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?