Nova Science Now: The Wisdom of The Crowds

June 27th, 2008 BTG Posted in Psychology, Stuff I Saw On TV No Comments »

I was watching Nova Science Now on PBS last night. They ran a segment on the wisdom of the crowds, which askes the question”can a group of people be relied upon to draw a correct conclusion in a given situation“?

Permission was granted by PBS to embed the above video

The segment tells the tale of Sir Francis Galton, who “scorned the masses” and wanted to prove the ignorance of the collective commoners. He wanted to prove this empirically however, and devised a simple experiment: he set up a contest to guess the weight of an ox.

800 people guessed (or, as Nova puts it, Galton had “800 data points”), but no individual landed the corect answer of 1198lbs. He returned home to mathematically point out exactly how wrong the 800 individuals in the crowd were, but was surprised.

When the data was plotted, the curve that appeared before Galton was the cumulative distribution function of the normal distribution. Yeah..never mind, Nova puts it in plain english for us:

“… while no individual guessed the actual weight, the average of all the guesses is exactly right!”

Basically while no individual was correct, together they were capable of getting the right answer, by finding the average (actually the median) of all the guesses. As Nova later claims “It’s just like Wikipedia!” (well, sort of…).

I had a different thought: it’s just like the stock market.

Specifically, it’s just like the efficient market hypothesis, a school of thought that is of the opinion that, in the long run, it’s impossible to beat the market. The theory is that the market is efficient and at all times, and all stock prices reflect all knowledge that could possibly affect a given stock (all relevant information that is, news can and still does shake things up, as by definition news is something unknown and unexpected). The market reacts so quickly to news however, that proponents of the efficient market hypothesis believe that it is almost impossible to exploit this new information for profit.

Maybe it’s just because I’m currently enjoying “A Random Walk Down Wall Street” by Burton Malkiel, one of the most notable champions of the efficient market hypothesis. Maybe I had normal distributions on the brain, but the “wisdom of the crowds” seems to describe the efficient market hypothesis to a tee.

Think of the ox example, but replace the question of guessing the ox’s weight: now try to guess the price of a stock tomorrow. In Galton’s experiement, the ox weighs 1198lbs, and just like in the stock market, we have clues as to what the right answer should be. For example, perhpas the ox is larger than an ox you know is 900lbs: this might lead you to guess that the ox weighs more than 900lbs. You may have a lot or a little experience with oxen, and your answer will thus be either closer or furthur away from the real answer. You may simply just guess at random in hopes of winning the prize.

Now think of the price of the stock tomorrow: if you guess correctly you get the prize (by buying lower today if the stock is “supposed” to go up tomorrow and selling tomorrow for a profit, assuming no fees). Here the goal is to guess the “correct” price, and just in our oxen example, there’s a prize for guessing correctly and clues as to what the “correct” price should be. Fundamental analysts and amateurs alike use news, history, and financial reports, as well as their own experience to attempt to guess as closely as possible to the “correct” price and win the prize: profit.

But this got me thinking: clearly not everyone always gets the “right” answer, the right price (by which I mean what price the stock actually sells for the next day, I do not mean to imply that there is a “natural” price each stock should sell for), else, everyone would be rolling in money right now. This is true for both individuals AND PROFESSIONALS. As stated in the Nova broadcast, no individual is expected to get the right answer: you are far better off taking an average of all the guesses than picking an individual’s guess at random.

What’s the best way to figure out this average? The efficient market hypothesis says “Let the market figure it out”; if we wish to invest in the average then, we should simply invest in an index fund that tracks the market.

Now please remember I am not qualified to talk about mutual funds on a professional level. My thoughts in this blog are opinions, not advice.

This is actually easier said than done, especially in Canada. In Canada we don’t have as many options in terms of good index funds, and even those that exist have ridiculously high MERs (basically management fees) compared to our neighbours down south (who have access to Vanguard funds >.<). Using Globefund.ca is one way to find and rate index funds (follow the Globefund for BTG’s tutorial on how to use it!). As always, do your own research first!

What do you think? Leave a comment and let us know!

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CNN Money and Getting Back To Zero

June 16th, 2008 BTG Posted in Banking/Credit/Credit Cards, Stuff I Saw On TV No Comments »

I am, as always, trying to get to financial independence. Today I learned that being financially independent means more than just accumulating a positive (and hopefully appropriately large) net worth.

It also means having the ability and ease of adapting to the little negative fiscal curveballs that life throws you every so often.
Interestingly, it took a good hard long look at my budget (which we’ll get to in a second), and a CNN Money broadcast to help me realize this.

I caught a broadcast of CNN Money today which discussed the issue of living sans credit card. The broadcast was brief though reasonably informative. It featured, I believe, a young woman named Terri Cullen, discussing some behavioural studies concerning the behaviours of people using credit cards versus using cash. One statistic I remember was that when shopping for groceries the credit card users will tend to overspend by about 30%. I imagine this is likely the same for other types of purchases as well.

I wish I could link to the video, but the CNN Money site does not have a link to that broadcast (if you follow the link and you get an overwhelming feeling of AHHH! AHHH! OH GOD THE ECONOMY IS IN RUIN from all the articles, don’t freak out, that’s just CNN on threat level orange for ya).

Now, usually I don’t give these little 2 minute personal finance sound bytes much thought beyond verifying if they are worth furthur investigation (they are usually rapid fire and thus are not very involving or in depth, sadly), but this one struck a chord. It has recently come to my attention that I am currently over budget for June 2008, by a factor of about 20$ (I know this thanks to my handy dandy BTG Budget Template, coming soon!)

Recall from my Ben and Jerry’s economic epiphany post however, that 20$ is about 8-10% of my overall budget. What would happen if I was 10% over budget every month for a year? Two years? Five? Twenty? What if I was over 30% every time I purchased groceries? Every time I purchased anything?

“Nothing good” is the short answer. What’s worse, I realized is that the majority of these things are were paid for via my credit card, which means that if I cannot find the extra 20$ between the couch cushions before payment is due, I will have to carry it forward and pay interest.

So I’ve decided to switch to cash. No more credit cards except for emergencies. There’s only one problem.

I have to get back to zero.

Right now, I’m negative. I am indebted to the credit card company 10% above what I had budgeted to pay them. Are you like me? Are you budgeting to pay your June 2008 expenses with money you will be receiving in July? If so, we must ask ourselves one question:

What if our sources of income were cut off for one reason or another?
We’d be screwed, as we would no longer have the funds to pay for stuff we bought, and mostly consumed, full month before, right?

I was (and am) counting on having that positive, steady inflow of cash every month, so for the last little while I was relatively comfortable buying now and paying later. I have been very fortunate in my frugality, as I have never had a late payment on my credit card, though there have been some close calls. But with summer vacation leading to more time for thinking, my thoughts inevitably turn to money, and life, and the interconnections of the two, and how one is dependent on the other.

Your money, your income, is dependent on your life, and vice versa.

If something changes in life that adversely affects your ability to earn money, if you are as I am currently, buying now and counting on paying later, it will catch up to us.

So, I say thee NAY good sir! No more of this tomfoolery! I have decided that I will pay off my June 2008 balance, and not spend a darn thing in July that I don’t have to, so that when August comes around I will be working with money that I actually have, not money that I am counting on receiving.

No it won’t be fun, but hey, if growing up (financially, of course) were fun, it wouldn’t be growing up then would it?

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What We Can Learn From Ed McMahon

June 12th, 2008 BTG Posted in Everyday I Learn Something New, Stuff I Saw On TV No Comments »

Don’t know anyone affected by the sub-prime crisis? Well now you do!

Ed McMahon was on CNN recently, speaking about his continuing mortgage woes.

You can check out an abridged version of the interview here and the video of the interview here.

Here’s a very quick recap: Ed McMahon (you know him as the guy who warmed the seat for Johnny Carson’s guests) broke his neck and has not been able to work since. Meanwhile, he is behind about $644,000 in mortgage payments on his 4.8 million dollar home.

Everyday I learn something new, and this is what we can learn from Ed McMahon:

1) A single event can change your life in a heartbeat.

This is so damn important for people to understand: your life can change in an instant. Ed McMahon broke his neck, and now he cannot work. You too, could be out of work, out of money in the blink of an eye. You could be killed or crippled or otherwise unable to work. You must, therefore, make provisions for such an eventuality.

You can do this in a number of ways, but two are the most important. 1) Be prepared! Start an emarergency fund with 3-6 months worth of living expenses (all of them!) and feel free to pad it a little if you anticipate expenses related to you being out of work that weren’t present before (ex: medical expenses, no more access to a company car, etc..). 2) Get insured. I’m not qualified to talk about insuarance products, and I haven’t had much experience with it professionally, but I know for a fact that this is something you will want to speak about to your financial planner. What sticks out in Mr. McMahon’s case is that it may very well be that his medical bills, along with living beyond his means, may have helped contribute to the mess he’s in now.

2) There is a difference between income and wealth.

The Millionaire Next Door, written by Stanley and Danko, illustrates this concept more completely than I can in a short blog post. But basically the whole premise of the book is that there is a difference between having a large income and being truly wealthy. Stanley and Danko give many examples (through some very nice quantitative data) of how people earning large incomes (ex: doctors, lawyers, business men, former tv sidekicks) do not necessarily lead to increased wealth, as many of these professionals get caught up in the trappings of social status and luxury goods.

For example: why would Ed McMahon buy a 4.8 million dollar home if he knew he would have trouble affording one? Why wouldn’t he buy a home he could pay for in cash? No matter who you are, or what you do, you must live within your means.



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Retirement Revolution on PBS and Site Updates

June 8th, 2008 BTG Posted in Saving/Retirement, Stuff I Saw On TV No Comments »

I caught a broadcast of Retirement Revolution a “documentary” (really it’s more of a helpful public service report, just with better production values) hosted by Paula Zhan on PBS this past Saturday morning, the 7th of June 2008.

Edit June 27th: HAHA! I have found the broadcast, in full! Click here to view retirement Revolution, hosted by Paula Zhan! I highly recommend it!

It is a really great little report (for lack of a more fitting term) about not only retirement, but also all things leading up to it, and the implications of managing these things either poorly or not at all. Topics included real estate, annuities, reverse mortgages, investments, savings, the negative impact of unnecessary debt (hoo boy, we should all know by now that THAT’S A BIGGIE!), and the importance of sheltering your investments from unnecessary taxation (that’s a biggie too!)

They interviewed some pretty heavy hitters in the financial industry. Along with the requisite slew of Harvard trained economists, there were people interviewed that even neophytes would recognize. For example, David Bach popped up during the segment on savings. I was quite happy to actually hear him speak, as my only experience with him has been through his books. After listening to him speak, I’m much more impressed with him, as sadly sometimes his writing is a little hoaky and comes off as a big speech. So it was nice to be able to actually hear rather than simply read his advice.

The heaviest hitter of all however, was none other than Burton Malkiel himself, author of A Random Walk Down Wall Street, a book that I consider required reading for anyone interested in taking control of their financial future (don’t worry BTG is in the process of reviewing this book, look for it coming soon!). I am almost sorry that I was taking notes during the broadcast, as I was so busy trying to write down that he was included that I completely missed what it was he was saying! I can only hope PBS has a repeat broadcast sometime soon!

Speaking of repeat broadcast, what the hell PBS? I caught this showing at 3 am on a Saturday morning (Friday night?…oh I just can’t keep it straight anymore). I’m not going to be naive and say that there’s no one watching PBS at 3 am on a Saturday, but it seemed like a report of this quality, with such a great message in a format which is easily digestible, deserves a better timeslot. Like, one where a whole lot of people have a chance to benefit form seeing it. I hold out faint hope that this was a repeat broadcast from prime time, but it seems like such a shame if it’s not.

The report is well worth catching if you can find it again. If you cannot however, let me sum up for you what is perhaps the most important lesson:

YOU CANNOT COUNT ON YOUR PENSION ALONE.

In this day and age, you must ensure that you are able to take care of yourself without becoming dependent on the government via social security, your company via your pension, or the market via risky investments.

You therefore must know two things: how much you will need in retirement (an excel template on just this subject is coming soon to BTG!), and how you are going to achieve that cash flow.

As a younger person, I feel it is our generation’s challenge to ensure that we are able to take care of ourselves. We don’t have the support that our grandparents had, and our parents are steadily losing theirs. It’s very likely that we won’t have it.

This means growing up, financially, from the infantile way things are now (some in the report speculated that the US savings rate was either as low as 4%, or was actually negative, meaning that people are spending money they borrow and cannot pay it back!).

It’s time for us to step up, grow up, and help those who cannot. It’s time for a resource like Bridging The Gaap, which I’m working my hiney off to make as high quality and helpful as possible to as many people as possible.

This brings me to the BTG SITE UPDATE:

I’m gonna go ahead and admit here that creating and maintaining such an ambitious project is harder than I thought it would be, though I am by no means discouraged. I just tried to build Rome in a day is all. Now I’m going to relax a little bit, and let BTG grow at a, shall we say, less frantic pace.

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