Tuesday, June 30, 2009

The value of a college degree - an example of bad math

The New York Post (not a renowned source for financial analysis) has an article by Jack Hough (an editor at "smart money") that argues that a college degree isn't worth the money.

The article also shows up here on the smartmoney website.

In finance lingo, he is saying that a college degree is a negative net present value project. At first blush it looks like he has a point. The first page of the article gives the example of two individuals. One starts work and the other goes to college and assumes a college loan. Mr Hough goes on to show that at retirement, the college grad will have about 1/3 of the wealth in his retirement account as his non-college going buddy.

Mr Hough then goes into a rather unfocussed rant explaining the reason for this - that basically professors are useless and we don't teach anything of value....

I smelled a rat.

Unfortunately the math in the example is completely wrong. The example assumes that both put aside 5% of their income to either retirement or paying down loans.

At age 22 the non-college guy will have a net pay of 16055 (assuming income growth and his 5% retirement payment).

The college guy on the other hand has a net pay of 22,329 after he has paid 5% of his salary to his loan (Mr Hough's assumption).

The example completely ignores the difference in their net pay, i.e. $22,329 - $16,055 = $6,274. It is implicitly assumed that college guy just spends this. But if he lived on the same net pay as the non-college guy, you can show that he'd pay of his loan in 3 years and retire with $3.4M (about 2.5 times as much as the non-college guy).

Now, in fairness to Mr Hough, he does note that:
I'm comparing only savings, not living standards.
Bill will presumably be able to afford nicer things than Ernie along the way.

But this is precisely the point! You have to look at total earnings, not just some arbitrary percentage of earnings. The difference in the two living standards is likely to be massive.

In my analysis, I assumed that this would all be invested by the college grad, but we could just assume that he'd invest enough to retire at an equal level with his non-college pal, and then enjoy the rest during his life.

I'm tempted to take a look at some ofMr Hough's other pontifications , but I need to do some real work. Maybe another day :)

In the meantime, Mr Hough really should brush up on his basic time value of money. That way maybe he won't give out as much bad advice.

Monday, June 29, 2009

Cap and Trade

Craig Newmark has an excellent post by Steve Margolis (another NCSU economist) on the "transitional gains trap" problem that lies in the proposed cap and trade legislation making its way through congress.

The transitional gains problem represents yet another compelling argument for a carbon tax.

Thursday, June 25, 2009

Six Sigma

I was reading an article about Jack Welch on the Economist website (I blogged it earlier today) and I clicked on the link about "Six Sigma". I don't know much about Six Sigma, I'll admit (I'm a finance guy, and I don't get too wrapped up in management bull crap buzz words), but apparently it means

a process must produce no more than 3.4 defects per million opportunities

So, the fact that the knob on my GE tumble dryer dropped off after about a year is a 1 in 294,117 chance event. That's good to know.

From here on, this blog is going to be a six sigma blog with a no more than 1 typo every 300,000 words writtun.

The Jack Welch MBA

Apparently Jack Welch of GE fame is joining up with some entity to create an online MBA. As the Economist points out - teaching Welch's management style could lead to some interesting classes...

for example, on exec pay..

One extremely popular class would be “Maximising Your CEO Pay”. This columnist once heard Mr Welch tell a chief executives’ boot-camp that the key was to have the compensation committee chaired by someone older and richer than you, who would not be threatened by the idea of your getting rich too. Under no circumstances, he said (the very thought clearly evoking feelings of disgust), should the committee be chaired by “anyone from the public sector or a professor”

and the accounting class should be awesome...

Equally unmissable would be the class on “Making Your Numbers”. Under Mr Welch, GE’s accounting was so creative it could be hung on the wall of the Museum of Modern Art (although it was all within legal bounds). Frequent use was made of off-balance-sheet vehicles, on a greater scale even than Enron. The firm’s huge, opaque financial arm, GE Capital, was used as a top-up fund in case profits in the rest of the business fell below the consistent growth promised by Mr Welch. Over the 80 or so quarters he was in charge, GE’s profits grew so consistently they were almost a straight line. Those were the days.

Jack's partner in this enterprise is a guy by the name of Mike Clifford who, to quote the Wall Street Journal...
previously worked in broadcasting and telecommunications, and with evangelical Christian leaders such as Pat Robertson, Jerry Falwell and Bill Bright.

Sounds like a winner to me.

Tuesday, June 23, 2009

Harvard cutting risk

Harvard is cutting risk in its monster endowment portfolio. The rationale for holding these risky assets was that as Harvard has a long term horizon (basically infinite), it can tolerate the ups and downs of risky assets. Turns out that the horizon isn't really as long as they thought. The endowment is expected to generate regular income for the school. The ups and downs (mostly downs) severely reduced this income generation. If Harvard was never planning to pull money from the portfolio, then this wouldn't matter, but then that would raise the question of what the point of the endowment was in the first place.

Tenure in academia

I'm a big fan of tenure, surprise surprise. A column today argues that the benefits of tenure are unclear and that

The truth is that tenure has served as an instrument of conformity since tenure votes are often glorified popularity contests. The fact that university professors donated to President Obama's campaign over John McCain's by a margin of eight to one is only the tip of the iceberg. Those professors who want tenure and disagree with the prevailing trends in their field -- or the political fashions outside of it -- know that they must keep their mouths shut for at least the first seven years of their careers.

I continue to be amazed by the unsubstantiated garbage that the WSJ will print on its Op Ed page. I have been involved in tenure decisions at my institution and they are not at all "glorified popularity contests" - they involve a very careful and rigorous scrutiny of the research record and potential for future research of the scholar in question.

There are many reasons why the US has the best higher education system in the world. I'd venture that tenure might be one of them, despite the musings of Ms. Riley, the Wall Street Journal's "taste" editor.

Triple A Punt - Credit Rating Agencies

The Wall Street Journal's opinion page argues that the Obama administration has left the ratings agencies pretty much unscathed in the round of new regulations for the finance industry.

I'm inclined to agree that a lot of the problems that we have faced in the past year or so have been due to a reliance on the three ratings agencies, who occupy a position of government mandated supremacy. Pension funds, endowments and other regulated investment entities like being able to delegate credit screening to these credit agencies - they don't have to do the credit screening themselves.

Now it turns out that S&P is planning to use the CDS market to help set their ratings. In effect they are going to take a clean market signal and repackage it as a noisy, infrequently updated credit rating.

As the CDS market providesan instantaneous market assessment of risk, the role for credit rating companies should be limited - except for the fact that they have a government mandate.

Monday, June 22, 2009

Where are cars made?

With all the talk about helping US automakers it is worth noting which vehicles are actually made in the US. This graphic provides some interesting information.

For example, the Toyota Sienna is assembled in Indiana using a US made engine and a US made transmission, whereas the Ford Mustang is assembled in Michigan with a V6 engine from Germany and a transmission from France or Mexico.

Thursday, June 18, 2009

The future of MBA education

The Financial Times talks about the apparent soul searching currently going on at Business Schools.

Personally, I subscribe to the opinion of the Richard Cosier who is the Dean of the Krannert School at Purdue who is quoted as saying:

Saying schools should not teach complex financial models is erroneous, he says. “That’s like saying you can’t teach chemistry because you can make things explode . . . People make their own decisions.”

What caused the financial crash...?

A whole bunch of things according to this graphic..

Saab - a negative NPV project.

I'm wrapping up teaching financial management of corporations to MBAs - the last class is tonight (my Monday and Thursday nights will be so empty!).

In class we have talked a lot about NPV as a decision rule for evaluating projects and the recent news of GM's sale of Saab made me wonder what GM's original 2000 NPV analysis of Saab looked like (assuming that there was one). I'm guessing that there wasn't one. But I bet that if there was, they used GM's cost of capital and not a far higher one that a risky division like Saab would merit. Rick Wagoner stated in 2000 that ''The brand attracts a very different consumer than we normally see in General Motors showrooms ..... We want to keep that brand very distinctive and very unique.'' Sounds risky to me.

But by 2002 things looked pretty grim. Indeed, GM admitted that Saab never made money and Rick Wagoner said of Saab "you have to play the cards you're dealt". Wow, what a lame excuse when considering that GM picked the cards it was dealt.

Unfortunately, the US tax payer is now playing those cards.

Examples of hyperinflation

A nice summary of some prior cases of hyperinflation from mint.com.

These are really just for interest only, as I don't believe that we are heading the way of Zimbabwe, despite the prognostications some "experts". See my recent post.

Monday, June 8, 2009

Best online tools for personal finance

The Wall Street Journal today has a feature about online personal finance tools. You can read it online here.

This American Life podcast on ratings agencies

This week, this American Life (talk show on NPR) did a story on rating agencies. You can listen to it here.

Saturday, June 6, 2009

A difficult time

Some of you may follow the blog of the unknown professor. The unknown prof blogs on finance matters and also on the day to day life of being a finance professor. Today he posted an update regarding the health of his son who has been battling cancer. The news is not good. Not good at all.

I personally know the unknown professor and he and his family are in our thoughts at this very difficult and very sad time.

Friday, June 5, 2009

Why active investing is a negative sum game

Fama French present very sound arguments why active investing is a negative sum gain (or game!).

The intuition is simple. Passive investors hold a market cap weighted portfolio. Active investors don't. They over or under weight certain stocks. The gains to one active investor must then be offset by losses from another active investor. But both pay higher expenses. Therefore, in aggregate, active investors cannot outperform passive investors. This applies to any time period.

Thursday, June 4, 2009

How accurate is the Dow?

The Dow Jones Industrial average has been reworked again to reflect the bankruptcy of GM. Both the Dow and the S&P 500 are periodically changed when something happens to one of their constituents. The selection process for the new stocks that are added to the indices is a bit of a black box, but one thing appears to be true - both indices may inadvertently engage in a buy high sell low strategy. In effect the stocks that are deleted are ones that have been beaten down, while the stocks that are added are often stars in their sector. Evidence for this is explained here in a nice article on seeking alpha

I blogged about this before, and more I think about it, I think there must be a market for a pure buy and hold mutual fund.

NC Pension fund expanding investment opportunity

The NC State Pension fund is going to be allowed to expand its investment options to TIPS and lower rated debt. Provided this is done carefully, the TIPS in particular should provide additional diversification to the portfolio overall.

Wednesday, June 3, 2009

Student evaluations

At most schools, students get to evaluate their professors using a rating scale and also written comments. In general, administrators pay attention to the ratings (1-5) and professors pay attention to the written comments.

I was just re-reading some of my comments from the spring, and one from my MBA investments class struck me as particularly good..

[professor is] wise enough to know that he can never know enough and that his trade is not as well mapped out as he would like it to be...

I think that this comment is relevant to all who work in investments - and in fact to life in general...