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.