Wednesday, April 22, 2009
Monday, March 23, 2009
Investing Fundamentals
I really thought I had a good handle on the basics of investing until I heard a speech by Peter Schiff. He has a really great way of speaking about basic investing in a way that really exposes what I think most people take for granted.
His first example was in the stock market. There are two basic ways to make money on a stock, through dividends and through appreciation. There are also basically two different kind of people in the market. Investors look at the price they need to pay for a stock, and then predict how much that stock is likely to pay out in dividends over a period of time, and calculate a rate of return to figure out if the stock is a good deal or not. Speculators don't care so much about dividends, but instead try to predict whether they'll be able to sell the stock to someone else later at a higher price. There's nothing wrong with speculation, but I think a lot of so called investors are truly speculators. I personally always considered myself an investor, but I'm now pretty sure what I was really doing was speculating.
Schiff's actual example was concerning the IPO of a startup during the .com boom. He was approached as an investor in this company. The company was selling the shares at a price that put the value of the company around $20 million (this isn't the right figure, but it doesn't really matter here). The company had no customers, no profits and very few real assets. So why was this company worth $20 million, when someone else could have started exactly the same company for nothing? When faced with this question, they replied that "he didn't understand how the stock market works!" They said that he would make his money because he'd be able to sell his stock to someone else for a higher price. But if the stock wasn't a good deal now, why would someone buy it at a higher price? The answer was that the market was not dominated by investors, but by pure speculators. The problem is that when speculators bid prices up beyond the fundamentals, it can't continue forever. It eventually became so ridiculous that bond holders were making much more money than stock holders were making on dividends, even though stock holders assume a higher risk. Of course, this came crashing back down soon after.
His second example was in housing. If you can rent a nice apartment for a cheaper price than you could own it, then why would you choose to own? The answer from a realtor in the height of the housing bubble was, "You just don't understand how the housing market works! You'll make money because you'll be able to sell it to someone else later for a huge profit." But again, if you can't make any money on a property at today's prices, why in the world would someone buy it from you for an even higher price? The answer again was that the market had become dominated by speculators, and as we now know that didn't last forever.
For me, the issue was that I always thought of speculation as something someone else did. I had several friends who bought houses on little income and assumed that price of their house would always go up. They were speculators just as much as if they had bought gold or paintings or anything else. It's easy to forget that investing is based on fundamentals. In stocks, it's the dividends that you expect it to pay; in real estate, it's the amount of rental income you can earn based on the property. Speculation is a fun game, but I don't think it's one that most of us are truly ready to play.
I highly recommend listening to Schiff's speech as well as searching for his books and writings online. He's one of the few people to accurately predict both the stock market bubble and the housing bubble.
His first example was in the stock market. There are two basic ways to make money on a stock, through dividends and through appreciation. There are also basically two different kind of people in the market. Investors look at the price they need to pay for a stock, and then predict how much that stock is likely to pay out in dividends over a period of time, and calculate a rate of return to figure out if the stock is a good deal or not. Speculators don't care so much about dividends, but instead try to predict whether they'll be able to sell the stock to someone else later at a higher price. There's nothing wrong with speculation, but I think a lot of so called investors are truly speculators. I personally always considered myself an investor, but I'm now pretty sure what I was really doing was speculating.
Schiff's actual example was concerning the IPO of a startup during the .com boom. He was approached as an investor in this company. The company was selling the shares at a price that put the value of the company around $20 million (this isn't the right figure, but it doesn't really matter here). The company had no customers, no profits and very few real assets. So why was this company worth $20 million, when someone else could have started exactly the same company for nothing? When faced with this question, they replied that "he didn't understand how the stock market works!" They said that he would make his money because he'd be able to sell his stock to someone else for a higher price. But if the stock wasn't a good deal now, why would someone buy it at a higher price? The answer was that the market was not dominated by investors, but by pure speculators. The problem is that when speculators bid prices up beyond the fundamentals, it can't continue forever. It eventually became so ridiculous that bond holders were making much more money than stock holders were making on dividends, even though stock holders assume a higher risk. Of course, this came crashing back down soon after.
His second example was in housing. If you can rent a nice apartment for a cheaper price than you could own it, then why would you choose to own? The answer from a realtor in the height of the housing bubble was, "You just don't understand how the housing market works! You'll make money because you'll be able to sell it to someone else later for a huge profit." But again, if you can't make any money on a property at today's prices, why in the world would someone buy it from you for an even higher price? The answer again was that the market had become dominated by speculators, and as we now know that didn't last forever.
For me, the issue was that I always thought of speculation as something someone else did. I had several friends who bought houses on little income and assumed that price of their house would always go up. They were speculators just as much as if they had bought gold or paintings or anything else. It's easy to forget that investing is based on fundamentals. In stocks, it's the dividends that you expect it to pay; in real estate, it's the amount of rental income you can earn based on the property. Speculation is a fun game, but I don't think it's one that most of us are truly ready to play.
I highly recommend listening to Schiff's speech as well as searching for his books and writings online. He's one of the few people to accurately predict both the stock market bubble and the housing bubble.
Thursday, March 19, 2009
Monday, March 16, 2009
What is Savings?
Because money dominates our lives, it's easy to forget that savings isn't actually about money. When you produce more than you consume, the difference is the amount you saved. Thomas Woods demonstrates this really well in his book, Meltdown. I'll summarize it briefly.
Imagine a simple economy with no money, and a baker who is able to produce 10 loaves of bread per day. He has a big family, so he needs to consume 8 of those loaves to feed his family. Now let's say he wants to buy shoes from a shoemaker. The shoemaker needs to eat, so he agrees to make a pair of shoes for 10 loaves of bread. The baker saves his extra 2 loaves until he has ten, and then gives it to the shoemaker who later gives the baker a pair of shoes. Here it's clear that savings is not money, but real goods.
Introducing money into the picture doesn't change anything. Let's say a loaf of bread is worth one dollar. The baker could then sell his loaves of bread to someone else, and then use the money to buy a pair of shoes. The shoemaker would then trade his dollars for the bread he needs. The shoemaker is still funded by the real bread savings of the baker. Money is just facilitating the transactions.
To really make this clear, imagine if a third party counterfeited an extra 10 dollars, and paid it to another shoemaker for a pair of shoes. Now there would be two shoemakers with 20 dollars total, but there still are only 10 loaves of bread savings. There is no way for both shoemakers to both buy 10 loaves of bread. This new counterfeiter has now consumed without producing, and it's pretty clear that this is not going to be beneficial to the economy.
None of this changes when you move to the much larger real economy. It also doesn't change when you replace our individual counterfeiter with the Federal Reserve printing money. Savings is not about the money, it's about producing more than you consume.
Imagine a simple economy with no money, and a baker who is able to produce 10 loaves of bread per day. He has a big family, so he needs to consume 8 of those loaves to feed his family. Now let's say he wants to buy shoes from a shoemaker. The shoemaker needs to eat, so he agrees to make a pair of shoes for 10 loaves of bread. The baker saves his extra 2 loaves until he has ten, and then gives it to the shoemaker who later gives the baker a pair of shoes. Here it's clear that savings is not money, but real goods.
Introducing money into the picture doesn't change anything. Let's say a loaf of bread is worth one dollar. The baker could then sell his loaves of bread to someone else, and then use the money to buy a pair of shoes. The shoemaker would then trade his dollars for the bread he needs. The shoemaker is still funded by the real bread savings of the baker. Money is just facilitating the transactions.
To really make this clear, imagine if a third party counterfeited an extra 10 dollars, and paid it to another shoemaker for a pair of shoes. Now there would be two shoemakers with 20 dollars total, but there still are only 10 loaves of bread savings. There is no way for both shoemakers to both buy 10 loaves of bread. This new counterfeiter has now consumed without producing, and it's pretty clear that this is not going to be beneficial to the economy.
None of this changes when you move to the much larger real economy. It also doesn't change when you replace our individual counterfeiter with the Federal Reserve printing money. Savings is not about the money, it's about producing more than you consume.
Wednesday, March 11, 2009
Meltdown
I just finished reading Meltdown by Thomas Woods. It's a look at the causes of the current economic crisis. It's written for the layperson, so anyone should be able to pick up and find out more about why we got into the mess we're currently in.
Unlike most of what you hear in the media or from the government, Woods doesn't offer up the flimsy arguments that point the blame at the unregulated free market. He first outlines the various government interventions into the economy, and then shows how each of them contributed to the crisis. He puts particular blame on the current system of banking including the Federal Reserve system. He makes a compelling argument that the right way forward is not to increase taxes, spending and regulation, but to reduce them.
Woods backs all of this up with well-reasoned arguments and historical examples. He spends extra time discussing Keynesian economics, which is the system of economics that has been guiding the federal government since the 1920's. I would highly recommend this book to anyone who is interested in the causes and solutions of the current economic crisis.
Unlike most of what you hear in the media or from the government, Woods doesn't offer up the flimsy arguments that point the blame at the unregulated free market. He first outlines the various government interventions into the economy, and then shows how each of them contributed to the crisis. He puts particular blame on the current system of banking including the Federal Reserve system. He makes a compelling argument that the right way forward is not to increase taxes, spending and regulation, but to reduce them.
Woods backs all of this up with well-reasoned arguments and historical examples. He spends extra time discussing Keynesian economics, which is the system of economics that has been guiding the federal government since the 1920's. I would highly recommend this book to anyone who is interested in the causes and solutions of the current economic crisis.
Tuesday, March 10, 2009
Not the Free Market #3: FDIC
The FDIC (Federal Deposit Insurance Corporation) is the government agency that insures deposits at almost all banks. It's clearly not a free market institution since it's a government agency, and there is an explicit guarantee that the FDIC will pull money out of the general fund even if the FDIC fund runs out.
The FDIC is designed to protect banks, although it does this by protecting depositors. Banks don't actually have all your money. They lend it out to others, and only keep enough on hand to deal with normal day-to-day deposits and withdrawals. In a bank run, too many people come asking for their money at once, and these funds are drained. At this point the bank fails, and the remaining assets are liquidated and distributed to the depositors, however they would typically only get a fraction of the money they had deposited.
This precarious nature of fractional reserve banking puts a natural, free-market check on how much of your money the bank will be willing to lend out. In order to get around this check, the banking industry proposed the FDIC. Now, people can always count on the government to bail them out, so they no longer have to worry about the solvency of their banks. This allows the banks to lend out much more money, and ultimately make much more money. This results in yet another distortion to the normal market process.
The FDIC is designed to protect banks, although it does this by protecting depositors. Banks don't actually have all your money. They lend it out to others, and only keep enough on hand to deal with normal day-to-day deposits and withdrawals. In a bank run, too many people come asking for their money at once, and these funds are drained. At this point the bank fails, and the remaining assets are liquidated and distributed to the depositors, however they would typically only get a fraction of the money they had deposited.
This precarious nature of fractional reserve banking puts a natural, free-market check on how much of your money the bank will be willing to lend out. In order to get around this check, the banking industry proposed the FDIC. Now, people can always count on the government to bail them out, so they no longer have to worry about the solvency of their banks. This allows the banks to lend out much more money, and ultimately make much more money. This results in yet another distortion to the normal market process.
Monday, March 9, 2009
Curling Club Nationals
Seattle currently has two teams playing in the Club Nationals tournament in Utica. You can track their progress here.
The Club Nationals is a confusing event for those not in the know. There are basically two sets of nationals. One of them leads to Worlds and the Olympics and is only open to US citizens. "Club Nationals" is open to any US resident with the additional requirement that all the team members must come from the same club. Club Nationals isn't quite as prestigious as the other event, but the competition is still very high, and lots of teams from around the country try to get in and win the event.
The Club Nationals is a confusing event for those not in the know. There are basically two sets of nationals. One of them leads to Worlds and the Olympics and is only open to US citizens. "Club Nationals" is open to any US resident with the additional requirement that all the team members must come from the same club. Club Nationals isn't quite as prestigious as the other event, but the competition is still very high, and lots of teams from around the country try to get in and win the event.
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