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Authors: Charles Wheelan

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When we cannot automate menial tasks, we may relegate them to students and young people as a means for them to acquire human capital. I caddied for more than a decade (most famously for George W. Bush, long before he ascended to the presidency); my wife waited tables. These jobs provide work experience, which is an important component of human capital. But suppose there was some unpleasant task that could not be automated away, nor could it be done safely by young people at the beginning of their careers. Imagine, for example, a highly educated community that produces all kinds of valuable goods and services but generates a disgusting sludge as a by-product. Further imagine that collecting the sludge is horrible, mind-numbing work. Yet if the sludge is not collected, then the whole economy will grind to a halt. If everyone has a Harvard degree, who hauls away the sludge?

The sludge hauler does. And he or she, incidentally, would be one of the best-paid workers in town. If the economy depends on hauling this stuff away, and no machine can do the task, then the community would have to induce someone to do the work. The way to induce people to do anything is to pay them a lot. The wage for hauling sludge would get bid up to the point that some individual—a doctor, or an engineer, or a writer—would be willing to leave a more pleasant job to haul sludge. Thus, a world rich in human capital may still have unpleasant tasks—proctologist springs to mind—but no one has to be poor. Conversely, many people may accept less money to do particularly enjoyable work—teaching college students comes to mind (especially with the summer off).

 

 

Human capital creates opportunities. It makes us richer and healthier; it makes us more complete human beings; it enables us to live better while working less. Most important from a public policy perspective, human capital separates the haves from the have-nots. Marvin Zonis, a professor at the University of Chicago Graduate School of Business and a consultant to businesses and governments around the world, made this point wonderfully in a speech to the Chicago business community. “Complexity will be the hallmark of our age,” he noted. “The demand everywhere will be for ever higher levels of human capital. The countries that get that right, the companies that understand how to mobilize and apply that human capital, and the schools that produce it…will be the big winners of our age. For the rest, more backwardness and more misery for their own citizens and more problems for the rest of us.”
13

CHAPTER
7
 
Financial Markets:
 

What economics can tell us about getting rich quick (and losing weight, too!)

 

W
hen I was an undergraduate many years ago, a new diet swept through one of the sororities on campus. This was no ordinary diet; it was the grapefruit and ice cream diet. The premise, as the name would suggest, was that one could lose weight by eating large amounts of grapefruit and ice cream. The diet did not work, of course, but the incident has always stuck with me. I was fascinated that a very smart group of women had tossed aside common sense to embrace a diet that could not possibly work. No medical or dietary information suggested that eating grapefruit and ice cream would cause weight loss. Still, it was an appealing thought. Who wouldn’t want to lose weight by eating ice cream?

I was reminded of the grapefruit and ice cream diet recently when one of my neighbors began to share his investment strategy. He had taken a big hit over the past year because his portfolio was laden with Internet and tech stocks, he explained, but he was plunging back into the market with a new and improved strategy. He was studying the charts of past market movements for shapes that would signal where the market was going next. I cannot remember the specific shapes he was looking for. I was distracted at the time, both because I was watering flowers and because my mind was screaming, “Grapefruit and ice cream!” My smart neighbor, who is both a doctor and a university faculty member, was venturing far from the halls of science with his investment strategy, and that is the broader lesson. When it comes to personal finance (and losing weight), intelligent people will toss good sense aside faster than you can say “miracle diet.” The rules for investing successfully are strikingly simple, but they require discipline and short-term sacrifice. The payoff is a slow, steady accumulation of wealth (with plenty of setbacks along the way) rather than a quick windfall. So, faced with the prospect of giving up consumption in the present for plodding success in the future, we eagerly embrace faster, easier methods—and are then shocked when they don’t work.

This chapter is not a primer on personal finance. There are some excellent books on investment strategies. Burton Malkiel, who was kind enough to write the foreword for this book, has written one of the best:
A Random Walk Down Wall Street.
Rather, this chapter is about what a basic understanding of markets—the ideas covered in the first two chapters—can tell us about personal investing. Any investment strategy must obey the basic laws of economics, just as any diet is constrained by the realities of chemistry, biology, and physics. To borrow the title of Wally Lamb’s best-selling novel: I know this much is true.

 

 

At first glance, the financial markets are remarkably complex. Stocks and bonds are complicated enough, but then there are options, futures, options on futures, interest rate swaps, government “strips,” and the now infamous credit default swaps. At the Chicago Mercantile Exchange, it is now possible to buy or sell a futures contract based on the average temperature in Los Angeles. At the Chicago Board of Trade, one can buy and sell the right to emit SO
2
. Yes, it’s actually possible to make (or lose) money by trading smog. The details of these contracts can be mind-numbing, yet at bottom, most of what is going on is fairly straightforward. Financial instruments, like every other good or service in a market economy, must create some value. Both the buyer and seller must perceive themselves as better off by entering into the deal. All the while, entrepreneurs seek to introduce financial products that are cheaper, faster, easier, or otherwise better than what already exists. Mutual funds were a financial innovation; so were the index funds that Burt Malkiel helped to make popular. At the height of the financial crisis in 2008, it became clear that even Wall Street executives did not fully understand some of the products that their firms were buying and selling. Still, all financial instruments—no matter how complex the bells and whistles—are based on four simple needs:

 

 

Raising capital.
One of the fascinating things in life, particularly in America, is that we can spend large sums of money that don’t belong to us. Financial markets enable us to borrow money. Sometimes this means that Visa and MasterCard indulge our eagerness to consume today what we cannot afford until next year (if then); more often—and more significant to the economy—borrowing makes possible all kinds of investment. We borrow to pay college tuition. We borrow to buy homes. We borrow to build plants and equipment or to launch new businesses. We borrow to do things that make us better off even after we’ve paid the cost of borrowing.

Sometimes we raise capital without borrowing; we may sell shares of our business to the public. Thus, we trade an ownership stake (and therefore a claim on future profits) in exchange for cash. Or companies and governments may borrow directly from the public by issuing bonds. These transactions may be as simple as a new car loan or as complex as a multibillion-dollar bailout by the International Monetary Fund.
The bottom line never changes: Individuals, firms, and governments need capital to do things today that they could not otherwise afford; the financial markets provide it to them—at a price.

Modern economies cannot survive without credit. Indeed, the international development community has begun to realize that making credit available to entrepreneurs in the developing world, even loans as small as $50 or $100, can be a powerful tool for fighting poverty. Opportunity International is one such “microcredit” lender. In 2000, the organization made nearly 325,000 low-collateral or non-collateral loans in twenty-four developing countries. The average loan size was a seemingly paltry $195. Esther Gelabuzi, a widow in Uganda with six children, represents a typical story. She is a professional midwife, and she used a tiny loan by Western standards to set up a clinic (still without electricity). She has since delivered some fourteen hundred babies, charging patients from $6 to $14 each. Opportunity International claims to have created some 430,000 jobs. As impressive, the repayment rate on the micro-loans is 96 percent.

 

 

Storing, protecting, and making profitable use of excess capital.
The sultan of Brunei earned billions of dollars in oil revenues in the 1970s. Suppose he had stuffed that cash under his mattress and left it there. He would have had several problems. First, it is very difficult to sleep with billions of dollars stuffed under the mattress. Second, with billions of dollars stuffed under the mattress, the dirty linens would not be the only thing that disappeared every morning. Nimble fingers, not to mention sophisticated criminals, would find their way to the stash. Third, and most important, the most ruthless and efficient thief would be inflation. If the sultan of Brunei stuffed $1 billion under his mattress in 1970, it would be worth only $180 million today.

Thus, the sultan’s first concern would be protecting his wealth, both from theft and from inflation, each of which diminishes his purchasing power in its own way. His second concern would be putting his excess capital to some productive use. The world is full of prospective borrowers, all of whom are willing to pay for the privilege. When economists slap fancy equations on the chalkboard, the symbol for the interest rate is
r,
not
i.
Why? Because the interest rate is considered to be the rental rate—
r
—on capital. And that is the most intuitive way to think about what is going on. Individuals, companies, and institutions with surplus capital are renting it to others who can make more productive use of it. The Harvard University endowment is roughly $25 billion. This is the Ivy League equivalent of rainy-day money; stuffing it under the mattresses of students and faculty would be both impractical and a waste of a tremendous resource. Instead, Harvard employs nearly two hundred professionals to manage this hoard in a way that generates a healthy return for the university while providing capital to the rest of the world.
1
Harvard buys stocks and bonds, invests in venture capital funds, and otherwise puts $25 billion in the hands of people and institutions around the globe who can do productive things with it. From 1995 to 2005, the endowment earned an average 16 percent annual return, which is a lot more productive for the university than leaving the cash lying around campus. (Harvard also managed to lose 30 percent of its endowment during the financial crisis, so we’ll come back to the Harvard endowment when we talk about “risk and reward.”)
2

Financial markets do more than take capital from the rich and lend it to everyone else. They enable each of us to smooth consumption over our lifetimes, which is a fancy way of saying that we don’t have to spend income at the same time we earn it. Shakespeare may have admonished us to be neither borrowers nor lenders; the fact is that most of us will be both at some point. If we lived in an agrarian society, we would have to eat our crops reasonably soon after the harvest or find some way to store them. Financial markets are a more sophisticated way of managing the harvest. We can spend income now that we have not yet earned—as by borrowing for college or a home—or we can earn income now and spend it later, as by saving for retirement. The important point is that earning income has been divorced from spending it, allowing us much more flexibility in life.

 

 

Insuring against risk.
Life is a risky proposition. We risk death just getting into the bathtub, not to mention commuting to work or bungee jumping with friends. Let us consider some of the ways you might face financial ruin: natural disaster, illness or disability, fraud or theft. One of our primary impulses as human beings is to minimize these risks. Financial markets help us to do that. The most obvious examples are health, life, and auto insurance. As we noted in Chapter 4, insurance companies charge more for your policy than they expect to pay out to you, on average. But “average” is a really important term here. You are not worried about average outcomes; you are worried about the worst things that could possibly happen to you. A bad draw—the tree that falls in an electrical storm and crushes your home—could be devastating. Thus, most of us are willing to pay a predictable amount—even one that is more than we expect to get back—in order to protect ourselves against the unpredictable.

Almost anything can be insured. Are you worried about pirates? You should be, if you ship goods through the South China Sea or the Malacca Strait. As
The Economist
explains, “Pirates still prey on ships and sailors. And far from being jolly sorts with wooden legs and eye patches, today’s pirates are nasty fellows with rocket-propelled grenades and speedboats.” There were 266 acts of piracy (or attempts) reported to the International Maritime Organization in 2005. This is why firms sending cargo through dangerous areas buy marine insurance (which also protects against other risks at sea). When the French oil tanker
Limberg
was rammed by a suicide bomber in a speedboat packed with explosives off the coast of Yemen in 2002, the insurance company ended up writing a check for $70 million—just like when someone backs into your car in the Safeway parking lot, only a much bigger claim.
3

The clothing and shoe company Fila should have bought insurance before the 2009 U.S. Open tennis tournament, but didn’t. Like other such companies, Fila endorses athletes and pays them large bonuses when they do great things. Fila endorses Belgian tennis player Kim Clijsters, winner of the U.S. Open, but opted not to buy “win insurance” for the roughly $300,000 in bonus money they had promised her for a victory. (This was an expensive decision, but perhaps also an insulting one for Ms. Clijsters.) The insurance would have been cheap; Clijsters was unseeded, had played only two tournaments since leaving the game to have a baby, and was considered a 40–1 long shot by bookies before the tournament.
4

The financial markets provide an array of other products that look complicated but basically function like an insurance policy. A futures contract, for example, locks in a sale price for a commodity—anything from electrical power to soybean meal—at some defined date in the future. On the floor of the Board of Trade, one trader can agree to sell another trader a thousand bushels of corn for $3.27 a bushel in March of 2010. What’s the point? The point is that producers and consumers of these commodities have much to fear from future price swings. Corn farmers can benefit from locking in a sale price while their corn is still in the ground—or even before they plant it. Might the farmers get a better price by waiting to sell the crop until harvest? Absolutely. Or they might get a much lower price, leaving them without enough money to pay the bills. They, like the rest of us, are willing to pay a price for certainty.

Meanwhile, big purchasers of commodities can benefit from being on the other side of the trade. Airlines use futures contracts to lock in a predictable price for jet fuel. Fast-food restaurants can enter into futures contracts for ground beef, pork bellies (most of which are made into bacon), and even cheddar cheese. I don’t know any Starbucks executives personally, but I have a pretty good idea what keeps them awake at night: the world price of coffee beans. Americans will pay $3.50 for a grande skim decaf latte, but probably not $6.50, which is why I would be willing to bet the royalties from this book that Starbucks uses the financial markets to protect itself from sudden swings in the price of coffee.

Other products deal with other risks. Consider one of my personal favorites: catastrophe bonds.
5
Wall Street dreamed up these gems to help insurance companies hedge their natural disaster risk. Remember, the insurance company writes a check when a tree falls on your house; if a lot of trees fall on a lot of houses, then the company, or even the entire industry, has a problem. Insurance companies can minimize that risk by issuing catastrophe bonds. These bonds pay a significantly higher rate of interest than other corporate bonds because there is a twist: If hurricanes or earthquakes do serious damage to a certain area during a specified period of time, then the investors forfeit some or all of their principal. The United Services Automobile Association did one of the first deals in the late 1990s tied to the hurricane season on the East Coast. If a single hurricane caused $1.5 billion in claims or more, then the catastrophe bond investors lost all of their principal. The insurance company, on the other hand, was able to offset its claims losses by avoiding repayment on its debt. If a hurricane did between $1 billion and $1.5 billion in damage, then investors lost a fraction of their principal. If hurricanes did relatively little damage that year, then the bondholders got their principal back plus nearly 12 percent in interest—a very nice return for a bond.

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