Tag Archives: Finance

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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You & The Distant Future

I spoke again yesterday to mostly retired folks at GMU’s lifelong learning institute, on “You & the Distant Future” (audio; slides). I talked on near-far theory, long-term bequests, and cryonics.

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Financial Mood

We care more about the future when happy:

We conduct a random-assignment experiment to investigate whether positive affect impacts time preference, where time preference denotes a preference for present over future utility. Our result indicates that, compared to neutral affect, mild positive affect significantly reduces time preference over money. … Happier respondents are [also] less likely to agree with the “live for today” statement than are less happy respondents. This holds even after controlling for covariates that have been shown to be related to happiness … High cognitive load increases time preference and … individuals with greater cognitive skills, as measured by IQ tests, exhibit lower time preference. (more)

This is predicted by near-far analysis, since happy is far, and the future matters more in far mode. This matters for finance today, as whatever sets discount rates, sets prices:

“All price-dividend variation corresponds to discount-rate variation.” … When it comes to broad price aggregates, such as stocks in general or land in general, price changes basically reflect crazily-changing [discount rate] values. (more)

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