Naked Economics - Blog Entry #7

Question #5

Wheelan's basic coin flip example I think brilliantly illustrates the importance of diversifying your money. It answers the question of how to safely store your money where it will yield a reasonable profit. The part it leaves out is exactly which specific companies do you invest in, but that all depends on the current market and predictions of the success of future products. Though, for this simple concept I think it is a valuable activity because it teaches students that investing all your money in one company could be terrific, or catastrophic. So, the safest place to put your money is many places. And off the top of my head, besides just telling students that diversifying your money is very important, I cannot think of another example that would teach students about financial markets.

I think the story of the monkey having just as good of a chance then an expert is weird to think about. These men are paid big pay checks to try to foresee, and in a sense assume what is going to happen and it is weird that Wheelen compares that to the chance a monkey could do it. Besides the scary idea that came to me when hearing a monkey had almost the same chance, it also made me realize that there is a good amount of luck in it all. My confidence in the financial market was lowered after hearing this analogy. But also adding to this the S&P example was one that brought my confidence up a little. Wheelen does a really god job showing that yes a monkey and an expert might have the same chance or luck but the expert knows that something like S&P has a lower chance of crashing because it has so many corporations or companies within one group. It is very intelligent to have many companies within one group and I don’t think that a monkey could do that not even curious George. Adding to that I also thought about that not only does having more companies within one group help the chance of not loosing everything, but also more time makes sense. Wheelen says that he can’t predict what your money will be in 6 months or even a year but he knows that in 10 or 20 years it will be more than it is now. Meaning not only does broadening your companies and putting them all together help but also having more time for things to grow and change helps. All together the monkey picking stocks was pretty weird but it showed that it isn’t all intelligence, no one can see the future. It also showed that there are many people trying to find the same or the best stock so it is a chance game. But there is some intelligence to the financial market and trying to find what you want and what will work best for you.

3. Later in the chapter, Wheelan shares some "lessons" about the markets. Comment on anything you "learned" in the anecdote about the "brownstone" or anything else.

I learned in the story about the brownstone that if prices of one thing on the market are high, you will not (or it is very, very unlikely) that you will find a cheaper price. The reason being the most basic idea in economics and as Wheelan says the idea that "you are trying to maximize your utility- and so is everyone else." Everyone is looking to make a profit and again as Wheelan says "no one is going to leave $250,000 sitting on the table."
I also thought it was interesting to read that half the investors selling their "hot stock" are just trying to get rid of it. It is amazing to me that things like this can happen/ continually happen. It is even more amazing to me that people can get away with this and that people fall for it. If you are investing your money into something that could potentially lose you large amounts of money I would think that people would double check to see if what they are buying is actually "Hot Stock" and if that is what will make them the most money.

(Question 4) This story wasn’t very surprising to me at all. The stock markets are essentially gambling and are very centered around chance, so, in my mind; it makes complete sense that a monkey could most likely do as well or better than the average investor. Though, I do completely agree with Wheelan’s point that the monkey should be throwing a “wet towel” rather than a dart. This point reinforces the fact that the key to a good investment portfolio is diversification. A well-diversified stock portfolio both minimizes and quite often ensures good, gradual return. This monkey throwing the darts/towel idea is really best summarized in this statistic on page 131: “In other words, 85 percent of the mutual funds that claim to have some special stock-picking ability did worse over two decades than a simple index fund [S&P 500,] our modern equivalent of a monkey throwing a towel at the stock pages.” In my opinion, this statistic can impart great wisdom to all: don’t waste money paying an extremely expensive stock broker when a simple index fund most likely will do better– the stock market is primarily a game of chance. This monkey business (pardon the pun) does not change my level of “confidence” in financial markets at all. The stock market is essentially gambling because so many unforeseen events can occur to the businesses/corporations that one is investing in. There may be poor management, illegal activities, a better alternative is created or there may be a natural disaster that greatly affects your investment. No one can predict the future and therefore, no investment is ever a completely sure thing. Though, there are stocks, such as McDonald’s, that one can most likely anticipate will continue to do well. If the monkey example has told me anything, it has told me to stick to a well-diversified simple index fund.

4. The story did not shock me very much... The statistics however were hard to believe at first, but once I thought about them... It made sense. The statistic that shocked me the most was that 85% of mutual funds that claim some special stock-picking ability did worse over 20 years than a simple index fund. 85% is extremely high and makes me think to not choose to put any or much money into a mutual fund with "super stock-picking abilities." Not only that, but this story makes me not want to put any money in the stock market at all... Personally, I'm not much of a risk taker, and I know that the stock market is all about risk, but this story showed me that there's even more risk and randomness involved than I originally thought.

When Wheelan talks about the monkey picking the stocks, I feel like he is doing so in a joking matter, but all the same the actual results show that a stock broker will be less successful than say a index stock in the long run. The example doesn’t really change my confidence in financial markets, they’ve failed sure and they aren’t doing well now, but as Wheelan says, in the long run (and possibly with some very strong help from the government) financial markets will rise in value. In terms of the diversify section, I do think that the flipping the coins is effective, I mean it physically shows the results and odds effectively. If I were to use finiancial markets, I would rank the four functions as follows, raising capital; storing, protecting and making profitable use of excess capital; insuring against rise and finally speculation. The first I believe is the best reason to use the markets because they flucuate but tend to go up, so you stand to make money, the second follows on the same principle they make money but to me that more anticipates that it’s not gaining much profit, it’s more about saftety, the third has to be in a safe place to really insure against risk and finially speculation the markets don’t shift fast enough in for this to appeal to me, this is very risky in my opinion and after taxes seems like its just to much work to be worth while.

(Question 5).

Wheelan, once again, did a great job of portraying his ideas with a more "regular person" outlook. The thought of flipping a coin and losing all of the money is truly devastating. He says the average outcome is very good, yet, having only a 50% chance, or, a coin toss, determine the future of such a great investment, is shown as completely insane. The point of having "heads" quadruple the investment also makes a point about gambling with your money & the markets. Often times people get greedy, so they'd immediately take that risk, without weighing the consequences. By offering the same deal with the money in ten different investments, he shows that this is a more ideal & beneficial way of perhaps taking risks in the economy without losing it all. Consistently throughout the book Wheelan does such a wonderful job "humanizing" all of the complex economic terms he discusses, and, as the penny activity shows, everything becomes more of a no-brainer idea than before.

4 I had already heard the story about the monkey and the dart before, but on rereading it, it did make more sense with a wet towel than a dart, as there would be more diversity in the picks. Thus, it actually raised my level of confidence in the markets as it at least showed that picking single stocks with darts is much riskier than the wet towel. I also agree with Charlie that the stock market is essentially gambling but gambling on how business will do rather than cards or where a ball will land, etc. and that a person should not waste their money on expensive stock brokers that on average lose to the modern equivalent of wet towel throwing monkeys (ie index funds) [131] Personally, I am fairly risk tolerant, though I don't like to gamble on things with less than a coin flip percent chance of success. Thus, if I invest in the future I will probably either throw a wet towel (or a couple dozen darts) at a list of stocks, or invest in an index fund over an actively managed fund.

5. In the section entitled "Diversify" (page 134), Wheelan urges his students to flip coins. Do you think this is a valuable activity here? Can you think of another that you would recommend for students learning about financial markets?

I think that the coin flip activity is a valuable exercise. It shows how while some investments don't pay off and some do spreading around the risk will result in a more balanced return. The coins are simplified however from real life scenarios as Wheelan admits. It will not be a calculated 50% chance or total loss or excellent return. Plus the market is tied in ways the coins are not. The entire economy could go down which no matter how diversified you are will effect across the board and same with it moving up. BUt while it is not a perfect exercise the lesson is still a valid one and my opinion of it remains the same.

In the section entitled "Diversify" (page 134), Wheelan urges his students to flip coins. Do you think this is a valuable activity here? Can you think of another that you would recommend for students learning about financial markets?

I think Wheelan's activity with the coins is valuable when it comes to teaching about finance. I do think it's very simplified, having only two options. In the real word I feel like the odds aren't exactly 50-50, but nonetheless this displays the risk and rewards well. When it comes to your return, if you win, you win big, but the possibly of losing everything would probably make anyone hesitant. Still, when it comes to economics, I think people have to take that chance, at least once in a while, otherwise our money would never be going anywhere. That being said, his point about diversifying your investments is also very good. By spreading out the money, there is more chances to have a good return, and while that means the possibility of losing everything is just as high, mathematically it would unlikely to lose at every "flip" (as Wheelan says). As far as showing this activity in a different way, I think they're are several options. Flipping a coin is a tool commonly used when you do anything dealing with chances or odds, but things like dies or a deck of cards also work well. With those two, you can still work it out as having a 50-50 chance, or since there is more variety, maybe you can have more possible outcome or options.