The Incidental Economist

A reader sent a link to the following paper. I had no idea.

Abnormal Returns from the Common Stock Investments of the U.S. Senate, by Alan J. Ziobrowski, Ping Cheng, James W. Boyd and Brigitte J. Ziobrowski, Journal of Financial and Quantitative Analysis, 2004, vol. 39, issue 04, pages 661-676.

The actions of the federal government can have a profound impact on financial markets. As prominent participants in the government decision making process, U.S. Senators are likely to have knowledge of forthcoming government actions before the information becomes public. This could provide them with an informational advantage over other investors. We test for abnormal returns from the common stock investments of members of the U.S. Senate during the period 1993-1998. We document that a portfolio that mimics the purchases of U.S. Senators beats the market by 85 basis points per month, while a portfolio that mimics the sales of Senators lags the market by 12 basis points per month. The large difference in the returns of stocks bought and sold (nearly one percentage point per month) is economically large and reliably positive.

Your tax dollars pay those savvy senators for early access to the information upon which they may be trading. Sounds rather unsavory. However, this study was conducted during the pre- or very early internet age. Whatever informational advantage senators have, it’s likely smaller now.

From Monsters in the Market, by Timothy Lavin (The Atlantic, July/August 2010):

Algorithms like Dagger can exploit the smallest inefficiencies in the market. They can parse trades in millionths of a second. Some species can detect other algos embarking on predictable trading strategies, and ruthlessly adjust their techniques. …

By some estimates, algorithms now trigger 70 percent of all trades in U.S. equities. The speed and volume of everyday trading have propelled the market into a new and esoteric dimension, and rendered traders in the pits largely obsolete. …

At least a few high-frequency traders have learned to make a killing by detecting the more simplistic algo strategies deployed by basic pension funds and mutual funds, buying the next stock the funds plan to buy, and then selling it to them at a higher price. …

If the majority of trades racing back and forth are simply lines of code swapping with other lines of code, moved by indicators obscure to even the mortal authors of the algorithms themselves, what exactly is the financial market? “The market structure’s totally changed, and it’s distorted what we do,” says Joe Saluzzi, the co-head of equities trading at Themis Trading and a vocal opponent of some high-frequency strategies. “The machine thinks for itself.”

I don’t have much to say, just this question: in the trading world, do humans still matter?

I used to blog more on personal finance. That’s because it used to occupy more of my interest. Once I got my finances in order and made big decisions about how to save for retirement and kids’ college expenses, how much life insurance to buy, and so forth, there was less to think and write about. Being a Boglehead-style, buy-and-hold, index fund type investor, I don’t need to pay much attention to my portfolio or the markets. An hour or two a few times a year is more than enough and hardly fodder for blogging.

I lost interest in personal finance books too, having read many, including a shelf of textbooks included in Certified Financial Planning curricula. If one is interested in the Boglehead approach, there is really no need to read more than a few books (see my comments on the Bogleheads’ Guide books).

But I heard that Perter Bernstein’s books were different. Less about investing guidance and more about the history of finance, markets, and the theoretical and academic underpinnings of them, they promised a different view of the subject. I’ve just completed his Capital Ideas: The Improbable Origins of Modern Wall Street, and it lived up to that promise. A review at MarketThoughts.com sums it up well.

The book traces the development of Modern Finance Theory, from the first recorded attempt at developing a mathematical theory to explain stock prices (Louis Bachelier’s dissertation entitled “Theory of Speculation” in 1900), to the work of the Cowles Foundation in the 1930s, and, of course, Harry Markowitz’s famous 1952 short paper titled “Portfolio Selection” – all the way to more modern theorists and practitioners, such as Paul Samuelson, Bill Sharpe, Fischer Black, Myron Scholes, Robert Merton … and Franco Modigliani and Merton Miller. Mr. Bernstein weaves his discussions together in one, neat timeline, interspersed with many fascinating stories along the way.

What fascinates me may not fascinate another (and vice versa). But trust me, if you’ve got any interest in finance theory and the history of markets, you’ll be intrigued by something in Bernstein’s telling of the story. One example of something I learned: I had not been aware of the role of portfolio insurance in the October 1987 stock market crash (nor the development of the ideas that contributed to portfolio insurance itself). Actually, there’s some controversy over the extent of that role, which Bernstein explains.

I also found interesting that Markowitz published a 1956 paper in National Research Logistics Quarterly titled “The Optimization of a Quadratic Function Subject to Linear Constraints.” Such an optimization problem is at the heart of the approach I took in my Master’s Thesis and a published paper in which I developed a computationally efficient technique for locating an anomalous region in an image formed from tomographic measurements. (I’d love to read that paper by Markowitz, but I can’t find it online.)

Bernstein has written several other books on the history of finance, some of which I purchased in a boxed set. They’re on my stack. Once I read them, I’ll post my thoughts.

The Finance Buff (TFB) has just published a truly wonderful little book called Explore TIPS: A Practical Guide to Investing in Treasury Inflation-Protected Securities. Nearly everyone should include TIPS in their portfolio. If you’re familiar with TIPS but don’t own any or if you’ve never heard of them, this book is for you.

I read a draft copy of TFB’s book and found it to be an excellent guide to TIPS, covering all important elements efficiently and clearly.

I’m a believer in do-it-yourself tax prep for situations that are fairly simple, as is mine (even with my wife’s small business to contend with). Following my own advice, I just did our taxes in about three hours. Consequently, I am now experiencing my annual post-tax-prep irritation at the complexity of our tax system and the amount of work required to comply. This year, for the first time, I’ll vent it on a blog, any blog. Oh, OK, this one will do.

Actually, with modern software (TurboTax, and the like) it is far easier than ever to prepare tax returns, but still not as easy as it should be. Because I use tax prep software the focus of my ire has shifted from the tax code to the software implementation (the existence of which facilitates tax code complexity, but that’s a different post). I’m rarely 100% satisfied with my software tax prep experience. There always seems to be little things that aren’t explained or don’t feel quite right.

This year, TurboTax nearly tripped me up by not offering to import my mutual fund data until after I had entered it by hand (which wasn’t hard). But when it finally got around to offering importation, which I accepted, I found my taxable events had been doubled, one set hand entered and another imported. Oops! Easy to fix, but sheesh! How many folks are going to catch that one?

I had a few other minor irritations in my encounter with TurboTax this year, but nothing easy to describe in words. So, let’s move on to my second source of annual tax frustration: the IRS withholding calculator and the use of allowances to index withholding.

Look, I have a very simple request to the IRS or Congress: give me the freedom to do withholding my way and in return you’ll get what I owe you with far less error. I know with better accuracy than anyone else in the world what my taxable income will be in the next tax year. I can look at my 1040 from the prior year, make a few adjustments for things I can predict, and voila, out pops a reasonable estimate of my taxable income. Next, I can look up the tax rates and, presto, I know fairly well what my tax will be next year. Call it X. Now, all I want to do is tell my employer how much to withhold from each of my 26 paychecks. This isn’t hard. It’s X/26.

But wait! I can’t just give that number to my employer. I have to convert it into some integer called “allowances.” The method of converting to allowances is complicated and, um, STUPID!!! To make it easier one can use the IRS withholding calculator. Except, that’s stupid too because it is not based on the entries in my prior year’s 1040. It seems as if it is, but it isn’t. For example, they ask you for your expected wages and your 401(k) contributions. That’s, must I say it again, STUPID. It takes far more work to figure that out than to just look up your taxable wages on your prior year’s 1040 (and then inflate that a little if you really want to).

Also, the withholding calculator has no way of handling self-employment income and the sundry deductions one gets for a small business. Guess where all that information is? ON MY LAST YEAR’S 1040!!! So, thank you very much IRS, but you’ve found a way to make a very simple thing–something I can do in my head–nearly impossible to do half as well and for no good reason.

I know I’m going to get a lot of advice on how to do this in a less frustrating way. Good, give it to me. I want it. And Uncle Sam should want me to have it because the biggest source of error in my tax withholding is due to the cockamamie ways the IRS offers to help me calculate it. And somebody please tell me why withholding allowances make sense. Can’t do it? How about just tell me the formula that converts allowances to dollars. Now that would be helpful!

By middle age or thereabouts, it is a good idea to know a bit about each of several issues relevant to retirement planning other than investing. The relevant topics include estate planning, annuities, social security, health insurance, among others. Knowing a bit about each will help one know which applies to one’s situation and when to learn more. Removing the unknown unknowns is a good idea.

Enter The Bogleheads’ Guide to Retirement Planning. In 20 chapters–each roughly 16 pages–it covers all the essential topics relevant to retirement planning, not just investing. Therefore, before you or your spouse is ten years from retirement The Bogleheads’ Guide is recommended reading (assuming you’ve already had a sound retirement investment plan for decades).

The Oblivious Investor reviewed The Bogleheads’ Guide last October and I agree with his broad sentiments:

I’ve read books that are intended to be “all you need to know about personal finance.” And I’ve read books that are intended to be “all you need to know about investing.” But The Bogleheads’ Guide to Retirement Planning is the first book I’ve read that’s “all you need to know about planning for retirement.” Note the distinction: This book is not about saving/investing for retirement. It’s about planning for retirement (and everything that’s a part of such planning). The best part about the book, in my opinion, is the breadth of topics covered.

Of course, each topic is treated rather briefly so one would need to turn to other sources for details. (Indeed, it doesn’t suffice as a guide to investing, but the other Boglehead book, The Bogleheads’ Guide to Investing, nicely fills the role.) Each chpater of The Bogleheads’ Guide to Retirement Planning ends with a list of further reading so it serves as a guide to the broader literature as well.

It was a particularly fun read for me because I know (in a sense) some of the authors through their participation on the Bogleheads Investment Forum. A few of them have a had important impacts on my own investment planning, notably tfb (of The Finance Buff) and EmergDoc (Jim Dahle). Another nice touch is that the book includes a chapter on dealing with financial disasters. Since a good portion of the population will face one (divorce, bankruptcy, and the like) it makes sense to be armed with a bit of information about what to do, if only to have a good idea of where to turn for help.

I did find it rather amusing that most chapters include the boilerplate advice to consult a paid professional. That’s odd coming from the Bogleheads who are notorious do-it-yourself-ers. Many readers and most full-blown Bogleheads will not need a professional to assist with some areas, like investment planning or taxation issues. All they need are some good books and a good place to find the details, like the Bogleheads Investment Forum. Seeking professional advice makes good sense for almost everyone in some areas for which legal precision is required, like estate planning.

In conclusion, my recommendation is that young investors read The Bogleheads’ Guide to Investing. That’s all one needs for retirement investment planning, though there are other good books too (many reviewed by The Finance Buff). As retirement approaches, or earlier if you’re just interested, complete your base of knowledge with The Bogleheads’ Guide to Retirement Planning.

Conventional wisdom is that we all should have an emergency fund (EF), a chunk of cash (or equivalent) set aside for use when financial trouble strikes. When employment prospects are good, I’ve seen recommendations for EFs as low as three months of salary. In times of high unemployment, some recommend EFs as large as one year’s worth of salary.

These are seat-of-the-pants estimates. If anything they’re based on how long it might take you to regain employment after loss of a job. But income replacement isn’t the only purpose of an EF. One might tap it in the event of any financial emergency (e.g. unexpectedly high health care costs, urgent home repair, etc.). My interest in this post is to explore a rational means by which to set one’s EF size. It is based on the work by Charles Hatcher, summarized in a prior post. (See also the Bogleheads Forum discussion of Hatcher’s methods.)

In Should Households Establish Emergency Funds? Hatcher compares the opportunity cost per year of having an emergency fund (the difference in rates of return between a more aggressive investment and that of the EF cash equivalent holding, denoted by the liquidity premium) with its per-year benefits if an emergency occurred (the avoided borrowing costs). The result is a simple expression for the minimum probability, p,  of an emergency in a given year such that holding an EF is rational: p=(r₂-r₁)/r_b, where r₂ is the rate of return on investments, r₁ is the rate of return of one’s EF, and r_b is the borrowing rate (Hatcher suggests a APR/2 is a good estimate of the borrowing rate).

Hatcher assumes that the EF is equal in value to the cash needed in an emergency so the expression of the probability of rationally holding an EF given above is independent of EF size. That provides an opportunity to use it to determine a rational EF size as follows. If we interpret p as the lower bound on the annual rate of emergency such that an EF is rational we can ask: what is a typical size for an emergency that occurs with at least that frequency? The answer to that question provides some guidance to the rational EF size.

Let’s use a concrete example. Suppose borrowing costs are 18% APR, which is typical of some credit cards but much higher than a home equity loan. Then r_b is about 18%/2 = 9%. Suppose also that the liquidity premium is r₂-r₁ = 2% then the probability of an emergency must exceed about 22% to justify an EF. That’s about one emergency every five years. Based on one’s own experience one might have a general sense of the size of an emergency that’s likely to occur at that rate. I certainly do. For me this would suggest that an EF no larger than two months of salary ought to be sufficient. Of course, my borrowing costs may be even lower and liquidity premium may be higher. So maybe I could get buy with an even smaller EF.

Instead of relying on my own intuition of typical emergency size over some time period, I’d love to see a study of such a thing. For example, an analysis of variation in monthly household outflow relative to income as a function of important variables like household size, age of head of household, education, and other relevant economic and demographic variables would be useful. From such a study one could estimate various measures of the likely largest emergency that would occur over an interval of time.

I think the foregoing approach is one reasonable place to start in determining a rational EF size. But I wouldn’t end here. I’m not convinced one can know one’s borrowing costs and liquidity premium at the time of an emergency. The former could be higher and the latter lower, suggesting an even higher EF is rational. That’s one reason to increase one’s EF beyond the size suggested above. Another reason is peace of mind. There is no law against being irrationally conservative. Sleeping well at night is worth something.

In a NY Times Economix post last November David Leonhardt interviewed Sandy Baum, an economist at the College Board and lead author of the its annual report on college tuition. Baum said several things about the amount of grant aid (as opposed to loans) available to offset the rapidly rising college sticker price.

The majority of students receive some grant aid. According to Baum, two-thirds of full-time college students receive some grant aid and 80 percent attending private institutions do. All that aid reduces the effective price considerably.

The average grant aid for full-time public two-year college students is more than enough to pay the $2,544 published tuition price. So the average net tuition price at these schools is actually zero. At public four-year colleges the average net price is about $1,600 (compared with a list price of $7,020). At private four-year colleges, it’s about $11,900, compared with a list tuition price of $26,273.

These prices don’t include room and board or other costs.

Grant aid has been rising faster than college tuition recently so the net price has been dropping for those receiving aid. Not all the grant money is distributed based on need. Some is distributed on merit. So even if you’re reasonably well off you may not pay full price.

At public four-year colleges, about two-thirds of the institutional grants awarded are non-need-based. And of course, federal tax credits and deductions go primarily to middle- and even upper-income students and families.

For more from the NY Times on college admissions and aid see their The Choice blog. Leonhardt suggested these three posts in particular.

It is a shame that markets for the most important services (health, education) also have the most opaque pricing. At least when it comes to college, the price is likely to be lower than we fear. The same cannot be said for health care.

This year is my family’s costliest one for child care. With two children in paid care arrangements we’re really feeling the pinch. It doesn’t help that we live in the costliest state for child care, according to The National Association of Child Care Resources & Referral Agencies report Parents and the High Cost Price of Child Care: A 2009 Update. Fortunately, things will ease up considerably next year when our oldest enters kindergarten and our youngest enters our town’s (paid) public pre-school program, which is far cheaper than day care.

Day care costs and arrangements are insane in this country, at least that’s our experience. We’ve attempted to keep costs reasonable and tried lots of different arrangements. But it has been a crazy patchwork quilt. Since turning one, our older daughter has been in four day care/pre-school settings and both our children have had a half dozen different nannies or baby sitters.

We’ve changed providers so much in part because our family’s needs have changed and in part because of quality issues. A shockingly small percentage of providers we’ve tried impress us. We’re delighted that our town’s public pre-school program is an exception. It is very impressive and has been the highest quality early childhood education our older daughter has experienced. Bravo!

One other bit of insanity associated with child care is the web of cash flows. Take our younger daughter’s current arrangement, a nanny share with another family. There are nine different financial entities involved in flow of money from the families to the nanny:

• Three bank accounts: one for each family, one for the nanny,
• Two employers, each with two dependent care flexible spending accounts (I’m counting this as four entities),
• Two governments: federal and state, for collection of payroll and income taxes, unemployment and worker’s compensation fees.

It is a stunning amount of paperwork and shuffling of money for the care of such a cute, tiny being.

Sometimes I wonder why child care in the U.S. is so complicated and inconvenient. Every parent goes through several years to a decade dealing with it. Few like it. Hardly any I know find it sensible or easy to manage. Nearly everyone thinks it is expensive. It sucks, and it sucks for everyone.

One hypothesis why it doesn’t improve is that parenthood is just so darn exhausting and the demands are unrelenting. Plus, by the time you’re through with it anything you do to improve it won’t affect you. Day care is just one of the earlier challenges of parenthood, but no where near the last. When my kids are through with day care I’ll probably behave just like most other parents who dealt with it: put it behind me, try to forget about it, and not lift one damn finger in trying to fix it. I’ll be too busy dealing with the problems of primary and secondary education, among others. They’re messed up too in their own special ways.

The Obama Administration is looking for ideas in the area of taxing financial transactions. Ezra Klein asked for thoughts. Even though I haven’t read deeply into this area (*) I have an idea to share. I would not be at all surprised if it has already been proposed or considered by those more knowledgeable in this area than I am. Nevertheless, here goes:

We already tax financial transactions in a way via short- and long-term capital gains, the cutoff between the two being one year. If a policy goal is to reduce high-frequency trading I have two ideas that build on the current tax framework: (1) Include a “very short” category with, say, a cutoff of a quarter year, or month (or whatever makes sense to the folks who really know this stuff). This very short category could have, though need not have, an even higher capital gain tax rate than the current short-term one does; (2) Eliminate the ability to write off short-term (or very short-term) capital losses. Ideas (1) and (2) need not be combined.

A third idea is to remove the taxation exemption from otherwise tax preferred accounts (401(k)s, IRAs, 529s, etc.) but only for very short-term trades. I can already hear the howls on this one as it might be characterized as the first step down the slippery slope toward elimination of tax advantaged vehicles. Still, if we want to provide an incentive for buy-and-hold, we can’t ignore tax advantaged accounts, can we? High-frequency trading can be done under those vehicles so why should they be exempt?

The point here is not to penalize everybody who wishes to participate in the market, but to make some (perhaps crude) distinction between types of market behavior. We already do this, as I said, so why not build on it?

What do readers who know finance better than I do think? (TFB, Mike, others?)

(*) This disclaimer serves as notice that this is a deviation from my M.O. You’ve been warned!

Note: I added the paragraph about tax advantaged accounts in a later update to this post.