S&P 500 down 9.1 percent

In 2000, both indexes had a decline in total return, with the
S&P 500 down 9.1 percent while the Russell 2000 was off just 3
percent. They did not move in opposite directions, but that is often
what a low correlation actually is: not a rise versus a fall, but a
much smaller rise or a much smaller decline. These different paces
in the same direction change the risk of your portfolio. That is, it
is better to have half your portfolio falling 3 percent while the rest
is dropping 9.1 percent, which translates into a decline in return
of 6.1 percent, instead of all of it plunging 9.1 percent. You might
retort that if all the portfolio were in the Russell 2000, it would
have fallen just 3 percent.

Rise substantially

In this case, the quantity supplied is the same regardless
of the price. As the elasticity rises, the supply curve gets flatter, which
shows that the quantity supplied responds more to changes in the price. At the opposite
extreme, supply is perfectly elastic. This occurs as the price elasticity of supply
approaches infinity and the supply curve becomes horizontal, meaning that
very small changes in the price lead to very large changes in the quantity supplied.
In some markets, the elasticity of supply is not constant but varies over the
supply curve. Figure 5-7 shows a typical case for an industry in which firms have
factories with a limited capacity for production. For low levels of quantity supplied,
the elasticity of supply is high, indicating that firms respond substantially to
changes in the price. In this region, firms have capacity for production that is not
being used, such as plants and equipment sitting idle for all or part of the day.
Small increases in price make it profitable for firms to begin using this idle capacity.
As the quantity supplied rises, firms begin to reach capacity. Once capacity is
fully used, increasing production further requires the construction of new plants.
To induce firms to incur this extra expense, the price must rise substantially, so
supply becomes less elastic.

Changes in the price.

The price elasticity of supply depends on the flexibility of sellers to change the
amount of the good they produce. For example, beachfront land has an inelastic
supply because it is almost impossible to produce more of it. By contrast, manufactured
goods, such as books, cars, and televisions, have elastic supplies because
the firms that produce them can run their factories longer in response to a higher
price.

Your portfolio needs

The idea is that your portfolio needs to have something that is
going up when other parts of the portfolio are going down.
Knowing that something in your portfolio is likely to go up no
matter what will make it easier for you to sleep. And diversification
can protect your portfolio from absolute routs

Suppose the government increases

Suppose the government increases the number of federal agents devoted to
the war on drugs. What happens in the market for illegal drugs? As is usual, we
answer this question in three steps. First, we consider whether the supply curve or
demand curve shifts. Second, we consider the direction of the shift. Third, we see
how the shift affects the equilibrium price and quantity

Adding Treasury bills

Adding Treasury bills, notes, and bonds and other fixed-income
securities—a completely different asset class—gives you an even
better chance of having one part of the portfolio going up while
another part is falling or just creeping higher.
When the S&P 500’s total return fell 11.9 percent in 2001,
the return from the Lehman Brothers U.S. Aggregate Index, including
Treasury securities, investment-grade corporate bonds,
and mortgages, was 8.4 percent.

WHY DID OPEC FAIL TO KEEP THE PRICE OF OIL HIGH?

Many of the most disruptive events for the world’s economies over the past several
decades have originated in the world market for oil. In the 1970s members of
the Organization of Petroleum Exporting Countries (OPEC) decided to raise the
world price of oil in order to increase their incomes. These countries accomplished
this goal by jointly reducing the amount of oil they supplied. From 1973 to 1974,
the price of oil (adjusted for overall inflation) rose more than 50 percent. Then, a
few years later, OPEC did the same thing again. The price of oil rose 14 percent in
1979, followed by 34 percent in 1980, and another 34 percent in 1981.

Total return for the S&P 500 dropped 11.9

In 2001, when the total return for the S&P 500 dropped 11.9
percent, the total return for the Russell 2000 rose 2.5 percent; in
1998, when the total return for the S&P 500 was a gain of 28.6
percent, the return for the Russell 2000 dropped 2.6 percent.1 So
when one was up the other was down. That is diversification. To
reduce risk you have to accept the fact that something in your
portfolio may not always be doing well.

world’s stock markets

The rest of the world’s stock markets, and other asset classes
like bonds and commodities, provided what investors needed to
diversify—foreign markets and other investments than stocks
that would move in the opposite direction of equities in the
United States.

Risk shortfalls

Despite these risk shortfalls, let’s not be unfair to the appetite
and learning curve of American investors. Their risk exposure
has been expanding for years, except for what appears to
be a small retreat after the stock market crash. So this means
they are going in the right direction and can adapt to taking on
more risk.

Investors can choose

To get more risk out of the bond market, investors can choose
high-yield or so-called junk bonds. These are corporate bonds
that are rated below investment grade, which means there is a
much greater chance that the company that issued them will default
on its payments of principal and interest. But these bonds
have become a popular addition to many portfolios because of
the much higher potential yields they offer compared to Treasury
securities and investment-grade corporate bonds.

Bond market

To get more risk out of the bond market, investors can choose
high-yield or so-called junk bonds. These are corporate bonds
that are rated below investment grade, which means there is a
much greater chance that the company that issued them will default
on its payments of principal and interest. But these bonds
have become a popular addition to many portfolios because of
the much higher potential yields they offer compared to Treasury
securities and investment-grade corporate bonds.

Ice government regulation

To see how price controls affect market outcomes, let’s look once again at the market
for ice cream. As we saw in Chapter 4, if ice cream is sold in a competitive market
free of government regulation, the price of ice cream adjusts to balance supply
and demand: At the equilibrium price, the quantity of ice cream that buyers want
to buy exactly equals the quantity that sellers want to sell. To be concrete, suppose
the equilibrium price is $3 per cone.
Not everyone may be happy with the outcome of this free-market process.
Let’s say the American Association of Ice Cream Eaters complains that the $3 price
is too high for everyone to enjoy a cone a day (their recommended diet). Meanwhile,
the National Organization of Ice Cream Makers complains that the $3
price—the result of “cutthroat competition”—is depressing the incomes of its
members. Each of these groups lobbies the government to pass laws that alter the
market outcome by directly controlling prices.
Of course, because buyers of any good always want a lower price while sellers
want a higher price, the interests of the two groups conflict. If the Ice Cream Eaters
are successful in their lobbying, the government imposes a legal maximum on the
price at which ice cream can be sold. Because the price is not allowed to rise above
this level, the legislated maximum is called a price ceiling. By contrast, if the Ice
Cream Makers are successful, the government imposes a legal minimum on the
price. Because the price cannot fall below this level, the legislated minimum is
called a price floor. Let us consider the effects of these policies in turn.

But what about the amount of drug-related crime

But what about the amount of drug-related crime? To answer this question,
consider the total amount that drug users pay for the drugs they buy. Because few
drug addicts are likely to break their destructive habits in response to a higher
price, it is likely that the demand for drugs is inelastic, as it is drawn in the figure.
If demand is inelastic, then an increase in price raises total revenue in the drug
market. That is, because drug interdiction raises the price of drugs proportionately
more than it reduces drug use, it raises the total amount of money that drug users
pay for drugs. Addicts who already had to steal to support their habits would
have an even greater need for quick cash. Thus, drug interdiction could increase
drug-related crime

Adjust your Investment portfolio

But you have to take a first step. Then, over time, you can
learn to adjust your portfolio, not only to take on more risk, but
also to respond to changes in the market environment.
If you are very conservative, with most of your money in
Treasury securities and money-market funds, your first move is
to shift money into investment-grade corporate bonds, which
have higher yields than Treasury securities and money-market
funds. Then you could shift some of your money into stocks, knowing
that you intend to keep it there for the long term, at least
10 years.

Total returns for stocks

To put it another way, total returns for stocks over the past
two decades are irrelevant in considering the merits of stocks for
the next two decades.
Now that we are at a level of inflation that is hovering around
2 percent and staying there is the goal of economic policy, there is
a smaller chance for an extra boost to asset valuations and aboveaverage
profits for investors.

Managers PIMCO

The money managers at PIMCO, the big bond mutual fund
company where McCulley works, are predicting that the yield on
the Treasury’s 30-year bond, which was revived by the government
in 2006, could fall below 4 percent in the next three to five
years. It was at 4.81 percent at the end of 2006. How tempting is
it to tie up your money for 30 years for an annual return of 3.5
percent? You’ll just have to look elsewhere and try a new dance
step with the risk in your portfolio.

S U P P L Y , D E M A N D , A N D G O V E R N M E N T P O L I C I E S

Here we analyze various types of government policy using only the tools of supply and demand. As you will see,the analysis yields some surprising insights. Policies often have effects that their
architects did not intend or anticipate.
We begin by considering policies that directly control prices. For example, rentcontrol
laws dictate a maximum rent that landlords may charge tenants. Minimumwage
laws dictate the lowest wage that firms may pay workers. Price controls are
sually enacted when policymakers believe that the market price of a good or service
is unfair to buyers or sellers. Yet, as we will see, these policies can generate inequities
of their own.
After our discussion of price controls, we next consider the impact of taxes.
Policymakers use taxes both to influence market outcomes and to raise revenue for
public purposes. Although the prevalence of taxes in our economy is obvious,
their effects are not. For example, when the government levies a tax on the amount
that firms pay their workers, do the firms or the workers bear the burden of the
tax? The answer is not at all clear—until we apply the powerful tools of supply
and demand.

S U P P L Y , D E M A N D

Economists have two roles. As scientists, they develop and test theories to explain
the world around them. As policy advisers, they use their theories to help change
the world for the better. The focus of the preceding two chapters has been scientific.
We have seen how supply and demand determine the price of a good and the
quantity of the good sold. We have also seen how various events shift supply and
demand and thereby change the equilibrium price and quantity.
This chapter offers our first look at policy. Here we analyze various types of
government policy using only the tools of supply and demand. As you will see,
the analysis yields some surprising insights. Policies often have effects that their
architects did not intend or anticipate

Government increases problems

Suppose the government increases the number of federal agents devoted to
the war on drugs. What happens in the market for illegal drugs? As is usual, we
answer this question in three steps. First, we consider whether the supply curve or
demand curve shifts. Second, we consider the direction of the shift. Third, we see
how the shift affects the equilibrium price and quantity.
Although the purpose of drug interdiction is to reduce drug use, its direct impact
is on the sellers of drugs rather than the buyers. When the government stops
some drugs from entering the country and arrests more smugglers, it raises the
cost of selling drugs and, therefore, reduces the quantity of drugs supplied at any
given price. The demand for drugs—the amount buyers want at any given price—
is not changed. As panel (a) of Figure 5-10 shows, interdiction shifts the supply
curve to the left from S1 to S2 and leaves the demand curve the same. The equilibrium
price of drugs rises from P1 to P2, and the equilibrium quantity falls from Q1
to Q2. The fall in the equilibrium quantity shows that drug interdiction does reduce
drug use.

Dollars problem

In dollars, this downshift in returns since the 1990s means
that a portfolio invested all in stocks would have a 8.5 percent
nominal return, which is Siegel’s 6 percent prediction for the afterinflation
return, with 2.5 percentage points of inflation added
on. It would take eight and a half years for the portfolio to double
in size. At 6.5 percent, including inflation, a much more pessimistic
assumption, the portfolio would take 11 years to double
in size.

What economists call mean reversion

One reason for this belief is what economists call mean reversion,
which says that over time the return from the stock market
will revert to its historical trend. So if you have had a period
when market performance was well above its long-term trend—
like the 18.5 percent compound annual pace from 1982 through
1999 or the 28.6 percent run from 1995 through 1999—then a
period of subtrend growth is due. This means that returns should
move below their long-term average.

Now the stock market should return to its

First, let’s take a look at expectations and reality.
The 28.6 percent compound annual rate of return for the
stock market at the end of the 1990s is a dream now.1 Those returns
were the product, in part, of a revolution in the investing
environment as the Federal Reserve, the nation’s central bank,
conquered inflation and the federal government seemed to get
sensible about its own fiscal policies, which led to an all-too-brief
period of federal budget surpluses. While the term new economy
may have fallen into disrepute, the sometimes baffling surge in
worker productivity that characterized this period was also behind
the rise in equities, as was more than 18 years of economic
growth, interrupted by just one recession.

Widely accepted equity

The ability-to-pay principle leads to two corollary notions of equity: vertical
equity and horizontal equity. Vertical equity states that taxpayers with a greater
ability to pay taxes should contribute a larger amount. Horizontal equity states
that taxpayers with similar abilities to pay should contribute the same amount. Although these notions of equity are widely accepted, applying them to evaluate a
tax system is rarely straightforward.

Diminishing expectations

Diminishing expectations and a harsher reality are the reasons
for this new investor choreography.
Too many people have been expecting the much higher than
average returns of the end of the 1990s to carry them through
their retirement. The truth is that future returns are unlikely to
repeat this performance and could be less than average

Ideas in Your Financial Edge.

Many of the ideas in Your Financial Edge come from McCulley’s
columns. PIMCO has graciously allowed us to refer to these
ideas and use many of the columns in this book.2 Fuerbringer has
written about emerging markets and diversification in The New
York Times; in stories in the business section; in his column,
“Portfolios, Etc.”; and in his contribution to the book The New
Rules of Personal Investing, edited by Allen R. Myerson and pub-
lished by Times Books in 2002. The New York Times and Times
Books have graciously allowed him to examine these and other
ideas in Your Financial Edge.

Lifestyle of a person with a Ph.D.

PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN
Decisions in life are rarely black and white but usually involve shades of gray.
When it’s time for dinner, the decision you face is not between fasting or eating
like a pig, but whether to take that extra spoonful of mashed potatoes. When exams
roll around, your decision is not between blowing them off or studying 24
hours a day, but whether to spend an extra hour reviewing your notes instead of
watching TV. Economists use the term marginal changes to describe small incremental
adjustments to an existing plan of action. Keep in mind that “margin”
means “edge,” so marginal changes are adjustments around the edges of what you
are doing.
In many situations, people make the best decisions by thinking at the margin.
Suppose, for instance, that you asked a friend for advice about how many years to
stay in school. If he were to compare for you the lifestyle of a person with a Ph.D.
to that of a grade school dropout, you might complain that this comparison is not
helpful for your decision. You have some education already and most likely are
deciding whether to spend an extra year or two in school. To make this decision,
you need to know the additional benefits that an extra year in school would offer
(higher wages throughout life and the sheer joy of learning) and the additional
costs that you would incur (tuition and the forgone wages while you’re in school).
By comparing these marginal benefits and marginal costs, you can evaluate whether
the extra year is worthwhile.

Labor tax

Although the size of the labor tax is easy to determine, the deadweight loss
of this tax is less straightforward. Economists disagree about whether this 50
percent labor tax has a small or a large deadweight loss. This disagreement
arises because they hold different views about the elasticity of labor supply.
Economists who argue that labor taxes are not very distorting believe that
labor supply is fairly inelastic. Most people, they claim, would work full-time
regardless of the wage. If so, the labor supply curve is almost vertical, and a tax
on labor has a small deadweight loss.
Economists who argue that labor taxes are highly distorting believe that labor
supply is more elastic. They admit that some groups of workers may supply
their labor inelastically but claim that many other groups respond more to incentives