More money than sense

Cropped Thinking 500x144Daniel Kahneman, the 2002 Noble laureate in economic sciences, proved that value is a relative concept1. Marketers of luxury goods are very successful at using Kahneman’s ideas. In the stores that cater for people with more money than sense, you will find at least one item that even the wealthiest won’t buy. Those highly overpriced items are there to establish the relative value, so that a $12,000 handbag, is a good deal in relation to the one placed ostentatiously in the center of the store, priced at $37,000. They make huge profits using that technique.

That’s until Oprah, believing she is the world’s wealthiest woman, wants to buy the $37,000 handbag. The store assistant has been told not to sell that bag – it makes the store a lot of money just sitting there – but she can’t tell Oprah that, so she says it’s not good value, and that Oprah can’t afford it.

Actually, the wealthiest woman in the world is the Queen of England, who is also a very astute businesswoman. It also helps that for most of her life she was not liable for tax. She only appeared on Forbes’ list of wealthiest people once in the 1990s, and immediately afterwards ‘arranged’ her affairs so that she never appeared on the list again. She certainly would not buy a handbag costing $37,000.

Perhaps that’s because she has more sense than money.

More at:
Daniel Kahneman, Thinking Fast and Slow
Oprah Winfrey ‘racism row’ a ‘misunderstanding’

  1. Daniel Kahneman, Thinking Fast and Slow chapter 16 []

What were you thinking, man

Hindsight is 20/20 vision, but sometimes so is foresight. Investment is simply a numbers game, and the mathematics of compound interest form the foundation of how well the investment performs. Often using the magic of compound interest, and the history of past performance, investment sales people offer the promise of fantastic wealth extrapolating from an often selective history.

Right from the outset the extrapolation is dangerous, but when one takes account of the twenty and twenty fee structures that hedge funds charge, the wealth becomes illusory.

Just playing a little bit the spreadsheet makes this obvious.

if you want to invest in equities, the lowest cost options are index linked funds. These are funds that aren’t managed, but have a portfolio made up of the shares that comprise a specific index, say S&P, or Dow Jones. Usually for an index linked fund the fee runs at 0.2% of the capital invested. A hedge fund would need to outperform the index linked fund after deducting its higher expenses.20121222 FNC667

Plugging the figures into the spreadsheet makes it apparent how difficult that is. If the index is growing at 7%, which over an extended periodis considered to be very good, the hedge fund would need to be earning 12% just to break even with the index linked fund, after expenses.

Playing a little bit more with the numbers, the reality hits home. Taking economic growth of 3% over an extended period, together with the 7% return used earlier, a $100 billion hedge fund, which is small to medium-sized fund in relation to the $2 trillion hedge fund market, after 40 years would be the market. And that’s just assuming that the fund makes returns that break even with an index linked fund. If, after fees, it outperforms the indexed linked funds, as they promise, then it gets to be the market quite a bit sooner.

Perhaps that explains why the hedge fund market is shrinking now, quite rapidly.

More at:
Going nowhere fast
Rich managers, poor clients
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Hedge funds for beginners
Index Fund Understanding