Author Archives: James Dow

Finances of the Undead

This blog post on ”finances of the undead” compares vampires with zombies to make a point about good personal financial habits. Obviously we approve of zombies, vampires and financial prudence.  Indeed, one of my chapters talks about what vampires can teach us about investing strategies. But in some ways I think the author is a little unfair to the zombies when she claims vampires as the better financial managers. After all, vampires start with several advantages including a functioning brain and the ability to speak. They’re also better looking, which economists have found to matter for income.

Of course, the undead differ on more than just their financial acumen. In chapter 10, Lorna Piatti-Farnell considers how vampires and zombies represent different aspects of consumerism, vampires as representatives of status-conscious behavior while zombies are more mindless consumers. They return to the mall in Dawn of the Dead because that’s what they know. But do we really want to consider this mindlessness? They know what they want, they try to get it and they don’t care what others think. If you leave aside eating people, there’s something likably simple about zombies.

In fact, zombies are now seen as being so reasonable that AT&T uses them to pitch their cable system. Maybe zombies are financially responsible after all.

Estimating Returns for Very-Long-Term Investors (and Vampires)

(Cross-posted at the Volokh Conspiracy)

As Glen will discuss in his Friday post, the women in books and movies these days all seem to want to date vampires. Of course, not any vampire, but a rich vampire, and there seem to be a lot of them around. What is the secret of how those vampires got so rich? In my chapter “Investing Secrets of the Undead” I’ll show you how to turn a $1,000 investment into a lifetime of wealth that will allow you and your family to…oops, sorry, wrong audience. Actually, in the chapter I use vampires in the media to illustrate some important academic principles of financial analysis as it relates to investing.

The first and obvious answer to why vampires are so rich is that vampires live (so to speak) a long time and so are in the position to take advantage of the power of compounding. Compounding does matter, but there’s more to investing than that.

In the chapter, I talk about various ways in which time interacts with risk for long-term investors, such as why time diversification does not work the way many people think it does, how mean reversion potentially offers opportunities for long-term investors, and the non-financial problems that might be associated with vampires delaying their consumption until the distant future. For this post, I want to briefly discuss one particular issue: how survivorship bias can affect the use of historical data when forecasting long-term investment returns.

There have been many studies looking at US stock returns in the post-war era. However, an investor with a very long investment horizon might be interested in how stocks have performed over the last 100 years in a variety of different countries. During that period, stocks have actually done quite well and a sophisticated vampire might decide to take advantage of that. As I describe it in the chapter:

Before I answer, let me tell you another story from a lesser-known piece of vampire fiction. Baron Federov was a minor aristocrat in the court of Alexander I of Russia in the early 1800’s. Known mostly for various bits of scandal related to the wife of a fellow noble, he lived a life of genteel poverty. However, his life radically changed one night when he was visited by Count Vardalok, who drank his blood and left him for dead. Accidentally, some of the Count’s blood dripped down the Baron’s throat, and so Federov woke that night as a vampire. Now, the Baron was a practical man and understood compound interest. Selling off what possessions he had, he invested in several promising Moscow properties and businesses, making a will that gave his assets to a “future descendant.” He faked his own death as a human and then hid away in a crypt, confidently planning to return many years hence to claim his inheritance and live the rest of his time in prosperity.

In 1917 he awoke to claim his riches. Unfortunately for the Baron, this also happened to be the time of the Russian Revolution, and he awoke not to the riches that compounding promised, but instead to see all his property taken away in the communist revolution. Penniless, he wandered the streets and was staked the next night by a patrolling revolutionary guard.

Okay, that isn’t a real story, but it illustrates an important point. It’s said that history is written by the winners, and that’s true for investing stories as well. Nobody is going to tell you about the money they lost playing the stock market. Because of that, you get a distorted idea about how likely it is for you to win. In the study that came up with our 7% average return, all the countries in the survey were winners. They were around in 1900 and they’re around today. If they weren’t, they couldn’t be included in the study.

The name for this problem is survivorship bias and it results in return numbers that are too optimistic because poor performers (in this case, stock markets and economies that fail) are excluded. The problem of survivorship bias is well understood and adjusted for in the best stock return databases, but this is often not done with unusual or specialty asset return data. Investors beware.

Economic Recovery after the Zombie Apocalypse

(Cross-posted at the Volokh Conspiracy)

Most zombie preparation guides focus on helping you survive the first few weeks with the idea that sooner or later the authorities will defeat the zombie menace and order will be restored. However, what we know from the literature (e.g. Dawn of the Dead and The Walking Dead) is that it’s quite possible that the zombies will do enough damage to knock society back to a more primitive social structure. Several chapters of the book, including one of my own, address the question of how people might begin to rebuild the economy after the apocalypse. (Spoiler alert: I’ll be referencing parts of World War Z and The Walking Dead, so stop here if you don’t want to know. Although, if you care that much, why haven’t you seen them already?)

Before we can face the zombies, we need to step back a bit and consider a basic principle of economic organization. Economies are built around connections between people, either through “hierarchical” organizations such as firms (or armies or families) or alternatively through market systems which are decentralized and built around organized systems of exchange. Each method has its own advantages and disadvantages. Hierarchies can be efficient since there is less time spent in negotiation; however, as the size of the organization gets larger, it’s harder for the person in command to have the specialized expertise needed to make the right decisions at each level. Markets, while seeming inefficient, allow economies to scale up in size which implies more specialization and so greater productivity.

We see both sides of this in the zombie war described in the book World War Z. The anti-zombie forces are finally organized under a centralized command, which allows quick decisions to be made on how to fight the zombies. On the other hand, it is often the people who are directly engaged in battle rather than the people at the top who are most effective in discovering new forms of weaponry and fighting techniques. Fortunately for the humans, the army command recognizes their efficacy, but if they did not, there would have been no alternate channel for the developers to offer their innovations.

The weapon that is the turning point in the war is a new exploding anti-zombie ammunition built in a factory in Hawaii, which is safe from zombies. Unfortunately, the development of this ammunition seems problematic in the environment of World War Z. To make something so sophisticated would require expertise in chemistry, machinery, mining, logistics and a variety of skills that would be spread across the globe in a modern economy. But in a world overrun by zombies, the specialization and trade that these markets would require would become impossible. As the zombies advance and global markets collapse, the things an economy could produce would become less and less sophisticated. I expect World War Z is offering us far too optimistic an outcome.

A more likely vision of the new world is given by The Walking Dead, where society has broken down and survivors clump together in small communities such as Woodbury, which is ruled by the authoritarian “Governor”. This world would be built around production in small, local hierarchical organizations such as communities and extended families rather than around long distance trade which would suffer from insufficient support for modern transportation technology and the risk of being eaten (Brian Hollar has a nice chapter in our book that discusses precisely the issues of specialization and trade in a world full of zombies).

However, one might think it would be easy to revert back to normal once the zombies are gone; after all, we know how modern technology works and what a functional economy looks like, so it should just be a matter of reproducing what we know. On the other hand, the countries of the developing world know the same things too, and yet many of them still fail to move forward.

The typical Econ 101 model of development makes things too simple. It states that poor countries just need to save and as they build up their capital they’ll become rich countries (and yes, sometimes it even happens that way). However, a more sophisticated version of this model says that this only works if there is an effective legal system that identifies and protects property rights.

But this just pushes the question back one step: how does political and legal order come about? It often seems that a certain level of economic development is needed before you can have reliable and unbiased systems of property rights. But it also seems that you need those systems in place before true economic development can occur. This could either result in a positive feedback loop where small advances along one dimension promote development along the other or in stagnation where neither gets started because of the lack of the other. The older name for economics, political economy, reminds us that the long-run nature of the economy is not only based on competing firms but also on competing centers of power. How do you move from a dictatorial leader who keeps a community together in the face of the zombie hordes to a system of distributed property rights and neutral arbiters of disputes? Would the leader realize he would need to give up control, or would society have to relive 200 years of revolutionary history to move forward? Personally, I’m not an optimist about either zombies or humans, so I’m not planning for a quick recovery.

The Humans Fight Back

In my last post, I talked about early economic work studying the undead, in particular, a paper that showed how vampires could optimally manage the human population. Not surprisingly, not everyone in the profession thought that developing these methods was a good idea. In a subsequent paper, an economist criticized the earlier work by saying:

“Clearly this approach is somewhat misguided. One wonders what conceivable interest the authors could have had in helping vampires solve their intertemporal consumption problem. The implicit assumption of the Invisible Hand (or Fang) -whereby vampires, in pursuing their own interests, pursue those of human beings as well – is of questionable validity.”

In his paper, this author constructed a simple model of an economy that produced only widgets and stakes and determined the optimal stake production strategy and how low the humans should drive the vampire population. It turns out that the optimal policy is not to drive the vampire population to zero. Perhaps surprising, but this result shows up in many models of undesirables. Even though we don’t like crime, it’s probably not optimal to spend the necessary resources to completely eliminate it; particularly in the vampire case where the costs are predominantly paid up front while the benefits come in the discounted future.

Unfortunately the paper is gated (so may not be available to those without academic access) but I wanted to mention it to assure readers that economists were hard at work on the undead problem.

Optimal Control of the Humans

Of course, we were not the first to look at the connections between economics and the undead. Here’s a paper from 1982 that examines the optimal management of humans from the vampires’ point of view. Warning – the paper is very mathematical (much more than we are, but this is what happens when people who like math get bored).

Leaving the math aside, the basic idea is that vampires value humans for their blood, but taking blood turns the humans into vampires which both increases the number of predators and reduces the number of prey. The paper develops an approach for determining the optimal number of humans relative to vampires – a “steady state”. It then raises an interesting question. Say that there are currently 7 billion humans but the goal is 15 billion humans. What is the best way to get there? Do you temporary stop killing humans completely to grow the population as fast as possible? Or do you keep killing a few humans now to enjoy the blood even though it will take longer to get to the desired stock?

The answer turns out to depend on marginal utility, that is, the amount of enjoyment you get from each additional pint of blood. If the 10th pint of blood is just as good as the first, then you’ll want to get to the steady state as fast as possible (the “bang-bang” solution). On the other hand, if a pint is worth much more when you haven’t had much to drink, a more gradual path to the steady state is better.

It’s never this simple, of course. As Glen explains in Chapter 15, vampires have an incentive to behave individually in a way that undermines the optimal solution for the group.

Also, if you haven’t had enough of dynamic systems — and who has? — Bishop, Tufte and Tufte take a non-mathematical look at the how the population of zombies might rise or fall over time in Chapter 6.

Vampire Squids

In the wake of the recent financial crisis, the role of the financial system in the economy has been under debate, with some arguing that it needs a complete overhaul, while others making the case that it’s mostly doing fine as it is right now. In the latter camp was Lloyd Blankfein, CEO of Goldman Sachs who said that financial institutions were “doing God’s work”. He received a fair amount of criticism for that statement, but I think they missed the point. The real question is – which god?

Perhaps Matt Taibbi gave us a hint with his famous description of Goldman Sachs as a “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”

Here’s what an actual vampire squid looks like. But while a vampire squid may sound scary, it’s far too natural of a creature for us at Economics of the Undead. So I’d like to suggest that Blankfein may have had a different cephalopod in mind.

Getting Ready for the Zombies

Lots of people, including National Geographic, are using the coming zombie apocalypse as a way to introduce disaster training in a humorous way. But it does raise an important question since we face a variety of different disasters in addition to zombies. How much should you prepare for a potential disaster?  The standard economic answer is that you should compare the cost of making preparations with the expected benefits from surviving a disaster in the future (expected benefits are the benefits from preparation multiplied by the probability that the event happens).  The basic idea is that the higher the probability of the event, or the worse the event is, the more you should spend in preparation.  It’s worth it to prepare for a low cost but high probability event like an ice storm.  It’s also worth it to prepare for a high cost but low probability event like a big earthquake. 

 But you want to be careful not to confuse the extremity of the event with the benefits of preparation. As the dangerousness of zombies increases, it seems like you should spend more on preparations; however, if you imagine zombies to be so dangerous that no one will survive, then it’s optimal not to prepare at all.  National Geographic asked their interns about how they would fare when the zombies come.   My interpretation of Caroline’s curl-up-and-die strategy is that she is indeed taking a rational response to expectations of a very extreme zombie event.  Josh too, although he’s definitely looking on the bright side.