Naked Economics by Wheelan, Charles (spanish books to read .txt) 📕

they will fix the very inefficiency that they exploited (by bidding up the price of the underpriced stocks until they aren’t underpriced anymore). Think about the original analogy of trying to find the fastest checkout line at the grocery store. Suppose you do find one line that moves predictably faster than the others—maybe it has a really fast cashier and a nimble bagger. This outcome is observable to other shoppers; they are going to pile into your special line until it’s not particularly fast anymore. The chances of you picking the shortest line week after week are essentially nil. Mutual funds work the same way. If a portfolio manager starts beating the market, others will see his oversized returns and copy the strategy, making it less effective in the process. So even if you believe that there will be an occasional $100 bill lying on the ground, you should also recognize that it won’t be lying there for long.

Second, the most effective critics of the efficient markets theory think the average investor probably can’t beat the market and shouldn’t try. Andrew Lo of MIT and A. Craig MacKinlay of the Wharton School are the authors of a book entitled A Non-Random Walk Down Wall Street in which they assert that financial experts with extraordinary resources, such as supercomputers, can beat the market by finding and exploiting pricing anomalies. A BusinessWeek review of the book noted, “Surprisingly, perhaps, Lo and MacKinlay actually agree with Malkiel’s advice to the average investor. If you don’t have any special expertise or the time and money to find expert help, they say, go ahead and purchase index funds.”8

Warren Buffett, arguably the best stock picker of all time, says the same thing.9 Even Richard Thaler, the guy beating the market with his behavioral growth fund, told the Wall Street Journal that he puts most of his retirement savings in index funds.10 Indexing is to investing what regular exercise and a low-fat diet are to losing weight: a very good starting point. The burden of proof should fall on anyone who claims to have a better way.

As I’ve already noted, this chapter is not an investment guide. I’ll leave it to others to explain the pros and cons of college savings plans, municipal bonds, variable annuities, and all the other modern investment options. That said, basic economics can give us a sniff test. It provides us with a basic set of rules to which any decent investment advice must conform:

Save. Invest. Repeat. Let’s return to the most basic idea in this chapter: Capital is scarce. This is the only reason that any kind of investing yields returns. If you have spare capital, then someone will pay you to use it. But you’ve got to have the spare capital first, and the only way to generate spare capital is to spend less than you earn—i.e., save. The more you save, and the sooner you begin saving it, the more rent you can command from the financial markets. Any good book on personal finance will dazzle you with the virtues of compound interest. Suffice it here to note that Albert Einstein is said to have called it the greatest invention of all time.

The flip side, of course, is that if you are spending more cash than you earn, then you will have to “rent” the difference somewhere. And you will have to pay for that privilege. Paying the rent on capital is no different from paying the rent on anything else: It is an expense that crowds out other things you may want to consume later. The cost of living better in the present is living less well in the future. Conversely, the payoff for living frugally in the present is living better in the future. So for now, set aside questions about whether your 401(k) should be in stocks or bonds. The first step is far more simple: Save early, save often, and pay off the credit cards.

Take risk, earn reward. Okay, now we’ll talk about whether your 401(k) should be in stocks or bonds. Suppose you have capital to rent, and you are deciding between two options: lending it to the federal government (a treasury bond), or lending it to your neighbor Lance, who has been tinkering in his basement for three years and claims to have invented an internal combustion engine that runs on sunflower seeds. Both the federal government and your neighbor Lance are willing to pay you 6 percent interest on the loan. What to do? Unless Lance has photos of you in a compromising position, you should buy the government bond. The sunflower combustion engine is a risky proposition; the government bond is not. Lance may eventually attract the capital necessary to build his invention, but not by offering a 6 percent return. Riskier investments must offer a higher expected return in order to attract capital. That is not some arcane law of finance; it is simply markets at work. No rational person will invest money somewhere when he or she can earn the same expected return with less risk somewhere else.

The implication for investors is clear: You will be compensated for taking more risk. Thus, the more risky your portfolio, the higher your return—on average. Yes, it’s that pesky concept of “average” again. If your portfolio is risky, it also means that some very bad things will occasionally happen. Nothing encapsulates this point better than an old headline in the Wall Street Journal: “Bonds Let You Sleep at Night but at a Price.”11 The story examined stock and bond returns from 1945 to 1997. Over that period, a portfolio of 100 percent stocks earned an average annual return of 12.9 percent; a portfolio of 100 percent bonds earned a relatively meager 5.8 percent average annual return over the same period. So you might ask yourself, who are the chumps holding bonds? Not so fast. The same story then examined how the different portfolios performed in their worst years. The stock portfolio lost