Naked Economics: Undressing the Dismal Science pdfdrive com

CHAPTER
7

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Financial Markets:
What economics can tell us about getting rich quick (and losing
weight, too!)
W
hen I was an undergraduate many years ago, a new diet swept through one of
the sororities on campus. This was no ordinary diet; it was the grapefruit and ice
cream diet. The premise, as the name would suggest, was that one could lose
weight by eating large amounts of grapefruit and ice cream. The diet did not
work, of course, but the incident has always stuck with me. I was fascinated that
a very smart group of women had tossed aside common sense to embrace a diet
that could not possibly work. No medical or dietary information suggested that
eating grapefruit and ice cream would cause weight loss. Still, it was an
appealing thought. Who wouldn’t want to lose weight by eating ice cream?
I was reminded of the grapefruit and ice cream diet recently when one of my
neighbors began to share his investment strategy. He had taken a big hit over the
past year because his portfolio was laden with Internet and tech stocks, he
explained, but he was plunging back into the market with a new and improved
strategy. He was studying the charts of past market movements for shapes that
would signal where the market was going next. I cannot remember the specific
shapes he was looking for. I was distracted at the time, both because I was
watering flowers and because my mind was screaming, “Grapefruit and ice
cream!” My smart neighbor, who is both a doctor and a university faculty
member, was venturing far from the halls of science with his investment
strategy, and that is the broader lesson. When it comes to personal finance (and
losing weight), intelligent people will toss good sense aside faster than you can
say “miracle diet.” The rules for investing successfully are strikingly simple, but
they require discipline and short-term sacrifice. The payoff is a slow, steady
accumulation of wealth (with plenty of setbacks along the way) rather than a
quick windfall. So, faced with the prospect of giving up consumption in the
present for plodding success in the future, we eagerly embrace faster, easier
methods—and are then shocked when they don’t work.
This chapter is not a primer on personal finance. There are some excellent
books on investment strategies. Burton Malkiel, who was kind enough to write
the foreword for this book, has written one of the best: A Random Walk Down
Wall Street. Rather, this chapter is about what a basic understanding of markets
—the ideas covered in the first two chapters—can tell us about personal
investing. Any investment strategy must obey the basic laws of economics, just

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as any diet is constrained by the realities of chemistry, biology, and physics. To
borrow the title of Wally Lamb’s best-selling novel: I know this much is true.
At first glance, the financial markets are remarkably complex. Stocks and bonds
are complicated enough, but then there are options, futures, options on futures,
interest rate swaps, government “strips,” and the now infamous credit default
swaps. At the Chicago Mercantile Exchange, it is now possible to buy or sell a
futures contract based on the average temperature in Los Angeles. At the
Chicago Board of Trade, one can buy and sell the right to emit SO
2
. Yes, it’s
actually possible to make (or lose) money by trading smog. The details of these
contracts can be mind-numbing, yet at bottom, most of what is going on is fairly
straightforward. Financial instruments, like every other good or service in a
market economy, must create some value. Both the buyer and seller must
perceive themselves as better off by entering into the deal. All the while,
entrepreneurs seek to introduce financial products that are cheaper, faster, easier,
or otherwise better than what already exists. Mutual funds were a financial
innovation; so were the index funds that Burt Malkiel helped to make popular.
At the height of the financial crisis in 2008, it became clear that even Wall Street
executives did not fully understand some of the products that their firms were
buying and selling. Still, all financial instruments—no matter how complex the
bells and whistles—are based on four simple needs: