Monday, March 28, 2011

Comments/Observations on Issues Raised in Today's Session

Here I want to take up some points that were raised by Adam in the discussion of the Naive Investing chapter. Some of these may be controversial (regulate or not). Others I take to just be common sense. Either way I welcome feedback - publicly as a comment to this post or privately by email if you prefer.

On the time profile of the riskiness of the portfolio

Let me use a metaphor to start on this topic. It is a standard idiom to get right back on the horse after falling off. For kids, in particular, you don't want the pain from failure to harden. On the other hand, if a kid is beginning to learn to ride the kid should start out on a gentle pony, not a bucking bronco. The latter is a good challenge for an experienced cowboy. For the rest of us, it is suicide.

If you are an otherwise experienced investor then it is definitely a true statement that when you are younger you should be taking more risk, because there is more growth potential in that. However, if you are not yet an experienced investor it may be prudent to take a rather safe approach to portfolio selection, try to ensure that early investments do pan out, and build confidence based on that experience. As you learn, your tolerance for taking risk will likely increase. You may then experience a failure in your investments but can better take that in stride and keep at the general approach.

On your own risk attitudes

There is a question of whether you know your own attitudes toward risk. Presumably different people of the same age and general size of the portfolio will nonetheless have different degrees of risk in their portfolio because of their own risk preferences. But how do you know what your risk preference is?

I recall a line from the version of A Random Walk Down Wall Street by Burton Malkiel that I read as an Assistant Professor back in the 1980s, to the effect...

...If your investments are keeping you from sleeping at night, your portfolio is too risky.

I subscribe to that point of view, though I've now reached the age where many things keep me up at night, so the test has lost some of its power. It would be nice if there was a different sort of test for a portfolio that is too safe. I don't have a cutesy story for that but I will say you really only learn about your risk aversion after having lost something. It is very hard to understand your sense of risk in prospect without having been previously burned.

On the government provision thing versus laissez-faire

1. I do have the sense that many of you are bursting on this issue. That's fine. It can serve as motivation. But I would ask please the following based on the sense of this Churchill quote.
“It has been said that democracy is the worst form of government except all the others that have been tried.”

In other words, regulation may very well have issues with it. Adam discussed the capture theory in that regard. Below I will provide some other arguments against. Laissez-Faire, however, may also have issues with it. The book discusses disreputable brokers fleecing ignorant investors. Sometimes medicine is a good thing. Other times the cure is worse than the disease. To determine which is which, you have to look at both scenarios, not just one. It's hard to do that, but it is what we should be doing in this class.

2. There is no getting around that you are students at a Public (i.e., government provided) University and that those of you who are in-state residents are also receiving a rather large subsidy on the cost of your education even as you may be paying substantial amounts in tuition and fees. There is also no doubt that the University is a heavily regulated environment operating under Federal regulations like FERPA (my sense of which is that most people view the goals of this as laudable and that mainly we should work to abide by the regulation), State of Illinois regulations like the mandatory filing of conflict of interest statements (again, sensible in my view) and the mandatory annual ethics training (which I believe to be heavy handed and largely redundant for experienced employees), and its own internal regulations like having an add and drop date for course registrations. Presumably you are here because it dominates the other alternatives that presented themselves to you. So this is one case where you seem to be voting for government provision.

3. There are many different ways to regulate economic activity. One is by altering the tax code and creating "tax preferences." For example, there is the mortgage interest deduction. Another relevant example is that income put into approved retirement vehicles can be tax deferred. Personally, I am the beneficiary of both of these. But I want to note that these incentives, irrespective of their other effects, have an income redistribution consequence where the rich are the primary beneficiaries. Richer people take out bigger mortgages so get a bigger deduction. While IRAs and 401K plans have upper limits, people of modest income might not contribute at all in the absence of tax incentive, while people of higher income will surely save some of it so the effect may merely be to move savings around to get the biggest tax benefit and not change overall saving.

On the other hand, people may view already established tax incentives as a more benign form of regulation than having a government agency regulate the activities. So in class today the argument was put as either for or against, but there may be differences in degree. Some of you might be ok with tax incentives but not OK with putting your trust in the SEC.

4. Here let's focus on some specific financial regulation. One is Deposit Insurance provided by the FDIC. For savers this guarantees their account balances when put into insured accounts. For lenders, to qualify for government insurance there is regulation on reserve requirements. These lenders must keep some assets to back up the loans. Note that the existence of this type of regulation may bias investors toward safer assets. A reason to keep your money in a bank instead of under your mattress is the deposit insurance. But you might also keep your money in the bank instead of putting it into other non-insured securities. One argument for deposit insurance is to deter bank panics. My sense is that it has been largely successful that way. Another argument for deposit insurance is to provide a baseline "safe" asset in the system. (Note that if the interest isn't indexed to inflation, these assets aren't fully safe from risk but they are safe from the default risk we discussed in class today.) I believe this to be a relatively uncontroversial regulation.

Let me turn to one where there is/was more controversy, the repeal of the Glass-Steagall Act. I should make two disclaimers here. One, I'm not an expert on Banking or Finance. Two, I thought it was wrong to repeal the act. Now back to the story. In general regulation proscribes certain behaviors. When a regulated entity (like a bank) feels overly restricted by the regulation, the natural reaction is to lobby to undo the regulation. In this case it is interesting to note that Glass-Steagall was finally done in while Clinton was President. But it was a long time in the making. My interpretation of banking is as a two pronged activity - one is pure intermediation - people save in their checking accounts, savings accounts, and CDs, and those funds are lent out for mortgages and small business loans. In aggregate the activity can be pretty safe, especially if the bank as intermediary acts as an honest cop on which loans should be made. The other prong is much more speculative lending - investment banking - primarily for providing capital to startups, which desperately need the cash but which will have a high failure rate. There is no question that investment banking provides an important function, but the reward for making these type of loans has to be large when they do pay off because of the downside risk. So it is more like equity financing, but before the startups are ready for that. Glass-Steagall kept these activities separate. Under its repeal, they were integrated.

5. I promised some other arguments against regulation or at least against further regulation. Here are three.

a) Regulations are hard to remove once they are in place, but the context may change. So even a well-conceived regulation that was appropriate when written may eventually not make sense yet it persists because there is some beneficiary from it and no general outcry against. I'd put the mortgage deduction in this category, for example. Knowing this is apt to happen, it may make sense not to regulate at the outset.

b) We're not that smart or the law of unintended consequences. The Peltzman paper we read makes this point. Intent in design is far from the same thing as consequence. Usually intent is laudable. Consequence may be much less so.

c) The political process may muck things up. The expression half a loaf is better than none simply may not be true with regard to regulation. A strong regulation or total laissez-faire may each be preferred to a weak regulation, which ends up producing the worst of both possible worlds. If true, but political compromise causes weak regulation, one can be for laissez-faire as the best possible outcome.

On an entirely different note, I feel much better now than I did this morning, where I was much better than yesterday. So I hope to engage the future teams more than I did in today's session, but even better would be to see the class do that on its own.

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