University: Is it worth it?

Next year, university students will have to pay £9000 a year for tuition, but is this fair and is it still beneficial to go to university?

Uni as an investment

Despite the tripling of fees, university still adds up as a good investment. By the time you are 43 you would have earned more than someone who only completed their A levels, even though they had a three year head start (see below)*.

However, if you were to take a gap year and choose a low earning degree (art, music, media studies etc) then it simply doesn’t become a worthwhile investment.

Recently the amount the average graduate earns over their lifetime has narrowed when compared to that of a non-graduate. The reason is a simple case of supply and demand. A sluggish economy means subdued demand, plus an ever increasing amount of graduates desperate for a job means that the wage they can command will be less.

Recently there has been a strong increase in the amount of graduates applying to science, maths, medicine and of course, economics. This is because such subjects not only improve the chance of graduates being employed but also the wage they will have when they find employment. This is a direct result of recent increases in the cost of attending university.   

Fairness

Many of the recent protests regarding the increase in tuition fees are quite understandable. These students will be paying 3 times more for their degree than the previous year. It doesn’t sound very fair. But actually the tax payer has had the unfair deal for the last few decades.

Before the cuts the government would spend £7.2bn on universities, that’s £272 per household per year. When you consider that the primary beneficiaries of that money are the students themselves, it’s quite a lot. Effectively what you have is the less well off being taxed to pay for the future rich students. Certainly there are a lot of social benefits from having a more educated workforce and universities should receive subsidises from the government. However, when the student takes on so little of the cost, the result is inequitable and a waste of resources, especially when the costs go on a course which will provide little benefit to anyone.

You should go!

For students that have carefully considered their course, are self motivated and determined, university is definitely worth it. The above graph only shows the tangible financial benefit, but going to university has so many other benefits. For example living with other young, like minded people is very liberating and a lot of fun. All of those experiences at university that you cannot count certainly add value to to going.  Any graduate will tell you that the happiest days of their life were those spent at university.

* The cumulative earnings are linear as they are based on average earnings, therefore, form the data based on the graph, you cannot judge the time at which a degree would surpass the earnings of A levels

The Lottery: 99.999999% certain it’s not going to be you

You’ve seen it in the news, all your friends are talking about it, the Euro millions jackpot is over £150m. You start to imagine what it would be like winning all that money; houses, cars, yachts and planes fill your mind. You don’t care what the odds of winning are, some has to win it and as Camelot says “it could be you!”

 Sound familiar? Then you have a classical case of probability blindness.

The human brain is not really wired to calculate things. It has evolved to catch prey, grow crops and generally make living easier. So when the chance of all up wildest dreams coming true is up for grabs the smart part of the human brain shuts down. For example take this simple maths question, which you are going to get wrong.

A bat and a ball cost £1.10 in total. The bat costs £1 more than the ball. How much does the ball cost?

Got the answer?

Even though I forewarned you about your error, you still think the answer is 10p. Don’t feel too bad, almost everyone answers this question wrong. The reason being is the brain sometimes jumps to the answer without reviewing the calculation. We often have to force ourselves to do the calculation.

So, if the ball costs 10p and the bat is £1 more, then bat is £1.10 which totals £1.20. But if the ball cost 5p and the bat is £1 more then the bat is £1.05 totalling £1.10. Not rocket science, but we have to force ourselves to do the calculation and it is the same case with the lottery. The brain thinks “there is a chance of winning £150m, the ticket only costs £2 - it’s a good deal”. We have to stop ourselves becoming emotional about the lottery, stop ourselves imagining what it would be like to win and start thinking about why we are throwing away £2 every week?

To help break through this irrationality you can use a simple tool, Expected Monetary Value (EMV), which is the probability of winning times the winning amount.

EMV

To know weather your ticket is good value or not, first you must consider the odds of winning.

To calculate this, you take the odds of guessing a single number correctly, that is 1 in 50. Guessing the next ball is slightly easier since one ball has been removed. So 1 in (50 x 49). You will need to match 5 numbers. But you don’t need to match them in any order, so you divide by the number of permutations factorial (5x4x3x2x1).

So far we have (50x49x48x47x46) / (5x4x3x2x1) = 2.1million to one

Not bad you might think, but in the Euro millions they add another set of numbers, ironically called ‘Lucky Stars’. Here you have to guess another two numbers from a pool of numbers. So an additional (11x10) / (2x1) = 55 but we are not adding we are multiplying (55x2.1milion) = 1 in 116.5million!!!!!

But the jackpot could be massive; a few weeks ago it was £166m (which it was capped to)! So is it worth it?

The EMV is the probability of wining (in decimal form) times the winning value. If the EMV is lower than the cost of the ticket, it is not a good investment.

EMV = (1/116.5million) x £166million = £1.42

The ticket cost if £2.

There are of course other prizes to be one, (not that you really care about those), if we included those it only increases the EMV to £1.80.

So the highest ever jackpot for Euro millions was still not worth buying.

There was one case where a ticket was worth buying. In 1992 some Australian investors noticed that the Virginia state lottery had an EMV of $3.95 when the ticket only cost $1.   So they quickly found 2500 investors, investing $3000 each and set about buying every possible combination of tickets. The problem they had was trying to them all in a week (they had to buy over 7 million tickets). They hired 125 people to fill out the tickets manually in stores across Virginia, but it wasn’t enough. By the time the draw went ahead the investors had only 60% of all possible combinations.  They also had another fear, what if they had to share their jackpot? In both cases the investors were massively exposed to a big loss. They watched the draw nervously, to their delight there was only one winner and it was them.

Ambition Depressor

On a concluding note, the lottery is only £2, it’s not a massive amount of money to throw away, but I do have concerns that the lottery inhibits ambition. Dale Carnegie, author of How to Win Friends and Influence people writes that one of the main hungers we have is for ‘money and things that money buys’, in other words ambition. Ambition however can be satisfied without actually encountering the money, so long as you’re moving in the right direction. For example when looking for a new job you have an ambition to move on, a hunger, but when you send off your CV to a company you feel satisfied that you are moving in the right direction. For people buying lottery tickets, I believe the hunger for ambition is being satisfied, even though there is practically no chance of winning. How many times have you herd someone who is unhappy with their job or in a bit of financial trouble part jokingly say “I’m hoping to win the lottery”? 

If everyone stopped buying lottery tickets, stopped fanaticising about the event which will never happen and instead focused on practical ways of improving their life, 99.999999% of people would be a lot better off.

Economics of Rioting

The mass riots across our green and pleasant land have left many with a sense of disbelief and shock. The reasons behind what occurred are long and complex and most are beyond the scope of this blog, but there are some aspects that can be explained by simple economics. 

How it Started

Like many previous mass riots, the spark is usually related to race. Many young black men feel that they are discriminated against. They feel that the government and the institutions it supports are prejudiced against them. And to be fair, they have a point.

If you’re black you are 8 times more likely to be stopped and searched by police than a white person. Jermain Defoe had to get a restraining order so that Essex police stopped pulling him over ever time he drove around Essex. David Starkey, a respected Historian with a TV series on the BBC, has recently spoken on an interview regarding the riots saying “the whites have become black” as if they have caught some sort of criminal disease. So when a man was killed by police in suspicious circumstances, for the young black people of Tottenham this was a tipping point of outrage.  

The riots were intensified with false rumours sent around via Blackberry messenger saying that other black man had been killed by police, and soon similar protests erupted around London. The police gave the rioters some space, understanding that a full blown confrontation could exacerbate the situation. However neither they, nor anyone else expected the onslaught of the opportunist looter. 

The Rational Looter

When the riots in Tottenham had reached a critical mass the opportunists suddenly gained an incentive to riot.

Consider this,

Cost = Probability of being caught x Cost of being caught (including social costs)

Benefit = value of probable haul + value of emotional thrill

For most of us the cost of being caught would be horrific. We would lose our jobs, our friends and any value we appoint to our social standing. For the young, unemployed and low paid, this cost is significantly lower. They also value the haul more than we would. Many of the young crowd involved use their branded clothes, watches etc as a way of showing social status. Thirdly, many of the rioters were teenagers, who are generally emotionally volatile anyway, would find looting a greater thrill than the more mature civilian.

Generally however, a looter is no different from you or I. They will consider the benefits and costs and make a rational decision. When the police held back on engaging the rioters at first, it created an interesting affect on their cost calculations.

If we expand on the ‘Probability of being caught’, we can gain an insight into the mind of a looter.

Probability of being caught  =  (Number of police x  arrest % per officer) / Number of rioters

Before the riot we could assume to see something like this (300 * 80%)/400 = 60%

We assume a 60 % chance of being caught would not make looting a worthwhile (60% x Cost of being caught is grater than the benefit). But when the police initially held back from the rioters, the arrest % fell to a low figure say 20%.

(300 * 20%)/400 = 15%

Now looting becomes a little more attractive.

Potential looters will assign different levels of value to the haul and to the thrill of rioting, but as the number of looters increase, the probability of being caught falls. This means more and more will find looting attractive.  Imagine a 200 increase in the number of looters.

(300* 20%)/600 = 10%

This is a chain reaction, the more people start rioting the more that will find it attractive. A spiral will start with an ever falling probability of being caught. Looking at the overall cost Benefit analysis then looting becomes completely rational.

The reader might think, “I would never steal, even if the benefits outweigh the costs”. Ask yourself; have you downloaded any songs that you have not paid for? Any DVDs that are not entirely legitimate? When you stole the music or the brought the illegal DVD you did the exact same Cost-Benefit analysis as the looters.

If the government wanted to stop wide spread looting in the future it should do the following.

1. Make sure that either police numbers are high or arrest rates are high (preferably both)
2. Increase the cost of being caught, with stiffer sentences and larger fines.
3. Increase the value that young people assign to their community. Currently in large cities the value young people assign is small.

Obviously there are lots of things to discuss here; I would love to hear your thoughts on the riots so please comment below.

Stock Market Speculation

A few weeks ago a colleague of mine was telling me how he had been watching this great company and was thinking of investing in it. All the pundits had said that the stock is on the up and it was a great deal – a “strong buy” they said, but he paused mid way though his sentence and said “why would anyone sell me their stock if they knew the price was going to rise?”

He had inadvertently stumbled upon the Efficient Market Hypothesis (EMH).   

The Competition

In the US 57 million households own shares out of 115 million, if we apply this logic the rest of the west there is a total of 139million people holding shares. Not all of these will be actively trading them; many will be sitting on the asset in the hope of selling it when it reaches a certain height, but a lot of them will be. The big money is controlled by hedge fund mangers, who can push and pull money around the world in an instant. They have the tools which provide them the latest information before anyone else (other non-traders), the minute a news story hits, millions of pounds are traded in an instant. They use every statistical and mathematical modelling there is to help them make the best purchasing decisions.

Often you will hear a friend say “invest in this company it’s under priced, you’ll make a fortune!” Before you do, ask them, “Do you think you have seen something that none of the 139 million traders haven’t?”

EMH

If an asset market, that has good level of liquidity (lots of buyers and sellers), the price is a perfect indicator of value. That is, the price reflects all information that is available. If the price was not truly reflective of the value of the stock, the millions of traders around the world would identify it and trade until the price did. 

Imagine a new piece of news hits the market that would cause a change in the value of the share. The price would respond almost immediately. By the time you read about it the paper the next day, the price is already fully reflective of that news story. If you were to buy the asset then, you are no longer going to gain from that particular news story. However you do have a 50:50 chance of gaining on the next story, before it comes out. This is the only way, according to the Efficient Market Hypothesis; you can beat the market and earn a short term return.

The price of an asset as an aggregate reflection of the combined wisdom of all the traders and analysts, with millions of traders speculating around the world, often disagreeing on strategy, no one trader can be expected to consistently gain over the others. When prices are not fair, they are randomly so, this means a trader will gain as much as they loose.

In short, when you think you can beat the market because you’ve heard a news story or just have a belief in a stock just remember “Trust markets, not people”. This also applies to the analyst in the papers that tell you to buy or sell a share; in this respect they are no different to an astrologist.

Animal Spirits

Like many economic theories, there is a slight problem with the EMH, humans are animals and are not entirely rational.

Humans suffer from all sorts of irrational behaviour, for example underestimating the odds of wining the lottery is common one. This irrationality also applies to the markets. Some traders hold a false belief that a stock is going to continue to rise due to cognitive biases (when holding a belief, the trader will search evidence that support that belief and ignore the evidence that does not).   

Prices can offer suffer mass distortions of value by traders not looking at the value of stock, but at what other people think the stock is worth. John Maynard Keynes (the equivalent of Jesus to economists) said “We have reached the third degree where we devote our intelligences to anticipating what the average opinion expects the average opinion to be.”

In a case of some bad news hitting the markets, traders are not looking at what the true value of a stock is, but what the average person is going to do with that stock. This creates herd type behaviour, where every shareholder runs for the exit in a mass panic with a ‘beggar thy neighbour’ mentality – Get out before anyone else does.    

Equally bubbles can form, where an assets price is massively overvalued. Because the average person believes the average person believes the stock is going to rise, it will do - in a self fulfilling prophecy.  A great example, I believe (although I suffer from cognitive biases as much as the next…) is gold. Gold historically was used for the basis of several currencies; in that respect it was an excellent store of value. Today however it is not the basis of any currency in the world. It’s only practical use is for jewellery and electrical products. However speculators believe that the average person believes that it is still a good store of value. As such, during the recent tough times, the price of gold has increased 160%. Buyers of gold believe they can sell it to a greater fool, and that greater fool believes he can sell to an even greater fool, and the bubble continues.

John Maynard Keynes lost a fortune, to what he called the ‘animal spirits’ in the markets. When a wheat was under valued he brought tonnes of it, assuning it would rise, however the rest of traders continued to sell, causing Keynes to left with tonnes of wheat that he was unable to sell .  

The list of irrational behaviours is a long one, and judging when markets will behave rational (EMH), and when it will not (animal spirits), is a difficult task.

 

If you’re thinking of investing in a stock, ask your self this – does the average opinion expect the average opinion to be rational? 

US Debt Default: What if?

Currently Barack Obama is doing his utmost to avert a financial disaster. The US has a debt limit of $14.3 trillion dollars. This has already been surpassed (see US debt clock below) and is being financed by short term emergency arrangement with the Fed which involved holding back aids to states and borrowing from Federal pensions. By 2^nd August if the US has not raised their debt ceiling, they will default. 

Current US Debt as of 12.01 17/07/2011

At the moment the Republicans, who control the House of Representatives will not agree to a debt ceiling increase without planning significant spending cuts. Presumably at some point a compromise will have to be met and the US debt clock can continue ticking. But what if they didn’t agree, what if the unthinkable happened, the US defaulted -time for some ‘back of the envelope’ calculations and a hypothetical scenario.

Firstly the impact of default all depends on the type of default. For this calculation there needs to be some broad sweeping assumptions.

THE DEFAULT: If the US defaults on the interest payments only and not on the principal this will change the $14.3 trillion to a mere $502bn loss, assuming a 3.5% interest on the debt.

THE IMPACT: Many countries have large holdings of US debt, China would take a hit of $38bn and Japan $31bn. In the UK most of the holders of US debt are pension funds and private banks; they would be hit with an initial collective $11.5bn hit (£7bn). Note that this initial impact only hits the P&L. This would hit the profits of these companies but would not necessarily kill them.  The problem is when the value of the bonds falls.

Assuming that the risk reward appetite has not changed (which it certainly would), the value of the bonds would continue to fall until the expected return of the asset equalled 3.5%. For example bond with a face value of $100 will fall to $96.62 This would mean an additional £7bn write down of assets.

THE CONCEQUENCES: The problem with an asset write down, is that if it leaves a company with more liabilities than assets, no one would lend to it. The reason being is that if the bank was liquidated, the lender would not be able to get all their money back. If a bank were to have this problem, no bank would lend to it and all its creditors would try to regain their money. In other words, there would be a Run on the bank.

The Banking sector has a further Macro issue. When a bank looses money, it is not able to lend it out. Normally a bank will lend out many times what it has in cash reserves, this known as Fractional Reserve Banking. In this instance the£7bn hit to assets turns into around a £70bn loss of available credit, which would otherwise have gone to businesses, mortgages etc.

There is also something far greater to worry about…systemic risk. All banks have lent money to many other banks.   In the case above where a bank fails, all the other banks that have lent to it are also hit. They in turn will have to make asset write downs, perhaps not as big as the US default write down but if it is the tipping point for one bank then the rest of the industry will have to make another write down, and this process could potentially continue through several banks. This was the precise fear that stuck the banking industry when Lehman Brothers went down in Sep 2008.

Since 2008, banks have been increasing their reserves and improving their balance sheets so that risk of such an event would not happen again. But would it be enough? Recent stress tests showed that European banks would require another 80bn Euro to protect themselves form a Greek default, a US default would require significantly more.

A US default like the one described above would be unlikely to herald the end of capitalism as we know it, but it could prove to be the tipping point for several companies, banks and, possibly nations.

Thoughts, comments and questions welcome.

Quantitative Easing: Inflating Hardship

Quantitative Easing is a policy used by the Bank of England, but what are the consquences?

Quantitative Easing (QE), as it’s oddly called, is a means of increasing the flow of money in the economy. It works by a central bank (Bank of England) purchasing financial assets off banks and other financial institutions and leaving them with a pile of cash to spend.

QE helps the Private Sector in three key ways. Firstly the purchase of the financial assets will increase their price and cause the interest rate that the asset yields to fall. If a company is considering a major investment project, it will have a greater incentive to invest it in a project rather than buying a financial asset. More generally the Opportunity Cost of consumption and will fall.  Secondly, where before the bank had an asset giving a fixed return each year, the bank now has cash which does not give any positive return (unless deflation is taking place). The bank will then lend this out to aspiring entrepreneurs, company’s looking to invest and consumers looking to take advantage of the reduced interest rates. Lastly, there are the multiplier effects that follow this.

Whilst QE sounds sensible, it has many unintended consequences.

Firstly the supply of sterling has increased significantly. This means that the Pound is worth less. This is good news for exporters as their products will be cheaper on international markets however imports like oil and other commodities become more expensive. This problem is further exacerbated by other retaliating countries following similar policy. Since QE policies have been adopted by several central banks, there has been a great deal of volatility between currencies, in what some commentators have called a currency war.   All this volatility has lead many investors to search for solid stores of value i.e commodities (see below).

FX indexed GOLD (BBC)

$/oz Silver

The increase in commodities has pushed inflation even further. Considering the role of the Bank of England is to control inflation is QE logical? -beacuse the results speak for themselves (see below)

Thoughts and comments welcome.