Incentives

I have been reading Richard Posner's book "A Failure of Capitalism". I will probably have more to say about this book but for now want to discuss a small point. On page 290 Posner includes in a list things that perhaps should be restricted:

... the right (which fosters overindebtedness) to eliminate debts by declaring bankruptcy. ...

This is a very simpleminded way of looking at things. It is true that the ability to discharge debt in bankruptcy does to some extent encourage reckless borrowing. However it also discourages reckless lending. So it is unclear whether it fosters overindebtedness on balance. Furthermore the ability to discharge debt also encourages prudent borrowing. Which means restrictions on bankruptcy might primarily deter prudent borrowers (who are more likely to worry about such things). So determining socially optimal bankruptcy regulation is considerably more complicated than Posner indicates here.

In general I think efforts to discourage inappropriate loans should concentrate on the lenders. After all we generally expect that people who have money are smarter and more prudent than people who don't have money and thus are easier to deter with evidence that a loan is likely to go bad.

Stone Walls

While walking in the parks around here I often see old stone walls. Some of them are surprisingly well made and are still in pretty good shape especially considering how old they must be. I had been under the impression that New England farmers built stone walls mostly to just have a place to pile the rocks that would constantly appear in their fields. In which case no great workmanship or long life would be expected. However it appears there was more to it than that.

... Some farmers could build a wall with stone that was found on their farmland. Most farmers however, had to steal or buy the stone. ...

Surprisingly (to me anyway) stealing stone is still a problem .

I took the picture Thursday in Kitchawan Preserve . This time I explored the trails on the other side of the North County Trailway . Incidentally I have found the trail map for Kitchawan preserve linked in my earlier post does not exactly depict how the trails are currently blazed.

Tax efficiency

I have just spent a couple of days entering data for some mutual funds I own into my new Quicken program . I had been vaguely aware that index funds have tax advantages over actively managed mutual funds but a concrete example was still startling. I owned $X of index fund A and $Y of actively managed fund B on 12/31/1986. In both cases I have reinvested all distributions and paid the taxes with other income. As of 10/28/2009, A was worth 7.21*X and B was worth 6.69*Y. So ignoring taxes the annual rates of return for A and B are about 9.04% and 8.69% respectively. The higher fees of active management don't seem to be adding value. However the after tax picture is even worse. Over the years the index fund has distributed 2.28*X while the actively managed fund has distributed 8.01*Y. So the tax cost of B has been much higher than A. This probably has increased the after tax difference in annual return by 1% or so.

Now much of this tax advantage would disappear if I sold both funds as the distributions have increased the basis so selling A would produce a substantial capital gain and selling B would produce a substantial capital loss. However under current law if I hold until death the basis will step up preserving the tax advantage.

Another way of looking at this is to assume annual returns of 9% consisting of 3% in dividends and 6% in capital appreciation. Suppose the index fund just distributes the dividends while the actively managed fund distributes the dividends and the capital gains. Then if you assume a tax rate of 20% and that you pay the taxes from the distributions and reinvest the remainder, the index fund will grow at an annual rate of 8.4% while the annual rate of growth for the actively managed fund will be 7.2%.

To substantially benefit from tax free compounding rather long holding periods are required. Suppose we ignore dividends and assume capital appreciation of 6% a year. Assume we hold for n years, then sell and pay 20% capital gains tax and reinvest. Then as n goes to infinity the effective annual yield rises from 4.8% (n=1) to 6% but rather slowly. It is an interesting exercise to determine how big n is required to be to get half the benefit (ie an annual yield of 5.4%).

Breaking the Buck

One of the casualties in last falls financial crisis was the Reserve Primary Fund which broke the buck after its holdings of Lehman paper became worthless with Lehman's bankruptcy.

It has been repeatedly claimed (large pdf file, see page 10) that this was only the second time a money market had broken the buck. The previous instance having occurred in 1994. This claim is false as I have reason to know as I was a shareholder in the Merrill Lynch Ready Assets Trust on August 27, 1982 when it broke the buck. To be sure it didn't break it by very much, the value of a share falling to about $.999671. This was before the SEC adopted penny rounding (allowing money market funds to round their value to the nearest penny) in 1983. Contrary to current propaganda by the money market fund industry this was not the end of life as we know it. The fund computers had no trouble dealing with this event and as far as I know there was no panic or run on the fund.

In my view the SEC was wrong to allow penny rounding in the first place and should take this opportunity to eliminate it. It is ridiculous that some fund computers can not handle prices other than $1.00. And if small fluctuations were visible this would encourage the funds to operate in a more conservative way. Finally this would discourage runs because if fund assets are fairly valued every day there is no advantage to redeeming first when a fund runs into trouble. Unlike the case at the Reserve Primary Fund where many investors were able to get out whole sticking the slow and trusting with the entire loss.

The picture is a scan of one of the two letters I received concerning Ready Assets breaking the buck.

The Great Unraveling

I recently read another book, "The Great Unraveling", by Paul Krugman. This 2005 book largely consists of reprints of Krugman's New York Times columns. I was not reading his column at the time so most of the material was new to me. Still I found the book disappointing. Many of the columns are about hot issues of the day and have little lasting interest. And when grouped together by theme they can be quite repetitive.

The book makes the general argument that Bush couldn't do anything right. I actually tend to agree but that doesn't mean I feel a need to read 400 pages of examples. I would advise skipping this book.

Quicken

I recently acquired Quicken Premier 2010. With the demise of Microsoft Money, Quicken seemed the obvious choice. I got the Premier version because I want to track my investments as well as my spending. My first impressions are pretty negative.

The biggest issue I have is there does not seem to be a safe way to import my bank account transaction data automatically. It doesn't seem like good security to give Quicken the id and password needed to access my bank online. This would not be necessary if I could download the transaction data to a file and then import the file into Quicken. However Quicken appears to have gone to great lengths to make this impossible. It is my understanding that they have done this so they can collect fees from my bank. This is pretty obnoxious and means I have been entering transactions manually which is painful.

The investment portion of the program has a number of issues as well. I would like to be able to enter a stock purchase in say 1985 (which I have not sold) and have Quicken automatically fill in splits, spin offs, dividends etc. This does not seem to be possible. The stock price look up only seems to go back 5 years and it does not appear to provide other information like dividends. This means the program does not seem able to provide an estimate of annual dividend income from a portfolio of stocks. There is also an issue with mergers. For example Wyeth was recently acquired by Pfizer. As a result all historical price information for Wyeth seems to have disappeared from their data provider (at least I can't figure out how to get it) making it impossible to track performance across the merger (without entering all the Wyeth price data manually).

In fairness it is possible that I will like the program better after becoming more familiar with it. However at the moment I am wondering whether I should have tried GnuCash first.

Time and Chance

Matthew Yglesias blogs about a paper which claims to find that graduating from college and entering the job market in a recession year has long term negative effects on your career. This seems plausible although the paper has the weakness that it only looks at a small number of years. So even if you show that people who graduated in high unemployment years did worse it is possible that these years were bad for other (or additional) reasons than high unemployment. However it is certainly true that chance events play a big part in life. This is not a new observation.

Ecclesiastes 9:11

I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.

Yglesias goes on:

... If you’re graduating from college this spring, you’ll be sitting around at the age of thirty-five still suffering from the fact that Susan Collins, Olympia Snowe, Ben Nelson, and Kent Conrad decided to make the stimulus bill stingier in order to better bolster their credentials as preening centrists. When thinking about short-term inflation-unemployment tradeoffs, this sort of thing is crucial to keep in mind. Inflicting a high unemployment rate on the population has incredibly punitive and deleterious long-run consequences for young people.

I think this is pretty wrongheaded. First if you are looking for villains the people who caused the recession would seem better candidates than a few moderate Senators. Second optimal economic policy is not as obvious as Yglesias would have us believe. Third any policy has winners and losers. One could equally say "inflicting a high inflation rate on the population has incredibly punitive and deleterious long-run consequences for old people on fixed incomes".