Friday, October 21, 2005

Idea Disparity Follows Income Disparity

In case you haven't yet heard, there's a contest going on at to come up with fresh common-sense ideas for improving the day-to-day lives of ordinary Americans, helping working families succeed in the global economy. The first place idea will receive $100k, and second and third place ideas take home $50k apiece. So far, in the initial two and a half weeks of the contest, people in all 50 states and the District of Columbia have submitted thousands of ideas. Have you got a novel idea that you can explain in 175 words? If so, surf on over--you have until December 5 to join the conversation!

With entries streaming in across a multitude of topics--tax, education, wages, savings, medical insurance, energy, outsourcing, etc.--below is the ranking of the 10 most active and 10 least active states by number of entries, as of this morning when a total of 2,750 entries had been submitted:

State (2000 population in millions): Number of Entries

1. California (population of 33.9 million): 326 entries
2. New York (19.0): 203
3. Washington (5.9): 160
4. Texas (20.9): 150
5. Illinois (12.4): 138
6. Florida (16.0): 133
7. Michigan (9.9): 124
8. New Jersey (8.4): 117
9. Pennsylvania (12.3): 115
10. New Mexico (1.8): 114

42. Hawaii (1.2): 8
43. Utah (2.2): 7
44. Idaho (1.3): 6
45. Wyoming (0.5): 6
46. Montana (0.9): 6
47. Alaska (0.6): 6
48. North Dakota (0.6): 3
49. Deleware (0.8): 2
50. South Dakota (0.8): 1
51. Mississippi (2.8): 1

As should be anticipated based solely on population figures, i.e., based on the number of possible entrants in each state, the most populous states generally submit more entries, while the least populous states show far less entry activity.

But, there's another trend in the data that is more interesting to point out than the state-by-state absolute number of entries. If we correct for population by looking at number of entries submitted per million people, we can re-rank the states to find:

State (2004 per-capita income in $k): Number of Entries per Million People

1. New Mexico ($26k per-capita income): 63 entries per million people *
2. District of Columbia (52): 47 **
3. Washington (35): 27
4. Vermont (33): 18
5. New Hampshire (37): 18
6. Virginia (35): 15
7. New Jersey (41): 14
8. Michigan (32): 12
9. Wyoming (34): 12
10. Oregon (30): 11

42. North Dakota (31): 5
43. Idaho (27): 5
44. Indiana (30): 4
45. Louisiana (28): 4
46. Arkansas (26): 4
47. Tennessee (30): 4
48. Utah (27): 3
49. Delaware (36): 3
50. South Dakota (31): 1
51. Mississippi (25): 0

* A single entrant submitted 75 of New Mexico's 114 entries. Without the remarkable participation of this prolific "idea man," New Mexico's tally would drop to 21 entries per million people, behind the District of Columbia and Washington state, placing New Mexico in third rank.

** The SinceSlicedBread idea contest is being sponsored by an organization called Service Employees International Union (SEIU), headquartered in the District of Columbia. Factors that contribute to D.C.'s high participation rate include high per-capita income, higher-than-average political and policy awareness of D.C. residents, and proximity to the sponsor.

Examination of the data for all 50 states and the District of Columbia reveals a rather high correlation (0.5) between per-capita income levels and number of entries submitted per million people, indicating a noticeable relationship between income and ideas. Those who have higher incomes typically spend more time online, have more years of formal education, and may be inclined to devote more of their leisure time to participating in "idea" contests like this one.

Implications we can draw from how contest entries are coming in are:

1. As with income, wealth and education levels in society, the propensity for idea generation is very skewed, perhaps best described by a Pareto-like distribution with "power-law" fall-off as a function of rank. Despite so-called "equal opportunity" in America, there is strong evidence for a "natural law" indicating that outcomes in human endeavors--whether in school, work, sports or contests--inevitably end up as unequally distributed as our physical and mental abilities.

2. Hence, if SEIU really would like to hear the "common sense of the common man," a team should be appointed to solicit ideas from a) residents of those states with the lowest contest participation per million people, and b) non-Internet users and low-income people in all states who have not yet heard of the contest. This way, we would all benefit from extending this conversation to the "other half" of America as well.

(Disclosure: I am participating in the SinceSlicedBread contest. Included among my entries to date is an idea for funding stock investment accounts for kids by tapping half of the annual $1,000-per-child tax credit every year from birth through graduation from high school. Other ideas I have submitted with a primarily economic slant are a procedure for normalizing distortions in wealth distribution, tax-for-labor swaps to reduce unemployment and welfare dependence, and asset taxation to replace income taxation.)

Sunday, October 16, 2005

Who Gets Rich with Options?

I picked up my local Sunday paper this morning and glaced at the lead story in the business section: "Bet on the future with options." As I scanned the article, I learned that options volume is now 5.6 million contracts, up about 1 million contracts (or 22%) from a year ago, according to the CBOE. Apparently the "little guy" is getting involved, writing covered calls, buying protective puts, and speculating with naked calls and puts.

I'm glad to see that more people are participating in the markets. However, unless this is just another dose of sensational journalism, we can be certain that the proverbial "little guy" is once again getting "fleeced" by seminar speakers, brokers, and financial professionals, who peddle products for fees and commissions and hardly give a second thought to pulling the wool over the little guys' eyes.

Let me explain my stance. First and foremost, options (along with futures and other derivatives) are a "zero-sum" game. For every derivatives contract, there are a buyer and a seller, who take positions on opposite sides of a market (stocks, bonds, currencies, commodities, etc.). As time passes, the market moves, and, when the contract expires, one party has a gain while the other has an equivalent loss. In other words, for every winner, there is a loser.

If that were the whole story, I wouldn't be so negative. Importantly (and this is the part that usually goes unmentioned), there are third parties involved who always come out ahead in the game. Brokers take their commissions, market-makers extract the bid-offer spread, and advisors (to the extent that they are involved) earn their cut. So, if a net amount (upfront premium plus final settlement) of $100 changes hands during the life of the contract, the losing party is worse off by $100, the winning party is better off by, say, $95, and the brokers, market-makers and advisors end up ahead by the remaining $5.

Because the fees and commissions in options trading are so much higher than in trading the underlying stock, and because options contracts are all by their very nature short-dated (volume becomes very thin beyond a few months), the annualized frictional costs for even moderately active options traders can easily run beyond 5% or 10% of the principal amount of the underlying stock. A hurdle this high is very difficult to surmount for any options players hoping to realize consistent profits.

Now, there are many who believe that they have a "knack" for guessing short-term market direction correctly and, consequently, can benefit from the leverage opportunity that options provide. Then, there are others who advocate the insurance aspects of buying puts or selling calls to reduce the volatility of underlying buy-and-hold positions. To the short-term market-timers, I say "best of luck"--in my opinion, making consistent profits in options trading, particularly with the high frictional costs, is as difficult and unlikely as winning consistently in Las Vegas. My rebuttal to the insurance argument is simple: Make sure that you really need the insurance against market volatility before you buy it--short-term profits are, of course, possible on the options component if you happen to be on the right side of the market, but in the long run you will likely be better off just riding the market's rollercoaster, without trying to smooth the bumps with calls and puts (and suffering from the frictional costs).

My advice is straightforward: Avoid options and save on fees and commissions. Accept the volatility of the market, patiently letting the market's secular rise propel the value of your portfolio upward over the long haul. There may be a few professional traders who have enough of an "edge" to profit consistently from options trading, but, if you're a little guy, the options cards are stacked against you from the start.

Tuesday, October 11, 2005

What Household Balance Sheets Tell Us About Wealth-Building

If you have ever wondered what balance sheets of typical U.S. households looks like, the Fed's triennial Survey of Consumer Finances (SCF) is a good place to go for insight. Because results of the 2004 survey will not be announced until early 2006, I reference data from the 2001 survey, as reported in a paper by Arthur B. Kennickell.

Taking a look at balance sheets of average households in different percentile classes arranged by net worth ranking, we have:

Category: "Poor," "Middle Class," "Well-Off," "Rich," "Super-Rich"
Net Worth Percentile Class: Bottom 50%, Next 40%, Next 5%, Next 4%, Top 1%
(Figures shown below are percentages based on total assets of 100%)

Asset Percentages:
Cash accounts: 5, 5, 6, 5, 4
Bonds, CDs: 1, 3, 4, 3, 5
Stocks, retirement accts.: 9, 22, 33, 32, 27
Other financial accts.: 4, 6, 8, 8, 9
Vehicles: 17, 6, 3, 1, 1
House: 60, 46, 28, 19, 8
Other real estate: 2, 7, 8, 13, 11
Business (closely held): 1, 6, 10, 18, 34
Collectibles, etc.: 1, 1, 1, 1, 2
Total: 100, 100, 100, 100, 100

Debt Percentages: 56, 19, 9, 6, 2

Net Worth Percentages: 44, 81, 91, 94, 98

Average Net Worth Per Household: $23k, $270k, $1.0 mil., $2.5 mil., $13 mil.
(The total 106.5 million U.S. households have an aggregate net worth of $42.4 trillion.)

From the structure of the balance sheets revealed using a percentage breakdown of assets and debt, we can see how the typical consumer balance sheet changes with rising net worth:

1. Leverage: The poorest households have the highest debt burden (56% debt-to-asset percentage), versus the other extreme of almost no household leverage for the super-rich (only 2% debt-to-asset percentage). (Note: High net worth households tend to have "indirect" leverage through ownership of equity in both public companies and closely held businesses, which in turn have liabilities at the company level. This indirect leverage is not quantified in the SCF data.)

2. Primary Asset: The primary asset of the "poor" and "middle class" households (bottom 90%) is home ownership. With increasing household net worth, the primary asset shifts to stock ownership and retirement accounts for the "well-off" and "rich" (next 9% of households). For the "super-rich" (top 1% of households), closely held businesses become the primary asset, followed by stock ownership.

3. Fixed Income: Across all net worth categories, bonds, CDs and other fixed income investments represent less than 5% of household net worth.

4. Cash: Consistently across all categories, cash represents around 5% of household net worth.

In terms of a gaming analogy, the data reflect typical "levels" along the road to riches:

Level 1: Get a job.
Level 2: Buy a house.
Level 3: Invest in stock, retirement accounts and maybe some additional real estate.
Level 4: Become an entrepreneur and open a successful business.

The poorest U.S. households have a difficult time getting beyond Level 1. Most households advance to Level 2, realizing the "dream" of home ownership. Only about 10% of households become full-fledged Level 3 participants, with investments supplanting home ownership as the household's primary asset. Finally, really only about 1% of households reach Level 4 status, with a truly successful business becoming the primary asset, allowing net worth to grow by leaps and bounds.

Lesson: You can become very rich by investing; however, if you are interested in becoming super-rich, you are likely better off turning your attention to starting and nurturing a highly successful business.

Monday, October 03, 2005

Two Cultures: Yahoo and Google, and a Look Ahead

"The number 2 is a very dangerous number: that is why the dialectic is a dangerous process. Attempts to divide anything into two ought to be regarded with much suspicion." --C.P. Snow, "The Two Cultures" (1959)

"It is probably too early to speak of a third culture . . . But I am now convinced that this is coming. When it comes . . . the focus of this argument will be shifted, in a direction which will be more profitable to us all." --C.P. Snow, "The Two Cultures: A Second Look" (1963)

As I read the news this morning about Yahoo's new foray into the book scanning business, following Google's lead last year, I was reminded of C.P. Snow's well-known essay "The Two Cultures." Writing some 50 years ago, C.P. Snow had in mind, of course, the rift between literary intellectuals and scientists, two cultures that hardly communicate with one another. A similar disparity in underlying philosophy is evident in the publicly visible actions of arch rivals Yahoo and Google.

Historically (i.e., on the scale of "Internet time," wherein ten years are an eternity), back in 1995, Yahoo came to life as a popular human-powered directory of the best of the Internet, only to be surpassed five years later by Google with its innovative automated relational search engine capable of outfoxing Yahoo's human content editors in breadth, depth and even relevancy in most searches we as consumers have interest in doing. Yahoo has attempted more recently to catch up with Google in search but, when measured by consumer reach, Yahoo appears to have lost the battle. Score: Google one, Yahoo zero. Or, to put it another way: one victory for the scientists, and one defeat for those of a more literary persuasion.

Last year Yahoo made a splash by opening a new office in the bright lights and glamor of Hollywood, presumably with the intention of snuggling up a bit closer to the creative talent and celebrities of the entertainment world. Accentuating its contrasting style, Google just last week announced collaboration with true rocket scientists from NASA's Ames Research Center to explore everything from supercomputing to bio-info-nano convergence. What could be farther apart than the glitter of a Hollywood movie screen and the drone of a NASA spaceship control room?

Also last year, Google created a stir by beginning to scan books from Stanford University's library, for the purpose of expanding the electronic universe accessible to their search algorithms. Google's objectively comprehensive though indiscriminate approach to selecting books for scanning piqued the ire of publishers and authors alike, who fretted over the legality of Google's placing copyrighted material into a public database, and remain unappeased by Google's assurance that only snippets, not whole books, are to be displayed in the search results. Then, this morning's news shows Yahoo teamed up with the newly formed Open Content Alliance, sensitively taking a more publisher- and author-friendly approach to book scanning, by seeking permission from copyright licensees prior to electronically scanning the pages. Although Google is still in court from the fallout of its initial scanning efforts, and Yahoo's participation in the Open Content Alliance is just beginning, I venture a guess at the eventual outcome, which I believe will be a victory for Yahoo's measured approach and a little egg on Google's face. Updated scorecard: Google and Yahoo tied at one apiece.

I do not claim to be have the foresight to know whether Google's "scientific" methodology or Yahoo's more "literary" inclinations will win out in the end, and, in fact, I suspect that it could be neither. To borrow and modernize a C.P. Snow analogy, what could result instead is the development of a "third culture," one that contributes to bridging the chasm and concurrently redefines the Internet. Extrapolating from the progress being made by open-source software (Linux, Firefox, etc.), wikis (e.g., Wikipedia), consumer-generated content (blogging, photo sharing, etc.), social networking sites and other decentralized movements, I wonder if what lies ahead is a diffuse form of Web "ownership" in which this time it is all of us users-at-large who co-own the content and share the entire benefit, without another pair of young Internet billionaires being minted in the process.