Handling Finances

I’ve read a lot of commentary on the economic stimulus package that passed this week, including quite a few comments from fellow financial bloggers like My Two Dollars and I’ve Paid For This Twice Already. People generally think the stimulus package is a great idea or the stupidest thing they’ve ever heard, but I’ve rarely seen much discussion of why our government thinks it needs to prop up the economy. No, it’s not a matter of keeping the 1-2% of jobs we might lose in a recession. Quite simply, our government is one of the only governments in the developed world that has done away with state-funded retirement pensions and instead invested our retirement funds in the stock market through 401(k) and IRA plans.

Yes, we still have social security, but it was always intended to simply supplement pensions earned through employment — with average monthly payments sitting around $1000, it’s hardly enough to cover rent or mortgage payments in many communities! That’s totally fine if we assume that most retirees have significant savings, but since only 36% of workers offered 401(k) plans in 2004 participated, it’s pretty clear that there’s going to be a whole lot of retirees in poverty in the next few decades.

But here’s the kicker — if the stock market drops dramatically, even those with retirement investments will be depending on insufficient social security payments! The whole idea that government pensions (A.K.A. social security) should be privatized might make sense by itself, but history has shown that the average American is not willing or able to save for their retirement and when they do, poor investment decisions and volatile market conditions risk personal retirement savings across the board! Neither can we move back to employer-based pensions as they’ve been reduced or outright removed as corporations recognized the huge savings in paying defined contributions (i.e. 401(k)) vs. defined benefits (pensions).

I have my own opinions about the wisdom of privatizing social security (I still can’t understand why Bush says we should emulate Chile where privatization has slashed benefits and greatly increased government costs) but this article isn’t really about how we, as a culture, should take care of our elderly. The point is that we can’t just continue to ignore the elephant in the room and pretend that this is all about the economy or just blink in amazement wondering why both major political parties agree that more debt will help the nation. The real issue here is that if the market drops, our current and future retirees will suddenly face poverty with only an unfunded government pension as a safety net. Until we acknowledge this problem and find ways avoid the potential consequences (besides simply borrowing more from China to keep stock markets high), the problem will only get worse.

Of course, we could always cut social security altogether, let the stock market go where it will, and simply let the unprepared starve in the streets, but never forget that a society is judged based on how it treats the poorest, not based on how easy it is for the rich and educated to succeed!

Fooled by Randomness by Nassim Nicholas Taleb is an absolute must-read for anybody involved with or interested in stock market investing. The book provides a much-needed reality check in an investing world where, despite the ubiquitous disclaimers suggesting that past performance does not guarantee future returns, we make our decisions based largely on past performance and recent past performance to boot! Of course, Nassim explains it as only one with extensive experience (as a professional trader) could, but here’s a taste of some of his wisdom.

I haven’t read the entire book yet, but one point in the first few chapters jumped out at me as vitally important. It is a Bad Idea to judge market gurus and advice columns by recent performance because there is so much randomness in the market that huge risk will always propel somebody to the top of the heap. Articles and advice should always be judged based on the likelihood that the writer or adviser could have failed. For example, somebody heavily invested in Asian markets is taking a rather large risk. They may earn many times their investment as might have happened in recent years, or they might have lost everything in Japan’s crash in 1990. As Taleb puts it, “I will repeat this point until I get hoarse: A mistake is not something to be determined after the fact, but in light of the information until that point.”

Another example he refers to is winning the lottery. Somebody will always win the lottery (barring a rigged system). If we judged lottery winners by the same standard the media likes to judge traders or fund managers, we would herald each winner as a lottery genius — to be emulated and consulted on how to make money through the lottery. Because stock markets (and generally any widespread investing vehicle) is absolutely full of randomness, simply making large bets and taking large risks will similarly propel a small number of traders to vast fortune but they generally have earned their ‘winnings’ no more than the lottery winner. The only difference, is that we carefully listen to the advice of successful high-risk traders where a simple evaluation of their high-risk peers shows that they have simply benefited from luck, not any particular skill.

Don’t take this summary to suggest that Taleb is simply sitting in an ivory tower passing judgement on successful high-risk traders! He does not come off at all as bitter, though he readily admits to envy and then guilty satisfaction in one of his anecdotes about a high-risk colleague. Instead of chasing billions in the markets for his employers, Taleb has been content to accrue ‘mere’ millions by steady and relentless statistical evaluation of probabilities and a high aversion to risk. In short, he has been actively successful in methodically producing good gains when his peers would routinely fly higher and higher until, like Icarus, they crashed and disappeared.

The book is also not written on “how to beat the market” which is why I feel I can suggest it so strongly. The book simply provides a framework from which we can recognize our statistical biases (like buying based on recent past performance even as we are adamant we know it doesn’t guarantee future returns). I certainly don’t agree with everything he says, but I’ve never felt that one has to agree 100% with an author to learn from them. There are many great lessons to be learned in this book and I’m sure I’ll write about more as I delve deeper into the book. For now, all I can say is that this book (and Taleb’s newer book, The Black Swan) should not be missed by any investor!