Archive for the 'Finance' Category

Aaagh!

I am buying a house, and am therefore faced with the choice between a 15 year mortgage at 2.875% and a 30 year mortgage at 3.49% (as of a couple of days ago; those rates have probably changed a little by now).

The main advantage of the 15 year mortgage is that it comes with a lower interest rate and, because I’m making larger monthly payments, it keeps my money out of the stock market, which is good if the market tanks. The main advantage of the 30 year mortgage is that it allows me to keep more money in the stock market for a much longer time, which is good if the market does well.

How should I weigh those factors? Economics tells me that I will solve this problem by forecasting the return on equities over each of the next 30 years, and computing, on the basis of my forecast, which mortgage will leave me richer in the long run. No, that’s not quite right. Actually, economics tells me that I’ll make many forecasts, assign each one a probability, and thereby compute two probability distributions for my future net worth and then choose the distribution I prefer.

Now let’s get serious.

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Dow 36,000 12,000

In 1999, the journalist James K. Glassman co-authored a book called Dow 36,000. The eponymous prediction did not pan out. A couple of days ago, Glassman popped up in the Wall Street Journal, trying to explain where he went wrong. “The world changed”, explains Glassman. The relative economic standing of the U.S. is declining. Plus terrorists and economic instability made the world a riskier place.

But there’s a better explanation. Glassman’s story never made sense in the first place, for reasons Paul Krugman explained when the book first came out.

Glassman has a substantial history of confusion about how financial markets work. Ten years before he wrote Dow 36,000, he was explaining in The New Republic that stocks are better investments than real estate:

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Today’s Post is Optional

When I was young, the pricing of stock options and other derivatives seemed like an obscure black art. Then one day Don Brown showed me a simple example that made everything crystal clear. Today I’ll share an even simpler version of Don’s example.

Imagine a stock that sells for $10 today. A year from now it will be worth either $20 or $5. (Yes, I know that real-world stocks have a wider range of possible future prices. That’s why I called this a simple example.) What would you pay for an option that allows you to buy the stock next year at today’s $10 price?

You might think you’d need a whole lot more information to answer that question. You might expect, for example, that the answer depends on the probability that the stock price will go up to $20 rather than down to $5. You might expect the answer to depend on how much traders are willing to pay for a given dollop of risk-avoidance.

But the amazing fact is that none of that matters. The only extra bit of information you need is the interest rate.

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How to Get Rich

monopolymanA few years ago, billionaire David Koch donated $25 million to his alma mater, Deerfield Academy. From his presentation speech:

You might ask: How does David Koch happen to have the wealth to be so generous? Well, let me tell you a story. It all started when I was a little boy. One day, my father gave me an apple. I soon sold it for five dollars and bought two apples and sold them for ten. Then I bought four apples and sold them for twenty. Well, this went on day after day, week after week, month after month, year after year, until my father died and left me three hundred million dollars.

Now on the one hand I love this story. But wouldn’t it have been more plausible if he’d sold the first apple for, say, a nickel?

Well, maybe not much more plausible. Doubling your money every day, it takes just a little over a month to grow a nickel into three hundred million dollars.

I still like the story though.

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Eggs and Baskets

eggsOver at Marginal Revolution, Tyler Cowen puzzles over Ian Ayres‘s take on investment strategy:

In our risk-reducing implementation, we want people to borrow to invest more when young and then invest less when older. The lifetime exposure to stocks is held constant. Compare the following two investment paths:

Option 1:

  • Year 1 Invest $1
  • Year 2 Invest $2
  • Year 3 Invest $3

Option 2:

  • Year 1 Invest $2
  • Year 2 Invest $2
  • Year 3 Invest $2

Our view is that option 2 is the safer bet.

(Note that when Ayres says “invest $2″ he does not mean “Add $2 to your investment”. He means “Have a total of $2 invested.” So under Option 1 you add a dollar a year to your investment. Under Option 2 you do all your investment up front and then scoop out all the profits every year (or scoop replacement funds in if you’ve taken losses). Option 1, in other words, is the widely touted but thoroughly ridiculous strategy often called Dollar Cost Averaging.

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