If I Were a Rich Man . . .

Some estimates say that John D. Rockefeller was the richest American ever putting his wealth at the equivalent of ~$215 billion today*. There are a number of problems, though, with this simple process of taking a historic price and adjusting it forward by the inflation rate. Extrapolating a prior figure for inflation makes the extrapolation sensitive to the quality of the inflation estimate. That sensitivity grows and compounds as the time span grows. Additionally, other factors become very important in long spans while they are non-factors in small spans. Quality is one of these factors, and it matters a lot. This post will have a lot of lessons in how magnitude matters.  

I’ve been thinking about this post for a while since seeing a History Channel show about the wealthiest Americans in history. In yesterday's WSJ Don Boudreaux and Mark Perry have a great article on The Myth of Middle Class Stagnation, which inspired me to finalize this post. This is a must read piece that I can’t recommend enough. In it they give several examples of how problematic it is to simply take a historical price like average income and bring it up to the current through inflation adjustment for comparison to a similar figure today.

I would like to challenge the idea that John D. Rockefeller was the richest American ever. To do so I pose a question: Would I rather live today as I am, an upper-middle class father of three, or as Rockefeller in his day? Let’s think about this because it isn’t as easy as comparing my modest net worth (MUCH less than a small fraction of $1 billion) to his estimated at $215 billion today.

The most costly event in life is death. Let’s start with that. Life expectancy in the United States in the 1920s was about 55. At my birth it was about 72. Today it is about 78.

Perhaps the next most costly event for many of us is the potential of losing a child. Actually losing a child is the horrific realization of that cost. So let’s next look at infant and child mortality. For the U.S. in the 1920s & 30s both rates of death were about 6-8% (infant mortality covers children who die before one year of age; in this case child mortality covers children who die between age one and four inclusively). Today those mortality figures are about .6% for infants and about .1% for children aged 1-4. Those are remarkable reductions that are hard for us in this era to appreciate.

Another very costly event for a husband is maternal mortality (a mother’s death during childbirth). Here again we see stunning improvement. The rate was about .75% in 1920s & 30s. Today it is about .01% -- an improvement factor of 75 times.

Sources: 1, 2, 3.

Simply put when compared to today, living was more difficult and less likely in the early part of the 20^th century. All the kings horses and all the kings men could hardly nudge any improvement out of that harsh health reality. We may already have our answer, but let’s go on for good measure.

Let’s think about what I can do today as compared to what the wealthiest man of that era, Rockefeller, could do then including some of the inconveniences and limitations that he faced that I do not. Specifically consider:

• People I can communicate with. I can reach out to my family and friends virtually any time of day no matter where I am or where they are. I can connect and correspond with people I have never met but with whom I share some common interest. 
• Places I can go. I can travel at home and abroad generally more easily, more quickly, and in more ways. In fact, I can go places inaccessible even to him in his day. Even going to work, the car I ride in is better from seat warmers to safety.
• Conveniences I can expect at the places I can go. When I arrive at my destination, be it my office or a foreign tropical beach, I don't have to plan ahead nearly as much or spend nearly the resources to have many comforts and options to make my experience there quite enjoyable. 
• Food I can eat. My food options dwarf his. I eat in greater confidence about the safety and freshness while I enjoy cheap, abundant, and extremely various food and drink much of which is of a quality he would envy. 
• Entertainment I can enjoy. Music is incredibly better for me from the quality to the genre variety to accessibility. He could never see a television show or anything reasonably resembling a modern movie. His book options were quite limited relative to mine not to mention periodicals, research papers, blogs, and the like. I can see more theater in a few weeks than he could enjoy in years. Sports are other worldly today compared to what he could take in. 

I could go on and on from how I can engage in financial markets in ways he couldn't dream to how I can know things about the universe confusing and unknown in his day to how I can dress more comfortably than him to how . . . . In summary I can do most of what he could do even with his vast wealth, and my options tend to be deeper and richer. I take back what I said earlier--this is as easy as comparing my wealth to his. Mine is higher.

*To reach this figure I took the NY Times estimate from 2007 and similarly increased it by the recent CPI inflation rate bringing it up to 2013.

PS. I owe Billy Ray $1. He bet me that I couldn't get rich and put Rockefeller in the poor house at the same time.

The alpha dog don't hunt (maybe)

As a strong proponent of the semi-strong version of the Efficient Market Hypothesis (EMH), I have a bone to pick with the idea of alpha generation. First some terms explained.

Money managers such as mutual fund managers and hedge fund managers operate under the following premise: The attempt to grow investors' money over time. Some managers attempt to outperform the market (active managers) while others just attempt to replicate or stay with the market (passive managers). For this discussion we are only concerned with the investments of active managers. Whether successful or not (and success is a complicated determination as we will see), the investments will have some kind of results. There are two components of those results, alpha and beta.

Answering the last part first, beta is the component of a money manager's results (performance) that is attributable to or describable by the underlying market's results. That is to say someone who simply invests in the stock market will have results just from being invested in the stock market--regardless of the individual decisions that investor makes. A manager or investor who exactly mimicked the results* of the stock market would have a stock market beta equal to 1. One who exactly doubled the stock market's results* would have a beta equal to 2. Keep in mind that these figures apply up and down such that a portfolio with a beta of 2 would expect to have twice the up or down results of the underlying market. Comparing a manager with a beta of 1 to a manager with a beta of 2, we could say that the manger with beta equals 2 is expected to be twice as risky relative to the other manager considering the same underlying market for both.

Alpha on the other hand is the component of a money manager's results (performance) that is in excess or deficiency of the underlying market's results given the risk the manager took on. That is to say someone who simply invests in the stock market will have results just from the individual decisions that investor makes--regardless of the results from just being invested in the stock market. A manager or investor who exactly mimicked the results of the stock market would have a stock market alpha equal to 0% at any given level of beta.

The problems of moving from these theoretical constructs to the real world begin with the fact that if the market is really, really good at identifying, processing, and applying information (that is to say the market is highly efficient), then alpha shouldn't be possible (market participants shouldn't be able to out think the market). Our problems continue once we realize that it is very difficult to look at a money manager's results and separate out alpha and beta. The two get quite confoundedly interwoven for a number of reasons.

For one, when do we stop defining down the proper market comparison (benchmark) for a manager? Suppose he purchased 499 of the 500 stocks in the S&P 500 index in proportion to their weight in that index less the left out stock. Seems reasonable that the S&P 500 would be the proper benchmark. But the stock that gets excluded will make a big difference in how representative the S&P 500 is for his performance. Excluding Apple (currently ~4% of the index) versus excluding AutoNation (currently ~.01% of the index or 1/400 the value of Apple in the index) would have a significantly different effect. Suppose another manager purchased the same 499 stocks as the first but in quite different proportions. Suppose another only purchased 10 of the stocks. Describing all of these managers or any of them as compared to the  S&P 500 might not be a very meaningful description.

Another reason alpha and beta are difficult to separate is that manager process and performance is not always very transparent. This makes finding suitable benchmarks more difficult. We could go on, but the foundation of the problem is already well established. A manager's alpha might just be the beta of a better defined benchmark.

So what to make of the elusive search for alpha? My thought is that the only true alpha is good beta management--perhaps "meta beta"would be the clever term for it. The goal then for a money manager is to achieve a beta appropriate for the investor and opportunistic when and if possible. A beta of .5 would be great in relative down markets but would have an obvious cost of underperformance generally. A beta of 2.5 would be great most of the time but would have the extreme risk of permanently impairing capital some of the time. Opportunistic beta management is dangerously close to market timing, which almost certainly is a fools errand. Yet there may be some ability to capture gains once we consider the position of the individual investor we are attempting to match up with an appropriate beta (e.g., relatively high beta for an investor with no withdrawal needs, a high capital base, a long time horizon, and otherwise high willingness and ability to take on risk).

I look at this, my understanding of and belief (or disbelief) in alpha, as a work in process. I have to reconcile any degree of belief in alpha with any degree of belief in efficient markets. Starting with my assumptions and belief in efficient markets does have a flavor of receiving the answers in advance of asking the questions, but I'll try to keep an open mind. I'll keep thinking . . .



*Mimicking results, doubling results, etc. with regard to beta means both the end result (return) and the path to get there (volatility).

Partial list of my favorite things . . .

Partial List of My Most “Controversial” Views

(in no particular order and subject to change)

1.  Government should ideally exit fully from the activity of funding, administering, sanctioning or otherwise engaging in education. As a second-best solution, the government should only facilitate the funding of education by fixed-amount vouchers issued directly to parents and redeemable by any entity that can demonstrate to a non-government third party that they are an education provider. A qualified third party would be one that a significant number and variety of education providers themselves would recognize as being a legitimate if not desirable third-party evaluator.
2. Free movement of people into and out of the United States of America should be allowed unencumbered and unlimited except for those who are known felons or who are carriers of highly dangerous communicable diseases.
3. As a corollary to the previous, the free movement of goods, services, and investment should also be free of encumbrance except for the most extreme cases of vital national interest with great burden of proof put upon the justification for any such limitation. 
4. The federal government of the United States should eliminate fully the income tax (both personal and corporate), all taxes on capital including dividends and capital gains (short and long term), all excise taxes, and all taxes on estates. There are two desirable replacements for the current tax structure: One is a payroll tax of a certain and consistent (i.e., flat) rate applicable to all employment arrangements whereby the tax is assessed on the fair market value of the total compensation (salaries, wages and benefits) earned by an employee. Another perhaps preferable solution would be a certain and consistent (i.e., flat) rate of sales tax applied to the purchase of all final goods and services. As a method to reduce regressivity, a federal tax rebate could be created whereby all adult citizens are issued a refund equal to the sales tax rate multiplied by the dollar value of the poverty level of consumption and all citizens claiming a dependent would be issued a refund equal to 25% of the sales tax rate multiplied by the dollar value of the poverty level. To aim further in adding progressivity to the system, a marginal 10% payroll tax could be applied to all total compensation above $100,000 with this threshold indexed to grow with inflation. 
5. All narcotics and other drugs should be completely legalized.
6. Nearly all if not all zoning laws should be discontinued and dissolved.
7. Prostitution should be legalized.
8. The state should cease and desist from all activities involving sex offense registries and notification requirements.
9. Copyright laws and rules should be very significantly reduced in scope and scale.
10. Patent protection should be considerably rethought with the aim to greatly reduce their anticompetitive and antidevelopment characteristics.
11. There should be no occupational licensure enforced by law.
12. Most not-for-profit, charitable activities are slightly counter-productive at best, highly destructive at worst.
13. Price controls are an extremely poor solution that fails on efficiency as well as liberty grounds. They should be avoided to every extent especially in times of emergency and crisis. 
14. Central banking should be replaced by free banking (first-best solution), replaced by a gold standard as described by George Selgin, et al. (second-best solution), conducted with fixed rules in a regime of NGPD level targeting as described by Scott Sumner, et al. (third-best solution).

What is the price of worthless information?

Consider the following hypothetical:

You meet a benevolent stranger on the street. Just assume that you have every reason to believe and trust him that the following offer is on the level. He has both $100,000 cash and $100,000 worth of an S&P 500 stock at current market value. His offer is to give you either the cash or the stock, but you have to pay him to learn what company the stock is for. It is the middle of regular business day; so the market price of the stock is changing as you decide, but once you decide, you get $100,000 worth at that moment (assume fractional shares are available).

How much do you pay?

The answer below the fold.

Hint: This might just be a story about Billy Joe and Bobbie Sue.

Highly linkable

Here is the first of what I hope is a regular feature here at MM.

Market Watch has some very sensible advice on retirement don'ts.

Arnold Kling looks at drug prohibition through the lens of his Three Axes. And he also takes on the tasks of persuasion through said lens.

Steve Horwitz explains some confusion about applying the conventional wisdom to the recommendations of Market Monetarist.

Stewart Baker discusses the recent denial of service attacks on banks allegedly propagated by Iran. It is true that regardless of the perpetrators this is not the equivalent of the Germans bombing Pearl Harbor.

Don Boudreaux takes a great, final for now, shot at explaining the problem with writing off debt we "owe to ourselves".

Mungowitz reminds us that incentives not intentions matter.

And Steve Landsburg's head hurts.

James Buchanan, RIP and ATRA

This past week we lost an intellectual giant, James Buchanan, whose contributions were and are still under appreciated. Among other contributions, Buchanan helped discover and bring to a fuller light facts that should have been obvious: political actors are subject self interest and incentives just like everyone else and government failure is as much if not more a fact of life as is market failure.

See these excellent appreciations of the Mr. Buchanan's life work:
     From Alex Tabarrok
     From Steve Horwitz
     From Arnold Kling
     From Don Boudreaux
     and From the WSJ editorial page

It is a bit fitting unfortunately that Buchanan's death would come so closely to the passage of the American Tax Relief Act of 2012 (ATRA)--the resolution to the so called tax portion of the Fiscal Cliff. This disgusting example of political corruption would have been well understood by Buchanan. The act contains nothing resembling fiscal responsibility or improvement. It is a giveaway to the special interest of the tax lobby (tax preparers, tax advisors, estate lawyers, et al.) and other corporate special interest. It leaves us with a tax code more punishing on work and savings, more complicated, more encouraging of the rich to spend and use rather than save and share, more taxing on all taxpayers as everyone's income tax burden has increased (not just but especially those making more than a couple hundred thousand in a particular year--the $450,000 is a fiction), and more likely to bring us fiscal problems down the road. But it should have all been of no surprise to any of us; I was not surprised. The whole thing reminds me of this exchange:

Muriel Blandings: You remember Bunny Funkhouser, dear, that clever young interior decorator that we met at the Collins' cocktail party.

Jim Blandings: You mean that young man with the open-toed sandals? What about him? 

Muriel Blandings: Well, you know how long we've said we've got to do something about fixing up this apartment. Well, a couple of weeks ago, he called, and I asked him to come over, and he had some simply wonderful ideas, and I didn't want to bother you with sketches and estimates until I knew whether we could afford it. So I sent them over to Bill. 

Jim Blandings: How much? 

Muriel Blandings: What's the point in asking how much until you know what you're going to get?

Jim Blandings: I've seen Bunny Funkhouser. I *know* what I'm going to get. 

RIP, James Buchanan. We still have a lot to learn from you.

Helium: a lesson on "shortages", preferences, and rationing

The Independent reports on the latest scare in precious commodities. It seems we are running low on helium. "Low" is a relative and subjective term, of course. We are also running low on gold, beach-front property, private airplanes, and a bunch of other stuff. It's been that way for some time. I guess it is only news when a scientist complains.

"...Now supplies are running so low scientists want to ration it."

Maybe these scientists at Cambridge should head over to the Econ department to see if anybody has ever come up with a good way to ration scarce goods.

I like this quote as well:

"Cheap helium also drives misuse. A staggering 8 per cent of the world's helium supply is currently used for filling party balloons," he said.

I like how only scientists get to define "misuse". What would the buyers and sellers of party balloons say?

But he does seem to understand something about market interference:

"It is difficult to imagine an adequate market incentive to collect helium during natural gas extraction while the US government is selling off its entire stockpile at bargain prices," Dr Stokes said.

Professor Ned Brainard was unavailable for comment.