Tuesday, July 31, 2012

Life accounting & confusing greek letters

Last night I had a really hard time falling asleep – I was mulling something over and trying to self-analyze my emotions, and it’s also really hard to fall asleep after watching the Olympics.  After refreshing facebook about 8 times and realizing there was nothing on the internets that I hadn’t already read, I decided to distract/calm myself by calculating how much money I had saved, and how much of my income that was.  Is that normal?  Probably not – my first thought last week, upon not being able to find the binder of documents my financial advisor put together for me was “omg, what if someone stole them”.  In my defense, it’s pretty challenging to lose track of things in a <600 sq foot studio.

It feels like a good time to take stock of my life.  Next month marks some big things – one year at my job, my 23rd birthday, and the start of my vacation to Greece (a place I have dreamed of visiting since watching the Sisterhood of the Traveling Pants movies).  I opened and maxed out a Roth IRA for 2011 and 2012, contributed to my 401K, and stashed some liquid savings in my HSBC savings account.  Overall, I saved 27.56% of my income from this year.  Factoring in some investment growth & a generous employer contribution to my 401K as well, it feels good to say that I now have a net worth of (very slightly) over 30K.

I’ve been reading Malkiel’s ‘A Random Walk Down Wall Street’ – woohoo random walks are getting the attention they deserve!  Also, great book.  It’s always interesting to read about the overlap of finance and academia, and how theoretical ideas hold up in practice.  For instance – diversification is a pretty straightforward concept.  Ideally, you want a mix of different assets such that when some go up, the others go down, and your returns are more consistent and less volatile.  We’re working to mitigate systematic and unsystematic risk in our investments.  The latter (unsystematic) covers things that can happen to any one company – a bad investment, a corporate scandal, or a tsunami destroying everything.  By investing in many companies, you reduce this unsystematic risk and the likelihood that anything terrible happening in a particular company will hit you hard.

The tricky thing, however, is that stocks tend to move in tandem – when things are good, many stocks are up, and similarly many move down together in a similar pattern.  This is the systemic risk – cannot be avoided by simply spreading investments across many companies.  So people came up with a term – beta – to describe systemic risk.  Essentially, you assume an index fund covering a broad spectrum of stocks to be equal to ‘1’, and rate every other stock by its volatility in relation to the index.  So, if a stock falls only by 10% when the index drops by 20%, and similarly fluctuates less in the upward direction, it would be said to have a beta of .5.  If a stock is twice as volatile as the index, it has a beta of 2.

It’s commonly accepted that a lever for increasing earnings is increasing risk – the logic goes that people need to be compensated for the greater risk by larger returns, else they will stick to the safer investments.  The capital-asset pricing model (CAPM) states that investors with a larger beta for their portfolio will have higher returns.  The funny thing is that research has come to some different conclusions about the efficacy of this strategy.  So many theories do tend to fall apart when you uh, apply them to reality.  That amuses me.

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