Practical Economics

The Economics of Voting and Governance

2007-12-22T22:11:00.000+08:00

In a recent paper (2007), Economist Douglas A. Hibbs Jr. ran an Econometrics analysis and plotted this graph:

The interpretation should be obvious: Higher economic growth = More votes for politicians currently in power.

Read the paper here:
http://www.douglas-hibbs.com/HibbsArticles/QJPS_%202007.pdf

Do the rich get richer?

2007-11-27T21:59:00.000+08:00

Source: http://www.realclearpolitics.com/articles/2007/11/the_transient_income_classes.html

Books that purport to teach people the "secrets of the rich" should take a course in Econometrics (Economic Statistics).

Quote:

Americans in the top one percent, like Americans in most income brackets, are not there permanently, despite being talked about and written about as if they are an enduring "class" -- especially by those who have overdosed on the magic formula of "race, class and gender," which has replaced thought in many intellectual circles.

At the highest income levels, people are especially likely to be transient at that level. Recent data from the Internal Revenue Service show that more than half the people who were in the top one percent in 1996 were no longer there in 2005.

Among the top one-hundredth of one percent, three-quarters of them were no longer there at the end of the decade.

These are not permanent classes but mostly people at current income levels reached by spikes in income that don't last.

Note:

Warren Buffett and Bill Gates seem to be up there for a very long time.

The Tragedy of the Commons

2007-11-22T21:36:00.000+08:00

Based on an article on Real Clear Politics: LINK

Isn't sharing wonderful?

The first European settlers in America certainly felt so. Their farm economy was set up according to the principle of sharing everything equally: everyone worked on public land and split the harvest equally. With such grand visions of teamwork and kinship there has to be only one outcome...

They nearly all starved.

One of the principles of Economics is that people are driven by incentive. If people get the same reward from putting in a small amount of work as with a large amount, they will chose to put in a small amount of work. This is exactly what happened to the settlers as they faked illness, make little effort and even stole. Total production felt below what was required and a famine resulted.

The first Americans certainly learned their lessons in Economics: Once farmland were divided so that each person had to grow his own crops, they ended up with a huge surplus.

Hence, America held its first Thanksgiving.

The Economics of Gender

2007-11-03T00:30:00.000+08:00

"Violence, learning, and the gender divide" By Edward L. Glaeser (Professor of Economics, Harvard University)

In the United States:

Men are more than 8 times as likely as women to commit murder.

Men are more than 50 times as likely to engage in a gang-related killing.

84 percent of all violent crimes are committed by Men.

Young men are 4 times more likely than Women to carry a gun.

94 percent of suicide bombers are Male.

Men are 5 times more likely to commit suicide than Women.

90 percent of those incarcerated for crimes are Men.

"Principles of Criminology," notes that crime rates for men greatly exceed those for women "for all nations, for all communities within a nation, for all age groups, for all periods of history for which reliable statistics are available, and for all types of crime except those peculiar to females."

The Economics of Marriage

2007-10-14T13:40:00.000+08:00

The Economist ran an rather interesting article on marriage:

http://www.economist.com/world/na/displaystory.cfm?story_id=9218127

MORE EDUCATION LESS DIVORCE

The first finding was that education is negatively correlated with failure in marriage. That is, the higher your education level, the less likely you will divorce your partner.

Based on my many years of experience (translated: zero experience), my hypothesis is that people who obtained higher education levels tend to spend more time in school and thus marry later than those who achieved lower levels of education. Hence, they are more likely to know what they want in a partner and have less tendency to marry on impulse. I am sure it is generally agreed that people are more likely to know what they want at the age of 24 (undergraduate/postgraduate) than at 18 (high school).

Note that the data for PhDs is missing. :)

MORE EDUCATION, LESS SINGLE-PARENTHOOD

The second finding was that children raised by single mothers tend to have mothers of lower education levels. That is, the lower the education of the female, the more likely that she will become a single parent.

This is probably an implication of the first finding.

Do we suck at picking investing strategies?

2007-10-02T12:40:00.000+08:00

Or why is it so hard to prove that winning methods works and losing methods sucks.

This article serve to highlight what i think is the fundamental problem of investing. It is probably also the source of the biggest fallacy currently circulating around the investing world. (the fallacy that past performance is a definitive indicator of future performance)

The problem can be stated simply as such:

Failure to take into account the existence of probability.

THE CULPRIT

"It made money, therefore it works."

Shockingly, I have heard this being used as a justification for investment decisions. The issue with this is: past results tells us nothing about future performance. To see why, imagine an asset that has performed well in the past. To many investors, this will be deemed as a "good investment" simply because of its history. However, if we stop to think for a moment we might realize that there might have been two possible scenarios:

1) The asset is good and therefore past performance is good.
2) The asset is bad but performed well in the past by pure chance.

How can we tell which one is true?

Even if there are "good reasons/fundamentals" for the asset to perform well, how do we know if these reasons and/or fundamentals are not painted on after the fact? What if a good asset, despite having good fundamental attributes, continue to perform poorly due to chance? Is it a failure of our fundamental criterion or is the asset "bad" to start with?

Can we ever really tell?

STATISTICS 101

To illustrate how probability distorts investing decisions in the real world, lets suppose we have a very lousy mutual fund manager. Lets call him Bob.

Bob really sucked at fund management: 70% of the time, he end up losing money overall for the year. 30% of the time, he beats the market for the year. Would I invest any money in him? No way!

However, Bob beats the market 30% of the time. This means that he has a 0.81% chance of making money 4 years in a row. Out of 125 fund managers like Bob, there is likely to be 1 who shows a stellar track record of 4 consecutive winning years.

Investors might then see advertisements that say:

Make your fortune with Bob's Fund, the premium investment vehicle with an excellent track record of 4 consecutive market beating winning years!

Will investors who placed their bets on Bob necessarily lose in the coming year by virtue of him being a bad fund manager? It need not be so. Bob still have a 30% chance of making a profit.

And then advertisements will say: "5 years of excellence in fund management".

Are stock prices unpredictable?

2007-09-20T21:18:00.001+08:00

"Surely, one of the best-established facts in economics is that changes in stock prices are essentially unpredictable. And just as surely, this fact is one of the least believed and most disliked."

- "Macroeconomics" by Dornbusch, Fischer and Startz.

There are many practical economic evidence that suggests speculators cannot make supernormal profits by predicting the direction of stock prices. Some of these have been around since the 1960s but remain largely unknown to the general public.

I shall try to explain one such piece of evidence.

"TIME SERIES ECONOMETRICS"

Regression analysis is a popular statistical method used by many scientists to detect relationships between phenomenas. (Like the link between smoking and lung cancer for example.)

This is a chart showing the relationship between values of the S&P 500 index one month ago and its current values:

(Source: "Macroeconomics" by Dornbusch, Fischer & Startz)

A straight line can be drawn roughly joining all the points on the chart. In fact, all the data points are clustered around this line so much that they look like a smear of black ink blots. Statisticians call lines like that "very good fit on the data". But what does this mean? It means that there is a very powerful link between the past values of the S&P and the current value.

THE EQUATION

An equation can be written to show this relationship mathematically:

"P(t+1)" stands for current stock prices. It can be explained by three factors: "a" is the expected return to holding stocks. "P(t)" is last time period's price. "e" represents the unpredictable random errors that resulted in the "ink blot smear" we observed in the previous diagram. (without the random error, all the data points would have formed up in a smooth line by themselves)

The equation shows a process known to statisticians as a "random walk" or more precisely, a "random walk with drift".

Implications of the equation:

P(t+1) - P(t) = Change in Stock Price = a + e

Hence, other than the very small "a" component, the changes in stock price can be attributed to the unpredictable "e". (Which is relatively small, as seen by how close the data points are from the line.)

Also, changes in stock prices are independent over time: If stocks did well last month, they are no more likely to either do well or do poorly this month than at any other time.

TO BE OR NOT TO BE

The conclusion I formulated from reading such practical evidence is that while stock picking might still be possible, it is unlikely to be an easy source of profit for the common man.

Readers are advised to come to the same conclusion.

The Economics of Saving the World

2007-09-19T01:53:00.000+08:00

Sometimes, Economics can help save the world.

Exhibit A

Problem:

Environmentalists alerted the world about the rising level of pollution. Countries come together and decide that each of them should reduce greenhouse gas emissions by a common amount.

However, developing countries argue that wealthy developed countries emits most of the pollution and therefore should bear the responsibility. To make poor countries reduce emissions would hamper their efforts at industrializing and catching up to the living standards of rich countries.

Negotiations then fall apart.

Solution:

Economists invents tradable "Pollution Permits" that allocate a fixed amount of emissions to each country. The global amount of emissions allowed can be set to shrink every year.

This way, poor countries are given the option of either selling their emissions allowances or using them to set up industries. They benefit either way.

Through the market mechanism, global pollution abatement takes place at the cheapest location. (Countries that find it cheap to avoid polluting will do so and sell excess emission allowances to countries that find it expensive to avoid polluting.)

Exhibit B

Problem:

Diseases like malaria and AIDS plagued poor third world countries and hamper their growth. The United Nations and World Bank estimates that malaria alone slows down GDP growth by more than 1% a year. (Elimination of malaria 35 years ago would have given Africa a $100 billion boost in GDP.)

Pharmaceutical companies do not have enough incentives to invest in expensive and risky research projects to produce new vaccines because of the low returns and high risks.

It is clear that healthier and more prosperous third world countries benefits everyone globally both in terms of lowering the risk of global epidemics and increasing international trade. But who should foot the bill? And how do we ensure that funds are being used efficiently for research of new medicines?

Solution:

Economics to the rescue: Governments of rich countries set up an international agreement to guarantee the purchase of a minimum amount of any effective vaccines.

This agreement costs rich countries nothing until an effective vaccine is found. Pharmaceutical firms have an incentive to enter the market due to the large potential profit to be made. They would want to succeed because they get nothing otherwise. (As opposed to receiving subsidizes or research grants.)

(This article is based on the wisdom imparted by the book: "Sex, Drugs & Economics")

Are wines bad investments?

2007-09-15T01:12:00.000+08:00

I always wondered if there are any economic research regarding wine investing. (among other interesting things like marriage, which i think is akin to "investing" in people) As it turns out, there had been several economic studies on wine investing in the past.

This blog post is dedicated to listing these research.

WHAT THE EXPERTS SAY

Below are links to journals containing the research done on wine investing. Access to most of them are restricted from non-subscribers but an excerpt of the findings can be read for free. I have written a few lines summarising the findings for each of them but readers are strongly encouraged to read the excerpt for themselves.

Excerpt from: The Rate of Return to Storing Wines (1979)

In the journal "The Rate of Return to Storing Wines", the author conducted empirical studies which suggests that the rate of return for investing in wine is no larger than investing in riskless assets. (Government bonds etc)

Excerpt from: Wine as a medium term investment vehicle (1978)

The journal "Wine as a medium term investment vehicle" look into the prospects of investing in wine. After tabulating the yield of wines sold in auctions, they concluded that investors are better off drinking the wine than investing in them.

The Rate of Return on Investment in Wine (2001)

This "recent" research concluded that wine does not yield greater returns than financial assets like stocks and bonds. This finding was further accentuated when volatility of return and transaction costs are accounted for. The methods used here appears to be pretty sophisticated!

THE USEFULNESS OF VINTAGE CHARTS

An interesting piece of research showed up during my search.

Dr Roman L. Weil, a professor of the world renown Chicago Business School and also Co-Chairman of the Oenonomy Society of the US, discovered in his experiment that wine tasters cannot differentiate the quality of wines as shown by the vintage charts. Those who could do so produced judgment that differ from those expressed by the charts.

The Death of the Vintage Chart (2001)

The link above links to a PDF file containing the research journal. It is free to download and read for all.

CONCLUSION

So are wines good investment?

There fact that there exist economic studies that find wine to be poor investments raises some interesting questions. The apparent ineffectiveness of the vintage charts further raised more alarms.

Wine investing is certainly not a simple and straight forward affair.

The Value of a Good Education

2007-09-12T21:43:00.001+08:00

INTRODUCTION

What is the value of a good education?

Intuitively, we know that having university certification is important in finding employment that pays well. But is our intuition correct? As it turns out, some economists thought the same way and dug up enough data to make some basic deductions regarding the matter.

MOTHER KNOWS BEST

The United States government conducts censuses on the various characteristics of its citizens. Among these are education and wages, which they have kindly assembled together in one chart:

(Source: United States Department of Labor, Bureau of Labor Statistics)

It would appear that, in the United States, income is highly correlated to the level of education. I suspect the same phenomenon to also exist in other countries. So our mothers were right in their preachings after all!

NO MONKEY BUSINESS

A MBA (Masters in Business Administration) certification is very sought after for its perceived ability to increase wages, especially (and probably only) if it comes from a well known business school.

This chart shows the effect of obtaining MBA certification on salaries:

(Click image for a clearer view. Source: http://www.businessschooladmission.com/mbasalaries.php)

Wages appear to have risen after obtaining MBA certification. Some as much as 211%! Hence, the perceived value of a MBA seems to be valid.

CONCLUSION

Higher education levels does not guarantee higher wages. However, the data suggests that higher education levels is correlated with higher wages. So far the data supports my intuition: attaining higher education levels will increase a person's chances of earning higher salaries. It should be noted that no data on MSc (Masters of Science) and PhD (Doctor of Philosophy) was presented in this article.

I shall leave readers to draw their own conclusions regarding the value of education.

Is stock index investing a sham?

2007-09-08T00:14:00.001+08:00

A common piece of financial advice is to invest some money in the stock market.

But I have often asked myself: "Why should this be good advice?"

Stock indexes have always been an indicator of the broad market movements that affects all stocks simultaneously. Mutual fund managers traditionally compare their performance against that of a stock index. Hence the term "beating the market". Around forty years ago, some very intelligent people thought it will be easier to start a fund that mimics the performance of stock indexes instead of trying to beat it.

And this was how index funds came about.

However, the whole deal about "investing in the market" hinges on the crucial assumption that the stock market tend to go up over time. How can I be sure that this remains true in the future? I thought it would be wise to look at the data.

AN APPLE INC. A DAY

The S&P500 is one of the most popular stock index in the financial arena. Consisting of 500 stocks of mostly US companies, it serves as an indicator of how the world's largest economy is doing.

Performance of the S&P500 from 1980 to 2000:

(Click image for a clearer view. source: yahoo finance)

It is not hard to see why investing in stock indexes is so compelling. In the 20 years between 1980 to 2000, the US stock market has experienced impressive growth.

THROUGH THE LOOKING GLASS

The performance of the S&P500 during the years 1998-2007, however, paints a difference picture:

(Click image for a clearer view. source: yahoo finance)

If this chart consists of the lifetime performance of the stock index, i don't suppose many investors would agree that stock index investing is a good idea!

Joining the two charts together, we get a view of the entire history of the S&P:

(Click image for a clearer view. source: yahoo finance)

The uncertainty about the S&P's future performance is clear:

Given the run up in stock prices during the period of 1980 to 2000, I might be tempted to conclude that investing in the stock index is a good idea. However, the volatility of the S&P in recent years does not appear to support that notion. Volume too has risen considerably during recent years (lower part of the chart). Is this an indicator that the markets have changed?

Could the returns of the past be a statistical illusion? Or will it persists into the future despite the recent changes in the performance of the index?

A FALLING INDEX IN THE LAND OF THE RISING SUN

Japan is the world's second largest economy, behind the United States of America. (in terms of nominal GDP) The Nikkei225 is a stock index comprised of Japanese stocks. It is the most watched index in Asia and has a well populated futures market.

This chart shows the performance of the Nikkei225 over the last 23 years:

(Click image for a clearer view. source: yahoo finance)

Surprisingly, stock index investing never worked for the Nikkei225 even as the Japanese economy is growing. For example, if i had invested in the index at its peak in 1990, i will still be stuck with a net loss 17 years later today!

How do I know whether the same thing would happen if I try to invest in other, more optimistic looking indexes?

CONCLUSION

Scottish philosopher David Hume once said that if all the swans we saw were white, we would conclude that all swans are white until we discover Australia and find black swans. Likewise, I have always assumed that stock indexes tend to rise in the long run (and hence are great long term investments) until I saw data on the S&P and that of the Nikkei225.

So is stock index investing a sham? Given that many economists, including Nobel Prize winners, advocate a index fund approach to stock investing, I certainty wouldn't dismiss it as a sham!

However, the data presented in this blog post does raise some interesting questions.

P.S.
Please don't take the title seriously. :)

Why most teenagers don't act like economists

2007-08-31T23:36:00.000+08:00

Dr Diane Coyle (PhD Economics, Harvard) has some interesting ideas in her book "Sex, Drugs & Economics". One of this is the analysis of why teenagers tend to be irrational risk takers: unprotected sex, illegal drugs, tobacco, alcohol, fast cars, gang violence, night lives, the list goes on.

This seems to run contrary to the basic assumption of economics: that people make choices that benefits themselves. So much of what young people do are clearly not in their best interests, despite them knowing the risks involved. (The author says evidence from psychology shows teenagers to be as aware of the risks as adults are.)

BEHAVING LIKE ECONOMISTS

The principles of economics still applies to risky choices. This is evident by phenomenon such as the fall in the demand of tobacco or marijuana after their prices have risen. Dr Coyle argued that the difference between adults and teens is their risk preferences; apparently, teens are a lot more willing to take risks.

Outlined in her book are several characteristics suggested by the branch of Behavioral Economics to explain the excess willingness of teens to take on risks:

1) Time Inconsistency

There exists a strong human preference for immediate gratification at the expense of future satisfaction. In simple terms: the outcome we prefer now is not the same as what we would have preferred when we get to the future. For example, drug addicts cannot stop the allure of short term gratification but would prefer not to indulge in drugs in the future. The same thing may be said of smokers. (May I suggest marriage as another case study?)

2) Projection Bias

It was also noted that humans are very bad at predicting how they will feel about different outcomes in the future. To loosely quote the author: the young might not appreciate that a steady job and nice home will seem more appealing at fifty than hanging out on the street corner smoking dope with friends.

Evidence shows that young people have a stronger preference for immediate gratification and are not so good at predicting their future preferences as older people. Dr Coyle explains that older people might have the upper hand due to the greater amount of life experiences they possess. As such, teens suffer from a shortsightedness that results in the overindulgence of risky behaviors.

3) Diminishing Marginal Sensitivity

Decreasing values will generally be attached to additional increments of income or other indicator of well-being. For example: An increase from $100 to $200 is valued much more than an increase from $1100 to $1200 even though the increase is the same in both cases. When framed in the context of the risks involved with risky actions (like taking drugs), it implies that people can greatly underestimate the risks of their actions every time except the very first attempt.

THE POINT OF IT ALL

While Dr Coyle agrees that being able to model their behavior will not help much in persuading adolescents not to take silly risks, it could help answer policy questions with regards to preventing/controlling destructive behaviors.

Personally, I think this area of study have tremendous potential in the science of parenting and government policy making. After all, teens are economic agents driven by incentives.

Just like everyone else.

I support Global Warming

2007-08-25T00:42:00.001+08:00

To state for the record: I am not announcing to the world that I support Global Warming. The title was in fact a gimmick to seize your attention. Economics has always been notorious for meddling with the affairs of other disciplines. Yes, even climate change isn't spared from its tenacious tendrils.

The media has been pretty aggressive when it comes to reporting Global Warming. It didn't help that Al Gore, the 45th Vice President of the United States, produced the excellent document "An Inconvenient Truth". I was completely sold on the idea of Global Warming.

Until it hit me that I haven't looked at the data.

Data can be misleading if the statistician is selective. (Recommended reading: How to Lie With Statistics by Darrell Huff) Enter exhibit A: Global temperatures in the last 150 years.

(Source: http://www.globalwarmingart.com/)

From this chart alone, things look pretty bad. Temperature levels appeared to be shooting through the roof.

Lets zoom out a bit and look at things over a greater scale. Advances in Paleoclimatology has allowed us to take a peek at global temperatures over the last 450 thousand years.

(Source: http://www.globalwarmingart.com/)

We are currently at "0" on the x-axis. The blue and green lines are the temperatures tabulated at two research stations in Antarctica. (EPICA and Vostok)

Suddenly things doesn't look so bad. Global temperatures have actually reached higher levels more than once in the past.

To take it to the extremes, we can zoom out to a scale that span over 540 million years!

(Source: http://www.globalwarmingart.com/)

When viewed from this scale, the Earth seems to be in danger of Global Cooling instead! Global temperatures levels are currently pretty deep into the "cold" end of the chart, relative to the Earth's past temperature levels.

NOT SO SIMPLE CONCLUSION

The lesson I learnt from examining historical data of global temperature levels is not that "Global Warming is false". Rather, I have seen the ways in which information can be warped by the use of scale: The price of a stock can appear to be hitting new highs when viewed on a scale of a year while actually hitting rock bottom levels when viewed on a scale of 10 years.

However, for those interested in the argument against Global Warming, there are some excellent resources on the internet:

http://en.wikipedia.org/wiki/Global_warming_controversy
http://www.aproundtable.org/tps30info/globalwarmup.html

As for me, I prefer to remain neutral about the topic. :)

Are HDB flats long term investments?

2007-08-24T15:03:00.001+08:00

HDB = Housing and Development Board. It is the institution that govern public housing in my home country of Singapore. Public housing are known affectionately as "HDB flats" by Singaporeans.

I have always harboured the notion that HDB flats will increase in value over time. After all, the population is always on the rise while land space is severely limited in Singapore. And then we have inflation: an increase in the general price level will include the prices of public housing doesn't it?

A PRELIMINARY SKIRMISH

A search on HDB's website reveal that they do in fact tabulate the historical prices of HDB flats. This information is constantly updated and free for all to view. Reproduced below is the chart depicting the average price levels of HDB flats across the country from 1st quarter 1994 to 2nd quarter 2007.

(Note: numerical info in the picture might be fuzzy. check the source at Housing & Development Board of Singapore)

Other than the Real Estate boom and bust during the 1994 to 1998 era, the average price level appeared to be relatively flat in the last 10 years.

LONGER VIEW

HDB's website contain data of price levels all the way back to the 1990s. Below is a chart plotted using the data for 1st quarter 1990 to 2nd quarter 2007.

The source of my impression regarding public housing prices becomes clear: there appeared to be a public property boom between the period of 1st quarter 1992 to 1st quarter 1997. Growing up in Singapore during this period might have fostered in me the notion that public housing makes excellent long term investment

The long term view brings several questionable points to my long held belief:

1) Given that for the last 10 years (1997 to 2007) public housing prices have been relatively stagnant, can I expect the performance of the 5 years between '92 and '97 to continue into the future?

2) Should I depend on historical information to infer future trends? Like the British philosopher Karl Popper once argued: If all the swans one have seen so far are white, can one thus infer that no black swans exists?

The best way to do charity is to get a PhD

2007-08-22T16:38:00.001+08:00

I am beginning to think that the charitable act that could generate the most impact is the dissemination of information. That those who wish to commit themselves to altruism would do the most good going for a PhD and contributing to the advancement of science.

There is one frightening example of how knowledge can save lives. I was first exposed to it through a bestseller that deals with applied statistics but ran into it again in an introductory statistics class in recent years and was surprised at tepid response it generated. (Indeed, this example appears to be very common in introductory statistics classes.)

I shall present the example in story form below.

A TALE OF ONE CITY

A volunteer doctor arrives at a town with a population of 100,000 people. Suppose that studies shows around 0.2% of the population living in a town like this is HIV positive*. To improve the welfare of the villagers, the doctor decides to conduct a free village wide HIV screening.

The Elisa test is a common test for AIDS. It has a sensitivity of 0.998, which means that 99.8% of the people who are HIV positive will be identified as such. The test also has a specificity of 0.998, which means that 99.8% of the people who are HIV negative will be rightfully identified as so.

If you are one of the town folk and the test shows that you are HIV positive. What is the chance that you are truly HIV positive? What is the chance that test has wrongly diagnosed you when you are in fact healthy?

The answer is 50% percent.

BORING FIGURES

For those interested in the details, the results of the mass screening conducted using just the Elisa test is as follows:

100,000 population

People who are truly HIV positive = 0.2% x 100,000 = 200

People correctly identified as HIV positive = 99.8% x 200 = 199.6

People who are truly HIV negative = 100,000 - 200 = 99,800

People who are identified falsely as HIV positive = 0.2% x 99,800 = 199.6

Total number identified as HIV positive = 199.6 + 199.6 = 399.2

Hence, if you are tested positive for HIV, you either belong to the 199.6 who are truly HIV positive or the 199.6 who are identified falsely as HIV positive. There is a 50% chance of either being true.

AN UNSETTLING CONCLUSION

To be diagnosed as having an illness when you are healthy is known as a "false positive". The issue of false positives have been plaguing the medical community for as long as there were doctors. This was especially critical with regards to AIDS screening where some people who are diagnosed with AIDS chose suicide. Given that the probability of a false positive can reach 50%, the number of lives lost due to suicide or mistreatment can be substantial.

The HIV test oddity is well known and probably poised much less of a problem now than when it was first brought up. However one can't help but wonder about the oddities that we don't know about.

Imagine the standard of living mankind could be having if it was common to run research on matters such as the above (but not limited to any one field or subject) and that the results were widely understood.

*Actual studies shows that 1% of the world population aged between 15-49 is HIV positive.
(Source: UNAIDS, 2006 Report on the global AIDS epidemic)

Hedging

2007-08-22T00:32:00.000+08:00

The dictionary definition of "hedge" is as follows:

To protect oneself financially:

a) to buy or sell commodity futures as a protection against loss due to price fluctuation
b) to minimize the risk of a bet

(Source: Merriam-Webster dictionary)

Though the dictionary definition is simple, it doesn't really tell us much about the concept of "hedging" in financial economics. There isn't really much to it. However, I have encountered people who were pretty amused upon hearing my explanation and thought some readers might find this information interesting too.

A SIMPLE EXAMPLE

I can think of a primitive example to illustrate hedging:

Suppose you bought 100 shares of a company today and the price of the share rose by $1. This net you a total profit of $100, if you choose to sell the shares now.

What if for some reason you do not wish to realise the $100 in capital gains until a later date? (Perhaps due to taxation) However, if you continue to hold onto the 100 shares, you risk losing the $100 profit due to a future fall in price.

So what can you do to keep the $100 profit unrealised but safe from future price movements?

A simple way is to sell 100 shares of the same company at the current price, while still holding onto the original 100 shares. This can be done through a separate brokerage account but is generally allowed within the same account.

A $1 movement in the long position (original 100 shares) in any direction will be matched by a $1 movement in the short position (sale of another 100 shares) in the opposite direction. Hence, any future losses or gain experienced by the original 100 shares is perfectly nullified by the short sale of 100 shares. The $100 profit remains no matter what happens to the price of the share.

The portfolio is thus hedged.

APPLICATIONS

The basic principle of hedging can be applied to many other situations.

For example, suppose you buy an investment denominated in foreign currency and hold it for one year. Thus, in one year's time you will receive two components:

1) The return on the investment
2) Profit/loss due to currency exchange rate changes

If your investment goal is solely to earn the returns on the investment and want to avoid currency risk, you can hedge the currency risk using the same mechanics outlined before.

For example, the currency risk component of using US dollars (USD) to buy a Japanese Yen denominated asset for one year is the same as having a short position on USD/Yen for one year. To hedge, we simply buy an equivalent amount of USD/Yen to create a long position. Any profits or losses made in the short position is offset by those of the long position. This leaves the portfolio perfectly hedge against currency risk.

The possibilities are endless...

Does Inflation erode our savings?

2007-08-17T17:39:00.001+08:00

INTRODUCTION

An advertisement on the train promoting a savings plan that is tailored to hedge against inflation risk got me wondering about the erosive effects of inflation.

Among the people that I have met, the loss of purchasing power due to inflation is the most cited reason for taking up various investing product. Some say that money in a deposit account at the local bank is susceptible to inflation, in order words: "rotting away in the bank". Others might recommend investing in assets like Real Estate or Mutual Funds to protect their money against inflation.

DEPOSIT ACCOUNTS

Out of curiosity, I took a quick look at the rates of inflation around the world and the termed deposit rates of the biggest bank in each respective country. (termed deposits are also known as fixed deposit, time deposits or certificates of deposit in some countries)

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It appears that putting our money in a term deposit account does protect it from inflation, as far as these six countries are concerned. (I apologise if I left your country out!) On top of that, we can earn an additional rate of return as shown in green.

A note about my home country of Singapore: The 1.80% rate shown above is offered by DBS and require a hefty deposit of SGD50,000. There are other accounts with differing rates and much lower capital requirement. (Citibank offers 2.08% for a SGD10,000 12mth fixed deposit account) However, to keep everything standardized, I chose to stick to the plainest deposit accounts offered by the largest bank of each country instead of hunting for the best rate.

GOVERNMENT BONDS

Many economics or financial publications talk about something known as the "risk-free rate". They are referring to the minimum rate of return an investor can earn without taking on any risk. A very good benchmark for this rate comes from the Bonds issued by the government of the investor's country; After all, governments of developed countries are not likely to default on their debts.

Comparing inflation in various countries and the returns on their respective government bonds:

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Government bonds appear to achieve the same effect as bank deposits in that they nullify the effects of inflation and give an additional rate of return on top of that. Bonds also appear to pay more than termed deposit accounts.

These bonds are easily accessible to citizens of the respective countries. Interested readers should check with their local government or national banks for details.

CONCLUSIONS

Putting our savings in the right deposit account or the local government's bonds will protect it from erosion by inflation. On top of that protection, we can earn an additional rate of return.

Deposit accounts and government bonds are almost risk-free assets. As such, I think they are a decent benchmark by which I can compare all other investment vehicles. Indeed, I would want to ensure that all my money are placed in deposit account or government bonds before considering other ventures.

Footnotes

1) These data was collected on 28/07/07. As such, some of them might be different now.

2) Inflation figures are taken each respective government's statistics department. They are calculated using a Consumer Price Index (CPI).

3) Term deposit rates are taken from the largest banks in the respective countries.

4) All rates are quoted in percentage per annum.