Basic Economics

by Thomas Sowell

  Someone planning for retirement decades in the future may find a suitable mixture of stocks a much safer investment than someone who will need the money in a year or two. “Like money in the bank” is a popular phrase used to indicate something that is a very safe bet, but money in the bank is not particularly safe over a period of decades, when inflation can steal much of its value. The same is true of bonds. Eventually, after reaching an age when the remaining life expectancy is no longer measured in decades, it may be prudent to begin transferring money out of stocks and into bonds, bank accounts, and other assets with greater short-run safety.

  Risk and Time

  The stock market as a whole is not as risky as commodity speculation or venture capital but neither is it a model of stability. Even during a boom in the economy and in stocks, the Dow Jones Industrial Average, which measures movements in the stocks of major corporations, can go down on a given day. In the entire history of the American stock market, the longest streak of consecutive business days when the Dow Jones average ended up higher was fourteen—back in 1897. In 2007, the Wall Street Journal reported: “Until yesterday, the Dow Jones Industrial Average was on its longest winning streak since 2003—up for eight straight sessions. Had it continued one more day, it would have been the longest streak in more than a decade.”{481} Yet the media often report the ups and downs of the stock market as if it were big news, sometimes offering guesses for a particular day’s rise or fall. But stock prices around the world have been going up and down for centuries.

  As an extreme example of how the relative risks of different kinds of investments can vary over time, a dollar invested in bonds in 1801 would have been worth nearly a thousand dollars by 1998, while a dollar invested in stocks that same year would have been worth more than half a million dollars. All this is in real terms, taking inflation into account. Meanwhile, a dollar invested in gold in 1801 would in 1998 be worth just 78 cents.{482} The phrase “as good as gold” can be as misleading as the phrase “money in the bank,” when talking about the long run. While there have been many short-run periods when bonds and gold held their values as stock prices plummeted, the relative safety of these different kinds of investments varies greatly with how long a time period you have in mind. Moreover, the pattern is not the same in all eras.

  The real rate of return on American stocks was just 3.6 percent during the Depression decade from 1931 to 1940, while bonds paid 6.4 percent. However, bonds had a negative rate of return in real terms during the succeeding decades of the 1940s, 1950s, 1960s and 1970s, while stocks had positive rates of return during that era. In other words, money invested in bonds during those inflationary decades would not buy as much when these bonds were cashed in as when the bonds were bought, even though larger sums of money were received in the end. With the restoration of price stability in the last two decades of the twentieth century, both stocks and bonds had positive rates of real returns.{483} But, during the first decade of the twenty-first century, all that changed, as the New York Times reported:

  If you invested $100,000 on Jan. 1, 2000, in the Vanguard index fund that tracks the Standard & Poor’s 500, you would have ended up with $89,072 by mid-December of 2009. Adjust that for inflation by putting it in January 2000 dollars and you’re left with $69,114.{484}

  With a more diversified portfolio and a more complex investment strategy, however, the original $100,000 investment would have grown to $313,747 over the same time period, worth $260,102 in January 2000 dollars, taking inflation into account.{485}

  Risk is always specific to the time at which a decision is made. “Hindsight is twenty-twenty,” but risk always involves looking forward, not backward. During the early, financially shaky years of McDonald’s, the company was so desperate for cash at one point that its founder, Ray Kroc, offered to sell half interest in McDonald’s for $25,000{486}—and no one accepted his offer. If anyone had, that person would have become a billionaire over the years. But, at the time, it was neither foolish for Ray Kroc to make that offer nor for others to turn it down.

  The relative safety and profitability of various kinds of investments also depends on your own knowledge. An experienced expert in financial transactions may grow rich speculating in gold, while people of more modest knowledge are losing big. However, with gold you are unlikely to be completely wiped out, since gold always has a value for jewelry and industrial uses, while any given stock can end up not worth the paper it is written on. Nor is it only novices who lose money in the stock market. In 2001 the 400 richest Americans lost a total of $283 billion.{487}

  Risk and Diversification

  The various degrees and varieties of risk can be dealt with by having a variety of investments—a “portfolio,” as they say—so that when one kind of investment is not doing well, other kinds may be flourishing, thereby reducing the over-all risk to your total assets. For example, as already noted, bonds may not be doing well during a period when stocks are very profitable, or vice versa. A portfolio that includes a combination of stocks and bonds may be much less risky than investing exclusively in either. Even adding an individually risky investment like gold, whose price is very volatile, to a portfolio can reduce the risk of the portfolio as a whole, since gold prices tend to move in the opposite direction from stock prices.

  A portfolio consisting mostly—or even solely—of stocks can have its risks reduced by having a mixture of stocks from different companies. These may be a group of stocks selected by a professional investor who charges others for selecting and managing their money in what is called a “mutual fund.” Where the selection of stocks bought by the mutual fund is simply a mixture based on whatever stocks make up the Dow Jones Industrial Average or the Standard & Poor’s Index, then there is less management required and less may be charged for the service. Mutual funds manage vast sums of investors’ money: More than fifty mutual funds have assets of at least $10 billion each.{488}

  Theoretically, those mutual funds where the managers actively follow the various markets and then pick and choose which stocks to buy and sell should average a higher rate of return than those mutual funds which simply buy whatever stocks happen to make up the Dow Jones average or Standard & Poor’s Index. Some actively managed mutual funds do in fact do better than index mutual funds, but in many years the index funds have had higher rates of return than most of the actively managed funds, much to the embarrassment of the latter. In 2005, for example, of 1,137 actively managed mutual funds dealing in large corporate stocks, just 55.5 percent did better than the Standard & Poor’s Index.{489}

  On the other hand, the index funds offer little chance of a big killing, such as a highly successful actively managed fund might. A reporter for the Wall Street Journal who recommended index funds for people who don’t have the time or the confidence to buy their own stocks individually said: “True, you might not laugh all the way to the bank. But you will probably smile smugly.”{490} However, index mutual funds lost 9 percent of their value in the year 2000,{491} so there is no complete freedom from risk anywhere. For mutual funds as a whole—both managed funds and index funds—a $10,000 investment in early 1998 would by early 2003 be worth less than $9,000.{492} Out of a thousand established mutual funds, just one made money every year of the decade ending in 2003.{493} What matters, however, is whether they usually make money.

  While mutual funds made their first appearance in the last quarter of the twentieth century, the economic principles of risk-spreading have long been understood by those investing their own money. In centuries past, shipowners often found it more prudent to own 10 percent of ten different ships, rather than own one ship outright. The dangers of a ship sinking were much greater in the days of wooden ships and sails than in the modern era of metal, mechanically powered ships. Owning 10 percent shares in ten different ships increased the danger of a loss through a sinking of at least one of those ships, but greatly reduced how catastrophic that loss would be.

  Investing in Human Capital

 
Investing in human capital is in some ways similar to investing in other kinds of capital and in some ways different. People who accept jobs with no pay, or with pay much less than they could have gotten elsewhere, are in effect investing their working time, rather than money, in hopes of a larger future return than they would get by accepting a job that pays a higher salary initially. But, where someone invests in another person’s human capital, the return on this investment is not as readily recovered by the investor. Typically, those who use other people’s money to pay for their education, for example, either receive that money as a gift—from parents, philanthropic individuals or organizations, or from the government—or else borrow the money.

  While students can, in effect, issue bonds, they seldom issue stocks. That is, many students go into debt to pay for their education but rarely sell percentage shares of their future earnings. In the few cases where students have done the latter, they have often felt resentful in later years at having to continue contributing a share of their income after their payments have already covered all of the initial investment made in them. But dividends from corporations that issue stock likewise continue to be paid in disregard of whether the initial purchase price of the stock has already been repaid. That is the difference between stocks and bonds.

  It is misleading to look at this situation only after an investment in human capital has paid off. Stocks are issued precisely because of risks that the investment will not pay off. Given that a substantial number of college students will never graduate, and that even some of those who do may have meager incomes, the pooling of risks enables more private financing to be made available to college students in general.

  Ideally, if prospective students could and did issue both stocks and bonds in themselves, it would be unnecessary for parents or taxpayers to subsidize their education, and even poverty-stricken students could go to the most expensive colleges without financial aid. However, legal problems, institutional inertia, and social attitudes have kept such arrangements from becoming widespread in colleges and universities. When Yale University in the 1970s offered loans whose future repayment amounts varied with the students’ future earnings, those students who were going into law, business, and medicine usually would not borrow from the university under this program, {494}since their high anticipated incomes would mean paying back far more than was borrowed. They preferred issuing bonds rather than stock.

  In some kinds of endeavors, however, it is feasible to have human beings in effect issue both stocks and bonds in themselves. Boxing managers have often owned percentage shares of their fighters’ earnings. Thus many poor youngsters have received years of instruction in boxing that they would have been unable to pay for. Nor would simply going into debt to pay for this instruction be feasible because the risks are too high for lenders to lend in exchange for a fixed repayment. Some boxers never make it to the point where their earnings from fighting would enable them to repay the costs of their instruction and management. Nor are such boxers likely to have alternative occupations from which they could repay large loans to cover the costs of their failed boxing careers. Professional boxers are more likely to have been in prison or on welfare than to have a college degree.

  Given the low-income backgrounds from which most boxers have come and the high risk that they will never make any substantial amount of money, financing their early training in effect by stocks makes more sense than financing it by bonds. A fight manager can collect a dozen young men from tough neighborhoods as boxing prospects, knowing that most will never repay his investment of time and money, but calculating that a couple probably will, if he has made wise choices. Since there is no way to know in advance which ones these will be, the point is to have enough financial gains from shares in the winning fighters to offset the losses on the fighters who never make enough money to repay the investment.

  For similar reasons, Hollywood agents have acquired percentage shares in the future earnings of unknown young actors and actresses who looked promising, thus making it worthwhile to invest time and money in the development and marketing of their talent. The alternative of having these would-be movie stars pay for this service by borrowing the money would be far less feasible, given the high risk that the majority who fail would never be able to repay the loans and might well disappear after it was clear that they were going nowhere in Hollywood.

  At various times and places, it has been common for labor contractors to supply teams of immigrant laborers to work on farms, factories, or construction sites, in exchange for a percentage share of their earnings. In effect, the contractor owns stock in the workers, rather than bonds. Such workers have often been both very poor and unfamiliar with the language and customs of the country, so that their prospects of finding their own jobs individually have been very unpromising. In the nineteenth and early twentieth centuries, vast numbers of contract laborers from Italy went to countries in the Western Hemisphere and contract laborers from China went to countries in Southeast Asia, while contract laborers from India spread around the world to British Empire countries from Malaysia to Fiji to British Guiana.

  In short, investment in human capital, as in other capital, has been made in the form of stocks as well as bonds. Although these are not the terms usually applied, that is what they amount to economically.

  INSURANCE

  Many things are called “insurance” but not all of those things are in fact insurance. After first dealing with the principles on which insurance has operated for centuries, we can then see the difference between insurance and various other programs which have arisen in more recent times and have been called “insurance” in political rhetoric.

  Insurance in the Marketplace

  Like commodity speculators, insurance companies deal with inherent and inescapable risks. Insurance both transfers and reduces those risks. In exchange for the premium paid by its policy-holder, the insurance company assumes the risk of compensating for losses caused by automobile accidents, houses catching fire, earthquakes, hurricanes, and numerous other misfortunes that befall human beings. There are nearly 36,000 insurance carriers in the United States alone.{495}

  In addition to transferring risks, an insurance company seeks to reduce them. For example, it charges lower prices to safe drivers and refuses to insure some homes until brush and other flammable materials near a house are removed. People working in hazardous occupations are charged higher premiums. In a variety of ways, insurance companies segment the population and charge different prices to people with different risks. That way it reduces its own over-all risks and, in the process, sends a signal to people working in dangerous jobs or living in dangerous neighborhoods, conveying to them the costs created by their chosen activity, behavior or location.

  The most common kind of insurance—life insurance—compensates for a misfortune that cannot be prevented. Everyone must die but the risk involved is in the time of death. If everyone were known in advance to die at age 80, there would be no point in life insurance, because there would be no risk involved. Each individual’s financial affairs could be arranged in advance to take that predictable time of death into account. Paying premiums to an insurance company would make no sense, because the total amount to which those premiums grew over the years would have to add up to an amount no less than the compensation to be received by one’s surviving beneficiaries. A life insurance company would, in effect, become an issuer of bonds redeemable on fixed dates. Buying life insurance at age 20 would be the same as buying a 60-year bond and buying life insurance at age 30 would be the same as buying a 50-year bond.

  What makes life insurance different from a bond is that neither the individual insured nor the insurance company knows when that particular individual will die. The financial risks to others that accompany the death of a family breadwinner or business partner are transferred to the insurance company, for a price. Those risks are also reduced because the average death rate among millions of policy-holders is far more predictable than the
death of any given individual. As with other forms of insurance, risks are not simply transferred from one party to another, but reduced in the process. That is what makes buying and selling an insurance policy a mutually beneficial transaction. The insurance policy is worth more to the buyer than it costs the seller because the seller’s risk is less than the risk that the buyer would face without insurance.

  Where a given party has a large enough sample of risks, there may be no benefit from buying an insurance policy. The Hertz car rental agency, for example, owns so many automobiles that its risks are sufficiently spread that it need not pay an insurance company to assume those risks. It can use the same statistical methods used by insurance companies to determine the financial costs of its risks and incorporate that cost into what it charges people who rent their cars. There is no point transferring a risk that is not reduced in the process, because the insurer must charge as much as the risk would cost the insured—plus enough more to pay the administrative costs of doing business and still leave a profit to the insurer. Self-insurance is therefore a viable option for those with a large enough sample of risks.

  Insurance companies do not simply save the premiums they receive and later pay them out when the time comes. In 2012, for example, more than half the current premiums on homeowners’ insurance were paid out in current claims—60 percent by State Farm and 53 percent by Allstate.{496} Insurance companies can then invest what is left over after paying claims and other costs of doing business. Because of these investments, the insurance companies will have more money available than if they had let the money they receive from policy-holders gather dust in a vault. About two-thirds of life insurance companies’ income comes from the premiums paid by their policy-holders and about one-fourth from earnings on their investments.{497} Obviously, the money invested has to be put into relatively safe investments—government securities and conservative real estate loans, for example, rather than commodity speculation.