The Lyons Den

Happy New Year!

The following is a guest post by Kim Butler of Partners For Prosperity

“The ignorant will not in general defer to the opinion of the informed.” – Economist Frank Knight, 1921

For the majority of Americans, 2008 has been a wild financial ride, one that has run mostly downhill. As one year comes to a close, and another one begins, it’s worth pondering what we’ve learned. Here are three items to consider.

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“All I can say is, beware of geeks…bearing formulas.”  – Warren Buffet

In 1921, University of Chicago economist Frank Knight made a famous distinction between risk and uncertainty. Knight said risk was characterized by randomness with knowable probabilities, while uncertainty was randomness with unknowable probabilities.

According to Knight, in risky situations we don’t know the specific outcome, but we do know what the overall distribution of outcomes looks like. For example, we don’t know which number will result from rolling two dice in a craps game, but we do know the possibilities and probabilities: The possible combinations range between 2 and 12, with 2, 3, 11 and 12 the least likely combinations, while 7 occurs most often. Actuaries, through their detailed analysis of large amounts of data, can make similar risk calculations of the likelihood of having an accident, becoming disabled or dying. Actuaries don’t know who will experience these events, but they have a good idea how many people will. Applied to economics, one of the characteristics of financial risk is that there is some method to insure against it.

In contrast, economic uncertainty has no known range of outcomes, so you can’t limit possible damage through preventive measures. So while history may reveal why something happened (like the Great Depression or the tech bubble), it doesn’t provide any certainty that what happened before will happen again – even though there may appear to be some repeatable patterns. This is especially true when a particular issue is influenced by multiple variables. You can’t tell which variable will have the greatest impact, and thus determine the course of events.

However, because many random, uncertain events seem to have patterns, people keep trying to find ways to change uncertainties into knowable risks. They develop formulas for profiting in the stock market, predicting elections, selling products, finding a spouse, etc. Now that computers can process infinite amounts of information, there is an accompanying belief that almost every activity can be quantified and predicted. But recent events would indicate this belief is wrong. Economic uncertainties cannot be changed to knowable risks.

One of the first “domino factors” that served as a catalyst for the recent meltdown in the financial markets was the credit-default swap (CDS). A CDS is a private contract similar to an insurance contract designed to pay investors when a bond or company defaults. CDSs, often purchased by investors for speculation, hedging, and arbitrage, are described in an October 31, 2008 Wall Street Journal article as “devilish complicated deals.”

But several large financial firms believed brokering CDSs could be an extremely lucrative business, provided they could accurately define the risk. To that end, these companies hired some of the brightest economic talent to devise computer models to determine which CDSs were good bets. For almost a decade, the formula seemed golden.

Unfortunately, not all of the potential problems with CDSs were taken into consideration by the computer models.

According to the WSJ article, the companies “didn’t anticipate how market forces and contract terms not weighed by the models would turn the swaps, over the short term, into huge financial liabilities.” As a result, many of these once-stalwart financial institutions have been brought to ruin.

The ability to process large volumes of information in complex ways may provide new financial insights about what happens, and why. But it is dangerous to believe that uncertain financial opportunities can become manageable risks just because there is more information available. When there are too many factors that can impact the outcome, the end result is still uncertainty.

For Americans who bought the hype of “new formulas” for wealth and accumulation, the past year has been a wake-up call. Uncertainty – and the possibility of losing it all – is still an unfortunate financial fact of life.

Things can change quickly – for better or for worse.

The average price of gasoline in the United States was over $4.10/gallon on July 4, 2008. By November 17, 2008, the price had fallen to $1.85/gallon (see graph below). That’s a decline of almost 60% – in less than five months! By late November, some areas reported prices below $1.40/gallon, a price level lower than the late 1970s.

Be honest: After this summer, did you ever think gas would be less than $1.50/gallon? Did you ever think the drop in price would happen this fast?

Fluctuation of Gasoline Prices

On October 9, 2007, the S & P 500 index reached its all-time high of 1565. Just less than a year later, on October 1, 2008, the index stood at 1161, a decline of 26%. From October 1, 2008 to November 24, 2008 – just 55 days – the index fell another 26% to 851. The total decline from the October 2007 peak: 45%.

The values for several individual stocks have dropped even more – a 90% drop in share value has not been unusual, and some of the biggest names have fallen the hardest.

For the Baby Boom generation, the oft-repeated media mantra for the stock market has been: “Buy and hold. Look at the long-term perspective.” Thus, as the market began its downward slide through early 2008, many pundits congratulated the behavior of small investors who stayed the course, even as losses reached 25%. After all, they said, it is not unusual for the stock market to fluctuate on a yearly basis.

However, it is historically atypical for the fluctuation to be so large, especially downward. When the steady 10-month slide finished with a steep drop in less than two months, the descent came so quickly many didn’t have time to respond, or even know if they should. Conditioned to stay in the market, many now feel they have no choice but to stay in, hoping that a new upward trend will quickly recover the losses.

Most good financial decisions are predicated on taking long-term perspectives as opposed to constantly changing plans in response to each daily turn of events. You don’t refinance your mortgage every time interest rates drop, you don’t trade in the SUV for a fuel-efficient sedan when gas prices move up a few cents, and you don’t buy or sell a home based on the price your neighbors paid (or received) last week for their home. Big decisions made in haste usually turn out poorly.

But since circumstances can sometimes change quickly, it is prudent to have an idea of how you might want to respond. For example, some investors give themselves pre-determined limits. If an investment rises to a certain level, they sell and secure the gain; if it drops, they sell and stop the loss. Being aware of dramatic changes – and having a contingency plan for them – may not only minimize losses, but also open the door to financial opportunities as well.

The mixed economy is not a controlled economy

The phrase mixed economy describes an economy in which both public and private enterprises participate in the production and supply of goods and services. Typically, a mixed economy is one that combines elements of capitalism and socialism, of free enterprise and government regulation, of privately owned and centralized, government-run businesses. Given this definition, almost all countries from Cuba to the United States have mixed economies; the difference is the proportion of private or public influence.

In the United States, one of the rationales for government involvement in the economy is that it promotes the public good.

* The Federal Reserve System exists to provide a stable and standardized money supply.

* The missions of Fannie Mae and Freddie Mac are to make home ownership possible for a wider range of citizens.

* The Interstate Highway system facilitates commerce and national defense.

Another rationale for government involvement is that it can act as a stabilizing force against the excesses and fluctuations inherent in capitalism. Free-market competition not only produces great wealth and prosperity, but it also drives less productive businesses out of the market, and this “creative destruction” catches some people and businesses financially unprepared to cope with the changes. In consideration of the public good, the government may step in by protecting pensions, extending bailouts, increasing the money supply, providing subsidies, lowering interest rates, etc.

In theory, these government measures are meant to harness the positive benefits of capitalism and minimize the negative aspects of free-market change, providing greater opportunity in good times and a “soft landing” for the economy in downturns.
In practice, governmental involvement can also distort productive activity and incur unintended consequences. And in some cases, whatever is happening in the private marketplace will override any governmental intervention, no matter how well-intentioned.

During the Great Depression, unprecedented steps were taken by the U.S. government in an attempt to right an economy staggered by the stock market crash of 1929. The Roosevelt administration created massive public works projects, reorganized the financial system, provided an extensive welfare security net – yet the economy remained mired in a depression that didn’t let go until the country entered World War II. While government intervention could influence free market activity, it couldn’t control it.

It is impossible to tell whether today’s economic situation will rival the Great Depression. But it is almost certain that any government involvement will have the same impact as it did 70 years ago. Contrary to the claims of earnest, well-meaning politicians, no amount of financial assistance/bailout or government oversight will be able to guarantee a stable and prosperous economy. Centrally controlled communist governments of the late 20th century attempted to regulate all aspects of their economies and failed miserably, so it is illogical to believe that a government operating in a mixed economy can exert greater control. It is impossible to legislate economic stability or prosperity.

With this in mind, individual citizens must carefully observe the ways in which governments will attempt to calm the current financial turmoil. The combination of financial distress and a new administration have spawned all sorts of rumors: minor changes to retirement plan distributions, higher estate tax levels, government-managed retirement accounts, mortgage relief programs for foreclosed homeowners, etc. Any number of government mandated changes could have significant impact on your financial condition, so it is essential that you pay attention and adjust if necessary.

But paying attention to government involvement in your personal financial affairs is only half the story. You must also consider what’s happening in the marketplace. An exquisitely crafted estate document or a stretch-IRA strategy isn’t worth much if there’s nothing available to spend or pass on because you have made poor decisions about where to save and invest.

From Knowledge to Action

If you’ve read this article carefully, several relevant questions should be bouncing around in your head. Questions like:

* How much of my financial life is subject to uncertainty?

* Should I attempt to replace those uncertainties with knowable risks?

* Am I prepared for quick changes in my financial world? Do I have a plan for protecting myself against sudden change or seizing sudden opportunities?

* At a personal level, what is the impact of government involvement on my financial decisions? Are my financial decisions based on artificial government factors (like tax deductions) or is there a good economic reason as well?

Looking for some answers? Maybe it’s time to review these ideas with us. And, considering how quickly things can change, the sooner the better!

To your prosperity!