S&P at your finger tips

Political calculations has two excellent calculators online that show the performance of the S&P 500 over different time periods and also the amount you'd make by investing in the index over different time periods. Excellent stuff.

HT: FinanceProfessor.

Inflation illusion at the movies

Inflation illusion is usually defined as the failure to take account of inflation. Not too surprisingly, it turns out that movie box office numbers suffer from inflation illusion. Consider this report on "the Hangover". Apparently the Hangover is the biggest R rated comedy of all time. It has grossed $235 Million, eclipsing Beverly Hills Cop in 1984 at $234 Million.

Of course, these numbers are like apples and oranges. The CPI in 1984 was 105.3 today it is 215.693. To convert BHC to todays numbers we multiply 234 by 215.693 and divide by 105.3. This gives us a whopping $479.32 Million for Beverly Hills Cop in today's dollars.

You can get the CPI hot off the press from the Bureau of Labor Stats here.

Clearly, the Hangover has a way to go before it trounces Eddie Murphy.

However, I have to say that the Hangover was pretty much the funniest movie I have seen in a long long time.

The question remains hwoever, why don't journalists pay attention to inflation?

Textbook Economics

Ever wondered what goes in to the price of a text book? Greg Mankiw's econ book gets the once over here. And a little more here.

HT: Newmark's door

Robert Shiller on sub primes...

Robert Shiller talks about sub prime mortgages here. He argues that a consumer protection agency should promote plain vanilla debt products for consumers - including sub prime loans. I think this is quite reasonable. In the same way that the junk bond market was hugely successful by financing lower credit quality borrowers, the sub prime loan market can also be successful and fill a gap in the market place. The key is to ensure that those making the loans fully bear the risk of the loans that they are making, and that those taking the loans fully understand the terms.

Felix Salmon disagrees and thinks this is a bad idea. But I think Felix is off the mark here. His criticisms of Shiller's argument are all based on sub prime borrowers getting loans that they couldn't repay. A transparent sub prime market where lenders bear risk would reduce the chance of this happening.

The end of asset allocation?

Felix Salmon blogs that asset allocation is dead. He argues that the basic idea of spreading your risks across asset classes with low correlations isn't working anymore, in part due to commodity ETFs being bought up by investors in the name of diversification. Apparently, this action brought the correlation between equities and commodities closer to 1.

I don't really buy this whole, "the correlations have gone to 1" argument. First of all Felix states that correlation is impossible to measure and cites a wired article about the Gaussian Copula. This is a bit of a straw man. Correlation isn't hard to estimate at all. Felix's second point is that correlation is backward looking and therefore no good. I agree that it is a backward looking measure, but I wouldn't through the baby out with the bath water quite yet.

You have to consider what are the alternatives there are to asset allocation. Felix states:

In investing, nothing lasts forever. And the era of asset allocation is in its waning years. The problem, of course, is that no one has a clue what might replace it.

Asset allocation is not a trading or market timing strategy which might loose its ability to generate returns over time. Asset allocation is a method of managing risk. It will reduce portfolio risk overall, but as we have seen, in severe events, correlations do not necessarily go to 1, instead the impact of the market component on diverse assets becomes far more important. Nothing except being in cash would have saved you in the recent market drop, but for most time periods, asset allocation has and will continue to reduce portfolio risk. Put another way, if you are driving a car a seat belt (asset allocation) will help a lot, most of the time. But there are times when it won't (i.e. you drive off a cliff). That still doesn't mean that you shouldn't wear a seat belt.

Damodaran's blog

Aswath Damodaran, an NYU finance Prof is a well known expert on valuation and corporate financial policy. Prof Damodaran has a blog here. Well worth reading. I'll be adding it to my blog reader.

FinanceProf posts a video of one of Damodaran's lectures with the great tag line "dividends are like getting married, buybacks are like hooking up".

stocks for the long run?

Greg Mankiw blogs on a recent article in the WSJ about some of the problems with the thesis that stocks are for the long run - i.e. that they consistently beat other asset classes.

Turns out, some of the data for the first 100 years or so was perhaps a little shaky.

I have a new fave blog

Check out http://self-evident.org/. Particularly the Bond Crash/Course section. Great stuff on the mechanics of swaps and loads of other goodies.

Finding this stuff interesting is a sign that you are a true finance geek! For example, the most recent post explains how you can extract inflation expectations from swaps. Brilliant stuff!

How to deal with foreclosures

The Economist reports on a recent Fed study that tries to explain why so few mortgages that are in default are renegotiated. Turns out, it is not really because of securitization. Instead, banks tend to be reluctant to renegotiate because a) many renegotiated loans end up defaulting anyway and b) some loans that are in default "cure themselves" - in other words - come out of default. So more often than not, not doing anything is the best strategy.

Did Diversification Fail When We Needed It Most?

Ken French talks about diversification

Ken argues that the observation that correlations across asset classes went up recently is "probably a mis-perception". He argues that really what is happening is that the market component of risk became more significant, and to the extent that all assets have a market component, they will all be affected by this component.

However, at the end of the day, for an individual investor this is probably semantics. Pretty much everything went down!

Pope calls for new economic system

The Washington Post today reports that the Pope has weighed in on the current financial situation. He bemoans that:

"Without doubt, one of the greatest risks for business is that they are almost exclusively answerable to their investors, thereby limited in their social value."

I think the Pope is a little off the mark here. There is actually tremendous social value in an enterprise whose goal is to maximize shareholder wealth. First, millions of us rely on these firms to create wealth for our retirement. Second, maximizing shareholder wealth often results in greater resources being available for charitable work - take the Bill and Melinda Gates foundation for example. Third, the free market system in which capital flows to the most productive use is responsible for the improvement of the lives of millions - through medical advances, technology etc.

I don't think that this is the first time the Pope has been off the mark, but this is a finance blog so we won't go there.

Evil market jargon?

Jack Hough writes about evil market jargon such as "alpha" "beta" and "second derivative".

Jack doesn't think that we should use such words as they are hard to understand. He suggests instead the following....

Legally, I can’t recommend that you use it to punish those who use the four self-important terms below. That said, if you hear someone use one of the terms, and if you happen to be standing behind them, and if you love America and you’re not holding a dangerously hot coffee at the time (or if it at least has a lid), I think we both know what needs to be done

Jack goes on to say about beta..

In one common but flawed approach, a stock’s risk is defined by its past trading volatility.

Uh, I don't think that's right actually. But I hate to throw the "covariance" word in to the mix given the tone of the article.


Excellent stuff. Mr Hough's columns are brilliant comic relief.

How maths killed Lehman

A cute article written by an Oxford Ph.D. in Mathematics. (Note to US readers - Maths is the English way of saying "Math".) The article explains nicely how cross-asset-correlation, and the faulty assumption of independence of bad events could be seen as an explanation for Lehman's demise.

The online magazine "Plus - living mathematics" has a few other nice articles related to finance...

What does a financial engineer do?

How to price derivatives

and is Maths to blame?

Rolling Stone: Blame Goldman Sachs

I haven't had a chance to wade through this one, but Rolling Stone has a long article on how Goldman has had its fingers in every major bubble in recent history.

Felix Salmon, also reviewed the article and found much to agree with.

Finally, Felix gets a response from GS.

I have to say though that Mr Salmon's stock went down a bit with me after he referred to vegans as "bonkers".

Anyhow, good stuff if you've got some spare time to read it all.

Is the worst over?

According to NPR, "most" economists think so. Unfortunately, what really matters is that most consumers think so too.

Federal debt and the level of interest rates

Econ 101 states that as the federal debt grows, interest rates will rise and this will have a crowding out effect on private investment. A recent article suggests that this might happen.

Behavioral economics / finance

Behavioral economics (and finance) has fully matured into its own sub-field. In essence, it examines how psychological factors influence the behavior of participants in various markets.

It is important to distinguish between the behavior of people reacting to incentives, which might seem irrational, and true behavioral factors. In the book "Freakonomics" there is a section on a day care center which tried to deal with tardy parents picking up their kids by imposing a fine on late pickups. The result - more late pickups, because the fine was less than the hourly cost of daycare, and parents rationally responded to the offer of this "after hours" care. This is not really an example behavioral economics.

An example of behavioral finance is the 1/n rule. If you give people "n" choices - say 4 mutual funds in their retirement plan, folks will tend to put 25% of their money in each fund, when optimally a different allocation is probably best.

Anyhow, Scientific American has a piece on how bubbles develop.

The article first talks about "money illusion" a topic close to my heart as this was the focus of my PhD dissertation and subsequent publication in the Journal of Financial and Quantitative Analysis. Money illusion occurs when individuals fail to appreciate the effects of inflation on asset values. To quote from the article:

Robert J. Shiller, a professor of economics at Yale University, contends that the faulty logic of money illusion contributed to the housing bubble: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.”

The article goes on to cover several other well documented examples of behavioral irrationality. Overall an excellent read.

Bond data online

FINRA now has bond data online. You can find some of this on yahoo finance, but this is a particularly nice setup.

HT: Felix Salmon