Why Everyone Should Vote No on MA Question 3

I've been remiss in my posting for a while.  So, what better way to get back on the horse than to ride that horse directly into a political fire?

Let's talk about taxes, particularly the ballot question in Massachusetts proposing that we lower the state sales tax from its current 6.25% to 3%.  I argue that citizens of the Commonwealth of Massachusetts should vote No on this proposal, regardless of your political leanings.  This is why:

A state has to generate revenue through taxes one way or another.  Options include income tax, property tax, corporate tax, alcohol tax, cigarette tax, hotel tax, automobile excise tax, many other smaller taxes, and sales tax.  In Massachusetts, income, property, auto excise, and sales are the best known among the typical voter.

Here are some examples of voter ideologies, and why they should all vote No on Question 3.

Voter Opinion: The state should provide the same amount or more services as it does now.
Vote No Because: Any decrease in state revenue will hamper this goal.

Voter Opinion: There should be as few taxes as possible or "I can't afford all these taxes."
Vote No Because: If you want to cut taxes as much as possible, going after the sales tax is not the most effective route.  The state income tax is the biggest part of your state tax burden, which costs you 5.3% of all your earned income.  The sales tax is 6%, but only on money spent on applicable goods.  Your rent/mortgage and groceries, for example, are not subject to sales tax.  You spend much less money on sales tax than you do on income tax.  Also, for bigger purchases (dishwasher, tv, computer), you can utilize the yearly sales tax holiday in August.

Voter Opinion: MA residents get taxed more than their neighbors (like New Hampshire)
Vote No Because: While it is true that NH residents don't have income tax or sales tax, the MA sales tax is one of the few ways that we level the total tax playing field.  The sales tax is paid by everyone buying goods on our fair state, not just MA residents.  Consider all the revenue generated by tourists buying Harvard t-shirts and business people eating at restaurants while at a conference.  Cutting the sales tax has a larger marginal cost to the state for a smaller marginal benefit for its residents.

Tomorrow is election day.  Don't know where you vote?  Look here.  Go vote, and vote No on Question 3 in Massachusetts.

What's Next?

I've neglected the blog for the past month, because I have been super busy with my new part-time permanent job and a new client in my technology consulting business. 

Matt asked me to tell him "what's next" for him to work on financially.  I will post more meaty (or soyey?) entries soon.  I expect life insurance to be an upcoming topic, as Nicole and I recently went through this process.

An observation:
The best way to build financial security and wealth is to be employed.  All the other tools I mention are supplementary to a stable and sufficient income stream.

Example of Currency Arbitrage

So at a party recently, I hijacked an otherwise pleasant conversation to explain currency arbitrage.  I created this blog to provide a venue for this sort of thing so I wouldn't do it at parties.  I failed, clearly.  The example I used was a good one, though, so I'll repeat and refine here.

Imagine a big multinational company like Toyota needs to make payroll on Friday.  They have to make a $500 million dollar payment to the US bank that pays their US employees on Thursday night.  The cash that they have to make this payment is in their Japanese bank, though, in Yen.  They arrange to use Yen to buy the $500 million that they need.

Now, suppose that before this trade, anyone engaging in relatively small amounts can trade 1 US Dollar for 90 Yen.  They can also trade 1 Euro for 109.8 Yen, and 1.22 US Dollar for 1 Euro.

When Toyota executes this large trade, though, it pushes the price of dollars up in relation to the price of Yen (it takes more Yen to buy a Dollar).  I touched on the reasoning behind this in the liquidity miniseries.  If an asset is suddenly desired more (less) than it was a moment ago, it's price will go up (down).  Dollars and Yen are simply assets being bought and sold.  So, instead of getting their $500 million Dollars for 45 billion Yen, the exchange rate changes, and Toyota has to pay 45.25 billion Yen.

Meanwhile, Euros are trading with Dollars and Yen at the same rates they were before.  This is where an arbitrageur makes some money.  A trader in Boston sees the Toyota trade go through the market, and she does the following:

• Borrows $100,000 from her firm's trading account.
• Sells 100,000 Dollars to Buy 9,050,000 Yen (moving the opposite direction as Toyota).
• Sells 9,050,000 Yen to Buy 82,423 Euro.
• Sells 82,423 Euro to Buy 100,556 Dollars.
• Pays back the $100,000 to her firm's trading account.
• Takes her husband out on a hot $556 date.

Arbitrageurs do this until the three currencies move back into equilibrium.

Broker versus Market Maker

I'm reading a book where the main character's father owns a book store and specializes in rare books.  He is also known around the world as someone who can find extremely rare books for those who want them.  I think this literary example might help some of you understand the difference between brokers and market makers.

He is acting as a broker when he helps find extremely rare books.  A buyer comes to him and says, "I want a first edition 'On the Origin of Species.'  Can you find one for me?"  He then works his network and keeps an eye out for that book.  When he finds one that someone is willing to sell, he assists in the negotiation of a price between the buyer and seller.  He takes a cut of the deal for his services as a broker.  A broker helps connect potential buyers and sellers so they can exchange goods.

His shop, with its stock of books (less rare of course), is a market maker.  He buys books that he thinks will sell at some point, puts them in his store at a higher price, and waits for buyers to purchase them.  The buyers and sellers never interact with each other, they only deal with the shop, the market maker.

We're the Red One, Redux

In We're the Red One, I mentioned that I couldn't find the original graph that was on the cover of Investor's Business Daily.  Then Nicole said she really preferred that graph, and I would find it if I loved her.

With this alignment, you can see that we eased into this recession more slowly than most previous recessions, but then it just kept getting worse.

When you hear people worrying about a double-dip recession, they are talking about something like what happened in 1948.  In that recession, the first bottom was at month 10, followed by a short recovery and a deeper bottom at month 13.

You Could Use a Mint, Part III

So I am little annoyed with Mint at the moment, because it isn't syncing with all our accounts properly.  Notably, it won't connect with Sallie Mae for our student loan accounts.  That is understandable, I suppose, since Sallie Mae isn't that big of a lender, and doesn't service MILLIONS of Americans' student loans.  Lots of people are having the exact same problem I am, and Mint provides a pretty good forum to submit problems and find others with the same problem.  According to the listing for this bug, Mint is working on it.

On the plus side, I'm getting the hang of the budget functions.  It allows you a good amount of flexibility with different types of budgets.  Most of the budgets I set up are standard: so many $ per month for rent, cell phone, internet, utilities, etc.  You can also set up a budget that rolls over from month to month.  This is great for our eating-out budget, so we can save up for a big night out or even borrow for it ahead of time.  I also used that type of budget for things we buy regularly but not every month, like cat food.

I've discovered how Mint makes its money.  The service is free for me to use.  There is a tab on the site labeled "Ways to Save," that suggests financial services that I may be interested in.  For example, I can get a list of available CDs that have better interest rates than my savings account.  I can also shop for credit cards, banks, brokerages, and auto insurance.  I'm sure Mint gets a finder's fee for any service I buy through their site.

The Antibiotic Insurance Policy

Marketplace had a brief report yesterday on the FDA's new rules about giving food-producing animals antibiotics.  Read the article here or listen to it now.

This will cost the food industry, especially large cattle farms.  Likely, that cost will get passed on to us in the form of higher meat prices.  I wish Marketplace had gone into some more details about those costs and their extent.

BUT, it helps stave off the microbe apocalypse.  We make an investment now to change the way we handle raising animals for food, followed by a somewhat more expensive ongoing process, but those premiums are paying to reduce the likelihood that a superbug will kill us all.

Next step, stop asking your doctor for antibiotics every time you stub your toe.

You Could Use a Mint, Part II

I started adding accounts and checking out the different features.  Adding accounts is fairly simple, similar to logging into a credit card website.  Some accounts are easier to add than others, though.  Our primary bank took less than 30 seconds, while the servicer of most of our student loans can't seem to connect correctly.

The expense tracking and budgeting tools are the first features I noticed.  Mint pulls the transaction data from our checking and credit card accounts.  It then assigns categories to most of those transactions (food, restaurants, gas, student loans, etc.), and I have to assign the category to some transactions (it doesn't know that big paper check transaction every month is the rent).

It uses this data to build pie charts of where we are spending our money.  We can also build budgets, which is useful for tracking our going-out-to-eat budget.  For a broader view, it can give you Net Income numbers for every month; so you know when you are living in the black or the red.  In the long run, the Net Worth number will also be good to track, but right now it's just depressing.

At the moment, I feel like Mint is a better connected and cleaner version of Quicken.

You Could Use a Mint, Part I

Last year sometime, I heard an article similar to this one, and thought about using a site like Mint.com to help manage our finances.  I signed up, but when it got to the point of asking for usernames and passwords to get access to my bank accounts, credit cards, and brokerages, I took a step back to make sure I wanted to put all that information into one place.  It is now ten months later, and that account is just sitting there.

Today, though, I got a message from a friend asking what I thought about sites like this, and I remembered my account.  I'm going to give it a try, and document my experience here.

I don't need Mint.com to manage our finances.  I do it pretty well with a spreadsheet, a check register, and my brain.  That said, those tools have some disadvantages:

• I sometimes find myself doing the same cash flow calculations multiple times during a complicated month; perhaps a site that put all our accounts together could help there.  
• We have money sitting in a savings account for Nicole's maternity leave that might earn a better return at our brokerage invested in Treasuries or CDs, but I often think about savings and brokerage accounts as being holders of money for different uses (a common behavioral finance trap).  Perhaps seeing these accounts together would make me more efficient with our cash and liquidity management. 

I think Mint.com will be most useful, though, if I get hit by a truck (a useful potential scenario for lots of life planning).  Nicole has access to all the usernames and passwords for all the accounts, but she doesn't interact with them as often as I do (such as my Roth IRA or student loans).  I hope that having all that information listed in one place will allow her to more easily see our overall financial status, and take over as the primary money manager if needed.

Sociological Disclosure: Yes, I am a man, and currently the primary money manager in our family.  Nicole is currently the primary breadwinner.  We both keep house.  Don't judge.

I'll start entering my information, and will post about the process as I go.

We're the Red One

Investor's Business Daily had a graph on their June 7 front page that compared employment losses of all the recessions since 1953.  They cited Calculated Risk as the source.  I couldn't find the exact same graph there, but I did find the one below, which I thought was pretty interesting.

Questions?  Comments?

Relax Luther, it's much worse than you think.

Sydney posted some good questions on What is Arbitrage?.  I'll take them one at a time over the next few weeks.  First, I have to contest the assumption that money in the bank is totally safe and secure.

It is true that money you have deposited to your FDIC insured bank is guaranteed by the federal government against loss.  If your bank goes bankrupt, and they don't have enough cash to pay you back, the FDIC steps in and pays you for every dollar up to $250,000.  Banks and the tax payer fill the pool to provide this insurance.

But what about the robot apocalypse?  Your trust in the bank and the FDIC rests on the belief that the federal government will always be there.  I think this is a fairly reasonable assumption, but you should be aware of it.  Also, one could argue that your American dollars won't be very useful in this scenario anyway.  Food, water, and a gun big enough to hurt robots would be preferable.

Here is the other, and more applicable, problem.  Your money is losing value in the bank.  Very few banks pay interest that is higher than inflation.  So you might get paid 1% a year by your bank, but when inflation goes up by 2%, you lose.  You have a little more money, but it doesn't buy you as much stuff.

I understand the desire to accept zero risk (assuming no robot apocalypse).  There are other investment options available to a risk averse investor that pay better than saving accounts, such as United States Treasury bills and bonds.  I'll describe them in detail soon.

What is Arbitrage?

My latest post, which happened to involve food, got more visits and acclaim than my typical posts.  In fact, one reader explicitly said that food based finance was more accessible.  So, let's try it again.

The term arbitrage is common in the finance industry.   Performing arbitrage is profiting from the variance in prices in the market.  Take the vanilla bean example in my last post.  Imagine that the big grocery store had a really liberal return policy, and they would let me "return" vanilla beans with or without the original container at the price of $16 for 2 (the price they sell them).  I could go to the local spice shop, buy 10 beans for $20, and then go sell them to the grocery store for $80.  I keep the $60 as profit and have successfully arbitraged. 

This helps explain why many stores require a receipt and/or original packaging to accept returns.

The Economics of Vanilla Beans in Cambridge

Here is a real life example price variance and inefficiency in the market place:

Nicole found this Cherry Vanilla Bean Milkshake recipe in a recent issue of Eating Well.  It says that you can use vanilla extract, which we have, but she wanted to try it with an actual vanilla bean.

So, while I am doing the grocery shopping, I go to the spice aisle in our chain grocery store which carries a nationally known spice brand.  They will sell me two vanilla beans in a glass jar for $16.  I think that is an expensive milkshake, and I don't buy them.

The next week, we are in the neighborhood of our amazing locally owned spice store, Christina's (they also make great ice cream next door).  We go in to restock our regular spices, but also to see how much they charge for vanilla beans.  They offer us a single bean for $3 or five beans for $10 (wrapped in plastic bags).  We buy five.

So instead of paying $8/bean at a huge company that has notable economies of scale, we pay $2/bean at a tiny spice store with likely razor thin profit margins.  Perhaps the jar is made of crystal?

More likely, product specific economies of scale are at work.  Very few people who visit the big grocery store would buy vanilla beans at any price.  The store stocks a few anyway, but they have an expiration date (they have to throw some out sometimes) and the store buys them already packaged from the spice manufacturer.  The costs for that store to provide vanilla beans are fairly high.  Christina's, on the other hand, probably has people buying vanilla beans fairly often, provides spices to local restaurants, and uses vanilla in their own ice cream business.  They probably buy vanilla beans in bulk, and package them on-site for their retail customers.  They pass their lower costs onto us.

Now we just need to buy the cherries and ice cream.

Card Comparison

Check out this useful charge/credit/debit card comparison from Loans & Credit.  I don't think that Debit Cards are quite as good at the "No Temptation" feature as they claim.  Many banks allow you to overdraw on your account with a debit card purchase without any warning.  They are effectively extending you a line of credit "as a convenience."  Then they charge you lots of fees.  I hope this is getting fixed with the new consumer credit legislation.

The Difference Between Correlation and Causation is Statistically Insignificant

Read this News in Brief from America's Finest News Source.

Clearly, the examples the The Onion gives are ridiculous.  There are plenty of times, though, where real people try to find meaningful connections between data that is simply random correlation. 

A cool example where the correlation is meaningful, though, is the orange market.  The companies that interact in the orange commodities market care a lot about the weather in Florida.  If there is a frost in Florida, oranges die, orange supplies go down, and the price of oranges go up.  These companies generally aren't satisfied with the detail and quality of the weather forecast provided by typical sources, so they hire their own meteorologists to hang out in Florida during the colder months to give private detailed reports.  They then make trades in the orange futures market based on the data they receive.  The result is that when there is a chance of frost during a few days or weeks, the orange futures market is a better predictor of actual frost than the National Weather Service.  If orange futures spike up in price during the afternoon, expect frost that night.

For another post on interpreting data better, read Points are for Sports, Pay Attention to Percentage in Finance.

Religion Driven Financial Innovation

The CBC reported this last week: Manitoba Credit Union 1st to Offer Islamic Mortgages.  Here is Assiniboine Credit Union's announcement.

I didn't know until recently that Islam forbade the payment of interest.  Perhaps I have a reader who can point us in the right direction for more information on that.

I don't fully understand how this system isn't effectively paying interest, with it just hidden as a profit payment.  The credit union gets the money it loans to the home owner from a market that is based on interest rates, so the set profit payment would need to reimburse them sufficiently.  It sounds like a fixed interest rate mortgage.  The product seems to have the endorsement of Winnipeg's Imam, though, so it presumably meets the religious requirements. 

What happens if the home owner defaults?  Typically, the bank would seize the house, sell it, take the money that is still owed to them, and the rest goes to the home owner. Can the owner sell the house before the contract period has ended?  Can the owner make accelerated payments to end the contract early?  These are questions that are easily explained and calculated with a typical mortgage and its amortization table (with an interest rate).

I also think it is interesting that this happened in Canada before the United States.

Who Cares About Liquidity?

This is the fourth and final entry in the Liquidity miniseries.  Read What is Liquidity?, What Determines Liquidity?, and How is Liquidity Measured? to catch up.

Everyone cares about liquidity.

Clearly, those who invest in the stock market care about liquidity.  If you place an order to buy a stock, you want to be able to get it for close to its current price.  Similarly, when you sell later, you don't want your sale to push the price down significantly.  Liquid stocks are more attractive for this reason.

Liquidity factors into everyday decisions too.  Consider this example I gave to my family last year (yes, my family has social conversations about this sort of thing; we are all nerds):

The bid-ask spread is one measure of liquidity.  For example, I would be willing pay you $1 for four quarters and you would probably be willing to sell them to me for the same price.  So, the bid-ask spread of four quarters is zero, and US currency is very liquid among its denominations.  This also implies that you and I consider quarters and dollar bills to be equal, which we might not in the real world.  Dollar bills suddenly become less liquid when you are trying to buy a candy bar from a vending machine that requires exact change.  In that case, I might pay you a dollar for three quarters just to get the change.  I am paying for liquidity, in that case.

This is an example of how currency isn't always fungible, which is a prerequisite for liquidity.  Two dollar bills are fungible with each other, but dollars and quarters aren't always.  The same is true for your electronic money in your checking account and cash from your checking account.  There are times when you would gladly pay a $3 fee to turn that electronic money into cash at an ATM.

The average person rarely notices liquidity when dealing with liquid goods, which most goods are.  People's decisions in aggregate make changes in the market, but these are hard to perceive at ground level.  One of your best opportunities to experience illiquidity is to do something like bid on a house, sell a used car at an auction, engage in salary negotiations at a new job, or buy a thinly traded stock.

Thursday Went Out Swinging

In case your media source is so preoccupied with the Oil Spill that you didn't hear, Thursday, May 6 was a historic day in the stock market.  The Dow recorded its biggest intraday drop ever. At one point, the Dow was down 9.2% from Wednesday's close.  The Nasdaq was down 9.0%.  The S&P 500, 400, and 600 were down 8.6%, 8.3%, and 7.6%, respectively.  All of these indexes recovered quite a bit during the day, still ending down for the day, but significantly higher than their lows.  Look at this Google chart for a visual representation:

We're still trying to figure out exactly what happened.  The market was depressed all week by concerns about Greece and the Euro, so it wasn't surprising the market was heading down on Thursday.  Something happened around 2:30pm, though.  There was speculation that a trader accidentally entered a trade for a billion instead of the intended million; this has not been confirmed.  It could be that the initial problem was related to Proctor & Gamble or 3M, who together made up a huge chunk of the Dow's drop.

Whatever started the drop, the continuation was likely caused by quantitative, computer executed portfolios.  Some asset managers run portfolios by creating models that are then executed automatically by a computer.  They might have rules in place that say something like "if P&G goes down more than 3% in 10 minutes, then sell a third of our holdings."  This sort of trade would push the price of P&G even lower.

Clearly, other asset managers, either manually or via other quantitative models (probably both), jumped on the sudden drop and started buying.  This brought the market back up close to its earlier levels.  Also, some of the trades that happened during this 20 minute window are being canceled.

The markets continued to suffer on Friday, and the volatility of the S&P 500 hit its highest in over a year.  At the time of this posting on Monday, May 10, though, the markets are up between 3.8% and 4.5%, and volatility is down over 34%.

How is Liquidity Measured?

This is the third part of my miniseries on liquidity.  Start with What is Liquidity? and What Determines Liquidity?.

As I discussed in those posts, how much the price of a good moves when people buy and sell it is one way to measure the liquidity of that good in the market.  This can be observed in a formal art auction easily, but can also be observed in other markets, like the example of gasoline.

The stock market has liquidity measures that are easy to observe.  The stock market is an ongoing auction with many buyers and many sellers.  Each stock is very fungible (one share of Apple's stock is the same as another), so that prerequisite for liquidity is achieved.  Some companies have more shares of stock in the market available for trade, which increases the potential liquidity.  This is why you might hear people talk about how one company's stock is more liquid than another.  For example, consider Dell (with 1.96 billion shares) and Super Micro Computer (with 35.9 million shares).  Dell's stock is potentially more liquid than Super Micro Computer's stock.  Note: this is different than a business' internal liquidity, which is related to how much cash they have on hand, a topic for a different post.

If you wanted to put the effort in, you could watch each trade for a stock as they happened and measure how much the price changed.  There is an easier way for many stocks:

Look at this detailed quote of Google on Yahoo Finance.  Check out the numbers for the Bid and the Ask.  The Bid is the highest latest price someone has offered to buy the stock, and the Ask is the lowest latest price someone has offered to sell the stock.  The difference between these two numbers is a measure of liquidity.  The closer these two numbers are, the more liquid the stock.  You can imagine, that if these two numbers were always the same, people would buy and sell the stock freely and the price would never change.  That is the definition of perfect liquidity.

What actually happens, though, is a buyer decides that the seller's Ask is good enough (or vice versa), and a trade is made.  The latest price for the stock is set to that trade's price, and the next lowest seller's offer becomes the new Ask.  The farther apart the Bid and Ask are, two things happen: it is less likely for someone to decide that an offer is good enough to make a trade, and when that trade does happen the price moves more.  In other words, lower liquidity.

What Determines Liquidity?

This is the second part of my miniseries on liquidity.  If you haven't already read What is Liquidity?, then do it now.

So what makes one product very liquid and another illiquid?  There are a number of factors that contribute to the overall liquidity of a thing:

1. Higher fungibility generally leads to higher liquidity.  A perfectly fungible good is identical to and interchangeable with other such goods.  Barrels of oil, $100 dollar bills, and gallons of tap water are usually very fungible.
2. Higher volume of trade of a good leads to higher liquidity.  The gasoline example in my last post speaks to this.  There are rarely large price jumps in the gasoline market.  Longer periods of time between trades often leads to larger price jumps when those trades happen.
3. In order to have the potential for high trading volume, you need high availability of the good.  There are lots of $100 bills and barrels of oil to be traded.  There are very few Picasso paintings.

What is Liquidity?

Investopedia defines Liquidity as "the degree to which an asset or security can be bought or sold in the market without affecting the asset's price."  In other words, if offering to buy or sell a thing doesn't have any effect on the price of that thing, the market for that thing is perfectly liquid.

In daily life, it would appear that almost everything is perfectly liquid.  Prices are set, and they don't change when make purchasing decisions.  In reality, though, aggregate purchasing decisions of the entire market do move prices, and illiquidity is everywhere.

Most everyone is familiar with an auction.  The market we all use every day is very much like an auction, but with many sellers along with the many buyers.  The price of gasoline fluctuates as buyers and sellers negotiate prices.  You negotiate with your local gas stations by buying from the stations with lower prices.  Your choice to buy from the cheaper stations will cause the more expensive stations to lower their prices.  That shows that the gasoline market is not perfectly liquid.  In fact, no market is.

Gas is still fairly liquid, though.  Other goods are extremely illiquid.  Consider a fine art auction, where every time a person raises their hand, the price of the good being auctioned could go up $5000.  Picasso's paintings are extremely illiquid.

Credit Rating Agencies "Look Like Idiots"

The Financial Times published "Emails Detail Role of Ratings Firms in Crisis" today.  It appears that employees of the two big credit rating agencies (Standard & Poor's and Moody's) thought that their firms' own ratings of some mortgage backed securities were faulty.

A big problem in the way the ratings market does its job is who pays for the work.  When S&P or Moody's are hired to rate a fixed income security about to go to market, they are paid by the people trying to sell the security.  This incentivizes the rating agency to rate in favor of the security seller, to encourage future business.

This is akin to you trusting a used car dealer's mechanic regarding the quality of a car you are considering to buy.  A savvy used car buyer has the car checked out by their own mechanic before buying.  Of course, this means you likely pay your mechanic for their trouble, but that fee is worth the information you gain before making the commitment to buy the car.

Investors should be doing the same thing with their fixed income securities.  Go hire your own credit rating agency.

Fixing Environmental Externalities

I had a comment on my Externalities post asking about the Cap and Trade program being considered as a way to combat carbon emissions.  The cap and trade idea isn't new.  In fact, the United States has had a successful cap and trade plan in place for over ten years in an attempt to curb sulfur dioxide and nitrogen oxides in the atmosphere.  It is called the Acid Rain Program.

In the case of acid rain, an externality exists: coal-fired power plants (and other polluters) put sulfur dioxide and nitrogen oxides into the air, which then come back down and kill forests (among other bad things).  The residents and businesses that use those forests are harmed.  This is a negative externality.

Cap and trade programs aim to reduce these pollutants (and by extension the externality) by using the theory of free markets.  The government issues permits that allow the holder of the permit to pollute a certain amount per year.  The sum of the permits at the time of issuance will often be close to the current level of pollution.  The permits might be given to the current polluters for free or auctioned off, or some of both.  Then, these permits can be bought/sold at an exchange by anyone at prices that vary via market forces.  A new factory can choose between buying a pollution permit or investing in technology that pollutes less.  An environmental non-profit or the EPA can buy permits and then never use them to reduce overall pollution.

Cap and trade systems work; there isn't a substantive debate there.  The controversy around carbon emission cap and trade is that not everyone agrees that carbon emissions are a problem.  That is a debate for a different blog.

Moral Hazard & WaMu

Moral hazard has gotten a lot of attention throughout the financial crisis, and rightfully so.  There was lots of it going on, and not only at the top.  Investopedia defines moral hazard as "the risk that a party to a transaction has not entered into the contract in good faith."  For a better definition with examples, though, check out Wikipedia.  It does a pretty good job, at the moment.

Marketplace had a piece this week centering around the moral hazard that was going on at Washington Mutual (WaMu).  Marketplace didn't label it as such, but the behavior they report that WaMu's employees were engaging in was definitely moral hazard.  Bank employees were encouraged to give loans to risky borrowers.  None (or very little) of the risk of these mortgages was being borne by WaMu or its employees.  They made the loan and then quickly sold it, so the risk that they created by making the contract was no longer theirs but the new investor's.

WaMu employees were also given bonuses when they overcharged home buyers.  So WaMu was cheating both the home buyer and the mortgage investor, while profiting from the loan origination fee.  WaMu likely wasn't the only bank doing this...

Listen to or read Did WaMu's Fraud Lower Rest of Market? (April 13, 2010).

The Dow Broke Through 11,000 this Week! Who cares?

Every time an index, especially the Dow, approaches and goes beyond round numbers (e.g. 11,000), you'll hear about it on the news.  Look to the New York Times, the Wall Street Journal, and the Chicago Sun-Times for examples.  Some claim it provides a psychological boost for the market.

Concentrating on a particular number as a milestone is silly.  11,000 is better than 10,990 the same amount that 10,980 is better than 10,970.  You don't see articles about 10,980.  11,000 is only impressive, because we use a base 10 number system.  If we used binary, reporters would have been going nuts when we crossed 10,000,000,000,000 back in July 2009 (that's 8,192 for those of you who aren't engineers).

It is useful to stop and reflect now and then, and perhaps using such numbers is as good a marker as any.  The markers shouldn't be given any special meaning, though.  The importance of particular numbers is simply a human construct placed upon an otherwise insignificant label.  The value of dollars and gold has a similar issue, but that is a conversation for another day.

A Tax Refund Isn't a Good Thing

Tax Day is coming up this week.  If you haven't already filed, then get it done.

Many people get excited about the prospect of a refund on their taxes.  If you are a competent saver, though, you shouldn't be.  Getting a refund means that you overpaid taxes during the past year.  The IRS has been happily taking your money, earning investment income on it, and will give it back to you after you file.

Instead, you should arrange your W-4 with your employer to withhold less of your salary for taxes.  The goal is to owe a little to the IRS when you file your taxes.  That way, you keep your money as long as possible, and you earn interest on it instead of them.  Don't lower your withholdings too much, though, or the IRS will fine you.

This method also means you won't be waiting around wondering if your tax paperwork got to the IRS successfully.  You'll know when they cash your check.

Externalities

Externality is an economic term that everyone should know.  The Glossary of Research Economics defines it as "An effect of a purchase or use decision by one set of parties on others who did not have a choice and whose interests were not taken into account."  That may be a bit hard to digest, so I'll give some examples.  Externalities can be both positive and negative, meaning the effects on the party who was not involved in the choice can be good or bad.

Imagine a homeowner spends $1000 and twenty hours of his time planting a garden in front of his house.  He is not planning to sell his house any time soon; he just loves gardens.  If he did sell, though, this improvement could increase his asking price and/or sell his house faster, because when potential buyers first visit the house they will likely have a more positive outlook when they see the nice garden.  Now imagine his next door neighbor is trying to sell her house a month after he plants the garden.  Potential buyers of her house will see his garden and could have similar feelings.  She would benefit from his economic decisions, and it is highly unlikely that she will write him a check for a few hundred dollars when her house sells.  This is a positive externality: his decision to plant a garden (a decision she was not involved in) benefits her and she does not reimburse him for the benefit.

For a negative externality, imagine the same two neighbors.  Now, though, instead of planting a garden, he has a broken down Pontiac sitting on his front lawn that he works on perpetually.

Negative externalities get much more attention from economists and policymakers than positive externalities, understandably so.  They are especially important in environmental policy.  I think about them during social welfare debates, too.

Saving and Debt to Income Ratios

My parents mailed me this Wall Street Journal article back in 2005: Ugly Math: Soaring Housing Costs Are Jeopardizing Retirement Savings.  I found it while cleaning out some old file folders.

It talks about how rising home prices of that time were keeping people from saving as they should while also ratcheting up their debt levels.  We're dealing with other economic problems these days, but the table in the article is still a great wake up call.

So, let's say you are 30 years old and making $50,000 a year.  You should have at least $5000 in savings, preferably in a IRA or other retirement tax shelter.  Meanwhile, your debt (including credit cards, student loans, car, and mortgage) should be no higher than $85,000.




Don't get too depressed; most of your friends aren't there either.  Just think about this when you get your next bonus or other windfall.  Perhaps you should split it between savings and student loans rather than buy a new TV.

The Market is More than Three Numbers

When you hear and read financial news, you likely get reports on the Dow, the S&P 500, and the NASDAQ.  These are indexes that track particular segments of the stock market.

They don't track the whole market, though.  More than 9,000 stocks are traded in the United States stock market.  The Dow Jones Industrial Average is limited to thirty very large companies.  The Standard & Poor's 500 tracks five hundred large cap companies.  The NASDAQ Composite tracks the stocks that trade on the NASDAQ stock exchange, but that only covers about a third of all the stocks and they are often more technology focused.

For a more complete picture, you should also pay attention to other indexes.  Check out the S&P 400 (a mid cap index) and the S&P 600 (a small cap index), for example.  The Russell Investment Group also has a set of indexes, as do other organizations.  Here is a good list of United States indexes.  You'll see on that Wikipedia page that many countries have their own indexes.

Insider Trading and your Elected Officials

Insider trading is a serious issue in our financial markets. It is hard to say how often it happens or how much money is involved, and it comes in many different flavors. The easiest example is that of the corporate executive who buys (sells) her own company's stock before the public release of good (bad) news. She then profits on her early access to information that can affect the stock price.

I heard this piece on Marketplace a while back:
Lawmaker's Inside Advantage to Trading September 17, 2009

This story brings to light a form of insider trading that is currently legal. Congresspeople can make stock trades using information from their private committee meetings. For example, if Barney Frank (Chairman of the House Financial Services Committee) was informed by the Consumer Credit sub-committee that they were going to recommend legislation that would potentially lower MasterCard's profits, he could sell his holdings in MasterCard (or sell short) before this news was publicly released. He, just like the executive in the example above, would profit from his early access to information that can affect the price of a stock.

Louise M. Slaughter (D-NY-28) and Brian Baird (D-WA-3) have introduced legislation that would create rules for congresspeople similar to those that exist already for corporate executives. They call it the STOCK Act, and you can read about it here and here.

Back on the Horse

I've been neglecting the blog for the past nine months, and it's time to attempt to revive it. It's amazing how busy unemployment can be. I've had some friendly encouragement lately, along with some advice from a marketing expert friend about how to post in a sustainable way. So, I'm going to attempt to post more often, but the posts will likely be shorter and involve more use of outside sources to get conversations started.

Today, I'll refocus the mission. I can't remember where I heard the theory about the three types of education needed to succeed, perhaps it was from Rich Dad Poor Dad (which I haven't read) or Why Smart People Make Big Money Mistakes & ... (which I have read and found to be good). Anyway, the general idea is that a person needs three types of knowledge to succeed in life:

• Book Smarts: factual knowledge, an employable skill, literacy, the ability to write a memo and do algebra, etc.
  
• Street Smarts: how to make friends, code switching language style based on audience, how to flirt, etc.
• Finance Smarts: understanding how your markets work, the ability to manage your money and other resources, etc.

Everybody has heard of the first two, but Finance Smarts is new to many. In fact, it seems that a lot of people think that finance and economics shouldn't be understood by all. "Economics is too complicated, leave it to the experts, and it wouldn't help me anyway," is the argument.

You don't need to be intimate with the orange futures market to succeed in life, true. You do need to understand how the prices of goods and services (e.g. gas, milk, housing, education) are set. You do need to know why a bank pays you 1% on your savings account, and charges 6% on your mortgage. You do need to understand what steps to take to successfully retire at age 65 and still have a place to live at age 105. You do need to understand how an investment in education affects you and your society in the long-run.

I hope Grokking Finance will help you learn about these things (and others) and build your Finance Smarts.