Archive for Myth Busting

William Vickrey’s 15 Economic Myths Debunked

This is an oldie but a goodie.  William Vickrey was a Canadian economist and Nobel Laureate.   He was well known for being critical of most things out of the Chicago School of Economics.  This piece on 15 economic fallacies has been largely ignored, but the lessons are important and certainly as relevant today as they were in 1996 when Vickrey wrote them.  Here are three of my favorites:

Myth 1 – Government deficits are inherently bad and burden our children.

“Deficits are considered to represent sinful profligate spending at the expense of future generations who will be left with a smaller endowment of invested capital. This fallacy seems to stem from a false analogy to borrowing by individuals.

Current reality is almost the exact opposite. Deficits add to the net disposable income of individuals, to the extent that government disbursements that constitute income to recipients exceed that abstracted from disposable income in taxes, fees, and other charges. This added purchasing power, when spent, provides markets for private production, inducing producers to invest in additional plant capacity, which will form part of the real heritage left to the future. “

As I often note, deficit spending adds to the private sector’s net financial assets.  Now, this doesn’t necessarily mean that government spending is always good or efficient, but Vickrey clearly understood double entry bookkeeping.  He understood that a government’s balance sheet was not like a household’s balance sheet and so we shouldn’t be so quick to jump to conclusions about the damage of government spending.  Just as all private spending isn’t necessarily good, all public spending isn’t necessarily bad.

Myth 2 – In order to improve the health of the economy we must all save more so we can spend and invest.

“Urging or providing incentives for individuals to try to save more is said to stimulate investment and economic growth. This seems to derive from an assumption of an unchanged aggregate output so that what is not used for consumption will necessarily and automatically be devoted to capital formation.

Again, actually the exact reverse is true. In a money economy, for most individuals a decision to try to save more means a decision to spend less; less spending by a saver means less income and less saving for the vendors and producers, and aggregate saving is not increased, but diminished as vendors in turn reduce their purchases, national income is reduced and with it national saving. A given individual may indeed succeed in increasing his own saving, but only at the expense of reducing the income and saving of others by even more.”

This is a point I really hammer on in my book because it’s so common and so destructive.  We often hear this fallacy of composition about saving more and how more saving means you can spend more later.  Of course, if you save more of your income then someone else earns less income.  In the aggregate this means that output will fall.  Saving doesn’t lead to more future consumption.  In fact, it is investment that adds to total aggregate saving.

Myth 3 – Inflation is always a bad thing.

“Inflation is called the “cruelest tax.” The perception seems to be that if only prices would stop rising, one’s income would go further, disregarding the consequences for income.

Current reality: The tax element in anticipated inflation in terms of gain to the government and loss to the holders of currency and government securities, is limited to the reduction in the value in real terms of non-interest-bearing currency, (equivalent to the increase in the interest rate saving on the no-interest loan, as compared to what it would have been with no inflation), plus the gain from the increment of inflation over what was anticipated at the time the interest rate on the outstanding debt was established. On the other hand, a reduction in the rate of inflation below that previously anticipated would result in a windfall subsidy to holders of long-term government debt and a corresponding increase in the real impact of the debt on the fisc.”

In a fiat monetary system with endogenous money the money supply is just about always expanding.  That is, we are constantly creating money via bank loans or other sources in order to meet our economic goals.  When used productively, this increase in the money supply does not hurt our living standards.  In fact, so long as our incomes keep up with the rate of inflation then we are likely to be better off even with some inflation because we not only have a higher income, but we have the productive resources we created from using the newly created money.  Inflation does not represent our standard of living.  You must keep things in the right context.

Read all the myths here.

H/T Lars Syll

This Commonly Referenced USD Purchasing Power Chart is Useless

You’ve almost certainly seen the chart below over the years – it shows the purchasing power of the US Dollar over time.  It looks terrifying.  And it’s constantly cited by hyperinflationists and other people trying to convince you that the world is quickly coming to an end thanks to the “fiat monetary system” and all the “money printing” that’s going on due to nefarious governments.  Well, the chart is basically a misrepresentation of anything important.

USD_PP1

(Figure 1 – Stupid Chart)

The problem is, this chart doesn’t show whether per capita wages are rising or falling.  For instance, if your dollars buy you half as many eggs today as they did in 1913, but your income is twice as high as it was in 1913 then you haven’t gone backwards.  Yes, the USD’s purchasing power has fallen, but your ability to buy the same quantity of eggs has remained exactly the same.  Your living standard hasn’t fallen even if the purchasing power of the dollar has declined.

So, it’s important to put this in the right perspective here.  And when we look at this discussion it’s best to use an inflation adjusted perspective of wages and salary accruals on a per capita basis.  And when we run that figure the chart looks a lot different (reliable data only goes back to 1947):

avg_wage

 (Figure 2 – Smart Chart)

It’s not exactly a thing of glory (especially the last 20 years or so), but it clearly tells a very different story than the chart above which really tells us nothing.  So, next time some hyperinflationist throws the USD purchasing power chart in your face refer him to this post and tell him he isn’t telling the full story.

Related:


Buy Cullen Roche’s New Book Pragmatic Capitalism – What Every Investor Needs to Know about Money and Finance

There Isn’t $10.8 Trillion “Stuffed Under Mattresses” Because of QE

I have to comment on this MarketWatch piece because I’ve now seen a number of people comment on it claiming that consumers are choosing to hold more low interest bearing assets in recent years.  This just isn’t correct.

The article claims that Americans are stuffing $10.8 Trillion into mattresses and that QE has resulted in them simply saving all of this money:

Data from the little-noticed financial accounts report show the American people have $10.8 trillion parked in cash, bank accounts and money-market funds that pay little or no interest.

At the end of the first quarter, low-yielding assets totaled 84.5% of annual disposable personal income, the highest share in 23 years. Sure, people need to keep some money handy to pay their bills and some folks might have a few hundred or a few thousand in a rainy-day fund, but no one needs immediate access to the equivalent of 11 months of income.

In essence, there’s $10.8 trillion stuffed into mattresses.

That $10.8 trillion hoard represents a failure of Fed policy.

Since the Fed began quantitative easing in September 2012, U.S. households have socked away $1.17 trillion in their low-yield accounts. That means that 95% of the Fed’s $1.24 trillion QE3 ended up not in bubbly markets but in a safe and boring bank account.”

This is a very common misunderstanding of how QE works and it results from the confusion over what is “money” and what isn’t.  So let’s get a few points out of the way first:

  • When the Fed implements QE they are not increasing the QUANTITY of savings in the economy.  To keep things simple, the Fed swaps a bond for bank deposits.  The private sector’s quantity of net financial assets doesn’t increase, but its composition does change (from safe interest bearing assets to safe low interest bearing assets).
  • The Fed, by buying the bond, is temporarily removing it from the private sector which results in an increase in deposit liabilities (and assets), but also reduces the quantity of T-bonds.  This is the equivalent of the Fed unprinting a T-bond and a bank (acting as the middleman) printing a deposit.
  • Since the Fed remits interest income to the Treasury every year (which reduces the budget deficit), the private sector is losing all of this interest income it would otherwise have earned (which has been about $100B per year for the last 5 years).
  • You can point to an increase in deposits as a sign that people have more short-term assets, but we should also point out that they have fewer long-term assets.  None of this increases the quantity of savings or means that households are saving more.  In fact, households are saving LESS of their income in recent years:

psavert

But the most important point here is that households are not choosing to hold fewer T-bonds.  The T-bonds are being removed from the private sector by the most powerful entity in the economy.    If the Fed were to reverse QE tomorrow there would be no shortage of demand for T-bonds in the private sector.  Just look at how voraciously the private sector has driven down yields in recent years.  The private sector can’t get enough US government bonds.

Changing the composition of private sector savings doesn’t mean the private sector has chosen not to hold these assets in aggregate.  It just means that the Fed has succeeded in altering the composition of private sector financial assets.  And that, by definition, has forced investors to look for other sources of safe interest bearing assets.  After all, that is one of the primary purposes of QE (in the Fed’s words, “to keep asset prices higher than they otherwise would be”).  Anyone who rejects this just hasn’t been paying attention to the 150%+ explosion in junk bonds in the last 5 years, the 6% compound annual growth rate in T-bonds since the crisis lows, the record low spreads in junk relative to Treasuries or the record setting levels of junk bond issuance.  There is very clearly a high demand for higher interest bearing assets as a result of this portfolio rebalancing imposed by the Fed.

hy_bond_issuance

Yes, consumers are still spending too little to drive the recovery into a higher gear.  But it’s not because they have all this money stuffed under their mattresses.  In fact, there’s a good chance that the reduced interest income via QE has actually contributed to their lack of spending as a result of changing the composition of financial assets from safe high interest bearing assets like T-bonds to safe low interest bearing assets like deposits.   But the key here is that there isn’t necessarily more savings under mattresses as a result of QE.  The composition of that savings has simply changed.

Sources:

1.  Sack, Brian – Managing the Federal Reserve’s Balance Sheet

2.  Roche, Cullen – Understanding Quantitative Easing

 

The Myth of the Passive Investor

By Patrick Rudden, AllianceBernstein

Some investors have such little faith in the merits of active management that they prefer to take a 100% passive approach. We think they may be making more active decisions than they realize.

Those who go passive know why they’re doing it. Instead of paying active managers to try to select securities to beat a particular index, they’ve decided to hire managers to track that index. Yet this approach involves several active choices.

First, passive investors must decide how to allocate their assets. A US investor, for example, might decide to be 50% in US bonds, 25% in US equities and 25% in international equities. Next, passive investors must choose which indices they want tracked. Our US investor might select the Barclays US Aggregate Bond, the S&P 500 and the MSCI EAFE indices respectively.

So far, so straightforward. But getting to this point has required a lot of active decision making. The important decision about how much to allocate to bonds versus equities is an active choice. And so is the decision about how much to allocate to US versus non-US stocks.

Who decides what?

In the case of US equities, by choosing the S&P 500 as the index to track, our investor has outsourced stock selection decision making to the S&P committee. This committee actively selects the 500 companies that it believes most accurately represent the US economy. The committee’s periodic announcement of which stocks are being added to, and which stocks are being deleted from, the index creates investable price anomalies.

Investors who don’t track the benchmark can profit from not taking the closing prices on the day the index is reconstituted. Indeed, investment banks have historically had units focused on capturing the profit from going long a basket of index additions and short a basket of index deletions.

Active decisions are also unwittingly being made in non-US benchmarks. By selecting MSCI EAFE as the index to track, an investor has chosen to exclude smaller-cap stocks and the stocks of companies listed in emerging markets. MSCI also appropriately makes active decisions about how it will build its index, including how it best represents the equity opportunity. For example, MSCI determines the classification of countries as emerging or developed—this can create substantial differences versus the classification by other index providers like FTSE.

Choices, choices, choices…

When it comes to selecting a passive manager to track the index, there are further choices to make. Does the manager attempt to fully replicate the index or not? If fully replicating, does the manager have leeway to trade intelligently around index reconstitutions? Taking the closing price on the day the index is reconstituted will minimize tracking error, but comes with an opportunity cost. If the manager is sampling, rather than replicating, an index, what is the sampling methodology?

Some investors don’t believe they can successfully identify stock pickers on an ex ante basis. Therefore, they—quite rightly—choose not to do so.

But passive investing may be a misnomer. Asset allocation and index selection are important active decisions. And so is the decision about how a tracking manager will track. So investors should recognize when they are making active decisions that are likely to have a significant impact on their investment outcomes—and think carefully about the choices they make.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.

Patrick Rudden is co-manager, Dynamic Diversified Portfolio at AllianceBernstein (NYSE:AB).

Debunking Some Common Investment Myths

I’m going to need a shower after this week because I really whored myself out to the financial news media for the book.  I continued the media parade on Fox Business yesterday where I talked with David Asman and Liz Claman about some common investment myths.  These segments are always so short, but here are the key points I was trying to make:

  • Most of us don’t have to “beat the market” (the stock market) in the long-run.
  • In fact, most of us have financial goals that don’t require us to perform with the variance of the S&P 500.  Most of us are looking to beat inflation and do so without exposing us to huge amounts of permanent loss risk.  The S&P 500 doesn’t perfectly achieve those goals and so building a portfolio that’s entirely stocks could actually expose you to unforeseen risks and create unnecessary turbulence in your life.

 

  • Don’t assume you can replicate what Warren Buffett does.  Buffett is an exceedingly sophisticated investor running and incredibly complex operation.  Berkshire Hathaway is essentially a multi-strategy hedge fund running an insurance writing house that operates like an option writing house combined with several global macro strategies including distressed debt, derivatives, forex and private equity.  Replicating this is extremely difficult so don’t assume that buying some “value” stocks in your brokerage account is the same thing Warren Buffett does.

 

  • You don’t always get what you pay for.  Wall Street wants you to believe that higher fees are worth it because of the bells and whistles that come with certain strategies.  But a lot of the time we pay for a Ferrari that runs like a Pinto.  Look under the hood of actively managed funds.  Make sure you benchmark properly and risk adjust their returns so you can properly evaluate funds and performance.

 

  • Lastly, don’t be dogmatic in your views.  In the interview I specifically discuss fundamentals vs technicals, but this applies to so many things in finance.  A dogmatic view will almost always lead you astray.  Stay open-minded.  There are no holy grails.

7 Market Myths that make Investors Poorer

I have a new piece over at MarketWatch summarizing the market myths chapter in my new book.   You can read the whole thing over at MW:

Financial markets are complex dynamic systems, populated by irrational and biased participants. Because of this we have a tendency not only to misunderstand how the financial markets function, but we tend to buy into myths that often harm our financial well-being.

But by better understanding the financial markets, ourselves and the behavioral flaws that drive these persistent myths we can increase our odds of achieving our financial goals. Here’s what investors need to watch out for:

1. You too can be Warren Buffett

Over the last 30 years the world’s greatest investor has come to be idolized. But the way Warren Buffett has amassed enormous wealth is often misunderstood. The myth of the simpleton from Omaha who just picks “value” stocks has driven an entire generation to fall for the myth that they can easily replicate what Buffett does.

Make no mistake — Buffett is not a simple value-stock picker. What he has built is far more complex and resembles something that few retail investors can even come close to replicating.

Berkshire Hathaway, Buffett’s firm, essentially acts as a multi-strategy hedge fund. Berkshire engages in sophisticated insurance underwriting, complex fixed-income strategies, multi-strategy equity approaches and tactics that more resemble a private equity firm than a value-based brokerage account. Replicating this isn’t just difficult — it might well be impossible.

Read the whole piece here.  

How Much Longer Will the Dollar Remain the Reserve Currency of the World?

The US Dollar’s status as a reserve currency seems to be a perennial concern for many people these days.  I think this concern is often dramatically overstated.  I was reminded of this point as I was reviewing the slides from Jeff Gundlach’s presentation yesterday which showed the following chart:

gundlach1

(Source: DoubleLine)

As you can see, no one maintains reserve currency status forever.  That shouldn’t be remotely surprising.  The global economy is dynamic and market shares shift.  And at the end of the day that’s what reserve status is really all about.  Think about it – nations accumulate reserves of US dollars today because the US economy is the dominant player in global trade.

Of course, the US Dollar isn’t the only currency that nations maintain reserves of.  The Euro is also a major reserve currency and the Yuan is fast becoming a major reserve currency.  But since the USA produces 22% of all world output it happens to play a particularly special role in the global economy.  By virtue of being the largest economy in the world the accumulation of US dollar denominated financial assets happens to dominate the global financial system.  It’s sort of like being the top market share producer of a particular product in a particular industry.  Other entities accumulate your products because you’re the top producer.   And that changes over time.  Market shares change and regimes shift with the evolving economy.

So, will the USA lose its reserve currency status at some point?  Yes.  In fact, it’s already starting to lose its reserve status to Europe and China.  Will it be the end of the world and will it cause everyone to suddenly ditch the dollar?  Probably not.  It just means the USA will produce a lower proportion of global output and therefore, as a matter of accounting, the rest of the world will hold a lower percentage of US dollar denominated financial assets as a percentage of global output.  It’s not the end of the world.  It’s just a sign that market shares change and when you’re #1, well, there’s only one direction to go.

Myths and Misconceptions About Indexing

By Ben Carlson, A Wealth of Common Sense

“Despite the theory and publicized long-term success of indexed investment strategies, criticisms and misconceptions remain.” – Vanguard

Because low cost, indexed investing is considered so simple, many investors don’t realize that Vanguard regularly puts out terrific research pieces. Their latest, Debunking some myths and misconceptions about indexing, continues this trend.

The authors of the white paper go through the following five myths and back everything up with hard data as to why they don’t stand up to further inspection:

Myth #1. Indexing only works in ‘efficient’ markets.

Myth #2. Who wants to be ‘average’?

Myth #3. You get what you pay for – Higher cost + Higher ratings = Higher returns.

Myth #4. Market-cap weighting overweighs the overvalued.

Myth #5. Index funds underperform in bear markets.

I love this type of myth-busting data because far too many investors tend to follow rules of thumb based opinions and not the facts.

I’ve been looking at similar information and graphs for a number of years now that are just like the following one from this report, but this type of information never ceases to amaze me:

vg

 

So 70-80% of index funds have outperformed their active fund counterparts in pretty much every single category and asset class over the past 10 years.

The consistency of these index fund ouperformance numbers over the years is one of the most impressive long-term track records in the business.

Read the entire Vanguard paper here for more:
Debunking some myths and misconceptions about indexing (Vanguard)