Friday, September 21, 2012

Education: Signaling Model vs Human Capital Model

I was going to selectively quote from this article by Bryan Caplan, but I ended up copying and pasting the whole darn thing. Just read the article; it's pretty short.

Bryan Caplan is a economics professor who writes a lot on the "signaling model of education": the idea that education is valuable not because of the knowledge and skills it teaches (as per the "human capital model") but rather because of the certification and fancy initials you get to put after your name (B.A., MBA, LL.D., Ph.D, etc.). In other words, education is valuable as a "signal" to others of your supposed abilities, regardless of whether you actually have them or whether said abilities are even relevant.

This isn't a new idea in and of itself, but it's become increasingly relevant as youth unemployment remains high, tuition costs remain unaffordable, federal student loans are reexamined and student debt reaches record levels.

Bryan points to a lot of strange distortions due this signaling effect dominating the pure intellectual effects of education. For example, if human capital model were correct and education's true value lay in its transfer of knowledge and skills, then everyone should audit.

The best education in the world is already free of charge. Just go to the best university in the world and start attending classes. Stay as long as you want, and study everything that interests you. No one will ever "card" you. The only problem is that, no matter how much you learn, there won't be any record you were ever there.

So why doesn't everyone do this? One theory could be that everyone actually really wants to, but the physical difficulties of being in the right location (geographically near a top university) and free at the right time (class hours are usually at daytime on workdays) are prohibitive. Fortunately, these are the problems that online courses (or if you prefer, MOOCs) try to tackle.

Thus, if the signaling model were false, instead of going to a real universities, online courses (of the same academic caliber and rigor) should be a perfect substitute. In my ideal world, they would be, but of course, that's not actually the case. Otherwise, why would online courses be trying to move into the certification business?

Has this always been true? More specifically, has the signaling effect always dominated the pure intellectual effects of education? I would argue no. Then why has it changed? Very simply, the price of knowledge has significantly decreased. This is due to technological advances and the democratization of information. In fact, the existence of sites like Wikipedia shows that knowledge is practically free (free as in free beer, not free speech). It doesn't make sense that as the price of knowledge decreases, the cost of education hasn't gone down (rather, it's gone up).

The final question remains: even if you're right, so what? As long as rational employers are fully conscious of the signaling model and completely cognizant of the fact that their hiring decisions are based on possibly nothing more than fluff and air, why should we care? If they choose to hire an ignorant Harvard grad over a more capable state school grad because they're too lazy to do their due diligence and look beyond credentials, then that's their loss. They'll fully bear the costs of their own decisions, as they are forced to pay for employee training programs to teach the skills that universities never did.

However, the reason that we should care - that everyone should care - is because of the negative externalities this imposes on the system. This is visible in the higher degree treadmill process observed in the US labor market: today we have so many bachelor's degree holders that job seekers are increasingly jumping to master's degrees. This has reached the point where jobs previously only requiring bachelor's degrees now require master's degrees, despite no obvious increase in job difficulty or worker aptitude. These inefficiencies incur costs that will eventually be born by everyone.

Of course, the real world is rarely this black and white. Most realistically, education displays both effects of the signaling model as well as the human capital model. There are still people who care about learning for learning's sake and there are still industries which select candidates on a more meritocratic basis (programming and investing are two examples). Unfortunately, this seems to be the exception rather than the rule.

Wednesday, September 12, 2012

WOTD: ersatz, zaftig, tchotchke, risible, rigmarole, bromide

New words of the day!

Ersatz [er-zahts]
adj. inferior substitute

It's originally a German word meaning substitute, although in German it has with no connotations of inferior quality. In WWII, Nazi-captured POWs were given ersatzbrot, which was bread (brot) filled with sawdust, and English speaking POWs adopted the word after returning from the war.

This next one is from Christina.

Zaftig [zahf-tik]
adj. pleasingly, plumply pulchritudinous; alluringly curvaceous

For a more explicit definition, look up zaftig in Google Images.

Tchotchke [chahch-kuh]
n. a small toy, gewgaw, knickknack, swag, bauble, thingamajig, doodad, lagniappe, trinket, or kitsch

That one was from Conrad. Apparently, it also means bimbo or slut. I'm not sure what Conrad was trying to say to me...

Risible [riz-uh-buhl]
adj. causing or capable of causing laughter; laughable; ludicrous.

Rigmarole [rig-muh-rohl]
n. an elaborate or complicated procedure 

Rigmarole / rigamarole is one of those words that's heard in speech more often than seen on paper. I've always wondered how it's spelled.

Bromide [broh-mahyd]
1. a person who is platitudinous and boring. 
2. a platitude or trite saying. 

Bromide also has a third definition, which is "a salt of hydrobromic acid consisting of two elements, one of which is bromine". From The Economist:

AS I mentioned in last night's live-blog, if sequestration comes to pass, Barack Obama will have to make do with a defence budget roughly equivalent (in real terms) to George Bush's outlay for 2007. That budget surpasses average annual military spending during the cold war. In other words, even with sequestration, America will still be in pretty good shape militarily. It will still spend as much as all of the other big militaries combined. It will still hold an immense advantage over China and the rest of Asia, where the Obama administration is focusing its resources, and Russia, which Mitt Romney thinks is America's greatest foe. [...] This is also a potent critique of Mitt Romney's call for increased defence spending. He offers little explanation of why America must spend more, besides bromides about American leadership.

Romney is a bromide who speaks in nothing but bromides. He leaves a bad taste in your mouth. Probably similar to the taste of bromide.

Tuesday, September 4, 2012

Strategic Asset Allocation: Endowment Model

This is a first in a series of posts covering different competing philosophies of strategic asset allocation*, and how one could replicate these philosophies. This post focuses on endowments.

Endowments (of colleges and universities) are basically funds of funds with two important differences: there's only one client and the time horizon for investments is extremely long term. This gives endowments a few advantages over other investors: they don't have to deal with marketability or PR, and they can allocate to non-public illiquid securities (which can take years or decades to realize their alpha).

Thus, a significant amount of the new thought in strategic asset allocation* is contributed by endowments and their managers.  The traditional strategic asset allocation standard has been the Modern Portfolio Theory-influenced 60/40 stocks/bonds portfolio that financial advisers love to reference (even now, I'd wager that most 401k's look like this). However, there is nothing "modern" about MPT or these portfolios - it's a sixty year old model. For the post-MPT world, there are a few competing philosophies when it comes to asset allocation:
  1. the endowment model (most commonly represented by Yale and Harvard)
  2. the Norway model (a sovereign wealth fund)
  3. Risk Parity (most famously espoused by Ray Dalio of Bridgewater)
Here is a good summary by one of my favorite bloggers of what exactly the endowment model entails:

DIVERSIFIED:  Broad diversification is embraced.  
HIGH-RETURN ORIENTED:  Equities and high-return alternatives are favored.  Other than as a safe-harbor, bonds are eschewed.
PERPETUAL INVESTMENT HORIZON:  While endowments have always had a perpetual horizon, the endowment investment model actually attempts to take advantage of this.
ILLIQUIDITY SEEKING:  One means of doing so, is to accept illiquidity and demand, in consequence, a higher return.
GLOBAL:  This is a corollary of diversification, but the endowment investment model was more global earlier than other investors.  The current manifestation of this approach is to overweight emerging markets relative to naive benchmarks.
LONG-TERM IN PERFORMANCE MEASUREMENT:  This is the corollary to the perpetual investment horizon, but merits separate mention.  EndowmentInvestor believe successful endowment management requires a long term view in evaluating managers and strategies.
ACTIVELY MANAGED:  Most endowments use active investment management heavily.  This is a requirement in asset classes like hedge funds and private markets where indexing is not an option.  Many commentators would characterize active management as an essential characteristic of the endowment investment model, but EndowmentInvestor does not believe it a requirement to be 100 percent active.
POTENTIALLY CONCENTRATED:  Those that believe in active management in the endowment world [the majority] avoid closet indexing by favoring a handful of concentrated managers.

As an example, on the right is the asset allocation of Harvard's endowment.

Following the popular nomenclature, I would call this portfolio a 36/13/51 allocation (36% to stocks, 13% to bonds, the rest to alternatives). We can see it's highly diversified, with no more than 14% to any single asset class. Furthermore, the high-return focus is obvious with a 87% combined allocation to equities and alternatives. Private equity, absolute return (hedge funds) and real estate are 37% of the portfolio, reflecting their capture of the illiquidity premium. 

The allocation to public equity makes up 36% of the portfolio, and of that portion, equal parts are given to domestic, foreign and emerging markets. In comparison, free float adjusted market cap weights in the MSCI ACWI (All Country World Index) gives 50% to domestic, 40% to foreign and 10% to emerging markets. Some investors don't even follow the ACWI, instead indexing their equity allocations to the S&P 500. This overweight of domestic equities is called home bias, which reflects the tendency to favor the familiar. Harvard is heavily overweight international equities, especially emerging markets, relative to the ACWI. Although Harvard's public equity allocation is one of the more extreme examples, it's an excellent reminder of the importance of avoiding home bias through global diversification. On a long term basis, most investors would benefit by following the more diversified ACWI rather than the US-only S&P 500.

One significant feature of endowments which was omitted from the otherwise comprehensive list above is the emphasis on real assets. Harvard's allocation to real estate and commodities is 23%. Unfortunately, most 401k options don't give you commodity funds (although some give you natural resource equity funds), but that doesn't mean this real asset bias is impossible to replicate. David Swenson, CIO of Yale, advocates a 20% REIT allocation in his book Unconventional Success (if anyone wants to borrow a copy, ask me). Yale's endowment itself has a 29% allocation to real assets (20% real estate, 9% natural resources). The idea is that although short term volatility could be high, even bubble-like (considering real estate's recent global boom and bust), long term fundamentals are excellent: it's the perfect hedge against inflation, and the world is running out of natural resources

To summarize, an endowment replication portfolio would be heavy in equities (particularly international), real estate, commodities and natural resources. Although private equity and hedge funds aren't available to many investors, finding a good uncorrelated absolute return manager or strategy isn't impossible (he might even be your old college roommate).

Next few posts in this series will cover 1) Norway's sovereign wealth fund and 2) Risk Parity.

*The difference between strategic asset allocation (SAA) and tactical asset allocation (TAA) is that SAA is static and TAA is dynamic. SAA can be thought of as a framework upon which TAA is overlaid, although this is not always the case. Here's a few ways in which the two are combined:

1) On one extreme, you may have a SAA with no TAA, in which case you consistently rebalance to the same static allocation (such as 60-40 stocks-bonds) and never deviate. In this case, 100% of your alpha will come from your SAA.
2) On the other extreme, your strategy could be completely TAA with no underlying SAA allocation. Mebane Faber's TAA model (here's an implementation in R) rotates among the top performing x out of 5 asset classes. This asset allocation has no "base" case since the portfolio can look drastically different at each rebalance period, such as switching from 100% stocks to 100% REITs (as it did recently) in the x=1 scenario. In this case, 100% of your alpha will come from your TAA.
3) Finally, you may have a combination of both (1) and (2). For example, your SAA may be a 60/40 stocks/bonds allocation, but your TAA strategy is to shift +/-x% depending on recent outperformance in a two-asset version of Faber's rotation system. If x=10, your final allocation will vary between 50/50 to 70/30. Both SAA and TAA contribute to your alpha, but obviously as x increases, more of your alpha will be attributed to your TAA rather than your SAA.

This post is mainly about SAA, which is irrelevant to investors who use 1) completely TAA methods, 2) bottom-up individual security selection (such as value investors) and 3) shorter term trading. However, to anyone who has 401k in which there is limited security selection (which usually consists of diversified mutual funds) and short-term trading restrictions (which usually range from a month to a quarter), SAA is pretty much the only game in town since any of those other strategies are pretty much completely forbidden. Although it is possible to use a quarterly rebalanced TAA strategy in a 401k, most investors with 401k's are in the "set it and forget it" or "buy and hold" category, which again is basically SAA.

Monday, September 3, 2012

Jae's thoughts from starting a business

Here are the two of the most important things I feel I've learned throughout the process of starting my own business. Both points are pretty cliched, but I don't think that makes them any less important.

Know Thy Customer

The best business ideas are the ones that customers actually want. Seems fairly fundamental, but its a concept that is oft forgotten. Many businesses end up falling in love with a "cool" idea and launch without paying heed to the customer. Unfortunately, even the coolest ideas make poor businesses if nobody wants to pay for it, and committing to an idea without knowing the customer is an unnecessary and potentially ruinous risk.

One of my new acquaintences gave me a good personal example. He had thought about working on a mobile app that would help people in NYC find clean bathrooms throughout the city for handy, quick use in lavatorial emergencies. Sounded like a good idea - it provides a solid solution to an urgent problem. However, after asking around in the city, he found that almost nobody he talked to would have found the app useful since they already knew where to find a clean bathroom on any block in the city - Starbucks.

My friend averted any major committments and expenses by speaking to his potential users early on; however, not all have been as prudent. WebVan, a once dotcom darling, earned the title of e-commerce's biggest bust of all time in part due to its failure to understand its target market. WebVan's hook was convenience. Customers in specific metro areas could purchase all their grocery needs online and have it delivered to their doorstep. No more waiting in line at the register, no more wasting gas driving to the store. WebVan raised ~$1b and quickly launched. Once again, the idea seems pretty neat, until you consider that WebVan would have to sell regularly to ~10-15% of the target population to support its expenses. Not even has that sort of market share today in the highly standardized consumer electronics industry with today's computer-literate shoppers. There's no way customers would actually want to purchase perishable goods online back in 1999 in sufficient quantity to support WebVan.

Its important to remember what all businesses depend on - the customers. Know who they are, know what they are looking for, and build something that they will actually value.

Inspiration vs Perspiration

As important as it is to get the right, customer-centric idea, an idea is necessary but not sufficient for starting a business. Execution is the key. If you think your business is just an idea, then you don't have much, and it will drive you crazy. Anytime you see someone with a similar idea (and you will, guaranteed), you'll panic. Anytime you see a competitor getting ahead, you'll be disheartened. Your ability to execute is the only constant, and its the only thing that can add value to your business in a unique way that cannot be touched by others.

I ran into a post by Derek Sivers a while back that I feel really illustrates this concept. It states that "Ideas are just a multiplier of execution."


GREAT EXECUTION = $1,000,000

To find the value of a business, one should multiply the two together. Even the best idea is worth nothing more than a NYC lunch without execution.

Anyways, its mad late, and had no intention of writing so much, so I will end it here. Hope you guys enjoyed it, and I hope the points weren't too corny.