It's the universal American dream: to strike out on your own, become your own boss, and—of course—become fabulously wealthy. It is a dream shared by men and women at all levels of society from janitors to executives. I'm convinced it is the reason why many middle income and even lower-middle income people are diehard political conservatives; they truly believe that they are a few steps away from becoming a business owners who, by definition, would be adversely affected by high taxes and burdensome health/safety/labor/environmental regulations.
Certainly there are possibilities for the meteoric rises from “rags to riches” that we all celebrate, such as the orphaned, high-school dropout Dave Thomas, who went on to create a world-wide restaurant chain: Wendy's. However, we must remember these are exceptions; we can't base policy decisions on a few outliers. Without outside influence, people generally stay in the socio-economic class that they were born in, which—at best—is a little better than their parents. These non-contiguous jumps in success that we all dream of, whether in business, sports, or entertainment, are actually extremely rare. When it comes to small business, we must acknowledge the fact that the vast majority of them fail within the first few years, and not only dwell on a few success stories.
This is why I've become convinced that—just as it is foolhardy (and cruel) to pump up poor, inner-city youths with dreams of becoming basketball or rap stars—it is cruel to even tacitly encourage a friend who, with little more than contempt for his employer, wants to strike out on his own. A friend should be the voice of reason in these circumstances, and test the budding entrepreneur’s commitment, knowledge, discipline, and capabilities in this area. Someone who is really intelligent and capable enough to succeed in this respect will have no problem answering the tough questions, starting with how he (or she) is going to support himself, and what evidence there is that this will actually attract customers and make money.
Although there are thousands of self-described independent business people and even more business licenses & incorporation filings, most are not successful—even if they do show some kind of profit. To be a successful entrepreneur, first of all you have to make enough from your salary and/or profit to at least equal your previous job. Too often I hear self-employed friends talk about how much they made in that one good week or month, but are silent about their yearly income. Later, when they run out of money, I often hear they went back to their old job…apparently their business wasn’t as successful as they made it out to be.
The next measure of success is return on investment (ROI) or return on assets; if you already have (or inherited) buildings/facilities/real estate, vehicles, and equipment, you must consider the value of these in any calculation. There is an opportunity cost for these items; could these items could be sold or leased if you were not utilizing them? If so, then this must be determined and subtracted from your profit statement.
There are many other ways of measuring financial success, but my final question would be: how much would someone buy your business for? Obviously part of the equation is the value of cash, inventory, and assets (minus depreciation, of course), but a successful business is really measured by how much money it makes (and is expected to make in the future), and this is where it often becomes sticky for sole proprietors who do not recognize all their cash income and mix business and personal expenses. If I want to buy your business, and you say, “Well, I receive a lot more income than I report on my taxes” then I must trust your word on how much you actually make, since you certainly wouldn’t risk keeping separate books reflecting this additional income (because that would guarantee a conviction in a tax evasion case.)
Too often entrepreneurs end up buying themselves a low-paying job (especially considering the long hours involved) for tens or hundreds of thousands of dollars and only seem to be successful because they own or control significant assets, while their spouse is actually earning the family’s income from a conventional job.
Corporate rip-off
I will come back to possibly successful entrepreneurial business ideas, but first I want to address why you can’t beat the big guys in the consumer retail sector by defending supposedly evil corporate bad guys against incessant criticism from consumers and small businessmen. I am blown away when I hear local would-be entrepreneurs declare how they could bring goods and service to customers at a lower price than large corporations…who, then by definition, are ripping us off. Their unsophisticated analysis show they do not understand the efficiencies, especially in supply chains, that large corporations have, and ignore the overhead costs in delivering goods & services (I’ve even heard redneck business owners claim to have “low overhead” without realizing that they actually have higher overhead per unit!)
Likewise nearly everyone complains about how cable TV, satellite, and mobile phone companies are ripping them off. The assumptions is that, as an intangible good, data must have a marginal cost near zero, so why should they be getting dinged tens of additional dollars every months for overages and arcane fees for using these services? What is forgotten is the capital tied up in infrastructure and ongoing expenses in maintenance of these massive networks. This reality is divorced from what the advertising/marketing department must do to increase market share: namely get customers to sign contracts for $x9.95/month with—of course—an asterisk at the end! Recently I’ve watched a nearby AT&T tower go up (easily a 7-figure project) and watched dozens to hundreds of UTMS cabinets being assembled for installation around the state as AT&T upgrades their network for 3G. Now I understand why they need $70 a month for the unlimited iPhone data plan.
On the left/green front, some assert that the local & organic food movement stands to gain efficiencies (and reduce carbon footprint) by not transporting food hundreds (or even thousands) of miles across the country or world as the incumbent, industrial food/agriculture industry does. Their childish logic implies that these giants are transporting goods over long distance for no good reason. In fact, large concerns such as Wal-Mart are very careful to minimize the carbon footprint of each product; they just don’t call it that, but use a perfect proxy: money! The less money they spend on diesel fuel, the more profit they make; this is why they pack their 18-wheelers to the roof and use all kinds of logistics experts and computer software to minimize transportation cost (and therefore carbon footprint as well.) Although your local organic farmer doesn’t move his produce as far, it is likely that, on a per pound or kilogram basis, it could actually have a bigger carbon footprint!
Finally, corporations exist in a marketplace of competitors and potential competitors, which—in the long term—make any advantage temporary. Regardless of how much or little they pay their executives, large corporations—across the board—generally make single-digit (percentage) profits. In industries/niches where profits are higher, more players naturally enter the market and dilute any above-average profits.
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I don’t necessary disbelieve the get-rich-quick crowd’s claims of how much money they have made; however, what each one fails to disclose is that they now have a new money-making scheme: selling get-rich-quick books, recordings, and training. They may have very well discovered a lucrative arbitrage opportunity some years ago, but it has since dried up or been diluted by new entrants. Now they are essentially selling nothing more than their life’s story to suckers whom they have convinced can repeat their success. Now, this view is only the most charitable possibility; actually I do believe that most of these charlatans go way beyond exaggeration and embellishment to outright deceit.
Innovative niche entrepreneurship
So, in what field is it prudent to become an entrepreneur? First of all, it has to be a niche that is not adequately served now. Even in the mature economies of the west, there are products and services that a small businessperson can provide other businesses (generally never to consumers) that provide such a great value, they practically sell themselves. With the application and integration of modern technology, it is possible to revolutionize tedious business processes that organizations would like to outsource anyhow. A startup based on the founder(s) competencies/expertise in a given field, and the development of innovative software and/or other systems for several client businesses is a great start. However, notice it must be in your field of expertise. If you haven’t already been working in a particular business or sector for many years, you are simply not qualified to start a business in that area. You can’t just dive in the deep end and expect to learn as you go. If, for example you a machinist who is tired of getting oil under your fingernails, and decide you’re going to change directions and teach yourself computer programming in order to start a business, then you are certainly doomed to fail. (Incidentally, it should go without saying that unless you’ve been a general manager of a restaurant for several years, you should never consider opening a restaurant—even if you have this experience, the odd are against you as an independent restaurant, bar, cafe, etc.) If you really want to make a big change in your professional life, you’re better off going back to school to learn a new profession, work in this new profession for a few years and only then think about starting a business in that area. [UPDATE 7-29-2010] Two researchers from the Haas School of Business at UC Berkeley, Pino Audia and Chris Rider published a paper debunking the "myth of the garage", that is, the humble & isolated beginnings of many tech startups. It turns out that most successful startups leaned heavily on information, skills, and networks established while working with their previous employers. (FastCompany article)
I am sorry for sounding so negative, especially now that I am considering starting my own business, but I’ve written this in part to sharpen my own view on the issue. I’m just tired of conversations about entrepreneurship focusing only on the best-case scenarios, while ignoring the significant costs involved that often are never recouped. Whenever someone whispers, “you know, there’s good money in x” I reply, “yes, there is good money in everything.” Every potential investment or business idea requires a comparable mix of capital, risk, and plain old hard work to produce a comparable income. For example, being a landlord is an excellent way of building wealth, since your tenants are paying the mortgage—building your equity in the property. However, it also means you’ve got to deal with collecting rent, fixing broken plumbing, etc. If you decide to hire a management company so that you don’t have to worry about these things, you will find (with the management fee deducted) your investment now returns about the same as if you just bought stock in a REIT (real estate investment trust.) This is how a capitalist system works; the market determines the value of all inputs through their reward. If an opportunity temporarily returns better than expected returns, then more people will flock to it and dilute the returns.
Showing posts with label personal finance. Show all posts
Showing posts with label personal finance. Show all posts
18 July 2010
11 April 2009
Devil's Advocate
As our economic woes deepen, everyone is eager to place blame at the feet of whatever nemesis his or her ideology deems fit. On the right, this entire downturn was precipitated by undisciplined and untrustworthy individuals getting sub-prime mortgages to buy homes outrageously out of their price range and then defaulting on said mortgages…triggering an avalanche that eventually lead us into the current credit crunch. Furthermore, many will claim that lenders were forced to do this because of federal “fair housing/lending” and “anti-redlining” regulations.
On the left, there is an agreement that sub-prime mortgages are at the heart of this mess, but blame is placed on the unscrupulous brokers who apparently tricked unsuspecting (and admittedly unsophisticated) homebuyers into taking risky loans just to make a quick commission, and on the “financial geniuses” who devised the now toxic “collateralized debt obligations” as well as other exotic derivatives. From this view, the whole of the rest of the cascade of events that has brought us to this point is entirely the fault of greedy (and by virtue of this unraveling—incompetent) executives, brokers, and associated “money-men.”
My view
I say there is enough blame to go around; we ALL contributed to this mess! Collectively and individually, as corporations, and governments—almost as a rule—we overextended ourselves in respect to debt; and from the most unsophisticated wage earner to the brightest minds working in the most prestigious investment firms, we all assumed that asset values, growth, and incomes would only go up. This crisis is finally the slap in the face that we all needed: we cannot borrow our way into prosperity! As the offspring of depression-era, immigrant parents, financial discipline and thriftiness was ground into me from an early age, so I have been aware of—and avoided at all costs—the trap of living beyond ones means. Never the less, I will not even hold myself blameless; I truly believe that all of us in the materialistic west have some culpability in this mess.
Reaction
No doubt, new government regulations addressing the problems that got us into this mess will be soon be put into effect; unfortunately, as backward-looking legislation, they will generally not address those issue that will eventually precipitate the next economic crisis. In fact, it is almost impossible to predict the future in this respect. The only thing we can hope for is that the laws our governments are creating will make the financial world a little more transparent; the bright light of transparency in the murky world of finance is the only reform that, in the long term, really ever works.
What I find disturbing though, is this “eat the rich” sentiment that lumps all executives and everyone in the financial industry together as greedy, incompetent, and useless. There is a disconcerting air of bolshevism in a lot of the rhetoric I’ve been hearing lately. Yes, a lot of the financial middlemen will rightly lose their jobs, and I admit that I feel a certain schadenfreude in seeing the business school colleagues who went into the finance specialty losing their lucrative positions. However it is naive to think that these functions are unnecessary and that “workers can control the means of production,” as the communist experiment of the last century disproved. We will always have executives and financiers who—by virtue of their extraordinary skills and intelligence—will demand and receive compensation commensurate with their abilities, just as highly skilled entertainers and athletes do without question.
The worst possible outcome would be the introduction of salary caps; they would most certainly be circumvented, further muddying the waters of the business and financial worlds—the opposite of what we want: transparency! Likewise, a ban on derivatives (which given the simplest definition—a bet on an underlying security—sounds like a good idea,) but would contribute more opaqueness, as these instruments would be reinvented in other forms. These exotic vehicles actually have a legitimate use: they hedge and balance other business transactions.
Bailouts
I am generally not in favour of “rescue packages” for private businesses, even large ones like General Motors that will effect dozens or hundreds of partners, thousands of employees, and maybe hundreds of thousands of others not directly employed by the company. I just have an aversion to anything that creates a distortion in the marketplace, be it subsidies, regulations, or taxes that affect one company or industry more severely than another (or, more perversely, prevents a business from entering a certain field/industry or—in the current situation—prevents it from failing/dissolving.)
That being said, I do understand why large financial institutions cannot be allowed to fail, as the resulting banking and credit crisis the would cause the entire economy grind to a screeching halt. Therefore the questions are: “how are bailout funds to be used” and “who decides how the money is used.” Specifically, whom do you trust more to “save” these firms: corporate executives—the rascals that caused (or at least contributed) the failure, or the rascals in Washington (or where ever your lawmakers/bureaucrats reside.) Quite frankly, I’m not sure of the answer myself.
Where does the money go?
On the most basic level, the problem with these troubled institutions is that their balance sheets were out of whack: their assets no longer equaled their liabilities, and therefore the government infused this money—fixing the problem. Now the question is: what happened to this bailout money? There aren’t little cubbyholes in the company’s treasury for general funds, bonus funds, electricity expenses, etc. it just become part of the company’s assets and is used in the same way that all the rest of its assets are used—fulfilling the company’s obligations to its stakeholders: investors, partners, employees, vendors, and yes—executives.
When you or I start a job, we generally negotiate or just accept a certain hourly wage or weekly to monthly salary plus a possibility of a bonus and benefits. At a certain level, these wages/salary become trivial compared to the prospect and promise of bonuses, stock options, golden parachutes, etc. Corporations must make these lucrative offers in order to hire & retain the best and brightest in the field, just as professional sports team have to offer star players multi-million dollar contracts. To those who are outraged at bonuses paid to executives at failing companies such as AIG, I ask: “where do you make the cutoff?” Imagine that you cut all bonuses and stock options for a CEO who earns a salary of $1 per year (actually very common), what is he to do? Furthermore, with this reputation, how do you expect to hire a new CEO in the future? Remember, in 1994, Ben & Jerry’s Ice Cream initially insisted that they would only pay their CEO seven times what the lowest paid employee made; despite their progressive credentials, they soon had to abandon this promise in order to find an individual of the caliber needed to guide what had become a large corporation.
Outcome
Regardless of what new regulations are enacted, we are seeing the end of the secretive back-room dealing-making that has characterized so much of the financial industry. Even if governments do nothing, the market will demand more transparency and lower costs (spreads) for financial transactions. The result will be higher returns for investors and less cost to borrowers, which of course means lower earnings for the businesses and individual that broker these transactions…and, of course, less of those high-paying financial-sector jobs.
More specifically, we will see a convergence of returns. We all know that riskier investments demand higher returns. This relationship is not punitive—it is not just to punish the reckless—it is to cover the inevitable losses that riskier investments entail. In the long-term everybody gets about the same return plus a premium proportionate with the volatility the investor must endure. What everyone has looked for was that elusive, safe investment with a higher than normal return. While there have always been a few of these, I predict that these “secret” investment will all but disappear, to the point at which we can finally say with certainty that the outliers on the risk to return graph are definitely scams (as should have been obvious with Madoff.)
The one bright spot for governments investing (and it is not just the US Federal government that is doing this) in private industry is that they are buying in at a low point; In a few years they will almost certainly have realized a substantial profit—at which time they should divest of these private concerns. It is a mistake to think that these bailouts are a gift from government to private industry; remember that Chrysler was bailed out in 1979, and by 1983 had totally repaid it 1.5 billion dollar loan to the government.
Opportunities
I find that, as individuals, this hand-wringing and finger-pointing is entirely useless; what does it help you or me to assign blame to this or that group, person, or ideology? In a time of turmoil such as now, it is prudent for a bright, young person to look around and ask, “where is this going, and where should I place myself to benefit from the inevitable changes ahead?” I really think now is the time to position oneself for the new business, regulatory, and financial climate that is coming upon us, and I am convinced that it will be characterized by more transparency—and therefore be more information-oriented, and consequently utilizing more information and communication technologies.
We have seen part of this technological revolution in finance on the personal investment front; we no longer call our broker to place a trade (from which he would take a percent or two in commission.) Instead we log on to our discount brokerage website and enter trades ourselves for a fixed $12-$15! Furthermore, on the NASDAQ stock exchange, there isn’t even a trading floor; it all takes place inside of computers. Yes, there are still brokers and market makers, but we’re definitely seeing the disintermediation of actual human beings transacting financial business. Likewise, we see that the computers of Experian, Equifax, and TransUnion (in communications with the computers of nearly all consumer credit providers) automatically determine an objective credit score for nearly every adult in America. Even loan origination (well, shopping at least) is being automated by sites such as LendingTree.com.
The ratings of corporate entities however, have long been suspect. With this crisis, we have confirmation that the stars and letter grades assigned to bonds, equities, and derivatives by the likes of Moody and MorningStar are worthless. So the obvious need is an objective system like that of the FICO (300-850) credit scores assigned individuals. I assume that someone like Dun & Bradstreet is ideally positioned to fill this need. Obviously you can’t as readily assign a single number to represent the fiscal health of a complex organization with all its divisions, subsidiaries, assets, investments, and liabilities, but together with governmental and market pressure for more transparency, I am convinced we will see the creation of one or more objective, independently audited corporate/financial rating service.
With the availability of all this data, the next obvious step is an electronic marketplace where businesses and investors can transact short and long-term lending directly without the packaging and interference of financier or their hefty commissions.
So, dear reader, if you agree with my predictions, how do you think an IT nerd with an MBA like me should position himself to catch this next wave? More specifically, where is this financial information revolution going to start—geographically and with what companies/groups? (Obviously I’m not talking about the existing and useless “financial news” industry that just speculates and rehashes earnings reports, annual reports & 10-Qs, nor the endless speculation of pundits.) I’m serious about this; I would appreciate any advice.
On the left, there is an agreement that sub-prime mortgages are at the heart of this mess, but blame is placed on the unscrupulous brokers who apparently tricked unsuspecting (and admittedly unsophisticated) homebuyers into taking risky loans just to make a quick commission, and on the “financial geniuses” who devised the now toxic “collateralized debt obligations” as well as other exotic derivatives. From this view, the whole of the rest of the cascade of events that has brought us to this point is entirely the fault of greedy (and by virtue of this unraveling—incompetent) executives, brokers, and associated “money-men.”
My view
I say there is enough blame to go around; we ALL contributed to this mess! Collectively and individually, as corporations, and governments—almost as a rule—we overextended ourselves in respect to debt; and from the most unsophisticated wage earner to the brightest minds working in the most prestigious investment firms, we all assumed that asset values, growth, and incomes would only go up. This crisis is finally the slap in the face that we all needed: we cannot borrow our way into prosperity! As the offspring of depression-era, immigrant parents, financial discipline and thriftiness was ground into me from an early age, so I have been aware of—and avoided at all costs—the trap of living beyond ones means. Never the less, I will not even hold myself blameless; I truly believe that all of us in the materialistic west have some culpability in this mess.
Reaction
No doubt, new government regulations addressing the problems that got us into this mess will be soon be put into effect; unfortunately, as backward-looking legislation, they will generally not address those issue that will eventually precipitate the next economic crisis. In fact, it is almost impossible to predict the future in this respect. The only thing we can hope for is that the laws our governments are creating will make the financial world a little more transparent; the bright light of transparency in the murky world of finance is the only reform that, in the long term, really ever works.
What I find disturbing though, is this “eat the rich” sentiment that lumps all executives and everyone in the financial industry together as greedy, incompetent, and useless. There is a disconcerting air of bolshevism in a lot of the rhetoric I’ve been hearing lately. Yes, a lot of the financial middlemen will rightly lose their jobs, and I admit that I feel a certain schadenfreude in seeing the business school colleagues who went into the finance specialty losing their lucrative positions. However it is naive to think that these functions are unnecessary and that “workers can control the means of production,” as the communist experiment of the last century disproved. We will always have executives and financiers who—by virtue of their extraordinary skills and intelligence—will demand and receive compensation commensurate with their abilities, just as highly skilled entertainers and athletes do without question.
The worst possible outcome would be the introduction of salary caps; they would most certainly be circumvented, further muddying the waters of the business and financial worlds—the opposite of what we want: transparency! Likewise, a ban on derivatives (which given the simplest definition—a bet on an underlying security—sounds like a good idea,) but would contribute more opaqueness, as these instruments would be reinvented in other forms. These exotic vehicles actually have a legitimate use: they hedge and balance other business transactions.
Bailouts
I am generally not in favour of “rescue packages” for private businesses, even large ones like General Motors that will effect dozens or hundreds of partners, thousands of employees, and maybe hundreds of thousands of others not directly employed by the company. I just have an aversion to anything that creates a distortion in the marketplace, be it subsidies, regulations, or taxes that affect one company or industry more severely than another (or, more perversely, prevents a business from entering a certain field/industry or—in the current situation—prevents it from failing/dissolving.)
That being said, I do understand why large financial institutions cannot be allowed to fail, as the resulting banking and credit crisis the would cause the entire economy grind to a screeching halt. Therefore the questions are: “how are bailout funds to be used” and “who decides how the money is used.” Specifically, whom do you trust more to “save” these firms: corporate executives—the rascals that caused (or at least contributed) the failure, or the rascals in Washington (or where ever your lawmakers/bureaucrats reside.) Quite frankly, I’m not sure of the answer myself.
Where does the money go?
On the most basic level, the problem with these troubled institutions is that their balance sheets were out of whack: their assets no longer equaled their liabilities, and therefore the government infused this money—fixing the problem. Now the question is: what happened to this bailout money? There aren’t little cubbyholes in the company’s treasury for general funds, bonus funds, electricity expenses, etc. it just become part of the company’s assets and is used in the same way that all the rest of its assets are used—fulfilling the company’s obligations to its stakeholders: investors, partners, employees, vendors, and yes—executives.
When you or I start a job, we generally negotiate or just accept a certain hourly wage or weekly to monthly salary plus a possibility of a bonus and benefits. At a certain level, these wages/salary become trivial compared to the prospect and promise of bonuses, stock options, golden parachutes, etc. Corporations must make these lucrative offers in order to hire & retain the best and brightest in the field, just as professional sports team have to offer star players multi-million dollar contracts. To those who are outraged at bonuses paid to executives at failing companies such as AIG, I ask: “where do you make the cutoff?” Imagine that you cut all bonuses and stock options for a CEO who earns a salary of $1 per year (actually very common), what is he to do? Furthermore, with this reputation, how do you expect to hire a new CEO in the future? Remember, in 1994, Ben & Jerry’s Ice Cream initially insisted that they would only pay their CEO seven times what the lowest paid employee made; despite their progressive credentials, they soon had to abandon this promise in order to find an individual of the caliber needed to guide what had become a large corporation.
Outcome
Regardless of what new regulations are enacted, we are seeing the end of the secretive back-room dealing-making that has characterized so much of the financial industry. Even if governments do nothing, the market will demand more transparency and lower costs (spreads) for financial transactions. The result will be higher returns for investors and less cost to borrowers, which of course means lower earnings for the businesses and individual that broker these transactions…and, of course, less of those high-paying financial-sector jobs.
More specifically, we will see a convergence of returns. We all know that riskier investments demand higher returns. This relationship is not punitive—it is not just to punish the reckless—it is to cover the inevitable losses that riskier investments entail. In the long-term everybody gets about the same return plus a premium proportionate with the volatility the investor must endure. What everyone has looked for was that elusive, safe investment with a higher than normal return. While there have always been a few of these, I predict that these “secret” investment will all but disappear, to the point at which we can finally say with certainty that the outliers on the risk to return graph are definitely scams (as should have been obvious with Madoff.)
The one bright spot for governments investing (and it is not just the US Federal government that is doing this) in private industry is that they are buying in at a low point; In a few years they will almost certainly have realized a substantial profit—at which time they should divest of these private concerns. It is a mistake to think that these bailouts are a gift from government to private industry; remember that Chrysler was bailed out in 1979, and by 1983 had totally repaid it 1.5 billion dollar loan to the government.
Opportunities
I find that, as individuals, this hand-wringing and finger-pointing is entirely useless; what does it help you or me to assign blame to this or that group, person, or ideology? In a time of turmoil such as now, it is prudent for a bright, young person to look around and ask, “where is this going, and where should I place myself to benefit from the inevitable changes ahead?” I really think now is the time to position oneself for the new business, regulatory, and financial climate that is coming upon us, and I am convinced that it will be characterized by more transparency—and therefore be more information-oriented, and consequently utilizing more information and communication technologies.
We have seen part of this technological revolution in finance on the personal investment front; we no longer call our broker to place a trade (from which he would take a percent or two in commission.) Instead we log on to our discount brokerage website and enter trades ourselves for a fixed $12-$15! Furthermore, on the NASDAQ stock exchange, there isn’t even a trading floor; it all takes place inside of computers. Yes, there are still brokers and market makers, but we’re definitely seeing the disintermediation of actual human beings transacting financial business. Likewise, we see that the computers of Experian, Equifax, and TransUnion (in communications with the computers of nearly all consumer credit providers) automatically determine an objective credit score for nearly every adult in America. Even loan origination (well, shopping at least) is being automated by sites such as LendingTree.com.
The ratings of corporate entities however, have long been suspect. With this crisis, we have confirmation that the stars and letter grades assigned to bonds, equities, and derivatives by the likes of Moody and MorningStar are worthless. So the obvious need is an objective system like that of the FICO (300-850) credit scores assigned individuals. I assume that someone like Dun & Bradstreet is ideally positioned to fill this need. Obviously you can’t as readily assign a single number to represent the fiscal health of a complex organization with all its divisions, subsidiaries, assets, investments, and liabilities, but together with governmental and market pressure for more transparency, I am convinced we will see the creation of one or more objective, independently audited corporate/financial rating service.
With the availability of all this data, the next obvious step is an electronic marketplace where businesses and investors can transact short and long-term lending directly without the packaging and interference of financier or their hefty commissions.
So, dear reader, if you agree with my predictions, how do you think an IT nerd with an MBA like me should position himself to catch this next wave? More specifically, where is this financial information revolution going to start—geographically and with what companies/groups? (Obviously I’m not talking about the existing and useless “financial news” industry that just speculates and rehashes earnings reports, annual reports & 10-Qs, nor the endless speculation of pundits.) I’m serious about this; I would appreciate any advice.
19 March 2007
Insurance is a rip-off
Before you get the idea that I just figured this out (and because of my business education,) let me assure you that I’ve been of this opinion for quite a long time now. I’ve just recently become aware of otherwise intelligent people around me buying silly insurance policies such as extended warranties and mobile phone insurance—I thought everyone was already aware of what a waste of money these are. As Groening, et al derisively had Homer say when Dr. Nick restored his stupidity in episode BABF22: “Extended warranty? How could I lose?”
Before we begin, let me be clear about my thesis: insurance is too often assumed to always be a prudent purchase that demonstrates the purchaser is a grown-up, responsible adult. I therefore propose that, at least as a first approximation, we assume that insurance is always a bad investment since, by definition, the average buyer—in the long run—will pay more in premiums than he or she will incur claims (otherwise the insurance company would go out of business, right?) Furthermore, since we can't predict catastrophic events, we can never time when to buy a policy (or let it lapse.) Therefore we commit ourselves to a periodic (most often monthly) expense for the rest of our lives, and this is the worst part: we never see this money again... it's really gone...we could have saved it or at least spent it more prudently, on something that would benefit us or our family now.
Let’s start with the basics: insurance is a financial instrument used by individuals and organizations to protect themselves against a risk (a greater potential financial loss.) You pay a (relatively) small amount of money over time to protect yourself against a possible catastrophic monetary loss. The insurance industry hire actuaries to determine the likely amount and frequency of payouts, adds their (hefty) profit margin, and comes up with the premium to the policyholder. (Granted, this is a simplified view.) Therefore, before we even get into paying middle men (agents/brokers) and for insurance fraud, you will always pay more in the long run with insurance than without, unless you happen to be one of the few exceptions that does indeed experience a catastrophic loss that the carrier actually covers (and, by definition, you can't possibly know if you are going to suffer a catastrophic loss.) To those that say “I know that I'm a unlucky person, so I will buy the best insurance”, I hear “I'm a careless person” and rest assured the insurance company will learn this and cut you off before long.
HEALTH
This is probably the most sensible—and, in fact, prudent—insurance out there. Since you can quickly incur tens or even hundreds of thousands of dollars of expenses due to a serious illness or injury in the US, you need to protect yourself from the financial devastation this would create. Note: despite the perception that insurance is required to be treated in our mostly private health care system, insurance is actually for protecting your assets and credit standing after being treated for a major illness or injury. Even the prestigious Mayo Clinic regularly serves the indigent local population of Rochester, Minnesota knowing they will never be paid for their services. This is the law in the US; hospitals cannot refuse service to anyone in need. Of course, this causes a major problem; hospitals must charge those that can pay more to offset these losses. As a result, conscientious people with health insurance are underwriting the whole system.
Therefore, it is reasonable to propose a reform that would include everyone in the coverage and payment pool. However, I am not naïve enough to think that a single-payer system would necessarily put a dent in our outrageous health care costs (17% of GDP!) I am afraid that trading the corporate profiteering of our current (private) model for the bureaucratic inefficiencies of a single-payer system would do little to reduce cost; sadly, limiting (that is rationing) health care is the only way, and Americans will not stand for this—so expect no change here.
By the way, dental insurance is overrated; suppose you visit the dentist every six months for a cleaning and pay $70 each visit. With insurance, you may pay only a $10 co-pay, and the insurance plan may have negotiated a lower price—let’s say $50. So their payout is at least $100 per year; what do you think they will charge you (or your employer) as an annual premium? I don’t think it would be a stretch to assume that it would be more than $140—so where is the savings?
LIABILITY
The second prudent choice in insurance is liability insurance for your home, vehicle, and business. In our litigious society, you could lose everything in a court judgment, even if you are not at fault by any reasonable person’s estimation. The solution to the growing cost of liability insurance (especially professional malpractice insurance) is tort reform—but I don’t see that happening soon, since our legislators are usually lawyers, and the legal community has immense influence in government at all levels.
LIFE
Life insurance was designed to allow a family to live on with the same standard of living after the death of the breadwinner. This can still make sense for a modern, dual-income family, but these policies are being over-sold. The most egregious example of this excess is the marketing of policies for children; I find this disgusting! How can money ever alleviate the anguish of losing a child? Generally, you should only buy term life insurance to cover the loss of family income from yourself and/or spouse until your children are of age; in this age of equality of the sexes, your spouse will be able to support himself/herself after that, right? I see no reason why a family member’s death should be treated like a lottery windfall—in fact I find this concept revolting.
I understand that a funeral can be costly, but it’s not an open-ended expense; you can cap this under $5000—something that could be covered by a “rainy day” fund—money that is accumulated when it is no frittered away in premiums to an insurance company for an occurrence that is very unlikely to happen to a relatively young person.
DISABILITY
There is normally some kind of disability coverage in a life and/or health insurance policies, but what is becoming more popular is short-term disability policies to “help pay the bills” while one is out of work due to an injury/illness. While this sounds to be a prudent policy for working class people, it is just one more drain on their already overstretched budget. From what I can tell, the rise in popularity of this type of policy is due entirely to the massive advertising campaign of one particular company and it’s spokes-duck.
HOME
Since most homeowners have a mortgage on their property, the lender usually requires homeowner's (fire) insurance; they know that if your home were destroyed, (or uninhabitable) you would have little incentive to continue making mortgage payments. This is reasonable; most people don’t have an extra $50,000-$100,000 lying around to rebuild a house in this case. However, I see no reason to pay extra to insure the content of you home—you really don’t have to replace all that junk you’ve collect over the years, do you? The same goes for renter’s insurance; if your apartment burns down—taking your nice, new flat-screen TV with it—you certainly would appreciate having a policy that would let you replace this. However, can you honestly justify paying a monthly premium to protect this and other non-essential belonging against something that is such a rare occurrence?
AUTO
Liability insurance is required by the state (to cover damages/injury you may cause), and a lender will require you to buy collision (your own fault) and comprehensive (acts of nature) insurance. Eventually though, you will own an automobile outright, and I posit that by this time you will be financially secure enough to self-insure repairs to your own car. It will really hurt when you dent your own bumper and have to pay for it out of your own pocket, (especially if it’s a brand new car) but you will certainly save money over the course of your lifetime.
RECOMMENDATIONS
This list could go on and on, so I will just stop here and say that every other type of policy (at least for individuals) is a waste of money! All these other policies and add-ons add up and start to cost real money, and worse—it is a recurring expense that you will pay every month for the rest of your life. You are much better off to set aside this money in a “rainy day” fund for several reasons:
DISCLAIMER: This should not be construed to be professional financial advice; it is merely a thought-provoking suggestion for intelligent and financially disciplined individuals.
Before we begin, let me be clear about my thesis: insurance is too often assumed to always be a prudent purchase that demonstrates the purchaser is a grown-up, responsible adult. I therefore propose that, at least as a first approximation, we assume that insurance is always a bad investment since, by definition, the average buyer—in the long run—will pay more in premiums than he or she will incur claims (otherwise the insurance company would go out of business, right?) Furthermore, since we can't predict catastrophic events, we can never time when to buy a policy (or let it lapse.) Therefore we commit ourselves to a periodic (most often monthly) expense for the rest of our lives, and this is the worst part: we never see this money again... it's really gone...we could have saved it or at least spent it more prudently, on something that would benefit us or our family now.
Let’s start with the basics: insurance is a financial instrument used by individuals and organizations to protect themselves against a risk (a greater potential financial loss.) You pay a (relatively) small amount of money over time to protect yourself against a possible catastrophic monetary loss. The insurance industry hire actuaries to determine the likely amount and frequency of payouts, adds their (hefty) profit margin, and comes up with the premium to the policyholder. (Granted, this is a simplified view.) Therefore, before we even get into paying middle men (agents/brokers) and for insurance fraud, you will always pay more in the long run with insurance than without, unless you happen to be one of the few exceptions that does indeed experience a catastrophic loss that the carrier actually covers (and, by definition, you can't possibly know if you are going to suffer a catastrophic loss.) To those that say “I know that I'm a unlucky person, so I will buy the best insurance”, I hear “I'm a careless person” and rest assured the insurance company will learn this and cut you off before long.
HEALTH
This is probably the most sensible—and, in fact, prudent—insurance out there. Since you can quickly incur tens or even hundreds of thousands of dollars of expenses due to a serious illness or injury in the US, you need to protect yourself from the financial devastation this would create. Note: despite the perception that insurance is required to be treated in our mostly private health care system, insurance is actually for protecting your assets and credit standing after being treated for a major illness or injury. Even the prestigious Mayo Clinic regularly serves the indigent local population of Rochester, Minnesota knowing they will never be paid for their services. This is the law in the US; hospitals cannot refuse service to anyone in need. Of course, this causes a major problem; hospitals must charge those that can pay more to offset these losses. As a result, conscientious people with health insurance are underwriting the whole system.
Therefore, it is reasonable to propose a reform that would include everyone in the coverage and payment pool. However, I am not naïve enough to think that a single-payer system would necessarily put a dent in our outrageous health care costs (17% of GDP!) I am afraid that trading the corporate profiteering of our current (private) model for the bureaucratic inefficiencies of a single-payer system would do little to reduce cost; sadly, limiting (that is rationing) health care is the only way, and Americans will not stand for this—so expect no change here.
By the way, dental insurance is overrated; suppose you visit the dentist every six months for a cleaning and pay $70 each visit. With insurance, you may pay only a $10 co-pay, and the insurance plan may have negotiated a lower price—let’s say $50. So their payout is at least $100 per year; what do you think they will charge you (or your employer) as an annual premium? I don’t think it would be a stretch to assume that it would be more than $140—so where is the savings?
LIABILITY
The second prudent choice in insurance is liability insurance for your home, vehicle, and business. In our litigious society, you could lose everything in a court judgment, even if you are not at fault by any reasonable person’s estimation. The solution to the growing cost of liability insurance (especially professional malpractice insurance) is tort reform—but I don’t see that happening soon, since our legislators are usually lawyers, and the legal community has immense influence in government at all levels.
LIFE
Life insurance was designed to allow a family to live on with the same standard of living after the death of the breadwinner. This can still make sense for a modern, dual-income family, but these policies are being over-sold. The most egregious example of this excess is the marketing of policies for children; I find this disgusting! How can money ever alleviate the anguish of losing a child? Generally, you should only buy term life insurance to cover the loss of family income from yourself and/or spouse until your children are of age; in this age of equality of the sexes, your spouse will be able to support himself/herself after that, right? I see no reason why a family member’s death should be treated like a lottery windfall—in fact I find this concept revolting.
I understand that a funeral can be costly, but it’s not an open-ended expense; you can cap this under $5000—something that could be covered by a “rainy day” fund—money that is accumulated when it is no frittered away in premiums to an insurance company for an occurrence that is very unlikely to happen to a relatively young person.
DISABILITY
There is normally some kind of disability coverage in a life and/or health insurance policies, but what is becoming more popular is short-term disability policies to “help pay the bills” while one is out of work due to an injury/illness. While this sounds to be a prudent policy for working class people, it is just one more drain on their already overstretched budget. From what I can tell, the rise in popularity of this type of policy is due entirely to the massive advertising campaign of one particular company and it’s spokes-duck.
HOME
Since most homeowners have a mortgage on their property, the lender usually requires homeowner's (fire) insurance; they know that if your home were destroyed, (or uninhabitable) you would have little incentive to continue making mortgage payments. This is reasonable; most people don’t have an extra $50,000-$100,000 lying around to rebuild a house in this case. However, I see no reason to pay extra to insure the content of you home—you really don’t have to replace all that junk you’ve collect over the years, do you? The same goes for renter’s insurance; if your apartment burns down—taking your nice, new flat-screen TV with it—you certainly would appreciate having a policy that would let you replace this. However, can you honestly justify paying a monthly premium to protect this and other non-essential belonging against something that is such a rare occurrence?
AUTO
Liability insurance is required by the state (to cover damages/injury you may cause), and a lender will require you to buy collision (your own fault) and comprehensive (acts of nature) insurance. Eventually though, you will own an automobile outright, and I posit that by this time you will be financially secure enough to self-insure repairs to your own car. It will really hurt when you dent your own bumper and have to pay for it out of your own pocket, (especially if it’s a brand new car) but you will certainly save money over the course of your lifetime.
RECOMMENDATIONS
This list could go on and on, so I will just stop here and say that every other type of policy (at least for individuals) is a waste of money! All these other policies and add-ons add up and start to cost real money, and worse—it is a recurring expense that you will pay every month for the rest of your life. You are much better off to set aside this money in a “rainy day” fund for several reasons:
- If no major calamity ever transpires, you still have the money.
- This “rainy day” fund will eventually become a sizable investment that starts earn money on its own, that then can be used for other purposes (college fund, real estate down payment, retirement, etc.)
- Best of all, you will never have to jump through hoops and fight for a payout.
- You need health insurance, but go with the highest deductible you can; you will get less in payouts, but the lower premium costs will offset this.
- If—and only if—you have dependents, and you contribute significant finances or labor (child care) to your family, buy term life insurance for yourself and/or spouse, so that your family can live in relative comfort in the unlikely event of your early demise. Once these “dependents” are independent, cancel the policy.
- Ensure you have liability insurance to shield you assets from seizure by court judgments; this means home, car, and malpractice if applicable.
- Carry insurance that the state and your lender may require for your home and car, but run the numbers on the cost and possible benefit of any additional insurance.
- Generally speaking, don’t buy any other kind of insurance; especially don’t insure anything you can live without.
- Always shop around.
DISCLAIMER: This should not be construed to be professional financial advice; it is merely a thought-provoking suggestion for intelligent and financially disciplined individuals.
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