The Intuition Behind Simsek's, "Speculation and Risk Sharing with New Financial Assets"

Mark Thoma guides us to an article about a very interesting new finance paper by MIT economist Alp Simsek, “Speculation and Risk Sharing with New Financial Assets” .

If I might take a stab at the intuition:

Suppose you have a world with just two underlying assets, A and B, which are highly negatively correlated.

And there's only one security people can buy. It's 1/2 A and 1/2 B. So everyone has just this security in their portfolios.

Now suppose the financial system becomes more sophisticated, so people can now choose from three securities: Just A, Just B, and 1/2 A and 1/2 B.

If there are sharp disagreements in beliefs about the assets A and B, everyone might go from a portfolio of just 1/2 A and 1/2 B, to a portfolio of either only A, or of only B. So, the average risk of people's portfolios would go up greatly; total risk in the economy would go up greatly; diversification would go down greatly.

Essentially, the more you give people options and ease to gamble based on strong and differing beliefs, the more they will drop some of their diversification and go in and gamble against the people with sharply differing beliefs, like in a winner-take-all-tournament. As Simsek says in the article, “as you increase assets [what I call securities above], this speculative part [of risk] always goes up.”

In Praise of the 15-Year Fixed Mortgage -- as Opposed to the 30

Recently there's been talk in praise of the 30-year fixed mortgage.

I teach one of the largest personal finance courses in the country at the University of Arizona and am president and founder of National Personal Finance Education, one the largest licensed providers of a personal finance course required for people in bankruptcy.

I've thought about this a lot.

My opinion on this is that usually 30 years is too long, at least for most college graduates with a decent income. And if it's a Wal-Mart worker couple, they should be very careful about buying any home they can just barely afford with a 30 year mortgage. The focus should really be about trying to upgrade their skills and education, and especially the education of their children, so as not to be a Wal-Mart couple.

Anyone who's followed my blog knows I have a lot of sympathy for the working poor. I'm a strong advocate of not only free universal high quality pre-school, but also free universal high quality bachelor's degree, or worthwhile vocational training. I favor free universal healthcare, like Medicare for all, and a stronger safety net. But a Wal-Mart couple doesn't help themselves by creating severe financial stress to just barely be able to afford a home with a 30-year mortgage. It doesn't take anything that rare or unlikely going wrong to lead to a traumatic foreclosure. Living even in a modest house can be much more expensive than living in an apartment in a comparable neighborhood; consider the mortgage, the downpayment, maintenance, property taxes, insurance, increased furniture and utilities costs, an attitude that you should spend more with a house, and more. It would be better for the kids to live in a more affordable but decent apartment complex, and have some financial security, accumulate a cushion of thousands of dollars in the bank, and to help yourselves and your kids you focus on education, education, education.

So while I think for the working poor a 30-year mortgage may be necessary -- if it is prudent and affordable to buy the home -- usually the 15-year fixed is best for the solidly middle class and college educated (and even then it's often best to make additional payments to end it even sooner). The interest rate is lower, usually by a lot; the payments aren't that much higher (due to the lower interest rate and the surprising exponential nature of compound interest over long periods of time – Try comparing the monthly payments and see.), and it's so valuable with the country so financially insecure for families to get to no mortgage as quickly as possible. Elizabeth Warren in her seminal personal finance book, "All Your Worth", rightly stresses the great importance of getting your "Must-Haves" (basically fixed expenses) low in today's dangerous America, and having no mortgage is a great way to lower your Must-Haves. Get some solar panels (in the right area with the right tax spiffs), and now you have little or no utility bill too.

Life, especially today, gets a lot riskier as you get older. At 25 you might have super health and resilience and no dependents, and be able to live happily and healthily on nothing, eating macaroni and cheese, sleeping on a futon, and driving a beater. That becomes way harder when you're 45, with kids. And if you lose your job at 45, it will be a lot harder to find one close to as good, or good enough, with age discrimination, declining health and energy, and perhaps antiquated, or rapidly antiquating, skills. 45 is a really good time to have no mortgage payment, as opposed to not until 60.

In addition, as usual, positional/context/prestige externalities are profound and huge. When a family thinks 15-year mortgage, they are likely to buy a smaller home, not get so much wood, granite, and stainless steel, buy less large and expensive vehicles, etc. But because they get used to that level -- and don't start getting used to a higher level of position, prestige, etc., the decreased utility is not that much, and the increased security of having no mortgage right when the kids are setting off for college can be huge. And how important it is for kids to be able to go to college without having to flip burgers 20-40+ hours per week, a great advantage for graduating, GPA, and learning. And in any case, the buying a smaller home, cars, etc., can mean that total payments aren't even higher.

Interestingly, given the ginormous importance of positional externalities, if the government nudged forward 15 year mortgages, you might see people commonly owning their own homes twice as quickly with little loss of utility, as you wouldn't lose position, prestige, or context of quality if everyone else was also doing 15-year mortgages and so they also had commensurately less to buy a home with.

Of course, we'd also have to control home equity predators from undoing this.

Is maximal profit at any cost really what shareholders want?

Rajiv Sethi has a great post on the recent reprehensible behavior of Goldman Sachs.

What I'll add is this: There's the horrible argument that Goldman Sachs should do these horrible things because they should do whatever maximizes the profits of their shareholders – Sell crack, poison the streams children drink from, whatever, it must be good because invisible hand! But, of course, any trained and decent economist knows about all of the ways the pure free market and invisible hand can go horribly wrong, especially if you care about optimizing total societal utils, which I consider ridiculously more important than Pareto optimality. These ways include externalities, asymmetric, and just poor, information, monopoly power, relatively high transactions/negotiations costs, giant economies of scale, zero marginal cost idea/information goods,...

But here's something you rarely hear: Are you really optimizing shareholder utility, or doing what shareholders really want, if you do anything that maximizes profits? And the answer is often, of course not. Would the average shareholder of Goldman Sachs vote for these (and many more and far worse) horrible actions in exchange for what's sometimes just a relatively small increase in return (to their portfolio as a whole), if they had to spend the time to vote and were completely informed of what was going on, and the implications?

Many shareholders hold extremely diversified portfolios. So they can vote that none of the companies in Goldman Sach's industry do these horrible things, and thus the decrease in profits is much less than if Goldman Sachs is the only one acting ethically. And, even if it would hurt Goldman Sach's industry, it might (and very likely would) help other industries in a well diversified investor's portfolio.

And on top of that, any decrease in return would apply to everyone, and this is huge due to ginormous positional externalities. You basically don't lose prestige, position, context, due to falling behind others in wealth and consumption. Everyone's return is lowered the same amount.

Of course, the vast majority of shareholders hold only a micron of each company, and so it's not worth their time to vote, and if you own through a mutual fund, the mutual fund votes for you anyway. I've owned a piece of pretty much every company on every major exchange for years, at least through mutual funds and ETFs, but I've never voted. So, who controls tends to be rich individual major shareholders (often very greedy), pension funds, mutual funds, and other institutions and companies, and/or the managers themselves.

With regard to institutions, like pension funds and mutual funds, their managers basically consider it their fiduciary duty to vote however maximizes the dollar returns of shareholders, regardless of ethical/social issues. I was in an MBA program in the 90's and a finance Ph.D. program in the 2000's; the constant message was, a mangers duty is to do whatever maximizes shareholder wealth, or return. And I've seen a lot more evidence of this through the years in experience and study. It's a very, invisible hand, greed is good, message. The culture is very important and different from a generation or two ago. Because the policeman can't be everywhere, and the law can't cover every kind of situation and gaming that can come up, culture and norms are very important.

So, with regard to the shareholder voting of mutual funds, this quote from a 2006 Wall Street Journal article is consistent with my experience and study:

On proposals related to social issues, fund companies commonly vote against them or abstain, basing their decision on whether the measures would financially benefit shareholders.

Now, interestingly, you have the word, "commonly", as if sometimes the mutual funds do vote for social proposals. And you can see in that article that there are significant percentages of times when they do. And also here, with regard to global warming proposals. But I suspect that most of the voting for social proposals is for profit reasons, to protect the name of the corporation and its brands, something Apple may be making a mistake in not worrying about more (but remember, the managers may be long gone, with their huge bonuses, before the long term price is really paid). Of course, the argument that corporations will always be forced to act ethically to protect their reputation is very wrong. Amongst other problems, often the vast majority of the public won't know what's going on, and often the profits will outweigh the bad publicity, such as it gets known.

But the bottom line is that, the shareholders only care about money at any cost, greed is good, invisible hand, message is wrong, and the change in our corporate culture towards this has been extremely harmful. Maximal profit at any cost is not always what the average shareholder wants, even weighted by shares owned. The average shareholder, even weighted by shares owned, is often very willing to have a slightly lower return on his total portfolio to have his companies not doing horrible things.