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Someone in linkedin asked how human behavior contribute to financial bubbles and how to manage such risk.  Here is my answer:

If you think of a bubble being the consequence of inefficiencies in the market, then we can examine how the two premise of efficient market theory can be broken:

1. Misinformation. Academics assumes perfect information to make their models work. In reality, misinformation is everywhere. To be more precise, misinformation is greatest when something is new. That’s why bubbles are always associated with innovation or “new concept”. The fact that no one can accurately value “new paradigms” (ie. dot-com technologies, sub-prime derivatives, etc) leads to bad investment decisions.

2. Irrationality. Academics assume people to make rational decisions based on perfect information. The perfect information part is addressed above. Rationality is also challenged when misinformation is rampant, because now people have to rely more on “gut feelings”. When emotion becomes the vehicle for decision making due to the lack of predictability of “new paradigms”, greed and fear lose balance. The imbalances are small at the beginning, and often go away as more accurate information unravels. In rare cases, the misinformation persists because innovations become more complicated, and rising asset prices reinforce the greed, then people start attributing their success on their own intellect … and a real bubble is born. Self-proclaimed “Experts” would start to write books and show on TV to “teach” others how to get rich, effectively worsening the misinformation. Then you have the academic bunch who believe that “the market is always right” writes papers about “how this time is different”. The politicians cheer at their success of creating “prosperity”.

It’s about time when envy kicks in and everyone becomes invested.

When everyone wants to invest becomes invested, the prices start to go down ….. and BOOM !

admin :: Oct.29.2009 :: Finance/Investment :: No Comments »

The recent stock market boom is a symptom of excess liquidity caused by government policies. The liquidity is supposed to be injected into the real economy, but instead it is causing asset bubbles. The premise of the stock market rise is a falling dollar. Recently sentiment of the dollar has become so negative that a correction is over due. However, the government has no sign of monetary tightening, so it is fair to expect the dollar to resume its fall and stock market continue to rise.

Several scenarios are possible that would strengthen the dollar and depress asset markets:

1. Another financial crisis, may it be commercial real estate or credit cards defaulting. This would cause another liquidity crunch. (very likely to happen).

2. Global economies fail to recover. This would cause “flight-to-safety” and all the hot money flown to emerging markets will come back. (fairly unlikely)

3. Increasing opposition to Obama’s spending spree. The failure to pass healthcare and cap-and-trade would mean less money printing and less deficit, which are the causes for the dollar devaluation. This might actually be bullish for stocks. (fairly likely)

4. the Fed shows plans to raise interest rates and signals monetary discipline. In my opinion this won’t happen until employment starts to recover. (fairly unlikely)

If your investment has a long term horizon, then don’t worry too much about the coming correction. With all the structural problems of the U.S. economy, dollar is destined to fall much lower in the long term and stocks would be a fairly good hedge. Though as to diversify, it would be wise to own some gold and foreign stocks and bonds.

admin :: Oct.29.2009 :: Market Analysis :: No Comments »

Recently I had a conversation with a friend, who asks me, “why is gold valuable?  It is just a metal that people dig it up and bury it again underground.  It is not income-generating.  You can’t eat it or use it in any productive purpose.  Then why do people buy it and invest in it?”

I think he is right in that gold does not have much value as a productive asset.  The value of gold, however, comes from it being a globally recognized hard money.   Money is what makes trade and division of labor possible.  Without money, trade breaks down and society would go back to bartering.  That means, if you want food, you have to produce some type of goods or services and trade them with the farmers directly.  Therefore, money comes to existence to support indirect exchange.

Being a medium of exchange, there are some attributes that any form of money should have:

1.  Durable.  Meaning it should last a long time without changing or corroding.  Therefore metals like iron would not work because it rusts.

2.  Portable.  Meaning people can easily carry it.  Therefore assets like real estate would not work because one cannot carry land with them to trade.  And oil would not work because to carry $700 dollar worth of money in oil means carrying 10 barrels of it.

3.  Divisible.  Meaning it must be easily divided into small pieces.  Therefore valuable stones like diamond would not work because it takes a lot of technology to cut a diamond into smaller pieces, and the value of a diamond decreases exponentially when it is divided.

4.  Has limited supply.  Meaning that it must be rare and difficult to be brought into existence.   Therefore sand would not work because there are abundant amount of it easily accessible to the public.

Throughout human history, gold has been the ideal form of money because it satisfies the above requirements.  In modern society, paper money has replaced gold as the medium of exchange.  Paper money is fairly durable; it is certainly portable; it is divisible into paper money of smaller face value or coins.  The only problem with paper money is that its supply is artificially controlled.

Central banks controls the monetary supply in modern economies and they have the rights to print money.  Therefore with undisciplined central banks, the supply of paper money can easily get out of control.  When the supply of paper money in an economy increases, the value that existing paper money holds are diluted.   This means inflation:  prices go up and the same amount of paper money cannot buy as much stuff as before the dilution.  When inflation gets out of control, as inflation usually breeds more money printing and more inflation, trading with paper money breaks down.  Who would want to offer their products or services for pieces of paper that lose value the next day?  But then, how can anyone survive in today’s society if trading reverts to bartering?  And thus, people would start to use gold and would only accept gold as payments.

That’s the value of gold.  Even though it is not used as money today, it reflects the risks of a complete break down of the paper money currently in circulation.

admin :: Oct.14.2009 :: The World, Finance/Investment :: No Comments »