Tuesday, February 26, 2013

Investment Part 1: The Basics

One of those quirks of being an economist is few people really understand your job. A large portion of introductory conversations eventually turn towards the next hot stock tip or investment idea. The fact is that while most economists probably have an opinion of what direction the economy is moving in, they probably don't have much interest in individual stocks. While economists are well equipped with the tools for financial analysis many if not most (at least within academia) simply do not pursue that vocation.

The overall mechanisms of investment and trade however are important concepts in economics. This posting will attempt to provide a basic outline of investment principles from which to expand in next weeks submission, which will discuss equity pricing.

The fundamental idea behind investment is essentially the same regardless of mechanism.  You employ resources now in order to realize future gains.  The most commonly discussed resource is currency, but other resources include time, materials, land, and anything else that can be utilized or expended for gain. For example, spending the time and money in order to gain a high school diploma is an investment. An individual loses the time they could have been using in more financially productive ways in order to gain higher average wages later in life.

However, most of the time when people discuss investment they mean using excess money (or credit) to earn returns at a future point. Currency can be used in several ways in order to gain a return. Stocks, bonds, real estate, currency trading, commodity trading, annuities and entrepreneurship are only the most common. I'll touch briefly on each of these before exploring stocks and bonds in greater depth next week.

Annuities are very simply directly buying a revenue stream. A person who has more money than they require at the moment may purchase an annuity which will pay out a larger amount of money over time. The core concept behind this investment is the time value of money. Essentially money now is worth more than money in the future (due to expected inflation, risk and liquidity factors). Therefore some firms are willing to take $1000 now and return a larger amount, for example $1200, over the next ten years. The amount returned varies proportionally with the agreed upon time period. In other words the longer the period you are paid back over the more you will receive overall.  Annuities are generally a safe but not very profitable investments. The investor is generally left better off than if they did nothing with their excess funds, but not by much after inflation is considered.

Many investments directly mirror the annuities "pay now get more back later" style. Certificates of deposit for example are essentially a promise to allow a bank to hold your funds for a given time. In return they provide interest to compensate you for the use of your funds. The only real difference between purchasing an annuity and "rolling" certificates of deposit is that the certificate gets the benefit of compound interest.

Of the methods of investment listed entrepreneurship is the most unique.  Utilizing resources in order to establish a business which will provide a future revenue stream is a concept most people can easily grasp.  If an individual expends a thousand dollars in order to create a business that returns a dollar a day he has from a financial perspective bought a revenue stream very similar to an annuity. However, owners have a great deal more influence on how much a business returns than annuity holders have over their annuities. Business ownership rewards many factors which other investments neglect, such as innovation, the owner's labor, and sound planning. No matter how intelligent or hard working you are it's unlikely you'll find an annuity that provides a much better return than the market average.  Businesses are also the most independent of market forces.  While a portfolio consisting of Apple stock will vary exactly with the price said stock, an arts and crafts store will not immediately declare bankruptcy if the price of paper increases significantly.  That's not to say that the price of real estate won't have a large impact on a real estate office, but more factors go into a business than most investments.

Real estate, currency trading and commodity trading all work given a relatively simple market system. As supply rises or demand falls prices fall. When demand outstrips supply prices rise. A variety of factors complicate the market but at it's core supply and demand rule. Thus when the world economy is booming more power is demanded to keep all the factories, cars and new electronics running so oil prices rise. When the economy pulls back some of those factories shut down, more people are out of work (and thus commute less), and oil prices fall.  Similarly when the United States prints more dollars supply rises and the value of the dollar falls.

Next week I'll continue on this topic with a focus on stocks, bonds and in particular how the prices for those two investment vehicles are created.

Tuesday, February 19, 2013

Media Bias and Economic Pessimism

Earlier this week during a discussion of Walmart's recent sales numbers I was asked to explain what, "Consumers tend to react to the downside more aggressively and more quickly than the upside." meant. I explained that, simply put, people reduce their spending more quickly and in greater amounts when they feel times are difficult than they increase spending when times are favorable. Unsurprisingly, people's current actions reflect their beliefs regarding the future.

If you're a viewer of cnbc, bloomberg or another financial news channel you're likely familiar with this idea in the form of "consumer confidence." The Conference Board polls five thousand households monthly to establish their opinions on both current and future economic conditions. These opinions are used to craft the CCI, Consumer Confidence Index, which is believed to be an important economic indicator.

There is little disagreement that the CCI represents important insight on consumer behavior. In no way do I feel that it is inaccurate or unimportant. When consumers feel financially uncertain they spend less. When  they feel secure they increase spending. These facts are well established and directly linked to the CCI. However, I do feel a bit uneasy when it comes to the basis of the index.  After all, if the survey is simply the opinions of five thousand average households I have to wonder how those opinions are formed.

There's a few different ways individuals could establish their opinions regarding personal economic outlook.  Obviously personal experience is a leading contributor. Someone who has just been laid off or had their hours reduced is likely going to feel that the future is uncertain.  Anecdotes from friends and family are also likely to be very influential. If your brother John tells you that his company is looking to fire six thousand workers you're likely to wonder if things aren't going well. Of course if you're interested in economic news you may even be reading monthly economic reports which directly tell of growth and unemployment rates. I suspect that's a rather small minority however.

For the majority what's forming our opinion of economic outlook? Undoubtedly it must be media coverage of the economy. If the CCI is a measure of our collective opinions, and our opinions are heavily influenced by the media, the question of "is the media fairly representing the economy" is obvious. The answer is resounding no (See Economic Affairs, Media Coverage, and the Public's Perception of the Economy in Germany.)

This paper written by Marcel Garz sought to examine the connection between German media coverage of unemployment rates, public perception of unemployment rates, and actual changes in unemployment. Garz found that positive and negative news coverage of the economy had relatively equal effects on public perception on a per story basis. However, negative news stories were far more prevalent overall, and thus led to economic pessimism. In Garz's words,

"The results, which are robust over time and across demographic groups, suggest that a
single negative report has a long-run effect that is similar to the influence of a positive
report, but their higher numbers relative to positive reports causes an asymmetric reaction
in unemployment expectations."

It is important to note that over the course of this study unemployment actually declined by nearly two percent. Thus, the negative reporting was not due to particularly difficult economic times.

If this data is accurate (and many studies would suggest it is) then it's difficult to come to a conclusion besides negative economic news reporting is damaging to the economy. The previous statement in no way implies that media outlets should not honestly report economic troubles. It is simply a statement of objective fact. Further, given the nature of news television it is unsurprising that an overly pessimistic economic outlook prevails. The public is simply less likely to pay attention to a news anchor who claims everything is going well than a news anchor who presents a grim and cautionary outlook.

As unfortunate as the situation is there is no easy remedy. Freedom of the press is far more important than a phenomenon that while damaging to our economy is also at worst a minor contributor. Still, it would be nice if the media painted a more accurate portrayal of the current economic outlook.

Tuesday, February 12, 2013

The Impossibility of Continued Compound Economic Growth

If there is a holy grail in the domain of pop economics it must be economic growth. By all reports keeping a national economy growing at a steady annual rate eventually cures all ills. Deficits vanish, everyone is estatic and all fiscal difficulties are but a memory consigned to text books for future economics students to digest.

The unfortunate problem is such a solution in perpetuity is a fantasy.  Before getting into the details of why compound growth can't continue indefinitely let's consider some definitions. Imagine a very simple economy that produces only widgets. In this economy we'll consider economic growth to have occurred on any year in which more widgets were produced than in the previous year. So if a thousand widgets were produced last year and a thousand and ten were produced this year we can claim our economic growth was 1%.

Given our sample economy we'll now establish a mechanism of production. Again to keep it simple we'll just assume we have a magic box called a factory. You simply pour inputs of production into it and the factory spits out widgets and heat. Even better, factories are free, take up zero space and are available upon request to everyone. Thus essentially we are left with only two obstacles between us and economic growth. One, we must come up with more or better inputs each year and two we must get rid of the waste heat somehow.

In this simple case let's say that our inputs of production are simple energy and labor. Since our factories take up zero space we can't very well have people working inside them, but we'll just assume that someone standing near a factory not doing anything else increases it's production by a small margin. Given that people take up physical space it's academic to show that there is a finite amount that can fit on our planet. Further, anything that has a hard limit can not be a source of compound growth indefinitely. Thus we can conclude that increasing labor is not a viable way to continue compound economic growth.

Energy is similarly constrained. In the long term the only viable energy sources are renewable in nature. Essentially that boils down to solar power.  Given that only a fixed amount of sunlight strikes the earth each day, total energy inputs are limited by solar output striking the earth times the efficiency of our gathering apparatus. While this is an immense amount of energy it is still limited and thus can not support compound growth indefinitely.

If neither of our inputs are as limitless as we'd hoped perhaps we can simply use what we have better. Or in other words perhaps technological gains can deliver us to the promised land. However, even here the are boundaries we can not cross.  In our simplified example we're converting energy to matter. Physics demands a certain quantity of energy for each widget we produce and no technological improvement can bypass this restriction.  In a more practical sense at the point that you're gathering all of the energy that strikes the planet (impossible) and converting it to useful work without losses (also impossible) you can't get any further improvements.

Nor do the problems end there. Our example also included one unavoidable and undesirable waste product: namely heat. The earth only radiates heat into space at a given rate. Once your heat production exceeds the rate of radiation things begin to heat up. Each year more waste heat is produced and each year the earth can radiate a smaller proportion of that heat away into space. Eventually the oceans boil away, though not before that everyone has died anyway.

These problems seem like abstractions.  Reading about it likely feels similar to having a museum guide inform you, with a conspiratorial wink, that a meteor like the one that killed the dinosaurs will one day be headed for earth... but probably not tomorrow.  While the end of compound economic growth isn't quite so dire a catastrophe it's also a lot closer to hand.

Looking at the primary difficulties we can examine how close we already are to our limits. Researchers currently estimate that the world population will peak at around ten billion persons somewhere around the end of this century. So in terms of that input we have approximately a hundred years of growth.

Currently the world population utilizes around five hundred exajoules of energy annually. By the time we reach peak population and bring everyone up to a reasonable standard of living that number will easily exceed a thousand exajoules. Total solar input on the earth is approximately four million exajoules. If energy inputs are increased at a rate of 1% per year in order to continue economic growth than we'd have approximately eight hundred years of that free ride until we reached our limit.  However, it's important to note that the practical limit is far far shorter unless we develop 100% efficient solar cells and cover every surface of the planet with them.  A more reasonable assumption would assume approximately five hundred years of possible gains. Of course the problem worsens as the rate of growth rises. At a 2% growth rate we start running into problems in approximately two hundred and fifty years.

The problem of heat is equally dire. The point of heat generation that causes oceans to boil likely seems remarkably far off. However, given current energy growth rates and the laws of thermodynamics it's likely that the earth would heat to the point of boiling water in under five hundred years. Clearly well before that things will begin to grow uncomfortable. Obvious changes begin to occur again around the two hundred and fifty year mark and accelerate rapidly from there.  Note this phenomenon is completely separate from (though would be exacerbated by) any global warming effects due to green house gases.

It seems that we've got at most a quarter millennium to get our finances in order before the miracle of compound growth is forced to a screeching halt. In practical terms growth will slow over time until we reach a relatively steady state. However, the idea of simply growing out of any fiscal difficulties has an eventual expiration date. And it's not all that far off in historical terms.

A couple hundred years may seem like a long time, but given the rate of progress in Washington D.C. I'm not sure it's long enough.

A bit of an addition set apart from the main body of the post:  I'm well aware that there are possible solutions to the problems presented above. In this posting I've treated the earth as a closed system for reason of simplicity. You could conceivably move industrial production off planet in order to mitigate problems of heat and energy (as you wouldn't be pumping heat into the planet's environment nor using it's surface area to gather energy). The point is not to propose a certain date at which point economic growth must halt. Rather it's to demonstrate that compounded growth must halt at some point.  To carry it further, if all economic activity requires some energy then energy input must grow at a compound rate as well. If that is the case then given current energy expenditure growth rates how long until we're consuming the entire annual output of the sun? How long until we're consuming the annual energy output of the galaxy for that matter. Doing the math on such questions still leads to dates measured in historical, not geological terms. The fact is our society as it exists now can not support the current growth model indefinitely.

Tuesday, February 5, 2013

Time and Preference for Choices

There is a fundamental misconception rooted in the collective psyche of Americans that more choices are better. What is particularly confusing about this phenomenon is that nearly everyone has direct personal experience that refutes the idea.  Recently I had to seek out a new bag to hold my laptop for when my backpack wasn't appropriately formal. I was confronted with a dizzying array of choices. Even after establishing relatively rigorous guidelines I still had to choose between several dozen very nice bags. Any of them would have been perfectly suitable and yet I spent hours choosing between them. Was I better off having spent all this time selecting between options that were fundamentally the same in terms of function and personal utility? Not especially.

Recent research suggests that had I been choosing a bag to receive a year from now I might have found the decision quite a bit easier to make. The ideas of Joseph Goodman and Selin Malkoc propose that as distance (both temporal and geographic) increases from a decision a person's preference for more choices diminishes.  In other words the sooner you have to make a decision the more options you are likely to desire.

The main idea behind Goodman's research is that the further removed from an individual a decision is the more abstractly the individual thinks about the decision. For example, when planning an evening out an individual might want to see a movie and get some dinner and dessert. As the movie ends the individual may begin thinking that some cheesecake would be a great way to end the evening. Finally, when the waiter comes to ask what they would like the individual might settle on a raspberry chocolate cheesecake slice. At each of these stages it's likely the individual's desire for more options increases.

Goodman and Malkoc created several simple experiments to test their ideas. The first experiment involved two treatment groups. The first group selected a free entree coupon for two restaurants they were told were opening the next day. Restaurant A had a menu approximately twice the size of restaurant B. In this treatment group participants selected the restaurant with the larger menu 63% of the time. Conditions were the same in the second treatment group with the exception that participants were told the restaurants were opening in six months. Participants in this group chose the restaurant with the smaller menu size the majority of the time (54%).

In the second experiment participants were asked to imagine two ice cream shops that were either in their town or in a far away location. Once ice cream shop had six flavors while the other carried eighteen. Participants then selected which ice cream shop they preferred.  When participants imagined the ice cream shop in their town they selected the shop with more flavors 85% more than when they imagined the far away shop.

These two experiments demonstrate very simply Goodman and Malkoc's ideas of how temporal and geographic proximity influence the desire for number of options. However, now that the effect has been demonstrated the question of mechanism must be answered. It seems likely that as choices are more psychologically distant options seem more substitutable. After all, at noon anything sweet after dinner will do for dessert. However, when that dessert cart comes rolling around the berry parfait seems very different from the raspberry cheesecake. Similarly, when planning to furnish a new home six months from now plans might include a coffee table. At that point all coffee tables may seem more or less the same. Yet when it comes time to make a purchase every small detail from height to surface type is a make or break proposition.

An alternative theory regarding the mechanism of action is that participants simply do not care about decisions which are significantly removed by time or geography. Therefore they select their preference for more or less options in a more random manner. The researchers conducted further experiments similar to the ones discussed above but including measures of participant involvement. In each case participants were found to be equally invested in both proximal and distal scenarios and still favoring more choices in proximal scenarios compared to distant scenarios.

The end results seem relatively conclusive. Individuals simply desire more options the more immediately they must make a decision. If you'd like to read about the experiments in more depth Goodman and Malkoc's work can be found in the Journal of Consumer Research as well as online.