This is an incredibly inspiring speech by Robert F. Kennedy on the use of the Gross Domestic Product (GDP) to measure economic well-being in the United States of America. Obviously, GDP isn't something we should abandon because it provides a very useful metric to see how we're doing relative to the past and to see how we're doing relative to other nations, but it doesn't come close to painting a complete picture for various reasons, one of them being described in a beautifully poetic way by Robert F. Kennedy in this video.
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Soccer (or Football in most of the world) has become a great demonstration of perverse incentives. If you haven't watched the video above before reading this, take a moment to watch it now. When economists say that incentives are perverse they mean that they are "off" in some way, not that they are perverted in the sexual sense of the word.
Incentives matter a lot. You may want people to behave a certain way, but what really will affect behavior is incentives. Incentives are incredibly powerful and economists understand this fact much more than most other individuals. Misunderstanding the importance of incentives causes individuals and organizations a lot of headaches and confusion.
One example of perverse incentives is the diving that now occurs in soccer throughout the world. I'm fairly young and I've grown up in an increasingly diving-prone soccer environment, but I still understand that diving is absolutely ridiculous. Few soccer players don't dive today and I deeply respect them, but are the rest of the players who consistently dive just crazy for engaging in such a ridiculous and degrading act?
Obviously most soccer players don't engage in the absolute ridiculousness demonstrated in the above video, but in my opinion, diving is degrading and pathetic if you dive to get a penalty kick. Diving to prevent injury or to minimize the chances of being injured is a completely different story. Still, soccer players often dive at what appears to be a slight touch. Soccer players dive and send their bodies on trajectories that in no way match the ballistic trajectory that would be expected from the initial contact. Most soccer fans can tell that these players are diving and playacting. Then why do these professional athletes engage in such a ridiculous act? The answer is incentives. Incentives align in such a way to make such action profitable despite the costs (which I believe are not insignificant).
The incentives for diving and playacting should be fairly obvious. Diving increases the chances that a foul will be called, benefiting the player’s team. Over time, as more people do this sort of thing, the pull to do it also increases because if everyone is doing it, you are penalized in a way if you don’t do it. It’s the same thing with steroids. If everyone in a sport takes steroids and you are the only one that doesn't do it, you are deeply penalized because you will likely always under-perform. That explains in part why athletes often take steroids despite the fact that taking them is a foolish and dangerous act.
The costs of diving are not insignificant in my opinion, however. Diving is a bit ridiculous and degrading when overdone. A soccer player should epitomize sportsmanship and strength, not be always on the lookout for an opportunity to fool the referee. This is degrading to the soccer player personally and degrading to the sport generally. Another cost is just looking foolish, but that cost has greatly decreased because more and more people are engaging in this behavior.
So, we have a situation in which the benefits of the action seem to outweigh the costs. Over the last few decades this difference has increased greatly due to the fact that more and more players engage in diving. The larger number of players engaged in diving lowers the costs because it seems less ridiculous and degrading. The benefits seem to have remained the same for the most part.
But what did I mean when I said there were perverse incentives? Why are the incentives to dive perverse? Let’s begin with a general definition of perverse incentives.
A perverse incentive is an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers. Perverse incentives are a type of unintended consequences. (Wikipedia)
Can you think of other perverse incentives? How about the perverse incentives to lend too easily during the last decade. Those perverse incentives brought on the financial crisis and the Great Recession? Easier lending regulations and practices were created to promote a noble cause, increased home ownership. These easier regulations, combined with mortgage securitization (where originators of loans didn't really hold on to their loans but instead sold them off, often packaged with other loans), created a situation with perverse incentives, ultimately leading to a very unpleasant global financial crisis.
We can learn, from both diving in soccer and from other situations where perverse incentives exist, that incentives matter a lot. Noble causes may be espoused and rules may be created, but the wise economist knows that if you really want to predict how people are going to act, looking at the incentive structure that exists is one of the best ways to begin analysis. Perverse incentives and unintended consequences are real things that can lead to sub-optimal outcomes and everyone from parents to teachers to various rule-makers to policy-makers and to law-creators should take care to make sure that incentives line up in the right ways lest unintended consequences and perverse incentives bring on disaster.
I learned about this video while I was an undergraduate pursuing my degree in economics. Learning economics and being a genuine economics nerd, I fell in love with the video and the concept. I remember thinking that it was amazing that someone or some group would make a video like this. I thought that the ideas presented were important, but that the subject matter was fairly narrow and that only a small audience would really appreciate this video. I was surprised, therefore, that the production quality of this video was so high.
I later found out that the video was made by a group called ECONSTORIES and that the host of my favorite podcast, Russ Roberts, was a big part of the making of this video. Russ Roberts has a weekly podcast called EconTalk that I listen to every week and highly recommend. You can learn more about this great podcast here.
The Keynes vs. Hayek rap video is a short music video with characters playing the roles of economists John Maynard Keynes and Friedrich Hayek. John Maynard Keynes is portrayed as a confident, self-assured, slightly wild, and popular man while Friedrich Hayek is portrayed as more cautious, attempting to obtain recognition, and a lot less popular. This parallels the real world as a lot of a people know of British economist John Maynard Keynes, while in my experience it seems that only economists and policy makers have some knowledge of the Austrian economist Friedrich Hayek.
Each economist describes his world-view and economic philosophy in the music video in simple and easy to understand ways. Being an economist I understood everything, but I feel that the video will not have the same effect on a non-economist. It's easy to understand, but it seems to me that a non-economist might not understand certain concepts and terms (eg. Keynes’s “animal spirits”). Keynes describes his top-down stimulus spending approach and how that approach can help reenergize the economy when there is a general glut. Hayek argues that such a top-down approach only leads to perverse incentives and ignores the importance of savings to changes in the economy and increases in productivity, which Hayek believes is the true path to prosperity. Hayek believes that the government intervention that Keynes argues for creates boom and bust cycles.
The video was created by ECONSTORIES, a media channel dedicated to exploring the world of economics with visual storytelling and entertainment. You can learn more about them and watch other very interesting and informative videos here.
"The ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist."
The conventional wisdom is that diversification is an integral part of successful investing. Although the idea of diversification has been around for centuries (and is mentioned in both the Bible and the Talmud), the modern idea of financial diversification can be attributed to the work of Nobel prize-winning economist Harry Markowitz and his Modern Portfolio Theory. We won't get technical here and we by no means will cover anything in depth, but it's a good idea to realize that too much diversification will prevent a portfolio from achieving great returns.
For most people who are not in the game to get amazing returns (who are in it to protect and grow their money at a reasonable pace), broad diversification is a great idea and will likely protect them. For those individuals who are in the game to make spectacular returns (and who should be able to tolerate more risk), diversification beyond a certain point makes them worse off. I'm not sure exactly where that point is. Some people say ten investments or stocks and some say a little more or a little less. Warren Buffett has stated that six is a good rule of thumb.
Whatever the number, the important thing to understand is that if a portfolio has too many stocks an amazing performance by a single stock gets diluted. If a stock goes up 10x (a ten bagger as Peter Lynch would call it) and it represents only 1% of your portfolio, your portfolio only goes up by 10%. The stock went up 1000% but your portfolio only went up 10%. If you want to make spectacular returns, energy must be focused on picking great businesses to invest in and discipline must be exercised to not overcrowd your portfolio.
Additionally, a part of diversification involves investing in different sectors (eg. energy, healthcare, financials, etc.). However, why would one need to invest in one hundred businesses in every sector? Wouldn't it seem wiser to invest in the best businesses in each sector?
Again, this isn't meant for individuals who dabble in the stock market, who can't tolerate the risk that comes with investing for spectacular returns, or who don't have either the time or the inclination to research businesses in an in-depth way. However, if you want to make great investing returns don't over-diversify and do your best to stay focused and disciplined on high-quality investments.
It's key to not that this entire discussion only applied to advanced and experienced investors - novice investors or investors with a moderate level of knowledge and experience should not attempt to pick individual stocks. Novice investors and moderately-experienced investors will be best served by sticking to good mutual funds and ETFs.
Check out the video below to hear a few words form world-renowned investor Warren Buffett on the topic of diversification:
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