reasonable-bystanders

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Location: Georgia Southern University, Georgia, United States

Tuesday, November 01, 2005

In Texas Suburbs Conserving Energy Isn't The Only Thing That Doesn't Come Easy

In an October 20th article of the WSJ entitled, "In Texas Suburbs, Conserving Energy Doesn't Come Easy", the tradeoffs of trying to conserve energy were presented. In the discussion, one property owner anticipated that the additional $17,000 he spent on his home for energy efficient features would save $64 a month. He figured that the savings would pay off the cost in about 22 years. Since one of the other enjoyments of life we have besides reading the WSJ is teaching finance, we thought we ought to shed some light on this calculation.

The homeowner has taken his $17,000 initial cost and divided it by his anticipated monthly savings of $64. This yields a payoff of about 266 months which divided by 12 give us approximately 22 years. However, as we like to point out to our students, what happened to the opportunity cost of his initial investment? Or in others words money has time value. For instance, if we assume the owner took out a 30 year mortgage with rates of about 5.7% a year, then his initial $17,000 investment would be costing an additional $98.67 on his 30 year monthly mortgage payment. So at that interest rate the $64 a month savings evaporates. Indeed we find that at the 5.7% annual interest rate, if the $64 a month savings is anticipated to run on forever, (known as a perpetuity), then it is worth about $13,474. Not quite the $17,000 we need to justify the inital investment.

But not to worry. One thing we can be sure of in finance as with life is that the future brings with it a host of possible outcomes. So if the $64 savings the homeowner generates through time increases at say a rate of 0.2% a month or about 2.4% year, then the initial $17,000 will be paid off in about 40 years. Given the recent increases in the cost of energy, this investment in energy efficiency will more than likely pay for itself. Unless of course some unforeseen innovation makes the current energy market obsolete. But that is another story.

Tuesday, October 04, 2005

Reversion to the mean? - Critique of 9/28/05 WSJ article

As mentioned in our first post on this site, The Wall Street Journal is our favorite newspaper. Nevertheless we will continue to point out when its writers commit a faux pas. The September 28, 2005 Common Sense article on Energy Prices asserts in its discussion of reversion to the mean that "The classic example is a series of coin tosses. If a coin comes up tails 90 times out of the first 100 tosses, look for heads to make a comeback over the next 100."

A coin toss is a classical example, but not of reversion to the mean. We refer to another of our favorite sites, Wikipedia.org, for a discussion of the "Law of Averages":
"There are common ways to misunderstand and misapply the law of large numbers:

* "If I flip this coin 1000 times, I will get 500 heads results." False. While we expect approximately 500 heads, it is not the case that we will always get exactly 500 heads results. If the coin is fair the chance of getting exactly 500 heads is about 2.52%. Similarly, getting 520 heads results is not conclusive proof that the coin's true probability of getting heads on a single flip is .52

* "I just got 5 tails in a row. My chances of getting heads must be very good now." False. It was unlikely at the beginning that you would get six tails in a row, but the probability of six tails was the same as five tails followed by a head: 1/64. Looking forward after the fifth toss, these probabilities are still equal. The only difference is that there are no other possibilities, so the probability of either outcome is 1/2."
As the last paragraph makes clear, after tossing a 'fair coin' 100 hundred times, the probability that 90 will be tails is slim indeed. But even if that turns out to be the case, over the next 100 flips of the coin we still expect that approximately 50 will be heads. Granted if 50 of the next 100 tosses are heads then indeed "heads has made a comeback" from 10 out of 100 to 60 out of 200. Nevertheless, as noted in the "Law of Averages":
"However, it is important that while the average will move closer to the underlying probability, in absolute terms deviation from the expected value will increase. For example, after 1000 coin flips, we might see 520 heads. After 10,000 flips, we might then see 5096 heads. The average has now moved closer to the underlying .5, from .52 to .5096. However, the absolute deviation from the expected number of heads has gone up from 20 to 96."
Note in our example, the absolute deviation from the expected value has remained unchanged.

Sunday, October 02, 2005

Boom Towns

Didier Cossin, Harvard educated UBS Professor of Banking and Finance at IMD in Switzerland and one of the world's experts on leading-edge financial technology, remarked in a story appearing in the Belgian business newspaper De Tijd*, “...every financial innovation is associated with scandals. Think of Michael Milken for junk bonds, Metallgesellschaft for oil futures, Procter & Gamble for currency swaps, Barings for shares futures, the list goes on. As a result of these scandals, checks are tightened up and no one now denies the benefit of, say, futures or junk bonds. Perhaps we need a few scandals in credit derivatives for them to gain acceptance."

The professor's point is well taken, but the notion of "scandals" doesn't capture the essence of the financial innovation environment. A more apt analogy is the frontier boom town. The boom town would spring up virtually overnight to exploit the discovery of riches for the taking. The boom town was a rough and tumble place, a place where the usual rules didn't apply and the law hadn't caught up yet, a place for prospectors, gamblers, rowdies and thieves. Today's financial boom towns are springing up in cyberspace to exploit a different kind of riches for the taking. But the frontier elements remain. What ultimately brings financial innovations into the mainstream is not a scandal per se, but for the frontier to be tamed - for "decent folk" to show up and feel safe.

*17 May 2005, De Tijd, Written by Kurt VANSTEELAND

Tuesday, September 13, 2005

How Soon We Forget

George Santayana wrote, "Those who cannot remember the past are condemned to repeat it." (Life of Reason, Reason in Common Sense, Scribner's, 1905, page 284)

And so they do. On Monday, September 12, 2005, the Wall Street Journal carried a front page column titled, "How a Formula Ignited Market That Burned Some Big Investors." The story is about how a mathematical computer model used to price exotic credit derivatives based on correlations failed to capture the way the market actually responded to events in the credit market. The fault lies with both the model and its users, but the result was big money lost.

How soon we forget. It was only a few years ago that Long Term Capital Management was arbitraging credit markets with a sophisticated mathematical computer model based on correlations that failed to capture the way ... well, you know the rest of the story.

Models of markets can never be 100% accurate and are always the product of underlying assumptions that may or may not correspond to how the market reacts. Blind faith in their ability to work is a bad habit, and apparently a difficult one to break.

So the next time someone tells you he has heard of a mathematical computer model that uses correlations to arbitrage credit markets remember what Yogi Berra said, "This is like deja vu all over again."

Saturday, September 10, 2005

Politics as Usual

The Governor of Georgia has led the State legislature to repeal excise and sales taxes on gasoline. At the same time, he threatens retribution against gasoline retailers caught "price gouging." Let's see how this works, shall we? A Catergory 5 hurricane wipes out major southeastern oil port and adjacent refineries - oil and gas supply are signicantly reduced at a time when world supply can barely keep up with demand. Basic economic principles are validated as retail gas prices quickly rise in response to panic buying and decreased supply. Basic government knee-jerk response is also just as predictable - accuse sellers of gasoline who charge what people are willing to pay of "gouging" and threaten to prosecute them, making certain that gas suppliers from other regions have no incentive to reroute gasoline our way. And, to top it off, since the problem is a short-term shortage of supply, for good measure reduce the price at the pump so drivers will not be encouraged to conserve, keeping demand high.

It all rather reminds us of something H.L. Mencken once wrote, "Democracy is the theory that holds that the common people know what they want, and deserve to get it good and hard. "

Not that we don't like tax cuts, we do. But we prefer the permanent kind rather than transitory relief that distorts markets. Speaking of which, why is it that newspapers consistently refer to this tax rollback as "costing the government"? We have yet to see it characterized as "saving the taxpayer."

Wednesday, September 07, 2005

Even Homer Nods - critique of 8/23/05 WSJ column

The Wall Street Journal is our favorite newspaper. Being such big fans of the WSJ it pains us to see the paper commit a non sequitur. The August 23, 2005 Smartmoney Fund Screen article on Global Funds begins by asserting "It used to be a tenet of portfolio allocation that a well-diversified investor should maintain a careful balance between foreign and domestic funds, in order to avoid overexposure to slumps at home or abroad."

The column continues, "...it's becoming less clear that mixing and matching funds by broad geographical categorization provides any protection at all." One assumes that since the topic is diversification, the idea of "protection" means from widely fluctuating returns. But what is the evidence cited to support the conclusion that geographical diversification is passe? - that the difference in returns over five years from different funds "...is little more than rounding error."

Well, concluding that diversification doesn't work anymore because the returns are similar is a non sequitur - it simply doesn't follow. Diversification is about reducing the volatility of portfolio returns, those ups and downs that cause investors to lose sleep at night. To say that investments that produce the same return over some period of time are equivalent is to ignore the risk of the investments entirely. The benefits of diversification are in risk reduction, not returns per se. To show that diversifying internationally isn't what it's cracked up to be requires showing that by some measure of volatility - variance or standard deviation of returns during the five-year horizon - there was no difference between the investments.


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