The Gold Standard, Alpha, Beta, and now…Gamma.

Question: Should the US return to the gold standard, so that the Fed can’t “create money out of thin air”?

To answer that question David Andolfatto, Vice President and Economist with the Federal Reserve Bank of St Louis recently published a piece entitled, The Gold Standard and Price Inflation. You can view it here. The author cites an historical example to conclude the following:

…the gold standard is no guarantee of price stability. Moreover, the fact that price inflation in the U.S. has remained low and stable over the past 30 years demonstrates that the gold standard is not necessary for price stability. Price stability evidently depends less on whether money is “created out of thin air” and more on the credibility of the monetary authority to manage the economy’s money supply in a responsible manner.

I agree with Dr. Andolfatto’s conclusion. And I would also ask, why gold? Why not silver, or platinum? The only reasonable logic behind a gold standard is that it would allow some growth in the money supply, but presumably not too much. The amount of new gold, and therefore new money would be arbitrary. In my view an independent Fed making the decision about how much money the economy needs at a given moment is a better approach.

The world of finance is replete with statistical terms. Two such terms that are commonly used when discussing the risks and rewards associated with ownership of financial assets are alpha and beta. Beta has to do with the overall, systematic risk of a market, and alpha has to do with the reward (if any) specific to a particular asset.¹ Good investment policy recognizes the statistical properties associated with various investment choices in order to develop a portfolio with risk and return qualities appropriate for the situation.

Financial planners know that alpha, beta and the various additional statistical metrics developed for portfolio analysis do not tell the whole story. Indeed, the likelihood that a person will achieve his financial objectives can be greatly affected by decisions not directly related to investment choices at all. For example, it is common for a non-disabled spouse to become impoverished as a result of the costs associated with providing for the long term care needs of a disabled spouse. This undesirable result can happen regardless of whether the investment policy was good or bad. And retirement lifestyle can be adversely affected by a lack of understanding of and the use of available tax incentives, again in spite of good investment choices. Throughout one’s lifetime a person makes decisions not directly related to specific investments, but which can have a bearing on her net worth and quality of life, and the quality of life of the people she loves. Enter gamma.

Recently David Blanchett, CFA, CFP® and Paul Kaplan, Ph.D., CFA presented a concept that they have referred to as “Gamma” which is designed to measure the value added achieved by an individual investor as a result of making more intelligent financial planning decisions. Their paper can be viewed here. The bottom line is that many of the decisions we make from day to day, though not directly related to specific investment choices can nonetheless have a significant effect on whether or not we succeed financially.

In other words, in the complex world of the 21st century having a good investment strategy is not enough. Increasingly, good financial planning advice is required for financial success.²

After publishing my recent blog entry about Peter Diamandis’ book, ABUNDANCE: THE FUTURE IS BETTER THAN YOU THINK I realized that I neglected to include several excerpts from the book that support his optimistic view of the future. I have now revised that posting to include the additional information. (Occasionally in life we get a do over, right?) If you would like to get the rest of the story you can see it here.

I recently had my annual physical checkup and my doctor said that she considers me to be “young and healthy.” My plan is to avoid “old and unhealthy” for as long as possible. I guess I had better do some push-ups now.

Chuck Norris Pushups

 ¹ It should be noted that in the context of finance theory the term risk has a meaning which differs from the common usage. It has to do with the extent to which a financial asset’s price varies. The variation could be positive or negative, however the term risk is only interested in identifying the magnitude of the variance, not the direction. An asset with a greater risk measure could lose more value than one with a lower risk measure, or it could gain more value than one with a lower risk measure. In other words; the range of possible outcomes is wider the riskier the asset.
² Thanks for comments to Dr. Thomas Eyssell of the University of Missouri at St Louis on an earlier draft of this manuscript.

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