What Is The Hardest Truth Of Economics?

Complexity can kill.

I saw it 20 years ago, and I’m seeing it today, and it’s one of three hard truths about economic and finance. Here’s what I mean:

So I was working out at the gym today, and CNBC had yet another story on Coinbase, which is a marketplace where Americans to buy and sell Bitcoin, the virtual currency. The price of Bitcoin has increased sharply in recent months due to rampant speculation. Am I the only person who’s not making a fortune owning Bitcoin?

Stop a hundred people on the street and ask them to explain Bitcoin. Better yet, ask a hundred Bitcoin investors to explain Bitcoin.

No one is really sure- and that’s a huge problem.

 

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20 years ago

I saw the exact same thing 20 years ago. It’s the last 90s and I’m standing in a Barnes and Noble (remember bookstores?) glacing at Forbes magazine. Tech stock prices are going through the roof- am I the only person who’s not making a fortune owning tech stocks?

Just as with Bitcoin today, very few people really understood if most tech stocks would ever grow sales and generate a profit. With Bitcoin today and tech stocks in the late 90s, many investors are saying to themselves:

“I’m not quite sure how it works, but I don’t want to miss out on the profits.”

Tech stocks crashed in the early 2000s, and many tech stocks went out of business.

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Harsh economic truth #1: Complexity can kill you as an investor, because you not able to judge the performance of a company or a product that you don’t understand. Warren Buffett, the billionaire investor, often says that he doesn’t invest in companies that he doesn’t understand.

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#2- Regulation is necessary to protect the public- but regulators are nearly always late to the party

We absolutely need regulators to protect the public, particularly in the investment arena. The trouble is that it seems to take a disaster to get industry officials and politicians to pay enough attention and pass legislation. Here are a few examples:

 

  • Stock market crash (1987): Black Monday, as this event was called, was partially caused by speculation but also by program trading, which refers to the systems set up by large firms to analyze and trade large blocks of stock. Regulators did not clearly understand the potential impact of program trading on stock prices, and prices dropped sharply on Black Monday. After the crash, the exchanges put in rules that require stocks to stop trading for a period of time after a sharp decline. These controls were put in place to avoid panic selling.

 

 

  • Enron (’01 to ’02): Enron collapsed after issuing bogus financials statements for years- financials that were not audited by a public accounting firm that was truly independent. After the collapse in the early 2000s, Congress passed the Sarbanes-Oxley (SOX) laws to ensure that company management would be held accountable, and the auditors and more company board members were independent. To learn more, check out the amazing documentary, The Smartest Guys in the Room.

 

  • Subprime mortgage crisis (’07 to ’09): “Subprime” refers to mortgage loans issued to riskier borrowers- those with less income, poor credit, or other lending risks. This crisis occurred as lenders created more complex financial products that included highly risky loans. The Big Short is a great movie that explains what happened with humor and irony.

 

In each instance, increased regulation was put in place after the disaster. Now, that’s not all bad, because the regulations were badly needed. It would be better if the controls were installed before each crisis.

#3- Perception drives market prices- for just about everything

Now, I think most of us are familiar with the old supply and demand curve, and I don’t think it’s breaking news for anyone. This third point is directed at entrepreneurs and business owners, specifically.

Creating a successful product is really difficult, even if you solve a problem that’s an urgent need for a customer. “Wait- I solve an urgent need….isn’t that the key?” Well, that’s important, but you need something else to sell the product and be profitable over the long term:

The customer has to be willing to pay a price that allows you to generate a profit- and that price is driven by the customer’s perception of the product’s value.

In other words, you can solve a problem and not be able to charge enough operate profitably.

An example

Say, for example, that you come up with a self-inflating bike tire tube. Serious bike riders love it, because they don’t need to carry a bike pump or other devices on long rides to change a flat. Awesome!

If your costs per tire tube are $15 and no client is willing to pay more than $6, you don’t have a business.

Food for thought.

Ken Boyd

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

Co-Founder: accountinged.com

(email) ken@stltest.net

(website and blog) http://www.accountingaccidentally.com/

(you tube channel) kenboydstl

This post was originally posted on my Quora page. This post is for educational purposes only.

Image: Bullseye, Jeff Turner CC by 2.0

 

 

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