Tag Archives: Finance

If More Now, Less Later

On Thursday I talked, together with Elie Hassenfeld of GiveWell, at the UC Berkeley Faculty Club on Effective Altruism (audio here). Scott Alexander wrote a thoughtful report, which Tyler blogged. One claim I made that I’ve before (here, here, here) is that because real interest rates (i.e., average investment rates of return) tend to be positive, it is more effective to wait, investing now and then donating later. Since many continue to question that claim, I thought I’d elaborate a bit.

In the past I’ve used Ben Franklin as an example of the possibility of using trusts to save for a very long time. But I think that distracted from my basic point, which can be made just by suggesting that you wait until the end of your life to donate. Waiting longer might in fact be better, but it has more tax and agency issues; you can’t as easily ensure your money is spent the way you want.

I admit that a good reason to donate now is if you believe that we are quickly running out of worthy recipients of charity, either because the world is getting richer and nicer, the charity world is getting more effective, or we happen to live in an unusual time of great need or danger. People who think that global warming and ecological collapse will soon make the world a hell can’t believe this, nor can those who fear great disruption in an em transition. But others may.

I also agree that tax considerations will change the rate of return you can expect, and that by giving over a period of time you may learn from your early gifts to better pick later gifts. But it should be enough to start this learning process when you are older; your life experience will help you learn faster then.

The issue I want to focus on in this post is: how high do interest rates have to be to justify saving to donate later? I’ve sometimes said that interest rates need to be higher than growth rates, and some have questioned if interest rates are in fact higher than growth rates. Others, like my co-speaker Ellie Hassenfeld and his college Holden Karnofsky at Givewell, argue that giving now to help people who are sick or under-schooled creates future benefits that grow faster than ordinary growth rates. But now I think I was mistaken – if real charity needs are just as strong in the future as today, then all we really need are positive interest rates. Let me explain.

When a person chooses to save financially, they choose to spend a bit less in their usual ways, in order to give money to someone else, in the expectation of getting money back from that someone else at a later date. If they had instead not saved, and spent the money instead, that spending may well have also indirectly benefited them in the future. They might buy some medicine, get more exercise, get more sleep, try out some new products, make some new friends, or learn some new skills, any of which might help their future self.

But at the margin, a person who saves another dollar, or chooses not to borrow another dollar, must typically expect the financial returns from their investments will help them more in the future than will such indirect effects of spending today. In fact, they should expect this savings will benefit their future self more than any of these other ways of spending today. After all, why give up money today if that both gives you less to spend today, and gives you less in the future? So there wouldn’t be any savings, or less than maximal borrowing, if people didn’t expect more gains later from saving than from spending today.

This implies that unless charity recipients are saving nothing and borrowing as much as they possibly can, they must expect that you would benefit them more in the future by saving and giving them the returns of your savings later, than if you had given them the money today, even after taking into account all of the ways in which their spending today might help them in the future. So there really must be a tradeoff between helping today and helping later; if you help more today, you help less in the future. At least if you help them in a way they could have helped themselves, if only they had the money.

Of course you might not care as much about future suffering, or future folks might suffer less. But if you do care as much, and there is as much future need to help, then if interest rates are positive you can obtain more real resources with which to give more real help if you will save now, and donate later.

You might wonder: what if a deserving charity recipient is borrowing, and at a higher interest rate than you can get from by investing? This implies that you might benefit them and yourself by loaning them money, if you could overcome the barriers that have prevented others from doing so. It also implies that if you were going to help them, you might want to do it now rather than later. But this doesn’t change the fact that there is a tradeoff between helping today vs. tomorrow. And if there will be people later in a similar situation of need, you can do more good by waiting to help them later.

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In the long run, we’re all still exposed to risk

Many of you will be familiar with the fact that past returns from notable stock indices, such as those in the US, are a biased indicator of the likely future returns to investing in equities. The problem is that due to war, government interference, and financial collapse, some stock markets disappeared altogether, wiping out investors. In some countries this has even happened multiple times. Historical stock indices that went to zero tend not to be remembered, and so are under-sampled. The result is ‘survivorship bias‘, a problem that shows up in many other research questions as well. When these defunct investments are put back in the sample, average returns are quite a bit lower than when you look at just, for example, the NY stock exchange.

A lesser known result is that a broader and representative sample of stock histories shows that investing over long time horizons doesn’t reduce the variability of your return. Contrary to convention wisdom, even young savers need to diversity across different assets types and countries in order to get that effect and be confident of retiring in comfort:

“One of the most enduring question in finance is the persistence of investment risk across time horizon. This issue of time diversification is crucial to long-term asset allocation decisions.

There is a widespread view that the longer the horizon, the more investors benefit from investing in equities. Young investors, for instance, are typically advised to allocate more to equities than those whose retirement is imminent, on the grounds that equities are less risky over long horizons. A common rule of thumb is that the percentage of stock allocation should equal 100 minus an investor’s age.

Some researchers claim to have found empirical evidence that equities are less risky over long horizons because of mean reversion. Mean reversion implies that the variance of stock retums does not grow linearly with time, contrary to a random walk. As a result, several authors have claimed that greater equity allocations are justified on the grormds that shortfall risk lessens as the horizon is extended.

This conclusion seems hardly justified. Previous findings of mean reversion have considered seventy years or so of U.S. data. For long-horizon retums, say ten years, this implies only seven truly independent observations, which seems insufficient to support robust conclusions about the risk of ten-year equity investments. The problem is that, with a fixed sample size, the number of efiective observations diminishes as the investment horizon lengthens. Another problem is that markets with long histories may not represent investment risk for reasons of survivorship bias.

One solution is to expand the sample by adding cross-sectional data. We describe the distribution of long-term returns for a sample of thirty countries for which we have long series of equity prices. The empirical evidence expands on the work of Jorion and Goetzmann (1999) and substantially extends results described by Dimson, Marsh, and Staunton (2002), who analyze a century of stock market returns in fifieen countries.

The results are not reassuring. We find no evidence of long-term mean reversion in the expanded data sample. Downside risk declines very little as the horizon lengthens. In addition, U.S. equities appear systematically less risky than equities of other markets.

Mean reversion is analyzed first in terms of variance ratio tests. There is no evidence of mean reversion from variance ratio tests across this sample, taking into account statistical properties of these tests. Furthermore, markets that sufiered interruption displayed mean aversion, or the opposite of mean reversion. Therefore, statistical properties such as high average retums and mean reversion may be an artifact of survival. Probabilities of losses on equities are reduced very slowly, if at all, with the horizon. In fact, shortfall measures such as value at risk (VAR) sharply increase with the horizon.

There is, however, some positive news. Diversification across assets pays. Over this century, a global stock market index would have displayed less downside risk than any single market. The conclusion is that across-country diversification is more effective than time diversification.” (HT Ben Hoskin)

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Beware Life Insurance

Life insurance is bought more because it sounds like a good idea than because it is actually needed. In fact, most people who buy life insurance never actually get paid when they die:

Almost 85% of [US life insurance] term policies fail to end with a death claim; nearly 88% of universal life policies ultimately do not terminate with a death benefit claim.  In fact, 74% of term policies and 76% of universal life policies sold to seniors at age 65 never pay a claim. …

We document the following core facts about the U.S. life insurance industry, which has over $10 trillion of individual coverage in force …:

  •  A death benefit is not paid on most policies. For “term policies” that offer coverage over a fixed number of years, most are “lapsed” prior to the end of the term; a majority of permanent (e.g., “whole life”) policies are “surrendered” (i.e., lapsed and a cash value is paid) before death.
  • Insurers make substantial amounts of money on clients that lapse their policies and lose money on those that do not. Insurers, however, do not earn extra-ordinary profits. Rather, lapsing policyholders cross subsidize households who keep their coverage.
  • Real premiums decrease over time (i.e., policies are “front loaded”) rather than increasing with age in a manner more consistent with either actuarially fair pricing or optimal insurance in the presence of reclassification risk where new information about mortality risk is revealed.
  • As an industry, insurers lobby intensely to restrict the operations of secondary markets. In other markets (e.g., initial public offerings or certificates of deposit), the ability to resell helps support the demand for the primary offering. …

While consumers correctly account for mortality risk when buying life insurance, they fail to sufficiently weight the importance of background risks. … Since consumers do not anticipate the need to lapse, this front-loaded policy appears to be cheaper than a policy that is actuarially fair each period. … The introduction of a secondary market undermines this cross-subsidy by offering lapsing households better terms relative to surrendering. (more)

We cryonics patients are hopefully an exception – we really do need the money to pay for the cryonics treatment. More info on cheating insurance agents:

We construct a rich dataset describing individual insurance agents operating in Texas. We match licensing data with company affiliations and detailed sales practice complaint records from the state regulator. From the company affiliation data, we identify two types of experts: monitored agents from large, branded companies, and unmonitored agents working as independents. We fid that the odds of monitored experts from large, branded companies taking advantage of their customers are 21 to 98% greater than the odds for unmonitored independent experts. In a supplemental analysis, we use national sale practice complaints data to confirm our results. Finally, we find that more experienced agents are significantly more likely to mislead their customers. … Company agents may earn 50 to 70% of the gross commissions of their sales, depending on the type of insurance product. (more)

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Was Intrade being manipulated over the last month?

Intrade’s betting odds on the 2012 presidential election have differed significantly from those available elsewhere. For the 48 hours preceding the election, the difference in the implied probability of Obama winning on Intrade relative to other betting agencies like Betfair, was 8 to 15 percentage points. This persisted until a large share of Ohio votes had been counted and Colorado and New Mexico were starting to count, at which point the difference quickly evaporated. Over the previous 3 weeks or so, the difference had moved in the range of 5 to 10 percentage points.  The same distortion was observed in favour of McCain during the election in 2008, though to a lesser extent.

This provided an opportunity to make substantial money by betting on Obama on Intrade and Romney elsewhere – a so called dutch book, or ‘arbitrage‘. I joined some colleagues at 80,000 Hours doing this yesterday to earn money for our favourite cost effective charities. We each walked away with about $500 after all of the associated fees. Eyeballing it, a dutch book is profitable, ignoring the cost to your time, if the probability gap is larger than 3 percentage points; below that, the fees involved will eat up your winnings.

Why was this possible? I don’t have a good answer, but I can suggest one possibility. Some noteworthy aspects of the situation are:

  • Americans can’t deposit money into Intrade using credit and debit cards – they have to use bank transfers.
  • Bank transfers take at least two days to arrive and cost over $20.
  • Everyone else can choose between cards and bank transfers.
  • Cards are instantaneous and free (if denominated in US dollars anyway) but have a $2,000 deposit limit in the first month, and $5,000 thereafter.
  • It takes at least a day, probably two, to open a new Intrade account and have it approved.
  • There are other significant barriers to entry – knowing about the issue, learning about the fees, opening an account with another betting agency and finally having the time and confidence to correctly place the hedge.
  • Intrade seems very widely covered by the US media.

A single person with a huge amount in their account from a wire transfer could manipulate the market by selling Obama’s shares down, or buying Romney’s up. This appeared to be happening in the 67-72% likelihood range in which Obama was stuck for a long period of time, while other larger agencies were placing him around 82%. Several people on Intrade’s forum spotted what they thought were abnormally large bids for Romney’s stock.

Once someone started doing this, it would take at least two days, probably three, for a wealthy or ambitious person to respond by wiring in enough money to bet against them. They would have to hope that the manipulation persisted long enough for them to profit from it. Until then, people outside the USA would be limited to putting at most $2000 or $5000 into their accounts, which is barely worth the effort for someone with the required skill. Someone could plan to do this over the last few days of the election without generating much resistance.

The volume yesterday on Obama’s Intrade shares was about 600,000. If all of those trades involved one person, who was losing 10 percentage points on each share, they would have blown $600,000 to keep Obama’s odds down. The volume over the previous three weeks is hard to read from Intrade’s graphs, but looks to be about the same again. So a single cunning person willing to lose $1 million could have singlehandedly driven the price difference, if they wanted to influence perceptions of the race and encourage voter turnout. Out of the $6 billion spent on the election so far, that’s not a big investment. Intrade will face the risk of this until they make it easier for wolves to fund their accounts and go out hunting sheep.

Weaknesses of this theory are:

  • Why didn’t manipulation over the previous three weeks prompt someone to move a large sum onto Intrade in anticipation?
  • Why haven’t wealthy Obama supporters attempted the same trick?

Nonetheless, I think this is more likely than a broad pool of Intrade participants being enthusiastic about Romney against all the evidence, and unaware that they could get better odds elsewhere.

If I were a Democrat supporter with a lot of money, I would plan to profit from similar situations in the future while simultaneously improving Intrade’s performance.

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Young Idealist Reply

I wrote:

Humans … slowly gain competence over a lifetime, usually reaching peak productivity in our forties and fifties. … When people get idealistic, they tend to forget this. … They want to know how to most help the world in the next few years, not over their lifetime. … Young folks … should expect to prepare and learn while young, and then have their biggest influence in their peak years.

Alex Waller disagrees:

When I’m 50 I don’t really want the world to be the way it is now. I don’t want to bide my time and merely learn and network idly for another decade or two while someone else is responsible for enacting positive change in the world.

News flash: you are just one of seven billion, so you aren’t going to personally make much difference. The world will have nearly as many problems worth solving then as now, with or without your help.

Let’s say I was the CEO of a small corporation that developed medical devices. … A sustainable revenue stream requires projects with a variety of timelines. Similarly, I shouldn’t only invest my company’s resources in a project with a huge payout that will take 15 years.

The world already has a big portfolio of idealistic projects. If you want your life to be one of those projects, you should accept that it has a natural timescale. There’s a best time to invest, and a best time to reap returns.

Hanson elicits skepticism in the idea that social changes enacted now will positively impact the future, without justification.

I’m not skeptical of future impacts, just of their typically growing in impact faster than financial investments.

However, I’d counter-argue that his position is just as weak: name someone who is making better-than-inflation on their investments in the last 11 years?

The last few years have been quite unusual in finance. Feasible long term financial rates of return are higher than economic growth rates.

If I am to put off charity for 20 years to compound interest, why not put it off 40 years to compound even more? Why not put it off for 100 years?

Why not indeed? If you think that your personal monitoring adds much value, you might want to spend before you die, so you can personally monitor your charities. Else you might instruct your charity fund to grow until it seems that worthy causes are about to run out, or that investments no longer grow.

Hanson totally misguides when he suggests that Young Idealism is sexually motivated.

I said “signal one’s attractiveness to potential associates.” I didn’t mention sex.

Then what explains extra altruism in the old?

I said “people tend more to form associations when young.” This implies only that old folks have a weaker need to signal, not that they have no need to signal.

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Impatient Idealism

Humans have long lives. We are unusually dependent on our parents when young, and we then slowly gain competence over a lifetime, usually reaching peak productivity in our forties and fifties. Most of the time we are aware of this. For example, we count on our peak earning years by taking out loans as young students, and later saving for retirement. And we prefer leaders at those peak ages.

But when people get idealistic, they tend to forget this. Young idealists often ask me and others what they can do to most help the world. Which is a fine question. But such folks tend to be impatient – they want to know how to most help the world in the next few years, not over their lifetime. So when they consider joining an idealistic project, they focus more on whether the project will succeed than on what skills and contacts they would acquire.

Yet young folks shouldn’t expect to have their biggest influence when young. Yes young folks have higher variance, and so sometimes get very lucky, but they should expect to prepare and learn while young, and then have their biggest influence in their peak years. Why such a short term focus? Especially since idealism should if anything induce a far view. Yes young folks are often short-sighted, but why be more so about altruism than about school, relationships, etc.?

This seems related to the puzzle of why people don’t leverage the power of compound interest to donate to help the future needy, instead of today’s needy. Some argue that the future won’t have any needy, or that helping today’s needy automatically helps future needy, at a rate growing faster than investment rates of return. I’m pretty skeptical about both of these claims.

One plausible explanation is that a habit of extra youthful altruism evolved as a way to signal one’s attractiveness to potential associates. People tend more to form associations when young, associations that they tend more to rely on when old. And potential associates like to see altruism, because it correlates with generosity and cooperation (as near-far theory predicts). But if you save money to help the future needy, or if you invest now in skills useful in future idealistic projects, that is less clearly a signal of altruism, because you might later change your mind and use that money or those skills for other purposes.

So to signal your youthful idealism to potential associates, you must spend the money and time now, even if such spending is less effective toward the idealistic cause. But hey, at least the cause gets something.

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Good friends can make bad business partners

A new NBER working paper suggests that similar venture capitalists (VCs) are worse at making or managing shared investments:

This paper explores two broad questions on collaboration between individuals. First, we investigate what personal characteristics affect people’s desire to work together. Second, given the influence of these personal characteristics, we analyze whether this attraction enhances or detracts from performance. Addressing these problems in the venture capital syndication setting, we show that venture capitalists exhibit strong detrimental homophily in their co-investment decisions. We find that individual venture capitalists choose to collaborate with other venture capitalists for both ability-based characteristics (e.g., whether both individuals in a dyad obtained a degree from a top university) and affinity-based characteristics (e.g., whether individuals in a pair share the same ethnic background, attended the same school, or worked for the same employer previously). Moreover, frequent collaborators in syndication are those venture capitalists who display a high level of mutual affinity. We find that while collaborating for ability-based characteristics enhances investment performance, collaborating for affinity-based characteristics dramatically reduces the probability of investment success. A variety of tests show that the cost of affinity is not driven by selection into inferior deals; the effect is most likely attributable to poor decision-making by high-affinity syndicates post investment. Taken together, our results suggest that non-ability-based “birds-of-a-feather-flock-together” effects in collaboration can be costly.

Given that homophily rather than heterophily remains the norm, it seems these investors are not learning this lesson, or value working and affiliating with similar peers over maximising profits. All very well for them. But if you have a project that you truly want to succeed, you may be better off doing it with a talented stranger rather than the college mates you clicked with on day one. And if you are letting others invest on your behalf, you should beware of handing your money over to a homogeneous friendship group.

I wonder if this kind of research influences the institutional investors who often fund VCs? If not, it would suggest that even this highly competitive investment market is falling short of its potential to fund and grow promising new companies.

Some research suggests that corporations with more female board members perform better, though the direction of causality is disputed. I doubt females are innately more talented board members, so the causation, if real, could be the result of female ‘outsiders’ generating better management than a clique of natural friends. Shareholders don’t share the benefits of board members enjoying each other’s company, so if they had effective control of  the companies they owned you might expect then to appoint a diverse ‘team of rivals’ to the board to closely scrutinise one another’s ideas.  My impression is that precisely the opposite is the norm.

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Private Firms Earn 3% More

More evidence that privately owned firms do better:

We present evidence on the performance of nearly 1400 U.S. private equity (buyout and venture capital) funds using a new research-quality dataset. … Average U.S. buyout fund performance has exceeded that of public markets for most vintages for a long period of time. The outperformance versus the S&P 500 averages 20% to 27% over the life of the fund and more than 3% per year. Average U.S. venture capital funds, on the other hand, outperformed public equities in the 1990s, but have underperformed public equities in the 2000s. … Within a given vintage year, performance relative to public markets can be predicted well by a fund’s multiple of invested capital and internal rates of return. (more)

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Econ Advice Confirmed

We … construct management data on over 10,000 organizations across twenty countries, … [and] use a new double-blind survey tool. … We define “best” management practices as those that continuously collect and analyze performance information, that set challenging and interlinked short-and long-run targets, and that reward high performers and retrain/fire low performers. … Our management scoring grid … was developed by McKinsey as a first-contact guide to firms’ management quality. … We also test (and confirm) that these practices are indeed strongly linked to higher productivity, profitability, and growth. (more)

Not a bad quick measure of the quality of management practices. They find:

In manufacturing American, Japanese, and German firms are the best managed. Firms in developing countries, such as Brazil, China and India tend to be poorly managed. American retail firms and hospitals are also well managed by international standards, although American schools are worse managed than those in several other developed countries. We also find substantial variation in management practices across organizations in every country and every sector, mirroring the heterogeneity in the spread of performance in these sectors. One factor linked to this variation is ownership. Government, family, and founder owned firms are usually poorly managed, while multinational, dispersed shareholder and private-equity owned firms are typically well managed. Stronger product market competition … [is] associated with better management practices. Less regulated labor markets are associated with improvements in incentive management practices such as performance based promotion. …

Publicly (i.e., government) owned organizations have worse management practices across all sectors we studied. … Multinationals appear able to adopt good management practices in almost every country in which they operate. … The level of education of both managers and nonmanagers is strongly linked to better management practices.

So, the world would get more productivity and growth if it had fewer government-owned organizations, less labor regulation, stronger product market competition, and more things run by multinational firms. Gee, sounds a lot like standard economists’ advice.

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Info Market Failure

Unless project gains can be very clearly proven to analysts, or perhaps so small and numerous to allow averaging over them, public firms are basically incapable of taking a loss on earnings this quarter in order to make gains several years later. … CEOs are strongly tempted to instead please analysts by grabbing higher short-term quarterly earnings. …

Private firms are 3.5 times more responsive to changes in investment opportunities than are public firms. … IPO firms are significantly more sensitive to investment opportunities in the five years before they go public than after. (more)

A month ago I said that these results imply that we need wealth inequality, to ensure we make the discretionary investments on which all our future wealth depends.

Today I want to admit that these results also imply that even thick speculative markets, full of lots of people trading lots of money, often have big info failures. While I am a big fan of using speculative markets to aggregate info, I must admit that they quite often fail to aggregate all relevant info, even when a lot of money can be won there.

CEOs at private firms choose investments based on private info on likely rates of return. If the same firm were to be made public, however, the above evidence suggests that CEOs would make less than 25% of those investments. In the other 75+% of cases, the CEO would estimate that market speculators would not credit the stock price for the value of those promising investments, but would instead punish the firm for lower short term earnings. It seems that market speculators cannot distinguish these investments from other less promising ones that CEOs would undertake if speculators were to credit these. CEOs typically know crucial investment details not available to speculators.

Now I can see ways to improve existing stock markets, so that they could aggregate more investment info. We could allow and even encourage “insider” stock trading by firm insiders like the CEO. And we could create decision markets, trading the stock value conditional on specific investment decisions. But while these changes should raise that <25% figure, i.e., the fraction of investments by private firms that would also be made by a public firm, they might not raise it by much.

Speculative markets can work info aggregation wonders, at least compared to common methods like surveys or committee meetings. But if you really want as much info as possible on big investments, we still know of nothing better than rich private investors with a lot on the line.

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