Simple Pound

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I read the following anecdote on Wise Bread a few days ago and figured it was so well written and to the point that I needed to help it spread. Let me know what you think!

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that’s what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve.

“Since you are all such good customers”, he said, “I’m going to reduce the cost of your daily beer by $20″. Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his “fair share?”

They realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:
The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now pay $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

“I only got a dollar out of the $20,” declared the sixth man. He pointed to the tenth man, “but he got $10!”

“Yeah, that’s right,” exclaimed the fifth man. “I only saved a dollar, too. It’s unfair that he got ten times more than I!”

“That’s true!!” shouted the seventh man. “Why should he get $10 back when I got only two? The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison. “We didn’t get anything at all. The system exploits the poor!”

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn’t show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

David R. Kamerschen, Ph.D.
Professor of Economics, University of Georgia

I couldn’t have put it any better!

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I was just watching one episode of Channel 4’s documentary “Dispatches” that examines the root causes of the subprime crisis and the financial meltdown that followed.

Close to the message the documentary was supposed to bring across, it was called “How the banks bet your money” and I somehow knew there were going to be a number of things I would disagree with.

In one way or another, the documentary blames banks, credit rating agencies, regulators, governments and banks again for what has been an enduring theme across the public press for the last 6 months. The banks are blamed for creating the product that made the crisis possible and for becoming a victim of their own greed for higher and higher margins and the profits that were hoped to follow. The credit rating agencies are criticised for rating these financial products with one of their best ratings available in the market (S&P’s AAA-rating) and hence creating the fallacy that those products were inherently low-risk while at the same time understanding little of how they operated and apparently receiving payments from banks for these individual ratings. Gordon Brown is reproached with decoupling the financial regulation from governmental interference and thus having created a tripod of financial supervision. The FSA is accused of not acting in a way it was expected to when Northern Rock became a problem. And the list goes on…

Overall, I’m not disagreeing with many of the rational arguments that are being made in this documentary. I am, however, disagreeing with how it is presented and what misconceptions it will cause with people who don’t have a thorough understanding of how financial markets really operate (i.e. the majority of the population).

The suggestion that the invention of collateralised-debt-obligations (CDOs) was purely evil and driven exclusively by the bank’s greed is an immense exaggeration that fails to own up to the positive effects that financial innovation brings. The banks merely created the vehicle that was subsequently abused - and I’m not disputing that greed led to this abuse. Without financial innovation we wouldn’t be as developed a nation as we are. We wouldn’t have access to all the financial products we take for granted if it wasn’t for banks’ natural strive to create newer, better and ultimately more profitable products.

Credit cards are the best example - they’re not inherently evil. It’s just people’s misjudgement of their own abilities that can turn them into a harmful invention. Technically speaking, credit cards provide you with a 50-day interest free loan every month. It is not their fault that you think your cash supply is limitless.

Similarly, nobody forced people to take out mortgages they couldn’t afford. Of course the bank will try to sell you something they’ll eventually make a profit of. That doesn’t mean you’re supposed to blindly trust everything your banker is telling you. If you don’t feel you fully understand what you’re signing, then just don’t sign it.

The important side effect that people seem to ignore is that it also gave those people that didn’t have a long credit history the opportunity to own property while a few years back no bank would have even bothered to see that they might be eligible for a mortgage. It gave people who understood their limitations (!) the opportunity to buy their own place despite never having owned a credit card or never having taken out a loan. It’s not a flaw of the product that made people take out mortgages that were far to expensive for them in the first place. It’s also not the product’s fault that people wanted to own properties that were way out of their realistic budget.

If you expect that your bank will lecture you about what you can and cannot afford, then you’ve missed the fundamental principle of capitalism. At the end of the day, a bank is a company like any other that can only exist if it returns a profit at the end of the year. After all, Walkers doesn’t tell you to stop eating their crisps because they’re bad for you either. Don’t expect banks to operate as a super-human institution that would rather see it’s customers be happy than return a profit.

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I was grocery shopping the other day when the woman in front of me in the queue handed the cashier a piece of paper and got a payout of £100. Lottery ticket – as you might have guessed. I immediately felt the urge to buy some tickets myself to try out my luck, maybe do the unthinkable – get an immediate return from just one random lottery ticket. I resisted.

Most people would surely not consider playing the lottery a sound financial decision as the odds are phenomenally against you. Yet so many people seem to do it regardless and while fully aware of the fact they’re effectively throwing their (hard-earned) money out of the window.

Technically, premium bonds belong to the same category unsound investment you would associate lottery tickets with, nevertheless roughly half the UK owns them. An estimated £36 billion (that’s £36,000,000,000 !) is held in these “investment” vehicles that are guaranteed by the government.

The idea is that you buy a number of bonds of £1 nominal value (minimum £100, maximum £32,000) each of which is entered into a prize draw once a month. Depending on whether you’re lucky or not, you’ll get a cash prize of between £50 and £1,000,000. The catch is there is no guarantee that you will receive any payout whatsoever… so in the worst case, you could be owning £32,000 worth of bonds for years and never see a single pound return on your investment. In the best case you buy 100 bonds tomorrow and win £1,000,000 in the prize draw next month… I’ll leave it to you to work out which scenario is more likely to happen.

But to be honest with you, I’m still thinking about buying a few of those bonds – just to see whether I can win anything. It might not be the wisest thing to do with my cash, but then I already have all of my savings in accounts that earn between 6.30 – 6.76% AER which is quite possibly the highest return you can get in the market at the moment. So why not be just a tiny bit irresponsible?

I guess the moral of the story is that you should always fully understand the investments you pursue and only proceed if you are completely happy to accept the risks that come with it.

If you are considering joining the crowds to put your money to work in a Premium Bond, I strongly suggest you read the following article (twice): Premium Bonds - Are they worth it? If you’re still convinced Premium Bonds are the way forward, I’ll keep my fingers crossed that you’ll experience lots of happy months with decent returns accompanied by the excitement of having “beat the system”.

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The first month of 2008 is over and we’re 1/12 through a year which may not enjoy as much economic growth as we’ve seen since the beginning of the decade. No, I don’t want to call it a recession. Just because we’ve seen some increase volatility on the stock market does not necessarily mean we’re heading towards a Japan-style recession. Unfortunately, the more “so called” experts are discussing the likelihood of exactly this happening, the more probable a real recession becomes.

In any case, I’m losing myself in a rather dull rant that I don’t want to subject you to (well, at least not beyond this short introduction to make sure everyone knows what I think of pessimists… ). Let’s get started on the actual purpose of this post - my monthly review. The good news is that I’ve had a sizeable increase in my net worth of 11.30% in comparison to last month’s figure. This was mainly brought about by an increase in my assets of 11% and a total elimination of all my outstanding debts. The bad news is I’m unlikely to be able to repeat this whopping increase because much of it was related to my January bonus or “discretionary incentive award” (depending on whether you like to call things by their name or not… ).

Sticking to a budget was strange and needless to say I didn’t always manage. Especially as we had dinner at Hakkasan, one of my favourite yet slightly more upmarket London restaurants - that totally ruined the concept of having a budget for dining out. To even it out I spend less on taxis, clothes and cosmetics than I could have and didn’t get that monthly pampering session (manicure, facial, hair cut - you know the girly ways of relaxing!) either. Moreover, I did not spend a single penny of my bonus but put it all into a 6-month high-interest bond (Icesave!) with a rate of 6.76% AER that I probably won’t be able to get for much longer (assuming the Bank of England will cut interest rates again fairly soon).

All in all, it was a good month but I’m still determined to spend less next month. Especially on things like coffee and lunch as I should simply overcome my laziness and prepare some sandwiches to take to work. It shouldn’t be that difficult, should it?

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