Now that times are getting bad, protectionist sentiment seems to raging all over the world. Everywhere you look, there are calls to “buy American”, “buy Canadian”, and “buy local”. The economic stimulus package that recently passed in the U.S. Senate also originally contained a buy American requirement for receiving funds. Hmm…

At its core, protectionism is based on the feeling that it is better to buy goods and services produced locally rather than produced far away. The rationale is that if I spend my money locally, it’s more likely to then be spent at other local businesses, including potentially my own. Or more generally, it means preferring to employ my fellow countrymen rather than foreigners. After all, we have to protect our own first, right? Well, before you jump on the “buy American” bandwagon, just make sure you understand its costs first…

The standard of living for those of us living in the western world has dramatically improved over the last hundred years. Today we have more books, clothes, iPods, big screen TVs, and cars than our grandparents would have imagined possible. We also have bigger houses, we work shorter hours, and we often have health coverage and pensions. We, on average, have a much more comfortable standard of living than those living a hundred years ago. So how did we achieve such levels of prosperity?

1. Huge breakthroughs in manufacturing technology and materials
2. Efficient global shipping & transportation
3. Government deficits and borrowing from our children
4. Outsourcing labor to emerging economies

People like to complain about their jobs going overseas and protectionists may argue about the benefits of outsourcing, but it’s quite straightforward if you think about it.

Labor costs, just like everything else in free markets, are driven by supply and demand. If you’re offering your services at a cost of $40,000 a year, and someone else is offering the same services at a cost of $4,000 a year, what do you think is going to happen? As long as there are enough people willing to do the job for $4,000 a year, eventually no company (that wants to remain solvent) will be willing to pay $40,000 for that job anymore.

And outsourcing isn’t the only reason why the value of a job can drop. The same thing happened with automation in factories – millions of jobs were destroyed and replaced by cheaper machine labor. And the refrain was the same: machines are bad, they put people out of work – we must protect our good paying jobs.

You might call outsourcing labor to emerging economies exploitation, but then it becomes a moral debate. The fact is, if you can pay someone overseas (or build a machine) to produce goods for you at a fraction of what it would cost to produce locally, the economy will benefit because companies are able to do more with less.

The mistake protectionists make is to think that they can somehow prevent this natural revaluing of jobs; that somehow we can pretend that a job is magically still worth $40,000 a year when it’s not. In order to artificially “protect” domestic jobs you can do a couple of things. You can subsidize domestic production, or you can tax or add tariffs to foreign products. But both options reduce the society’s wealth, and thus standard of living, because it protects less efficient methods of production and puts that cost onto the society. Does anyone think it’s a good idea to tax machine-created products, or subsidize manual labor over machine labor?

Protectionism often seems more interested in protecting the effort associated with producing goods. But don’t forget, the point of the economy is not to create jobs for people; it’s to produce stuff. And the only reason to work is to have money to buy that stuff. And despite many decades of outsourcing, we don’t seem to be running out of jobs yet. People get retrained and find new jobs.

There may be legitimate political reasons to endorse protectionism, like avoiding dependence on less than friendly foreign regimes, but there aren’t good economic ones.

[Content © 2009 SorryToConfuseYou.com, All Rights Reserved.]

I saw a local news story a little while ago about a 70 year-old barber winning a $32 million lottery jackpot. Apparently he and one of his customers had been playing the lottery together for 35 years.

My first thought was: wow, I bet he wished he had won the lottery 35 years ago instead…

My second thought was: wow, how many people are out there wasting their money playing the lottery for 35 years and not winning?

Playing the lottery is an attractive thing in that anyone, at any time, can win it big. It’s the great equalizer; the great hope; the great fraud… I find it sad really, the false hope that these lotteries generate.

There’s even a whole industry built around "helping" you improve your odds of winning the lottery. Whether it’s magic mathematical systems or divine inspiration, there are hundreds of web sites willing to take your money in order to let the government take your money. For example, one system I saw boasts:

"Win more than every 8 out of 10 times – guaranteed"
"The secret to real lotto system winning success that no other lottery system tells you about."
"Discover the lotto winning solution that really works!"

Brutal! They even offer an affiliate program to ensure that they have an army of people producing "unbiased" testimonials to drown out unhappy customers.

Bottom line, there are only 3 groups getting rich off of lotteries:

• The government (who takes half the ticket price)
• The scam-artists who sell these magic "systems" to "help" you win
• The store clerks who steal their customer’s winning tickets

The odds of winning the grand prize in your lifetime is, at best, something like 1 in 4,000 (1 in 14,000,000 x 35 years x 52 weeks x twice a week) – obviously it depends on which lottery you play. By the way, the odds of being struck by lightning in your lifetime is around 1 in 5,000. Hmm…

If the barber and his friend had invested the $3 they spent twice a week, for 35 years, adjusted for inflation, it could have been worth about $35,000 today. Obviously $32 million is much better, but for the 99.975% of people that will never win the jackpot in their lifetime, $35,000 is better than zero.

In fact, if you invest just $30 a week for 35 years (like some people spend on lottery tickets), you could have a pretty good retirement nest egg of something like $175,000+.

So, how do you win at the lottery? You don’t play…

[Content © 2009 SorryToConfuseYou.com, All Rights Reserved.]

Our public officials sometimes seem to think that more government intervention is better than less; that somehow central planning creates better results than free markets. Apparently we didn’t learn from the Soviet experience… There are probably a million different examples I could use to illustrate this point, but one specific local situation has been in the news recently.

In the city where I live, the municipal government decided 3 decades ago that it should license and regulate the taxi business. Fine, we wouldn’t want convicted felons driving taxis, right? But as part of this process, they also decided to cap the number of licenses they would issue. Hmm… Maybe someone thought having too many cabs would be a nuisance, or maybe it was the cabbies that wanted some guaranteed job security. Either way, it was a really bad decision that has led to a number of predictable and undesirable consequences:

1. Since licenses are scarce, people sell them for $100,000+, even though they’re not technically worth anything
2. Since the licenses are worth so much, the city can’t issue more without destroying some of that value and thus making the existing license holders irate
3. The service is generally mediocre because there’s no incentive to improve and no risk of competition
4. The service is slow, especially at peak times, because there’s artificially too few cabs

Wouldn’t it make sense if the city issued as many licenses as the free market demanded? Then if we needed more cabs because, say, the city grew, more people could get licenses. If we had too many cabs, some people wouldn’t be able to make a living and would find other jobs. Better yet, maybe some people would decide to drive cabs part-time. That way, they could choose only to work on the busiest nights, to make a little extra cash on the side. These part-time drivers would also be available to help increase service in situations like transit strikes, as we happen to have just survived.

But as with most situations of goofy government intervention, the free market finds a way to fill the void anyway. In the case of our local taxi service, we now have so called ‘bandit taxis’, which run completely outside of the regulations. Despite being illegal, the need is so great that drivers and passengers are still willing to take the risk. Since unlicensed cabs are obviously not the best solution, maybe city officials should take a hint, although so far they claim to be ‘perplexed’ by the situation…

[Content © 2009 SorryToConfuseYou.com, All Rights Reserved.]

Starting in January 2009, Canadians will have access to a new investment vehicle called the tax-free savings account (TFSA). Ads for these new accounts have been popping up everywhere, and people seem to be touting them as the greatest thing since sliced bread. Some have said the TFSAs are even superior to the traditional Registered Retirement Savings Plan (RRSP). For example, a recent Yahoo Finance article had the following expert advice:

• People making $35,000 or less are often better off with a TFSA than an RRSP
• People with pensions are often better off with a TFSA than an RRSP
• High income earners whose tax brackets won’t fall significantly after retirement may be better off with a TFSA than an RRSP

The biggest problem with many of the articles I’ve seen is they make recommendations, like the ones listed above, without really explaining the rational behind them. Could TFSAs really be better retirement vehicles than RRSPs? Let’s see if we can prove these claims.

Account Comparison

The mechanics of the two account types are straightforward:

Ignoring the contribution limits and withdrawal rules, the real difference between these accounts is when the money is taxed. Taxes on RRSP contributions are deferred until withdrawal time. So if your income will be lower in retirement (not a bad bet), you’ll pay less tax compared to a TFSA. But even if you’re in the same tax bracket, RRSPs still have an advantage. Remember that at contribution time, the tax break for RRSPs is at your marginal (highest) tax rate. But at withdrawal time, thanks to our progressive tax system, the first chunk of income you pay no tax, the next chunk you pay some tax, etc, making your average tax rate less than your marginal tax rate.

This difference in tax rate means that an RRSP will always outperform a TFSA, right? The answer is: yes but… To explain, let’s go back to scenarios from above (I’ve invented some more concrete pseudo-representative numbers).

Performance Comparison (Scenario #1)

The number of years your savings would last would be something like:

Hmm… If the RRSP is more efficient, why does the TFSA outperform the RRSP? The difference is government benefits. In all three situations you would get the same amount of Canada Pension (CPP) and Old Age Security (OAS). The difference is, with the TFSA you also get Guaranteed Income Supplement (GIS) because TFSA withdrawals aren’t treated as income. Also, the RRSP doesn’t have any tax advantage over the TFSA because all of your income is in the lowest tax bracket.

Verdict: Lower income earners (less than $39,000) with no pensions are much better off with a TFSA than an RRSP. Breakeven is somewhere around $60,000.

Performance Comparison (Scenario #2)

The number of years your savings would last would be something like:

This time, the pension income negates the GIS benefit, and thus the advantage of the TFSA. But the pension income negates the advantage of the RRSP because the RRSP withdrawals end up being taxed at the same rate as at contribution time. This leads to identical performance between the two.

Verdict: Middle income earners with pensions will not likely be significant better off (or worst off) with TFSAs, assuming equal contributions. TFSA do have the advantage that contribution room is not reduced by pension contributions, like RRSPs.

Performance Comparison (Scenario #3)

The number of years your savings would last would be something like:

I’m actually cheating here because the contribution limit for the TFSA is $5,000 per year, but the results are still interesting. Even though CPP benefits with RRSPs are reduced starting at $66,000, the tax advantage of the RRSP still gives it a big advantage.

Verdict: Higher income earners are definitely not better off with a TFSA compared to an RRSP, even if they’re not in a lower tax bracket in retirement.

Conclusions

Advantages of RRSP:

• More tax efficient for those earning more than $40,000, except if you’ll will be in a much higher tax bracket after retirement (which most of us won’t have to worry about
• Higher contribution limits than TFSA for anyone earning more than $27,777

Advantages of TFSA:

• Able to collect GIS if CPP / pension income will be less than $15,000
• Money can be withdrawn and recontributed at any time without penalty
• Doesn’t require employment income to earn contribution room
• Contribution limit not reduced by pension contributions
• Can continue to contribution after retirement, and no forced withdrawal

So does the TFSA make RRSPs obsolete? Clearly not. But TFSAs obviously complement RRSPs very well.

For those earning less than $50,000, the TFSA is probably the better choice. For those earning more than $70,000, the RRSP has a big tax advantage. Ideally people would use both their RRSP and TFSAs to full advantage. But since only 10% of people currently maximize contributions to their RRSP, this simply isn’t going to happen. My fear with TFSAs is that the ease of withdrawal will encourage people to skim from their TFSAs (and thus their retirement) more than they would from their RRSPs…

[Content © 2009 SorryToConfuseYou.com, All Rights Reserved.]

I’ll be taking a break for the next several weeks to enjoy the many holiday season festivities, and catch up on some long neglected projects. I shall return in the new year with new (and hopefully interesting posts) – thank you for reading, and enjoy the season!

What drives the price of stocks on a day-to-day (or year-to-year) basis? What causes the price to go up or down? A lot of people talk about “cash flow”, and money flowing in and out of the market. For example, it’s not uncommon to hear snippets on the news like:

“Liquid capital could come back and fuel a rally.”

“There is a lot of money waiting on the sidelines.”

“I think there’s enough cash on the sideline that any pullback is being greeted with buying.“

But does cash really drive markets? Let’s see…

1) Say Bob has a comic book that he bought for $5, and $15 cash for buying other comic books. Jim has $20 cash for buying comic books.

2) Jim offers to buy Bob’s comic book for $10 because he thinks that it’s going to be more valuable in the future. Bob agrees to the price. The comic is now worth $10, and Bob makes $5 on the deal.

3) A few days later, Bob regrets selling the comic and really wants it back, so he begs Jim to sell it back to him. Jim reluctantly agrees, and sells it back to him for $25. The comic is now worth $25, and Jim made $15 between the two transactions.

4) The next day, the comic publisher announces that it will run another printing of Bob’s comic because it’s so popular. Now anyone can buy that comic for $5.

Notice two things:

• The total “cash on the sideline” doesn’t change. Every time a transaction takes place, cash moves, but the total cash available doesn’t change.
• The system is not a zero-sum game – it’s possible for everyone to win (or lose) at least for some period of time.

This is exactly what happens in the stock market every day. There are a fixed number of shares in the stock market (except when there’s a secondary offering, or an IPO). A rally doesn’t actually “use up” (nor require) cash sitting on sideline. Cash moves around from person to person, but doesn’t “enter” or “leave” the market except when its owner decides to reallocate that cash for some other purpose. Hmm…

So what happens when a bunch of people want to move a bunch of cash from other asset classes into the stock market? Back to the above example: if Ted has $1,000 and wants to get into the comic business, he might buy Bob’s comic for $50 (or not). His decision isn’t based on the fact he has money burning a hole in his pocket. His decision is based on whether he can buy the comic at a lower price than that at which he can later sell it – i.e. it’s all about sentiment. If Ted doesn’t believe that he can make money buying the comic at $50, regardless of how much cash he has, he’d be an idiot to pay that much for it…

The same thing happens in the stock market. The only reason to buy something is if you believe you can make money in whatever timeframe you’re looking at – it doesn’t matter how much cash you have. Prices rise when greed and optimism are prevalent. Prices fall when fear and pessimism rule the day. All cash does is provide liquidity for this to happen efficiently (“sideline” cash has actually been rising for years by the way). Don’t worry – there will always be more than enough sideline cash looking for opportunities regardless of the state of the market. The thing that changes on a day to day basis is sentiment.

So when some talking head says, “the markets will rally when cash comes into the market”, what he really means to say “the markets will rally when optimism comes into the market”.

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

Leading up to this U.S. election, there’s been lots of talk about how to fix the economy, and which Presidential candidate would be best for the country. Sometimes, someone will come up with reasonable, unbiased analysis like Andy on the Saving to Invest blog. But more often than not, the debate will degenerate into partisan bickering.

For example, a common tactic is to compare stock market returns under Republican Presidents and Democratic presidents – as was discussed on the Carpe Diem blog. The claim there was that if you had invested money since 1929 under one party or the other, the outcome would have been:

• Democratic Presidents: $10,000 became $360,000
• Republican Presidents: $10,000 became $11,000 (or $51,000 skipping the Hoover years)

Hmm… This merits a little investigation. The first thing to wonder is why they would start the comparison in 1929, just before the great crash? It would have been nice to at least go right back to the turn of the century. Too bad. I’m starting in 1929 because Yahoo only provides data back that far.

The next thing to do is to make sure we’re comparing apples to apples. Were Republican’s Presidents in power as much as Democratic Presidents? Yes, 40 years each. Good.

How consistent were the returns? I’m not sure which markets they were analyzing, but I’ll use the Dow Jones Industrial Average.

When looking at these numbers, 2 outliers stand out – Hoover and Clinton. What if we compare the average % return per year without these outliers?

Hmm… Was Hoover (or the Republican presidents before him), directly responsible for the 1929 crash? I don’t know enough history to know. But I wouldn’t be surprised if it was just lack of economic knowledge at the time, where anyone would have made the same mistakes.

Was Clinton directly responsible for the historic bull market during his term? Not really. The bull market started back in 1980, and continued through the end of the century. Was Bush responsible for tech crash in 2001? No. If anything, we can blame Clinton for creating the tech bubble, which led to the outsized returns during his term… Can we blame Bush for the current credit crisis? Sure…

But overall, looking at the chart, there are obvious bull periods, and obvious bear periods.

You can slice and dice the numbers however you want, and come up with just about whatever result you want…

Bottom line, the economy has larger business cycles, that I think have little to do with the Presidents of the day. Besides, how much policy does the President implement? He can’t pass laws, he can only veto them….

So back to the original question, who’s the best person to help the stock market? Neither, I fear.

Everyone’s trying to figure out how to avoid a recession. The problem is, recessions are a natural and necessary part of the business cycle. “Creative destruction” cleans out the deadwood and inefficiencies in the economy, and leads to prosperous periods in the future.

The 2003-2007 bull market was based on false growth created by spending money we didn’t have, in order to avoid having a mild recession. Now we’ve created an even bigger mess, and presumably an even bigger recession. Eventually we need to pay the piper.

There is no quick fix to our problems because our problem is not lack of available credit or lack of confidence – our problem is lack of reasonable expectations. Until we, as a society,  change our mind set about what is reasonable and normal, we can’t move on. We had a 20-year bull market, we had 25 years of housing price appreciation compressed into 5, and we had commodity prices triple this decade. These things are not normal. Artificially pushing up prices faster than is warranted just leads to a bubble, not sustainable growth…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

Much of the financial mess we’re experiencing has been attributed to financial derivatives (like credit default swaps), or as Warren Buffet describes them – financial weapons of mass destruction.

But why are derivatives such a problem? Is it that they’re opaque and hard to value? Is it that they’re kept “off-the-books”? Is it that they’re a vehicle  for speculation? Well, maybe… But I think the bigger problem is that they led to moral hazard in the financial industry.

What is moral hazard? Moral hazard is essentially the premise that:

“An individual or institution insulated from risk may behave differently from the way it would if it were fully exposed to the risk.”

Would you buy the same expensive car if you didn’t have insurance? Would you speed if you knew there was a cop on every corner? Would you steal a million dollars if you knew the worst that would happen would be a week in jail? Balancing risk and reward plays a big part in our decision making process.

Why were all those banks giving away subprime mortgages to unqualified borrowers? Because they could… Derivatives can be used as a form of insurance. The banks got to reap all the rewards and the record profits coming from issuing those mortgages, and got to delegate all the risk to someone else through the use of credit default swaps. With such a system in place, it’s no wonder they indulged…

Now that the worst case scenario has come to pass, are all these institutions going to suffer the consequences? No, because they’re “too big to fail”. The government is taking billions of bad decisions off their hands – reinforcing moral hazard even further.

What’s the solution to this mess? Both U.S. presidential candidates are talking about more government regulation. But does that really stop moral hazard? Probably not… Bureaucracy and regulation don’t get rid of moral hazard – only full exposure to risk does.

Would the upper management of these financial institutions have been so reckless if they were personally responsible and accountable for the outcomes? No way. All the CEOs got paid their millions regardless of whether they drove their companies into the ground or not. What was their incentive to limit risk?

Why did our grandparents pay off their houses as quickly as possible, and save every penny they could? The prospect of literally being out on the streets with absolutely nothing was a scary proposition.

These days, we have unemployment benefits, homeless shelters, bankruptcy protection, and insurance on just about everything, leading to moral hazard that’s rampant not just in our financial industry, but throughout our society in general. I’m not suggesting we necessarily get rid of these things, but we need to understand the costs.

If we want to avoid future financial calamities, we need to take a hard look at the type of behavior we’re encouraging. Free markets can lead to a positive, self-reinforcing cycle, but only when there is full exposure to risk.

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

The dollar figures being tossed around with all of these financial “rescue packages” are staggering. A few dozen billion here, and few hundred billion there. Where is all this money coming from, and what are the costs of spending all this money?

Context

So far, the U.S. government has pledged to spend over $1.8 trillion to help stabilize the current financial crisis. That’s a BIG number. How big? $1.8 trillion is equal to:

• 75% of total 2007 U.S. government revenue
• 13% of total 2007 U.S. GDP
• $8,400 per U.S. worker

They’re going to spend the equivalent of 65% of the total cost to run the whole U.S. government for year, military and all, to bail out all these bone-headed financial institutions! Ouch…

And we likely haven’t seen the last of the bailouts yet either. None of the $1.8 trillion pledged so far helps the millions of homeowners who are facing foreclosure. Expect a trillion dollar homeowner bailout plan in the new year…

Currency

So where does all this money come from? Money doesn’t grow on trees, right? As I’ve been explaining to my son, money comes from helicopters…

One of the things that the U.S. government has been doing throughout this crisis is printing money. But printing money obviously has to come at a cost. In this case, the cost is devaluation of the currency; hence the declining U.S. dollar.

The effect is that each dollar becomes less valuable, and thus, each dollar has less purchasing power. So, even though U.S. wages have been basically flat this decade, they’re down significantly when compared to wages in other countries like Canada and members of the European Union because the currency has declined so much.

This is one of the reasons the cost of natural resources has appeared to have jumped significantly this decade. The cost of raw materials is increasing, but because oil and gold and other resources are measured in U.S. dollars, the price jump has been more significant. The result is inflation because everything appears to cost more to make, but in reality it’s as much about the fact that your money is worth less.

If printing money was the solution to financial problems, Zimbabwe would be the model financial system.

Debt

The other way the U.S. government can get money is by issuing bonds, but the government has to pay interest on these bonds every year until they’re repaid. The interest on current debt was about $239B in 2007, which is about 10% of government revenue, or $1,000 per U.S. worker per year, every year!

Issuing debt is essentially taxing your children. Not only do they have to pay the debt back, but they have to pay interest in the meantime. It’s essentially like everyone leaving $50,000 in debt to their children when they die rather than an inheritance.

I think Eric Sprott summed things up nicely when he said:

“Central banks cannot create wealth. Nor can they avoid losses. They can only convert one financial problem into another.”

Some are suggesting that these bailouts will be profitable for the government in the not-too-distant future. I’m not sure I believe it. I’d be surprised if the government got back more than a small fraction of this money.

In the end, I think we’ve been over-consuming with borrowed money for too long. At some point, we’re going to have to pay down our collective debts. That time appears to be now…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

Well, we officially have a stock market crash on our hands now… In the past two weeks, the wheels have finally come off, and there’s a definite sense of panic in the air. The first 20% drop in the market took one year, the next 20% took 2 weeks!

So what caused this sudden drop? The markets were falling at a nice gentle pace until recently…

Big Picture

The first thing to realize is that there are lots of interconnected, but not fully interdependent, parts to this puzzle – some of which I talked about in detail a couple of weeks ago.

The first shoe to drop was housing prices, which peaked in 2005 and have been falling ever since as they return to “normal”. Falling housing prices led to problems in the sub-prime mortgage market.  This, in turn, led to problems at the many financial institutions that were over-exposed to this “toxic paper”.

Problems and failures in some financial institutions caused them all to stop lending to each other, and to other companies, and to start hoarding their cash in order to increase their chances of survival – hence the credit crisis.

In order for our economy to function efficiently, companies need access to credit on a regular basis to function. But since their access to credit has dried up, the economy is being disrupted, which is causing it to slow down. Even the State of California is having problems accessing credit to meet payroll.

Falling house prices and rising interest rates have also taken a big toll on the economy because a big chunk of the economic growth since 2002 has been due directly to the housing sector and the wealth generated from increasing home equity.

The Crash

But back to the stock market. None of these problems explain the huge drop in the last two weeks because we’ve known about all these problems for a while. The economy hasn’t suddenly gotten significantly worse in the last two weeks, so what changed? What caused the great stock market crash of October 2008?

Well, the first big down day was September 29th, the day the U.S. House of Representatives attempted, and failed, to pass the $700B bailout package. Since that day, the markets have basically gone straight down. But, the same basic bailout package was passed later that week (with an extra $100B in pork). Why didn’t the selling stop? Because the failure of the bailout wasn’t the cause (or the solution!). It was aimed at the credit markets, not the stock market. But its failure triggered an unexpected chain reaction:

1) The bailout package was hyped up to be the “solution to all our ills” – which it was never intended to be. But in trying to get the bailout passed, people were predicting all sorts catastrophic problems if it didn’t get passed. This significantly raised the level of fear because such desperate action would only be required if we were in a truly desperate situation, right? Then, of course, the bailout didn’t get passed, and it added even more uncertainty to the markets.

2) September 29th was the second last day of the quarter, and many hedge funds need to honor redemption requests quarterly. I suspect there were many big hedge funds predicting a big rally when the bailout passed.  A rally would have given them a chance to sell and raise cash for all the redemption requests they’d received over the summer. But instead of a rally, the initial bailout proposal got rejected and the hedge funds (and many others) got worried and sold causing the Dow to record that famous 777 point drop.

3) This scared many average investors, who started pulling money out of mutual funds at record levels. Mutual funds don’t have the luxury of waiting for the end of the quarter like hedge funds; they need to fulfill redemptions within a couple of days. Since credit markets are frozen, mutual funds can’t borrow cash to tide them over, so they had to sell positions. This pushed the markets even lower.

4) As the markets continued to plunge, the hedge funds got margin calls.  This required them to sell even more positions, and the vicious cycle continued.

All of this forced selling drives the prices down very quickly because there are few buyers willing to be brave and try to catch the falling knife (or more accurately the falling piano!).

It’s ironic that a $700B bailout package that was supposed to help solve our financial problems may have triggered a $3 trillion+ crash in the stock market…

What’s Next?

It can’t go on much longer, can it!? The answer is: maybe…

The markets are now dropping on momentum alone, and all traditional ways to value stocks have gone out the window. But the longer this crash goes on, the bigger the bounce will be when we hit bottom.  This is because there are a huge number of people shorting the market that will have to cover their positions, causing a “short-squeeze”.

This is what, I think, we saw happening on Friday afternoon. After the markets were down 10% early, they rallied back. I don’t think this was buyers finding value.  Rather, I think it was mainly shorts getting nervous and not wanting to hold their positions over the weekend, especially with the G-7 conference going on.

But I suspect sometime soon (update: looks like today), we’ll get a break from the selling and a small rally as the shorts cover their positions. One sign the bottom may be near is that around midday Friday my boss said: “F***! I think I’m going to jump out a window! I’m down another 10% today!”  I’ve also seen some of the experts advising people to start covering their shorts.

But, this doesn’t mean the worst is over – the economy is still in big trouble. Some people are saying stocks are looking very cheap based on next year’s earning projections, but I think those projections are now based on an overly optimistic view of the next year’s economy.

During the tech bubble, it took 2 years for the markets to hit bottom – we’re only a year into this market decline. Some believe this crisis is much bigger than the tech bubble, which means it could take much longer than 2 years to work through all the problems…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

The stock markets have suffered some “historic” drops this past week. For example, the Dow Jones Industrial Average was down 777 points last Monday after the $700 billion federal bailout plan failed to pass in the U.S. House of Representatives. Then last Thursday, when the same plan with a few minor tweaks got passed by the House and the Senate, the Dow dropped another 350 points. And to top it all off, at one point today the Dow was down another 800 points. The news seems to be all doom and gloom. When will the bleeding end?!

[And just in case you missed it, last week I talked about how we got into this mess in the first place.]

Putting Things In Context

The first thing to realize is, while 777 may have been the biggest one-day drop on the Dow ever, at 7% it’s not even close to the biggest relative one-day drop ever. That distinction goes to Black Monday in October 1987 when the Dow dropped 22.6% in one day! There have been 16 other times in the last hundred years when the Dow has had bigger drops than last week, which is an average of one every seven years. So was Monday’s drop gut-wrenching? Yes. Was it historic? No…

A number of comparisons have also been made to the Great Depression. While this may be the biggest crisis in the U.S. financial sector since the Great Depression (it could be, I don’t know, I’m not qualified to say), we’ve still got a long way to go before things get as bad the Great Depression:

What’s Next?

So when will the decline end? The truthful answer is: I don’t know, and neither does anybody else. Not Ben Bernanke, not Henry Paulson, not Jim Cramer, not Warren Buffett, not anyone. One of the big myths of the investment world is that the experts can predict the future much better than everyone else. The reality is they can’t, especially in the short-term. They’re simply making wild-ass guesses just like the rest of us.

Take analysts ratings for example. Of the 17 analysts that covered Washington Mutual at the beginning of July, there was only one sell recommendation. The share price had dropped from $35 in January 2008 to $5 by summer, but it was still a “hold”. Hmm… Even at the beginning of September, only two of 14 analysts recommended selling. By the end of the month, Washington Mutual was bankrupt and their shares were worthless. Oops…

What about some of the big money players? Foreign sovereign wealth funds have been investing tens of billions into U.S. financial companies over the past year. Many of those investments are worth nothing today. The others are worth half of what they were when they bought. Hmm…

If you look at the news, some experts say the bottom is near, others say that this is only the appetizer. Jim Cramer likes to remind us that he called, within a couple days, the top of the tech bubble. What he doesn’t mention are the hundreds of other predictions he made that didn’t come true – selective memory wins again. Everyone’s right some of the time, just like a stopped clock is right twice a day. But guessing right is not the same thing as being right.

What Should I Not Do?

The average investor often makes terrible decisions because they’re making decisions based on emotion rather than based on some well thought out strategy. One thing I have learned about investing is that making decisions based on emotion is usually the opposite of the right thing to do. It seems like the times I feel most euphoric and invincible turn out to be the best times to sell, and the times I feel like giving up and selling everything turn out to be the best times to buy.

And research bears this out too. The average investor tends to significantly under-perform the experts because they’re chasing the hot sector or the hot mutual fund. They sell at the bottom and they buy at the top. In the end, they only earn a fraction of the returns of the indexes and most mutual funds.

So given that the news is so bad, we must be near a bottom, right? Maybe… Many of the investment newsletters are thinking the same thing. But this could be the smart money getting in at the bottom, or this could mean people are still too complacent…

What Should I Do?

The first thing you need to do is have a plan for your portfolio. And by the way, buy & hold is not a plan (at least not a very good one). Over the long-term buy & pray will do OK, but the markets can be flat for a decade or more. For example, if you bought and held the Dow, you’re down 10% this decade so far…

Over time, some investments will naturally do better than others. You need to prune the dead wood and let your best investments ride. Your investment plan should not only dictate what to buy, and when to buy it, but more importantly when to sell. For example, will you sell if your investments drop 10%? What about 25%? What about 75%? Knowing under what conditions you’re going to sell, before you buy, allows you to avoid the emotional traps of trying to figure it out during a crisis. This is the biggest difference between amateurs and professionals (the good ones anyway) – they manage (not micro-manage) their investments and they have contingency plans. So if your financial advisor only provides buy advice, but not sell advice, you probably need a new financial advisor…

The second thing you need is diversification. If all your investments rise and fall together, you’re not diversified. The point of diversification is to even out portfolio performance, and to avoid one catastrophe from doing serious damage to your portfolio. Even in markets such as these, there are some investments that are doing OK. You don’t want to put all your eggs in one basket, like many Enron employees who lost their jobs and all their retirement savings because they had everything invested in one place.

The third thing you need to know is: dividends are your friend. In the late 1990s people forgot about dividends because everyone was focused on growth companies. But over the last 100 years, dividends have accounted for 40% of stock market returns. Dividends allow you to get paid while you’re waiting for the markets to rebound.

The last thing you need to know is during turbulent times, you need to hedge your investments. There are several ways to do this, but the easiest way is through Exchange Traded Funds (ETFs). Many ETFs allow you to profit when the market goes down because they’re shorting the market. Some ETFs are inversely correlated 1:1 to the market, some 2:1. So, for example, if you had 10 – 20% of your portfolio invested in these bear-market ETFs, you’d have a cushion against any further big falls in the market.

So do I follow my own advice? Apparently not as well as I should have. I was busy plugging holes in my investment plan this weekend, hence the reason this post is a day later than normal. But it’s never too late to create (or fix) your plan. Burying your head in the sand (not opening your investment statements) isn’t going solve anything…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

The situation in the U.S. financial system grew even more dire this week with the failure of yet another bank (Washington Mutual), and predictions of imminent disaster without a mammoth $700B government bailout. Only time will tell whether this bailout actually solves anything, and whether this is the end of the big surprises; somehow I doubt it. But to me, the more interesting question is, “how did the mighty American economy, which represents 25% of the world’s GDP and 50% of the world’s wealth, get itself into such a horrible mess?” The simple answer is: massive disregard for financial prudence, caused by greed and incompetence…

Tech Bubble

A good place to start the story is with the tech bubble of the late 1990s. Bubbles are created when the value of something becomes disconnected from its true intrinsic value, and value starts rising on momentum alone. Usually this is caused by exuberance and herd-mentality; common sense goes out the window. In the case of the tech bubble, marginal tech companies with marginal business models got bid up beyond any semblance of realistic or historical valuations. To keep the bubble going required bigger and bigger suckers to buy at inflated prices. But eventually, as with all bubbles, reality set in. Once there were no more suckers left the price stopped rising and the smart money started getting out. Slowly prices started to drop, and more and more people started to sell. This drove prices down faster and faster and the bubble popped. In the end, prices reverted to their mean, the mediocre companies went out of business, and things returned to normal.

But, as a result of the tech crash and all the associated doom and gloom, the U.S. Federal Reserve thought it prudent to lower interest rates to historic lows (1%) in late 2001 to help cushion the effect on the economy and avoid an economic depression, or so they said. Well, it worked. People and businesses borrowed lots of money, and the economy recovered. The problem was, the Fed was avoiding a relatively small problem and encouraging a much bigger one…

Housing Bubble

Through the first half on this decade, U.S. housing prices grew, on average, at an extraordinary rate of 15%+ per year, which is way above the long-term average of 2-3% per year. This created yet another bubble, this time in housing.

So historically low interest rates certainly helped create the bubble, but as with all bubbles, it was hype and exuberance that really drove it. For example, speculators who couldn’t invest in tech stocks anymore switched to real estate. Housing was the new “hot” investment. The signs were undeniable. Everywhere you looked, there were seminars, books, and TV shows about flipping houses and how to make millions in real estate. In 2005, 28% of houses were bought for “investment” purposes. Builders cranked out new houses, there were bidding wars by buyers, and the whole industry got caught up in the mania.

But people’s incomes weren’t increasing at 15% per year, so how could they afford these rapidly increasing prices? This is where the banks and lending institutions magnified the problem because they too got caught up in the mania. The mortgages being offered by some of these institutions were ridiculous:

• Variable rate interest-only for the first 2 years
• Variable rate with interest rates as low as 1% in the first year
• Variable rate with payments less than interest for the first 5 years, meaning that the principle outstanding was growing
• Piggyback loans that allowed the downpayment to be borrowed against home equity
• No downpayment
• Cashback home equity loans beyond the equity in the house

There are estimates that 43% of first-time homebuyers in 2005 made no downpayment. The goal was for everyone to buy a house, whether they could realistically afford it or not…

Well, it worked. Millions of people bought houses they had no business buying. But why people would assume interest rates would stay historically low is beyond me…

Inflation

The next wrinkle was rising inflation. Since 2000, energy prices have increased significantly. For example, crude oil has gone from $30 a barrel to $120 a barrel. Why? Because we’ve run out of cheap oil, and emerging economies like China and India are using a lot more energy than they once did. So, as you’d expect, rising energy prices caused everything to be more expensive to produce, thus driving up inflation.

The Federal Reserve, wanting to control inflation (since that’s its job!), quickly raised interest rates from 1% to 5% to cool the economy. The problem was that all those people with variable-rate mortgages they already couldn’t afford had their mortgage payments double or triple. And it wasn’t only the dubious borrowers, with the so-called subprime mortgages, that got into trouble, but many borrowers with prime mortgages as well. Too many people got overextended. Default rates grew, and housing prices crashed, or more precisely, reverted to normal. But as you can see from house price graph above, they may still need to fall even further to get back to normal.

The net result was that by August 2008 approximately 9% of all mortgages were either delinquent or in foreclosure. Oops…

What isn’t clear yet is how this caused the financial armageddon we now see. So what if 5-10% of your customers are defaulting on their loans? The other 90% are still paying.

Derivatives

The problem is these lending institutions don’t have sufficient assets to cover their debts; they’re using leverage. Leverage is a great way to make lots of money, but it’s also a great way to lose lots of money. But these lending institutions aren’t just leveraged, they’re highly leveraged, some 20 to 1, others more than 30 to 1. So now if 3% of their loans default, that represents a loss of 60% of their assets if they’re leveraged 20 to 1, or a loss of 90% of their assets if they’re leveraged 30 to 1. Oops…

So that explains why all the lending institutions are in trouble – they were under-capitalized based on their risk exposure. Fine, so what about insurance companies like AIG? The insurance companies provided insurance to these lending institutions in the form of credit swaps and other financial derivatives. So when lending institutions wanted to collect on these insurance policies, the insurance company had huge problems because they too were highly leveraged. What do you do if you don’t have enough cash to cover your redemptions? You borrow more money. The problem is no one has any money to lend (except apparently the American taxpayer). All the financial institutions went to hide in their holes to wait for the carnage to end. So if you can’t pay your debts, and you can’t borrow any short-term money to tide you over, what happens? You go bankrupt, plain and simple.

Worst of all, all these financial institutions are so co-dependent through all of these credit swaps and other derivatives they’ve sold to each other that it’s like a big game of dominos. Knock one over and bunch more fall. Throw in a little market manipulation to bring down a few companies (à la Bear Stearns), and there you have it. One massive financial mess…

Lessons?

So what can we learn from this fiasco? Greed is extremely dangerous. The desire to make lots of money, regardless of the cost, is pervasive throughout the U.S. financial sector. All of these problems we now face were foreseeable. But the government did nothing to stop it. The Federal Reserve did nothing to stop it. The financial institutions did nothing stop it. Not that I think they could have. They always seem to be 8 steps behind. They move too slowly…

There were some experts that sounded the alarm bells years ago, but they were largely ignored. We’ll eventually get through this mess, but this isn’t going to be the last bubble. Where there’s greed, there’ll be speculators. The speculators will be always be looking for something new; there’s way too much money sloshing around to do otherwise. The next bubble may be agriculture, or energy, or alternative energy, or tulip bulbs, who knows…

The question is, what are you going to do next time? Are you going to become complacent like everyone else until it’s too late, or have you learned your lesson? Did your financial advisor help you avoid this mess? Probably not. Mine didn’t. Why not? That’s an interesting question…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

It’s an election year once again on both sides of the border in North America, and the spectacle that is our democracy is on parade again. As I get older (and apparently more crotchety), our electoral process disgusts me more and more every time I have to sit through it…

My main complaint is that our democratic / electoral / legislative processes seem horribly inefficient and wasteful given the quality of the results we receive. The problem, I think, is we’re focusing on the wrong things, like style over substance for example. Given we’re in the 21st century now, you’d think we could improve upon a process that’s been essentially unchanged for more than 100 years…

Representatives

Let’s start from the beginning. The intent of democratic government is essentially:

• “Government of the people, for the people, by the people”

In North America we implement democracy using representative government, meaning we select a local representative to run government on our behalf. Originally each representative represented 10,000+ people; it’s now 100,000+ people. How can these representatives know what their constituents want? They can’t. So a key characteristic of democratic representatives is:

• “While representatives are elected by the people to act in their interest, they retain the freedom to exercise their own judgement as how best to do so.”

In other words, I can’t possibly figure out what my constituents want, so I’ll simply explain my views, and if they elect me, then my views must be most representative of their views. In the 1800s, in the world of the horse and buggy, and no telephones, this process made sense. What other alternatives were there at the time?

But what about now? Do our representatives still need to be completely autonomous? Or could they instead be more of a conduit for our interests? Hmm…

Parties

So we’ve successfully elected representatives to represent us. But having a bunch of random people with a bunch of different views attempting to govern would be very difficult, nothing would ever get done. So long ago, candidates got together with other like-minded candidates and formed political parties to present a more unified set of views.

But slowly, over time, the importance of the individual representatives diminished and the importance of the parties increased to the point where the local representatives are now largely irrelevant, at least in Canada. For example, many people will vote for the same party every election regardless of who the local candidate is. I bet in many ridings you could elect a monkey – I know I’d vote for a monkey if it got the party I wanted elected…

Our local representatives could remain relevant if they sometimes voted against the party line, but they don’t. In Canada, voting against the party line will usually get you kicked out of the party. Constituents and conscience be damned – tow the party line or else…

So, during the election, we’re no longer voting for a representative individual, we’re voting for a representative party. Fine. This isn’t horrible. Our regional interests may not be well represented, but the federal government should, in theory, be dealing mostly with national issues anyway, right?

But at least the majority of voters will be represented by the governing party, right? Wrong. Because we have more than two major parties in Canada, and we don’t have proportional representation (which I’m not necessarily convinced is the answer to anything), the party that forms the government rarely gets more than 50% of the votes (it’s usually about 40% – 45%), even though they hold the majority of the seats. Oops…

But my main complaint about our party system is the governing party completely controls the agenda, which means the policies of the other elected parties are irrelevant. What if I like some policies from each party?

Campaigning

On to my least favorite part – the elections.

The amount of money and the number of people it takes to organize, run, and report on all the candidates’ campaigns is enormous. For example, the cost to the taxpayers for the last Canadian federal election was something like 300 million dollars. Which means it cost a million dollars per person elected. I don’t know about you, but to me, that seems like a lot of money to be spending every election. And I don’t think I want to know how much the U.S. spends…

But the worst part of the election is, it’s not about debating policy, it’s about appealing to the superficial desires and the basic instincts of the voter.  If you listen to politicians or their strategists in interviews, it’s all spin and rhetoric; same thing during the political debates. There’s no real debate, no discussion, no give and take, no listening, everything is about “talking points”.

Elections are popularity contests. It’s not about doing the “right thing”, it’s about winning. No one is ever going to admit they were wrong, or give their opponents credit because there’s no incentive to do so. The goal is to undermine your opponent as much as possible.

So in the end, the politicians treat the voters like children – and we let them! For example, if one parent offers broccoli and the other offers ice cream, what do you think the child is going to pick? The child doesn’t care what’s good for them, they want the instant gratification. So if one party offers new social programs, and the other offers to cut social programs, who do you think is going to elected? It’s not about intelligent, well thought out policy. It’s about manipulating votes – which leads to more and more targeted spending or micro tax break for very specific groups.

Governing

All the dirty campaigning and rhetoric leads to a thoroughly adversarial environment during the election. This adversarial environment carries over into legislative process, because there’s always another election eventually. The opposition will attack everything the government does, just because it was someone else’s idea. There’s very little civility or cooperation left in politics.

But if you think about a corporate boardroom or a project team, would this type of atmosphere be productive? Not likely… In fact, this type of poisonous environment would likely be extremely detrimental. Healthy debate is good, but the ability to compromise and cooperate is essential to make a team work effectively. The term “office politics” is used to describe negative, subversive behavior in the office. Yet this is what governing is about every day. Hmm…

So where does all this get us? Does it get us the best possible government? I don’t think so…

A Better Way?

Right now, there is no incentive for politicians to cooperate or be civil. Quite the opposite. They have every incentive to destroy their opponents. But all the energy spent on the rhetoric, posturing, and political theater is energy not spent on actually governing the country. So how do we take the “politics” out of politics?

I think the root of the problem is that in politics, personality and ego are attached to everything. But what if we broke this link? What if politicians didn’t pass laws? What if they simply wrote them? For example, what if we had the following system:

• Any elected representative (not just one from the governing party), or large group of citizens could propose an initiative
• All the representatives would then debate and frame the wording of the initiative, and come up with a reasonable set of choices for the voter
• The initiative couldn’t be put to voters until the all the representatives agreed on the wording and choices (with some remedy for dealing with obstructionists)
• The voters would vote, say once a quarter, through the Internet or mail, on finished initiatives, and the politician would be bound by the outcome
• Voters could reject an initiative if they weren’t happy with the list of choices provided
• Voters could recall representatives if they wanted

Since all representatives would need to approve the finished initiative, it would ensure that all points of view would be covered, and it would also require that politicians compromise in order to get their initiatives finished. Regardless of all its potential flaws, I think, at the very least, a system like this would put the emphasis back where it belongs, on policies rather than the politicians, and promote healthy debate rather than bickering.

Obviously there would be many criticisms of such a system. The most obvious ones would be:

• People aren’t interested in day-to-day goings on of government
• Laws are much too complicated for the average person to understand

But I don’t buy that people aren’t interested. The amount of media coverage of elections and government legislation is fairly high. If people didn’t care, they wouldn’t watch, and the media wouldn’t spend so much time on it. I think a substantial percentage of the population would like more input into the functioning of their government. As for the complexity of laws, I think forcing legislators to simplify our legislation would be a net benefit anyway. Our laws and our tax system, and government in general, is way too complicated already.

But would it really be possible to simplify all government legislation into bite-sized pieces? I think so. Start with the simpler social policy questions like the propositions that many U.S. states vote on already and work your way up.

Bottom line, I think our current representative democracy in Canada is seriously flawed, and could benefit from incorporating more elements of direct democracy. In some ways, the U.S. has much more input into their government than we do. For example, they have (and actually use):

• Citizen’s initiatives
• Referendums (ballot questions)
• Recall

But in the end, the problem, of course, is any changes require our elected representatives to make them, and they don’t really have much incentive to change the status quo, do they?

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

As I discussed previously, we don’t have a clear idea of the causes of many of the degenerative diseases we face today, like heart disease and cancer; all we have are risk factors. In some cases, we have a lot of risk factors. For example did you know there are now over a thousand known risk factors for heart disease? But which of these thousand risk factors actually cause heart disease? All of them? None of them? Why don’t we know what the causes of these diseases are yet?

Unfortunately, these diseases are extremely difficult to study because their causes are non-trivial. The biggest difficulty in studying them is they don’t develop overnight. Some scientists believe that diseases like heart disease and cancer can take 20+ years to develop. So how can we possibly know which combination of factors during all that time caused or contributed to the disease? Hmm…

Observational Studies

The field of epidemiology has been around for hundreds of years. Originally, it was used to study outbreaks of infectious diseases (i.e. epidemics). Today it’s a staple of scientific research, and there are thousands of studies published every year. Unfortunately, as Dr. George Davey Smith and Dr. Shah Ebrahim discuss in their editorial “Epidemiology — Is It Time to Call It a Day?“, the track-record for observational studies correctly identifying the causes of degenerative diseases is less than stellar. In fact, not only do they often find spurious associations, but sometimes they find the opposite of the correct answer. For example, as detailed in the New York Times article “Do We Really Know What Makes Us Healthy?“, doctors for many years prescribed hormone replacement therapy to older women to reduce their risk of heart disease, only to find out recently that it actually increases their risk.

The problem is observational studies are inherently limited. Observational studies involve monitoring a large group of people for some period of time, asking them questions or giving them medical exams at regular intervals, and recording mortality and disease rates. But how often do they monitor the people in these long-term studies? Certainly not every week. In the famous on-going Nurse’s Health Study, for example, they send out questionnaires every two years. Even if you’re monitoring something simple like birth control usage, how do you boil all the variations or permutations of potential usage down into a multiple choice question?

And after the researchers have collected their data, they plug it all into a computer and hope to find correlations. The better studies (prospective studies) as least decide what they’re testing before running the study so they can attempt to minimize confounding factors in the design of their study. The more dubious ones (retrospective studies) go looking for associations in data from studies designed for completely different purposes. Sandy Szwarc from the Junkfood Science blog has a long list of examples of this type of weak “data-dredge” study.

By definition, observational studies are largely uncontrolled (i.e no intervention and no randomization) and thus will have many confounding factors. This is where the judgement and biases of the researchers come in. It’s possible to get different results depending on how the researchers manipulate or “interpret” the data. If the associations being studied are small, the adjustments made to the data can easily skew the data to reveal associations where there are none.

And even if the studies find compelling associations, they’re still just associations. We don’t know why the association exists. They may be causative or could simply be correlated.

In the end, observational studies are like excavators. If you’re looking for big obvious things, like rocks, you’ll find them. But if you’re looking small subtle things, like fossils, you’re going to miss them. It’s the wrong tool for the job.

Clinical Trials

So if observational studies aren’t good at discovering the causes of diseases, what about clinical trials? Clinical trials avoid a number of the limitations of observational studies by design. The best clinical studies are double-blind so neither the doctor nor the patient know whether they’re in the study group or the control group. Clinical studies also are typically short and small in order to control for as many confounding factors as possible.

But if it can take 20+ years to develop these diseases, how much is it going to cost to run clinical studies for that length of time? This, of course, ignores the problem that people won’t like strict controls on how they live their lives for long periods of time either. In the old days, they experimented on patients in mental hospitals since they were a captive audience and not likely to object; but we can’t do that anymore…

Also, some things, like diet, aren’t suitable for double-blind studies because people know whether they’re eating low-fat or low-carb foods, for example, which introduces an additional set of confounding factors.

Clinical trials are useful for testing new drugs because they can use placebos to make the study double-blind, and the experimenters can focus on one specific variable. But for monitoring lifestyle or other human behaviors, clinical studies don’t seem particularly suited…

Biological Research

Our best hope for really understanding these degenerative diseases is to understand them at the molecular level – by understanding the biological mechanisms at work in our bodies. Observational studies and clinical trials can help to at least point us in the right direction since biological research is very expensive and time-consuming. I’ll explore some of the findings of current biological research in future posts.

But what can we do in the meantime? Who should we believe? That’s the hard part…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

We hear regularly about the “causes” and “preventions” for various diseases from the media. For example, high-fat diets cause this, and high cholesterol causes that, or as I discussed last week, coffee helps “prevent” heart disease. But do we actually know whether these things cause or prevent these diseases? If you read any of the major health sites you might think so. But if you read them again more carefully, you’ll notice they don’t actually talk about causes, they talk about risk factors. Take the American Heart Association web site for example:

So what’s the difference between a “cause” and a “risk factor”? Risk factors sound like risks, which are bad, right?

Let’s look at an example. What’s the leading cause of car accident mortality?

• Reckless driving? Nope.
• Speeding? Nope.
• Getting distracted? Nope.
• Bad weather? Nope.

None of these things actually cause death. Car accident mortality is usually caused by bodily harm incurred when we’re introduced to Newton’s First Law of Motion, i.e. “A body in motion will remain in motion unless acted upon by an outside force”, like a tree or another car!

Now you might argue that this is splitting hairs, but my point is that we need to be careful when talking about cause and effect. In order for something to be causative, we need to be able to link the series of events together with a clear relationship between them. For example:

• Serious bodily harm usually causes death because we lose too much blood and our internal organs fail, or our internal organs become too damaged to function

Straightforward, right? So back to our secondary factors:

• Speeding can increase the probability of an accident, and thus death, because you and the other drivers have less time to react to avoid a collision
• Bad weather can increase the probability of accident, and thus death, because reduced visibility / traction can prevent you from avoiding a collision

Still straightforward, right? If we analyze car accident rates, we’d expect that drivers who speed or drive recklessly would have higher mortality rates. We start with a plausible cause, and we can verify effect. If necessary, we can test our hypothesis in a controlled environment.

But say we notice that drivers with red cars also have higher mortality rates. Now what? We have effect, but what’s the cause? Working backwards is dangerous – just because something is correlated, doesn’t make it causative. For example, what happens if we ban red cars? Will we have fewer car accidents? Not likely. In this case, red cars may be correlated to personality types that are more likely to drive recklessly, rather than being causative in any way. Some people are going to drive recklessly regardless of car color. So red cars may not cause increased mortality, but they are a risk factor for increased mortality.

All of this is intuitive for car accidents, but what about diseases? If we look back at the American Heart Association web site information from above, how many causative factors are listed? None. How many correlated factors are listed? All of them. Oops…

Digging around a little, I couldn’t find any major health sites that said XXX causes YYY, besides smoking causing lung cancer. But some certainly imply causation:

“Extensive clinical and statistical studies have identified several factors that increase the risk of coronary heart disease and heart attack.”

Risk factors increase the risk of heart disease? I don’t think so… What they should have said is “they’ve identified several risk factors that are associated with an increased risk of heart disease”. It’s a subtle but important difference.

“People with diabetes are two to four times more likely to develop cardiovascular disease due to a variety of risk factors”

“Due to” implies “because of” – which certainly implies cause and effect. Hmm…

The definition of a risk factor is:

“A risk factor is a variable associated with an increased risk of disease or infection. Risk factors are correlational and not necessarily causal, because correlation does not imply causation“

So by definition, risk factors don’t cause anything. If diet and obesity were causative, they’d say so – but they don’t. So why are they trying so hard to get us to control risk factors that may or may not be causes? That’s a topic for a future post…

Risk factor != cause

Also, don’t assume that major risk factors are more likely causative than minor risk factors. “Major” simply means that they’re more strongly correlated. For example, yellow teeth are a major risk factor for lung cancer. So yellow teeth cause lung cancer?

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

The media seems to love scientific studies. Every week there seems to be a story on the local news about a new study telling us about how to reduce the risk of heart disease or cancer, or some other disease. Unfortunately, the news story invariably distorts the study’s results, doles out some dubious advice, and does a general disservice to their audience…

For example, recently I happened across a WebMD article entitled “Drinking coffee may extend life”. The first paragraph of the article reads:

“Coffee drinkers, rejoice. While you might be using it for a “pick-me-up,” coffee may also be extending your life.”

From this headline, your initial reaction might be:

Coffee’s good for you; it would probably benefit everyone to go out and drink coffee.

Unfortunately this assumption is pretty far from the truth. For example, further down in the article you get a quote from one of the study’s authors:

“We can’t say from this one study that coffee extends your life, but it does appear that it doesn’t increase the risk for death for people who are healthy,”

Wow, coffee doesn’t increase the risk of death for people who are healthy! That’s encouraging…

If you look up the actual study in the Annals of Internal Medicine – “The Relationship of Coffee Consumption with Mortality”, their official conclusion is:

“Regular coffee consumption was not associated with an increased mortality rate in either men or women. The possibility of a modest benefit of coffee consumption on all-cause and CVD mortality needs to be further investigated.”

Hmm… We seem to be getting further and further away from our initial assumption; maybe the devil really is in the details. Looking at the details of the study, I think an appropriate summary of their findings would be:

For those with no history of heart disease or cancer, over 20 years, your risk of dying of heart disease may drop by up to 20% in men and 25% in women, if you drink coffee.

The study doesn’t tell us anything about:

• Benefits to those that already have heart disease or cancer
• Benefits to those who aren’t at risk of heart disease
• Whether coffee increases the risk of dying of something else
• Whether coffee may negatively affect your health in other ways

So, now that we’ve correctly interpreted the study’s results, do we actually believe them? I don’t…

Why does coffee reduce the risk of heart disease? We can guess, but in reality, we have no idea whether coffee actually lowers the risk of heart disease or not, or whether these numbers are due to something else. The authors of this study don’t either. They weren’t working in a lab looking at samples through microscopes, they were crunching numbers in a computer. As I’ll discuss further next week, this is not an effective way to study diseases.

Bottom line, take your coffee (and the results of studies such as these), with a grain of salt…

[Image: www.stockvault.net]

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

Every year, the new life expectancy figures come out to grand fanfare. “Life expectancy is now XXX, up YYY years from last year”, but what does this number actually represent? Is it meaningful? You might think you know, but you’re probably wrong. I know I was…

I became curious about life expectancy statistics because my grandfather died a few years ago at the age of 94. It got me thinking, how long were people expected to live when he was born? Given all the scientific advances we’ve made in the last hundred years, how long did people of his generation actually live? Did he outlive his expected life span?

Life Expectancy vs. Expected Lifetime

Life expectancy for 2005 in the U.S. was 77.8. So, the assumption is that, on average, anyone born in 2005 can expect, on average, to live to the age of 77.8, right? Wrong.

In mathematics, expectancy is a term used to describe the expected future value of something, based on current knowledge. For example, if you flip a coin 10 times and you win $1 for heads and lose a $1 for tails, the expectancy for this game is $0 because you expect, on average, an equal number of heads and tails.

So life expectancy then is the expected average lifetime of someone born today, based on what we know today – i.e. the death rates for today. The way they calculate this (and have since the 17th century) is by using life tables. Life tables give you, based on your current age, the probability of living one more year. For example, they tell you that if you were 39 in 2004, that you had a 99.82% chance of making it to 40.

The problem is, to calculate the 77.8 life expectancy figure for 2005, they’re applying those chances of someone making it from 39 to 40 in 2005, and projecting them 39 years in the future to calculate future survivability. So, 77.8 is really a fictional number that says that for someone born in 2005, if death rates at a given age were to remain as they were in 2005, this is how long they’d live on average.

We can probably all agree that it’s likely a lot of things are going to change in the next hundred years that will impact mortality rates. For example, there may be some big scientific breakthroughs on cancer or heart disease, there could be another world war or infectious disease pandemic, or we could be attacked by aliens…

Either way, life expectancy is not the same as expected lifetime.

Life Expectancy vs. Actual Lifetime

So if life expectancy is a projection of present knowledge on future longevity, we should be able to see how far off these figures were. For example, life expectancy for someone born in 1900 was 49.2; what was their actual average lifetime?

As I was trying to find actual longevity information, I came across a text book called “Development Through Life” by Newman & Newman that said that current life expectancy values are calculated using life tables, whereas life expectancy values for someone born in 1900 are now based on actual rates of death. This completely confused me because it implied that life expectancy was a dynamic number. That somehow life expectancy values from previous years would be recalculated using actual death rates. This would also imply that comparing the life expectancy for someone born in 1900 vs. someone born in 2000 would be completely bogus because we’d be comparing apples and oranges.

Fortunately, this assertion doesn’t seem to be true. Going back to the life tables from the CDC published in 1900, the numbers appear the same as the numbers reported for 1900 today, so I’m not sure what Newman & Newman were talking about…

In the end, I couldn’t find the numbers I was looking for, so I calculated them myself. To estimate the actual average lifetime for someone born in 1900 you can incrementally use all the life tables produced over the last hundred years because those life tables are calculated based on actual death rates for that year. For example, if you managed to survive to the age of 40, then the life tables from 1940 for someone aged 40 will tell you what the chances were of living to the age of 41. The biggest limitation to this approach is we can’t control for things like immigration and migration. Oh well, c’est la vie.

From my calculations, the average lifetime for someone born in 1900 was actually something like 55 years, rather than the original life expectancy of 49.2. Notice that over time, average lifetime seems to consistently be about 10 years longer than life expectancy.

[Note that the lines converge because as we get closer to the present, more and more people are still alive, which means I had to use more and more life table data rather than actual death data. As we progress into the future, I expect the average lifetime to retroactively creep as people continue to live beyond their original expectancy (as least as long as life expectancy continues to rise).]

Life Span

Life span usually refers to the maximum lifetime of a species. So, given that life expectancy is going up, you might ask if human life spans also being extended? It doesn’t appear so. The maximum life span for humans still seems to be about 110 years.

So the fact that my grandfather lived to the age of 94 wasn’t really statistically extraordinary; it was just a lot less likely than me living to the age of 94.

Usefulness?

So now that we understand life expectancy, what can we do with it? You and me personally, probably not much. The fact that overall life expectancy was 77.8 years in 2005 is pretty meaningless because it’s a composite number for everyone alive in 2005. It’s not that useful for a new baby, because the figures don’t attempt to predict the future. And it’s not relevant to someone born 40 years ago because how do you combine it with the life expectancy from 40 years ago? The number might as well be 75, 80, or 85.

But the change in the expectancy figure year to year can tell us something. Namely, if life expectancy is going up, it tells us that we’re all currently, on average, living longer – which is probably a good thing (assuming we have reasonable quality of life).

What about the fact that the life expectancy for someone who was 80 in 2005 was 9 years? Medical science isn’t likely to change significantly in the next 9 years, so the number is at least relevant. That said, your remaining lifetime at that age is probably more heavily affected by your current health rather than these general averages, so maybe that’s not all that useful either…

What about retirement? Can you make financial plans using these life expectancy numbers? If you do, you may be in for an unpleasant surprise… If the current trend continues, life expectancy will continue to under-estimate actual lifetimes. Life expectancy was off by 6 years for people born in 1900. How far off will it be for your generation?

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

As I discussed previously, cognitive dissonance can cause us to rationalize and justify all sorts of strange beliefs and illogical decisions, but it has other effects as well.

Recall that cognitive dissonance causes us to deal with new incompatible information by either discarding our initial belief, or by dismissing the new information. It turns out that our brain has a strong preference for the latter. It would much prefer a stable set of beliefs rather than a constantly changing set. That way, the world seems to make more sense. The problem is, this can lead to an effect known as confirmation bias.

Professional Bias

As Carol Tavris & Elliot Aronson describe in their book Mistakes Were Made (But Not By Me), confirmation bias causes us to more readily accept information that confirms what we already know, and more likely to ignore or rationalize away information that isn’t compatible. We see what we want to see. It’s just another way the brain avoids cognitive dissonance.

The biggest problem with confirmation bias is that those with the strongest beliefs are those that are most likely to be affected by it. For example, all the big name experts in a particular field are some of the least likely people to be able to change their minds and admit to mistakes. Cognitive dissonance is strongest in them because they have the most to lose. In many cases, they’ve invested years or decades of their lives into an idea, so they’re not likely to want to admit that they wasted that much time on something that’s wrong – they’re supposed to be “experts”…

George Bush is a poster boy for this outcome. The more things go wrong in Iraq, the more he believes that it was the right thing to do, the more he comes up with new justifications…

Selective Memory

Cognitive dissonance also affects your memories. We like to think that our memories are accurate and objective, but they’re not. It’s not so much that we forget things, as much as we seem to remember ourselves more favorably or alter events to better fit our beliefs – i.e. we are all revisionist historians!

One of my first experiences with this process was late in my late teens – another teen and I had an “altercation”. A few hours later we were asked to recount the events as we remembered them. Incredibly, his story was completely different (and incompatible) with mine. It could have been he was lying to avoid getting in trouble, but I don’t think so. I think his brain had colored his memory and generated rationalizations for his actions in order to justify his bad behavior. I think he was describing events exactly as he remembered them. In the end, neither of our stories could be proven so it could just as easily have been me revising history. Either way, it was an eye-opening experience as to the malleability of the “truth”.

Selective memory also affects how we record history. There was a controversy a few years ago with an exhibit at the Canadian War Museum about the bombing of Germany in the World War II. The original text on the exhibit read:

“The value and morality of the strategic bomber offensive against Germany remains bitterly contested. Bomber Command’s aim was to crush civilian morale and force Germany to surrender by destroying its cities and industrial installations. Although Bomber Command and American attacks left 600,000 Germans dead and more than five million homeless, the raids resulted in only small reductions of German war production until late in the war.”

Seems perfectly reasonable to me… But some people were upset by it and asked (and eventually succeeded) to have the text changed to:

“Thousands perished in the raids and millions were left homeless. While these numbers are very large, they pale in comparison to the genocide perpetrated…by the Germans and their proxies.”

Mistakes were made, but theirs were worse. Who writes history? The winner of course…

Self-Fulfilling Prophecies

Why do good things happen to people with high self-esteem, and bad things seem to happen to people with low self-esteem like a big self-fulfilling prophecy? They don’t actually, it’s just how we remember things. If you have high self-esteem, you expect good things to happen to you – so when bad things do happen, confirmation bias shields you from it and you quickly forget the bad and only remember the good. The opposite would be true for people with low self-esteem, who will wallow in their perceived misfortune. It’s not positive thinking that brings us good things, it’s positive remembering that does.

We can’t actually change the way our brains work, but we can learn to recognize when they are playing tricks on us…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

As I discussed previously, truth seems to be subjective and personal rather than objective and universal. But beyond that, we always seem to have reasons and justifications for our beliefs, even when those reasons can seem utterly ridiculous to others. For example, tell me if this sounds familiar:

“I was talking to so and so, and we got into an argument over such and such because they were completely obstinate. They absolutely refused to listen to logic. It was totally unbelievable.”

Why does this happen?  Why are people so irrational sometimes? Why do people never seem to say:

“You’re right, I’m wrong. Thank you for showing the error of my ways.”

It turns out, the problem is in how our brains process information.

Dissonance

As Carol Tavris & Elliot Aronson describe in their book Mistakes Were Made (But Not By Me), when our brain is presented with new information that conflicts with something we already believe, our brains have a problem. This state is called cognitive dissonance. Our brains don’t want to stay in this state because it wants the world to be logical and orderly. So our brain essentially has two choices, discard our initial belief, or dismiss the new information.

The most interesting part of the cognitive dissonance resolution process is when we dismiss new information, it’s not good enough to simply dismiss it outright, our brains need some reason to dismiss it. This is why we end up rationalizing or justifying our decisions. It’s not something we do consciously; our brains do it for us automatically.

For example, when we make a mistake it can cause cognitive dissonance. I’m a smart / competent / skilled person, how could I make a mistake?  To resolve the dissonance we’ll find some excuse – like “it wasn’t my fault, it was because <insert lame excuse here>”, even when it was clearly our fault.

How about smoking? It’s nearly universal believed that smoking cigarettes is harmful (how harmful is still up for debate), but there shouldn’t be any good reason to smoke anymore, right? Ask any smoker why they haven’t quit yet and they’ll have a fine list of rationalizations:

• “I don’t inhale”
• “I’ve cut back recently”
• “The scientists exaggerate the danger”
• “I only smoke when I drink”
• “I’m too busy right now, I’ll quit next month”
• “It helps me relax”
• “It prevents weight gain”

What about personal conflict, like domestic violence? If the abuser believes themselves to be basically a good person, then hurting someone they love will cause dissonance:

• “They provoked me”
• “They deserved it”
• “They’re worthless and lazy”

What about military conflict? In a war, who are the good guys and who are the bad guys? Do you think the enemy really think of themselves as evil? Not usually, but we rationalize killing them by demonizing them and whatever atrocities they’ve committed.

Indoctrination

The other interesting part of our rationalization process is the effect can be cumulative. Once we’ve made a decision, it’s hard to undo it, especially the difficult ones. Our brains will make sure we have a justification for that decision so that we won’t forever be worrying that we made the wrong one. Over time, that initial decision gets reinforced to the point where we can’t imagine ever making the opposite decision, even when it was a toss-up originally.

For example, whenever we argue about something, the longer we argue about it, the more we’re going to become entrenched in our belief, even if we’re obviously on the losing side. Not only are we defending our belief now, but also the time and effort invested trying to defend it.

This also how people get brainwashed (or indoctrinated if you prefer).

How do you turn a normal, well-adjusted person into a devout cult member? How do you teach someone to be an effective soldier? How you get someone involved in illegal activity? A little bit at a time. Once you get the ball rolling, self-justification will do the rest.

For example, if you told someone walking down the street that aliens are coming on a spaceship to save us because the world is going to end, they’d laugh in your face. But if you indoctrinate them slowly over time, you can get seemingly normal people to leave their jobs, their spouses, and to give away all their possessions.

Obviously some people are more easily influenced than others, but don’t assume you’re immune. Anyone can be turned into a completely different person under the right conditions. The brain is a funny thing. Our ability to self-rationalize is extremely beneficial because it lets us sleep at night. Just try to avoid the slippery slope…

[Image: Peter Arno]

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

Canada is finally getting its own “do-not-call” list this fall, and with it, the promise of a quiet evening at home, or so the theory goes… I haven’t investigated thoroughly, but the Canadian version looks very similar to the American version. So I ask, how effective are these do-not-call lists? Could they be more effective?

The biggest flaw I see is the exemption list is too long. Who do you think calls me most frequently? Everyone that’s on the exemption list, of course:

• Charities
• Political parties
• Pollsters
• Newspapers seeking subscriptions
• Businesses with whom I have an existing business relationship

These things do tend to go in waves, but I suspect that 80% of the unwanted calls I get are from groups on the exemption list. For example, many of the calls I get are from companies with whom I do business already who are trying to upgrade me, or cross-sell me one of their 462 other products and services. The banks, cable and phone companies seem to be worst for that kind of thing.

The one obvious difference from the American version is that the Canadian version has an exemption for newspapers. The newspaper lobby must be stronger in Canada than in the U.S… Why should they be allowed to sell me something, but no one else can?

In the end, I think these lists are better than nothing, but I think they could be better. For example, how about:

• A “don’t-waste-your-time-calling-me-I’m-not-going-to-talk-to-you” list, which would apply to everyone, unless you’re calling me about problems with my existing service
• Require all corporations and organizations (for profit or not) to have their name show up on call display so we can screen our calls intelligently

Just a thought. In the meantime, I’ll continue ignoring most of my phone calls…

[Image: www.freeimages.co.uk]

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

“Truth” is an interesting concept. Every day we are presented with the “truth” of the world around us, whether through television, the Internet, or the people with whom we interact. But what is truth really? Who gets to define truth?

The dictionary will define “truth” to be something like:

“The true or actual state of a matter”
“Conformity with fact or reality”
“A verified or indisputable fact, proposition, or principle”
“An obvious or accepted fact”

So to me, these definitions imply that truth is something where there is only a single correct answer, something that is unambiguous. If that’s the case, what are some of the more common “truths” can we name?

• Humans are the primary cause of global warming? Maybe not…
• There is an obesity epidemic in the U.S.? Maybe not…
• Smoking is a huge health risk? Maybe not…
• High-fat diets cause heart disease? Maybe not…

I’m not actually expressing an opinion on any of these subjects (yet!). My point is that if you really think about it, there seem to be very few things that are universally accepted, beyond mundane stuff like the sky is blue and gravity keeps us from floating away. Why is this?

The first problem is our world is so complex that going from simple facts like, 33% of adults in the U.S. have a BMI over 30, to sweeping generalizations like “we have an obesity epidemic” is a huge leap. There’s so much room for individual interpretation that different people can (and do) derive different truths from the same basic facts.

The second problem is, very few people actually understand the intricacies of these complex issues. Most of us are left with second-hand, third-hand, tenth-hand accounts of the original truth. So instead, most of us get information that’s been distorted or misunderstood, and bears little resemblance to the original – just like in the children’s game telephone.

In the end, what we really have is a world where truth is subjective and personal. Or as Robert McKee described it in his book Story: Substance, Structure, Style and The Principles of Screenwriting:

“What happens is fact, not truth. Truth is what we think about what happens.”

This is the reality that I face while writing this blog. As I look for compelling evidence to back up my theories, I also tend to find compelling evidence disproving my opinions as well. Making sense of all the competing information that’s out there is hard, sometimes very hard, especially since I’m not an “expert” in the subjects I write about here.

So despite this blog purporting to be presenting the “truth”, I readily accept that it’s really more accurately presenting “my truth” – those things that I personally believe to be “true”. I don’t expect my truth to necessarily agree with your truth. Get over it, I have…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]