Lectures 16-22 Flashcards
capital income tax
taxes on the income you make from your investments (i.e. stocks)
Capital Income Tax System
how is interest taxed? Is this the same when interest is paid by the state and local governments (municipal bonds?)
how are dividends taxed?
interest is taxable at ordinary income tax rate (progressive)
when it’s paid in the form of municipal bonds (by the government), the interest you earn is tax-exempt
dividends are taxed at a lower progressive rate than interest
capital gains
profit for when you sell the asset for a higher price than you bought it
taxes for short-term capital gains vs. long-term capital gains
short term capital gains (ordinary income tax rate)
long term capital gains (dividend tax rate)
what happens if you hold on to your capital gains until you die?
the price of the capital gains is reset and the asset can then be passed on to your heirs
disincentivizes you to sell so you don’t have to pay taxes on it and you can just give it to your heirs
when are capital gains taxed?
when they are REALIZED (when the asset is sold)
vs. dividends are taxed when they are paid
therefore, even though the tax rate for long term capital gains and dividends are the same, it’s advantageous to convert dividends into capital gains
calculating the real interest rate without taxation
real interest rate = nominal interest rate - inflation
after-tax real interest rate
when is capital income taxation much higher?
when inflation is high, the discouraging effect of capital income taxation is much stronger
when inflation is higher, after-tax interest rate is much lower (even negative)
IRA
tax-favored individual retirement accounts
set up by individuals with low contribution amounts
401(k)
managed by private-sector employers
- higher contribution limits
- employers decide employee investment choices
- employers can make matching contributions to the plan
traditional IRA/401(k) vs. Roth IRA/401(k)
traditional: you don’t pay a tax when you put the money into the account, but you have to pay taxes when you take the money out
roth: pay taxes now on contributions, but no taxes later on withdrawals
and in both scenarios, the interest that you earn on the returns throughout the year is not taxed
which is better: Roth or traditional?
if you expect taxes to be higher in the future, do Roth over traditional
if you expect to be richer in the future (and thus expect to pay a higher marginal tax rate), do Roth over traditional
withdrawal rules for a traditional account
withdraw free of penalty after age 59.5
you must start to make withdrawals (required minimum distributions) after 72
if you want to withdraw money before, you pay a penalty
always pay Federal and state income tax on your withdrawals
withdrawal rules for a Roth account
you can always withdraw money without penalty (since you already paid taxes)
withdraw capital income earned in the account free of penalties after 59.5, if you account is at least 5 years odld
changes in asset allocations for 401(k)
less company stock (concentrates risk exposure), less money market funds (too low of a return to finance retirement)
more balanced funds which come in the form of target date funds
balanced funds
both stocks and bonds
target date funds
start out with more equity (stocks) and shift into bonds as your retirement date approaches
target date fund glide path
equity share starts out high and diminishes gradually to some much lower level in retirement
why do people suggest to invest more aggressively when you are young and cut back risks when you get older? (time diversification and human capital argument)
young people have high potential of human capital (future earning power- relatively safe asset)
when young, large implicit investment in safe assets (earning power) so you should compensate by having some extra risk in your financial portfolio (stocks/equities)
as you get older, your future earning power decreases and your financial savings increase
so when you’re older, with a smaller implicit investment in safe assets (less earning power) and larger financial portfolio, cut back financial risk as retirement approaches.
younger people can tolerate more risk (bc they have more time to recover from losses) but less money to invest … since they have a larger time horizon and they are expected to earn more money in the future, the risk of an asset stabilizes over long periods of time so it makes sense to be risker earlier on it life (time diversification)
older people have more money to invest, but less time to recover losses so they should be more conservative
time diversification
risk you take with equity investing is less If you spread the dollar investment out over a period of time rather than concentrating it all in a single period
diversifying the dollars you put in the stock market over time
“half stocks all the time” is safer than “all stocks half the time”
limitations of tdf’s (target date funds)
tdf only adjust equity share to your age, but if you have more savings relative to your income, you should cut back on your equity share
some TDF’s are actively managed, inadequately diversified, and charge inappropriately high fees
insurance manages which risks of life? (PPL)
personal (death, illness, disability)
property (fire, flood, theft)
liability (risks to others for which you are responsible)
property and causality insurance (P & C)
homeowners, renters, auto insurance
moral hazard
the probability or cost of a loss, once you are insured, will go up
(probability) since you know you’re insured, you’re going to be more careless about the way that you behave
(cost)
if you know you’re insured, you let insurance company pay for repair, as opposed to trying to find a cheap repair
lack of inventive to guard against risk when one is protecting from its consequences
deductible
the amount you’re responsible for paying if a loss/repair is needed
incentivizes you to be careful and doesn’t allow you to claim for minor losses
premiums
how much you pay to have insurance
future insurance costs,
if you make a claim, your premium will rise
cost of property and causality insurance depends on
value of property
location of property
risk rating of owner
security devices you install
deductible
coverage limit
coverage limit
the maximum amount of insurance a company will pay
low deductibles: money wasted
summary of article
on average, you can save more money from having a higher deductible than having a lower deductible
people are extremely risk averse and are paying extra (close to $100) in premiums to only be protected an extra $20 bucks
do lower deductibles have higher or lower premiums and why?
low deductibles have HIGHER insurance premiums
- if companies have to process more small claims, operating costs of company increases
- moral hazard: if people are less exposed to losses, more likely to file claims/get into trouble, raising cost of insurance
why do people like low deductibles?
typically for people who lack emergency funds
if you find it difficult to save, this insurance serves as a commitment device when losses occur
but they’re expensive and a better alternative is to combine high-deductible policy with an emergency savings fund
do those who have been insured longer get more sophisticated and change their deductibles from lower to higher?
no!
low deductibles used to be cheaper, but as home values rose, difference in premiums also rose
renewal contracts do not list this new menu?
insurance companies cover ____ losses
unknown losses
preexisting conditions
known losses, won’t be covered by unregulated private insurers
medical history of a serious problem
before 2012, large group poliicies covered preexisting conditions, but individual and small group policies either excluded or charged high prices for coverage
after affordable care act, it was forbidden to exclude or charge more for preexisting conditions
continuation coverage
you’re still given healthcare insurance for 18-36 months if you lose access to a group policy due to job loss, divorce or death from employee
medicare v medicaid
medicare
- for people over 65 (federal)
medicaid
- for lower income people (state-administered)
- think AID, financial AID, poor
two main challenges to u.s heatlh care system
- preexisting conditions
- health care costs (companies try to cut cost by having a select list of providers, having high deductibles etc)
basic v major medical health insurance
hospital, surgical, and physical health expenses
major: anything beyond that
long term care insurance
worth considering if you are over 60 and lack family care options
marginal utility of wealth
high when wealth is low
low when wealth is high
diminishing marginal utility
think ec10 (100 to someone who makes 1,000 is much more than 100 to someone who makes 10,000)
actuarially fair price
the premium rate must equal the probability of an accident
would be possible if losses were idiosyncratic ( uncorrelated across individuals) and insurance company has no sales or operational costs
full coverage
loss has no effect on your marginal utility
full replacement of lost income, full coverage of medical costs,
partial coverage
insures only part of a loss
leaving marginal utility of the loss slightly greater than the marginal utility of the premium (base conditions
why is insurance not actuarially fair?
sales and operating costs
costs of fraud prevention
moral hazard (need to have some exposure to loss so that they can have an incentive to be careful)
adverse selection: makes insurance expensive for all but the riskiest people
adverse selection (in insurance)
people have different loss probabilities, and they know their own loss probability (asymmetric information)
insurance company either does not know loss probability or is prevented by regulation to adjust cost of insurance to reflect that
- i.e. Affordable Care Act- companies couldn’t charge extra for people with preexisting conditions (aka higher loss probabilities)
in adverse selection, who demands more insurance? high-risk people or low risk-people? how does this impact the cost of insurance?
high-risk people demand more insurance than low risk people
Lowers profits (high-risk people are more likely to file claims than low-risk people) which forces companies to drive up the price of their insurance
since the cost is so high, only the highest risk people will choose to buy insurance
death spiral
only the highest risk people will buy insurance
more people are dropping their coverage (particularly healthy people)
how affordable care act is trying to fight death spiral
a mandate to buy health insurance, with a penalty if you did not
tax credits to cover health insurance costs for low-income people (higher than medicaid but still low)
distilling accessible information and healthcare shopping
life insurance
offset losses caused by your death to the people who care about you
losses include
-funeral cost
- lost income
term life insurance
in force for a specified period
if you die within the term, you get a specified death benefit (face value of insurance policy)
you get nothing if you’re still alive at the end of the term
do life insurance premiums rise or fall over time?
they rise!!! as you get older, the more likely you are to die, which means the more likely that insurance companies are going to have to pay out and give you the death benefit
as you get older, risk to insurance companies increases
whole life insurance
forced indefinitely
if you keep paying premium, insurance pays death benefit
if you stop paying, you get specified cash value
variable v universal (whole life insurance )
variable: gives you low minimum death benefit and cash value, but if risky investments do well, you get more return
universal: low minimum required to get death benefit, but if you pay higher premiums you can raise cash value of benefit
lapsing (insurance)
when people take out policies and then fail to make their premium payments
companies profit when people lapse after a period of paying premiums, because they get all the premium money and then they don’t have to pay out the death benefit
is lapsing common?
yes!
lapse rate falls as people stay will policy, but it still exists <- lapse rate is higher in first year of policy than 5th year of policy
smaller policies are more likely to lapse! (smaller policies are likely bought by people with more volatile incomes, which means they just aren’t able to pay premiums as consistently)
do people anticipate lapsing?
no!
people are naive about their future behavior
why do people lapse?
income decreased, people forgot to make payments,
which life insurance is best to buy?
if you don’t think you’ll lapse, buy long term life insurance
if you think you will lapse, buy short term life insurance and scale back coverage later in life when premiums rise ad dependents are less likely to be vulernable
pricing between term and whole life insurance
short term life insurance (fairly priced- lower premiums when you’re young, higher as you get older)
long term life insurance or whole life insurance are typically more expensive in the early years and cheaper later (premium is high (fixed) but mortality risk increase with age)
annuities
while life insurance protects you from dying too soon, annuities protect you from living too long
immediate annuities
pays a stream of income for your lifetime, starting now
deffered annutiies
pays a stream of income for your life time, starting n years from now
is the interest rate paid by annuities higher or lower than the yield on an ordinary bond?
higher!
bc you may die early and never receive later payments, esp if you die before a deffered annuity plan
fixed annuity
makes fixed payments in nominal or real terms
variable annuity
makes payments that reflect the performance of the stock market
why is there a low demand for annuities
almost everyone has form of annuity in social security or defined benefit pension funds
private annuities are expensive because of adverse selection
people want to leave money for their children
estate planning
having a will
advanced directives (healthcare proxy and living will)
guide to healthcare if you turn into vegetable
living will - what you want to happen
healthcare proxy- gives power of attorney to someone to guide your healthcare decisions
prenuptial agreement
minimize impact of divorce
financial advisors and “one size fits all”
not getting customized advice
doing the same as target date funds by charging higher fees
what is the issue with investing only in company stock?
undiversifying your financial portfolio
do advisers steer their clients toward low cost-index funds?
no! steer them towards higher-fee strategies
not just because of alterior motives but also because of their own ignorance….they behave similarly with their own finances
how did financial advisers respond to these strategies (chasing returns, company stock, index funds)?
advisers recommend more strongly against index funds than chasing returns or owning company stock
from most supported to least supportive
chasing returns, company stock, index funds
fiduciary standard
legal obligation to act in the best interest of your client
suitability
less strict than fiduciary
just saying that you shouldn’t act crazy with someone’s finance, but still not held to the same standard
which financial advisers meet the fiduciary standard? (3 options)
CFP - certified financial planners
RIA- registered investment advisors
all advisers for retirement accounts
fee-only advisor
do not receive any income from commissions!!
stronger than fee-based, which allows for some commissions
robo-advisors
online interfaces for financial advice
structured products
offer a high headline rate (high interest rate)
but the fees are high and incredibly complex
essentially deliver high return by investing in risky assets, with little downside protection
they gotten more complex over time
tricks associated with structured products (and how companies don’t always get their pay in extra fees)
- and even if you get your money back, you’re losing money as compared to just investing in a safe investment
you’re getting a 0% return, which is lower than just putting money in a money market or bond
- get the price return on a stock index, but you’re not getting the dividend yield, which companies end up taking
sometimes the safe investment and dividend yield is v low….meaning that companies can’t always eat up those fees as much as they want
- generate income by selling out-?????
speculators
buy asset because you hope you’ll be able to sell for a higher price in the future
speculative assets
things that are easy to trade, but hard to assess the fundamental value
assets that offer a non-financial conveinence yield (i.e art, gold, jewelry)
assets in fixed supply with limited subsistuties, so demand shocks affect price and not quantities
speculative bubbles
A speculative bubble is a spike in asset values within a particular industry, commodity, or asset class to unsubstantiated levels, fueled by irrational speculative activity that is not supported by the fundamentals.
asset prices excel upwards, and then suddenly crash
driven by naive speculators who are chasing returns
fast v slow bubbles
if a bubble is driven by expectations of very high returns, it’s going to burst quicker because it can’t be sustained as long
if a bubble has lower expected returns, going to live for longer
bubbles are slower (and longer) for environments with low interest rates
a rise in interest rates, will make a bubble faster (and shorter)
bank run
when a large number of a bank’s customers hurry to withdraw their deposits simultaneously because they believe the bank may fail.
a deposit in an unregulated bank is a speculative asset so people believe that their money is safe if not everybody withdraws their money at the same time… if people think the bank may fail, they are quick to take out their money
stablecoin
cryptocurrency with a stable USD value
but they run like unregulated banks
ponzi schemes
disguise cash from speculators as fundamental cash flows
a form of fraud in which belief in the success of a nonexistent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors.
pump-and-dump schemes (three phases)
- get position in an illiquid asset (cannot be easily converted into cash for their fair market value) (Penny stock)
- attract naive investors with rumors of good news
- sell out to naive investors at an inflated price
In a pump and dump scheme, fraudsters typically spread false or misleading information to create a buying frenzy that will “pump” up the price of a stock and then “dump” shares of the stock by selling their own shares at the inflated price.
meme stock
any stock that, for some reason or another, has gained a frenzied following of retail investors, often due to its status as an “underdog” in the market.
fintech
financial technology
peer-to-peer lending
allows people to lend or borrow money from one another without going through a bank.
distributed ledgers
using blockchain technology
transactions are recorded and verified by a network of computers as opposed to a single database
decentralized finance (de-fi)
everything from simple transfers to complex financial functions are facilitated without any third-party involvement.
why?
- central databases have monopoly power <- higher prices, lower incentive to innovare
- lack of trust in financial institutions
smart contracts
contracts that can execute themselves without the need for financial intermediaries
non-fungible tokens (NFT)
unique Digital object that can replace membership cards and id’s
blockchain
transactions that are recorded and cryptographically linked
altering any one block will change the entire chain
proof of work (POW) system
Proof-of-work (PoW) is a blockchain consensus mechanism that incentivizes network validation by rewarding miners for adding computational power and difficulty to the network
problems
- transactions are expensive
- energy/electricity consuming
proof of stake (POS) system
It is a way to decide which user or users validate new blocks of transactions and earn a reward for doing so correctly.
allocating voters
some problems of cryptocurrency
transactions are expensive and slow
many have unstable USD so aren’t good for saving
diret ownersjip requires a private key, if you lose that you’re fucked
crypto exchanges are suspectible to fraud
oracles
systems that import data from the real world to the blockchain
vulnerable to hacking
disclosures
providing information at a time that a financial decision has to be made
nudges
making certain decisions slightly easier by establishing defaults
disclosure empire
terms of credit, informed consent in healthcare,
often complex and ignored
leakage
side effects/behavior that can offset the apparent gains from a disclosure or nudge
(borrowing more on second card to pay first card faster)
CARD act experiment
when people were given information about paying off their debt in 3 years, they were more likely to do it rather than just paying the monthly minimum
designing better disclosures (3 ways)
- simplify
- standardize (make comparisons easy)
- exploit social compettiveness
- Personalize info
- make it vivid
nudges in retirement saving and effects on contribution rate
automatic enrollment increases participation
many people participate with the default Savings rate (3% or 6%)
but too high of a savings rate can lead people to drop out and discourage people from saving more than the high default rate
Nudges that Fail (2 reasons)
- people actually have strong preferences
- women change their legal name even though that’s not the default
- there may be a counternudger - self-interested party that’s trying to undo the effect of the nudge
Responses to Nudge Failures
- give up and accept that people know what they want
- improve choice architecture (design of the nudge)
- restrict counter nudges
consumer financial protection
trying to regulate markers
ensures that markets for consumer financial products are fair, transparent, and competitive.
Consumer Financial Protection Bureau (CFPB)
- can’t pay more than the amount on prepaid cards
- rules on payday lending
a case is made for regulation when
externalities
asymmetric information
public goods
market power
externality
where one agent’s actions affect another in a way that cannot be charged for
i.e. air pollution (negative externality)
if negative, externality can be regulated with taxes and regulations
if positive, externality can be regulated with subsidies
asymmetric information
when some people in the market know more about their circumstances and behaviors than others
(selling a used car or buying health insurance)
market power
have a monopoly
high prices, underprovidision, and lack of innovation
in consumer financial markets, providers may have market power because consumers are too reluctant to search
public goods
can be enjoyed by all, but cannot be limited to those who paid for them
i.e Clean air or information (disclosure regulation)
paternalistic
that a consumer regulator knows what’s better for consumers than the consumers themselves
if you Care about the welfare of poor people, would you be more or less paternalistic?
more!
because behavioral agents are on average poorer than rational agents
Sharpe ratio
measures how well a stock is doing relative to a risk-free return
return of stock -risk-free return / sd of stock
measuring the performance of an investment relative to its risk
leverage
when you borrow money to buy an asset
leverage = value of the asset/ amount of your own money you invest
