, but not an obligation, to be helpful. This is what you want. You are inviting people to be helpful. You are not imposing any obligations on anyone. No one has to do anything to compromise their ethics or principles. You do not need to worry about any quid-pro-quos. If your business associates and past employers do come upon a particular opportunity that might pique your interest, they will have the option to inform you. Similarly, you have the option to investigate. There are no obligations. Everyone is better off. If an opportunity arises, you now have an increased set of choices, and your business associate has done you a favor. You are both better off. They might expect some quidpro-quo later, for which you should be happy to reciprocate with advice. Your request will also allow you to measure the value of your network. Many may never acknowledge your request. Some will acknowledge your request and reply that they will get back to you if they have something. Others will provide information, guidance, and leads, when they have them. This will allow you to judge the value of your network.

shootings. Thus, gun manufacturers benefit from upheaval, lack of trust and polarization following mass shootings. See, https://www.cnn.com/2019/08/05/investing/gun-stocks/index.html

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Understanding finance can be helpful in analyzing social networks. In fact, we can use an options approach to understand, analyze, and develop social networks. One important theme is that good things do not come free – we have to buy them and pay for them. Similarly, if we want to obtain an option, we have to pay for it. More generally, we have to pay for our social network. In sociology, this is known as reciprocity.389 As social creatures, we grow up within family units. Our immediate family keeps us alive and cared for, both physically and emotionally. We experience unconditional love and care. Eventually, as we grow up, we learn that reciprocity is expected from us once we become adults and are capable of being on our own, and our parents lose some capability. We learn and understand the importance of reciprocity. Without reciprocity, humans cannot function as a society. How do we build and enhance our social networks? We reciprocate with members of our network. We provide benefits to potential members of the network without an immediate expectation of an explicit repayment. The key to building a useful network is to provide benefits to your network members. This is especially important when they explicitly seek your help. Similarly, you may expect to receive benefits from your network members that you value very highly, which they can provide to you at a low cost to them. This gives each member incentives to keep up the network. If participants in the network do not benefit from it, it will not thrive. This is relevant to family members, friends, acquaintances, and business associates. When people become permanent burdens on their family and friends, they can impair the value of their networks. Similarly, as we stated earlier, networks work on trust. Furthermore, as finance has shown, there is no substitute for trust. If you lose your trust in someone, you cannot keep him or her in your network any longer.

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See for instance, https://www.ethz.ch/content/dam/ethz/special-interest/gess/chair-of-sociologydam/documents/datafiles/diekmann_jcr_2004.pdf

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Marriage A well-functioning marriage can be wonderful. It usually leads to significant increases in happiness and fulfillment for both partners. Marriage allows you to share your good fortune with a loved one. It provides physical and psychological support to family members. It provides the comfort of a wellkept home and constant companionship. Marriage provides financial and emotional security and a supportive environment to raise children. Whether we like it or not, marriage involves both economic and emotional relations with your partner. As a result, marriage can also involve the biggest costs you will ever encounter in your life. Consequently, you should approach a decision to get married carefully. You should assess whether you and your partner can form a lasting marriage. It takes a difficult and costly process to undo it. Marriage rates appear to be declining.390 Many millennials seem to be turned off at the thought of marriage. What is the downside of marriage? As we have said earlier, there is no free lunch. All good things must come with costs. One cost of marriage is loss of personal flexibility – that is, your right to make even some of the most basic decisions. As we stated, marriage entails rights on both parties in all aspects of their lives. A ‘right’ for one of the parties means an obligation for the other. There is no right without obligation. Obligation, in turn, means loss of flexibility.

What does this entail? First and foremost, marriage means commitment to a single person. This means the end of the bachelor(ette) lifestyle, the end of dating, and deciding unilaterally how you will spend your time. If this is not an outcome you can agree to, then you are not yet ready for marriage. Second, in most marriages, every planned activity or a change in plan must be communicated and negotiated in advance, or explained after the fact. Before marriage, you can do whatever, whenever, and wherever you like. As a single person, you can get up late, go to bed early, skip dinner if you 390

https://www.pewsocialtrends.org/essay/millennial-life-how-young-adulthoodtoday-compares-with-prior-generations/

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want to, or leave your bed unmade. You can decide to skip cooking dinner and watch a movie until 3am instead, and then go to bed. You do not have to inform anyone in advance or negotiate with anyone, regardless any kind of changes in your schedule. Nor do you have to explain or justify your actions after the fact. This is bachelorhood. As a married person, this type of flexibility disappears immediately. Usually, you need to let your spouse know in advance, where you are, how you are, what you plan to do, and inform and coordinate. By this, we do not mean you have to get permission from your spouse for your every move. We mean that your spouse has an interest in knowing the what, when, why, and where, of your daily life’s ebb and flow. In a loving relationship, this is only normal, as each spouse cares about the well-being of the other. If this bothers you, once again, you are probably not ready for marriage. Next, as a married person, your spouse will also have a stake in your current and future professions, where you work, what company you work for, and how much money you make. If you want to maintain a wellfunctioning marriage, you cannot simply quit your job because you are upset at your boss. In addition to your boss, you will also upset your spouse. You will need to discuss and negotiate a change of jobs, not only with your boss, but also with your spouse and other family members. Next, a marriage increases financial obligations. Increased financial obligation means a loss of some flexibility. If there is one income earner, that person now has to support two people, not just one. Further, with likely additions to the family, financial obligations are likely to increase. More of your time must be devoted to earning a living to support a family instead of supporting only one person. This means less time for leisure, hobbies, stargazing, or contemplating the meaning of life. It means less time for education and friends. In some marriages, both partners have jobs. In some of these dual-career families, the opposite can also happen. Marriage can increase some types of flexibility, while some other type of flexibility will be constrained. If both spouses work and either spouse makes sufficient amount of money to support the entire family all by themselves, flexibility will increase. This means that one spouse can quit his or her job and pursue additional education or training. It means one spouse can quit his or her job and start

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a business that involves more risk. Couples can alternate child-rearing responsibilities or home-keeping responsibilities. All of this confers additional flexibility. However, dual career families do not always experience an increase in flexibility. They can also experience a reduction in flexibility because of marriage. A dual-career family is another way to describe a family with two wage earners. To determine the exact effect on flexibility, it is important to consider whether one spouse is needed to support the entire family, or whether both incomes are needed. If the latter, then having a dual-career family does not confer any more flexibility than having a single wage earner who supports the entire family. If both incomes are needed to maintain the family’s basic needs, and some extras, then flexibility will be reduced since both couples are fully committed to their jobs, leaving little time for homemaking or child-raising responsibilities. Dual-career partners can reduce flexibility in other ways. Suppose that you have a dual-career family where each partner has only a few possible employers in a given city. This situation commonly arises when both members of a couple are academics, and working for large research university, or they are both working for a large employer in a small town. Typically, there is only one suitable university or one organization where both couples can work. If one of the couple loses his or her job, it may be difficult for that person to find a suitable job in the same city as the working spouse. Consequently, the entire family may be forced to move to another city to allow both to work for another suitable employer. Being forced to move may also involve a reduction in compensation for one or both spouses. This situation means that there is considerably less flexibility, compared to another dual-career family where each couple has independent job prospects. The key theme here is that marriage will have a significant effect on your flexibility. It can decrease or increase flexibility. Consequently, you will need to think about the effect of marriage on flexibility as you contemplate the possibility of marriage. It is important to discuss and agree on these issues prior to getting married. Will your spouse have a career? Are you both going to work in the same

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industry, or in different industries? How much money will your spouse make? Will he or she be able to support the entire family, or is this going to be a more traditional marriage, where one spouse is the breadwinner and the other stays at home? What are the time commitments of the job? Does it require regular hours in the same location, or unpredictable hours and unpredictable travel? There are additional factors that can affect flexibility, including the amount of job security each spouse has. If both spouses have considerable job security, then joint flexibility is further increased. If one of the spouses can be dismissed at will, then a dual-career setup does not contribute much to flexibility. Another factor is the number of potential employers for each spouse in a given location. The greater the number of potential employers, the greater the flexibility. How do you deal with the loss of flexibility in marriage? You should discuss and negotiate all of these issues prior to getting married. You should agree over issues such as who works, who supports the family, how many children you would prefer. The answers will differ from person to person. The most important consideration is to compare your flexibility as a single person with the family’s flexibility as a married couple. How important is flexibility in your personal life as a bachelor or bachelorette at this time? If you do not have much flexibility currently, you will value your flexibility very highly, and the contemplated nuptial arrangement will decrease it, so this would be a serious cost. If the contemplated arrangement will increase it, then this would be a serious benefit. Suppose you are 20 years old. Is this a good time to get married? It may be, if you think your personal choices and preferences are highly stable, you can support a family and possibly children, and you are in a loving relationship. Alternatively, suppose you are 26 years old. You are still in school, and you are paying for your own tuition and living expenses. You do not know what career path to pursue. In this case, marrying someone in a similar situation is going to decrease your flexibility. In this case, you must consider marriage very carefully.

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Unfortunately, many marriages do not last forever. As you contemplate marriage, you should also contemplate the possibility that the marriage may dissolve. Close to half of the marriages today end up in divorce.391 What are some of the basic flexibility issues in divorce? Divorce leads to significant loss of flexibility in most aspects of everyone’s life. While most young couples do not want to think or plan on what do in case of divorce, doing so will save major headaches down the road. At the top of the list, couples will have to agree on parental rights if there are minor children. Whether they end up with joint custody or single custody with visitation rights is one issue that is typically decided by the family court after much acrimony, stress, and expense. In order to understand how your flexibility will change and to plan accordingly, consider the following. Upon divorce, family courts usually assign custody of the minor children to the mother.392 If this is not acceptable to the father, both partners need to discuss these issues and agree on terms in a prenuptial agreement. Otherwise, the father may be subject to the decision of the court. In the United States, divorce laws give significant weight to the mother when it comes to custody of the children.393 Couples also need to think about spousal support and child support payments. If both couples have been working and they are able to support themselves, then there may, or may not, be alimony or palimony. However, both partners are responsible for ‘equitable’ child support payments, regardless of any spousal support. However, a judge will still review these decisions for you, and this may depend on the law of the state where you live. Property is divided in a divorce. In many states, marital property is considered to be ‘joint’ property, and subject to an equitable division. What if this is not agreeable to you? One possible approach is to separate your assets. Any assets that are acquired prior to the marriage and that are 391

https://www.pewresearch.org/2010/06/04/at-long-last-divorce/

392 See, Helen Smith, Men on Strike: Why Men are Boycotting Marriage, Fatherhood,

and the American Dream – and Why it Matters 2013, Encounter Books. https://www.the-american-interest.com/2013/06/06/are-divorce-courts-unfairto-men/ 393

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kept strictly separate from marital assets may be considered outside the marital property. Nevertheless, a judge will decide this. It may be easy to divide some marital assets such as stocks and bonds. It is more difficult to divide assets such as a house, land, or fine art. Valuation of these assets can be a challenge, as is ownership in a public or private company since it also involves voting or control rights. Once again, asset splits will lead to much acrimony, stress, and legal expenses. If couples cannot easily come to an agreement, there is significant potential for discord. If possible, it is better to make a plan prior to the marriage. Once again, the key to understanding the value of flexibility is not when you have it, but when you lose it. Who thinks of divorce when they are getting married? Many may think that considering the terms of divorce shows a lack of commitment to the marriage. However, given current trends it is a very real possibility for any couple today, and you will need to think about what is likely to happen to your flexibility and make plans before it is lost. A possible approach to maintaining your flexibility in a marriage is to determine how assets will be maintained and separated. In this approach, each spouse maintains their separate financial identity. In addition to their separate identities, partners also develop a joint marital pool of assets. They then simply contribute to a common marital asset pool in proportion to their resources for the purpose of maintaining their family life. Any amount not contributed is their separate individual property. This is a simple solution that can solve many potential problems. The prenuptial agreement can simply codify the terms of such an agreement. There is still, however, an important caveat. It is important that the couple agree to this separation during their marriage. If one or both couples mix individual and marital assets during the marriage, this can affect the terms of the prenuptial agreement. In this case, their situation is the same as if there was no prenuptial agreement. This will send them back to the Court and the divorce lawyers to help settle their disagreements. Another important caveat relates to documentation. It is also important to maintain all of the documents to prove that their individual and marital assets were kept strictly separate during the marriage years. This may require document retention over the decades that the marriage lasts.

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Marriage is a life-changing decision that should be based on love and compatibility, but it truly does benefit from rational planning. In fact, by insisting on protections for your flexibility up front, you can eliminate potential candidates who may have turned out to be wrong matches for you. There are advantages to doing this at the outset, rather than after 25 years of marriage.

Workplace Our work lives and workplaces involve decisions about options and flexibility. We continuously create, destroy, or limit, these options. Suppose you are a new college graduate, and you receive an offer of a good job. The salary and benefits are above what you expect. You are excited to start. The company tells you that you have three weeks to respond to the offer. What do you do? Should you accept immediately to signal your excitement with the offer? Will the company think more highly of you if you accept immediately? The company has given you an option to accept. This option has a 3-week life.394 Accepting today means that you value this option as zero. There is an argument that you should continue to search and make a decision at the end of the three-week period. If you receive additional offers, you will be better off. If you do not, you are no worse off than accepting on day one. Furthermore, by continuing to talk to potential future employers, you gain a better picture of the employment market and get a chance to leave a good impression on other future potential employers. Continuing with your job search as usual helps you build up a network of professionals in your specialty. This simple example illustrates a basic lesson of options. You do not want to exercise your options under normal situations too early. It is much

394

Using financial tools, we can compute the value of this option. See the textbook by Hull, Introduction to Futures and Options Markets, Prentice Hall, 1997, for option valuation formulas.

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better to hold on to them and exercise them at the end of the life of the option. Consider another example. You are interviewing for a job. The employer likes you and says, “Gee, we really like you a lot. If we were to make you an offer, what is the probability that you would accept it right now? What do you say? Is the employer being nice? Supposed you said 50 percent. Will you get a job offer? How about 80 percent? How about 100 percent? This is a difficult question. Unless you give a number either very close to, or exactly equal to, 100 percent, you incur the risk that you will not receive an offer. This question saves the employer time and expense. If you give a very high number, you may receive an offer right away. So, if you are not interested in an offer but you say 100 percent anyway, you may receive an offer right away and be given a contract to sign. If you give a low number, you will not get an offer even if the employer liked you. Why would they give you an offer and immediately be rejected? Consider another scenario. Instead of asking about the probability, the employer says, “Gee, we really like you a lot and we would like you start working for us tomorrow. This is a great place to work. Here is a great offer but you need to tell us right now, before you leave this room, whether you accept or reject.” What do you say? Is this a good place to work? Many people would be flattered by an offer on the spot and they would be happy to accept it. How can we think systematically about such an offer? An offer that expires immediately is called an exploding offer. There is a good reason why it is called an exploding offer. It can actually injure you when it explodes. Finance can help us evaluate an exploding offer. First, with an exploding offer, the company is not giving you any flexibility at all. It is a ‘take-it-orleave-it’ offer. In fact, you may not even have the time to read or think about any of the documents you will be asked to sign. All you know is the salary amount.

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Second, both the probability question and the exploding offer preserve the company’s flexibility. They allow the company to go to the next person immediately if you either give a low probability number or turn down the offer. There is no negotiation. Third, the exploding offer is designed to end your flexibility and stop you from exploring your full opportunity set. The firm is not giving up any of its own flexibility. Worse yet, if the potential employer realizes that a competitor is likely to make you an offer as well, an exploding offer eliminates the competition entirely. Why would a company give anyone an exploding offer? If the employer senses that you are very risk-averse, an exploding-offer will discourage you from continuing with your job search. Many people think ‘a bird-in-thehand is worth two-in-the-bush’ and go for the exploding offer.395 The preferable way to respond to an exploding offer is not to be surprised. You need to formulate an intelligent and rational answer before you encounter it based on the specifics of your own situation. Consider additional principles of finance to assess the situation. First, as we stated before, the exploding offer is designed to eliminate your flexibility. It is designed to favor the employer. Second, the value of an exploding offer to you depends on how long you have to think about it. One that expires on the spot is especially challenging, since you do not even have the time to study the details of the offer. If you have 24 hours, or 48 hours, you can at least study the offer in more detail. You will not be able to pursue other jobs. As we discussed earlier, the value of an option depends on its length of time. There could be additional reasons why a company may make an exploding offer. Suppose you are risk-averse, and you verbally accept the exploding job offer. Now the company wants you to sign an arbitration agreement.396 What exactly is an arbitration agreement? This is when employees give up their right to sue the employer in court for job-related issues such as breach of contract, discrimination, or wrongful termination of employment. 395 We do agree with the sentiment of this saying, we just think you should not apply

it in this scenario. 396 https://www.nolo.com/legal-encyclopedia/signing-arbitration-agreement-withemployer-30005.html

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In effect, the employer is asking you to give up your future flexibility to assert your rights in court. You may think, “No big deal. Arbitration is similar to a court hearing. Either way, if there is a problem in the future, it will be resolved”. However, this is not the case. Arbitration is likely to result in less favorable outcomes for the employees, since it typically restricts discovery or the amount of information the employer would be required to disclose in case of a dispute in the future. Since your employer has most of the documents you will need, restriction of discovery will only hurt your interest. The employer can also restrict the people you can call as witnesses. They can do so by naming those people as their own witnesses, and then not calling them to the arbitration hearings. The employer can also have the right to appoint the arbitrator. Arbitration can exclude punitive damages. Arbitration can require the employee to pay for his or her expenses. Arbitration can restrict who can represent the employee. Another feature of arbitration is that whatever the arbitrator decides is final. You cannot appeal this decision to anyone. In arbitration, you are literally giving up all of your flexibility when it comes to labor disputes with your employer. Is there a way around this? It depends. The company will say that the agreement is standard and that everyone must sign it. In some cases, the employer may make the offer contingent on signing the arbitration agreement. In such cases, you may not be able to get around the arbitration agreement. If you accept a job offer on the spot, you are giving up your future rights. To make an informed decision, you need to read all of the documents carefully before you sign them. It is not in your interest to sign documents before you read and fully understand them. Even if you cannot change the arbitration agreement, you still have some options. If you are potentially a valuable employee, you can try to negotiate the terms of the arbitration agreement. You can ask for expanded discovery, your right to name your set of witnesses first, and your right to agree on an arbitrator. You can ask the company to pay for

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the costs of arbitration. You can retain your right to representation by an attorney. By negotiating these terms, you can try to ensure that you do not lose all of your flexibility. You will need to retain an attorney who has significant experience in labor law issues. Suppose the company wants you to sign a non-competition agreement, which stipulates that you cannot work for a competitor if you quit your job or get fired. This is another way you are being asked to give up your flexibility. The company says it is a standard non-competition agreement that everyone signs.397 Now life is getting more complicated. We can use the principles of finance to analyze this arrangement. A noncompetition agreement burdens you with an obligation and gives an option, or flexibility, to your employer. Your obligation is that you cannot work for a competitor. On the other hand, the company has the right to fire you with little consequence. Once again, suppose that your employer says that the non-competition agreement is standard, and everyone has to sign it. This may be the case, but at least you can read it and decide for yourself. You can try to negotiate the terms of the non-competition agreement. You can try to restrict the duration of the agreement, the precise definition of the so-called competitors, and the geographic coverage. Suppose again you accepted the exploding offer on the spot. There are handshakes (or elbow bumps post COVID-19) and congratulations all around. You are then shown into a room with a stack of documents that need to be filled out and signed. It takes you half an hour to go through all the documents. Finally, you sign all the forms, including the noncompetition and arbitration agreements. You are done. You cannot believe it. You start work in one week’s time. A week later, you are an employee, and you are drawing a salary. You like your job. Your colleagues are great. Your boss is wonderful. All is going well, and you are happy. Two months later, the year-end is approaching. Your boss comes in and tells you that you are needed to stay late each day

397

About 16 to 18 percent of US workers are covered by a non-competition agreement. See, https://www.hamiltonproject.org/blog/the_chilling_effect_of_ non_compete_agreements

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and come in over the weekends to deal with all the extra work. You have to stay till around 10pm every weekday and put in extra time on Saturdays and Sundays. There is no overtime pay. You tell your boss you would rather not work the extra hours since you had made alternative plans with your fiancé for the weekends before being hired. You want to get to know your fiancé better before you get married. This is important for you. This goes on a few more times, and you keep resisting. You just cannot work every day. This is not reasonable. Suddenly, you find out that you are being fired for insubordination. It is Christmas, and you now find yourself with no job. Circumstances have changed. This is when the lost value of flexibility will become obvious. When you have something, you do not think much of its value. When you lose it, you appreciate it better. First, you cannot sue in court for wrongful termination. This is because you signed the arbitration agreement. If you go to arbitration, moreover, the company will appoint an arbitrator who is a former employee who is also currently retained as a consultant. How do you feel about this? Will this arbitrator be unbiased toward your claims? Second, unfortunately, you will not have good job prospects since you have also signed the non-competition agreement.398 You cannot even apply for a job with other most likely employers because they are all on the list of competitors. This is a surprise to you, since you didn’t read the document carefully enough in the first place. How much trouble you are in depends on the kind of non-competition agreement you signed. It may cover the city that you live in, the state, or the entire country. It may cover all the likely employers. You may be forced to move across the country, maybe even out of the country. The more restrictive the non-competition agreement is, the worse position you are in. What went wrong here? Clearly, flexibility did not seem important at the time you agreed to the terms of your job. However, the value of flexibility becomes all too clear when the circumstances change.

398

This situation happened to one of our colleagues, unfortunately.

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To appreciate the value of flexibility, you need to think, not based on today’s circumstances, but based on a changed set of circumstances. Thus, the time to think about flexibility is when you have it. You should have thought twice about accepting such an offer on the spot, especially without carefully reading all the documents you signed. You can find yourself trapped into a corner when circumstances change. Hence, flexibility is much more important that it may first seem. Lack of flexibility can constrain a career. What would a more informed decision look like? What questions should you have asked but did not? The bottom line is that you did not think explicitly about flexibility before you gave it away for free. Consider another job-related example. Jane and James D., a married couple, are both licensed electricians. They each make upwards of $40 an hour. They live in a nice house in an upper-middle class neighborhood, along with their three children. Jane and James have big aspirations. While they both love their jobs, they have always dreamt about starting their own company. They want to be their own boss. They have saved tens of thousands of dollars and they feel financially secure. Finally, one day, they decide to start their business. They both quit their salaried jobs and start their company. What can finance say about Jane and James’ decision to start a new company? It is a mistake. The mistake is not that they started their own company. This may or may not be a good idea. We simply do not know the specifics at this point. The mistake, however, is the way they went about it. They both quit their jobs at the same time when they started the company. Thus, they destroyed all of their flexibility. They have an option, but not an obligation, to quit their salaried positions to start a new company. To retain the value of this option, they could have started the company by working in the evenings and weekends while both of them were fully employed and continued to receive their salary and benefits. If the new start-up business grew significantly over time, where they could not keep up with the work in the evenings or the weekend, one of them could have quit while the other one continued with the salaried position. If the business grew

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further, they could have hired part-time or even full-time help. Options can be valuable, and should not be destroyed without significant analysis of their value. Suppose after they both quit their jobs, one of them becomes ill. How will they pay for the unexpected medical bills? Again, the time to think about the value of flexibility is when you have it, not when you lose it. The workplace offers many other examples of flexibility. Is there anything wrong with romantic relations in the workplace between consenting adults? Normally, consenting adults means it is nobody else’s business. However, if they work in the same company, in general, this is different. Once again, we need to put our finance hat on. Romantic relationships with work colleagues should generally be avoided. They usually lead to unwanted and unexpected obligations and loss of flexibility that can far exceed any benefits of these relationships. Suppose you are engaged in a consenting romantic relationship with a coworker, and now you want to end it, while your romantic partner does not want to do so. How will your romantic partner feel if you want to end the relationship? Suppose your partner feels hurt and vengeful. Now, you are putting yourself in a position to be blackmailed. What prevents your partner from claiming that this was a coerced relationship? You can try to prove your innocence, but at what cost? The consequences involve not only interpersonal relations but also your livelihood at this company. You can easily lose this job and also make it very difficult to obtain employment from anyplace else. Suppose you have engaged in a consenting romantic relationship with a subordinate. If people at work find out about it, their respect for you and your subordinate will plummet. You may be accused of favoritism towards your romantic partner, and thus discrimination against your other subordinates. You have effectively ceased to function as a fair, objective supervisor. Suppose nobody finds out about your romantic relationship, but your romantic partner starts slacking off. What can you do? You will not be able to discipline that person. Now, you have, again, just lost all flexibility as a

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supervisor. If you try to discipline your partner, you are once again setting yourself up for possible blackmail. Even if you do not discipline your slacking subordinate, suppose he or she wanted a raise and a promotion. If you fail to reward him or her, you may, again, be setting yourself up for possible blackmail. Once again, you have effectively ceased to function as a fair, objective supervisor. Thus, the consequences of office romance involve not only interpersonal relations but also your livelihood at this company. Once again, you can easily end up losing your job under many different scenarios.399 A recent survey indicates that 99 percent of employers with anti-romance policies disallow romantic relationships between supervisors and staff members. More than half disallow relationships between co-workers who report to the same supervisor, and over 10 percent do not even allow employees in different departments to form relationships.400 A similar set of issues occur at a university. Suppose you are a faculty member, and you get involved in a romantic relationship with a student.401 What if the student fails the exam? Can you still give him/her a failing grade? What if the student brags that you are his/her boyfriend? What will the other students think? Can they complain that you are favoring this

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A short list of CEOs who ended up resigning or fired from their positions after a badly managed romantic office relationship include Boeing CEO Harry Stonecipher in March 2005; Starwood Hotels CEO Steven Heyer in April 2007; HP CEO Mark Hurd in August 2010; Stryker CEO Stephen MacMillan in February 2012; Highmark CEO Kenneth Melani in April 2012; Best Buy CEO Brian Dunn in April 2012; American Apparel CEO Dov Charney in June 2014; Priceline CEO Darren Huston in April 2016; and Intel CEO Brian Krzanich in June 2018. See, https://www.usatoday.com/story/money/2018/06/21/number-ceos-leaving-afterbad-behavior-grows/721025002/ 400 https://www.thebalancecareers.com/tips-about-dating-sex-and-romance-atwork-1916861 401 A short list of universities that prohibit or restrict romantic relations between professors and students include Yale, Northwestern, Massachusetts Institute of Technology, University of Pennsylvania, Columbia, Duke, Cornell, University of Wisconsin, and University of California, among many others. See, https://www.insidehighered.com/news/2018/05/24/academe-sees-new-wavefaculty-student-relationship-restrictions-era-me-too

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student because you are dating? You can see that nothing good will ever come out of this. Suppose that you trust the student, 100 percent, that he or she will keep the affair private. Fine. What happens, however, if your partner gets pregnant? Now, her pregnancy is public. If she is not in a position to support her baby all by herself, she will need your help. Once again, the affair will be exposed. There are many hidden, potential obligations associated with workplace romances. Initially, these costs may or may not be obvious. However, depending on what happens later in the circumstances, these obligations can suddenly appear, and they can endanger your entire livelihood. It is best to avoid these problematic relations at all costs. In short, flexibility is like youth, good looks, and good health. We do not appreciate their value until we lose them. This makes it all the more imperative that we explicitly think, not just about the costs and benefits of a given decision based on the available information today, but also about flexibility, as the circumstances can change over time.

CHAPTER 12 UNDERSTANDING FLEXIBILITY IN THE WORKPLACE

“Beggars can’t be choosers”. —Proverb

The Market for Flexibility In our everyday business settings, we encounter countless situations relating to flexibility. The key difference in business settings is that flexibility or optionality is often explicitly given a specific value. A product with options is offered alongside another without options. These choices make it easier to understand and evaluate optionality. Airline tickets and hotel room reservations, for example, come in two varieties, cancellable and non-cancellable. In some situations, these choices have different prices. In other situations, the right to cancel is included as part of the good or service. Suppose, for example, that a cancellable hotel stay for one week costs $1,000 while the non-cancellable reservation costs $800. Our reservation is exactly three months in the future. Using the language of options theory, we have a three-month option to cancel a reservation (or sell it back). The cost of this option (also called option premium) is $200, or the difference between $1,000 and $800. The question, then, is whether you are willing to pay an extra $200 to have the additional flexibility to cancel your hotel reservation with a full refund. Similarly, when we purchase a car, we are offered a service contract to have it repaired for a certain period, say three years. The cost of the protection is included in the initial purchase price, or could be sold as an additional service. This additional service protects against the cost of repairs under usual circumstances. It is a particular kind of option (a put option, as we will see later). If you decide to lease a car, repairs are often

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covered for the life of the lease, without a specific charge – this being an example of an option that is not assigned an explicit amount for the purchaser. The terminology of options may at first seem intimidating, given the variety of different structures. We will take it in steps. First, we will review the key aspects of call and put options. We will then explore how these concepts can be applied to a wide range of situations, including ones we may have not previously realized. Soon enough you will find yourself applying options to many different kinds of situations. In fact, you may even consider reading this book as an option. You are an option buyer and your option premium is the cost of the book and the time you spend to read it. You have the right to learn about one of the most powerful and consequential topics in the history of finance.

Informal analysis of call options A call option is the right to buy something (called the underlying asset) at a fixed price (called the strike price) during a fixed length of time (called life of the option). There are also two parties to each call transaction, the buyer of the call and the seller of the call. Options can be further classified by the dates when the buyers of options can exercise their rights. Under an American option, buyers can exercise their rights on any trading day during the life of the option. Under a European option, buyers can exercise their rights only at the maturity of the option. It is important to remember that the buyer of the call option has purchased a right from the seller. Similarly, the seller has sold a right to the buyer. The seller of the call is therefore obligated to make the sale if the buyer exercises his or her rights in accordance with the terms of the transaction. Specifically, the seller of the call option has the obligation to sell something (called the underlying asset) at a fixed price (called strike price) during a fixed length of time (called life of the option). To acquire this right, the buyer of the call pays the seller of the call an amount (called the premium). Alternatively, to undertake this obligation, the seller of the call receives a premium as compensation. Figure 8.2 describes the payoff structure of a call option holder (the buyer of the call). As the underlying asset increases in price, the right to buy it at a fixed price becomes more valuable. If the price of the underlying asset

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falls below the fixed price (the strike price), the buyer of the call has no incentive to exercise the option. It is cheaper to buy the underlying asset in the market. Hence, the call holder has all of the upside and none of the downside. To obtain this benefit, the call option holder pays a premium to the call seller. In contrast, Figure 8.5 describes the seller of the call option. The seller has none of the upside and all of the downside. To agree to absorb all of the downside and none of the upside, the call seller has received an upfront premium as compensation. Consider a numerical example. Suppose that the equity shares of Apple stock are trading at $100 a share (that is, the price at which a seller is willing sell the shares). Suppose, further, that the call option gives the holder the right, but not the obligation, to purchase each Apple share for $110 anytime over the next three months. The purchase price (premium) of the call is $1. Apple stock is the underlying asset. The current price of Apple stock is $100. The $110 represents the strike price, and the life of the call option is three months. We can use well-established principles from finance to analyze the value of call options. Although there are formal and specific mathematical models behind these principles, here we will rely primarily on intuition and qualitative thinking. For readers who want to explore these concepts in more detail in a technical manner, see a financial textbook.402 The central intuitive ideas regarding the value of call options are as follows: 1- The value of a call option increases with the value of the underlying asset. 2- The value of a call option decreases as the strike price increases. 3- The value of a call option increases with the volatility of the underlying asset price. 4- The value of a call option decreases as the underlying asset price generates greater income in the form of dividends or other distributions provided to the holder of the underlying asset. 5- The value of a call option increases with the life of the option.

402

John Hull, Introduction to Futures and Options Markets, Prentice Hall, 1997

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We can apply these key ideas to everyday real-life situations. In the timeshare or vacation home examples we discussed in Chapter 11, we have an option to wait, instead of making an immediate commitment to buy a timeshare or a vacation home. In this context, volatility is related to the probability of losing our employment to support the vacation home or time-share purchase. What would also represent volatility is the uncertainty regarding when, and for how long, we can take a vacation. This, in turn, depends on what kind of job we have, whether we can be asked to come in on the weekends, and whether there are problems that require our physical presence in the office. If so, we have high volatility with respect to our ability to use the asset. As the volatility of our vacation plans increase, the option to wait becomes more valuable. This would encourage us to wait further (or postpone our commitment plans) instead of immediately making a commitment to determine whether the uncertainty is likely to be resolved. If not, a vacation home or a time-share is, arguably, not an advisable choice. We can also apply the options framework to the healthcare examples we discussed earlier in Chapter 10. The life of the option is the time period where we can become informed without significant adverse effects on our health. The volatility refers to uncertainty regarding our health. The surgical procedure also affects the volatility of the outcomes. If the surgical procedure itself involves the potential for complications and possibly no effective benefit, then holding all else constant, it is beneficial for us to wait and gather more information. Suppose we learn that the surgical procedure is usually effective, with minimal complications. In the light of such information (and holding all else constant), we should undergo the surgical procedure without delay. The adverse effect of waiting is similar to the dividends on the stock. We previously observed that dividends reduce the value of the option. In this case, the greater the adverse health effects of waiting, the less valuable the option is, and the more quickly we exercise our option for surgery.

Understanding put options A put option is similar to a call option, except that it provides the holder with the right to sell instead of a right to buy. Hence, a put option is the

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right to sell something (called the underlying asset) at a fixed price (called strike price) during a fixed length of time (called the life of the option). There are also two parties to each put transactions, the buyer of the put and the seller of the put. The buyer of the put option has the right to require the seller of the put to purchase the underlying asset at a specific price. The seller of the put option has the obligation to buy the underlying asset at the strike price during the life of the option. To obtain this right, the buyer of the put pays the seller a put premium. Alternatively, to undertake this obligation, the seller of the put earns a premium. Figure 8.3 describes the payoff structure of a put option holder. The put holder is protected from a price decline and has no obligation if the price increases. To obtain the upside (when the price of underlying asset declines) and none of the downside, the put option holder pays a premium to the put seller. In contrast, the seller of the put option has a payoff structure as in Figure 8.4. They have none of the upside and all of the downside. To agree to assume all of the downside and forgo the upside, the put seller earns an up-front premium as compensation. Consider a numerical example. Suppose that Apple stock is currently priced at $100 a share. Suppose also that the put option gives the holder the right, but not the obligation, to sell each Apple share for $110 a share anytime over the next three months. This put costs $14. In this example, the Apple stock is the underlying asset. The current price of the stock is $100. The $110 represents the strike price. The life of the put option is three months. The put premium is $14. Once again, well-established principles from finance enables the analysis of the value of put options. The central intuitive ideas are as follows: 1. The value of a put option decreases with the value of the underlying asset. 2. The value of a put option increases as the strike price increases. 3. The value of a put option increases with the volatility of the underlying asset price. 4. The value of a put option increases as the underlying asset generates greater income in the form of dividends or other distributions provided to the holder of the underlying asset.

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5. The value of a put option increases with life of the option.

The application of options to a house purchase agreement Call options are relevant to purchasing a house. In most financial transactions involving large sums of money, such as house purchases, we transact by using formal, written contracts. This is because the transaction is complex, the dollar amounts are large, and the transaction involves details, deadlines, and contingencies. Furthermore, flexibility and obligation issues are important. When the potential buyer has identified the house, and negotiated the purchase price with the seller, both sides sign a formal purchase agreement, which documents the conditions under which the purchase will take place. This contract is binding on both sides. To show that the buyer intends to honor the agreement, the buyer deposits an amount, usually 10 percent, into a specified account, called an escrow account. In return, once the deposit is made and the purchase agreement is signed, the house is typically taken off the market (sale pending) by the seller. The purchase agreement specifies the purchase price and the contingencies that the buyer requires, as well as a closing date. There are financing contingencies, as well as inspection contingencies, each with their separate deadlines. The closing date is when the final payment will be made, and the house is transferred to the buyer. The purchase agreement can be thought of as an option to buy the house. This particular option is what is known as ‘in-the-money’. The underlying asset is the house. The offer price is the exercise price of the option. Assume the offer price is the fair value of the house. This creates the ‘inthe-money’ option. If the offer price is below the fair market value, this makes the option ‘in-the-money’. The time between the closing date and the purchase agreement date is the life of the option. The uncertainty regarding the house value during the life of the option is the volatility of the option. The house does not provide any income during the life of the option. The option to buy is granted by the seller of the house to the buyer of the house. The house buyer benefits at the expense of the seller if there are any conditions of the contract that subsequently increase the value of the

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option. Similarly, the seller benefits at the expense of the buyer if there are conditions of the contract that decrease the value of the option. Now analyze the house purchase applying an options framework. An increase in house prices during the life of the contract makes the option more valuable, and makes it more likely that the buyer of the option will exercise the right to buy the house at the purchase price. This is because an increase in the value of the house makes the option an ‘in-the-money’ option. ‘In-the-money’ options should always be exercised at maturity and not before.403 Similarly, an improving economy, an increase in GDP, increasing stock prices, or other improving economic indicators, increase the value of the option as the value of the underlying asset increases. On the contrary, a decline in the economy and other economic indicators reduce the value of the option and move the option ‘out-of-the-money’. ‘Out-of-the-money’ options are never exercised at maturity. A longer life increases the value of the option. If the buyer asks for a longer closing period, that benefits the buyer at the expense of the seller. Similarly, an increase in volatility increases the value of the option. If the option ends up ‘in the money’, it is highly likely to be exercised at maturity. If the option ends up ‘out-of-the-money’, it is less likely to be exercised at maturity. Suppose you put your house up for sale and you get two offers. One offer has a closing date in one month’s time, while the second offer has a higher price with a closing date in three months’ time. Which offer is better? As we discussed earlier, holding all else constant, the longer life makes the option more valuable. Since the seller is giving this option, the seller would prefer the one-month-closing date, as this would reduce the potential costs of adverse events. If the offer prices differ, then clearly there is a trade-off. A one-month closing date will probably have a lower offer price than the three-month closing offer price. Next, we need to determine the value of lengthening the life of the option. To do this, we need to use a formal option pricing model, which is described in Hull.404 Intuitively, we realize that we prefer 403

This is true if there is no income lost from not owning the underlying asset prior to maturity. 404 John Hull, Introduction to Futures and Options Markets, Prentice Hall, 1997

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the higher price three-month option if the economic environment is stable. If the economic environment is highly volatile, we might prefer the lowerpriced, one-month closing offer. Most purchase agreements contain multiple contingencies. Each contingency represents a separate option to cancel the agreement. If the buyer deems that any one contingency is not satisfied, then the buyer has the right to terminate the purchase agreement and receive the deposit back. In addition, the purchase agreement can also specify an explicit option to terminate the agreement. Using an options approach, we can evaluate these contingencies in the context of the economic environment. In a highly volatile environment, it would be to our advantage to choose an offer with a limited number of contingencies.

How to manage options in business If we want to enhance our flexibility, we need to recognize it, create it (typically before others do), value it, buy it, or sell it, when it is advantageous to do so. There are common mistakes that people make regarding flexibility: waiting until everyone has recognized the need for flexibility, or overpaying for it; not exercising in-the-money options at maturity; exercising out-of-themoney options at maturity; and providing options at zero or below cost. Consider an example. In December 2019, we heard about a novel virus taking hold in China. We did not think this would be a problem in the US. Nevertheless, we might have decided to order a box of N95 masks and stock up on some hand sanitizers, just in case. We never expected to use them. We might also have chosen to sell all of our stocks. These were just precautions. They are examples of building flexibility in case a negative outcome occurred. This is creating options. Maybe you go to your favorite restaurant, looking forward to a great dining experience. You order a new item on the menu, excited about trying something new. Soon enough, your dinner arrives. There is nothing terribly wrong with it, but it just does not live up to its promise. What should you do? Should you keep eating, hoping that the taste will improve, or send it back?

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From our earlier discussion, going to a nice restaurant means that you are already paying for a taste-and-refuse option. You acquired a right to be reasonably happy with your meal. You do not have an obligation to eat whatever the waiter puts in front of you. In this situation, it would be appropriate to tell the waiter that the taste is off, and you want to order a familiar dish you will like. You have paid for an option (the cost of going out) and you do want to exercise it when it is ‘in-the-money’ (valuable). A related issue is the decision to tip. If you are happy with the wait-service, you can tip generously, somewhere between 15 and 25 percent . If you are unhappy with the service, you can tip a nominal amount to signal your unhappiness, say 10 percent. If you always tip the same amount, you will transform tipping into an obligation. This does not promote better service. We often buy gadgets to create flexibility for ourselves. This includes a lot of kitchen gadgetry, such as juicers and food processors, and do-it-yourself power equipment. Most of us use these pieces of equipment one or twice and then stack them someplace, to be thrown out years later. This could be an example of unnecessary flexibility at a high cost. Consider another example. Suppose that you can acquire a back-up power generator for your house in case you lose power. The generator costs $4,000 to buy and install. Assume it lasts ten years. You expect a power black-out on average one day every other year. Should you buy a generator to give you the flexibility against a black out? You need to assess whether you have a close friend or relative who lives in the same city who will welcome you into their house for a few days. If so, it may not be advisable to buying a power generator at $4,000 cost. From a strictly financial perspective, you could invest the $4,000 in an index fund and watch it grow over time. If you wanted less volatility, you could deposit the $4,000 in the bank and earn 1 percent interest on it. Thus we can generate an extra income of $40 a year, or about $80 every two years, by not buying a generator. The depreciation on the generator equals about $400 a year. Thus, the total annual cost of the generator is about $480 plus fuel costs. Suppose the cost of the power outage is less than $400 every other year, which would involve staying at a hotel plus losing the perishables). It may be needlessly expensive to buy the power generator to solve the black-out problem.

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On the other hand, during a crisis, such as the coronavirus pandemic, you may want the flexibility to remain in your house for an extended period so that you can cook the meals you like and watch your favorite movies with popcorn the way you like to make it. Similarly, you may have experienced a long-term power outage due to a hurricane, where you could not easily find a hotel room. You may have an aged relative nearby that you need to support. You say to yourself, “Never again”. You value the flexibility. The cost of the generator is the option premium you pay to remain in your own house, with its various comforts. Another example of flexibility relates to travel insurance. Should you buy it? Think of it as an option. Some insurance reimburses the fare if you need to cancel your travel plans. Other offers may include life or health insurance during your trip. Life insurance represents an option to provide for your family if the plane were to crash. Typically, however, these options are extremely overpriced. Suppose you can buy travel insurance that pays $100,000 in case you lose your life in a plane crash. The insurance costs $20. Assuming the probability of a crash to be one in 10 million, the expected payoff from the insurance is only $0.01. At $20 cost, it is overpriced. Yet another example of optionality is purchasing a home. Again, the most common mistake people make is purchasing flexibility at too high a cost. Suppose that certain neighborhoods in your city are highly desirable because of the reputation of the public schools. As a result, housing prices are double what they are in other neighborhoods. A house that is similar in all respects costs $400,000 elsewhere, while it costs $800,000 in the neighborhood with the schools of higher reputation. Should you buy a house to gain the flexibility to send your one child to a school in that neighborhood? We can save about $16,000405 a year by not locating in a prestigious neighborhood. If we have only one child, we might be better off sending our child to a private school with the money we save. Suppose you have three school-age children. In this case, our intuition suggests that we should relocate to the more prestigious neighborhood. Hence, living in the desirable neighborhood can make sense for some people based on flexibility issues alone. For others, this flexibility may not be advisable.

405

4 percent of the extra $400,000 we need to spend on housing in the desirable neighborhood.

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Now consider the decisions we make when we shop for food, clothing, cars, or other goods. We do not make a commitment to buy something immediately. Instead, we shop around. We talk. We wait. We negotiate. The act of shopping around is a process of creating options. In fact, we can create a more formal option by simply saying “Gee, thanks for the offer. I’ll come back to you”. Now we have an option to accept the offer or make a counter offer. The initial offer gives us an option, not an obligation. As we stated earlier, options are highly valuable. Finance also teaches us not to reject initial offers even when they seem downright unattractive. Suppose you were making $30,000 in a job and you got laid off. After only a week of interviewing, you receive a new job offer of $25,000. What should you do? Accept or reject?406 Nobody would be excited about the prospect of making less than they were at a previous job, but finance teaches us to graciously thank this potential employer and ask for a reasonable amount of time to think about it. Finance teaches us that even these seemingly unattractive offers (options) can be highly valuable depending on the relevant future conditions.407 As we stated before, we call these ‘out-of-the-money’ options. They also have value. We described this option as ‘out-of-themoney’ because the current offer is below what we think we can get. If we continue searching, we anticipate another job offer with a salary at least equal to our previous salary. Once we have this offer (currently the ‘out-of-the-money’ option), we can think of our next step. How many more offers should we generate? Should we accept this unattractive offer and try to impress the employer that we will become a valuable, indispensable employee who deserves a higher salary? When does it make sense to continue to search? How long should we search? As we will see, finance gives us guidance on these issues. More generally, we can analyze these situations as the difference between chicken and the pig. While both the chicken and the pig make contributions 406

The answer seems to depend on your age. Young workers typically land higher paying jobs (about 7 percent), while older workers, especially those over 55 accept jobs with up to 27 percent less pay after a period of unemployment. See, https://www.wsj.com/articles/even-a-booming-job-market-cant-fill-retirementshortfall-for-older-workers-11545326195?mod=djemRTE_h 407 Using financial tools, we can determine the value of this option.

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to the American breakfast, with bacon and eggs, the chicken is merely involved. The pig, however, is committed. The chicken approach (working on the startup on the weekend, taking a taxi, calling the front desk, saying ‘thanks’ and ‘I’ll come back’) is maintaining our involvement in the startup of a new company, purchasing a product, and commuting or arranging hotel accommodation, while the pig approach (quitting your full-time job, taking the initial offer, driving your old car, or walking into the front desk) is total commitment. Do you want to be a chicken or a pig? Sometimes, we will prefer to be the chicken and sometimes the pig. We will teach you how to choose intelligently between these two. Finance has applicable insights into most situations we encounter in our everyday lives. We can even analyze ethics or honesty as a financial decision. No, we are not saying that ethics can be reduced to a financial transaction.408 We are saying that we can analyze honesty or ethics from an options perspective. Crime and punishment have long been recognized as subjects that can be explained using economic analysis. To decrease crime, you need to increase the expected costs of engaging in it. 409 This is done by increasing the probability of getting caught, or the level of punishment. Most of our laws are written to ensure that rational actors evaluate the expected economic costs and benefits of crime, and voluntarily choose to be honest. Now, suppose you experience some flooding in your house and you need to hire a team to help clean up. You expect that this work will cost $3,000. The work is covered under your homeowners’ insurance, but you have a $1,000 deductible excess, which you must pay yourself. One contractor offers to overbill $4,000 and give you $1,000 to help you pay for the excess; the contractor says he can inflate the bill to the insurance company by $1,000 so that you will be reimbursed for the ‘full’ cost. It appears that the contractor is just helping you. Do you agree? Suppose there is no record of this offer. It will remain between you and your contractor. Nobody else will know. Suppose, literally, that the

408

We are definitely not that naïve. See Gary Becker, 1968, “Crime and Punishment: An Economic Approach” Journal of Political Economy, 76, 2, 169-217. 409

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probability of getting caught is zero. What do you do? Should you take up the contractor’s offer? Finance teaches us not to accept the offer. It may sound tempting, but it is definitely not free, even if the probability of getting caught is zero. If you accept the contractor’s offer to help, you will lose flexibility or options. You will no longer be able to complain about any shoddy work. You will no longer be able to complain about delays in completing the work. Even if the contractor cheats you later, you have no course of action you can take. Furthermore, you may even be setting yourself up for possible blackmail in the future, since the contractor now ‘owns’ you. Even if the insurance fraud is never discovered and prosecuted, do you want to sell your honesty, integrity, and flexibility for $1,000 - or any other amount? Paying the excess will allow you to retain all of your options, feel comfortable with your decision, maintain oversight of the remodeling work, and require the contractor to make adjustments as needed. In financial terms, you will retain all of your flexibility by paying the excess yourself. You will also feel good about yourself. More importantly, anyone who offers to cheat the insurance company can also cheat you as well. So, why deal with this contractor? Hire someone else who is honest and reliable.

Applications to Hospitality Services An options framework can also help us analyze decisions relating to hotels and hospitality. Suppose you are traveling and need to obtain a hotel room. At this point, you possess an option to contact any hotel and make a reservation. In finance, we can describe this situation as owning a call option. We have the option to buy something (the right to stay in a hotel room). When you exercise this right and actually make the reservation, you effectively no longer have the right. When you make a hotel reservation, you are asked to guarantee the hotel room with a credit card deposit. Consequently, you are being asked to make a commitment. This commitment means that you are giving up your flexibility to choose a different hotel, or a different kind of room, in a different location, or even a different city on a different date. In addition, you are also giving up your flexibility to have no reservation whatsoever. This commitment is costly. If

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you have to cancel your reservation later, you are subject to significant cancellation costs, including complete forfeiture of the entire cost of the hotel room. Why would anyone make such a commitment early? Finance teaches us that we should not exercise our options early unless there is a cost of waiting. Without such cost, it is rational for hotel guests to delay making reservations as long as possible In contrast, hotels want predictability. They want to be able to rent their rooms in advance so that they can plan scheduling of personnel, and room and catering services. Consequently, hotels need to get their guests to make a commitment early. We have just learned, however, that when there is no cost of waiting, the guests still want to delay their decision. Hotels solve this problem by offering an inducement to their guests in the form of an early-reservation discount. They also reduce the discount as the check-in date approaches. This initial discount, coupled with a continual reduction of the discount, imposes a cost for waiting. The longer the hotel guest waits, the smaller the discount. Guests, therefore, have an incentive to make early reservations. Online applications have made it easy to convince hotel guests to make early reservations. The first time a potential guest expresses interest in a particular hotel, he or she is shown a given price. If he or she does not make a reservation, he or she will wait and then will come back at a later date, when they are shown a higher price. This price increase repeats with each day waited. This continual process ‘trains’ the hotel guests to learn that there is an explicit cost of waiting. Eventually, they are convinced to make an early reservation. Flexibility plays an important role in the pricing and allocation of hotel rooms. Hotels also offer cancellability options. Some allow cancellability at no extra cost, up until the check-in date. Other hotels charge substantial fees to cancel unless cancellation occurs more than forty-eight or seventy-two hours in advance of the check-in date. Why do different hotels have these different policies? What can we learn from them? The fundamental question is who can create flexibility at a lower cost. If the hotels can do so, they can offer it to their customers for free or little cost to themselves. This enables them to provide an additional service to

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their customers. When it is costly for the hotels to provide flexibility, they charge for it. How can a hotel create flexibility at low cost? The answer relates to the occupancy rate of the hotel. If it is low, then there is little or no cost to the hotel from a last-minute cancellation. With or without cancellation, rooms will remain empty. In this case, hotels can offer a cancellability option to their guests up until the last minute. Holding all else constant, this free cancellability option can help them generate additional business at little or no cost to them. On the other hand, if the hotel’s occupancy rate is high, then a last-minute cancellation is costly. If the hotel has not reserved the room for a particular guest, it can rent it to someone else. Thus, the last-minute cancellation costs the hotel the opportunity cost of not renting the room to someone else. Is a free cancellability option a good practice? Why would a hotel offer one? It may be an indirect signal that the hotel’s occupancy rate is low. This, in turn, suggests that the hotel is in low demand. This is because its location may experience low traffic, it does not have sufficiently attractive facilities, or the price is relatively high. To determine this, we can obtain additional information about the hotel by reading comments from guests, and considering the location, age, and last renovation date, of the hotel. We can infer, therefore, that there should be an inverse relationship between the cost of the cancellation option and the occupancy rate. The more generous the cancellation option, the less attractive the rest of the package is likely to be. A cancellation option at no cost up to 24 hours before check-in time should coincide with a lower occupancy rate than another hotel that offers a cancellation option only up to forty-eight hours in advance. Consider the cancellability option from the opposing side’s perspective. Suppose you are planning a vacation and you make a reservation with Airbnb. You pay for the apartment with your credit card in full, and are about to board the plane to get to your vacation destination. Suddenly, you get a text message from the owner of the property telling you that

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your reservation is cancelled, through no fault of your own.410 Why would the owner cancel your reservation at the last minute? There are many possibilities. The owner may have experienced some unforeseen emergency, or he may have double-booked the room, or he may have received a higher price offer from another rental site. Suddenly you have no reservation. What recourse do you have?411 Furthermore, you need a back-up plan for your vacation, quickly. Any last-minute reservation with another vacation property on the last minute will be costly. Giving the opposing side unlimited flexibility can seriously undermine your own interests and your welfare. It is a good idea to read the reviews to make sure that the homeowner does not engage in systematic last-minute cancellations. What about a hotel-bidding service? These services offer discounts, and ask guests to make a commitment to a hotel without even knowing its name. The guests only know the star rating of the hotel (which does not always act as accurate signal of a hotel’s quality). In return for a blind commitment, the guests expect, and receive, a big discount. Why would hotels participate in such a system, and give away big discounts? Alternatively, cannot the hotels directly offer these discounts on their own websites with smaller discounts, since knowing the name of the hotel would reduce the discount necessary to sell the room? The answer is that the hotel does not want to publicly advertise these big discounts. If the hotel were to offer its vacant rooms at a big discount in a highly public manner on its own website, it would affect the demand for all the other rooms that they are renting at the regular price. The full-fare customers would baulk at paying regular prices once they become aware of the big discounts other customers are getting. Furthermore, the information that big discounts are necessary to fill the rooms sends another signal to everyone that perhaps the hotel is underperforming, and

410

Host cancellations appear to be the biggest complaint for Airbnb. See, https://www.asherfergusson.com/airbnb/ and https://www.abc.net.au/news/2017-12-22/aussie-blogger-analyses-airbnb-horrorstories/9280160 411 Airbnb will typically give you 10 percent of your deposit as credit on your account. See, https://www.abc.net.au/news/2018-04-11/airbnb-host-cancelled-stay-lastminute-what-to-do-next/9635896

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is thus using big discounts to attract enough customers. A blind offer avoids both of these negative signals. Consequently, it would make sense for the hotels to participate in these blind-offer systems. When would it make sense for guests to use these services? First, the guests will not learn the brand name of the hotel until after a commitment is made. Second, they do not know whether their big-discount bid will be accepted by the kind of hotel they want to stay at. How can they deal with these problems? Participation by guests can make sense if they already have a cancelable reservation. This way, they do not need to worry about not getting any takers for the discounted offers for the second reservation. Second, if they wait until the last minute and vacancies exist, they are likely to receive a good discount. If last-minute vacancies do not exist, then their effort to book a big discount at the last minute will fail, and they will fall back on their existing reservation. If the guests are successful in getting a big discount, they have an incentive to make a reservation, then to cancel their previous reservation. This makes more sense on a last-minute basis, as early on, they would be able to get the discounts from the brand name hotels that they choose as well. Furthermore, as the check-in date and hour approaches, hotels would have greater incentives to unload these rooms secretly, even at a big discount.

Applications to Timeshares How about other hospitality services, such as timeshare vacation homes? Similarly, there are condos-in-hotels that you can own and live in, and simultaneously receive hotel services, such as cleaning, catering, or concierge services that the hotel offers. All of these choices also involve various degrees of flexibility trade-off. The timeshare vacation-home concept involves making a long-term commitment to the same hotel, in the same location, for the same week, or weeks, each year. If people incorrectly estimate their own flexibility, they can pay for a timeshare that they hardly ever use while paying all the costs of ownership and maintenance. Even if they can make arrangements to ensure that they will be able to use their timeshare each year, it still involves the costs of rearranging their schedule to suit the timeshare

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schedule. In addition to the time commitment, the timeshare purchasers are also making a long-term commitment to the same location. While the location and its surroundings may be attractive now, it may subsequently offer a significantly different, and possibly less attractive, experience in the future. Does it ever make sense to commit to a timeshare? The fixed, long-term commitment involves costs, including out-of-pocket expenses, lost vacation time, a confining schedule, travel costs, and depreciation and wear on the furniture and physical space. To offset these costs, the management firm of the timeshare can offer to rent these rooms out to third parties, but the frequency with which these rooms can be rented out is low. We will later explore in detail the impact of a longer life on the value of options. A higher exercise price lowers the value of the options. The timeshare concept requires that we give up this extremely valuable option, since it involves exactly these very features. The commitment is for decades. The uncertainty involved in predicting one’s precise health, schedule, and other circumstances, five, ten, or twenty years down the road, is huge. The travel costs represent the exercise price of these options. Overall, a timeshare represents the epitome of inflexibility. The concepts involved in a timeshare also apply to vacation homes. While you are not restricted to a particular time of the year, you are making a permanent commitment to a particular house and location. This, most likely, precludes vacationing in other locations at any other time. Once again, buying a vacation home involves a lot of commitment. House-sharing services also require a commitment with very little information. At the time of commitment, there is very little information about the house, except for guest reviews which themselves have a lot of ‘noise’. On the benefit side, house-sharing services offer huge discounts, especially for large parties, for commitment, without a lot of information.

Air Travel Options play key role in airline travel. For example, a cancellable airline ticket always costs more than a non-cancellable ticket. Sometimes, substantially more. How should we evaluate a cancellable airline ticket?

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The first consideration is obviously the cost. The higher the cost, the less attractive is the cancelation option. Suppose the non-cancellable ticket costs $300, while cancelable ticket costs $500. Suppose also that there is a 30 percent chance that you will need to cancel, in which case you would need to purchase another ticket at a later date. What should you do? In this case, you should select the noncancelable ticket. With this ticket, there is a 70 percent chance that you will spend only $300 and a 30 percent chance you will need to buy an extra ticket, bringing the total cost to $600. Thus, the total expected cost of the non-cancelable ticket is $390, ($210 plus $180, or a total of $390). This is still cheaper than the cost of a cancelable ticket, which is $500.412 In this same example, if the cancellable ticket were to cost $375, you would have obviously chosen the cancelable ticket. Hence, cost is important. A second consideration is the length of your option? That is, how far in the future do you fly? If you are flying in one week’s time, then the cancelation option is typically less valuable. The likelihood of an adverse event requiring cancelation occurring over the course of one week, should be smaller. In contrast, if you are flying in three months’ time, then the cancelation option is more valuable. The further in the future we fly, the greater the uncertainty regarding potential adverse events, which may force you to cancel your trip. In this case, you would be willing to pay more for a cancellable ticket. Next, you need to think about what you receive if you cancel your trip. If you get cash, then the cancelation option is more valuable. If you get a credit (with a lot of restrictions) against a future flight with the same airline, then the cancelation option is less valuable. You may or may not be able to fly with that airline in the immediate future. Options are relevant to nearly every purchase you make. When you consider buying an airline ticket, you have an option to wait. You can buy your ticket as soon as possible, or you can wait until your plans are defined. The earlier you commit, the cheaper the price. There is also an increase in likelihood of an adverse event. By committing early and giving up your 412

To simplify the example, we ignored the likelihood of canceling twice, or even more times. Taking these possibilities into account does not change our decision in this example.

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option to wait, you can obtain the benefit of the lower ticket price. However, you also run the risk of making a commitment too prematurely. If you must cancel your flight later, you are burdened with additional costs. When you buy your ticket will depend on the average increase in price from day-to-day as the flight date approaches, and the likelihood of resolution of uncertainty at your end. If you perceive uncertainty as being low, you should buy your ticket as early as possible. If you perceive uncertainty as being greater, then you want to maintain your flexibility. Hence, if flexibility is important to fliers, the airlines need to ensure that the ticket price rises more substantially as the flight date approaches. Note that we trade flexibility with the airline around the ticket purchase date. Opportunities also exist to create flexibility around the flight date. Suppose that we can fly early in the morning, or later in the afternoon. We can also make adjustments regarding our arrival time. Suppose a business meeting is scheduled for the next morning. When should we fly, in the morning or in the afternoon? Holding all else constant, flying in the morning gives us additional flexibility relating to our schedule, or the possibility that the flight may be cancelled. Any delays with the airline can be disruptive to the underlying purpose of the flight in the first place. Airlines often oversell the seats since many ticketed passengers do not show up. This allows the airline to double sell some of the seats. However, problems occur when too many show up. How are these scarce seats allocated? In this case, the airlines have to purchase the seat back from some of the passengers by offering cash inducements. Hence, those most flexible passengers voluntarily give up their seat (their flexibility) back to the airline. By flying in the morning, we increase our flexibility, and we put ourselves in a position to sell our seat assignment back to the airline, take an extra cash payment, and take the afternoon flight instead. Whether we want to do this or not depends on whether we can make use of extra flexibility. When it is cheaper for us to create flexibility than the airline, we can benefit from it, and get paid for it. A key idea is that rights and obligations go together. There can be no right without an obligation. Consider our airline example. When airlines oversell the seats, who has a right to decide what happens to those oversold seats?

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Typically, airlines have written policies regarding how to allocate these seats. In so doing, everyone is aware of their rights and obligations. This does not always operate smoothly. In one publicized situation,413 United Airlines maintained a policy where it assigned itself the right (and the passengers the obligation) to vacate any and all seats, even after the passengers were seated. On a flight from Chicago to Louisville, United asserted its policy to randomly remove seated passengers from oversold flights and proceeded to tell certain passengers, after they had taken their seats, that they had to leave the aircraft to make room for additional passengers and some airline employees. United offered up to $800 for passengers to voluntarily give up their seats. When not enough passengers took up these offers, United told certain seated passengers that they were required to leave. Unfortunately for United, one of the passengers chosen to be removed from the flight had asserted his right to the seat. United contacted the airport police, who entered the airplane and used physical force to remove the passenger. Airline officials asserted that they were operating in accordance with their rights. (The incident exposed United to reputational damage, and it decided to give the right back to the passengers. This created a market mechanism to purchase the rights back from the passengers by lifting $800 maximum cap).

Restaurants Options frequently arise in the restaurant business. You decide to eat out. Immediately, you confront a range of choices. Does the restaurant take reservations? If it does, you get an option to arrive at your most desired time. The flexibility to make a reservation makes you better off. What if the restaurant does not take a reservation? Now you have an obligation to arrive at the restaurant, give your name to the hostess, and wait until a table opens. You do not know what time you will be seated. A reservation gives you options and imposes obligations on the restaurant. Not allowing for reservations gives flexibility to the restaurant and obligations to you. Typically, most people want to have dinner around the 413

United Flight 3411 from Chicago to Louisville on April 9 2017. See, https://www.cbc.ca/news/business/united-airlines-flight-overbooked-1.4063632

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same time. In the US, this is about 7pm. This tendency creates constraints for restauranteurs. It is either ‘feast or famine’ for them. Hence, taking reservations can, and does, impose sizable obligations on the restaurant. A typical restaurant is mostly empty at 5pm but full at 7pm, and then mostly empty again around 9pm. This problem is partially caused by the public’s preferences for the same dinnertime, but also by the fact that both the menu and the prices are the same for the entire evening, regardless of demand differences. It is important to note that the flexibility to make reservations is not priced. One way to deal with this situation is to put an explicit price on the flexibility to make reservations. The restaurant could do this by raising prices at 7pm, or by offering discounts for less crowded times. In fact, many restaurants do this by offering a discounted, limited, menu for early slots (the so called ‘Early Bird Special’). The early-bird menu asks the restaurant-goers to sell flexibility back to the restaurant. Thus, they get paid for not demanding the most popular dinnertime seat assignment. This is similar to the airline purchasing the seat assignment from the ticketed passengers for the over-sold flights. In this case, the restaurant buys the 7pm seating time from the restaurant goers. Meaningful price differences enable restaurants to fill their seats throughout the evening. There are other examples of flexibility in dining out. You have the option to pay for your bill with cash or a credit card. Most restaurants would prefer cash, since they pay transaction fees to the credit card company when they accept a credit card, which can range anywhere from 1 to 4 percent of the bill. Most customers would prefer the credit card payment due to its convenience. Nevertheless, the restaurants do not assign an explicit price to this flexibility. In either case, the amount remains the same. You also have the option to tip different amounts, typically between 10 and 20 percent depending on how pleased you are with the service. However, since tipping is voluntary, you even have the option to give a zero tip if you are extremely unhappy with the service. In fact, this is the whole point of tipping. It is designed to align the incentives of the wait-staff with those of the customers. The wait-staff can earn higher incomes by providing a better service to their customers.

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In Europe, a standard tip is included in the prices of the items. Thus, the option to tip is either completely eliminated or de-emphasized. This also means that there is little or no incentive for the wait-staff to respond quickly and politely to customers’ needs. Holding all else constant, you would expect the service to be friendlier, timelier, more accurate, and in general more pleasant in the US than in Europe, and most people would probably concur on this point. This option to taste-and-refuse is less important in so-called fast-food restaurants, since the food is standardized and is not likely to vary from sample to sample or from restaurant to restaurant. In fact, the whole point of fast food is that the food is exactly the same regardless of country, specific location, or time of day. This reliability (or quality control) means that customers do not need to incur information costs when choosing where to eat. When they go to a McDonald’s in Ann Arbor, Detroit, Columbus, Indianapolis, or Omaha, they expect to obtain food that is consistent and of the same quality.

Investing in the Restaurant Business The 2016 movie, The Founder tells the interesting story of the two brothers who founded McDonald’s restaurants with their business partner, Ray Kroc. At one point in the film, the McDonald brothers have already built five McDonald’s restaurants in California, while Ray Kroc was trying to convince the McDonald brothers to expand the chain nationwide. At the beginning of the movie, the McDonald brothers and Ray Kroc disagree about the feasibility of franchising. The McDonald brothers assert that they have already expanded and reached the maximum number of stores they can manage while ensuring quality control. They argue that any additional expansion would result in lower quality, loss of reputation for existing stores, and ultimately a lower value for the business. In contrast, Ray Kroc tries to convince them they can open hundreds or even thousands of restaurants across the country, and still maintain consistent quality. In the language of finance, they are disagreeing about the value of the option to expand. The brothers are asserting that the option to expand is worth a minimal amount, while Ray Kroc argues that the option to expand has significant value. The McDonald brothers eventually agree to let Ray Kroc experiment with some expansion.

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In another scene, Harry Sonneborn, Vice President of Finance for a local bank, hears of the financial difficulties that Ray Kroc is experiencing while trying to expand McDonald’s restaurants. Sonneborn is surprised that Ray Kroc is having financial difficulties, given how attractive the restaurants are, and offers to help. Upon examining Kroc’s financial books, Sonneborn remarks, “You have a miniscule revenue stream, no cash reserves, and an albatross of a contract that requires you to go through a slow approval process to enact changes, if they are approved at all, which they never are”.414 After learning that it is the franchisees who choose and lease the land to build the restaurants, Mr. Sonneborn remarks “You do not seem to realize what business you are in. You are not in the burger business, you are in the real-estate business”. Mr. Sonneborn recommends that Ray Kroc buy the land himself and lease it to the franchisees, instead of allowing the franchisees to pick their own land and/or lease it from third parties. This change allows Mr. Kroc to solve multiple critical inflexibility problems at once. First, using the threat of cancelling the lease, Mr. Kroc can exert complete control over the franchisees, enforce quality control, and collect lease payments. This solves one of the main concerns in expanding the business. The franchisee must now honor all aspects of the franchise agreement. If he does not, there is an immediate and effective remedy, which is the cancellation of the lease contract. Second, the lease payments can be made variable depending on the sales volume. The higher the sales volume, the higher the lease payments. This allows risk sharing. If sales fall, for whatever reason, the losses would be shared. The lower risk makes the new store more attractive to the franchisee. Further, this feature would allow Mr. Kroc to capture abovenormal lease payments from the franchisees in bountiful times. Third, this change allows Mr. Kroc to free himself from the restrictive contract he signed with McDonald brothers. The contract that McDonald brothers required of Ray Kroc and the franchisees was a one-size-fits-all, fixed royalty contract, which did not allow Ray Kroc to capture a bigger share of the profits from well-situated profitable franchisees. In contrast, the lease payments from the new contracts (which depended on the 414

See, https://www.moviequotesandmore.com/the-founder-best-quotes/

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location and profitability of the franchisees) provided him with extra revenue, allowing him to expand his borrowing capacity by using both the land as well as future lease payments as collateral and build capital. It also allowed him to effectively bypass the slow approval process by the McDonald brothers for any innovations or changes, since he gained significant negotiating advantage over the brothers. Mr. Kroc also gained the ability to impose his own requirements on the franchisees, over and above what the McDonald brothers imposed. In Mr. Kroc’s case, this adjustment became the difference between failure and prosperity. Flexibility can be that important. The key to making flexibility work is to recognize flexibility, value it, and compare this value to the extra price you need to pay to obtain it. In Mr. Kroc’s case, he was able to create flexibility for himself while eliminating the flexibility for the McDonald brothers, at a very low cost. The Founder illustrates another aspect of flexibility we have already discussed: For every right, there exists an equal and opposite obligation. In a typical situation, there are two opposing parties. For Ray Kroc, the opposing party was the McDonald brothers. A right for the McDonald brothers meant an obligation for Ray Kroc. Increasing flexibility for the McDonald brothers created more obligations for Mr. Kroc, and vice versa. The McDonald brothers retained the right to approve or reject all of Ray Kroc’s decisions involving the restaurants. They had the right to take as much time as they wanted. The slow approval process gave the McDonald brothers time to consider all aspects and implications of the proposed changes, and gave them flexibility to say yes or no while burdening Mr. Kroc with the costs of waiting. Ray Kroc could get a loan and buy a parcel of land. However, he could not build until the McDonald brothers gave him their approval. Meanwhile, Ray Kroc continued to incur costs, including interest costs, while waiting for approval. The power to say no to any decisions or proposed changes again gave the McDonald brothers more flexibility while burdening Mr. Kroc with the consequences of rejection. The reason a right can exist (for the McDonald brothers) in the first place is because obligations are imposed on the opposing party (Mr. Kroc). There can be no rights without obligations. When we analyze flexibility, we will pay particular attention to this dual nature of flexibility.

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Healthcare Next, consider the role of options in healthcare. You recently developed some heart palpitations. You go to your primary care physician who recommends a cardiologist. Over the course of the next ten days, you undergo various diagnostic tests. At the end of this process, your cardiologist indicates that you have a problem with your mitral valve, and he recommends a particular invasive medical procedure. While you are trying to absorb all of this information, a nurse comes in and gives you a consent form to sign. The nurse says that without the signed consent form, the doctor will not be able to schedule the surgery. Should you sign the form, or should you refuse? We can use the options approach again to analyze the medical situation. You have been given an option – you have a diagnosis and a recommendation for a particular medical procedure. At this point, you have no obligation to sign the consent form. Your next step is to understand this option better. For this, you need to ask the doctor some additional questions. The first question is how much time you have to think about this surgical procedure. Based on your symptoms, the problem is bothersome, but not urgent. Suppose that your doctor says that there is no urgency but ideally the procedure should be done over the next thirty days. At this point, you can attach a term for your option of thirty days. Your next step is to become informed about the risks and potential success rate of the recommended procedure. Instead of a take-it-or-leave-it choice, namely, to sign or to refuse, you can tell your doctor that you want to think about it and do some research for the full 30 days. In this case, you are telling your doctor that you understand that there is a 30-day period for you to decide, and you will use the 30 days to become better informed about the potential risks and benefits. During this period, you can research the medical literature415 and talk to other patients and cardiologists, and get a second opinion. You can talk to various people who have had this particular procedure, and learn more

415

https://pubmed.ncbi.nlm.nih.gov/ or https://www.ncbi.nlm.nih.gov/guide/all/

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about their own experiences with its risks and benefits. You can become informed about the success rate. You can learn about when, where, and who, is in the best position to perform this procedure. Finally, you can explore alternatives to this procedure, including doing nothing to see if the condition will improve on its own. The critical issue here, is that even though you did not sign the consent form, and the procedure could not be scheduled, you recognized that it was an option and not an obligation. By asking further questions to your doctor, you determined the parameters of this option to wait. Finally, after becoming informed about the alternatives over the course of the next thirty days, you are ready to sign, or not sign, the consent form. After all, the consent form is stating that you are making an informed consent about your own treatment. Only by giving yourself the maximum flexibility to become informed, are you in a position to give an informed consent one way or another. Now suppose that the doctor said that there is some risk of complications, and even death, if the procedure is postponed. As before, the nurse is waiting with the consent form. How do you deal with this situation? What is different now, compared to the previous situation, is that there are costs of waiting. In the previous situation, waiting did not impose significant costs and we took all thirty days to become informed. Now, there are significant costs of waiting and postponing the procedure. Becoming informed has just become more costly, possibly fatal. Since becoming informed has become more costly, does that mean we need to sign the consent form immediately? You do have more specific information, the cost of waiting. However, this new information does not change the fact that you still have an option, but not an obligation, to sign the consent form on that day. Once again, you need to ask your doctor additional questions to your doctor to flesh out these risks. What is the probability of developing complications over the next ten days - or thirty days? What is the probability of sudden death if the procedure is postponed for thirty days? The fact that there are costs of waiting probably means that you will not take all thirty days to become informed, but neither will you sign the consent on the spot.

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Holding all else constant, you will/should take less time to decide. How much less depends on the costs of postponing the procedure. The more serious the cost, the more quickly you will need to decide. However, your general approach remains the same, you just have a shorter, costlier option. Now suppose that you ask your doctor about the benefits and risks of the recommended procedure. You also ask about the alternatives. Your doctor now informs you that not only is the cost of waiting risky, but that the procedure is also risky. Everyone is different and it is hard to generalize, your doctor says, but any invasive procedure requiring general anesthesia is associated with a death rate of 0.02 percent for someone your age.416 Furthermore, the procedure is not beneficial for some people. In addition, the procedure does not work perfectly on some people, who will need a pacemaker inserted afterwards. In this case, you will need a second, separate, surgical procedure. Furthermore, the pacemaker only lasts for a certain amount of time, and it will need to be replaced by yet another, third, surgical procedure. What do you do now? Once again, the parameter values have changed. There are now two costs: a cost of waiting and a cost of having the procedure. How do you assess these costs? First, you need to realize that these costs offset each other. If these two costs are equally serious, your situation resembles the initial situation, where there was little net cost of waiting. You could take the full thirty days to become informed. Specifically, how long you will wait to become fully informed, and be ready to sign or decline the consent form, now depends on the exact magnitude of these two costs. Holding all else constant, the higher the health costs associated with the procedure, the more time you will wait to become fully informed. Holding all else constant, the higher the costs of postponing, the less time you wait. We are navigating a situation in which we are not subject experts. We are still relying on the specific advice and expertise of the medical doctors. Nevertheless, we can analyze it using a financial-options approach. We can 416

See, https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3147285/

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use the specific information we receive from doctors, other patients, and medical literature, and then put the whole picture together to make a more informed decision.

CHAPTER 13 UNDERSTANDING DEBT

“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world”. —Archimedes

What is Debt? When Archimedes says lever, he is referring to the physical world and a physical lever. Using a lever, we can accomplish many tasks not otherwise possible. Yet Archimedes’ observation is also applicable to finance, and the regular decisions we make about incurring debt. In fact, in American finance, debt is also referred to as leverage. In British finance, debt is referred to as gearing, again describing a type of leverage. Debt resembles leverage, or gearing. It can increase power and wealth; it can increase returns; and it can accelerate growth. Yet, debt also has the power to decrease investment returns and destroy wealth. In the process, it can also impair a person’s quality of life and livelihood. Debt is a powerful tool, but it must be used very carefully. How does debt work? A debt instrument is used to receive cash up front, with a promise to pay back an amount borrowed, together with interest, subject to an agreement that describes the terms of the indebtedness. Borrowers agree to pay it back over time, with interest. Although debt is a legally enforceable obligation, borrowers may avoid repaying some, or all, of the amount if they go into bankruptcy. Debt has distinct benefits. Debt can enable borrowers to achieve goals not otherwise possible. You can buy a house now instead of waiting fifteen to thirty years to save up enough. You can get a car today instead of waiting five to seven years to save the purchase price. You can pay for everyday items even if you do not have cash in your wallet. You can borrow money

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to attend college. Without debt, college would not be possible for children in middle-class families, while they would have to work their entire lives to be able to live in a house they own. Availability of debt has created possibilities that have a multi-generational impact. Debt, however, can also give rise to serious problems. It can restrict flexibility and impose obligations. Borrowed money is not free. It comes with a legal obligation to pay it back, with interest, and on time. If you do not honor your legal obligation, you can lose your house, car, and other possessions.417 Borrowers can discharge most debt obligations if they file for bankruptcy, but this is not universally true. Some types of debt cannot be discharged even if the borrower ends up in bankruptcy. Examples include tax liens, child support, and fraudulently obtained debt. Similarly, federally guaranteed student loan debt is usually not discharged in bankruptcy.418 To understand the leverage feature of debt better, consider a numerical example. Suppose that you have $1,000 of your money to invest. Now you also borrow another $1,000 at 5 percent interest rate. This means you are promising to pay back $1,050 at the end of next year.419 Combining your equity and borrowed money, you now have a total of $2,000 to invest, and you purchase diversified equity index funds. In this case, you have used leverage. Your investable assets have increased. You have also undertaken an obligation. Leverage will now magnify both the returns and risks. First consider the returns. Suppose that your index fund rises by 20 percent for the next year. In this case, your $2,000 investment will grow by 20 percent, or by $400 (before taxes). Now your assets have risen to $2,400 (again, before taxes).

417

In the old days, one would also go to prison for defaulting on debt. See, https://www.experian.com/blogs/ask-experian/can-you-go-to-jail-for-not-payingyour-bills/ 418 In 1976, Congress prohibited federally guaranteed student loans from being discharged in bankruptcy except in extreme cases of hardship. See, https://www.debt.org/students/bankruptcy/ 419 $1,000 is the principal sum, and $50 is the 5 percent interest on $1,000.

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But this money is not all yours. Since you also borrowed $1000, at 5 percent, you need to pay this back. At 5 percent, you owe $50 interest. So, you need to pay back the $1,000 principal sum, plus $50 interest, or a total of $1,050. Subtracting this from the value of your assets, or $2,400, your equity420 is now worth $1,350. Notice that leverage in this example has increased your profitability. Instead of earning 10 percent in the market, you now earn 35 percent on your original equity. Leverage can enhance returns. Notice that profitability increased even though your type of investment did not change. You still invested in an equity index fund. Hence, the higher equity return is due to leverage, not type of investment. Now consider the risks of debt. Once again, you have $1,000 of your money to invest. Again, you borrow another $1,000 at 5 percent, and invest a total of $2,000 in the stock market. Suppose now that your index fund falls by 10 percent for the next year. In this case, your $2,000 investment will go down by 10 percent, or by $200. Now your portfolio has fallen to $1,800. You still owe the $1,050 principal sum plus interest. Subtracting this from the value of your portfolio, or $1,800, your equity is now worth $750. Leverage has now decreased your profitability. Instead of losing 10 percent in the market, you have lost 25 percent on your original equity. This is how leverage can also accentuate losses. Leverage has increased your risk. If you just invested your own money, without any borrowing, the returns would have fluctuated between -10 and +20 percent, or a range of 30 percent. Taking in the effect of borrowing, your returns have fluctuated between -25 and +35 percent, or a range of 60 percent. Leverage doubled the range of returns (and hence the risk).

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Equity refers to what you own. It is computed as the value of your total assets minus the amount of your debt.

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The Benefits and Dangers of Leverage Does leverage in general increase profitability in the real world? If so, how much? Does leverage always increase risk? If so, how much? Are there other benefits and costs of debt in the real world? To answer these questions, we examine actual realized stock market returns over a ninety-year period. We also use borrowing rates that will reflect current market conditions. Assume that our objective is to invest in the stock market. We further assume that annual stock returns will vary, but the distribution of stock returns observed over the past ninety years will remain stable. This historical distribution will help us simulate the behavior of future stock returns. (Although this is a simple model, it is nonetheless useful for our purposes). We begin with an investment of $5,000 in the stock market. After the initial investment, we do not add or subtract from our investment, and we keep fully invested. Using the last ninety years of realized stock market returns, we randomly choose an annual Standard Poor’s 500 Index return and assign it to year one. We let our investment change by this return. We continue to randomly pick one of the annual returns from the realized returns over the past ninety years and use that for the next year’s return, applying it to our cumulative investment portfolio. We continue this process until we complete the forty-year investment horizon. We therefore have forty years of randomly chosen stock returns, using the actual historically realized returns. We started with a $5,000 investment. We have also computed the 40-year wealth path for a strategy of investing the initial $5,000. We then repeat this entire procedure 10,000 times. This gives us 10,000 possible paths that the initial $5,000 stock market investment could have possibly taken based on a historical distribution. This gives us a wide range of possibilities of investing in the stock market. Next, we order these 10,000 wealth paths based on final year wealth level. The lowest 40-year wealth level is assigned a rank of 1. The highest wealth level is assigned a rank of 10,000. Finally, we pick the bottom 2.5 percentile, or rank 250, as the lower wealth level; the 50th percentile or

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5001st rank as the median wealth level; and the top 97.5 percentile or 9,750 rank as the upper wealth level. The range of possible realized wealth levels between the 2.5 percentile and the 97.5 percentile will give us some idea of risk, with a 95 percent confidence level. Our results from this experiment are shown in Figure 13.1.421 We can see that the median wealth level is a little over $200,000. There is a 50 percent likelihood that a single investment of $5,000 will have turned into a little over $200,000, an increase of more than forty-fold. This is the multiplier effect of the stock market. In this case, this is over a forty-year period, which is similar to a life-time of investment prior to retirement. This is yet another example of the power of the stock market to create wealth over long periods. Figure 13.1 also shows the upper and lower wealth levels. The upper level is over $1.9 million, while the lower level is over $17,000. There is a wide range of outcomes. The multiplier effect ranges from three to over 380. As this example illustrates, the stock market involves risk (i.e., volatility).422 Our approach uses median wealth levels, not the average expected wealth levels. In other words, half of the wealth paths lie above, and half of the wealth paths lie below this level. You will also notice that wealth levels are highly skewed to the right, giving extreme positive outcomes. This ‘positive skew’ – a concept in statistics – means that the average wealth levels will somewhat exceed the median wealth. While not shown in the graph, the simple average wealth level for this exercise is about $390,000, giving a wealth multiplier of about seventy-eight instead of forty. Once again, the stock market has been a great engine of wealth generation over the past ninety years. It has the power to increase anyone’s wealth by close to 100-fold over a lifetime. It also involves a significant amount of risk (i.e., volatility) that must be carefully managed.

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These statistics are based on the author’s calculations, using MS Excel. Another caveat of course, is that the past does not guarantee the future. While thinking of risks, we only need to manage the risk that history may not repeat. 422

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Figure 13.1: Simply Invest $5,000

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While this sounds simple, it still requires a lot of discipline. In particular, it requires that we keep invested in good times and bad times, even when the world around us seems like it is falling apart, as the recent Covid-19 pandemic feels at this moment (March-April 2020). To execute this strategy, we need to close our eyes and ears and ignore the fact that market is fluctuating by 5 or 10 percent, up or down, day after day. This is very difficult. Now consider the outcomes when we borrow money and invest in the stock market. For this task, we make two assumptions. First, we have $5,000 to invest. Second, we borrow another $5,000, add it to our own $5,000, and invest all of the $10,000. The interest rate will be equal to the one-year Treasury-Bill rate. (Individuals would normally pay a slightly higher interest rate than the US Government). As before, we generate contemporaneous, but again randomly chosen, stock market and Treasury-Bill returns, and repeat our experiment for forty years. After each year, we subtract all debt with interest from our assets, and we compute our equity level. We continue this calculation for forty years. As before, we repeat our experiment again 10,000 times. These equity levels are shown in Figure 13.2.423 Figure 13.2 illustrates that leverage increases our median wealth level to $377,000, almost doubling it compared to an all-investment scenario shown in Figure 13.1. Similarly, our average wealth level also more than doubled to over $800,000 (not shown in graph). The upper bound also jumped to $4 million. The lower bound declined to $0. Borrowing generated considerable additional wealth, significantly increasing average, median, and upper bounds. Debt has a cost and increases the risks. The lower bound is now at $0. The difference between upper and lower bounds also more than doubled.

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Source: Author’s calculations.

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Figure 13.2: Borrow $5,000 and Invest $10,000

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Why is the lower bound now at $0? With an all-equity investment, the lower bound was at around $17,000. Why did it go to $0? What are the implications of zero wealth? When we do not borrow, and simply invest 100 percent of our own money (the first example shown in Figure 13.1), we can never be totally insolvent. Regardless of how unlucky we are, or how bad our investment returns are, our assets will never reach a zero value. This is because taking a fraction of a positive amount will still result in a positive amount. Our investments will always live to see one more day. This gives us the opportunity and the flexibility to come back and possibly make up the losses. In fact, while we did not show the absolute worst outcome in Figure 13.1, we had computed it to be about $2,000. Hence, the absolute worst outcome (after 10,000 repetitions) is that you would lose about 60 percent of your invested wealth. This means there is always the hope that you can come back and recover at least some of your losses. An all-equity investment preserves your flexibility. This is not the case when you borrow money (Figure 13.2). With debt, you can lose all flexibility. The value of your obligations will equal, and possibly exceed, the value of your assets. In this case, your equity value will be zero, or even negative. In such cases, you are now insolvent. There is no money left to invest. In finance jargon, we say the investor has ‘blown-up’. Thus, once you borrow money, the risk of insolvency is no longer zero. This is another dimension of risk that is masked by averages or the medians. This hidden aspect of debt is further illustrated in Figure 13.3.424 Here, we show the probability of blowing up. When you borrow $5,000, add it to your $5,000 in equity, and invest all the $10,000, the risk of blowing up after one year increases from zero to about 0.5 percent. The increase is a 6 percent after 10 years, and approximately 10 percent after forty years. Hence, borrowing can create a significant risk of becoming insolvent. Now debt can totally destroy all your wealth.

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Source: Author’s calculations.

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Figure 13.3: Risk of Ruin with Initial 50% Debt

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Notice that median wealth level or the average wealth level hides the risk of blowing up. Many people may be able to tolerate moderate or substantial declines in their wealth, but blowing up should be unacceptable. Consequently, we should view the risk of debt not just a source of fluctuations in our wealth, but also as the potential for complete blow-up. It is one thing to lose money, and something quite different to blow up completely. When we consider the amounts we can borrow, we may be tempted to ‘lever up’. On average, by borrowing an extra $5,000 on top of our $5,000 equity, we can double our wealth. However, we also need to be aware of the associated risks that our investments can decrease in value or become worthless. These risks increase the longer we remain invested. People often ignore the risk of blowing up [going bust] when they consider the benefits and costs of borrowing. For instance, hedge funds often use leverage. The most successful ones appear to be doing well.425 However, we generally do not consider the ones that closed, returned money to investors, or went bust. Looking only at the performance of successful survivors is known as ‘selection bias’ or ‘survivorship bias’. Nevertheless, the risk of ruin or of blowing-up appears to be still small, around 10 percent in our example above. In fact, many people may be willing to incur this 10 percent risk of losing their investment. If you can tolerate this risk, you may want to consider it. If you feel uncomfortable with it, you will need to reduce or eliminate the amount you have borrowed. Another word of caution is required here. In our example, we assumed that the investor blows up when his or her equity falls to zero or goes negative. However, most lenders will not wait that long. If lenders require a minimum margin of safety, they can call in the loan long before the equity position falls to zero. This has a name in finance. It is called a margin call. In effect, a margin call will force the investor to liquidate his position and realize his losses even after moderate adverse price movements, without

425

https://www.thestreet.com/personal-finance/education/what-is-a-hedge-fund14662109

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giving him any chance to recover later. Thus, margin calls have the effect of significantly increasing the tail risk, or risk of ruin, for the investor. We also examined the likelihood of a margin call. With an initial debt level of 50 percent and a margin call at 30 percent, the likelihood of experiencing a margin call quickly goes up to about 25 percent after 10 years. This represents a five-fold increase from the levels shown in Figure 13.3. Getting a margin call will force the investor to realize his losses at most inopportune times, force deleveraging, and will further erode his overall performance, even if the market bounces back later. Next, consider the potential outcomes if the leverage is further increased. Suppose we now borrow $45,000, contribute our $5000 equity, and invest all of the $50,000. Hence, we are borrowing $9 for each dollar of our equity. As before, we borrow at the one-year Treasury-Bill rate. While the relative amount of borrowing is large, it is still realistic. Many people borrow more than their annual projected income to pay for college or professional school. Others incur credit card debt much higher than their annual incomes. The results are illustrated in Figure 13.4.426 The higher leverage once again results in higher levels of risk, leading to an increased range of outcomes. The median wealth level actually declined to about $320,000 from $377,000. The upper wealth level jumped to over $17 million, while the lower wealth level is still at $0. The average wealth level (not shown in the figure) also jumped to $1.1 million.

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Figure 13.4: Borrow $45,000 at Treasury Bill Rate and Invest $50,000

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The challenge of debt is again shown in Figure 13.5.427 With higher levels of leverage, the risk of blowing up [going bust] increases significantly. Even after only one year, the risk of blowing up reaches over 20 percent. This probability then rises sharply to about 40 percent after six years. The risk of blowing up reaches almost over 48 percent after forty years. The odds of blowing up are approximately fifty-fifty. Both the benefits and risks of debt have increased, as illustrated in Figures 13.4 and 13.5. The highest wealth levels have more than quadrupled. The average wealth levels have more than tripled. However, the likelihood of achieving the median wealth level has declined. Furthermore, the probability of blowing up is now almost one in five after only one year, and approximately 50 percent after forty years.428 Figures 13.4 and 13.5 emphasize that we need to be careful and cautious when we borrow. The high levels of debt promise higher future levels of wealth, but the likelihood of blowing up has now reached unacceptably high levels. Most people would not want to have a one in five chance of blowing up [going bust] after just one year, or even a chance of totally blowing up their savings after forty years. You can incur too much debt. A good example is borrowing nine times your own equity. The risks can actually be worse with more realistic assumptions. Figures 13.4 and 13.5 are based on somewhat optimistic scenarios. For ease of illustration, we assumed that we are able borrow at the same interest rate as the US Government. Individuals clearly cannot borrow at such low rates.

427

Source: Author’s calculations. We are ignoring the issue of margin calls here. Assuming the investor in this situation gets a margin call when his equity falls below $4,000, the likelihood of a margin call starts at around 40 percent and rises to 70 percent after 10 years. 428

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Figure 13.5: Risk of Ruin with 90% Initial Debt at Treasury Bill Rate

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Next, we explore the effects of debt when the interest rates are more realistic. In 2017, the one-year Treasury-Bill rate was about 1 percent, while the average student loan interest rate was 5.8 percent. For large loans (plus loans), the student debt interest rate could be as high as 11 percent. In 2019, for instance, SallieMae was charging between 4.7 percent and 11.3 percent for fixed rate student loans.429 To take these differences into account, we add 5 percent to the Treasury-Bill interest rate and use this as a more realistic borrowing rate. Otherwise, as before, we are going to borrow $45,000, add our own $5,000, and invest the total $50,000. The results are shown in Figure 13.6.430 Now, we only show the upper bound, since both the lower bound and median estimates of wealth are literally zero. Also, using a more realistic interest rate reduces the upper bound somewhat. It declines from $17 million to $15 million. This is a relatively small reduction in the upper level. However, the most drastic consequences of debt occur when they are combined with leverage. Even the median wealth level is now zero. The lower bound is also zero. Nevertheless, high levels of debt, even at high interest rates, can still tempt borrowers with high levels of wealth if things go well. However, there is not much of a ‘safety margin’. It is relatively easy to spiral into financial disaster. Once again, the risk of debt is shown in Figure 13.7.431 The likelihood of blowing up jumps even more significantly. Even after just one year, this exceeds 22 percent. After ten years, it equals 62 percent. After forty years, it exceeds 75 percent. Hence, if you borrow $9 for each dollar of equity, even at a moderate interest rate, you have a more than one in five chance of financial disaster after one year, and close to two out of three chances in ten years. After forty years, there is more than three in four chances.

429

See, https://www.simpletuition.com/results?WT.mc_id=10328571 Source: Author’s calculations. 431 Source: Author’s calculations. 430

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Figure 13.6: Borrow $45,000 at Treasury Bill Rate + 5% and Invest $50,000

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Our findings suggest that many people focus on the prospect of wealth multiplication rather than the risks of borrowing. While there is a decline in the upper-bound, from $17 million to $15 million, this is a relatively small decline. To reach these upper levels, the investors were lucky enough to avoid bad stock market outcomes. Paying a higher interest cost does not make that much of a dent in your wealth if you are lucky enough to hit good outcomes in the stock market. Although the interest rate of Treasury-Bills, plus 5 percent, is appropriate for many applications, it is still too low compared to the credit card interest rates. The average credit card interest rate in early 2019 is about 17.5 percent.432 If the borrower were to miss a payment or two, this rate can easily jump to over 25 to 30 percent.433 This still results in an average interest rate of about 13.5 percent, which is still conservative. We also experiment with a 15 percent surcharge. The idea here is that the investor is borrowing on his credit card at 11 to 16 percent, and investing the amounts borrowed in the stock market. Here are some key themes arising from our analysis. If you pay higher interest rates on debt (as would be the case if you borrow on your credit card), you can still attain relatively high levels of wealth, assuming you have favorable market conditions. The upper wealth levels now reach over $4 million. While this is not nearly as good as those $15 million and $17 million levels when interest costs were lower, even this type of debt can still be tempting to some people. Both the median and lower bounds of wealth are still zero. Debt can still sound enticing. Yet consider the downside as illustrated in Figure 13.8.434 With a 10 percent interest surcharge, the risk of blow-up is over 30 percent after only one year; over 67 percent after 5 years; over 80 percent after 10 years; and over 96 percent after 40 years. High levels of debt simultaneously destroy wealth and increase risk.

432

See https://www.creditcards.com/credit-card-news/rate-report.php See for instance, https://www.creditkarma.com/credit-cards/i/late-paymentsaffect-credit-score/ 434 Source: Author’s calculations. 433

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We have also experimented with a 15 percent surcharge. While not shown as a graph, with a 15 percent surcharge (as would be the case if you borrow on your credit card at 18 percent), the risk of a blow-up starts out around 39 percent after one year, and rises to about 99.5 percent after 40 years. Thus, high levels of debt combined with credit-card type interest rate levels can virtually guarantee complete ruin. Borrowing can be both wealth enhancing and wealth destroying. Focusing only on the benefits of debt, even expensive debt, can hold out the promise of huge wealth multiplication. If everything goes in your favor (a small likelihood), you can build great amounts of wealth. The problem is the downside of debt which is the risk of going bust. If things go against you, debt can virtually guarantee (with 99.5 percent probability) destroying all your wealth. Remember that we did not borrow money for gambling or consumption purposes, but rather to invest in the stock market, which is one of the greatest wealth-creating engines. In spite of this, the negative aspects of debt overpowered the positive aspects achievable in the stock market, resulting in serious losses, perhaps even losing your entire savings. What would be the results if the borrowed money were spent on consumption, gambling, or illicit drugs? The distinction between investment and gambling is that the expected returns with investment are positive. The expected returns with gambling are negative. As we discussed earlier, the house always wins in most forms of gambling, while on average, all players eventually lose money. This is what is known as negative expected returns. With consumption, there is no financial payoff to your wealth. The expected financial return equals -100 percent. How do we interpret these findings? Our key themes are as follows: Debt can both create wealth and destroy wealth. The essential elements we need to think about are the levels of borrowing, the interest rates, and the length of borrowing. Consequently, we need to be extremely careful when we borrow, especially for long periods. This is regardless of why we borrow, whether it is for good investments, gambling, consumption, or risky investments. We have already seen that even borrowing money to make sound investments can easily destroy wealth.

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We have several final themes to emphasize. First, we need to keep debt levels manageable and engage in only prudent levels of borrowing. Anything more than one-for-one debt (one dollar of debt for each dollar of equity) results in unacceptable levels of debt for long-term risky investments. This is the case regardless of the interest rates. We should think of 50 percent leverage as an upward bound on prudent borrowing. Second, we need to pay close attention to interest rates. Borrowing money at high interest rates is never advisable. This conclusion is true even for investment purposes. High interest rates – such as Treasury-Bill rates plus 5 percent – will destroy wealth. Furthermore, it is virtually impossible to create wealth if you are borrowing at Treasury-Bill rates plus 10 percent or more. Third, the borrowing horizon is important. The risks of borrowing remain manageable at short-term horizons. However, these risks climb steadily as the borrowing horizon lengthens. Borrowing to consume is never advisable. If you cannot afford something because you do not have the cash, then surely you cannot afford it with a credit card. Borrowing will always increase the price of the item. Similarly, borrowing to gamble can only be described as a fool’s errand. Next, we apply these ideas to our everyday lives. Whether we do it consciously or unconsciously, we often make decisions about borrowing, including how much, from whom, and for what pursuit. If we understand borrowing and its consequences, we can do so more wisely.

Applications of Borrowing to our Daily Lives People typically borrow money to buy a house or a car, or to pay for college or professional school. Some borrow money to increase their current consumption. Others borrow to gamble. Is there a valid case for borrowing? Certain borrowing may enhance wealth over the long term, while most reasons to borrow give rise to bad outcomes. Borrowing money for consumption will guarantee wealth reduction. You are consuming something you cannot afford based on your budget. Borrowing increases the cost, and makes the affordability even worse. Borrowing to gamble is

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always bad. Borrowing for investment can be good or bad, depending on the circumstances. The first requirement for borrowing for investment is that you must earn a higher rate of return on the investment than the rate of borrowing. This is a necessary, but not sufficient, condition. If you borrow at 7.5 percent and earn 3 percent on your investment, you will surely be destroying value. In this example, the interest rate must be sufficiently below 3 percent before you should even consider borrowing. The second requirement for debt is that the investment itself must be sound. A low cost of borrowing will usually not transform a bad investment into a good investment. The third requirement is that you must earn a sufficient return on your investment over the rate of interest to offset all the costs of borrowing. Earlier in this chapter, we saw that one of the negative effects of borrowing is the risk of going bust, which represents an extreme loss of flexibility. Hence, you need to control your borrowing level to ensure that the risk of bankruptcy remains small. The fourth requirement is to limit borrowing to a prudent level. To do so, we need to compare the cost of borrowing to our income levels. We will discuss these issues in more detail later in this chapter. Insolvency or blowing-up is one of the costs of borrowing, but not the only one. Debt can lead to inefficient decisions, as well as constraining your flexibility. In finance, this is called debt-overhang. A key feature of debt is that it involves a requirement to pay the interest and the principal sum. You need to determine that you can honor this requirement under different scenarios and conditions, including an outbreak of war, a transit strike, a terrorist attack, a recession, or a global pandemic. Being able to do so can reduce or eliminate your flexibility and prevent you from doing things that you can otherwise benefit from. Debt overhang can prevent you from taking on value-increasing projects. Having to make timely interest payments on a regular basis can prevent you from paying other bills, pursuing an advanced degree, moving to another city in search of better opportunities, or even buying a house.

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Using Credit Cards Many people incur most of their debt with a credit card. Credit cards can provide flexibility, convenience, and access to emergency funds. If you lose your credit card, you are typically protected. With a credit card, you do not need to carry large amounts of cash. If your car breaks down in a rural area, you can use your credit card to have your car towed and repaired. Properly used, credit cards offer welcome convenience. Some credit cards come with rewards, such as cashback, hotel bonus points, or airline miles. You can earn a variety of rewards with credit cards. For some transactions, credit cards are a requirement; you cannot even rent a car or reserve a hotel room without a credit card. Having a credit card stolen is less worrisome than losing cash or having your debit card stolen. Losing cash means everything is gone. Similarly, with debit card fraud, you may be responsible for the entire amount stolen from your bank account. With credit card fraud, however, there is a $50 limit to your liability.435 If you use a credit card responsibly, you can build what is known as a credit score, which assesses your ability to borrow cheaply and pay off a loan. Typically, credit scores range from 300 to 850, with 300 being absolutely the worst and 850 being absolutely the best. Most financial transactions will require a credit score. Most credit scores fall between 600 and 750.436 The average credit score is about 706.437 If you have a credit score below 580, you will, most likely, not be able to access credit. About 16 percent of consumers fall in this group. With such a score, you cannot borrow money from a bank to buy a car or purchase a house. You may not even be able to rent a house. It is possible that a potential marriage partner may want to know your credit score.

435

See, https://www.experian.com/blogs/ask-experian/credit-education/scorebasics/what-is-a-good-credit-score/ 436 See, https://www.experian.com/blogs/ask-experian/credit-education/scorebasics/what-is-a-good-credit-score/ 437 https://www.wsj.com/articles/9-myths-about-credit-scores-11571623800? mod=searchresults&page=1&pos=1

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People with a credit score between 580 and 670 are considered sub-prime borrowers. These people will be able access some credit especially in good times, though at a higher cost. About 17 percent fall into this group. A good credit score is above 670.438 These people will be able to always access credit. A score above 800 is considered exceptional, and these people will have access to the least expensive credit. Only about 21 percent fall into this group. How do you build a good credit score? What should we do to avoid a bad score? First, you need to access credit (sounds like ‘catch 22’). Then you will need to maintain and build on your ability to use credit. For those just starting out, a good place to get a credit card is credit unions, which are non-profit institutions.439 Furthermore, interest rates on credit union cards may be lower, and likely approval rates higher. An alternative is a retail credit card. The credit limit on these cards is likely to be low, but nevertheless, it will help you establish a credit record, credit history, and help you build up a good credit score. One drawback to a credit card is that a lender may be able to repossess your car if you miss payments on your credit card.440 For those just starting out, an alternative is to get a secured credit card, where you make a deposit first, and then access your deposit using the credit card. About 35 percent of your credit score is based on your credit history.441 Thus, the best way to build your credit score is to pay all your bills, including your credit card bills, in full, and on time. Some bills are more important than others. You will hurt your credit score more if you miss mortgage payments, auto loans and credit card payments. A collection action, where the lender attempts to collect an outstanding debt, will also reduce your

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See, https://www.bankrate.com/finance/credit/what-is-good-fico-score.aspx https://www.creditcardinsider.com/blog/credit-union-credit-cards/ 440 https://www.creditcardinsider.com/blog/credit-union-credit-cards/ 441 See, https://www.creditcards.com/credit-card-news/help/5-parts-componentsfico-credit-score-6000.php 439

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credit score. Negative information such as collection action will remain on your record for about seven years.442 Second, about 30 percent of your credit score is based on your credit use. You need to make sure that you are not using most or all of the credit available to you. If you are using more than 30 percent of your available credit limit, you can lower your score. Keeping your credit usage under 10 percent will further improve your credit score. About 15 percent of your credit score is based on the length of credit history, or the age of the credit. The longer your credit history, the better it is. So do not cancel old credit cards. This will reduce your length of credit history. About 10 percent of your credit score will come from new credit. Having too many new accounts will lower your credit score. The signal you are sending is that you are under financial stress, and you need to increase your access to credit. Finally, a credit mix makes up about 10 percent of your credit score. Credit mix means that you have access to different types of credit, including auto loans, home mortgage loans, and credit cards. You can establish that you are able to manage different forms of debt. Inquiring about your credit score will not reduce it. However, inquiries which result in new credit can have an effect. Every time you apply for credit, you are sending a signal that you need more debt. You will reduce your credit score if you have too many hard inquiries for actual usage, especially spread over a longer time horizon. Carrying a credit balance will not help your credit score. In fact, the opposite will occur since it increases your credit usage and reduces your available credit. It is best to pay all your credit balance on time and in full. If you do not use an old card because of high interest rate, you should not cancel it. This will eliminate some of your longest credit history, leaving you with newer credit cards, and reduce your credit score. Instead, you should charge a small, recurring item on this card and then pay it on time. This 442

https://www.wsj.com/articles/9-myths-about-credit-scores11571623800?mod=searchresults&page=1&pos=1

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way, you will not incur the high interest rate. It will also help maintain your credit score and not require much too much attention from you. Credit cards are a useful financial service, but they require care and expertise. Unfortunately, many people treat them as a source of new money. This will lead you into trouble. Credit cards should not be considered a source of either short-term or long-term borrowing. They are just too expensive. As discussed earlier, the average interest rate on credit cards is over 17 percent.443 The average interest rate on private label credit cards is over 27 percent.444 Sustained borrowing at these interest rates will give rise to a huge unnecessary expense. Some people may consider it useful to use credit card debt to start a new business, or keep an existing business going. This is also to be avoided. No business can generate the kind of returns necessary to pay for credit card expense and still remain profitable.

Debt Trap Debt trap means that your debt burden increases with each passing day, leaving you no alternative but eventual bankruptcy. If people treat credit as free money and spend what they have not earned, they can easily fall into a debt trap. This can seriously impair the quality of their lives. Just because the bank gives you credit, does not mean you should take it or spend it. You need to make your own decisions about spending and credit. Credit card issuers do not necessarily have your best interests in mind. They are typically issued by a for-profit company. They want to make money for their shareholders, not you. They want to give you a high credit limit. They make money if you pay off the minimum every month. They want to upgrade you to the next level of ‘prestige’ service offerings, such as a ‘gold card’ or ‘platinum card’, which provide more services and higher credit limits. They want you to carry a balance and borrow as much, and for as long, as possible, at high interest rates. If you borrow and spend all

443

https://www.creditcards.com/credit-card-news/rate-report.php https://www.wsj.com/articles/9-myths-about-credit-scores-11571623800? mod=searchresults&page=1&pos=1 444

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you can, and carry a monthly balance, you would be one of their best customers. Banks suggest that it is acceptable to pay just the minimum payment amounts. The suggested minimum monthly payment amounts are typically only about 1 – 2 percent of the outstanding balance. Furthermore, if you miss a payment, the interest rate can easily jump to 30 percent or even higher. Banks love customers who just make the minimum payments. The surest way to avoid a debt trap is to manage your spending and debt levels. This raises another relevant question. How much should you borrow? When is the amount of debt too much? To answer these questions, you need to pay attention to credit score metrics such as debt service level (interest and principal payments divided by gross income). This ratio should be kept below the 25 to 30 percent range. If this ratio is above 40 percent, you have borrowed too much, relative to your income level.445 Debt-to-total-income is another important credit scoring metric. This ratio must be kept below 50 percent for debt to be considered prudent. Obviously, how much debt is excessive also depends on the interest rate and maturity. If the interest rate is high, or maturity is short, debt levels must be kept even lower. If the interest rate is negative (as in many countries’ sovereign bonds these days), or the maturity is very long, debt levels become less important. If this ratio exceeds 300 percent, you are getting into the danger zone even for moderate levels of interest rates.446 According to Bloomberg, global debt levels have exceeded 320 percent of global GDP in 2019.447 Sovereign debt in developed markets and business debt in emerging markets are especially high. Clearly, these debt levels require vigilance. Assume that you have borrowed $5,000 and went on a shopping spree. You are now carrying this extra $5,000 balance which you do not have the means to immediately pay off. You have been struggling with timely 445

https://www.tandfonline.com/doi/pdf/10.1080/00213624.2019.1603765 https://www.tandfonline.com/doi/pdf/10.1080/00213624.2019.1603765 447https://www.bloomberg.com/news/articles/2019-07-15/global-debtaccelerated-in-1st-quarter-outpacing-world-economy 446

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payments and the bank has raised the interest rate to 18 percent. Now, you have a $5,000 balance at an 18 percent interest rate and you are just making the minimum required 1 percent payments every month, or $50 to start. What will happen to your balance over time? Unfortunately, your debt will just keep increasing. After ten years, you will have already paid over $8,000. Your monthly minimum payments will have almost doubled to $90 and your balance will have also just about doubled to $9,000. After fifteen years, you will have already paid more than $14,000, your monthly payments have risen to $122, but you will still owe more than $12,000. A $5,000 debt has now become $26,000 ($14,000 already paid and $12,000 still outstanding). Both the amount you pay and the remaining balance just keeping growing. Your balance will never go down if your annual interest rate is above 12 percent and you only make minimum payments. In the example above, we assumed that you did not miss any payments. What happens if you miss a few minimum payments? The interest rate can easily jump to over 30 percent. At this rate, the balance will double approximately every two-plus years. Now, your minimum payments will hardly make any dent in your debt. The current balance on this debt is shown in Figure 13.9. If the interest rate were to increase to 30 percent, even with 1 percent monthly minimum payments, your initial $5,000 balance will grow to over $70,000 after 15 years. Yes, the $5,000 initial debt becomes over $70,000 debt while you will have already paid over $45,000 in interest to the bank. Hence, to pay off a $5,000 debt, you now need to pay at least $115,000. Your debt just continues to grow. Credit card debt can become a debt trap if not handled carefully, for just about anyone. A simple $5,000 over-borrowed credit card debt can have long-lasting consequences.

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Most credit card companies will not increase the credit limit to $70,000 for someone struggling with minimum payments. At some much lower level, the limit will be frozen, leading to further financial difficulties, and then followed by bankruptcy. You cannot depend on making only minimum payments. At some point, you have to stop the debt from growing. As set forth in Figure 13.9, the credit limit of $10,000 is reached after about four years. If this is a hard limit, bankruptcy may be looming within four years, after a borrowing of $5,000. What about so-called payday loans? About 12 million Americans use payday loans every year, borrowing over $7 billion.448 These loans can charge interest rates on an annual basis that range from 100 to 1,000 percent. We have just shown that a 30 percent interest rate is too heavy a burden for most people. No one can withstand an interest rate of 100 or 1,000 percent for too long. What is the answer? Obviously, there only one effective solution to this problem. Do not borrow to consume. You must control spending. You need to only put amounts on your credit card that you know for sure you can pay off in full by the time the statement comes. If you are not sure whether you can pay in full, and on time, then do not put it on your credit card. A credit card is not how you should borrow money, either in the short-run or the long run. In most cases, a personal loan from a bank is much cheaper. A credit card is meant for convenience, not as a source of funding, either for the short or long-term. Paying off your credit card balance, in full, and on time, will also enable you to increase your credit score, take advantage of all of the free benefits and rewards that your card offers, and enjoy all the conveniences and security that the credit cards offer. You do not have to worry about having enough money in a restaurant, fraud, losing your wallet, or renting a car. If you end up with a balance on your credit card, you need to pay it off first. This takes precedence over everything else, even emergency savings. This is because the credit card debt is the most expensive source of credit. You need to start with the most expensive credit card debt, pay it off, and move

448

https://www.pewtrusts.org/~/media/legacy/uploadedfiles/pcs_assets/2012 /pewpaydaylendingreportpdf.pdf

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on down. Once you finish paying off all of the credit card balances, you can get back to other savings and investments. What happens when you have too much debt? You send a signal that you cannot manage your financial affairs in a careful manner. Your credit score will decline, which will constrain or prevent your ability to borrow additional amounts for whatever purpose. This will include borrowing to buy a house, a car, or paying for other unanticipated expenses. You may not be able to buy furniture, rent a car, or even sign a lease. This is called debt-overhang. Too much debt will prevent a person from improving his or her life. If debt overhang gets worse, he or she will be forced to choose between two bad solutions, being constrained by the weight of substantial debt, or declaring bankruptcy.

Credit Repair We see television advertisements for credit repair. What does this mean? Is it possible to repair and increase your credit score? The answer is yes. First, by understanding how the credit score is compiled in the first place, you can undertake actions that will improve or repair your credit score. These include paying your bills on time, not using too much of your credit limit, establishing a long history of good credit, limiting the number of hard inquiries on your account, and managing a diverse mix of credit instruments. In addition, you should frequently review your credit report to ensure that there are no mistakes in it. Free annual credit reports are a good way to do this.449 If there are errors, you should dispute them. If there are collections on your account, you can contact the creditors and negotiate a settlement, in return for having the collection notice removed from your account. Let us pose the question again, is debt good or bad? We have seen that it can be both. Debt is a powerful instrument. Used prudently, debt can help us buy a house, a car, or pay for college. Used imprudently, debt can push

449

See for instance, https://www.annualcreditreport.com/index.action

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us into a trap which it can be hard to get out of. Instead of it controlling us, we need to control how much debt we utilize.

CHAPTER 14 USING INFORMATIVE PRICE SIGNALS TO AVOID SCAMS

“By directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he […] is led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it”. —Adam Smith, The Wealth of Nations 1776

Price Signals Prices serve as signals that guide and drive economic activity. This is one of the most important ideas in finance and economics. In capitalist economies, buyers and sellers freely interact with each other to arrive at prices. Using this informative price mechanism, goods arrive when and where they are needed and used. Materials and labor get allocated to their most productive purposes. Market prices are not just a record of activity, but highly informed and informative signals relating to inputs (materials, labor, and capital) and output (goods, products, and services). We can learn a huge amount from competitively determined prices. We can learn, for example, about the costs of producing goods and how the consumer values them. We can also learn about other factors that influence current supply and demand and what makes a buyer or seller behave as they do. Prices are an essential element of Adam Smith’s invisible hand. They are critical to the functioning of the modern economy.450 In this chapter, we focus on the stock market, but we also take a broader perspective and discuss what we need to understand about prices, and what happens when governments manipulate these prices. We will also 450

Friedrich Hayek "The Use of Knowledge in Society" The American Economic Review. 35 (4): 519–530 (1945).

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use the idea of informative prices in making our investment decisions as well as how we can protect ourselves against scams. If we understand the information content conveyed by prices, we can more effectively manage the various assets we own, or are considering. Suppose that you missed a few of your student loans as required. You receive a phone call from a student debt relief company who advise you that they can help restructure your loans and reduce your monthly payments from $1,200 a month to just $325 a month. They say they are registered with the Department of Education. To proceed, they ask you to provide them with your Federal Student Aid ID and a $1,000 advance payment before the end of the day. Do you say yes? Of course not! There are some obvious concerns. First, based on what we have learned so far, the offer seems unrealistic. It seems improbable that the payment can be reduced from $1,200 to $325. Second, it is illegal for companies to collect advance fees for debt-relief services. This should also immediately alert you that something is amiss. Third, you need to determine whether the company is actually listed as an approved service provider.451 Fourth, you should never share your Federal Student Aid ID with anyone. Armed with this information, a fraudulent company can change your contact information and not make any payments, regardless of how much money they receive from you. What was the information signal here? The presumed reduction from $1,200 to $325 should have sent red flags to you. It sounds too good to be true.452 Second, the urgency conveyed by the call should have sent another red flag.453 Why can’t you wait a week, investigate, and get back to them (looking up whether such a company exists and is registered with the Department of Education). Before you act on this ‘opportunity’, you need to investigate it carefully. How do price signals actually work? Suppose you want to buy a used car. There are two similar five-year old cars which had comparable prices when 451

https://studentaid.ed.gov/sa/repay-loans/avoiding-loan-scams?mod= article_inline 452 Using Bayesian inference, the likelihood that such an offer would arise in a fraudulent scheme would be hundreds of times higher than in an honest scenario. 453 Again, think Bayesian here. Why would an honest offer require such expediency?

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they were first introduced as new. Now, you look up average prices for these used cars, and discover that car A is, on average, priced at $8,000 while the other car, B, is, on average, priced at $10,000. What should we learn from these average prices? Which car is the better purchase, on average? Some people may prefer the lower priced car A, simply because it is more affordable. These cars were similar as new cars, yet now car A sells at a $2,000 discount. Thus, if you try to get the best ‘deal’, you will go for A. However, we can draw other insights from these price differentials. One possible explanation is that the cheaper car must have experienced more problems, on average, over the last five years. Consumers are aware of these problems, and they insist on a discount. Although both cars could be purchased at comparable prices when were new, now we have additional information about the average quality of car A relative to that of car B. In other words, in a competitive market, there is a positive relationship between price and quality, and lower price means lower quality. Prices serve as signals. They guide resources to their highest valued uses. Consider an example relating to carbon usage – a most topical theme. Many people are worried about the catastrophic effects of climate change. They argue that one of the primary causes of the problem is overuse of carbon dioxide and other greenhouse gases.454 They further argue that overuse arises because carbon emissions are not explicitly priced. The government does not regulate carbon dioxide or carbon monoxide emissions. Hence, corporations see carbon pollution as a private, costless, activity. If a highly valuable resource is free, companies will make private use of it. The problem is not so much with human or corporate greed, which is always present, but human folly, resulting from having a highly valuable resource that can be obtained for free. Finance and economics have suggested a solution, which is to have the government set a higher price on carbon emissions, and require companies to buy emission rights from the US Treasury, before they can emit carbon gases. This will better align the public and private costs of pollution, and 454

https://climate.nasa.gov/causes/

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allow us to reduce the carbon footprint on our environment.455 The ‘right’ price is the one that sets the marginal public and private costs equal. This price will lower the amount of emissions below a level that does not threaten environmental catastrophe. Air quality is a classic case of what the economists call a public good problem. Everyone uses and benefits from clean air, but no one wants to spend resources to clean it privately, since the benefits go to everyone. The clean air is the public good. It is highly valuable. It also available for everyone to use as they wish at a zero price. To ensure that we do not overuse it, it needs to have a positive price. Only the government can solve this problem by requiring a price for polluting the air from everyone. To get better allocational efficiencies, we could also allow public trading of these pollution rights between corporations. A corporation may buy rights, but after a while may not need them. Others may experience a sudden need. Furthermore, by using cross-border adjustments, a government can also level the playing field between domestic producers, importers, and exporters. While the consumers would pay more for goods and services with a carbon tax, they also get the benefits of lower taxes due to the emission revenue obtained by the government.456 This brings a market solution to a human-caused problem. You can think about the failure to act in this case as a government failure. Corporations simply do not want to pay to clean the air. Using their power to donate to the politicians, they ensure that the government does not act to clean the environment. Sometimes, governments also actively intervene and set arbitrary prices, thus preventing market solutions from taking effect. Although the intention may sound like government is trying to do good, centralized price control can lead to unintended consequences.

455 This is a solution that was recently advocated by a jointly signed letter from some

of the world’s top economists. See, https://www.wsj.com/articles/economists-statement-on-carbon-dividends11547682910?mod=searchresults&page=1&pos=3 456 See economists’ statement on climate control: https://www.wsj.com/articles/economists-statement-on-carbon-dividends11547682910?mod=searchresults&page=1&pos=3

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Some governments, for example, control or influence interest rates or exchange rates. Sometimes, they want to reduce the value of the domestic currency in order to encourage exports and build their domestic industry. At other times, they may want to expand government services, and do so by borrowing and increasing their budget deficit, which leads to higher inflation. In this case, they may typically want to fix the domestic currency at a highly inflated, pegged value. The problem with currency manipulation is that, at some point, the governments are forced to relent and let the currency bounce to its market-determined price. Sudden jumps in exchange rates can create financial crisis in many developing countries.457 Governments also manipulate the interest rates. As discussed earlier, adjusting interest rates is viewed as a monetary tool to make adjustments to the economy. Specifically, governments typically want to lower interest rates. Lower, or even negative, interest rates, in turn, reduce current budget deficits by reducing interest payments, and make it easier for the government to borrow and spend. Lower current interest rates also stimulate additional business activity, thereby leading to higher employment numbers. In response to the Global Financial Crisis, as well as the recent global pandemic, as part of its economic stimulus program of lower interest rates, the Federal Reserve increased the money supply (base-money), from $830 billion in January 2008 to about $5 trillion in October 2020, as shown in Figure 14.1.458 Both the size, and the relative increase in monetary base, are unprecedented in US history.

457

Following a public disagreement between the prime minister and the president regarding the pace of reform in February 2001, Turkish Lira was devalued by about 50 percent in short order, followed by about a nine percent contraction in real output in 2001. See, https://onlinelibrary.wiley.com/doi/epdf/10.1111/j.1467-9701. 2005.00691.x 458 See https://fred.stlouisfed.org/series/BOGMBASE

Figure 14.1: Monetary Base (shaded areas represent recessions)

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The problem of course, is that actions have consequences. There is no free lunch here. Nationalization of private debt, and the associated lower interest rates, may address current problems, but they create a future burden of extra debt. Lower interest rates also hurt today’s savers and retirees, since they live off interest income and distort everyone’s investment decisions leading to wasteful overinvestment, just as when individuals borrow and spend more than they earn creating short-term happiness, they are doing it at the expense of their own future. When the government does it, it comes at the expense of the future generations. An increase in the monetary base may need to be reversed at some point, with likely reversal of the initial beneficial economic effects. Consider Figure 14.1 again. As the Federal Reserve tried to reduce the monetary base in 2013, the stock market dropped (called a taper tantrum) even though the economy was growing strongly, and money supply was significantly above its pre-crisis levels. With strong criticism from the White House, the Fed gave up its effort to normalize the money supply.459 The result is, as ever, the ballooning of the money supply. At some point, we (or our children) will need to pay this piper with financial debt crises, higher inflation, or higher taxes. Governments also can set wages, usually with good intentions, by requiring minimum amounts per hour. Currently, there are calls for a nationwide $15 an hour minimum wage. Is this good for society? Is it good for the lowskilled workers? What are the likely consequences of a big hike in minimum wage? Raising the minimum wage sounds like a compassionate government policy designed to help unskilled workers. Depending on firms’ abilities to absorb these costs, and the cost of automation, minimum wage laws will also see higher levels of unemployment. In 2017, the unemployment rate was 2.5 percent for those with Bachelor’s degree 4.6 percent for those with high school degree, and 6.5 percent for those with less than a high school diploma.460

459

https://www.reuters.com/article/us-usa-fed-2013-timeline/key-events-for-thefed-in-2013-the-year-of-the-taper-tantrum-idUSKCN1P52A8 460 https://www.bls.gov/careeroutlook/2018/data-on-display/education-pays.htm

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There are costs to interfering in competitive markets, and minimum wage is no exception. The critical issue is the magnitude of these costs and benefits. There are basically two main effects when minimum wages increase. One effect is that some businesses affected remain sufficiently profitable, even at the higher minimum wage. These businesses will be able to pay higher wages to those workers who used to receive less than $15 an hour. In this case there is a wealth transfer from the owners of the businesses to the low-skilled workers. In addition, some businesses will become unprofitable at the higher minimum wage, especially those that are dependent on low skilled workers. If such businesses continually lose money because of the higher minimum wage, they will need to close. Many businesses that hire these low-skilled workers will need to either automate or shut down, resulting in additional unemployment.461 In either case, the requirement will actually hurt the people it was supposed to help.462 Clearly, it takes more than a government decree to raise living standards. After all, if a higher minimum wage brought higher income to the less-skilled workers, without hurting anyone, why stop at $15, why not make it $30 or $50? A 2019 report by the non-partisan Congressional Budget Office (CBO) estimates these costs and benefits for various Federal minimum wage levels. At a $15 an hour minimum federal wage, by 2025, CBO estimates that an additional 1.3 million workers would become jobless, while lifting another 1.3 million people above the poverty threshold.463 This is the difficult trade-off. Why, then, would anyone want higher minimum wage laws, since this will hurt both the business owners as well as many of the low-skilled workers who lose their jobs? Maybe because, in addition to those low-skilled

461

See the effects of New York’s minimum wages on the hand-wash car-wash industry https://www.carwash.com/new-yorks-15-minimum-wage-createscarwash-black-market/ 462 As large retailers such as Target, Walmart and Costco announced higher minimum wages between $13 and $15 an hour, they also started automating low skilled jobs. See, https://www.wsj.com/articles/walmart-is-rolling-out-the-robots11554782460?mod=hp_lead_pos5 463 See, https://www.cbo.gov/system/files/2019-07/CBO-55410-MinimumWage 2019.pdf

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workers who get to keep their jobs, there is another group who benefits – the trade unions. Higher minimum wages for unskilled workers, in fact, make the skilled union wages relatively less expensive. Suppose the minimum wage is raised so much that it is equal to the union wages. Why would any employer want to hire unskilled workers when they can hire skilled workers for the same wage? Consequently, minimum wage laws make unionized workers more competitive, and thus increase the demand for union work. Unfortunately, these benefits are not apparent. They simply assume that all workers benefit from the higher minimum wage laws. What about free education?464 Would free tuition make society better off? Would it lead to a more educated, higher skilled society? Would it make students themselves better off? Once again, there are trade-offs. Political solutions can have unintended consequences. Many students are excited by the prospect of free college education. Free education means more students will attend college. After all who can argue with more education? Many students, moreover, have to borrow large amounts (and such loans typically cannot be discharged in a bankruptcy). Is free tuition a good solution? Unfortunately, an accurate picture is more complicated. First, society has many jobs that do not require a college education, but rather various skills, such as carpentry, plumbing, electrical work, and masonry. If most students attend college, then these jobs would be done by college graduates. One must ask whether the time and expense for this will benefit skilled tradesmen. Second, tuition is only part of the costs of going to college. A significant cost is the opportunity costs. This is the amount students forego to be in school instead of working and earning a wage immediately after high school. This is one of the reasons why many PhD degrees are obtained by foreign students coming to the US from less developed countries.465 Since they typically cannot work in the US without an advanced degree such as 464

https://www.cnbc.com/2019/03/12/free-college-now-a-reality-in-thesestates.html 465 https://www.insidehighered.com/news/2013/07/12/new-report-showsdependence-us-graduate-programs-foreign-students

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a PhD, their opportunity cost of staying in school for the next five or six years to get one is less, in comparison with American college graduates. Free tuition does not change these opportunity costs. It will in fact exacerbate them. With free tuition, as more students attend so-called free colleges, the pressure to graduate from college in four or five years will reduce. Free tuition will encourage longer stays in school, thus further increasing the overall opportunity costs. Many who attend college are not likely to benefit from the experience. Many attend because of the availability of almost unlimited governmentbacked loans. Student debt levels are increasing rapidly for those college graduates.466 Clearly, many college graduates are not able to keep up with their student-debt repayments.467 What would free tuition do? When the price of a good goes down, the quantity demanded increases. Thus, with free tuition, college enrolment would further increase, and there will be more students who are not making an optimal choice. If tuition were free, the demand for a college education would increase sharply, while tuition revenues for colleges would fall. Deprived of tuition revenue, colleges would have to increase class sizes, hire even more temporary instructors, and make greater use of distance education. The quality of a college education would deteriorate further. The result would be that most people interested in attending college would do so. They would spend much longer periods attending college. However, if almost everyone attends college, the mere existence of a college degree willl not make much of a difference in their job searches or productivity. The bottom line is that their so-called free-college-degree will not buy much. This college degree will become similar to today’s high school degree. While the intentions may be good, economics tells us that manipulating competitive market prices has unintended, and in many cases opposite, consequences to those intended in the first place.

466

https://trends.collegeboard.org/sites/default/files/2018-trends-in-studentaid.pdf 467 https://trends.collegeboard.org/sites/default/files/2018-trends-in-studentaid.pdf

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This situation in illuminated by a natural experiment in Kalamazoo, Michigan. Some wealthy, anonymous, donors in Kalamazoo have been providing 100 percent-free college tuition to all local students since 2006. According to the Upjohn Institute, this free tuition had limited benefits.468 It has raised college enrollment from 58 percent to 75 percent in Kalamazoo. Unfortunately, college graduation rates within six years of high school graduation barely budged from 27 percent in 2003-2005 to 30 percent from 2006-2012. Among African American students, the graduation rates increased to 23 percent after the program, from 22 percent before the program. Apparently, free tuition does not solve critical social problems. Some argue that there are no negative consequences from government debt denominated in domestic currency.469 These people argue that the government should borrow as much as it needs and spend freely. It should provide unlimited free tuition for college students, forgive all existing student debt, and provide free prescriptions, free universal health insurance, and a living-wage to all.470 If this were the case, we could borrow another $20 trillion, $30 trillion or even higher. We could magically raise the living standards for everyone. This seems to be another case of ‘too good to be true’. The reality is otherwise. First, many governments borrowing in their own domestic currency have defaulted.471 Second, even if the US Government could find this amount of money, even at reasonable interest rates, how would it pay the interest due on this debt? A $40 trillion debt at a 5 percent average interest rate requires interest payments of $2 trillion a year. This amounts to approximately 100 percent of the tax revenues at the current levels. Why would anyone be comfortable lending the US this kind of money? Why would the rest of the world be willing to cut their consumption so sharply so that the US residents can consume above their earnings forever? 468

https://www.wsj.com/articles/does-free-college-work-kalamazoo-offers-someanswers-11561741553 469 See for instance statements by the newly elected democratic representative for New York, Alexandra Ocasio-Cortez. https://www.politico.com/story/2019/02/06/alexandria-ocasio-cortez-budget1143084 470 See, https://en.wikipedia.org/wiki/Green_New_Deal 471 See, https://www.bis.org/publ/work709.pdf

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Once again, these simplistic political solutions are simply cases of free lunches that are too-good-to-be-true.

Efficient Markets One of the most important ideas in modern finance is Efficient Markets Theory, which argues that the market prices of financial instruments incorporate most, if not all, publicly available information. In these situations, there is no better way to determine the value of an asset than the price. You will obtain no further benefit from studying and/or additional consulting with others, even a Nobel Prize Laureate in Economics. In other words, ‘The Price is Right’. Consider, for example, stock market prices. By law, public corporations must disclose timely, accurate, and full information that is of a material nature. Failure to do so can result in fines and criminal convictions. You can even go to prison. So there is a large amount of information about public companies that is available at low cost. It is widely disseminated, accurate, and detailed. It flows into the public realm where it can be analyzed, assessed and incorporated into stock prices. Consequently, stock prices will be highly informative about the future prospects of the underlying firms. Consider the electric car company Tesla, founded, and led by Elon Musk. On August 7 2018, Musk tweeted publicly “Am considering taking Tesla private at $420. Funding secured”.472 This tweet packs a lot of information. It was also widely disseminated. But the Securities and Exchange Commission thought the comments were “false and misleading”. On September 27 2018, the agency sued Musk.473 In its complaint, SEC stated: “Musk’s statements, disseminated via Twitter, falsely indicated that, should he so choose, it was virtually certain that he could take Tesla private at a purchase price that reflected a substantial premium over Tesla 472

See, https://twitter.com/elonmusk/status/1026872652290379776?lang=en See SEC’s complaint: https://www.courtlistener.com/recap/gov.uscourts.nysd.501755/gov.uscourts.nys d.501755.1.0.pdf. 473

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stock’s then-current share price, that funding for this multi-billion-dollar transaction had been secured, and that the only contingency was a shareholder vote. In truth, and in fact, Musk had not even discussed, much less confirmed, key deal terms, including price, with any potential funding source”.474 By suing Musk for a potentially misleading tweet, the SEC was also sending a message to all public companies that all communication must be full, accurate, and not misleading. Mr. Musk eventually settled SEC’s charges by stepping down from the chairman of the board position, and both Musk and Tesla paid a fine of $20 million each.475 The US securities laws require that all public corporations must disclose accurate and material information that is relevant to investors.476 This information then becomes reflected in the market price,477 and is the best determinate of a stock’s value. Consequently, we will not be consistently able to buy before prices go up based on new information, or consistently sell before prices go down. If, for instance, the stock price of the General Electric Corporation (GE) was $32 in December 2016, and it went down below $8 in November 2018, this does not mean that GE stock is cheap, or that it represented a better purchase in November 2018 compared to December 2016. Both prices, in general, fairly represent the true state of health of GE on these different dates. Prices are different because circumstances are different. Whether we buy GE for $32 in 2016, or buy it at $8 in 2018, we pay a price that best reflects its value at a given time. A useful way to understand the Efficient Market Hypothesis is that the market price is on average ‘right’. There are no ‘great deals’ or ‘bad investments’ by buying or selling a random stock at the market price. You ‘get what you pay for’.

474

https://www.courtlistener.com/recap/gov.uscourts.nysd.501755/gov.uscourts .nysd.501755.1.0.pdf, p.1. 475 https://www.cnbc.com/2018/09/29/sec-settles-charges-with-teslas-elon-muskwill-remain-as-ceo.html#:~:text=The%20SEC%20settled%20charges%20with, as%20chairman%20of%20the%20board. 476 See, Reg FD: https://www.sec.gov/fast-answers/answers-regfdhtm.html 477 You can think of the Efficient Market Hypothesis as being the equivalent of ‘The price is right’.

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This is a powerful idea! It was developed by Nobel Prize winner Eugene Fama of the University of Chicago, and he named it the Efficient Market Theory. It provides good news for the amateur investor. The efficient market idea states that you do not need to be a professional stock market investor to do well in the stock market. Every stock is correctly priced on an approximate basis. Hence, any amateur investor can earn similar (or even better) returns as an investment professional. Later, we will talk about the implications for individual investors. Consider the daily returns to Bank of America stock as a function of the prior day’s return over the past five years, from January 28 2014 to January 25 2019. These are illustrated in figure 14.2.478

Figure 14.2- Bank of America returns, 20140.1 2018 Today's Return

0.05

0

-0.05

-0.1 -0.1

-0.05

0

0.05

0.1

Yesterday's Return As you can see, there is no obvious pattern in successive days’ returns. The picture looks, approximately, like a shotgun picture.479 There is no big, observable relation between yesterday’s return and today’s return. Knowing what happened yesterday (whether the stock price rose or fell and how much) does not help much in predicting today’s return.

478

Source: Author’s calculations.

479 The statistical measure, Pearson correlation coefficient, is about 3 percent, which

is not statistically different from zero.

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If the stock price increased yesterday (a positive return), it is approximately equally likely to increase or decrease today. If the stock price decreased yesterday (a negative return), it is again approximately equally likely to increase or decrease today. This means that there is no correlation between yesterday’s return and today’s return. The result is similar if we examine weekly or monthly returns, instead of daily returns. This evidence suggests that it would be difficult, if not impossible, to benefit from stock return patterns, whether they are on a daily, weekly, or monthly basis. As we said before, ‘the price is right’. The reason today’s return does not depend on yesterday’s return is that prices do not overreact or underreact. Consequently, there are no big, obvious patterns in past stock returns that provide an investor with superior performance. Suppose stock prices reacted slowly to incoming news? What would the picture above look like? In this case, we would have expected daily returns to bunch around the positive 45-degree line. Why is this? Suppose good news came, and prices should increase 10 percent. However, there is a slow reaction, and it takes two days for this positive reaction to be completed. If this were the case, positive returns would be followed by another day of positive returns, thus giving a positive slope to the scatterplot. What kind of picture would we have seen if stock prices overreacted to incoming news? In this case, we would have expected daily returns to bunch around the negative 45-degree line. Suppose that same good news came, and prices increased by 20 percent. However, they should have only increased by 10 percent to fully reflect the information. Now, there is an overreaction, and once people realize the overreaction, the stock prices would fall by 10 percent the next day. If this were the case in general, big positive returns would be followed by subsequent days of negative returns, thus giving a negative slope to the scatterplot. Given the shotgun picture, we would expect to find no discernable pattern in successive daily returns. The price reaction to any day’s news is full, accurate, and complete. It is not slow nor is it an overreaction. Figure 14.2 uses daily returns. Once again, the picture remains qualitatively the same if we use minute-by-minute or hour-by-hour returns. There is no

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easily exploitable pattern in stock returns. This is one of the basic ideas of the Efficient Market’s Hypothesis. Another way to express this idea is that it is not easy to beat the market. This is true, not only for individual investors, but also for professional investors, including hedge funds and mutual funds. In an efficient market, even professional mutual fund managers should not be able to beat a simply passive index fund, such as the S&P 500 Index. If there were some publicly available, positive, information that was not incorporated into stock prices, you would expect professional money managers to seek out this information and trade on the basis of it. Using whatever public information available, we would expect professional investors to buy a stock when it is cheap, wait until price rises such that the stock is correctly priced, and then sell it at a high price to make money. Similarly, if they find out some negative information about any stock that is not incorporated into the stock price, we would expect them to sell the stock at the high price before others notice this information, and then buy it back cheaply after the information has been recognized and the price falls. If, on the other hand, professional investors cannot beat the market, this would be consistent with the efficient markets theory. If all publicly available information is already incorporated into the price, then the price is right. This means the professionals will not be able to predict the future direction of the prices. This would mean that the market is efficient. Consider the evidence. Table 14-1 shows the percentage of actively managed funds that underperform their benchmarks such as market averages.480 Focusing on a five-year performance, we can see between 76 and 93 percent of the funds underperform their market averages over a five-year period.

480

See, https://us.spindices.com/spiva/#/reports

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Table 14-1- Percentage of Funds in the US that Underperformed their Benchmarks in 2018

5-Year

3-Year

1-Year

Large caps v. SP 500

76.49%

78.64%

63.46%

Mid-caps v. SP MidCap 400

81.74%

83.28%

54.18%

Small-caps v. SP SmallCap 600

92.90%

93.59%

72.88%

This is exactly what one would expect in an efficient market. If market participants use all available information, then we would expect all publicly available information to be reflected in stock prices, quickly and fully. Consequently, it should not be possible to beat the passive stock market indices using publicly available information. Why, however, do professional managers underperform? It is one thing to match the performance of passive indices, it is something else to underperform. The answer is that it is expensive to acquire, analyze, and act on information. These mutual funds have to buy large amounts of expensive real-time data, then employ an army of analysts or computing power to process the information and then trade on it. This is expensive. Second, most of the performance of indices is driven by a handful of select firms. As of August 2020, without six stocks, Apple, Facebook, Amazon, Netflix, Microsoft and Google, the S&P 500 index which is up for the year, would be down 4 percent.481 If the fund happened not to include some of these six firms, it is likely to underperform the index. Furthermore, active money management is a zero-sum game. Some active fund managers can only make money at the expense of other active fund managers. Given that they all have to spend resources to acquire, analyze,

481

https://www.washingtonpost.com/business/2020/08/19/tech-stocks-markets/

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and trade on information, they would be expected to underperform passive benchmarks as a class. While US markets may be efficient on average, what about foreign stock markets? Can actively managed foreign funds produce above-average returns? The answer is still no. Stock markets in Canada are also efficient. Between 90 and 93 percent of the actively managed large-cap funds in Canada underperformed the S&P/TSP Composite Index, over five-, three-, and oneyear horizons. See Table 14.2.482 Smaller stock funds show similar underperformance. Most actively managed funds underperform their benchmark indices by similar percentages in other countries as well.483 Hence, markets are, in general, efficient. The only small exceptions seem to be India and Japan, where the actively managed funds either equal, or slightly outperform, the passive funds, by about 52 to 48 percent in India and 55 to 45 percent in Japan over a five-year period.484 However, they do not seem to be outperforming passive indices. Certainly, matching the performance of passive indices is no great achievement either. This could be due to small management costs. Table 14.2- Percentage of Funds in the Canada that Underperformed their Benchmarks in 2018

5-Year

3-Year

1-Year

Large caps v. S&P/TSX Composite

89.74%

90.91%

93.22%

Small to Mid-caps v. S&P/TSX Completion

60.47%

81.58%

90.91%

Focused equity v. Benchmark

97.50%

97.53%

94.44%

482

See https://us.spindices.com/spiva/#/reports See https://us.spindices.com/spiva/#/reports 484 See, https://us.spindices.com/spiva/#/reports 483

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At this point, you might still have reservations about the Efficient Market’s Theory. While most funds cannot beat the market, there are some funds that do beat the market. For instance, about 23 percent of the actively managed funds did beat the S&P 500 index over the last five years. Why do not we invest in them? There are two possible explanations for outperformance. It could be due to skill, or it could also be due to luck. So, how can we tell whether it is either? A test of luck versus skill is repeatability. If the performance is due to luck, this should be random. If a fund beats the index because of skill, then that ability should be repeatable. Thus, to determine skill versus luck, we examine whether managers that outperform in a given year continue to outperform. Similarly, if a given fund beats the S&P 500 index in one year and then underperforms for the next year, we would not consider that skill. If an outperformer in a given year continues to outperform in the future, that is likely to be due to skill. Evidence is shown in Table 14.3. In general, we do not observe short-term or long-term repeatability. Out of the 550 domestic equity funds that were in the top quartile as of September 2016, only 21.09 percent managed to remain in the top quartile in 2017, and only 7.09 percent managed to stay in the top quartile at the end of September 2018, after two years.485 This performance is worse than expected on a random basis.

485

See, The Persistence Scorecard at https://us.spindices.com/spiva/#/reports

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Table 14.3: Persistent Performance

Percentage of Top Quartile Domestic Equity Funds in 2016 that Remain in the Top Quartile % Remaining Funds in % Remaining in top September in top quartile quartile in 2016 in 2017 2018 All Domestic Funds All Large-Cap Funds All Mid-Cap Funds All Small-Cap Funds

550 212 76 130

21.09 14.15 23.68 32.31

7.09 6.6 3.95 7.69

All Multi-Cap Funds

132

21.21

9.85

In Table 14.4, five-year persistence is shown. In fact, the five-year performance persistence numbers look worse. For those funds in the topquartile of performance in 2014, less than 1 percent for the actively managed large-cap fund, none for mid-cap funds and none for small-cap funds, continue to remain in the top quartile, in 2018, after five years.486

486

See, The Persistence Scorecard at https://us.spindices.com/spiva/#/reports

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Table 14.4: Five-Year Persistent Performance

Percentage of Top Quartile Domestic Equity Funds in 2014 that Remain in Top Quartile

All Domestic Funds All LargeCap Funds All MidCap Funds All SmallCap Funds All MultiCap Funds

Funds in September 2014

% Remaining in top quartile in 2015

% Remaining in top quartile in 2016

% Remaining in top quartile in 2017

% Remaining in top quartile in 2018

561

21.03

3.57

1.6

1.43

220

21.36

22.27

0.91

0.91

83

15.66

2.41

0

0

129

17.19

3.12

0.78

0

130

25.38

6.15

4.62

3.08

This evidence strongly favors the conclusion that there is no persistent performance. Those funds that do well in a given year do not show up in the top quarter, or even the top half, in future years. This evidence is consistent with the conclusion that luck is an important element of why some funds outperform in a given year. Overall, the evidence suggests that professional money managers cannot beat passive indices using all publicly available information at their disposal. For most of us, the rule that market prices are right on average, and there is no free lunch, is a sensible conclusion. This brings up another important question: If professional investors cannot beat the market, then why pay for their expensive service? The answer is simple. You should avoid all actively managed funds. It is much better and cheaper to invest in passive, low-cost, and broadly diversified, indexed funds.

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There is no free lunch Once you appreciate that markets are, in general, efficient, your view of the world changes in a fundamental way. You realize, indeed, that there is no free lunch. If you want something, you have to pay for it. If something looks like it is free, then the true costs are hidden. Either someone else is paying for it (like taxpayers), or it simply is not free. Suppose that you have applied to a few colleges. You receive acceptance into a good state school, as well as a local private college, which is giving you free tuition, plus room and board. Is this a rare case of a true free lunch? The answer is probably still no. By now, you will realize that there must be a hidden cost. The local school is trying to raise its own stature by having you, Ms. Smart, as one of its current students, and later, as one of its graduates. You will raise the standardized scores, percentage of graduates with job offers, as well as the average starting salary for the local college. You might even, someday, give a large contribution to the school to establish a Women’s Studies program, or build a new training facility for women athletes. So what is the cost? It is possible that you could be even better off borrowing some money to attend a well-known research university with an internationally regarded faculty. Your starting salary, responsibility, and lifetime earnings, may be much higher. Once again, there is no substitute for doing your own homework here. How do you apply these concepts in your personal lives? Suppose that your friend says “Hey John, I invested with a guy named Mr. Madoff. He is great. I am earning about 10.5 percent, year in, year out. I recommend you do the same”. What do you say? It should strike you as suspicious that someone can earn a rate of return that is similar to the stock market average with little risk. There should not be market returns without market risk.

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Consider the evidence. Figure 14.3 illustrates the returns to Madoff’s fund from December 1990 until the discovery of the fraud in October 2008.487 During this approximately eighteen-year period, Madoff reported an average of 0.84 percent return per month, or a geometrically compounded, annual rate of return of about 10.5 percent. This is not spectacular, but certainly impressive. What is amazing, however, is that Madoff hardly ever reported negative returns. There are only 15 months with negative returns out of 215 months. This is less than 7 percent of the months, compared to about 36 percent of the months for the S&P 500 index during the same time period.488 Hence, Madoff is able to avoid about 80 percent of the down months. There are just two occasions with two consecutive months of negative returns. Furthermore, the negative returns reported by Madoff are very small. Even the largest negative return is less than 1 percent in absolute value. The worst return is reported in November 1994 at only 0.64 percent. Unlike Mr. Charles Ponzi, Mr. Madoff did not fool investors with too-goodto-be-true returns.489 His average monthly returns are comparable to, or actually slightly less than, Standard and Poor’s 500 Index returns. What was noteworthy about his performance is an almost complete lack of negative returns or lack of risk! Is it possible to examine what Mr. Madoff reported as his monthly returns in Figure 14.3 and conclude that he was scamming investors? Consider the evidence in more detail.

487

See, “Mr. Madoff ’s Amazing Returns: An analysis of the Split Strike Conversion Strategy” by Carole Bernard and Phelim Boyle, a University of Waterloo and Wilfrid Laurier University working paper. 488 https://www.multpl.com/s-p-500-historical-prices/table/by-month 489 Mr. Charles Ponzi promised 50 percent return every 45 days. See, https://www.wsj.com/articles/the-original-ponzi-schemer11602778470#:~:text=In%20Ponzi's%20case%2C%20he%20promised,Italian%20lir a%20and%20other%20currencies.

(1.00)

(0.50)

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

Dec-90 Jul-91

Jan-95

Oct-96 Dec-97 Madoff's Returns

Jan-02

Oct-03 Dec-04

Using Informative Price Signals to Avoid Scams

Figure 14.3: Madoff's Returns (%), December 1990 to October 2008

Feb-92 Sep-92 Apr-93 Nov-93 Jun-94 Aug-95 Mar-96 May-97 Jul-98 Feb-99 Sep-99 Apr-00 Nov-00 Jun-01 Aug-02 Mar-03 May-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08

435

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To understand what Madoff’s performance implies, we are going to do a similar hypothetical exercise, to the one we did earlier. Once again, we want to understand the risk and performance in Madoff’s fund. We assume that Madoff can continues to generate returns from the historical distribution he reported. By using this historical distribution, we will attempt to replicate the potential risk-performance tradeoffs. Given the low-risk Madoff reports, we will incorporate leverage. We begin with a 9-1 leverage. Thus we are going to borrow $45,000 at the Treasury Bill rate, add our $5,000 equity, and invest $50,000 in the Madoff fund. Using the 215 months of realized Madoff fund returns (always with replacement), we randomly choose a monthly return and assign it to month one. We let our investment amount change by this return. We continue to randomly pick one of Madoff’s monthly returns from his realized returns from December 1990 to October 2008, and use that for next month’s return, applying it to our cumulative investment portfolio. We continue this way until we complete a hypothetical sequence of a 215month investment horizon. This way, we have also computed the wealth path for a strategy of investing $50,000 with Madoff using $5,000 of our own money and $45,000 borrowed once at the very beginning. We then repeat this entire procedure 10,000 times. This gives us 10,000 possible paths that the initial $50,000 stock market investment could possibly have taken, based on historical distribution. This gives us the full range of possibilities of investing in the Madoff fund. Now we can observe both the level of performance as well as the risks associated with his stated returns. Next, we order these 10,000 wealth paths based on the final month wealth level. The lowest, final 215-month wealth level is assigned a rank of 1. The highest 215-month wealth level is assigned a rank of 10,000. Next, we pick the bottom 2.5 percentile or rank 250 as the lower wealth level; the 50th percentile or 5001st rank as the median wealth level; and the top 97.5 percentile or 9,750 rank as the upper wealth level. The range of possible realized wealth levels between 2.5 percentile and 97.5 percentile will give us some idea of risk, with a 95 percent confidence level.

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Our results from this experiment are shown in Figure 14.4.490 After paying off all debt with interest, our median wealth level is a little over $170,000. Thus, using Madoff’s fund, an investor could have turned $5,000 into $170,000, an increase of 34-fold. This is equivalent to over 21 percent per annum return, and corresponds to doubling your investment every three and a half years. The top end of potential wealth levels reaches $237,000, or a forty-seven fold increase in wealth, while the lower bound reaches $115,000 an increase of 23-fold. The mean wealth level is also $170,000, also a 34-fold increase. Obviously, to achieve these phenomenal performance numbers, we borrowed $45,000 and added it to our $5,000. This represents 9-1 leverage. So, the next question is, how risky is this? Do we go bankrupt borrowing this much money? If so, we ask just how often we go bankrupt with this risky, high-leverage strategy. To compute the probability of bankruptcy, we computed the number of times out of 10,000 replications that our debt ended equal to, or greater than, our assets, anytime over the 215 months. So, if the value of our assets falls below our debt, we are insolvent. Here is the answer: Zero times out of 10,000 replications. Literally zero. We borrowed 9-1, yet we did not create any risk of bankruptcy even with a huge amount of leverage. This is in sharp contrast to investing in the S&P 500 index and leveraging by say 2-1. We have already shown in Chapter 9 that even this modest level of debt to invest in stock market (or S&P 500 index) will create a probability of bankruptcy of about 10 percent.

490

Source: Author’s calculations.

438

$-

$50,000

$100,000

$150,000

$200,000

$250,000

Figure 14.4: Put $5000, Borrow $45,000 at Treasury Bill Rate and Invest $50,000 with Madoff

Chapter 14

$170,000

$237,000

Lower Wealth Level

Median Wealth Level

Upper Wealth Level

1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103 109 115 121 127 133 139 145 151 157 163 169 175 181 187 193 199 205 211

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A key theme in finance is that we cannot just examine the average returns and conclude whether this is a good average return or a bad average return. We also have to examine risk. Even small average returns may be, and should be, viewed with suspicion if they come with too low level of risk. Similarly, even high average returns would not be attractive if they come with even higher levels of risk. We cannot evaluate returns without evaluating the risk associated with them. It is now evident that what Madoff has done is to engage in fraud. Theoretically, Madoff has created a practically bankruptcy-free, money machine here. There is zero chance of bankruptcy, even if you lever up his returns by 9-1. This is what makes Madoff’s performance just too-good-tobe true. It is just about risk-free, and as bankruptcy free as you can get. To push this line of inquiry a bit further, next, we want to know what would happen if we doubled the amount of borrowing. Is there any risk now? Do we go bankrupt now and if so, just how often? To answer this question, we now borrow $95,000, add our $5,000, and invest $100,000 with Madoff. Now the leverage is 19-1. What would happen to our wealth and risk levels with this leverage? The median wealth after paying off all debt with interest is now around $325,000. This represents a jump of 65-fold in just 15 years. The equivalent annual rate of return now jumps to over 26 percent. Money doubles in less than three years. At this rate, $1 million becomes $65 million in 15 years. What about the bankruptcy probability? Our portfolio was insolvent just once in 10,000 tries. Risk is still mostly non-existent. Once again, this exercise makes Madoff’s returns just too good to be true. His returns were pretty modest. However, his risk level is just too low. We need to realize that, while we started out with a 9-1 leverage, we did not end up with it. Our equity position grew rapidly close to $170,000 while our debt only increased to about $75,000 after 215 months. By the end, our leverage was much less than 1-1. Given the so-called apparent success of Madoff’s fund, we could have maintained a 9-1 leverage throughout the entire period. After each month, if our equity grew too much, we would borrow an additional amount and reduce our equity to exactly 10 percent of our assets. If our equity did not

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increase too much, or it declined, we would need to pay off some of the debt and still maintain an equity level that equals 10 percent of assets. These transactions would allow us to maintain a 9-1 leverage throughout the hypothetical exercise. In Figure 14.5, we show the results of maintaining 9-1 leverage. Now the median equity levels jumps close to $11 million. The upper end reaches $66 million while the lower end also reaches $1.7 million. The implied annual rate of return is over 53 percent. It only takes about one and a half years for the money to double now. With all this leverage, the risk of bankruptcy after 215 months still remains at zero. The probability of bankruptcy is still literally zero after 10,000 replications. Now we can fully appreciate Madoff’s fraud. His reported performance is powerful enough to turn $5,000 into $11 million after only 18 years, with zero probability of bankruptcy. This should strike anyone as nothing less than absolutely magical. Given that Madoff reports good performance numbers with little risk, a rational and skeptical investor would ask the following question. Given his ability to generate good-sized, and highly stable returns, why does not Mr. Madoff himself borrow money from the banks cheaply, instead of asking for expensive, outside equity money from investors? After all, as we saw earlier, raising equity forces him to share his good fortune and great talent with outside investors. Why not keep it all to himself? He can do this simply by borrowing money instead of raising equity just as we did with the above exercise. For many hedge funds, 9-1 leverage is not excessive by any means. For instance, the hedge fund Long-Term Capital Management famously operated with about 300-1 leverage491 (One of the partners in this fund was Myron Scholes of the Black-Scholes option formula). Surely, Mr. Madoff could have borrowed 9-1, as in the example above, himself. He could, perhaps, have borrowed even more.

491

See, Trillion Dollar Bet, http://watchdocumentaries.com/trillion-dollar-bet/

$-

$10,000,000

$20,000,000

$30,000,000

$40,000,000

$50,000,000

$60,000,000

$70,000,000

$80,000,000

Figure 14.5: Put in $5,000, Borrow $45,000 at Treasury Bill Rate and Invest $50,000 with Madoff and Maintain 9-1 Leverage

Using Informative Price Signals to Avoid Scams

Lower Wealth Level

Median Wealth Level

Upper Wealth Level

441

$11M

$66 M

1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103 109 115 121 127 133 139 145 151 157 163 169 175 181 187 193 199 205 211

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Investors should have asked the following question: Why does Madoff need investors’ equity money, which is very expensive as we saw earlier, when instead, he could have borrowed cheaply from the banks? With hindsight, of course, we know the answer. His returns were fake. He could not have gone to the banks to borrow anything.492 How powerful is 53 percent per year? Consider the following experiment. Madoff Securities has been in business for about 48 years, from 1960 to 2008. What would happen if Madoff could use his own strategy of investing? If Mr. Madoff did this on his own, invested $1,000 of his own money in 1960, borrowed 9-1, or $9,000, and maintained this leverage ratio, he could turn $1,000 investment into more than $240 billion after 40 years. This is the power of 53 percent per year. He could have turned $1,000 into $240 billion and become the richest person on earth by the year 2000. Thus, we can now clearly see how Madoff fooled investors. He promised to give his investors average stock market returns with none of the market risk, creating an imaginary money machine in the process. This would be magic indeed, if it were to be true. Finance tells us however, that there are no money-machines. This basic lesson of finance should alert us to the possibility of fraud immediately. If someone were to discover a money machine, they would use it themselves. Anyone with such a magic touch does not, and should not, need any outside equity money. So, we have our answer. If anyone promised you either high returns with modest levels of risk, or good returns with zero risk, you should ask yourself: Why does he need my money? If he is so good, he can get any and all the money he needs from the bank. This sounds like it is too-goodto-be-true. And it probably is.

492

The observant reader will notice that banks specialize in due diligence that manage their risks whereas even wealthy investors or successful commercial companies often do not do a good job of due-diligence. A case in point is how wealthy, sophisticated investors in Theranos failed to conduct even basic due diligence. https://www.marketwatch.com/story/the-investors-duped-by-the-theranosfraud-never-asked-for-one-important-thing-2018-03-19

Using Informative Price Signals to Avoid Scams

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Scam Signals The general common feature of all scams is the promise that you get something for nothing. Madoff promised decent returns with little risk. Efficient markets theory advises us that this cannot happen. If there is no risk, there should not be much of a return either. We cannot repeat enough the statement that ‘there is no free lunch’. To avoid getting burned by scammers, you need to be alert to fraud. Discovering scams and scammers is not unduly difficult. Scammers give signals. We just need to know how to notice them. One of the oldest scamming tricks in the world involves pyramid or Ponzi schemes.493 You put some money into a pyramid organization (sometimes this involves buying a large inventory of whatever they market), recruit seven of your friends to do the same, and then have each of them recruit seven more friends in turn and so on. At some point, you are promised to receive the benefit of downstream recruits. While this scheme seems silly, unfortunately, many people get fooled. Ponzi schemes are doomed to fail, since the number of people needed to keep a Ponzi scheme going grows exponentially. A Ponzi scheme involving seven recruits requires 14 billion people to sign up to keep it going for just 12 rounds. One of the best ways to avoid investment scams is to limit your investments to publicly listed companies. Private investments (which may involve Ponzi schemes) require extra attention. Most people should avoid private investments. They may be appropriate if you are a wealthy, sophisticated, and experienced, investor with lots of time to devote. Once you make investments in public companies, it is advisable to consider restricting your choices to well-diversified mutual funds, not individual stocks. Mutual funds give you maximum diversification at low cost. This is extremely valuable, and very easy to achieve. Similarly, it is advisable to consider limiting your exposure to actively managed funds. Once again, an actively managed fund means a fund where the portfolio manager tries to beat the market. As we have seen, 493

For some examples, see https://complianceandethics.org/the-biggest-ponzischemes-ever/. Madoff’s fund can also be considered a Ponzi scheme since he used new money to pay off old investors.

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most professional managers not only fail to beat the market, but they also take extra risks and charge the investor a premium. Many actively managed funds are expensive without any upside benefit. Passive funds try to replicate the performance of broadly based indices, such as the S&P 500 index. They give you low-cost diversification. They also have very low expense ratios. For instance, the Vanguard 500 Index Fund has an expense ratio of 0.04 percent. This means that they manage $10,000 of your money for $4 a year.494 Another benefit of passive investing is that trading costs in your portfolio will be kept to a minimum. This is because they are not constantly buying and selling stocks. Instead, they simply replicate a passive index. This may increase your tax-efficiency, since you are not realizing taxable capital gains and thus increasing your after-tax returns. As long as you do not realize your capital gains there is no tax due. What matters is the after-tax returns net of expenses, not gross returns. Thus, a prudent strategy for most investors makes use of passive index funds using low-cost brokerage firms. If you want to make private investments, you have to engage in careful research. Again, we do not recommend this for the vast majority of investors. Here are some additional precautions to consider (and you also want to consult with a legal and accounting adviser). First, you need to do some research on your financial money manager. Make sure that the manager is registered with the SEC. By visiting the SEC website, you can find a lot of information about your chosen investment advisor.495 Look for possible ethics violations in the past. If there are any, simply avoid these funds. Also, if your investment advisor is not registered with the SEC, that should immediately send a red flag. Second, beware of any schemes that seem unusual. Be wary if the sponsor says you have to invest today, or if the opportunity is limited to the first 100 people. If this is a legitimate business, why would it be limited in time

494 John C. Bogle, the founder of Vanguard, who recently passed, revolutionized low-

cost investing for the middle class. See, https://www.nytimes.com/2019/01/16/obituaries/john-bogle-vanguard-dead.html 495 https://www.sec.gov/help/foiadocsinvafoiahtm.html

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or limited in number of people? The sponsor should be happy to get as much money as possible. Any deal shrouded in secrecy should be suspect. If the sponsors do not want to advertise their names, you should be suspect. Why should a successful businessperson want secrecy? They should be happy to have as much exposure as possible. Getting something for nothing should make you fearful, not greedy. After all, no one gets anything for free. It just seems that way. Suppose that a business proposition promises to pay between a return between 3 and 4 percent. Meanwhile the risk-free rate, namely Treasury Bills, are yielding 0.25 percent, while the stock market has averaged about 11.5 percent over the past 90 years. Thus, this investment offers much less than the stock market, but ahead of the risk-free rate. Should we worry about fraud here? Could this be a legitimate business opportunity? The answer is that it is most likely to be a fraudulent operation. How do we know this? There is no free lunch. Even this modest proposition must be suspect, because it is promising zero risk (nothing below 3 percent), while it pays greater than the risk-free rate (0.25 percent). Thus, it is promising to give you no risk, yet a positive risk premium. This represents something for nothing. In general, if something is truly risk-free, its return must be less than, or at best equal to, the risk-free rate. You need to be skeptical. Scammers need money. They like people to give them their money, and to be willing to wait for a long time. So, retirees are usually a preferred target. They will also pay people generously to direct other people’s money to them. Hence, if a business sponsor is paying generously for referrals, you should be suspect.496 How do we know this? Again if this business idea is

496

In fact, as we learned subsequently, many of the professional hedge fund managers that Madoff interacted with were part of his scam. They got huge referral fees by sending their client’s money to Madoff. Furthermore, Madoff paid these feeder funds a lot more generously than the industry norm. Many other professional investors smelled a rat and not only stayed away from Madoff but also refused to do business with him. See, https://www.sec.gov/news/studies/2009/oig-509/exhibit-0293.pdf and https://www.sec.gov/files/oig-509.pdf

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such a great idea, why should it require high referral fees to generate interest? Earlier we learned that, in a business relationship, character is the most important factor. If honesty and integrity are missing, you do not need spend any further time. Another useful principle is as follows: ‘Show me who your friends are, and I’ll tell you who you are’.497 If you are in doubt about any of the individuals who are affiliated with the organization for any reason, walk away.498 A good rule to keep in mind is that ‘tigers do not change their stripes’. Once a cheat, always a cheat. Keeping to this rule will protect you. If you think the sponsor is giving you a great business opportunity by cheating his other clients, this is a recipe for disaster. If the sponsor does not mind cheating some of his other clients, surely he will not care about cheating you either.499

Avoiding Identity Theft A big scam that we all worry about is identity theft. Tens of thousands of bits of identity information are available for sale on the dark net for less than $10.500 Our online bank account passwords, Facebook passwords and our mothers’ maiden names are all for sale. Is there anything we can do about this? The answer is that while we cannot protect 100 percent against identity theft, nevertheless, we can take some steps to reduce its damage.

497 This quote is

attributed to Vladimir Lenin but it also appears as a proverb in many cultures such as Assyrian, Mexican, Japanese, and others. 498 Early in his career, two of the feeder funds for Madoff were found guilty of accounting irregularities. They were ordered to return their customers’ money which they did by getting money from Madoff himself. This incident should raise sufficient doubts about the kinds of people Madoff did business with and raise a red flag. See, https://www.sec.gov/news/studies/2009/oig-509/exhibit-0293.pdf and https://www.sec.gov/files/oig-509.pdf 499 Many people apparently thought that Madoff was front-running his brokerage customers, and benefiting his clients in the hedge fund. This is a silly rationale for investment. See, https://www.sec.gov/news/studies/2009/oig-509/exhibit-0293.pdf and https://www.sec.gov/files/oig-509.pdf 500 https://www.nbcnews.com/tech/security/your-identity-sale-dark-web-less-1200-n855366

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First, check on your credit report at least once a year. You should review your credit history to make sure there are no errors. According to the Federal Trade Commission (FTC), about 20 percent of people had serious errors in their credit reports.501 You can check your history by going to http:/annualcreditreport.com, or by getting a credit card that provides monthly updates on your credit score for free.502 Second, use unique passwords for different purposes and change them frequently. To insure against having your passwords stolen, you can encrypt your password information by substituting a different letter or symbol for a given letter. For instance, you can record and store your password using the symbol ‘!’ instead of the letter ‘b’. Since only you know this, even if your passwords do get stolen, they will be useless to others. Third, use credit-monitoring services or credit-fraud alerts. You can also freeze your credits. Evidence suggests that a credit freeze is the most effective of the three options. You can call any of the credit reporting services, such as Equifax, Experian, or Transunion,503 and ask them to put a freeze on your credit. This will cost you a one-time fee of about $10. Fourth, generate credit information. Once you put in a credit freeze, you should try signing up for multiple credit cards. If you succeed in acquiring any new credit, that means the system did not work at some point. This means identity thieves can also acquire credit in your name. Armed with this information, you will need to go back and fix whatever did not work. Once you put a freeze on your credit, no one (including you) should be able to use your name or your security number to apply for new credit, sign a lease, buy a car or a house, or even get a new gas or electricity service. Anything that requires a credit check will automatically be blocked. If you do need new credit, you will need to lift the freeze temporarily yourself, and reinstitute it after say one or two weeks, with a temporary lift. This will cost you another one-time fee $10. A temporary lift will expire after whatever time period you specify, and the freeze will return automatically. 501

https://www.ftc.gov/news-events/press-releases/2015/01/ftc-issues-followstudy-credit-report-accuracy 502 For instance, the Discover card provides free FICO credit scores on a monthly basis. See, http://www.discovercard.com/ 503 See, https://www.equifax.com/personal/, https://www.experian.com/ and https://www.transunion.com/

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This is inconvenient but infinitely more convenient than having to deal with identity theft. Fifth, use a credit card instead of a bank debit card. With a credit card, your maximum liability is $50 if you lose your card and the charges are posted before you notice them.504 You are not responsible for any charges if they occur after you report your card missing or the number is stolen while you have not misplaced your card. Debit cards differ. If you report misuse within two days, you are, again, limited to $50 liability. Between two and 60 days, your liability jumps to $500. However, if you wait more than 60 days, you are liable for the full amount that is stolen. Thus, you need to carefully check all items on your debit card statement especially carefully and if you do experience unauthorized expenditures on your debit card, you need to report it immediately. 505 Sixth, you can refuse to provide detailed information about yourself such as your mother’s maiden name or your full social security number, even if a merchant asks for it. You can refuse to give your bank account information or any other useful personal information to anyone over the phone. If the merchant still insists, you can just walk away. You will need to guard all personal and financial information. Shred financial and tax documents instead of putting them in the trash; cut up old credit cards instead of discarding them; and keep a separate record of all of your credit card information so that you can report them as missing if need be. If you can afford it, you can also get a Virtual Private Network (VPN). This will protect your identity and encrypt your communications. Hence, VPN usage will make it difficult if not impossible for anyone to intercept your internet communications.

504

See, https://www.consumer.ftc.gov/articles/0213-lost-or-stolen-credit-atmand-debit-cards 505 https://www.experian.com/blogs/ask-experian/credit-education/preventingfraud/credit-card-fraud-what-to-do-if-you-are-a-victim/

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Why do so many scams succeed? Unfortunately, we get greedy, complacent, or lazy. We want something for nothing, and we are not inclined to do even a little work to protect ourselves. When we see something for nothing, we drop our guard, our rationality takes a break, and we want to believe in the tooth fairy. Thus, to avoid any scams, you should ask yourself why something-for-nothing would exist in the first place. This should make you fearful, not greedy, and force you to walk away.

CHAPTER 15 PUTTING IT ALL TOGETHER

“The real philosophers, however, are commanders and law-givers; they say: “Thus shall it be!” They determine first the whither and the why of mankind, and thereby set aside the previous labor of all philosophical workers, and all subjugators of the past- they grasp at the future with a creative hand, and whatever it is, and was, becomes for them thereby a means, an instrument, and a hammer. Their knowing is creating, their creating is a law-giving, their will to truth is – Will To Power”. —Friedrich Nietzsche, Beyond Good and Evil, Translated by Helen Zimmern.

We have come a long way and covered a lot of ground. Hopefully, your fear of finance is gone by now. Once the fear is gone, we need to build up courage and expertise. The key to understanding, mastering, and internalizing all of this knowledge is to put them to use and practice these ideas on a daily basis. Finance typically sounds easy and intuitive when it is explained. However, a better test of understanding is to put the ideas to practice on a daily basis. First, in this book we have provided the scientific framework to understand the world better. The framework includes the rational, scientific basis for new learning, namely the Bayes Rule. In addition, we have provided you with important concepts, such as cash flow analysis, information asymmetries, risk-return tradeoff, and the Efficient Market’s Hypothesis. One important lesson of finance is how to understand and deal with risk. Finance teaches us to pay attention to expected probabilities, expected payoffs, and expected returns. We calculate expected values by multiplying various likely outcomes by their probabilities. This means we are neither solely tempted by extremely positive outcomes, nor completely scared by extremely negative outcomes.

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To use the Bayes rule, we again start with probabilities and expectations. Once we understand probabilities and expectations, the world becomes a lot clearer. We start with objectively formed prior expectations. We then think about alternative hypotheses, and ask ourselves how likely the data that we observe are, based on these alternative hypotheses. This gives us our likelihood ratio. By multiplying the likelihood ratio with our prior odds, we form our revised world view, or our posterior odds. It is a good idea to be always cognizant of the Bayes Rule, and use it as often as we can. Using expectations, we learn that gambling is always a losing game, no matter how big the jackpot is. In fact, in the long run, the surest way to destroy your wealth is to gamble. We also learn to appreciate the slowand-steady wealth-building capabilities of the stock market. In the long run, despite all the risks, it is hard to replace the stock market as the main engine of wealth creation. In order to make smart decisions, we need to estimate expected cash flows. Here, a basic knowledge of probability is essential. Expected cash flow means the potential cash flow multiplied by the probability of attaining it. If we can earn $2.5 million a year playing professional basketball in the NBA, but the probability of signing with the NBA is 3 out of 10,000, then the expected value of NBA wages is only $750 a year. We need to pay attention to $750 a year, and not $2.5 million that successful players receive in organizing our priorities. One of our biggest challenges in life comes from the risk of financial security. We have argued in this book that attaining long-term financial security is within the grasp of most of us. To get started with financial security, we need to save first. Saving is a lot easier than increasing our income. Hence, the beginning point to financial security is always substantial savings. Typical Americans save 5 percent of their income. In many European countries, this figure is between 10 percent and 20 percent. So, aiming for a 10 – 20 percent savings rate is a good start. Understanding why we spend is necessary for us to begin to save. A lot of our spending comes from projecting an image of ourselves as successful, lovable, and respectable, people. Unfortunately, these are the very attributes we cannot buy with money.

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The idea of saving is to have you think about trade-offs. We asked you to compare the value that you get from current consumption against what you give up. A top-down approach to savings starts from a preset level of savings, and then allocates the remainder to consumption needs. It is also important to become an informed consumer in order not to be manipulated by commercial messages and to ensure that we are able to save a proper amount. Saving is simply the trade-off between short-term happiness and long-term happiness. Giving up something today and saving does not mean total abstinence. It simply means we have even greater consumption in the future in return for less consumption today. We need to aim to save a minimum amount of $5,000 a year when we are in our 20s. If we wait until our 30s, our minimum saving amounts rise dramatically. In fact, they triple to $15,000. If we wait until our 40s, the amount triples again. Hence, it is best to start as early as possible, but it is never too late to start. Once we save, we need to invest. By investing, we mean passive income generation. In this book, we ask you to stay away from active, private, investments unless you have expertise, experience, and the time to manage them. Most people do not. Private investments require expertise, experience, and time to determine the true value and the risks of the investment. In contrast, you do not have to be an expert to make public investments. Public investments benefit from timely, full, accurate, and legally-mandated information disclosures. Furthermore, competition among investors ensures that the price of an asset is approximately correct. There is no such assurance with private investments. Private investments may be wildly overpriced or even fraudulent. Without sufficient expertise, we are at a disadvantage. Consequently, we advise our readers to stay away from private investments. We also recommend that you stay away from active trading. What is the difference between investing and trading? Investing is simply buying risky assets with high expected returns and holding on to them for a long time. Trading means we buy an asset regardless of its true value, as long as we expect its price to go up a short time later. Trading requires special skills, which most people may or may not possess. In this book, we recommend staying away from trading.

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Thus, by investment, we mean publicly listed stocks and bonds in a passively managed portfolio. The returns on publicly listed common stocks have averaged about 11.5 percent per year over the past 90 years. These returns are sufficiently high to get us on the road to financial security. We do not need to earn 20 or 50 percent per year to achieve long-term financial security. Second, even stock market investing comes with a lot of risks. Stock prices do not go up every year. In fact, once every three to four years, stocks typically decline on an annual basis. We need to understand and feel comfortable with these year-to-year fluctuations. Thus, to become smart investors, we need to understand and manage the risks of investment. The first lesson in managing risk is to understand our own risk tolerance. We should not expose ourselves to greater risks than we can tolerate. If we do, we will find ourselves backtracking at the worst moments. Staying within our risk tolerance means that we are not going to be scared of market fluctuations. Even if the market declines by 50 percent, we are not going to pull out of the market. In fact, the decline in the market should encourage us towards greater investment (using a strategy of balanced-portfolio investment). One way to manage the risk in the stock market is to invest for the longterm. We learned that the longer we invest in the stock market, the lower is the probability of losing money. The risks decline with greater time remaining in our investment horizon. When we are young, we need to keep most (90 percent), if not all, of our savings in the stock market. As we get older and closer to retirement, we can shift greater amounts of our wealth and savings into long-term bonds. We need to take lots of risks when we are young. If we run into problems, there is a lot of time to make up for our mistakes, or bad luck. As we get closer to retirement, we can think about putting more of our money in less risky assets, such as long-term government bonds. A good policy is to put 90 to 100 percent of your long-term investments into the stock market when you are young. As you get closer to retirement, you can cut the stock market component to about 60 percent and put the remainder in realestate and long-term government bonds.

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We learned that we should not try to time the market. We should not go in and out based on market fluctuations. One of the worst things we can do is to exit the stock market when it is down. We would be locking our losses once and for all if we do this. This kind of discipline is easier said than done, as most people will panic watching their life-long savings decline day after day. Their first reaction is to pull out of the stock market. If you feel panicky about the stock market, you probably have too much risk exposure to begin with. We need to invest in low-cost, well-diversified passive index funds, instead of individual stocks. Keeping costs under control is important. Paying a 2 percent expense fee per year can eat into more than 80 percent of your returns in the long run. There are many stock mutual funds where the expenses are 0.10 percent or less. We do not need to buy individual stocks. Buying a few individual stocks does not give us diversification. We need to buy a well-diversified mutual fund instead. Index funds based on Standard & Poor’s 500 Index is one way to do this. There are lots of mutual funds that make available low-cost, well-diversified, indexed mutual funds. We do not need to forecast the future returns to the stock market. We do not need to choose the best stocks based on the current economic conditions and invest in those stocks only. The best portfolio for everyone is a well-diversified, low-cost index fund, regardless of the current economic conditions. Based on your own risk-tolerance, you can invest more or less of your savings in the stock market. Our next big idea is making smart personal investment decisions. We discussed two simple investment decision rules, payback period, and return on investment (ROI). Payback refers to how quickly you recover your investment. A short payback such as less than five years, is typically good. ROI shows the return on investment. We compute ROI by dividing the expected cash flow generated by the project by the initial investment required to take on the project. A good project has a higher ROI than you can earn elsewhere with our money. The finance approach is telling us to maximize the value of your assets. To maximize the value of your asset, you have to take all good projects (high ROI) that increase value, and reject all projects that decrease value (low

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ROI). A project creates value when its market value exceeds the cost of undertaking it. A good project pays for itself quickly and generates a high rate of return, typically, over 10 percent per year. Think of your current projects. Are they likely to create or destroy value? If they are likely to destroy value, think about abandoning them, regardless of how much you happened to invest in the past. If they are creating value, can you improve them? Let us apply these ideas to developing human capital. Your human capital is your big asset. Your human capital will help you get a good job, maintain good social relations, preserve your health and happiness, and enable you to stay out of trouble. Think of where you would like to end up forty years from now, where you are now, and what you need to do to get there. This is the cost-benefit framework of finance. Think about how you need to develop your human capital to achieve your objectives. This will force you to think about your talents, strengths, weaknesses, and resources. This may involve more education or more direct experience. It may involve making the right contacts and creating the right network, and it may involve reevaluating your current relationships. If there is not a good match between your objectives and your total resources or network, you may need to make some mid-course corrections. We then asked you to fill-in this big picture with individual projects. Once you frame an investment question, the finance approach requires you to gather real-world data. What is the salary level for different career paths? What investments do you need to make to change your career path? These numbers need to be the most up-to-date and accurate. You always need to ask, what is your projection, based on recent developments? Let us take college education as an investment in our human capital. Is this always a good investment? Should everyone go to college? The answer is no. Using the finance tools, we can compute the payback period and ROI associated with an investment in college. If for a given choice of college and major, your payback period is 20 years or more, you can easily conclude that attending college is a bad idea. Similarly, if the ROI from

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attending college is only 3 percent, while you are paying 7.5 percent to pay for student loans, once again, this is likely to destroy value. Using these finance tools, we discovered that getting a college degree makes good financial sense for some students. These are likely to be highly motivated, hard-working students who attend selective colleges, choose majors with a high college premium (80 percent or above), graduate in four years, and land a high paying job immediately after graduation. For most others who choose (or are forced) to go to non-selective colleges, graduate in six or more years, drop out of college, or experience substantial delays in getting a job requiring a college degree, attending college is not likely to make financial sense. In our business, social and personal interactions, understanding people’s incentives is important. Incentives can affect what people say, what they profess to believe, what they do and how they behave. If you are seeking objective advice, you should not only ask whether the person giving the advice is qualified, but also whether they are incentivized to do so. While determining the incentives of opposing players is never trivial, we can get some idea by asking questions as to who pays them and how much they get paid. If your financial advisor does not charge you directly, you can safely assume that they get a commission from the products they recommend that you buy. You can ask what this commission rate is. Suppose the admissions officer you are talking to works on a commissions basis only. He receives a $500 bonus if you enroll in that college, and zero if you enroll in another college. How does this information affect your opinion on the kind of information or advice you will receive? Are you likely to get objective advice from this person? How will it affect your college choice? What we need to do next is to see if there are conflicts between your interests and the opposing players’ interests. Suppose you have skin in a particular game (where you benefit from positive outcomes and are hurt by negative outcomes). The opposing player also benefits from positive outcomes but receives a zero payoff from negative outcomes. This means there are no conflicts from positive outcomes but there are conflicts from negative outcomes. One way to reduce these conflicts is to have the opposing player also participate (bear some of the costs) of negative outcomes.

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Many experts are highly qualified to provide guidance, but they may not be incentivized. This can be a big problem in science, medicine, and public discourse, areas where experts can shape public policy. If a scientist receives research funding from an industry player, they are more likely to espouse views that further the interest of the industry, instead of the consumers. The best remedy for potentially conflicted interest is sunshine and transparency. In science, authors must disclose the sources of any research funding that they receive. In medicine, physicians are required to disclose any payments they receive from pharmaceutical companies and device makers. By checking this site, https://openpaymentsdata.cms.gov/, you can have a better idea what payments your physician is receiving from drug manufacturers. This information can help you decide whether a particular medicine you are getting is likely to be influenced by the pharmaceutical company’s interests. Another big idea from finance is flexibility: We have talked extensively about flexibility and how to create and manage it. Pick an event in the past that involved gaining or losing flexibility and think about how you handled it originally. Having read the book, how would you handle it now? Based on what you have learned in this book, what some of the alternative ways of handling it? What are the advantages or disadvantages of each of these? It is this daily practice that is going to make all of these ideas your own. Financial security confers flexibility. It confers more confidence and control. It means that you have a menu of choices and you can choose the best alternative. It means you are in control. Financial flexibility means that you can take many hits in life, and still recover just fine. Without financial security, any kind of unfortunate event such as an injury, illness, or death of a loved one, can create permanent and irreversible damage. Consequently, without financial security, you can end up constantly worrying about life’s many ‘what ifs’, even if the probability is small, or even about past events that cannot be changed any more (where the probability of a different outcome is zero). What if you get seriously ill? There are precautions you can take today. Certain life-changing decisions lead to forks in the road, such as marriage, children, and career choices. Using finance, we can make more rational

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decisions about these risky choices. We have learnt that sometimes we need to ignore some of the irrelevant issues, such as what happened in the past, and learn to focus on relevant, incremental future issues.506 What is the alternative to financial security? you might ask. The alternative is simply financial dependence on others. There is a continuum of degrees of financial dependence, from minor to extreme. One minor outcome of financial dependence or financial fragility is that we must usually satisfy others’ wishes and play other people’s games, whether we want to or not. If we are out of work, and we need food and shelter, we will agree to whatever offer comes along. In the process of playing other people games, we make commitments to them and we suffer inflexibility and stress as a result. Some even more serious outcomes of financial fragility are that we can get stuck in undesirable, unethical, or even criminal, situations. Financial fragility involves degrees of emotional and physical stress, and can even lead to indentured servitude. Just because we have a well-paying job today does not guarantee protection from financial fragility. Without financial security, one possibility is that we bank on working until the day we die.507 For some, working till death may sound just fine. If we are healthy, able to work and truly enjoy our work, working till death may be absolutely fine. At least we stand on our own two feet and make the decision in good faith. If we can be proud, independent, and self-sufficient, this does not sound too bad. But is it realistic? Unfortunately for most, working till death is not realistic. In the US, about 85 percent of working Americans have already retired by the age of 65.508 Sometimes, there is simply no work available. Others get sick, and become unable to work. Other people get disabled, disillusioned, or simply become uninterested in work. At some point, just about everyone will grow old and

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The financial term here is sunk costs. Suppose something costly has happened in the past that we cannot change in any way. These are called sunk costs. Finance says we should just ignore sunk costs. We have discussed these issues in more detail in the book. 507 About one in four Americans working at age 58 retired earlier than planned. Loss of health is the most important reason to retire early. See, https://crr.bc.edu/wpcontent/uploads/2015/09/wp_2015-22.pdf 508 See, https://dqydj.com/average-retirement-age-in-the-united-states/

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lose their physical and mental capabilities. Our brains will not be as sharp as before. Our bodies will not comply. There are no exceptions to this. Even if we are mighty and powerful when young, we will all eventually get old, weak, and decrepit, if we are lucky. So, it is a good idea not to plan on working until dropping dead. Even if we do avoid getting sick along the way and we are able to work until death, the risks will still bother us. What if we are worried about getting ill, injured, or disabled because we have not planned for the future? Who will take care of us? What if we hate our jobs and do not want to work? This is the stress of financial fragility. Too much risk and stress are known to lead to early death. Another extreme outcome of not planning properly is that we will become dependent on others to take care of us, even early on in our lives. This could be the State, our spouse, or our children. What will they do? Will they take care of us? Rephrasing President Trump, maybe they will and maybe they won’t.509 Who can be sure? While our spouses and kids probably (hopefully) will not abandon us, if we’re under their care, we probably won’t have the earning power or flexibility that we desire. This is practically a given if we have to rely on the State. The bottom line is that, most likely, no one, including your spouse, children, friends, neighbors, cousins, employer, or government, will take care of you the way you would take care of yourself, if you had the resources or financial security.510 Why does it make sense to plan for financial security? In the simplest terms, financial security means having choices. We get to choose what is best for us, instead of taking what is being offered. Thus, it allows us to be proactive, not reactive. Financial security means not being stuck in a miserable, undesirable work environment. It means not having to work 24/7 to provide for a stress-free, 509

President Trump defends the Saudi Crown Prince in Khashoggi killing: “Maybe he did and maybe he didn’t”. https://www.npr.org/2018/11/20/669708254/maybe-he-did-maybe-he-didnttrump-defends-saudis-downplays-u-s-intel 510 Sometimes, you might be just be unlucky and end up dependent on others despite your best efforts. We do recognize this. This is part of life.

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happy, and healthy lifestyle in our twilight years. Financial security means we can stop worrying about potential negative outcomes that may or may not ever be realized. Financial security removes many obligations, monetary worries, concerns, and potential conflicts from our lives. It means that we can work on things we truly enjoy. It means we can live mostly on our retirement savings, meet unexpected medical costs, and deal with illnesses and potential misfortunes without undue stress while still maintaining a happy, healthy, and meaningful life. It means we can go to bed every night and sleep like a baby, dreaming sweet dreams of eating flan on the beach. Financial security also allows us to say no to other people’s silly games. We can say no to unattractive job offers, unethical bosses, and to shady, immoral, and illegal, propositions. Financial security will give us the confidence to say no to temptations. Financial security allows us to walk away from anything and everything we find undesirable. If we are financially secure, we can do what we want and live where we want, instead of living close to our place of employment and doing what our boss wants us to do, when he wants us to do it. We can still work, but only on what we find meaningful and fulfilling. Financial security allows us to throw away the shackles of financial servitude to our employers and bankers. It allows us to live our lives to the fullest, instead of becoming hamsters on a treadmill having to run faster and faster just to keep from being thrown off. With financial security, you are not going to get into conflicts with your family over every disagreement about what should and should not be purchased. You are not going to keep a detailed record of whether your friends are reciprocating your generosity. It will be okay for your dependents to spend money based on their unique tastes and preferences that you do not agree with. It will be okay for your children to make small mistakes with money. A small dent on the car bumper, a big dent in the garage door, or a lost wallet full of cash is not going to result in a family crisis. Instead of considering these as intolerable behavior patterns, you will see them as life lessons worth paying for. While it is never too late to make the right decisions, it is best to start as early as possible. It is quite possible that you never attain financial security. This is still perfectly fine. This is not a win-or-lose contest. We make many

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decisions over the course of our lives, either explicitly or implicitly. A better decision-making process will still be highly valuable. Avoiding a few costly mistakes and getting on the right path are still highly valuable. You will achieve greater financial security and have a greater cushion against life’s unexpected turns of events. In this book, we have provided you with a creative thought process that will hopefully become an instrument of living. You are on your way to discover some of the whithers and the whys of mankind, and set aside and reject some of your previous philosophical beliefs and received social conditioning. You are on your way.