Continuing with our series in summarizing and analyzing Thomas Sowell's Basic Economics, we now head into chapter 14 to talk about the more tantalizing subjects of stocks, bonds, and insurance.

The headliner quote for this chapter is:

Risk-taking is the mother's milk of capitalism

And with that intriguing premise, let's dive in!

Chapter Summary

In addressing risk in the market, we've previously talked about speculation, and how its function is actually a hedge against the volatility of markets, rather than a gambling with higher risk for greater rewards. Stocks and bonds are similar in this way.

Capital gains, which means a form of income that requires some time investment before anything is earned, is a useful term to refer to these items. Of course, this term actually includes other things as well, such as savings accounts. In any case, the level of gains, often in the form of interest, needs to outpace inflation in order for the rate of return to be worth anything. Since inflation varies from year to year (as well as locale to locale), it is a risk (one of many) that must be considered as one looks to invest in this area.

Since having money later is worth less than having that same amount now (due to inflation), people would rather pay more to have money now than later. This tells us that there is actually different value to money, despite it being the same “amount”.

With this understanding, let's look at why people get bonds. Though a bond guarantees you to receive a certain interest rate, you would not want to pay more than that interest rate to get the bond. Thus, for a $10,000 bond, you wouldn't want to pay more than $8,928.57 for it at a 12% interest rate. Any higher price than that 8k, and you'd rather put your money somewhere else. Thus, when interest rates go up, bond prices typically go down.

This all gets really interesting (and a bit of a headache) when factoring in taxes on the capital gains. One would need to know what their gain would be, the time required to make that gain, the inflation rate, and then the tax on top of that to see if, in the end, they would make a gain at all. Not all countries tax capital gains, but significant ones (like the United States) do.

Variable Returns versus Fixed Returns

Bonds are legal commitments of payment, while stocks are shares of a company that one can buy to participate in certain capacities of that business. Stocks are not guarantees of a business profiting (or even that the company will eventually give out dividends to stockholders), but a bond legally binds promised payment. In this way, bond holders are actually entitled to payment even before the owners of that business receive the results of their profits.

There is still risk of course, in buying bonds, since a failed business cannot repay those funds fully. Thus, whether to buy bonds or stocks of a business depends on whether one can afford the risk of getting only a small portion of their money back (bonds), or none of it back (stocks). The reward of stocks though, is that if a business thrives and its assets increase in value, the stock owner will receive compensation accordingly in stock value, whereas bonds won't budge above the promised payment.

Thus, stock investing for new businesses is often called “venture capital” investments. Venture capitalists often need to make at least 50% profit on their successful businesses to cover other losses. From an economic perspective, the long-term profit of venture capitalism shows an efficient allocation of resources, even though many new businesses seem risky.

On the other side, the kinds of businesses that would often issue stocks or bonds depend on this risk factor as well. New ventures or technology innovation companies usually issue things like stocks, because they would want to attract investors who want to earn high rewards. But other businesses like public utility companies tend to offer bonds, since there is little risk involved, and little desire to pay out much to investors.

In general, successful businesses' stocks will have a higher average rate of return than bonds. So while bonds might pay out more in a single year, over a period of 20-30 years, stocks have such high averages as to eclipse the rate of inflation, which bonds tend to be outpaced by during that same amount of time.

This doesn't mean the stock market has no risk, of course. Any portfolio that wishes to gain on average, no matter whether bonds and stocks lose or gain value over time, will diversify. Even if a portfolio was to have only stocks, it would de-risk through investing in a mix of companies rather than a single one. Here, professional speculators often have a group of select business stocks they manage, called a “mutual fund”, that other investors buy into. These are often less risky than investing in single stocks, though, of course, they have less potential for large gains.

When students take loans for the education, we can actually think of it like a bank is investing in a bond. After all, the student owes a certain amount of money, but rarely rewards the bank with more if they are successful. Because many students actually end up not graduating college, the structure of the bond as a loan allows banks to pool them together in order to mitigate that risk.

Here, Sowell offers an interesting speculation: if students could issue both 'stocks' and 'bonds' in themselves, it may be that both parents and taxpayers would not need to subsidize such education. Institutions could invest in these students with the expectation that a percentage of their earnings would go towards them, thus reducing the need to have the students pay such high rates up front.

Such investment in people could not only benefit students, but others as well. For example, in the world of boxing, boxing managers take a percentage of their boxer's winnings. In the world of filmmaking, agents who represent actors take a similar cut. While these different arenas don't necessarily use the terms “stocks” and “bonds”, the effect is essentially the same economically.

Insurance

First, it's important to establish the principles of real insurance.

Insurance companies deal with the inherent risk of losses. There are different chances of losses of course. For example, car insurance companies charges lower prices for safer drivers. By doing this, they can reduce their exposure to risk, and communicate through the higher prices the cost of having a more dangerous job or even location. Thus, since prices are pooled together by insurance companies, the risk of loss is mitigated on both a micro and macro scale.

Let's take, for example, at life insurance. Life insurance is a policy dealing with death, which is both a universal and yet unpredictable event. Because no one knows when they'll die, the money being paid into an insurance company is money to be paid back in the event of such a thing happening. Thus, the risk of untimely death is transferred to a the insurance company. Because the insurance is pooled across different people, the risk to the insurance company is reduced. In addition, the individual policy is worth more to the buyer than the seller, because the buyer will receive more benefits than if he or she did not have a policy.

What do insurance companies do with the premiums they receive? After paying claims, they typically invest the money they have, most of the time in government securities and conservative loans. Thus, if the insurance company knows what it's doing, it is taking your premiums and growing it, thus if a loss is incurred (e.g. someone has passed away), the amount the insurance company must pay for claims is then less than they have made.

Like in other arenas of the market, competition forces prices lower in the insurance market. For example, as the Internet began to boom, and insurance companies began to provide services on the web, prices of term life insurance began to decline. Furthermore, it wouldn't make sense for insurance to cost higher than an uninsured event (or else, no one would buy it). Such things, in addition to fraud prevention, have allowed general insurance costs to decline over time.

Of course, there are people who take advantage of their insurance by behaving more riskily than if they didn't have it. And people who are ill or live in areas where a specific issue (e.g. diseases, fires, etc.) are more prevalent are going to automatically be riskier to cover. Such things drive up insurance costs, since insurance companies must take those increased risks into account.

It gets more tricky as the government is involved. While governments can prohibit risky behavior (thus driving down insurance costs), some governmental policies can do the opposite. When governments force people or businesses to purchase insurance, it is typical for these entities to engage in riskier behavior. Additionally, when governments decide to politicize “fairness”, like forcing insurance companies to charge the same prices for everyone no matter who or where they live or what age they are, insurance prices are then driven up, because these companies must protect against risk.

Thus, politics that are concerned with fairness (an undefinable term, really) and not understanding risk actually cause more harm (i.e. make things more expensive) than good.

Government “Insurance”

There are governmental programs that also deal with risk, such as the National Flood Insurance Program or the Federal Emergency Management Agency (FEMA) in the United States.

The problem with these kinds of programs is that they are not really true insurance, because they don't reduce risk. Instead, these particular programs are making it cheaper (and thus incentivizing them) to live in more risky areas. Furthermore, they are putting the burden of that cost on all taxpayers, since that's how they make money.

The political part of these disaster relief programs often focus on the cost of the damage, and thus manipulating people to care for others and be willing to send money via tax to them. But they often don't talk about reducing the risk of damage. Thus, when governments force insurance companies to reduce prices, often, insurance companies just bail out of coverage of riskier places or raise all their premiums.

Insurance companies are competitive entities. Their entire business depends on their quality and speed. For example, they cannot afford to be later in their payouts than others, or else people would leave them en mass. In a comparison to the disaster relief of Hurrican Katrina in 2005, Sowell quotes the Wall Street Journal:

In August, 2005, Hurrican Katrina flattened two bridges, [a government] one for cars, [a privately owned] one for trains, that span the two miles of water separating this city of 8,000 from the town of Pass Christian. Sixteen months later, the automobile bridge remains little more than pilings. The railroad bridge is busy with trains.

Even in the areas of insurance, free-market-based mentality will always deliver where governmental ones cannot.

My Thoughts

The idea of risk-taking, and mitigating the chances of those risks, is really interesting. I've thought for a while now that stocks and bonds were simply ways for the average individual to participate in a bigger economy, and I'm glad that Sowell basically affirms that here. In economic terms, it's basically just allocating resources around more efficiently.

Furthermore, understanding how mutual funds, ETFs and insurance companies are really entities that mitigate risk is interesting. I think people are so used to the idea that insurance companies are ripping them off or fraudulent, that 'insurance' has basically become a dirty word.

It seems that the truth is actually both simpler and more devious. It is in the best interest of insurance companies in a free market to lower their prices, so as to get more customers. It is also in the best interest (especially in today's internet age) for these companies to offer quality and speed in their offerings. These incentives—better quality, more speed, and cheaper prices—are rarely ever met in any single business, but insurance companies in a competitive free market are incentivized to do so.

It is only two things that cause the prices to go up: when a political authority steps in and demands certain prices or behaviors from these companies, or when they have to deal with riskier ventures, locations, and even people.

But what these prices are telling us is not that the insurance companies are greedy (remember, they are actually incentivized to be the opposite), but rather that it is costing the insurance companies more to mitigate risk for everyone. THAT is the information people should walk away with, rather than a judgment on a company or group of people they don't know.

Even when we look at political authorities, we shouldn't necessarily regard them as evil or not. It's not that they are inherently evil. Instead, governmental authorities simply aren't elected because they are experts in the fields they attempt to address. They are only experts at getting elected. And thus, to have political authorities step in to deliver solutions is rarely the best option, simply because they don't know how. They only know how to make people feel good about them.

I think if people begin to regard prices as sources of knowledge rather than how they relate to the character of a business or group of people, we'd probably be in a much better state to address the real concerns happening around the world. And not be so easily seduced by easy answers from political authorities.