Does Active Investing Work in Theory?

We know active investing almost always doesn't work in practice. The vast majority of professional money managers underperform their respective index over meaningful periods of time. Let that sink in. Compared to what we could easily do on our own through indexing, most of the people we pay very large sums to invest our money give us back less after they do their job and take their fee. For those few that do, we say they earn alpha--return in excess of the market for the same level of risk taken. 

As a side note realize something. Your Uncle Fred with all the great stock picks or your friend who just quit his job to start day trading and who has actually has been making money trading stocks, bonds, options, or whatever HAS NOT been taking the same level of risk as any index. Those two happen to be winners in a likely random pool of many people taking on tremendously more risk than they realize. If 10,000 people all flip coins ten times in a row, some of them almost certainly will get ten heads in a row (singularly by itself a 1 in 1,024 chance). 

However, I am focused on professionals here. Guys and gals who dress sharp, use all the right jargon, are actually highly intelligent and reasonable, and who most of the time lose money for their clients. Perhaps their clients are buying something else than returns [paging Robin Hanson--investing professionally isn't about making money]. Highly likely in many cases. It feels good to deal with these pros. Plus they can in fact help investors stay disciplined--better to make 5% versus the benchmark's 6% over 10 years than to bail out when the market declines and earn only 1% over that same 10 years. Fortunately for EMH and unfortunately for this theory, this affect has been shrinking to recently be nearly nothing.

So, while active management doesn't work in practice, does it work in theory? Start with the assumption of a manager that can consistently and reliably earn 1% alpha. When her benchmark is up 6%, she is up 7% on average. Why does she need your money? 

I can think of two likely reasons:

1. She could want to use it to reduce her own risk. 
2. She could have more opportunity than she can herself realize.

Notice that these are not altruistic motivations. The first is fairly unfavorable for the client--you are giving her money not for your benefit but for hers. She uses the additional funds to smooth out the volatility in her own income. When you pay a management fee to her, you are directly subsidizing her income. And just the use of the funds themselves is an indirect subsidy allowing her to invest more broadly. All of this might be justified if the second reason holds.

In the second she only would invest your money once she has invested all of her own money including all the money she can borrow at less than the total return of the investment, which is the market return plus alpha (6% plus the 1% in this case). Theoretically and in practice she will charge you a small fee to cover transaction cost plus a little profit to her to let you participate in her investing endeavors. Yet as we saw in the first reason she should probably be paying you as you are giving her a benefit of lower risk in the form of a smoother income stream.

Essentially this is an arbitrage which we know is going to have a limited capacity. Even if she is in that elite company of professionals who can outperform the market, her last idea (say the last stock her analysis says to buy) will be her worst idea and only be at best just as good as the market itself. It seems very likely by the time she gets to your money, we are firmly in reason-one (personal risk reduction) territory. 

This is quite damning for professional money management--in theory. What might save it and asset managers like myself who do in fact invest client money with money managers? 

First, we must admit just how challenging it is to find professionals who can outperform the market. Second, we must consider that the first reason above, income-smoothing risk reduction, might actually have a win-win aspect to it. Yes, she does enjoy less risk by using your money, but she doesn't get this for free. In fact she is probably risk averse enough that the second reason doesn't hold firmly.

Rather than fully lever all of her available resources--put her risk at ludicrous speed--she would likely prefer giving you most all of the risk of her performance and collect a steady fee for doing so. She is giving up the potential for return upside so that she has only very little downside risk. This flips the concern from being a pure doesn't-work-in-theory problem to being a pure principal-agent problem. sigh We can't catch a break. Now we have to worry that she isn't incentivized properly to continue to do what we hope she can do--outperform the market at the same level of risk. But at least we partially rescued active management in theory.

As bad as this is (in theory), this is in public market active management. The same forces are at play plaguing private markets like private equity and private debt. At least public markets are not opaque, very hard to benchmark, illiquid, et al.

I Was Desperate. Honestly Afraid. And Completely Helpless.

At first it was gradual, and then all of a sudden it was acute. I could be blamed for putting myself in such a position--at least it was somewhat my fault. But live long enough and you'll inevitably find yourself at the mercy of those around you, willing and desperate to take their help, and completely without options. 

It was late. Very late. And I was on a rain-drenched highway. Tired. Unable to go farther. And very hungry. 

I hadn't called ahead because I hadn't planned to be there. But there I was on a highway in the middle of nowhere Texas. To say I was between large cities was both true and meaningless. The middle of the Pacific Ocean is between large civilizations. 

I am a strong believer in the power of the consumer--that if you shop around and negotiate, you can drive a great bargain. But I was at the mercy of the supplier--a mere price taker that night. 

A warm meal, a dry bed, a safe place. My needs were a short list. Yet not fulfilling each would be critically bad. Drive on and the risks grew exponentially. Try to negotiate a better deal, and my only options might evaporate before my desperate eyes. 

Any slightly observant person could see my position of weakness. Any slightly opportunistic person could sense my vulnerability. So how bad did it get?

Not too bad at all under the circumstances. The motel owner had stayed up late, as it turns out, just for me on the off chance I would be there in need of his accommodations. His accent made clear he and I were not born and raised in the same place. I was a stranger on his doorstep, but he welcomed me as one would a good, long-time acquaintance. I paid him $159 for a room with a hot shower and comfortable bed I would use for the next 8 hours. After, he (or his staff) would have to clean it up restocking and doing laundry. I would leave without saying goodbye. 

Before that shower, I needed food. Two in the morning is not when many meals are served as evidenced by the many closed restaurants. No one ever starves missing one meal, but it can be quite unpleasant to do so. And good decisions are not made on an empty stomach and a poor night's sleep from the same. The 24-hour restaurant made sure that wasn't my fate. I was their only customer in the 45 minutes I spent. At least three people (couldn't tell if there were more in the back) gave me nourishment and quiet companionship all for the price of $23.

The morning sun brought a new day and a fresh outlook. My car was safely waiting untouched for my departure. I grabbed coffee and a Danish set out for me at the motel before dashing out the door. A quick fill up at a gas station meant I could be on my way not needing to stop for hours. 

I felt slightly uneasy leaving so abruptly that morning. Guilty would be too strong a word, but I was dashing off having taken so much from so many who were so generous to have provided it for so little in return. I can't imagine I'll ever be back on that same highway, and even if I am, it is unlikely I'll ever stop in that little spot again. I hope someone else can do a little more someday to take care of the people who took such good care of me.

P.S. This post's story is truish. It is a amalgamation of true prior experiences in my travels for the purposes of making a point. Life is tough--use markets.

Walter Williams, R.I.P.

 

Walter Williams, one of the greatest communicators and expositors of freedom and economics, passed away this week. While I never had the pleasure of being in his classroom, he was quite certainly a teacher to me. My first encounters with his work were reading his articles in The Freeman and his republished op-eds in the Conservative Chronicle as well as attentively listening when he would fill in for Rush Limbaugh. Over time as I became enlightened, with no small part guided by Dr. Williams, it was only his moments filling in for Rush that I would find that show meaningful.

He was a teacher directly to many teachers I have had including ones who entered his classroom avid Marxists and exited passionate free-market capitalists. 

I strongly encourage you to read Don Boudreaux's tribute to him in the WSJ as well as watch the short documentary, Suffer No Fools.

For more tributes, see this list.

May he rest in peace, and may his great work, wonderful spirit, and inspirational message live on.

There Should Be A Law!

Partial list of areas where there might be a market failure and I might support government intervention:

• Masks and social/physical distancing rules in a pandemic - I much prefer persuasion in the marketplace of ideas backed by good and plentiful information. That said, in a very serious health crisis a government-enforced policy might keep the peace and prevent very costly experimentation from defectors like a business not complying. Bringing this to the news of the moment--I generally do not think SARS-CoV-2/COVID-19 qualifies. A failure on the part of government (and others) to even properly try the persuasion avenue does not then necessitate the force avenue. Further, compliance with practices consistent with most all of the nonpharmaceutical interventions has been remarkably high and widespread as well as ahead of the mandated institution of the NPIs. This is a point the advocates of force ignore until they wish to defend against the accusation that the economic and other costs have come as a result of forced NPIs. Then they are quick to point out that "it is the virus, not the lockdown". Careful thinkers realize it is both and the latter makes matters on net much worse.
• Zoning - but not in the way most people think. This one really is more of a government failure that perhaps needs collective agreement. Zoning way too typically becomes NIMBYism protecting vested current interests at the expense of potential and less powerful interests. Basically we may need higher-order (federal) laws preventing localities from encroaching in private property rights.
• Certain, limited cases of patents - Here is my prior thinking on this subject.

There are at least two problems with most cases of the discovery of market failure:

1. That you're overlooking some critical factor that negates the market failure condition. There is something else going on here; there are needs being satisfied along an unexplored dimension.
2. The market failure does exist but will be short-lived and thus insignificant. Short-lived might be in the eye of the beholder, true enough, but this is definitely an area where a longer than average point of view is needed (near-far mode if you will). 

[Updated 12/1/2020 adding to the partial list]

• Garbage collection
• Subsidies for under-produced goods (e.g., vaccines, General healthcare, education)
• General city planning such as road layout and utilities, etc.

It is best to think of these as coordination problems where a central actor can potentially lower transaction costs. The word potential here is doing a lot of work. Just because government theoretically can solve a problem doesn’t mean government in any way, shape, or form will solve that problem in a desirable manner. And note also that just because government might be desired to be a participant in the solution it doesn’t mean they have to provide the solution. Funding it can be a much better role for government to play with private actors actually doing the operational work. School vouchers are perhaps the best example of this, but garbage collection among many others fits as well.

My Futile Desire For People To See The Truth

I strive for epistemic humility, and my practice is to consider the confidence with which I hold various beliefs. As such I truly don't hold strongly many views and am quite willing to change my mind. Once I have done the work, though, I am willing to hold a view strongly. And I love to hate conventional wisdom.

Hence, this partial list of things about which conventional wisdom is wrong and about which I very much want people to understand the actual truth. 

The formula for when conventional wisdom is held in error is a seductive, persuasive narrative coupled with readily accessible, salient anecdotes that are not indicative of the broader evidence because that broader evidence is largely obscured.

The following are all beliefs that I hold quite confidently after years of study, analysis, and thought (listed in no particular order). Note that I am still learning about these, questioning my priors, and remain willing to change my mind. It is just that the probability I assign to being wrong for these is now quite low.

• The general causes of and problems in the Great Recession as well as the housing crisis before, during, and after the Great Recession.
• The labeling asset prices as being "bubbles" (e.g., tulip mania, dotcom tech, housing markets--see above, et al.) is neither useful nor helpful. The term is loose, vague, and indeterminate. A classic case of seeming to say something, but being so obscure as to be unfalsifiable. It is the modern financial economics equivalent of blaming disease on the imbalance of humors.
• The current and historical lack of parity in college football and other sports—my first great example of things not being what is so commonly believed in the conventional wisdom. Big firms like regulation and so do big sports programs. The NCAA benefits the blue bloods at the expense of the lesser schools.
• The cause and nature of the Great Depression and the subsequent recovery (it wasn’t WWII).
• The cause and nature of long-term economic progress as told by McCloskey, et al.; the true nature of economic inequality (consumption versus income); how good things actually are and how much they have actually improved.
• The shallow and near emptiness of news journalism and that watching and reading the main-stream media is a form of entertainment done at the expense of one’s intellect.
• The immorality of conducting and impossibility of 'winning' the drug war. One can extend this to all prohibitions on victimless crimes, activities and trades done by consenting adults that are labeled crimes not because of a violation of anyone's property or personal rights but because society has deemed it taboo, immoral, or otherwise contemptible (e.g., organ sales, prostitution, price gouging, etc.). 
• The harm and unintended consequences of price controls in all there guises: minimum wages, rent controls, anti-price gouging laws, restrictions on compensating college athletes, et al.
• The injustices that exist and persist in the world, how good it could be in terms of justice and wealth for all of us, and the multiplicative benefits of free markets and free minds.
• The economics especially and general state of the science concerning environmental policy.
• The policy responses to the COVID pandemic.

I should probably take a cue from Bryan Caplan and call “Impasse” more often. It would give my head a chance to recover from its battle with the wall. 

Tax Policy as Explained by DuckTales

 

It should be no surprise that in this presidential election we yet again hear nothing but nonsense regarding tax policy from those seeking office. Among the many principles being ignored are:

• You cannot tax wealth more than once--if you can even tax it the one time given tax avoidance and evasion opportunities and incentives.
• You cannot lower taxes and increase government spending--government spending is taxation (today through taxes or tomorrow through debt).
• You cannot tax without discouraging that which you tax--there is no tax free lunch.
• You cannot tax income--it may look like you are taxing income, but you are actually taxing consumption. On this point we have DuckTales and the hero Scrooge McDuck as the perfect illustration.

If you try to tax Scrooge McDuck, you will be unsuccessful. He is tax proof. You are ultimately taxing Huey, Dewey, and Louie, and they are not being taxed correctly in this scheme. You are taxing the wealth creator dissuading him from creating more wealth and at the same time not discouraging the wealth/resource destroyers.

Uncle Scrooge McDuck is the "wealthiest duck in the world". Hence, he is an obvious foil for those who despair at the thought of billionaires. But Scrooge McDuck should be considered a saint to those who truly wish the best for all the other ducks of the world. For he is the ultimate giver. 

He creates vast wealth through his many businesses, but he uses very little of it. In fact his number one entertainment is simply swimming through his money and treasure which he keeps in a giant money bin. So in exchange for creating wealth he takes basically only money (claims on resources) rather than resources himself. Outside of funding his adventures for more wealth, he lives a quite miserly life. Say what you will about that choice, it is consequentially a very good one for the rest of the ducks in his world. 

Who really pays taxes? 

Taxes are a method of the financing of government uses of resources. In order for a tax to be paid, it must be the case that someone, somewhere, sometime not use a resource so that government can use that resource. Therefore, the payer of a tax is ultimately the entity that must forego the use of a resource. It is decidedly not the creator of the resource, per se. 

Who should we want to pay taxes? What should we tax and why should we tax it? 

I always argue we should tax resource use rather than resource creation and do so as efficiently as possible. We should tax if the use of the taxed resource is better and necessarily done through government rather than private entities. If that seems like a high hurdle, it's because it is.

Attempts to tax Scrooge McDuck are bad faith and poor logic.

Oh, you left out a bunch of stuff.

The quick versus the dead. And a more complete review.

Imagine various conversations at a board of directors meeting of a major corporation. For example: Trying to save money by paying women less, trying to please customers by not hiring blacks, contemplating intellectual-property theft, discussing a new found way they can literally defraud customers, etc. These would all obviously be wrong and would not be within the scope of fiduciary duty or any reasonable ethical framework. I put cronyism in the same category. Contemplating how to get special favor and rent seeking from the government is unethical.

I've been thinking about this post for some time. It started five years ago reading this article.

Recently there have been several things that have me thinking on this again--making this as fine a time as ever to actually complete this post. 

Michael Munger has been thinking about this for some time. This EconTalk is a great discussion with him laying out the problem. And this more recent appearance on Free Thoughts is great as well. Still another discussion highlighting the nuances and difficulty of this topic is with Rebecca Henderson recently on EconTalk. 

The question that I think doesn't get asked enough is: At what point does activity like developing and utilizing business relationships, networking, and advocacy cross over to be cronyism? It is difficult to disentangle behavior and results between these two worlds. In fact people participating in the activity during or after the fact would find it quite challenging even if they could put their natural bias to the side--the bias to believe they were acting in good faith and to good ends using good information and sound logic. 

Use of other people's money is a big key, but it isn't necessarily a smoking gun. For example, Facebook uses cash (shareholder funds) to hire lobbyists to advocate for A) onerous regulations for social media companies or B) a continuation of the protections it enjoys under Section 230 of the CDA. The first case (A) is likely a blatant attempt to use the power of government to prevent startup competitors from challenging their market position. The second case (B) is likely a reasonably good protection of their shareholder's and other stakeholder's interests as well as actually a good protection of free speech and enabling force for social media in general. 

Other people's money can come not just from taxpayers and owners (shareholders in public companies most commonly but not exclusively) but from employees as well. Imagine employees of Facebook being asked to participate in a letter writing campaign to Congress. 

It is not so simple to assume that a company can or should endeavor to right the wrongs of society. Not everyone sees the problem the same way. And not everyone will agree on the means even when they agree on the side to take in the cause. I higher a business to do what they do best--make shoes, install tires, store my money, serve me food, etc. I will do my own charitable giving, thank you very much. This is one of many reasons why Friedman was right. 

How do we get out of this downward spiral? I don't believe it is easy. In fact it is quite challenging. Education and communication are likely keys. Transparency helps as well. But as long as government is both powerful and trusted, these problems will persist. 

Related: 

Just how captured is our economy?

Rent seeking: who is to blame?

What To Root For

In late summer every football fan begins to dream about the season to come with aspirational hopes for one's team and general excitement for what autumn will bring. That is every normal late summer. 

But this is 2020. So, here we go. 

I am torn as to what I should want to see happen. On the one hand I do not think cancellation of the season is the prudent choice from a health perspective. I would rather see options kept alive as the developing situation continues to play out. And this is strengthened by two underlying convictions as controversial as they may be: the health risk is generally minimal and people should have the liberty to choose for themselves what risk they wish to face. 

Note that there is a wide gulf between being completely back to a regular football season and no football season whatsoever. Minimal fans with abundant spacing and many other procedures can be a prudent compromise. No fans initially with potentially many or full fan attendance later in the season is also a possibility (keep your options alive). 

The pandemic is not completely understood, but we know A LOT more about it today than 6 months ago. And we are a lot further along all the curves including toward herd immunity. In just about every action we take we are potential externalities for our fellow man. And do remember that those run in both flavors (positive and negative externalities) and to many varying degrees. Magnitude matters. 

Are we so certain that this disease is too misunderstood, too deadly or otherwise too harmful, too contagious, and simply too terrible for people to make their own choices about exposure? For many people the answer to that question is yes, which raises interesting questions about many other activities and diseases. I do not believe the evidence supports this point of view. If we cannot have football in any manner, then how different should the rest of our lives be? Trust me, I know how some are willing and eager to answer that question. 

My threshold for the use of force is much higher than that. Like Bryan Caplan, "I accept a strong presumption in favor of human liberty. You cannot rightfully shut businesses and order people to 'stay at home' out of an 'abundance of caution'. Instead, the burden is on the advocates of these policies to demonstrate that their benefits drastically exceed their costs..."

Who am I to say an elderly man living with terminal cancer should not come to a football game? I am referring to a specific, very devoted fan and personal friend. I believe he should have the freedom to make that choice. I am a strong believer in freedom, fair dealing, and justice. 

Deciding for others is an invitation for injustice. Unfair bargaining is a method of unfairly restricting the freedom of others. All of which brings me to the other hand . . . The players.

The general data for the typical college age-person shows very low health risk associated with COVID. While particular individual players very certainly have underlying conditions or other circumstances like close contact with at-risk people, most do not. For those that do, accommodation and excuse from the risk is very much the right thing to do. 

It is not the player's health risk per se that I believe gives rise to an "other hand" concern, but rather it is the general injustice of players not being compensated with the added burden of a health concern bringing this disparity into sharp relief. 

Most people when confronted with this idea ask the wrong question--"Why should we pay players?" The correct question is the opposite--"Why should we NOT pay players?" The default presumption in a free society is that people should be paid for their labor. If you want the services of another person, you should expect to do so by reaching a mutually agreeable arrangement.

"But the players have agreed to play, and they are paid. Haven't you of scholarships?" is the typical response. That response is as wrong as it is common. That "agreement" is made repeatedly in a very one-sided deal between the individual player on one side and a very powerful buyer of services on the other--college universities. These colleges act in concert under the rubric of a pure cartel organization--the NCAA. This is not a pejorative, emotional charge nor is it name calling. It is a very well established factual depiction. And the power and extent of the NCAA is supported explicitly and implicitly by government action at every level. This shouldn't be a surprise as cartels do not withstand the inevitable forces of competition and free markets without state support.

As a cartel the NCAA and its member institutions conduct themselves as a single buyer of college athlete services--the technical term for this is monopsony. This affords them considerable economic power and leverage, which they use to enforce an arrangement that is very good for themselves at the expense of the athletes. The reason why college football and basketball programs are limited to what they can provide athletes is because doing otherwise would unleash that terrible scourge upon the Earth unto the halls of college sport purity--the free market with its evil property rights and competition. More specifically, the athletic departments and universities and all those who individually benefit financially from the current arrangement would have to share. 

The most succinct way to explain why athletes are not currently paid what they are worth is to simply ask why would NCAA regulations on what athletes can earn be necessary if they were currently earning their market wage. The more detailed way is to do the economic analysis as sports economist Dr. David Berri among others have done repeatedly. 

About those scholarships . . . There are two very strong arguments against the common refrain that they’re getting a college education. The first is that that college education is something they could attain anyway and do so with little to no expense. Most of these players would be eligible for need or merit-based scholarships as well as grants that would cover the cost of college. The second is that that college education is in fact not worth very much to many of them. For many people college is not the right decision. We push way too many people through the college system inside and outside of sports. For many a different route through trade school or other education or flat out immediate pursuit of a job would be a better option.

There are many other bad arguments made in defense of the system that we know. These include:

What will happen to the schools who can't afford to pay? and This will just mean that football ends at many places and only the biggest programs will survive. While a radical change may and probably will result in a lot of disruption, the market is more dynamic than its opponents' imaginations. Plenty of room exists for true amateur and other types of football aside from a professional college league. And it is very wrong to assume that Alabama, Ohio State, Oklahoma, and other blue bloods in football as well as Kentucky, Duke, Kansas, and other blue bloods in basketball would benefit from a world where direct, open payments were able to be made to players. These programs benefit the most from a limit on the very important competition dimension of wage compensation. Alabama does not hurt for the top talent in football. Paying players would be a pure expense for them with little to no incremental benefit. Oh, and are you soooooo sure players aren't already being paid in many cases. Black markets of illicit payments to athletes are alive and thriving in this world of prohibition. And they do so with all of the horrible consequences associated with black markets.

How will they be paid? Will it be a free-for-all? Will players make different amounts? I don't know and I don't have to solve this problem to be correct about much higher compensation being the rightful world to strive for. I don't know how much the local grocery employee should make. I don't know how much the CEO of Exxon should make. Hell, I am not quite so certain about how much I should make. The market is a marvelous process that reveals this knowledge to us and constantly refines it. Let the market work.

No one wants to see college kids make that type of money. While this is not true as professional sports, entertainment in general, and many other areas of life attest--IT DOESN'T MATTER. An unfair deal is not made fair because a beneficiary (direct or indirect) prefers it. 

They aren't worth that much. Supposing you have ignored the vast research in this area including that referenced above, let me give you a simple example using a different sport as this will also defeat some of the false arguments that relate to worries about other sports and athletes. At my favorite university, The University of Oklahoma, Patty Gasso is an extremely good coach of the extremely good OU softball team. Coach Gasso makes about $1.2 million per year for her services. Of her many talents, two of them relate directly to athletes--recruitment and player development. So I ask, how good do you think Gasso's OU softball team would be if she were required to randomly pull her players from the pool of all female OU students and how well would the team do if the women selected to play were redrawn at random before each game? More to the point, how much would Coach Gasso be paid in this hypothetical? To the degree players add value above random replacement we get some idea about the added value talented players bring and are worth.

Title IX completely disallows this in fact or in economic result. This is Myth #6 in economist Andy Schwarz's 13 Excuses, Not Reasons: 13 Myths About (Not) Paying College Athletes

There are other bad arguments. Many play upon our biases and jealousies. These too must be called out for what they are. Two wrongs don't make a right. Frustration that there are great rewards for great, rare talents is common but unjustifiable. There is no reason or virtue in adhering to the rules of the past when those rules are revealed to be wrong for today.

Simply put, any argument justifying the current arrangement must address the central question--why should we NOT pay college athletes.

If ever there were a season to make a change, this is it. Beyond the pandemic and all the economic and health disruptions, we of course are in the midst of an opportunity to take a major leap forward in the name of justice. Perhaps 2020 will eventually come to be remembered as the year when significant racial progress started. When old institutions were challenged and remade. When we realized it doesn't just have to be this way because it has always been this way. 

This is another example of my theory that the pandemic has accelerated already present trends. In this case we may be witnessing some version of the universities of the Power 5 conferences separating themselves from the NCAA and beginning of the dissolution of the NCAA cartel. Let us hope a new cartel does not rise in its place. My optimism for change is tempered and I know that any new result will be with its flaws. Don't let the perfect be the enemy of the good. Don't forsake progress for the fear or even the certainty that change will be flawed.

Perhaps a lost season is not required. Compromise with true pre-commitment to reform could be a way out. Let the universities call the players bluff, but also let the universities come back to the table with solutions. Make them put up contractual commitments, earnest money, and public promise of specific and explicit change. The road map at this point of the journey is quite blurry and very undecided. The most we can expect is to have a destination, boundaries for the eventual route to be found, and a burning of the bridge of retreat once the journey begins.

That is what I am rooting for.

I stand with the players. 

From Hong Kong With Love

We stand at the precipice of a great opportunity. The government of China is doing what governments do by going state on Hong Kong. The leaders there correctly perceive HK as a threat to their power and way of life. While I continue to predict that in the long run HK will eat China rather than the other way around, there are alternatives.

Many are suggesting a policy tool to challenge Beijing is to open borders to HK emigration. This is a classic tails we don't lose, heads we win situation. To wit: If China balks, HK keeps its autonomy and the progress of freedom marches on; if China digs in, we get a giant gift. I'm sure you can see the first case, but I expect the second case is a bit harder to swallow. Allow me to explain the benefits of Open Borders with this extreme example.

A few years ago I had the pleasure of visiting HK. Although I was fairly familiar with it, I was still completely amazed. I look forward to one day returning. At the time I planned on doing a post about the HK economy in comparison to my native Oklahoma economy. Unfortunately, I didn't get around to it, but I think I can quickly summarize one of the economic points I wanted to make: 

Hong Kong is 138% more productive than Oklahoma and most of that difference is because of population. The average Hongkonger is only 25% more productive than the average Oklahoman. And that is despite/because HK has much less land area on which to work. Key takaway: More people equals more opportunity.

(sources below)	Population	Area	2019 GDP (PPP)	2019 GPD per capita (PPP)
Oklahoma	3.95 million	69k sq miles	$206 billion	$52,150
Hong Kong	7.45 million	1k sq miles	$491 billion	$64,928
% difference	89%	-99%	138%	25%

My extreme example to illustrate the benefits of Open Borders begins with a bold proposition: I propose we open the borders of Oklahoma to ALL residents of Hong Kong to become permanent guests with the opportunity to become citizens if they so wish. 

I can already hear the dismissive laughter followed by the panicked apoplexy. "Dear God, you can't be serious!"

Of course I am! This is easy. Do you think there is something magical about the small island of Hong Kong? Well, there might be, but it is nothing a little policy changing can't fix. And fortunately Oklahoma is not too far off from the HK freedom trail. 

"But wouldn't that influx crash the local economy? Think of all those mouths to feed."

Yes, and think of all those hands to work and minds to think! 

The one big stumbling block to a massive migration like this would be finding a place to house all the people. Well, Oklahoma has 69 times as much space as HK and construction here is cheap. 

Not convinced? The heart of my extreme example is how this would affect my personal employment. When I was in HK, it was for a couple of CFA Institute conferences. While there I was treated to a personal tour of part of the city by the president of the Hong Kong CFA society. We had a chance to chat about our relative societies--I was president of CFA Society Oklahoma at the time. His society was one of the world's largest with about 6,700 members. Mine was one of the smallest with only about 170. 

So what would happen if 6,700 CFA charterholders began migrating to Oklahoma? Would there be pressure on my job? Probably not immediately as people aren't as interchangeable as classical economics assumes. Over time there would be competitive pressures, but so too would there be competitive gains. With that massive increase in talent would come much in the way of business opportunities. I would have new job offers as well as a bunch of new job competitors. Would the net effect be to lower my wages? Maybe, but even here there less to worry about. 

The median total compensation* for a charterholder in HK is about 4% higher than for a charterholder in Oklahoma. While the cost of living in HK is perhaps 67% higher than in Oklahoma, most of that is housing, which remember is much easier to come by in OK. And for those like me who own a home, this influx should greatly increase my personal wealth. 

Think about it this way: Should current charterholders in HK want more or fewer charterholders in HK? The instinctual answer is as simple as it is wrong--fewer sounds good until you answer the question of how would there be fewer. A shrinking market for any type of employment is not good for those in that line of employment. As a native charterholder I stand to gain much if other charterholders want to migrate to my community. The likely worst-case scenario isn't that I lose my job and/or take a massive pay cut. It is that my job changes and new opportunities force me to make some changes. Change is scary, but change is inevitable. I would much rather have the trends of change as tailwinds than crosswinds much less headwinds. Growth is good.

Open borders in Oklahoma for Hong Kong citizens is unfortunately not going to happen. And even if it did, 8 million people would not show up tomorrow. In fact, most would choose not to make the journey at all. But for those that did it would be a great benefit for those already in the place of their reception. 

Sources for data in table: 

https://en.wikipedia.org/wiki/Oklahoma

https://fred.stlouisfed.org/series/OKNGSP

https://en.wikipedia.org/wiki/Hong_Kong

https://en.wikipedia.org/wiki/Economy_of_Hong_Kong

https://www.imf.org/external/pubs/ft/weo/2019/02/weodata/weorept.aspx?pr.x=43&pr.y=16&sy=2016&ey=2021&scsm=1&ssd=1&sort=country&ds=.&br=1&c=532&s=NGDP_RPCH%2CNGDPD%2CPPPGDP%2CNGDPDPC%2CPPPPC%2CPCPIPCH&grp=0&a=

*CFA charterholder compensation data is from CFA Institute's 2019 Compensation Survey, which is proprietary to members--unfortunately, I can't directly share it.

Well, We're Movin' On Up

What’s great about this country is that America started the tradition where the richest consumers buy essentially the same things as the poorest. You can be watching TV and see Coca Cola, and you know that the President drinks Coca Cola, Liz Taylor drinks Coca Cola, and just think, you can drink Coca Cola, too. A coke is a coke and no amount of money can get you a better coke than the one the bum on the corner is drinking. All the cokes are the same and all the cokes are good. Liz Taylor knows it, the President knows it, the bum knows it, and you know it.  –Andy Warhol

Queen Elizabeth owned silk stockings. The capitalist achievement does not typically consist in providing more silk stockings for queens but in bringing them within the reach of factory girls in return for steadily decreasing amounts of effort. [...] [T]he capitalist process, not by coincidence but by virtue of its mechanism, progressively raises the standard of life of the masses.  –Joseph Schumpeter*

Partial list of goods and services that the Forbes 400 cannot have a better version of today than can the middle class in the U.S.—measured by quality, effectiveness, or status:

• Mobile phones
• Umbrellas
• Personal computers
• Toilet paper (notice how it required a pandemic and government intervention to make this temporarily drop off the list)
• Cloud storage
• Fast food and fast casual
• Casual clothing
• Payment processing
• Individual consumer-level tools (but not tool collections)
• Basic plumbing
• Video and music entertainment content
• Online shopping (especially important in quarantines)
• Corrective eye surgery such as LASIK
• Small package shipping speed
• Email
• All but the most exotic of beverages from bottled water to soft drinks to tea to coffee to beer to wine to liquor
• ... I could go on and on, but Qwern already has done so for me...

This shouldn't be surprising given that I am, as most of us so fortunately are, richer than Rockefeller. 

Related question: As a proportion of all goods and services available, are there more or fewer things like this today than there were 50, 100, 500, 1000, etc. years ago? I would submit that there are considerably more even with all the abundance and variety that we enjoy today. In the past the inequality separation between the super rich and the middle class (or closest approximation) was vastly larger. Add to that the fact that movement between classes was virtually impossible. It is telling that only in a modern fairy tale are lyrics like this conceivable. Today we enjoy the hockey stick of human progress.

Understanding what is going on here takes more nuance than the typical person allows. Russ Roberts has a good, short video series that explores this nuance. 

*The paper at this link, Manifesto for a Humane True Libertarianism by Deirdre McCloskey, is well worth reading. It is where I most recently read the Schumpeter quote.

What I Got Wrong

And what I got right... an analysis of my Trump predictions. 

I made a list of predictions at the very beginning of the Trump presidency. One year later I did an early analysis of them. Now that we are nearing the end of the first (only?) term, I thought I'd look back to see how my predictions fared. 

I was optimistic in three areas: taxes, regulation, and presidential power & authority. 

On taxes I was doubly right on the surface--the Congress was the key and they have gotten better. Specifically, we got the corporate tax reductions/improvements that Obama wanted but couldn't negotiate along with improvements for deductions (standard deduction increased making future itemized deduction eliminations more likely and SALT was limited making state and local taxes more burdensome thus more resented). Now, one could very correctly counter that the HUGE increases in fiscal spending fully supported by Trump during and especially before the pandemic are simply future tax burdens. This mitigates strongly against my prediction. 

On regulation I was mostly right if not a bit underestimating of the chances of progress. 

On presidential power & authority I was mostly wrong so far, but that prediction is a long-game idea that remains to be seen. Perhaps we have indeed grown and are continuing to grow more skeptical and reluctant on this front. Still, I see a conservative base that believes ever more in the legitimacy of strong central power and the left is still AWOL on the issue. I get the strong impression that the left still clings to the nonsensical unicorn theory of "if we just get the right person in charge, all will be well . . ."

The recent pandemic and subsequent police abuse protests stand as testament as the left criticized Trump for not being enough of a strongman and then the right rallied around the police state. And consider the reverse of the optimistic take. What if in 50 or so years people look back at things Trump said and somewhat of how he acted and take it way too seriously--like serious at all? For instance when he says I have absolute power, what if people in the future look back to that as a serious proclamation that a president claimed and wasn’t completely challenged on? 

On the initially overlooked judicial and U.S. attorney appointments I was right one-year in to be optimistic overall. Many have been very good to great like the high-profile case of Gorsuch. 

I was pessimistic in ten areas: trade, immigration, nationalism, war, drug policy, government meddling, free speech, internet freedom, surveillance state, and gender issues/tolerance. 

On trade (it took a while) and immigration I was very pessimistic and right on the mark. Being right about these and others is so very depressing.

On nationalism, gender issues/tolerance, and add to that the missing elements of social division and discord (especially the racial element) I was unfortunately wrongly not pessimistic enough--to be clear I would ideally have been wrong for being too pessimistic. He is a mass polluter in this realm. I fear this has knock-on effects for future "outsider" presidential candidates in that we will overvalue pleasantry over policy by mislabeling those who question the establishment as yet another divisive person.

On war, drug policy, and government meddling my initial (one-year in) analysis was that I had been not pessimistic enough. I think the following years have proved me more correct originally as the wrong positions of the Trump administration softened. 

On free speech, internet freedom, and surveillance state we have the reverse case where matters over gotten worse as of late. My predictions are moving from appropriately pessimistic to another unfortunate case of not pessimistic enough. We'll see...

I'll leave it to the reader to assess how my initial overall prediction has held up:

The Trump years (and they will be years despite the hope of so many for impeachment or that he would divorce America to be president of some younger Eastern European country) might be an odd combination of dramatic progress and colossal retreat. I think the eventual decisive factor will be how strong and righteous Congress is. I believe the case for optimism has a greater magnitude than the case for pessimism, but the negative sensitivity is high--meaning prospects are skewed with more downside risk than upside potential while the balance is still to the upside. 

For my grade on the last part (the balance or risk being to the upside), stay tuned for a provocative post comparing our presidential candidates. 

The Competitive-Efficiency Paradox

A more competition-friendly society will be more efficient (extract more wealth from a given level of resource consumption) which will make it wealthier which will allow it to have more inefficient production. For example, my ability to more cheaply purchase furniture from the finest woodworking craftsmen in the world allows me to myself dabble in woodworking at an uncompetitive, amateur level.

There are two sources of this effect:

1. My own wealth growing--call this the personal-income effect.
2. Society's wealth growing--call this the production effect.

I am generally concerned here with the second of these; although, the first is a derivative of the second thus it is in play as well. There are countless examples throughout culture and industry.

Think about this in capital markets. In the past few decades retail-investor trading costs in stocks have plummeted to now be explicitly zero. (Note: if your broker is still charging you a commission for trades, you might need to explore your options.) This massive reduction in cost has allowed a lot more trading to happen--both more traders especially amateurs and more frequent trading. Did this result in increased price-discovery efficiency? Probably some up until a point. But the next new person trading AAPL (Apple Corporation's stock) probably is not bringing new insight into the market. More likely that person is lowering average accuracy ever so slightly. Otherwise, why weren't they trading before this point There is probably enough liquidity in Apple stock so that is not a benefit of an additional trader's trades either.

Here we are suggesting another aspect of this paradox: without easy market entry/exit, we cannot maintain competitive markets. Yet, the next entrant into a highly competitive market is probably likely to be uncompetitive. Ban additional trading or traders for Apple stock and you will unravel quickly the efficiency we have come to enjoy in this highly-competitive market.

Back to the original paradox, is there more efficiency or less? To resolve the problem we should consider it as a continual process as opposed to being linear and finite. We should also expand our understanding of what ends we are achieving. The socialist's fallacy would be to look at two firms both producing cereal and declare this inefficient. "Obviously we could eliminate the duplication as well as the advertising costs by combining the firms," they would proclaim. But this would break the very process that allows for the desired efficiency (higher and higher production at lower and lower cost).

Imagine how disastrous a true socialists should view a marketplace like Etsy. Here the line between hobbyist and profitable craftsman is magnificently blurred. Magnificent because it is the essence of a culturally and materially rich society where experimentation is both allowed and enabled. A society that embraces competition necessarily invites dynamism. This is a foundational principle and an essential characteristic of growth. It is Schumpeter's creative destruction. It is a gift not a curse.

The Parallel Problems of TBTF and Poverty

The dilemma faced by central banks specifically and governments generally when considering corporate bailouts and other “market-saving” activities is very similar to the dilemma faced by those designing poverty-relief programs.

Essentially one wants to go with Bagehot’s Dictum: lend liberally on good collateral charging high interest but don’t bail out insolvency. I argue that this has some application to individuals as well as firms. And it applies not just to a central bank or government but really to anyone in a position to help another.

The general view seems to be that those suffering in relative or absolute poverty fall into one of two conditions: (1) Temporarily on hard times (solvent but for liquidity problems) and (2) Permanently unable to provide for oneself (insolvent due to fundamental problems). This was something in my notes from long ago, but it comes into high relief in the current pandemic crisis.

While I have tremendous and from my perspective very atypical faith in individuals' abilities to make the best choices for themselves and to have the corresponding responsibility for such, I do agree that for some people help is needed. For most people who end up in times of need, it is temporary (case 1). For some (few) it is permanent or for very long stretches and to a very large extent (versions of case 2). The dilemma is probably obvious: Is the person(s) in need going to be ultimately and truly helped by my charity or is it simply going to bailout and enable their poor choices? This is not an easy problem to solve. It is typically filled with emotional noise. There are always extenuating circumstances. Hypothetical narratives are easily constructed to fortify confirmation bias. In short it is fraught. And that is when we start with the presumption that there are real-world examples of case 2.

Under what circumstances would we put businesses into case 2? Presumably never except in the case of a truly public good--a rare thing indeed. Yet government's actions and the moral hazard that results implicitly create an environment where case 2 is common and pervasive. We are inappropriately continuing it with airlines, et al.

So this is why I title this as "parallel problems"--because we are making it as such. We are allowing a powerful group with concentrated benefit to dictate the narrative. We should call their bluff. If they are in case 1, then make the argument for being lent to at appropriate interest putting up appropriate collateral. Find a private source of funding even if that private source needs public backing in these extreme times. If they fail, then they were in fact case 2. That doesn't mean they get bailed out. It means they get extinguished to make room for another entity better suited for role they have failed at.

Harsh? Yes indeed. The market is harsh--by design. It is a feature of creative destruction. There is an old saying that in bear markets, stocks return to their rightful owners. The same can more generally be said of capital and economic downturns.

Who You Gonna Call? An Economist

If you had questions about the conditions of the local restaurant market, you wouldn't ask a chef or a restaurant manager.
If you had questions about the OPEC oil cartel or how it's actions affect the U.S. fracking industry, you wouldn't ask a petroleum engineer.
If you had questions about the affect charter schools have on education outcomes, you wouldn't ask a teacher.
If you had questions about the pricing and payment of medical services, you wouldn't ask a doctor.
If you had questions about fractional reserve banking, you wouldn't ask a banker.

Well, you might ask these people, and they might have brilliant, insightful answers. But if they did, it would be because they were using the tools and skills of economics. You might be better off just asking an economist--especially one with expertise in the specific area of interest.

Drs. Fauci and Birx are very important experts in immunology. Their understanding of infectious disease and their roles in the current crisis are keys to us conquering SARS-COV-2. But asking them when we should open society back up and revive the economy from the self-induced coma is likely asking them to speak outside their depth. I am not saying they are incapable of performing the necessary trade-off analysis, but if they are, it is because they will be employing economics not epidemiology.

Just as we did not prepare properly for a pandemic, just as we did not heed the warning signs as this one approached, just as we did not do the relevant cost-benefit analysis as decisions were hastily made and virally accelerated, I fear we are not willing to reasonably and scientifically consider, plan, and execute the return to normal life.

Reversing the lockdowns and shelter-in-place commandments should require us to consider the following at a deep level:

Benefit of reduced infection going forward minus Cost of change in way of life

What would we like to know includes:

1. R0 - the rate of infection now and going forward (both the average and the distribution of typical people and super-spreaders); Robin Hanson's analysis shows the need for an even deeper level of thought. 
2. How did R0 changed over time both as a result of human action and public policy as well as naturally?
3. How many people were infected and when?
4. How did the various policies impact viral transmission, viral impact (did putting asymptomatic infected people, mostly kids, in intense contact with at-risk people, mostly elderly, cause dangerously strong infections--dose makes the poison?), other health results, etc.?
5. How did the various policies impact our way of life? Just how damaging were the policies and how damaging was the virus?
6. What would we do different? How many lives on net did the actions taken save? How much was overall well being benefited by the actions taken? 
7. How would we do it differently in the future?

At this point we don't really know enough to depict the overall tradeoffs and how the equation above would plot in the graph below.

The x-axis runs from maximum virus eradication (all resources thrown at fighting the virus, which is well beyond even the extreme measures we have taken so far) to not changing our lives one bit other than perhaps dealing with infections as they arise including hospitalizations and death. The y-axis is overall societal well being. In the middle is the point of well being that is equal to a world where there was no SARS-COV-2.

Is the trade-off function like one of the solid-line parabolas? Don't get too hung up on the lines I've drawn other than to notice that one is at times above the other. And of course choices we make could allow us to jump from one trade-off frontier to another. But notice the other two stylized functions. Perhaps the virus is so dominant that any effort short of total effort to counter it was a net loser for societal well being (as depicted in the red-dashed line). This is possible but highly unlikely. Yet this in the extreme is the position implied by many in the populace as well as some in power. Alternatively, the virus could be an unfortunate circumstance but not one that at any level deserves us changing our way of life (as depicted in the green-dashed line). This is also possible but highly unlikely. Yet this in the extreme is the position implied by those who might be labeled virus deniers.

We would expect, however, that some type of parabolic function if not one with multiple peaks would properly depict the real world tradeoffs. The devil is in the details, and which function and how we might transform the function to improve our lot is the many-trillion-dollar question. I would like to see it asked more strongly and widely, and I would especially like to see it asked of economists. 

A Price Paradox

This is a continuation of my previous post "Markets Don't Hate Uncertainty".

Don’t think about the stock market like you do for a specific good like, say, bananas. If a large group of the banana-consuming public suddenly decides they don’t like bananas very much anymore, the demand curve for banana shifts massively to the left meaning market prices will fall greatly and future quantities produced/consumed will too--remember the immediate supply curve is nearly vertical and the long run supply curve is much closer to horizontal.

However, that is not the case for stocks. The value of stocks is determined by the net present value of future cash flows. In simple terms: Buying a stock means being a part owner of a company. As an owner you are entitled to a share of future profits (eventually paid out as dividends--a reasonable, simplifying assumption). Those profits come in the future, so we have to value them today at a discount since a dollar today is worth more than a dollar tomorrow--the so called time value of money (TVM). Adding up all future cash flows individually discounted for how far out into the future they are gives us a figure for net present value (NPV). This is the "value" of the stock, which should equal its price. Let's assume for now there is no uncertainty about expected future profits.

An essential premise in the banana hypothetical is that the value of bananas has plummeted. Remember value is always a subjective concept. Suppose a large demographic group like the Baby Boomers in aggregate start reducing their desire to hold equity investments (stocks), it is not because they don’t believe in the value of stocks in general. Rather it is likely due to the fact they don’t want to have an asset exposure so much tied to the volatility associated with stocks. So they want to reduce their investment holdings in stocks. So in one sense there is no reason to believe that their selling activity should materially change the price of stocks because the investment value of stocks (NPV of future cash flows) is unchanged in the market overall.

But they are trying to sell, and their selling has to be met by buyers. In order to find a willing buyer they should have to offer a more attractive (lower) price than the current price. Hence, we have a paradox--prices shouldn't change but they have to change. The solution lies in a reframing of what investors are trying to achieve. They don't want stocks for the sake of stocks--this would be the banana model. They don't want the future cash flows per se--those are only attractive relative to the price paid for them given the risk associated with realizing them. They want the expected return--the future cash flows purchased at an appropriate price today adjusted for the risk.

So in order for Baby Boomers to sell their stocks they have to increase the expected return of stocks from the perspective of the buyer. Since they can't affect the future cash flows, they have to do one of two things: Either lower their prices to attract buyers or find buyers with different discount rates (buyers who don't value a dollar today as much as a dollar tomorrow). Realize, we are still assuming no disagreement about the expected future cash flows. That wrinkle is not needed to explain this hypothetical or the paradox. Everyone can agree on the expected future cash flows and still people want to exchange their positions (i.e., Baby Boomers want to sell and reduce market risk and buyers want to take on that risk).

Here is the graphical way to think about those two options available to the stock-selling Baby Boomers:

The colored lines B and C represent the change in price over time. The slope of these lines is the expected return. In the first case (top chart) prices today decline along path A and the lower price after Baby Boomers try to sell stocks implies a higher expected return for all stock investors. The market's expected return has increased from the slope of line B to the slope of line C.

In the second case (bottom chart) the difference in how each investor discounts the future price implies a different rate of return. Baby Boomers selling stocks have an expected return of B and buyers of their stock have an expected return of C. (Note: This is related to but not dependent upon Baby Boomers having a shorter life expectancy than buyers. The buyer can be the exact same demographically as long as they have a different discount rate. When compared to the stock-selling Baby Boomers, the buyers value a dollar tomorrow as being closer to the value of a dollar today. Boomers can be selling to other Boomers with lower discount rates.)

You should be feeling uneasy about this for two reasons:

1. Why don't prices today equal that far-off future price? Didn't we assume there is no disagreement about the amount of future cash flows?
2. In the second chart why wouldn't this have already come to fruition? Did stock-selling Baby Boomers suddenly just now increase their discount rates?

The answer to the first objection is this. Even if we assume there is no disagreement about expected future cash flows, there is a degree of uncertainty for them; hence the word "expected". The compensation a buyer/holder of stock receives for risk of investing is the expected return--technically speaking, the equity risk premium. 

Assume a stock will pay a dividend next year equal to all of its assets and profits and then cease to exist. All market participants agree that the dividend next year will be either $0 or $2 per share and that the probability of each outcome is 50%. In that case the expected future cash flow is $1 next year. This means the stock today is worth $1 before any TVM discounting. Once the year has passed and the dividend realized, investors will either have $0 or $2 to show for the $1 they put at risk by buying the stock. Therefore, the future price has to be something greater than the current price or no one would be interested in risking the investment.

The answer to the second objection is a little less elegant. Well, basically we have to be assuming Baby Boomers wanting to sell stock have increased their discount rate (i.e., become more risk averse). Otherwise, we can't have the hypothetical. But this leaves another problem: Why isn't there just one expected return in the market? Well, there is, but in the second chart we are breaking up the market into two segments. The blend of the two lines B and C would be the market expected return. That would be some new line D with a new destination in between the two lines B and C. 

So, what is the solution to the paradox? Will prices change? And if so, did the value of stocks change?

The answer is another paradox: Stock prices changed by going down because stock value went up so stock prices could come down because stock value had to go up.

Baby Boomers in this hypothetical all of a sudden wanted less stock because they wanted less risk. In order to reduce risk they have to sell that risk to someone else. That someone else either must want that same risk relatively more all of a sudden (the source of the second objection to the bottom chart mentioned above) or the Baby Boomers need to reduce the risk by offering a lower price. Some of both will happen meaning stocks get less risky simply because Baby Boomers want less risk--a rather surprising result. Here are the implications:

• The lower the price of stocks, the less risky they are holding expected cash flows and discount rates constant.
• The change of ownership from higher-discount rate investors (Baby Boomers all of a sudden in our hypothetical) to lower-discount rate investors (the buyers of the Baby Boomer's stock) means stocks are less risky to those who now hold stock without any needed change in price or expected future cash flows. 
• Stocks become more valuable when prices go down without any other change or expected future cash flows go up without any other change or discount rates go down without any other change. 
• If expected future cash flows go down and discount rates go up (as has been the case circa March 2020), then prices must go down. 

The moral to this story could be: DON'T REASON FROM A PRICE CHANGE! Prices reflect value. Value for consumption goods and services like bananas and hotel rooms are subjective. Value for financial investment assets like stocks, bonds, and real estate are subjective too. But they are subject to expectations about the future and the value we place on money today versus money tomorrow.

Prices don't simply change, and a change in price doesn't really tell us anything. The price of bananas declining could be because people stopped liking bananas as much or it could be because it just got a lot easier/cheaper to harvest bananas. The price decline tells us that the value of the next (marginal) banana is lower, but that fact by itself doesn't tell us why that is the case.

Stock prices declining could be because investors in aggregate think earnings from holding stocks will now be lower than estimated before or it could be because investors in aggregate value money today more than money tomorrow. The price decline in stocks tells us that on net one or both of these has happened, but the fact by itself doesn't tell us which.

Markets Don't Hate Uncertainty

Markets don’t hate uncertainty.

Markets aren’t sentient beings with feelings. It is much more meaningful and accurate to say markets price uncertainties and risks.

As uncertainty rises, markets adjust prices to reflect that information. As risk tolerance changes, markets adjust prices to incorporate that as well.

The current financial environment gives a helpful, extreme example. Lower prices for stocks are likely reflecting two things: increased risk aversion (higher discount rates) and greater uncertainty about future wealth creation (lower earnings/profits, lower quality of life).

Let's look at each of those causes. First, increased risk aversion: If the average person is becoming more fearful of the future, the rational response for them is to increase how much they value a dollar today as compared to a dollar tomorrow. Technically this means they discount the future by a higher rate than previously. They are raising their discounting rate in the formula:

Money Today = Money Tomorrow less a Discount

$0.90 = $1.00 minus $0.10

[slightly more technically]

Money Today = Money Tomorrow times a Discount Rate

$0.90 = $1.00 * 0.9

(even more technically, 0.9 is approximately a 11.1% discount rate)

If our previous discounting rate was $0.05 for every dollar tomorrow and now it is $0.10 for every dollar tomorrow, then the current value of that future dollar has declined $0.05. Prices today on that future dollar fall from 95 cents to 90 cents.

Second, greater uncertainty about future wealth creation: If the average person thinks that future generation of wealth is going to be less than previously thought, the rational response is to lower their expectations for the future. They are lowering the expectation of money tomorrow in the formula:

Money Today = Money Tomorrow less a Discount

$0.90 = $0.95 minus $0.05

If our previous expectation was to generate a full dollar tomorrow and now we fear tomorrow will only see the generation (creation) of 95 cents, then prices today on that future amount fall from 95 cents to 90 cents.

What happens when both happen at the same time? We then would see a compounding effect in prices today. 

What was once

Money Today = Money Tomorrow less a Discount

$0.95 = $1.00 times 0.95

Is now

$0.855 = $0.95 times 0.9

Prices for money today have fallen $0.095 ($0.95 - $0.855) or 10%.

These are the underlying forces that drive the more complex world in financial markets. Investments in equities (stocks) have fallen significantly in the past month. This is very likely an example of both increased discounting of the future (greater risk aversion) and lower prospects on future wealth creation (lower expected future earnings). The market isn't hating the uncertainty about how risky the world is or what future earnings will be. Rather very appropriately the market is repricing the expected value of what the future will be. 

In every moment that passes new information is revealed about the world. This information is an update to all the prior expectations we had. Some of those expectations get confirmed. Some of them get rejected. But that is too binary a way to look at it. Don't think about right and wrong in terms of predictions. Think about constant adjustment. When substantial new information comes to light like when a virus comes into the world, the virus becomes abnormally very serious, and a pandemic emerges, big adjustments to prices today on values tomorrow naturally and appropriately result.