Educating Myself on Personal Finance

I recently finished reading A Random Walk Down Wall Street, and I’ve just started reading Irrational Exuberance. Financial literacy seems like the sort of thing that ought be taught in high school. Sadly, one learns hardly anything of practical value in high school. I don’t remember where I’ve heard about these books, but for some reason, I thought they were famous. In the case of Random Walk, that seems quite likely, since eleven editions of it have been published since 1973, and for what it’s worth, it has its own Wikipedia page. Irrational Exuberance was first published much more recently in 2000 (the second (most recent) edition came out in 2005). Indeed, the phrase is a famous one, but it was not coined by the author, Shiller, one of the co-developers of the Case-Shiller home price index. Rather, the phrase gained instant fame when former Federal Reserve Chairman Alan Greenspan uttered it in a speech, sending stocks tumbling in financial markets around the world. The latest edition of Random Walk also mentions Irrational Exuberance (the book) several times.

I have to admit, one reason that I picked up Random Walk is its title. Unlike so many books about personal finance and business success, the title is NOT of the form “N Secrets/Rules of Being Super Successful”, where N is some nice round number between 5 and 12. Those books are clearly engineered to maximize sales for the author and/or publisher. Therefore, sound advice is unlikely to be found in such books. It becomes obvious upon cursory reflection that the world isn’t simple enough to be described by a handful of rules. If things were that simple, economists would be able to predict and even prevent economic crises. The reality is that economists can’t even agree with one another on fundamental issues.

Another thing that appealed to me about the title is that it pays homage to an important concept in mathematics: random walks. An example of a random walk is a drunkard stumbling around. Where he ends up depends on how many steps he takes and is the product of a random walk. The book does not (over) promise certainty or success. Instead, it acknowledge one of the most disappointing facts about reality at the expense of mass appeal: we have a really poor grasp of how the world (particularly the economy) works, and our best models are non-deterministic. People are too often uninterested in models of the form “the outcome of A is sometimes B, sometimes C, and sometimes D”. They (understandably) prefer “the outcome of A is always B”, because the certainty of such models is very comforting, and does not require thinking about probability, which people find intimidating (rightfully so, since most people have poor intuition when it comes to probability). Despite the topic heavily relying on probability, both of these books strive and manage to be accessible to the layman.

I hate to obsess about the title, but one last comment that I have about it is that unlike other books on related topics, it does not try to impress you with “suits and ties”. Always look past the tidy presentation for the substance. I find it refreshingly whimsical.

What Can You Expect to Learn from Random Walk?

If I had to sum up the advice of this book in one sentence, it would be this: do not try to trade in and out of individual stocks (even the professionals fail at this); instead, buy indexes, and hold them for a long time. The main lesson of this book is that nobody knows how to predict stock prices, not even professional investors. This is a consequence of the “efficient market hypothesis” (EMH), perhaps the most important assumption in all of economics, and one well worth understanding, even if you don’t entirely believe in it (as I do not).

I just got done explaining how the world is complicated, and understanding it requires more sophistication than a small set of rules can possibly contain. A corollary of this is that the previous paragraph is a gross simplification, and that you should read the book to understand what you can expect from various investment strategies. Anyone who gives you advice without explaining it is selling you snake oil. Purveyors of snake oil often have a story for their advice too, but don’t confuse a story with science. What I mean by “story” is something that sounds plausible, but which offers little or dubious scientific support. Sadly, evaluating scientific evidence is another critical skill that is practically neglected by high school education.

This book not only contains practical advice like what I described above, it tries to give you a fundamental understanding of the stock market, one of the most important, interesting, and challenging parts of personal finance. It explains two basic theories for stock values: Fundamental Value, and Castle in the Clouds. It also explains two broad classes of investors: fundamentalists vs. chartists. It then goes on to criticize these theories and strategies (among others). This, again, throws to the wind spoon feeding comforting stories for the sake of appealing to a mass audience in an effort to drive book sales, and is the reason that this book should have real credibility. The book does not try to convince you of these theories. Rather, it explains the reasons you should believe them, as well as the reasons that you should not. Most theories have limits, which must be understood if they are to be applied effectively. Anyone who tries to sell you a theory but cannot explain its limits should not be trusted.

In addition to explaining the problems with the most important theories about the stock market, the book tries to inoculate against irrational exuberance by giving a brief history of finance, particularly highlighting bubbles, which we all hope to avoid repeating. The most famous (and colorful) of these is “tulip mania”, which occurred in 17th century Europe. The lesson that I take away from tulip mania (and other bubbles) is that it is easy for the public (professional investors included) to get caught up in rising prices and drive prices up still further (on the basis that some greater fool will buy from you in future) until they reach a point of collapse (the chain of fools runs out, much like a ponsi scheme).

Most of us have heard two of the basic rules of personal finance: have a well diversified portfolio (buying an index fund gives you this automatically), and allocate away from stocks and more toward bonds as you get older, because you will be less able to survive the the downturns of the stock market as you approach, and achieve retirement. The book elaborates on basic principles such as these.

The book also delves into more esoteric topics such as options and futures (the most important types of derivatives), although it doesn’t particularly recommend using them. Even if you have no intention of using them, you have no doubt heard about derivatives, assuming that you have been paying any attention to the financial news over the past six years. It seems that, for better or worse, an understanding of derivatives is becoming an important part of general awareness and civic participation. How can you know who to vote for, if you do not understand the positions that candidates hold on financial regulation (or lack thereof)?

Hopefully, I have convinced you that this book will not only give you sound advice, and reasons to believe such advice, but more importantly that it will give you much to think about. This is the mark of a truly great book, a quality that you will not find in “N Secrets/Rules to Being Super Successful”.

What About Irrational Exuberance?

Frankly, I haven’t gotten very far yet. But if you read my blog at all, you know I am quite interested in poking holes in the notion of rational agents (supposedly you and me) running the economy. Thus, I look forward to adding fodder to that pile of knowledge :) So far, it has failed to disappoint. It focuses on bubbles, such as those that occasionally occur in the stock and real estate markets, and tries to find explanations for them.

With respect to real estate bubbles, it is interesting to note that the second edition was published shortly prior to the 2007 collapse in house prices. This graph (taken from Wikipedia) of the Schiller-Case index tells much of the story:

Case-Shiller house price index from 1890 to 2012.

Case-Shiller house price index from 1890 to 2012.

Imagine you are looking at this graph around the time the second edition was released (i.e. a couple of years before the big peak near the far right). I suspect that with this long perspective of history, most people would be worried about prices falling, but like other bubbles, people were paying more attention to recent price increases, while paying little attention to such historical data, and concluding that jumping into the market was a smart move, fueling further price increases. It was a virtuous cycle, until the music stopped. Let’s hope we learned some lessons from that experience. That seems doubtful to me.

On a Personal Note

I was recently considering buying a house. What I saw was that prices are (again) rising steeply (in the San Francisco Bay area). I feared prices skyrocketing beyond my means. But fear of prices rising can be just as powerful as optimism about rising prices. The problem with following these emotions is that they tend to make one give less weight to the factors that anchor prices. When everybody is buying on these emotions, price stability suffers. If the Case-Shiller index prior to 1994 is indicative of trends in house prices over the long term (i.e. the economy has not, as many have repeatedly claimed, entered a new era of continual price increases), then houses are not a great financial investment, because they tend not to go up very much. The only sustained price increase in the graph coincides with troops returning from World War II. Instead seeing a house as a financial investment, it seems better to focus on other benefits that come with home ownership, like a sense of stability.

I’ve since stopped searching for a house to buy. Prices have increased dramatically in the past year. To me, this is a sign that prices are now high, and as we all know, buying high is a recipe for financial failure. I can’t say for certain house prices won’t continue to rise and sustain, but I also don’t have a particularly good reason to believe that would happen either. That seems like a good reason not to jump in. I haven’t given up researching housing though. It is, after all, a basic necessity.

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