The difficulty with an improving economy

Every once in a while, I run across a comment on a blog or news story that reads something like this: “If you’ve been unemployed for more than a year, you’re not looking hard enough.”

It’s mean, but I’m sure the writer believes what he says. They probably have a job and run across “Help Wanted” signs every once in a while, and can’t reconcile that with the fact that more than 6 million people have been out of work for more than 26 weeks.

But now the jobless face another problem. If you do have a job right now, you have more job security than at any time in the last decade.

On Friday, the Labor Department released its monthly report on the number of openings, hirings, and firings that employers posted in January. It’s a little different than the regular unemployment report that comes out at the beginning of the month. That one tells you how unemployment overall moved in the previous month. Whereas this one tells you how much hiring and how much firing added up to the overall unemployment figure.

The last few months of reports have been mostly the same. Firings have basically stopped. In fact, they’re at their lowest point since the government started tracking them in 2000. But hirings haven’t picked up at all, which leads to this worrisome conclusion (as stated by an analyst): “Generally speaking, all the data seem to suggest that if you already have a job, the labor market probably doesn’t seem so bad, but if you’re looking for a job, there’s been almost no job market improvement over the last few years.”

In other words, if you have a job, this economy doesn’t feel so frightening anymore. If you don’t, it’s still scary as hell.

When long-term unemployment becomes a fact of life

America’s traditionally been a country with rapid layoffs but rapid hiring. You’d be much more likely to lose your job at any given moment, relative to a country like France. But unlike the French, an unemployed American could get his job back quickly.

In fact, unemployment in countries like France, Greece, and Spain has been at 8% or so or higher for years. And at any given time, most of those people tend to have been out of work for more than six months.

Yet, you don’t get the sense of urgency in fixing the problem that you get here. At one point, unemployment stopped getting worse in those countries, and the governments and populace settled into complacency. Maybe 8% unemployment was as good as they could do.

We don’t yet know when and if the job-creation machine will revive in the U.S. But we’re already starting to see congressmen and some economists declare that the government can’t continue extending help to the long-term unemployed in the name of fiscal austerity.

It’s going to be much easier for them to focus on the debt if the average man on the street no longer fears that he’ll lose his job.

Unemployment is moving from “our” problem to “their” problem.

I have a job. And that BLS report I referenced tells me that job’s safer than it has been in 11 years. So now, unemployment isn’t so much an imminent threat that I want government to urgently address, but the problem of an ambiguous group of people who I only know through friends of friends or family.

Pretty soon, simply telling people that the unemployment rate is 9% isn’t going to make people bat an eyelash, and I wouldn’t be surprised if some politicians or jobseeker services start taking a lesson from foreign NGOs.

Are you more heartbroken by the estimated 925 million people who lived in hunger in 2010, or by this?

I

It’s no accident that the narrator said the name “Michelle” six times. No accident either that once you start giving, you’ll get a picture of the child and updates on his or her progress.

Economist George Loewenstein and Deborah Small ran an experiment where they presented potential donors a letter that requested money for a house being built for a family by Habitat for Humanity. In one version of the letter, which described the families, they were told that the family “will be selected” for the home. In the other version, they were told that the family “has been selected” and was just waiting for the donation.

Donations to the home for the family that “has been selected” were significantly greater. The reason? The economists think that making the beneficiary concrete and identifiable was all it took to pump up the giving.

I hope it doesn’t reach the point that we need to run commercials with panicked jobseekers in order to keep them in the public consciousness. But as time goes on, let’s not forget that one in 10 of the people we pass on the street every day are probably out of work.

The “crisis” that never comes

The recent deficit talk has people rightly concerned about whether or not Congress and the President have the cojones to bring our fiscal house in order. There are basically four ways to cut the deficit: grow the economy, cut spending, raise taxes, or print money.

Option one is the fun way to get out of it. If we sell more goods and services, government collects more taxes while citizens make more money, and everybody’s happy. However, the economy right now is growing slowly.

Options two and three are where all the debate is happening. However, political risk is frightening most politicians from addressing the beasts of healthcare and Social Security that need to be tamed for any real progress to be done.

Which leaves option four as the default way to pay. If Congress does nothing to fix the deficit, the government can “print money” to devalue those debts, which drives interest rates up and the dollar down. Bad for savers. Good for debtors.

While you might understand how all that could eventually affect inflation and the prices you pay for goods, you might be left scratching your head about just how much of a knock on your savings that last solution could translate to.

Here’s an attempt to explain it without getting too wonky or insulting your intelligence. But first, let’s set one thing straight.

Inflation is not here yet.

I’m kind of tired of the “is there or isn’t there” inflation debate going on right now. The government’s official inflation measure showed that prices rose by about 1.6% over the last 12 months. Food and energy prices accounted for more than two-thirds of the increase.

Inflation of less than 2% is extremely low, especially when you’re including food and energy prices, which swing up and down sharply based on crop yields, hurricanes, etc. Critics like to counter with nice-sounding anecdotes about how their personal grocery bills are rising. But even if we were to accept anecdotal evidence as valid, there’s reason to think those anecdotes are wrong.

Here’s the average grocery store purchase at a Hy-Vee in Des Moines, according to Mint:

Go to Mint’s data feed yourself and play around. Grocery bills aren’t going up. Unless people are eating less, or deciding to make multiple trips to the store in order to keep their average order down (diabolical!), it’s simply not true that grocery prices are already on the upswing.

But it could happen soon. As the WSJ points out today, the prices for some things are rising faster, and inflation is already much worse in places like China, where there’s not a bad economy to weigh against price increases.

I’ve written before about good and bad inflation fighters. But today, I want to write specifically about how rising interest rates could affect stock prices.

Starting with a risk-free rate of return

If you wanted there to be no chance for your investment to lose money, where would you put it? FDIC-insured bank accounts come to mind, but you’d do slightly better by investing in 10-year Treasury bonds, which yield about 3.6% a year right now. Don’t get me wrong. If interest rates rose while you had your bond, the price would go down in the interim. But as long as you held onto them for the entire 10 years, you couldn’t lose a dime unless the federal government were to default.

That’s about as close to risk-free as investors can get right now. And that means that anything they invest in that carries more risk needs to pay out more than 3.6% a year to make sense as an investment.

The bonds of Warren Buffett’s Berkshire Hathaway, for example, would seem to be extremely safe. It’s a big, established company that’s generating a lot of cash. But the yield of a Berkshire bond I’m looking at that matures in 2021 is 4.2%. That means that as safe as Berkshire is, investors want another 0.6 percentage points to take on the ever-so-slight risk that Berkshire goes belly-up before the bond matures.

As you can imagine, once you start getting down to auto companies, those bond yields start to get really high.

What it means for stocks

Stocks also have a yield, though personal finance magazines like to make it appear more complicated than it actually is. The “price-to-earnings” ratio that you read about all the time is really just an earnings yield in reverse. A stock with a P/E of 15, for example, has an earnings yield of 6.7% (1 divided by 15).

Since stocks are more risky than bonds, investors want to pay a price on a company’s stock that reflects the additional risk they have to take on. The price-to-earnings ratio of Berkshire Hathaway, for example is 17.6, which translates into an earnings yield of about 5.7%. (Admittedly, a P/E isn’t the best way to evaluate a holding company like Berkshire.)

So, what happens when the interest rates on Treasury bonds rise? Let’s say the interest rate on a 10-year Treasury bond went to 10%, as it was in the early 1980s.

An investor could earn 10%, while taking no risk, by buying Treasury bonds. So if he considered buying a stock, which carries a lot more risk, instead, he’d want to get a yield that’s better than that.

The earnings yield of the S&P 500 right now is about 4.3% (which is a P/E of about 23). So to get even close to the 10% yield of a Treasury bond, you’d need stock prices to fall by more than half.

In reality, the drop would be much less sharp—earnings would rise, too. But P/E compression, as the phenomenon I just described is called, is a very real fear that investors haven’t had to face for 20 years, since during that time bond rates kept dropping.

Long story short…

If investors fear inflation, and start to demand higher yields from Treasury bonds, that will mean that stock prices will have to make a corresponding drop, all else being equal. Stocks have benefited from a 20-year or so long-term drop in Treasury yields. But that party’s over.

Is there anything you can do to protect yourself from it? Not really. You could choose stocks that already have low P/Es, with the idea that those prices won’t compress as much when interest rates rise. However, buying individual stocks carries so many other risks, that it’s probably not worth your time, effort, or emotional fortitude to go through all that.

It’s just one of those things that you should save more to prepare for and to understand once it does start to happen. This deficit monster is probably going to extend its tentacles into more aspects of our finances than we can even conceive of.

I, for one, am hoarding piles and piles of gold bullion in an undisclosed location. So when Zimbabwe-like inflation causes food riots, I can…eat it…or something.

It’s getting better, but not for everybody.

By haves and have nots, I don’t mean the wealthy and poor. I mean those who have the right skills and the right jobs and those who don’t.

I’m not really one to make predictions most of the time. When I do, they’re often laughably false. But there’s been a trend emerging in today’s job market that most economists think will continue, and it’s something that you really need to pay attention to if you’re just starting out your career or are still in school. (Those of us who are midcareer are screwed. Kidding! Kind of.)

For the first half of this year, you’re probably going to see a lot of news about how things are getting better in the job market, how employers have more job openings, and how hiring in some sectors (Hello, software engineering!) is going crazy. If you’re outside of those sectors (Hello, construction workers!) the market’s going to feel just as bad as ever. Maybe even worse.

The phenomenon is called structural unemployment. It’s a different cat from the “cyclical unemployment” most economists hope we’re in. In a normal job cycle, the job market comes and goes with the regular business cycle. So things are bad now, but as the economy improves, companies hire more and unemployment goes down.

However, it’s possible that the cycle could be broken for now. That’s not because the economy’s not improving. It is. It’s because the kinds of jobs that employers need to hire for aren’t the kinds of unemployed people who are out there today.

Think about it. One of the sectors that’s seen the largest rise in unemployment is the construction industry. According to the Bureau of Labor Statistics, construction suffered from 18.8% unemployment in November (around 6.9 million worked in construction at the time). In November 2007, that rate was only 6.2% with 9.6 million doing construction work.

Let’s say all the jobs that the U.S. economy creates this year are in construction. Many economists expect the U.S. to create around 200,000 jobs per month this year. That adds up to 2.4 million in 2011. Even in that ridiculously positive scenario for the construction industry, their employment level still wouldn’t be back to where it was in 2007.

Now think of the new openings you’re seeing today. The housing boom hasn’t exactly returned, right? Instead, we’re seeing competition heating up in the technology and health care markets, which aren’t exactly the kinds of professions you can take a former carpenter and plop him into.

So far, I’ve been playing around with extremes, but obviously this matters when you’re deciding on what skill sets to learn going forward. Like I said, my crystal ball can at times be, um, defective, but here are a couple trends I’m pretty confident of.

For the love of God, go to college.

Much was written last year about how college degrees have less value than they used to. Something about how too many people are getting college degrees and too many people are majoring in useless stuff.

The thing is, the near ubiquity of college grads nowadays isn’t making the degree needless, it’s making it indispensible.

Seriously, this is not meant to be a knock on executive assistants. But there was one day when you didn’t need a bachelor’s degree to answer phones, screen calls, know your boss’s whereabouts, and, you know, fulfill his needs before he needs them.

Now, “B.A. required” is right on the job description. My favorite/saddest link I stumbled upon while researching this post was somebody asking if he or she needed a Master’s degree to become an executive assistant.

And it’s not even that employers actually think jobs that can be learned quick need college degrees. It’s that employers are desperately searching for some sort of filtering mechanism to bring the thousands of resumes they receive for every opening down to something manageable to look at.

Ex-con? Gone (despite sometimes being illegal, by the way). Unemployed? Gone. Bad credit? Gone. And requiring all of your applicants to have a college degree is just one more filter that allows a manager to bring his pile of applications down to something he can read in a manageable time frame.

How does that bear out in unemployment? The difference between the unemployment rate for those with a bachelor’s degree and up and those with just a high school diploma in November 2007 was 2.3 percentage points. The difference in November 2010 was 4.8 percentage points.

In fact, the unemployment rate for those 25 and up with at least a Bachelor’s degree was only 4.8% in November. That’s more than twice as bad as it was a few years ago, but that’s not the dire straights suggested by the overall 9.8% rate.

You’re not a profession. You’re a set of skills.

I’ve always found it depressing that “what do you do” is often the second question at parties, after “what’s your name.” Not only is it bad for that old, work-life balance, but it’s also a bad way to think about your career track.

How about we break that mindset? I’ll start.

I’m Pop. I’m not going to tell you my profession, and most of you who have guessed have been incorrect. Several of you have guessed that I’m Ben Bernanke. In fact, someone actually wrote this up in a college paper, which I won’t link to because I know how it feels to be embarrassed by mistakes. But I think I’m pretty good at writing, math, and turning complex subjects into something everyday people can understand. I (just recently) have gained basic web publishing and marketing knowledge. And I think I have a decent eye for catchy design.

Ok, so what profession am I? No idea, right? That’s the point. I could be a number of things. I could write technical manuals. I could be in marketing for an engineering company. I could be a teacher.

Those are all options because I’m not thinking of myself as “locked in” to one career track that one day could die, even if popular now. You know, construction managers used to have a pretty good gig.

I’m glad that I have several vehicles in my life that keep me learning, and with stuff like this blog, I have something to actually show employers I can do if I ever did need to find a new job. That’s a good feeling.

Now let’s take a hypothetical person in a job that’s “good” now, but who doesn’t keep learning new skills.

Let’s make him a software engineer and say he works for an investment bank maintaining their old, internal computer programs. At one time, he needed to know cutting edge programming languages, but he’s spent 10 years at this company, learning the ins and outs of a decades old system built on an ancient language.

Even though he’s nominally a “software engineer”, how much do you think that intricate knowledge of “proprietary computer system that no one uses” is going to help him on his resume? Almost none.

That’s one of the reasons why programmers are so cognizant of finding jobs that let them deal in the latest languages. It makes them more marketable if they ever do need to look for something else.

So before you’re in need of a new job, take an honest inventory of your skills to assess what you could do. Trust me, those construction guys are regretting that “construction manager” is the only thing they can think of to type into Monster.com.

Anyway, just some job thoughts to start off the New Year. Thanks so much for the feedback on the last post. I’ll hopefully come up with a more comprehensive survey sometime in the next couple weeks. Happy New Year!

If you have debt, inflation is actually good for you.

Americans hate inflation. Past studies have shown that our happiness is inversely related to how high the inflation rate is. Yale economist Robert Shiller, in a study of Americans, Germans, and Brazilians, found that non-economists almost universally believe that inflation lowers their standard of living.

Even though most economists predict that wages should keep up with inflation, non-economists believe in a “sticky wage” model, in which wages don’t rise even as prices do.

Of course, retirees, the unemployed, and anybody else relying on a fixed income should rightly be fearful of inflation, as it erodes the value of their savings. On the other hand, people with debt should be pretty happy if inflation strikes. While their wages rise with inflation, their debt stays about the same, making it easier to pay it off.

That’s also what some investors think will be the story of the U.S. government and its own debt. While raising taxes is almost universally despised by the public and politicians, inflation is a “hidden tax”.

Rather than pay its debt by taking money out of your pocket in a direct way, the government can print more dollars to pay its debt. Some investors and economists have gone so far as to say we need high inflation to get out from under trillions in dollars of debt.

First, the big disclaimer: Right now, we’re much closer to deflation than inflation—a much scarier problem that marked the Great Depression. I’ve written before about inflation-fighting tools, but I think it’s worth taking a look at what rapid inflation might actually look like for your personal finances.

For young earners, inflation might not be so bad.

As I wrote before, for people still toward the beginning of their earning years, rapid inflation shouldn’t have a large impact on their standard of living. Of course, this assumes that wages rise along with prices. How likely is that to happen?

In the late 1970s and early 1980s, inflation hit double digits. This is why some of you 30-year olds have parents who remember mortgages with 15% interest rates.

But here’s the thing, during those high inflation years, people also got outsized raises. The nominal (not inflation-adjusted) median income rose almost 8% between 1979 and 1980. This didn’t keep up with inflation—the real (inflation-adjusted) median wage fell 3%. But it wasn’t nearly as bad as a 14% inflation rate would suggest. By 1986, wages had caught up with inflation, and people were in just as good a shape as they were in 1979.

So maybe it’s good to say that wages are “kind of” sticky. It takes a little time for corporations to pass off high prices to their employees. It’s certainly not a permanent damper on standards of living though.

For those with big nest eggs, it’s a problem.

That is, if your savings aren’t keeping up with inflation.

Even though earners should theoretically get wage increases as their employers pass on gains from high prices, those living off savings don’t get that benefit. Instead with a 10% inflation rate, their $1 million nest egg suddenly has the spending power of $900,000—and so on, as inflation continues every year.

Of course, your investments are supposed to try to keep up with that trend. But in periods of especially high inflation, stocks have performed pretty poorly. It’s not that stock returns don’t eventually make up for inflation. It just takes a while.

Bonds do even worse. When interest rates rise, the value of bonds (and bond mutual funds) can drop precipitously. To see your exposure to this, you can take a look at your bond funds’ “average duration”. The Vanguard Total Bond Market Index Fund, for example, has an average duration of 4.3 years. This, roughly, means that for every 1% increase in interest rates, the fund’s value will drop 4.3%.

So if interest rates rose to the 14% or 15% that we saw in the late 1970s, the fund would theoretically lose more than half its value. (In reality, with extremely large swings in interest rates, durations are less precise, but suffice it to say, the fund price would drop by a lot.)

The price of gold—the inflation/disaster hedge du jour—has been more mixed in times of inflation. A lot of its rise happens in anticipation of inflation. The bottom line is that the price of gold, at $1,300 an ounce is still below its inflation-adjusted price in 1980 ($2,251). Not exactly a perfect inflation hedge.

All this is to say that savers don’t have many options. If they had the foresight to buy TIPS, they might be protected, but otherwise, a huge portion of their savings is thrown onto shaky ground.

Debtors should rejoice.

It’s not just the U.S. government that sees its debt devalued by the arrival of high inflation. Regular old schmoes with high debt also benefit.

Let’s say you have $300,000 in mortgage debt with a 6% fixed interest rate. If inflation skyrockets, and interest rates rise to 10%, your wages should theoretically keep up within a couple years. Suddenly your mortgage payment, which stays at about $1,800, look much less daunting.

That led John Paulson, a prominent hedge fund investor who made billions off the financial crisis, to tell members of the University Club in New York to run out and buy houses. Writes the Wall Street Journal: “If you don’t own a home, buy one,” he reportedly said. “If you own one home, buy another one, and if you own two homes buy a third and lend your relatives the money to buy a home.”

A lot more can go on behind the scenes that makes incredibly high inflation bad for the economy as a whole. If the U.S. went through a period of huge inflation, some countries might decide not to lend to the U.S. as liberally as they have in the past. But on the personal finance front, the bottom line is that we shouldn’t think of inflation as a universally bad phenomenon, and depending on your situation, it might actually benefit you in ways you might not have considered.

After 10 years, our incomes have gone nowhere.

Much has been written about the lost decade for stocks. Right now, the S&P 500 is at 1,125. Its high in September 2000 was 1520. That’s a sad stretch.

But there’s another lost decade that was even more painful. And for those of you who are just starting out your careers, this one was a hell of a lot more important than the S&P 500′s storm. According to a recent Census report, between 2000 and 2009, the inflation-adjusted median income of American households dropped 4.8%. (Hat tip to the WSJ.)

The poverty rate is also the highest since 1994, and the number of people in poverty is the highest in more than 50 years (the U.S. population has grown by a lot).

I hope none of you graduated during this awful period or are about to graduate. If you did, sit down while you read this. The starting salary for people graduating during this recession will be, on average, 17.5% lower than that of comparable peers graduating in better labor markets, according to a study by a Yale School of Management professor. The effect of their lower wages will likely persist for 17 years and cost them $70,000 in earnings over the next decade.

Few economists predict the labor market will get much better in the next few years. So if you’re between the ages of 19 and 24, you’re at risk of your earnings being permanently crimped.

A 1 percentage point increase in unemployment means a 6% to 7% drop in starting wages.

That’s one of the conclusions from that Yale paper, written by Lisa Kahn. She measured that by looking at the 1979 National Longitudinal Survey of Youth. Labor Dept. surveyors interviewed a group of Americans between the ages of 14 and 22 in 1979 and have been tracking their progress ever since. Kahn was able to see how the labor market disruption of the 1980s impacted the teens’ long-term performance.

In doing so, Kahn also found that graduates in a bad economy have a hard time shifting to “optimum” jobs when the labor market improves, which explains the lasting negative wage impact. Not surprisingly, recession grads are also more likely to get a post-graduate education.

The news ain’t so great for older workers either. America has historically been a place where job transitions were relatively frequent, but job bouncebacks were relatively quick. (Europe is the opposite, by the way.)

This time around, the long-term unemployed—those without a job for 27 weeks or longer—make up half of all unemployed people. The only other time the percentage of the unemployed who were long-term even cracked 25% was in the 1980s. Those of you who did have a job might have been at one of the 37% of companies that didn’t give raises in 2009.

What to do about it

At times, a booming economy can keep all workers afloat, even the ones who are just sliding by in jobs that don’t fit their skill sets. Those times are over, and it doesn’t look like they’re coming back soon. You don’t want to still be sitting behind a desk at age 70, thinking about how the Great Recession permanently stunted your career trajectory. So how do you mitigate the impact of a dismal economy on your long-term financial future?

1. A company never freezes the wages of its top workers.

The corporate message coming from your company might be that no one is getting cost-of-living increases this year. But the fact of the matter is, pay-for-performance programs are still going stronge. According to Hewitt Associates, as a percentage of total wages, variable pay (that is, pay-for-performance programs) reached 12% last year, which is even higher than it was in 2006. Be good at what you do. Ask to be compensated for it. And companies will give it to you.

2. Sometimes you need to change jobs to get a raise.

I didn’t see this addressed in Kahn’s study, but I bet one of the reasons it takes the wages of recession grads so long to recover is that they stay in jobs for an extended period of time. Even merit increases are based on your current wage.

Someone who starts at $50,000 during a recession will need four years of 5% merit raises to get to the $60,000 starting salary he or she would have gotten if he had been hired during good times. That inequity leaves the strong possibility of the underperforming 2006 hire being paid significantly more than the strong 2009 hire.

But companies will pay market-rate for top-performing new hires, no matter what they were paid at their previous jobs. Hopefully, your current company is concerned about losing you and will update your wages to reflect that. If not, changing jobs might be the way to break the wage hex of the recession.

3. If you’re young, recognize a dying industry today.

Sometimes I give the Bureau of Labor Statistics a hard time for trying to predict which jobs will have the most growth a decade from now. The highest growth professions will no doubt be in industries we haven’t conceived of yet.

It’s easier to recognize an industry or company in decline or going through a period of disruption. The media, automakers, airlines, the USPS, pretty much anything that can be outsourced…the list goes on. And yet, thousands of graduates enter those industries every year because they’ve been told to do what they love.

“Do what you love” is smart advice. But, if you’re a normal human, you probably have many interests. Pick the interest that offers the brightest future. Or if you pick an industry in disruption, make sure you’re entering it to lead the innovation rather than to be along for the ride. At the end of the day, we’re at our happiest when we’re successful.

This post was an editor’s pick at the Carnival of Personal Finance hosted by Investor Junkie. Thanks Investor Junkie!

What you don’t know can cost you money.

First, thanks to everyone who’s filled out my reader survey so far. I really appreciate the response. Since I’m all about incentives, I’m randomly picking two respondents who’ll win $10 Amazon.com gift cards. So if you haven’t filled it out yet, what are you waiting for?

So a few days ago, the SEC brought its first huge case against a major investment bank (though not technically an i-bank anymore). At the center of the controversy: Whether Goldman Sachs fraudulently misled one investor into thinking that another investor was betting the same way. It turned out that investor #2 was actually betting the opposite way, and investor #1 ended up losing nearly $1 billion.

That’s a gross simplification, and I’m not going to get into what I think the implications are for Goldman and everyone else involved. But the case does highlight one, immutable fact of the markets that applies to every economic decision you’ll ever make: Markets aren’t efficient unless everyone has all the information.

In the Goldman case, the SEC is alleging that had investor #1 known investor #2 wasn’t on its side, investor #1 would have never taken the bet. It’s kind of like how I would never trade players with John Schuerholz if I were a general manager in baseball. Schuerholz is so good at spotting talent that if he’s on the other side of the trade, you just know he’s getting the better end of the deal. (Sorry for the baseball analogy to non-watchers).

But the fact of the matter is, in almost every decision you make, your decision will be governed by how good the information you receive is. And most of the time, you won’t know everything.

Another strike against the “efficient markets hypothesis.”

It almost isn’t fair to beat up on this sucker now. I don’t think very many people believe in efficient markets anymore, save its economist creator, who will no doubt cling to his legacy until the day he dies. The theory basically says that market prices accurately reflect all known information about companies’ fundamentals. In other words, you can’t get a good deal on, say, Home Depot stock, because if there was any deal to be had, the market would have snapped it up already.

Most of the time, I rag on the efficient markets hypothesis because of behavioral issues. That is, investors don’t act rationally when they’re caught up in a bubble or frightened by a crash. So, you’ll get Pets.com stock going to incredible heights in 2000, even though there’s no apparent reason investors should be willing to pay so much for a profitless company.

But the Goldman case highlights the other problem: the informational imbalance. Goldman and investor #2 knew something that investor #1 didn’t. The SEC says that tricked investor #1 into making a bad bet.

That doesn’t happen often. Most of the market’s biggest investors do a ton of research before placing millions at stake. So unless someone’s breaking the law, they should know everything relevant there is to know before taking a position. However, that’s not always the case. Plenty of company weaknesses have been found out by intensive research of public documents. It’s not that investors didn’t think the info was relevant before the big, disastrous news story came out. It’s that they didn’t know the information was there.

Informational inefficiencies in everything you do.

You’re not immune to the phenomenon. Here are three big spots where you face an informational disadvantage.

The Markets

I won’t harp on this one too much. Mutual fund managers, hedge fund managers, investment bankers—all these guys spend thousands of hours per week trying to find mispriced investments to make a profit. You probably spend no time. If you’re smart, you just buy index funds and don’t worry about the mispricing.

The biggest mistake I see novice investors make is to go from spending no time on their investments to spending a couple hours per week on their investments and trying their hands at picking individual stocks. Because they spent no time on it before, researching a few companies for a few hours per week seems like a lot. But their informational disadvantage compared to a professional is still huge. Sure, they might get lucky or not suffer from a behavioral bias that’s hurting the professional, but I wouldn’t want to make a living doing that.

The worst part is that the underinformed investors actually have more confidence than the completely informed investors. A few Cornell school of management professors ran an experiment where one set of subjects got one point of data with which to make investment decisions and a second set got three points of data. The lesser informed set actually made investment decisions with more confidence. Until, that is, the professors let them know that there was a second set out there with more complete information.

So consider this your wake-up call: There are other investors out there who have WAY more information than you.

Your Career

Unless you work in public office (and perhaps even then), you don’t know what your coworkers make. Unless you get multiple offers from similar companies (and perhaps even then), you don’t know if you’re getting over or underpaid. For some reason, at some point in American history, employees started to equate their salaries with their self-worth. And because of that, everyone got uncomfortable talking about pay. And employers have loved that informational disadvantage ever since.

Luckily, with the advent of the internet, there are a few ways you can start to balance it out. First of all, if you are a government employee, what are you waiting for? It shouldn’t take much Googling to find a searchable database of your coworkers’ salaries. Here’s one for New Jersey. Unfortunately, the one place where salary info is transparent is probably the place where it’s the most regulated—so good luck doing something with that information.

PayScale.com is another tool that can give you general salary information based on your position, location, and experience. Visiting the site will let you get information based on your specific situation (it costs money), but here’s a little widget that will at least let you get a general sense based on a couple variables.

But perhaps my favorite example of employees striking back at salary misinformation is at GlassDoor.com, which allows you to anonymously post salaries on specific companies. So I can see, for example, that a software engineer at Google makes $98,924 on average, where a software engineer at Yahoo makes $101,878. The info might work even better at small companies (I’m sure software engineers at both Yahoo and Google do drastically different things), though you start to sacrifice anonymity the smaller you get.

Your purchases

Of the three I’m listing, this one is probably the weakest. That’s because on most products, stores freely advertise their prices in the hopes of getting you in the door. You probably know of PriceGrabber.com, Shopzilla.com, and any number of other price aggregators.

Instead, retailers get the advantage by selling baskets of products or upselling you on a service you don’t need. Comparison shopping for a cell phone provider, for example, gets confusing when you don’t know if you need the plan that charges a daily fee for access and $0.10 per minute rates or the one that has no access fee and $0.25 per minute rates. (BillShrink.com has a great tool that can analyze your usage though.) You’ll comparison shop on the flat-screen TV, but will arrive at the store having no idea that Best Buy’s biggest margins are on the ancillary products, like HDMI cables. Best Buy’s CEO famously called customers who buy baskets of goods “angels” for helping his company make money. (The guys who bought just the discounted TV were labeled demons.)

I guess self control is the best defense against this kind of edge. But if that Cornell study holds water, an awareness of your informational deficit should at least make you a little more cautious when making decisions.

Is the man in the banner controlling your mind?

This post is partly about the Federal Reserve. I didn’t put that in the headline, because I at least wanted you to get to the first line of the story before falling asleep. By now, I hope you’re committed enough that you’ll read on. That’s called social engineering. And now I’m mixing a poli sci lesson with an economics one. That’s like trying to mask the taste of peas with brussels sprouts. Sorry!

So anyway, every month and a half you probably see a news headline that says something like this: “Fed: Low rates will continue.” I’m guessing that you only have a vague idea of how that’s relevant to your life. Here’s an attempt to explain it.

The announcements are as much about suggestion as they are about action.

Like a really bad boxer, the Fed telegraphs any moves it’s planning to make far in advance. That gives the market time to anticipate a change before having to feel its effects. It’s kind of the same reason pilots tell you to brace yourself for impact before the plane goes down. It softens the blow, if only a little.

That’s why investors spend as much time parsing the language of every Federal Reserve statement as they do caring about what the Fed actually did, and why even a slight word-change can send the stock market soaring or reeling. The Fed doesn’t want to come out and say what it’s going to do, but to suggest what it’s probably going to do. That way, it keeps investors from putting all their chips on one outcome, which would be disastrous for many if the Fed changed paths.

So when Fed members publicly disagree, there might be social engineering at play.

I’m not saying this is happening for sure, but I wouldn’t be the first one to say it. Most of the time, Fed members disagree in private, but keep a united front in public. In the last year or so, several Fed board members have come out and expressed their opposition to the Fed’s official decision.

This could just be a product of the unusual economic environment we’re in. But it could also be a calculated effort to keep inflation fearers happy or to strike fear in the hearts of hedge funds making huge bets about how the Fed might raise rates. Instead of a unanimous board declaring what it’s going to do, you have a divided board that seems like it could tilt the other way sometime soon.

I wouldn’t call this as much a conspiracy theory as a guess that behavioral economics is becoming much more an accepted part of macroeconomic decision making. What you make people feel is just as important as what you make people think.

That said, there’s only one way rates can go: up.

That’s not technically true. The Swedish Riksbank is actually charging a negative interest rate on bank deposits—a tactic the Bank of Japan didn’t even stoop to during its ongoing financial crisis. But so far, that’s not a path the Fed has seemed willing to go down.

Many economists expect the Fed to change its language (i.e. telegraph a rate hike) sometime during the summer and actually raise rates at the end of the year or early next year if unemployment falls. Assuming that happens, what would that mean to you?

For one, it would signal that the Fed feels we’ve pretty much clawed our way out of the recession and aren’t in great danger of falling back in. Ben Bernanke has written papers warning of the danger of cutting off economic stimulus too early. So either he and the governors are satisfied, or some political pressure has fallen on them to move rates against their good judgment.

But that signal will probably have a negligible impact on your portfolio compared to the signal that money won’t be as easy to come by in the future. At higher rates, banks have less incentive to lend money to each other, which means less money is available to borrow and invest. That can have the effect of slowing the economy down, which lowers the premium stock investors are willing to pay for a company’s growth prospects. Of course, in tandem with a Fed announcement, any number of other things can be happening. So you won’t always see a down day in the market when a rate hike happens.

And the same goes for mortgage rates. Mortgage rates are affected by the supply of money in the economy, but there are lots of things that can drive them up or down, including inflation expectations and other government stimulus programs designed to influence rates. That’s why you won’t see a great correlation between Federal Funds Rate moves and mortgage rates.

You will, however, see a pretty big correlation between the Federal Funds Rate and Treasury rates. Generally, when the Fed Funds rate drops, so do bond rates and vice versa. For you, that means a Fed move could bring down the value of your bond portfolio (bond prices move down when interest rates go up), and that’s why many investors have recommended that you tilt your portfolio to short-term bonds that won’t be as heavily impacted.

Anyway, while the Fed didn’t change its rates or its language this time, I hope this helps you digest why your portfolio does what it does when the Fed makes a change.

Sometimes we forget we just lived through history.

Or I should say, sometimes we forget we’re living through it now. I read a post on Get Rich Slowly a few days ago that reminded me of that. Twenty years from now, kids are going to ask us what it was like to live through one of the worst recessions in American history, just the same way I asked my parents what it was like to live during desegregation and they asked their parents how it felt to fight a World War.

One time, at a circus, the performers brought me out of the audience to join in their crazy antics. I’m told I did really well. But looking back at the event, I really had no idea what was going on. Clowns danced behind me. Bright lights shone in my face. I knew the crowd was there but couldn’t see it. A performer whispered instructions in my ear seconds before I had to follow them. I was so focused on performing, that I took very little of it in.

I kind of feel like that now. I have almost no perspective on the recession and what it’s meant to my life. But I bet that very soon, we’re going to realize that we’ve lived through extraordinary times. And maybe when we’re all old and retired, our grandkids are going to want to know what it was like to be here, right now.

A few days ago, in a comment on that Get Rich Slowly post, I said that I didn’t think I’d have anything interesting to say. So far, at least, I’ve been really lucky and haven’t been directly impacted by it. However, I don’t think that’s going to be a good enough answer. This is a first draft of history if there ever was one, but this is what I think I’ll tell them.

 
Nobody thought it was their fault. But it was everyone’s fault.

No one admitted that they helped cause the recession. And if they did, they only did it in the context of laying blame on someone else. We heard bankers say, “Yes, we granted mortgages to borrowers who couldn’t afford it, but they chose to take on that debt.” We heard foreclosure victims say, “Yes, I took a mortgage I couldn’t afford, but I figured they wouldn’t give me a loan if I couldn’t handle it.”

But we all contributed to the crisis. Our family, too. Though they could afford it, your grandparents bought a house that was clearly overpriced. I didn’t bat an eyelash when the appraiser just happened to hit the exact value your grandparents needed to get the mortgage approved. At the time, I shrugged it off as standard practice. If an appraiser did that nowadays, we’d call it fraud.

The next time a home on their street was for sale, the sellers probably looked at how high a price my parents paid and tried to one-up it. And so the housing bubble rolled on.

That was just our family’s small contribution. The kindling for the Great Recession was a million little missteps stacked on top of one another. So when something finally did create a spark, it all went up in flames.

 
There were no soup lines. The worst of the pain stayed hidden. But it was there.

For me, it didn’t seem so bad. My investments were cut in half, but I knew I had decades until I had to worry about retiring. I didn’t see soup lines on the street like your great grandparents did or scores of newly homeless people crowding into tent cities.

But there were little signs of the pain all around us. Every once in a while, I’d drive down a street and wonder why I hadn’t seen a car in a particular driveway for a while. A few days later, I’d see dozens of garbage bags piled in front of the house. They held the family’s belongings. I’m not sure if the police would do that or if the bank sent a crew to clean it out. But that meant we had one less neighbor.

I didn’t lose my job, though I was always in fear of losing it. I did know several people who lost their jobs. Even if they didn’t have an emergency fund, most of them had families or friends to help. They didn’t starve. But the real toll was emotional. They’d start a job search with optimism. A few months later they’d cry at night. For so long, we measured our self-worth by the strength of our careers. Not having one felt like a personal failure.

 
We went from feeling like we could control our own destinies to feeling like our destinies controlled us.

For a long time, politicians and economists wondered why a certain strata of poor, lower-class Americans strongly opposed taxes on the rich. Our best guess was that even though they were poor now, they believed that some day, if they worked hard, they could be among the ranks of the wealthy. America offered that kind of upward mobility.

But after the crisis started, many of us stopped believing that hard work equated to increased wealth. It seemed much more random. Workers near retirement saw their investments drop by 25% or more. So they had to work for several more years even though they followed all the standard financial advice. The advice wasn’t wrong. It just didn’t prepare us for the outside possibility that something so bad could happen.

 
What I hope I can say:

We started to see wealth as a way to make us happy, not as an end in and of itself. And we realized we were more than satisfied with what we already had.

We stopped blaming each other for what had already happened, and instead worked together to make it better.

I started an award-winning blog that now has more than 20 million subscribers and launched the career of a generation-defining pop artist (just kidding).

What would you say? What are you hoping you can say?