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Monday, January 19, 2009

Risk and Taxes

Consider the following two portfolios over a ten year period.
  1. The 1st portfolio will have a 4% per year guaranteed return.
  2. The 2nd portfolio will have either a 50% or -25% annual return for each of the 10 years. The returns for each year are completely random and independent.
Which is better?

Well, that depends. At the end of 10 years, portfolio 1 will have increased 48% (with compounding). Portfolio 2 will have a return somewhere between -95% and 5,500% and the expected (geometric mean) return is 80%. 80% is a lot better than 40%, but only about 13 out of 20 people would end up doing better with portfolio 2 than with portfolio 1, the rest would've been better off sticking with portfolio 1.

In my experience, about half (maybe somewhat more than half) would choose portfolio 1 and the others would choose portfolio 2. Those who are more risk-adverse would go with portfolio 1 and those who have a higher tolerance for risk would go with portfolio 2. There is nothing wrong with either choice. It's completely subjective.

However, the rich generally can be more risk-seeking. If you lose 95% of $1 billion, you still have $50 million left, which is a bummer, but no threat to survival or even comfort. If you lose 95% of your $200,000 of retirement savings, you're in serious, serious trouble.

Now let's consider what happens when taxes are added to the equation. Let's use the nice round number of 50% as the tax rate. For a rich investor in California if Obama increases taxes on assets for the rich as he said he would while campaigning, 50% is a pretty realistic number.

Portfolio 1's after tax return is 2% per year which would compound to 22% for the 10 year period.

Portfolio 2 is more interesting. The results depend not only on chance, but also on order. If the early returns are good, they're heavily taxed, and later losses will badly hurt the overall return. If the early returns are losses, then later profits go tax-free until you make the losses up (assuming that losses can be carried forward). Indeed, the calculation is complicated enough that I had to write a short matlab program to calculate the results.

The bottom line is that the expected 10 year return for portfolio 2 is now negative (between -3% and -4%). As a result, except for very risk-seeking individuals, portfolio 1 is now much better.

The point: Taxes on capital punish risk. This isn't an opinion, it is a mathematical certainty. While the above example was specifically picked to help illustrate this point, under a high-tax regime, higher risk investments are negatively impacted more than lower risk investments, and therefore, investors will have a greater incentive to avoid higher risk investments.

In a future post, I'll look at the ramifications of discouraging risk-taking.

Wednesday, January 14, 2009

Making Women Feel Cheap

I had no idea that prostitution pays so well:
Natalie Dylan, a 22-year old woman from San Diego, has brazenly offered her virginity for auction and is currently courting offers as high as $3.7 million, according to Fox News. Dylan, who has a degree in Women’s Studies ironically, came to the idea for an auction when her sister, Avia, 23, paid for her own degree by prostituting herself for three weeks.

That's an astonishing amount of money for one night.

I have two questions.

Why on earth would anybody pay that much?

Why doesn't every woman sell her virginity? Work one night and then you're financially set for life! This woman is not ugly, but she's not particularly good looking either, so this opportunity is available to many young women (who are still virgins).

The usual answers: that she'll feel degraded; she'll lose her self-respect, etc.; aren't convincing to me. In every job we have to submit to bosses, clients, investors, and others and some of those interactions, especially over a lifetime of work, are degrading. We all lose some self-respect in those inevitable situations when we pretend to like a client that we actually loathe, exude excitement over a project we hate, or laugh at stupid jokes made by some moron with control over us. We do it, we get over it, we move on. It's part of life.

She only has to do something degrading (assuming she feels that way) for one night. Everyone else does it for a lifetime.

But there's something related to this that I find very disconcerting. Won't women who don't sell their virginity always feel cheated in comparison? For example, if a woman saves her virginity for marriage, and her husband's total lifetime income won't come anywhere close to $3,700,000.00, why won't she feel rather ripped off? Why won't she resent this man who can't provide for her nearly as well as a complete stranger will provide for Ms. Dylan? How can any marriage ever work again? Heck, how will my marriage continue to work if my wife finds out what she could've had (hopefully she won't read this)?

Yes, I know that the answer is this thing called "love". But it seems to me that the huge inherent monetary value of a woman substantially reduces the power and extent of love. Love is great, but if over decades of being with your partner there isn't the general feeling that you did relatively well for yourself, I suspect that for many, there could easily be some regrets.

For example, when I consider my own marriage during times of stress (not that my marriage is very stressful), I get nearly unlimited sustenance by assessing the situation and being able to honestly say to myself, "I simply could not have done better." Love sustains me too, for sure, but there is no doubt that feeling that there was no better path helps as well. Men will still be able to say that. Will most woman be able to say that there was no better path with confidence with the $3,700,000.00 question out there?

I would guess not.