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Venture Capitalists Expect to Lose Money on Some Investments

April 12, 2010 Leave a comment

Wall St. Cheat Sheet argues that there is a bubble in software companies and that it is going to end badly for investors.

The thing is, all of the companies cited are funded by venture capitalists and angel investors, all of whom build into their businesses a number of failures. So, I don’t really see where the bubble is, or why its consequences would be like that of the dot-com bubble. The distinction here is that a lot of the dot-com companies were publicly traded and so the man on the street could gamble with them. The small software companies building web apps, like AppMakr, ManyMoon, BaseCamp, and FourSquare (all of which are cited by Wall St. Cheat Sheet) are not financed by public equity holders, and so are not analogous to the dot-com companies. These companies are funded with private money.

The business model of venture capitalists and angel investors has always been that a few outsized hits will more than recoup the losses that most of their investments incur. This is why venture capitalists and angel investors are known for their “high risk/high reward” business model. (This is also why most individual investors had no business investing in dot-coms, but that is another story entirely.) But the notion that these companies represent a dot-com-style bubble is rather far-fetched.

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The Optimistic Case for the US Economy

April 11, 2010 Leave a comment

Daniel Gross waxes optimistic about the state of the American economy:

But the long-term decline of the U.S. economy has been greatly exaggerated. America is coming back stronger, better, and faster than nearly anyone expected—and faster than most of its international rivals. The Dow Jones industrial average, hovering near 11,000, is up 70 percent in the past year, and auto sales in the first quarter were up 16 percent from 2009. The economy added 162,000 jobs in March, including 17,000 in manufacturing. The dollar has gained strength, and the United States is back to its familiar position of lapping Europe and Japan in growth. Among large economies, only China, India, and Brazil are growing more rapidly than the United States—and they’re doing so off a much smaller base. If the U.S. economy grows at a 3.6 percent rate this year, as Macroeconomic Advisers projects, it’ll create $513 billion in new economic activity—equal to the GDP of Indonesia.

This is all well and good, and it would be nice if it comes to pass. But here’s the thing: Gross is essentially being a contrarian here. He looks good if the economy turns out to perform better than the consensus opinion suggests, and, well, if the economy crashes, none of us are exactly going to be looking to him for guidance anyway.

“People with mortgages are still renters…”

April 11, 2010 Leave a comment

An incisive comment about people’s misunderstanding of what a mortgage represents: it is a promise to pay back a creditor a lump sum plus interest payments. In what real sense, then, is a mortgage holder an owner of a piece of property?

Via Felix Salmon’s Twitter feed.

Should You Invest with the Random Guy Down the Street?

April 11, 2010 Leave a comment

Apparently the new thing is for people to invest with miscellaneous investors who have generated some good returns:

Who needs a stock broker or mutual fund when you can take on the big shots at their own game? A growing number of investors are casting their lot not with Wall Street’s giants but with the small-time stock pickers on Main Street.

Covestor.com, the site that Mr. Risch uses, has grown from a handful of registered users to more than 27,000 since it launched in 2007. Another upstart, kaChing.com, says it has attracted more than $6 million from clients who follow its “geniuses”—seasoned pros plus a handful of individual investors who have racked up exceptional records verified by the site. Those individuals include a former chemist, a health-care industry worker and a college student who caught the investing bug after watching the Oliver Stone movie Wall Street (and who is up more than threefold in the past year).

The assumption seems to be that these individual investors have some insight into the market that professional market players don’t. Admittedly, a lot of the advice proffered by self-described market pros isn’t worth the energy they expend propounding on the markets, but it doesn’t follow that following the random investment ideas of small investors will yield better returns over time. In any event, these services are a rather expensive proposition:

Fees for most managers on Covestor average $98 a year for each $10,000 invested, but managers charge up to 2.3% for the more actively traded portfolios. That doesn’t include trading commissions that clients pay separately. KaChing’s fees average 1.25% before commissions, and it has some managers who charge more than 2%. That compares with the fund industry’s average expenses of 1.4% for actively managed domestic stock funds. KaChing CEO Andy Rachleff says the fees aren’t high when you factor in other expenses, such as marketing fees and sales charges that can jack up the costs of mutual funds. Covestor CEO Perry Blacher adds, “There are no hidden fees, no middlemen, no Wall Street conflicts of interest.”

It seems to me that the standard advice of a broadly diversified portfolio of low-cost index funds is what most small investors should choose. Boring, but (relatively) safe.

Bad Business Models and the Consequences of Union Labor

April 8, 2010 Leave a comment

Megan McArdle has an incisive post about the problems that have driven US Airways and United into each others’ arms:

The airline industry is not a particularly attractive market. You’re selling a perishable commodity–once the doors close, any unfilled seats are worthless–to an audience that stubbornly resists treating your product as much other than a commodity. Attempts by the airlines to resist this, with their byzantine pricing rules and frequent flier programs, have by and large not succeeded particularly well; business travelers tend to have multiple frequent flier accounts unless they live near a single airline’s home airport, and economy fliers don’t care. Meanwhile, software is steadily eroding their ability to thwart bargain-hunting consumers through pricing power.

Clearly, the airlines have plenty of reasons for their current parlous state. But it is interesting to consider that, given the blame intransigent labor unions have in this state of affairs, how few people make the connection between rigid labor rules and poorly managed companies. Companies with a history of rancor between labor and management–which describes most unionized workforces–spend a lot of time and energy managing that fractious relationship and so spend less time on operational goals such as product innovation and revenue growth. Compare and contrast Apple and Google with the airlines.

Real Estate and its Consequences

April 7, 2010 Leave a comment

One of the interesting things about thinking about finance in terms of cognitive bias is that you suddenly see how pervasive certain biases are. In real estate, confirmation bias seems pervasive. For young professionals in their 20s or 30s, the thinking goes something like this: My parents bought real estate in the late 1970s or early 1980s and have made a lot of money on paper (or have sold real estate multiple times); therefore, it’s a great investment over the long term. Or, real estate flippers reason: My friend acquired multiple pieces of property and put his kids through college with the proceeds; surely, I am smarter than him.

The problem with this kind of thinking is that it ignores the underlying economy. If the economy does not grow, then real estate prices don’t grow. Real estate prices, over the long term, are a good proxy for an economy’s trajectory. If real estate prices are increasing, the economy is growing because personal incomes are growing and capital is cheap.

The other problem with the real-estate-is-a-good-investment thesis is that bankrupt municipalities and state governments do not make for places where people want to live. Or, rather, owning real estate in states and municipalities that can’t pay their bills is a troublesome concept. Just think of what happened to New York City real estate prices during its fiscal crisis of the late 1970s.

So, there are a lot of problems with owning residential real estate. The most important of these problems, and the one least in control of the homeowner, is the fiscal stability of the local and state government.

But, beyond those factors, about which much more could be written, lie a number of other troubling aspects.

Felix Salmon writes eloquently:

Homeownership is, if anything, a drag on the economy, since it funnels resources into unproductive overconsumption, and helps to impede labor mobility. There is absolutely no reason to believe that countries with high levels of homeownership, like the U.S., have better economies than those with low levels of homeownership, like Germany.

The survey just gets more depressing from there. Americans think now is a good time to buy a house, largely because they think it’s always a good time to buy a house. And they reckon — even now — that house prices are going up, or will at least stay stable.

Of course, free marketers will argue that people ought to be free to spend money on whatever they please, and if real estate pleases people, so be it. This is true. But it’s also important to remember that the real estate market is neither a free market nor a liquid one. One’s real estate follies can’t as easily be reversed as one’s foolish investment in overpriced Apple stock. The real estate market is also manipulated by the government, firstly by allowing homeowners to deduct interest from their taxes, and secondly by serving as a backstop in the form of Freddie Mac. Indeed, it has been the explicit social policy of the United States government over several decades to encourage homeownership, especially among the poor. While its origins have a laudable goal–encourage access to responsible use of credit–the practical realities of expanding homeownership to ever-greater numbers of people has been that many people who are not able to parse the terms of a mortgage document, or build a loan amortization table, or earn enough money on a monthly basis to service the debt inherent in taking on a mortgage, have become homeowners. Not all of these people should own homes. We’ve moved from being a society where housing is seen as a civil right to where homeownership is seen as a civil right. The former makes sense; the latter does not.

Finally, a note on rentals. Megan McArdle notes that rental prices in many metro areas have been increasing recently. Arguably, this bodes well for the economy: if rental prices are picking up, it means that tenants feel that they can pay more because they are more secure in their jobs. However, she also notes that rental price increases may also be a consequence of the government’s intervention into the housing market, which intervention has kept housing prices artificially high. This of course raises the question: if the government’s explicit policy is to encourage homeownership, why does the government also intervene to keep market prices high? The answer to this is obvious: the government likes to have its cake and eat it, too.

Update: Matthew Yglesias makes some very perceptive comments about how Greenspan & Bernanke egged the housing bubble on.

Offshoring Jobs and the Myth of a Static Economy

April 6, 2010 1 comment

It has become a commonplace that American jobs have been eliminated in favor of cheaper labor overseas. To some extent, this is true, but it misses the real story. Most of the jobs that have moved overseas, and which are not coming back to the United States, are jobs for which educational requirements are minimal. The poorly trained and uneducated are the victims of structural changes in America’s economy.

(Other victims of structural changes in the American economy are the overeducated who pursue education in fields for which there is very little demand, such as humanities PhDs. But there is little sympathy for naive academics who find themselves unemployable.)

But, there’s nothing new about this. When elevators went from manual to automated, the people who lost out were elevator operators, who, of course, did not need much in the way of education to do their jobs. Likewise, when sock or textile manufacturers move their operations from, say, the Midwest, to China, it is the employees of American textile mills, who, by and large are relatively uneducated, who lose. Other Americans gain.

Now, to a very large extent, this is blaming the victim for economic forces beyond his control. That is true. However, it is also true that if the American economy wants to continue to grow over the coming decades, there will be winners and losers in it. Egalitarianism is a false ideal upon which Stalin murdered tens of millions of people. That is what social safety nets are supposed to account for (in part). It is also incumbent upon people to realize the precariousness of their current employment and pursue opportunities to develop skills that are transferable. The United States’ deplorable educational system does not help in this regard.

But we can’t conclude from any of this, as some do, that the overall number of jobs in the United States has decreased because a lot of those jobs have been moved overseas. Neither the economy nor the number of jobs is a static thing. Buggy whip manufacturers were driven out of business by the development of the internal combustion engine, but in the decades since the internal combustion engine was invented, many more jobs than were ever lost by buggy whip manufacturers have been created.