Apparently, investors, on average, know very little about what they are doing. Professor Bainbridge links to an LA Times article detailing the results of a study by the NASD (National Association of Securities Dealers) which shows how woefully incompetent the average securities investor is. Quoting from the article:

Recent surveys found widespread confusion about the relationship between interest rates and bond prices. The National Assn. of Securities Dealers surveyed more than 1,000 investors last year and found that 6 of 10 didn't understand that bond prices fall when interest rates rise.

That is just scary. Quick primer for those of you who can manage to stay awake: As an investor, bonds are a promise to pay a sum (known as principal), on a certain date (maturity date), at a specified rate of interest (the coupon rate). Along with the coupon rate is a schedule of interest payments (typically annually or semi-annually). So let's say you buy a $10,000 bond from Incredible, Edible, Inc. with a 5% coupon rate, payable annually, that matures 5 years from today. Every year on this date (for the next 5 years) Incredible, Edible, Inc. will send you a payment of $500. On May 4th, 2009, Incredible, Edible, Inc. will pay you your last interest payment ($500) + the return of your principle ($10,000).

Now, the coupon rate stays static for the life of the bond. Basically, you are getting the same annual coupon payment for the life of the bond (as with everything there are exceptions but we're keeping this simple). Meanwhile, in the real world, interest rates are changing on a daily basis. What does this mean for the investor buying bonds? Well as interest rates rise, your bond is losing value, and as they fall, the bond is gaining value. To explain why, imagine that I make a promise to give you $10 every year for the rest of my life. If we experience inflation from one year to the next, the $10 I give you can buy less than the $10 from the year before. If we experience deflation from one year to the next then the $10 I give you can buy more than the year before. If you were to try to sell my promise to someone else they will be willing to pay more or less depending on what they expect inflation to do. Bonds work the exact same way.

If a company promises to give you a 5% return on your money and the banks are offering you a 10% return on your money the rational person is going to put their money in the bank instead of buying the bonds. So, in order to avoid having to rewrite bond contracts whenever interest rates change, companies just offer the lower return bond at a discount to the face value (the principle) of the bond in order to bring returns in line with the market. So if you have a 5 year, risk free $10,000 bond at a 5% annual coupon rate and the prevailing interest rate is 10% then the bond will be issued at about $8,100. This brings the "real" return of the bond up to 10% even though the coupon rate is only 5%.

So as interest rates rise, the bonds have to be incrementally discounted to keep them in line with the market. For future buyers of these bonds this is a good trend, but for current holders it is like watching someone siphon dollar bills out of your wallet.

If you fall into the above category (of not knowing what you're doing), you probably shouldn't be managing your own money. via [Professor Bainbridge]

9:59:30 AM  #  

Get your random numbers right here. via [ Marginal Revolution ]

2:12:40 PM  #  

Bush's Pension Relief plan that was signed into effect a few weeks ago is definitely a step in the wrong direction.  Oligopoly Watch has a pretty good analysis of the situation.

Pension plans are federally insured, so that, if worse comes to worse, pension funds can dump liability on the government. In this way, once again taxpayers are being asked, indirectly, to subsidize large corporations, many of whom, it has been recently revealed, manage to avoid paying nay income taxes at all.

The entry also points to the Heritage Foundation which say on its website:

By allowing companies to avoid funding their pension plans' deficits, the new law makes it likely that taxpayers will have to pick up that liability. The sad fact is that many companies that qualify for the funding holiday will be in equally poor financial shape in 2006. The delay is likely to cause these plans to accrue even higher funding deficits. Moreover, once the companies submit their even more underfunded plans to PBGC, that agency will be further down the road toward an inevitable taxpayer-funded, multibillion-dollar bailout.

via [Oligopoly Watch]
2:01:10 PM  #  

SEC Suspends Ernst & Young (Reuters). Reuters - A judge suspended Big 4 accounting firm Ernst & Young LLP on Friday from accepting new, SEC-registered audit clients for six months in a case involving software group PeopleSoft Inc. (PSFT.O), handing a victory to the U.S. Securities and Exchange Commission. Is this the beginning of the Big3?  I wonder at what point the government will actively step in and try to save a Big Accounting firm?  via [Yahoo! News - Business]
9:25:03 AM  #  

FastCompany discusses Google.

"Flexibility is expensive," says Craig Silverstein, a 30-year-old engineer who dropped his pursuit of a Stanford PhD to become Google's first employee. "But we think that flexibility gives you a better product. Are we right? I think we're right. More important, that's the sort of company I want to work for."

The emphasis added was mine. While I applaud the man's passion about his job, and I applaud the work that Google has done, I question the veracity of the statement. As an engineer you should be searching for the empirical evidence, not giving knee-jerk responses. Also, you need to understand that the sort of company you want to work for is irrelevant to the survivability of said company.

I'm sure anyone who reads this will assume I'm bashing Google. I'm not. I'm extremely interested in the upcoming IPO because it will lay bare the truth of the enterprise. How much money do they make? How much do they spend on employee perks? Do these things really contribute to the bottom line? Most importantly, can Google survive being a public company? Wall Street has an insane pull on people and Google's culture seems to border on geek-communism. It will be an interesting clash.

11:00:33 AM  #  

Berkshire Hathaway's 2003 Annual Report is out.  I'm super-swamped at work and school right now, but I plan on sitting down and going through it over the next few days when I get a chance.

9:14:41 AM  #  

Lessons Learned the Hardest Way, by Going Belly-Up. Fifty percent of small business fold after four years. The reasons vary, but the failures often carry valuable lessons for the owners and administrators.

The dot.com bubble ran about 4 years (1997-2001) from beginning to absolute end.  Coincidence?  Probably not.  via [New York Times: Business]
12:56:00 PM  #  

Apparently, U.S. Consumers are struggling under a mountain of debt. Who knew? I believe this is the primary reason that the Fed has been so hesitant to raise interest rates. If you haven't noticed, most of those 0% interest plays in the auto, and high-end retail sector move to an APR style agreement after about a year. If the interest rates rise (which they will) then American consumers could be in a world of hurt.

That's my reasoning for taking fixed rates (which are slightly higher) on everything. Of course I could be wrong and end up looking like a sucker in 5 years. The good news is that I already look like one since I'm paying higher rates today so it won't be too much of a change. I'm willing to look stupid for the sake of safety.

The problem that I see coming is that the low rates encourage more borrowing, not resolution of the debt issues.  So right now we're just digging ourselves deeper and hoping for a bailout from somewhere.  Many people point to the rise in equity prices as a solution.  If the market is growing at a 15% clip and we're paying 12% on credit cards, then we're okay.  This fails to resolve for two primary reasons.

1. The market is like the lotto, "you gotta be in it to win it."  Every dollar spent servicing debt or consuming goods is another dollar that can't go into equity investments. So the issue becomes what percentage is invested vs. servicing debt and for most Americans the math won't work out in their favor.  American consumers have the highest worldwide debt level per capita of any nation.  This is money that is not flowing into the markets to take advantage of any gains.  Also, all this consumer debt is driving earnings at companies.  If interest rates rise people will curtail spending, and begin servicing debt which will drive earnings down, which will dampen market returns. 
   
2. Inflation drives down market returns.  Inflation basically means that cash is weakening relative to other assets.  You can buy less with the same amount of cash.  The value of a stock is simply a determination of what the market thinks the present value of a companies future cash flow is.  In a world of rising inflation, future cash flows mean less than they did the day before.  As this happens people place less and less value on the size of future cash, driving prices down.  In short as inflation goes up, market returns go down in an absolute sense.  If your interest rate on your debt level is rising in step with inflation then the spread between market returns and the debt interest narrows at an alarming rate and will most likely invert at some point.
   

10:12:11 AM  #