Dilbert, Agency Costs, and Silly Budget Games

I've taught Capital Budgeting every semester since 1996 at some level or other (sometimes at the Intro level, sometimes in the Advanced Corporate class, and sometimes in the CFA prep course). One of the key concepts in capital capital budgeting is that in estimating cash flows you should always use the marginal cash flows attributable to the project at the company level and not at the divisional level. In fact, one of my favorite cases to teach this concept involves a multi-divisional company where each divisional manager is trying to allocate the revenues from the project to their division and the costs to someone else's.

The problem comes because of a classic agency problem: divisional managers are compensated in part on the basis of the financial performance of their division. Shareholder, in contrast don't care which division the costs and revenues are allocated to, since they have a claim on the cash flows of the entire company. So, the interests of the agents (the managers) diverge from those of the shareholders (the principals) and voila: the managers take actions that shareholders would prefer they didn't.

Now I have the perfect Dilbert cartoon to illustrate the concept:

HT: The Conglomerate Blog.

The Year In Review

I know the year's not yet done, but I was thinking of all the changes for the Unknown Household in the past year:

• A move back to our "homeland" in the Northeast USA, which puts us within 80 miles or so of both parents and all myriad nephews, nieces, etc...
• A new school for me. This part is particularly good, since whenI first went on the job market in my final year of grad school, I identified 3 schools I would love to be at. This was one of them (it took 8 years to get here, but hey - some things take time).
• I'm teaching two new classes in a different sub-field fo finance. It's a lot more work, but I'm learning new things.
• I'm also teaching CFA prep classes, which helps to pay for our oversized mortgage (Northeast real estate prices are high).
• The Unknown Son goes to a new new school which is much better than his old one (after all, it's a University town). Even better, the two little darlings that used to pick on him in his last school are no longer around.
• The Unknown Daughter is now in kindergarten, and loves it. It's part of the same school as the Unknown Son's, so they get to ride the bus together.
• We're now in a neighborhood that we simply love, with plenty of young families with kids and dogs (for the Unknown daughter to walk).
• Of course, I have to work a lot harder here than in my last school, but I also have a 2 mile commute rather than the hour it used to take. So, it's a lot easier to pop home for a bite or to play with the kids for a bit before night classes.
  

That's it for me and mine. If I don't say so later on (after all. there's still 2 days left to the year), here's wishing all the best for all of you.

And thanks for stopping by.

Private Equity and Debt

A recent Wall Street Journal Article ("Buyout Bonanza Compels Firms to Pile on Debt") reports on increasing debt levels for companies that were recently taken private. It's worth reading and keeping in the folder for the next time I teach about corporate restructuring:

A look at recent buyout deals shows not only that they are getting bigger in dollar terms, but also that larger companies are being pushed to pile on increasingly heavy loads of debt.

Private-equity investors -- which make money by buying control of companies in the hopes of cashing out through a stock offering or outright sale -- have been emboldened by low interest rates and generous credit markets. They are pushing companies further out on a limb in the process. In some cases, this gives their newly private companies little breathing room to execute growth plans and stay afloat were economic and market conditions to turn sour.

In many cases, companies will need to devote at least half their yearly cash flow to meeting interest payments on their debt.

Corporations that were acquired in leveraged buyouts in the fourth quarter have a ratio of debt to cash flow of 5.7 times on average, according to Standard & Poor's Leveraged Commentary & Data Group. That is up from an average of 5.3 times in 2005. In 2002, when lenders were less willing to finance risky deals, this ratio was close to four.

The last time leverage in buyout deals averaged 5.7 times cash flow was during the merger boom of the mid-to-late 1990s. In the years that followed, some debt-heavy companies, like barbecue-products maker Diamond Brands and animal-feed producer Purina Mills, defaulted on their debt when their bets went wrong.

Read the whole thing here.

It's not all that surprising that these firms are highly levered - that's what the "L" in LBO stands for. In an LBO, the acquirer (a "private equity", or "PE" firm) takes a firm with decent cash flows that is arguably underleveraged and gears it up with more debt. This potentially creates value through a number of channels:

• The old risk-return tradeoff: Increased debt levels makes the firm's equity riskier, but magnifies returns in good times. So, why don't the managers of the public firm do this themselves? They might be too risk-averse to take the debt up to ooptimal levels. If a firm restructures in banckruptcy, the CEO is often out of a job, and may have difficulty getting another one. Hence, too little debt.
• Tax shields - interest on debt is tax-deductible (this is known as the "tax shield" of debt).
  
• Debt helps manage agency problems: having a lot of cash makes a company's future less sensitive to recent performance. taking on more debt means that the firms has to look at every decision more closely, since they're walking a tightrope.

Down the road (after a few years), the PE firm takes the LBO firm public once again. And according to the evidence, these firms do pretty well in the post-IPO market.

But, the process is full of risk. With greater risk comes a greater chance of failure. This is why PE forms make so much money - they're willing to take on the huge levels of risk that managers of publicly-held companies aren't.

Thursday Link Dump

It's been a good day - I spent several hours poring over the first draft of a paper by my Ph.D. student (actually, a student whose dissertation I'll be co-chairing). The paper will eventually be the first essay of his dissertation -- he should be ready to defend his proposal in March or April. He's gathered a lot of data he's about 75% done), and this is his first attempt to put stuff down on paper. It's not overly terrible, but it'll need a lot of work before it's ready.

Now that I'm on this side of the table, I have a lot more respect for what I put my own professors through. Forgive me, for I knew not what I was doing...

Having done that, it's time to blog. There were some interesting pieces in the news (or in the blogosphere) lately. Here they are:

There's a must-read piece in yesterday's Wall Street Journal on the history of executive stock options. If you want to understand some of the issues related to back-dating, reloading, and so on, this is the piece for you.

Ticker Sense has a list of analysts' price forecasts for the S&P 500.

Business Week lists The Big Private Equity winners of 2006.

This week's Carnival of The Capitalists is up at Worker Bees Blog. My picks of the week are Dan Melson's piece Choosing Buyer's Agents By Commission Rebate: Penny Wise, Pound Foolish and Free Money Finance's how to make our children into millionaires

Finally, from Seeking Alpha, we have two conflicting indicators as to what will happen in the market: Yaser Anwer tells us that Short interest declined (that's a bullish indicator), while John Hussman tells us that insider selling is up and money managers are overwhelmingly bullish (both are bearish indicators). So take your pick - it reminds me of the need for "one-handed" economists".

Enjoy.

A Charlie Brown Christmas And It's A Wonderful Life

Growing up, we'd watch two TV specials every Christmas season (and often repeatedly).

The first was the Peanuts Christmas special, and the second was (of course) It's a Wonderful Life.

Thanks to Youtube, here they are.

Linus' Reading of The Christmas Story.

The Ending of It's A Wonderful Life.

When you get off track this season, apply both liberally as needed.

And a very Merry Christmas to all of you and yours from the Unknown Household.

Regulation and Venture Capital: The Unintended Consequences Edition

There were some interesting Venture Capital related pieces in the paper over the last few days. Most are related to some of the "unintended consequences" of Sarbanes-Oxley and other recent regulatory changes. These changes might (repeat "might") have some benefits, but they were enacted without much serious consideration as to the costs they might impose on the capital markets. Here are a few more examples of these costs (nothing new, but still worth reading):

First, here's a Wall Stree Journal editorial by Michael Malone titled The Pump-and-Dump Economy. He lays out some pretty good arguments showing how the VC and Private equity world have been affected by Sarbanes-Oxley, Regulation FD, and the calls for options expensing. As a result, he argues that they'll end up having far-reaching effects on the rest of the economy.

Batting in second place is another article from the WSJ titled "Venture Capital's New Adventure". It discusses how the slowdown in IPOs from Sarbanes Oxley has made VCs job much harder. In particular, it highlights the case of Drew Lanza, a tech VC who's recently started doing roll-ups in the chip industry.

Finally, the NYtimes tells us that VCs are looking overseas for exits. It seems that the increased regulation in the U.S. market is making foreign markets more preferable for staging IPOs for exits.

as one of my econ professors always said, the Law of Unintended Consequences is like the law of gravity - you can tell yourself it's not there, but it'll get whether you believe it or not.

A Few Questions

I just received this from one of my friends, so I thought I'd put it up here. Some of these sound like they came from Steven Wright:

1. Is it good if a vacuum really sucks?
2. Why is the third hand on the watch called the second hand?
3. If a word is misspelled in the dictionary, how would we ever know?
4. If Webster wrote the first dictionary, where did he find the words?
5. Why do we say something is out of whack? What is a whack?
6. Why does "slow down" and "slow up" mean the same thing?
7. Why does "fat chance" and "slim chance" mean the same thing?
8. Why do "tug" boats push their barges?
9. Why do we sing "Take me out to the ball game" when we are already there?
10. Why are they called "stands" when they are made for sitting?
11. Why is it called "after dark" when it really is "after light"?
12. Doesn't "expecting the unexpected" make the unexpected expected?
13. Why are a "wise man" and a "wise guy" opposites?
14. Why do "overlook" and "oversee" mean opposite things?
15. Why is "phonics" not spelled the way it sounds?
16. If work is so terrific, why do they have to pay you to do it?
17. If all the world is a stage, where is the audience sitting?
18. If you are cross-eyed and have dyslexia, can you read all right?
19. Why do you press harder on the buttons of a remote control when you know the batteries are dead?
20. Why do we put suits in garment bags and garments in a suitcase?
21. How come abbreviated is such a long word?
22. Why do we wash bath towels? Aren't we clean when we use them?
23. Why doesn't glue stick to the inside of the bottle?
24. Why do they call it a TV set when you only have one?

No, this has nothing to do with Finance or Economics, and Yes, I'm avoiding doing some work. Bad Professor!

Thursday Link Dump

The Unknown Wife and I braved the mall yesterday, and did almost all our Christmas shopping. I still have to buy my traditional Shiny Thing for her, but that's about it. With all this, I didn't get around to emptying my feed reader, so have a few links to things that I came across in the last day or two. None are specifically finance or business related, but they're all thought provoking:

Mary McKinney at Academic coach talks about procrasdistraction - this is the phenomenon of when you finally sit down to a task you've been avoiding and a list of all the OTHER things you have to do springs to mind.

Joe Carter of Evangelical Outlook has a great piece about the philosophical contrasts between It's A Wonderful Life and The Fountainhead.

Finally, Tyler Cowen Marginal Revolution discusses a paper that shows what many of us already know, but it's good to see it measured: hard-working coworkers make us work harder.

Off to work - I've procrasdistracted enough for now...

The End of The Semester Is Nigh

Only four or five student project to grade and then I'm done, done, done. All in all, I'd give myself a C+ for the semester. It wasn't great, since I was teaching two new classes, and one was pretty effort intensive. But I got through the material, and even did a little research. First semesters at new schools are always much, much more difficult than you'd think.

I'm looking forward to the break so I can spend more time on research - I realized that I'm not doing nearly as much as I should be. In fact, I think I'll go back to logging my time and my output (i.e. how much time spend each day with fingers to keyboard and how many pages of product). The times I did that last year were among the most productive I've had in recent vintage. And I'll post my results here weekly in the spirit of transparency (and maybe get some of you to do likewise).

For the Finance & Accounting academics among you: yesterday, I finally figured out how to use SAS to remote access the Wharton Research Data System (WRDS) databases we have access to. For years, I'd done it the "old fashioned" way - used the WRDS web interface to download the data and then massage it locally using SAS. I finally bit the bullet and worked through the system documentation - it was surprisingly easy. Now I can do all the work on the Wharton system and use their resources to massage the data and merely download the finished product. Unfortunately, I lost track of time until Unknown Wife called me at 6:30 (oops).

This should help since some of the things I'm working on are real memory hogs. They should execute much faster using the servers at Wharton than they do on my relatively dinky system --it'll be nice to use up Wharton's resources instead of mine.

Today it's time for Christmas shopping and grading those last few projects.

Does Where Your Name Sits In The Alphabet Affect Academic Career Success?

Does the first letter of your surname's position in the alphabet affect your career success? According to a study by Liran Einav and Leeat Yariv (from Stanford & Caltech, respectively), the answer seems to be yes, at least for economists:

We begin our analysis with data on faculty in all top 35 U.S. economics departments. Faculty with earlier surname initials are significantly more likely to receive tenure at top ten economics departments, are significantly more likely to become fellows of the Econometric Society, and, to a lesser extent, are more likely to receive the Clark Medal and the Nobel Prize. These statistically significant differences remain the same even after we control for country of origin, ethnicity, religion or departmental fixed effects. All these effects gradually fade as we increase the sample to include our entire set of top 35 departments.

We suspect the "“alphabetical discrimination"” reported in this paper is linked to the norm in the economics profession prescribing alphabetical ordering of credits on coauthored publications. As a test, we replicate our analysis for faculty in the top 35 U.S. psychology departments, for which coauthorships are not normatively ordered alphabetically. We find no relationship between alphabetical placement and tenure status in psychology.

Read the whole thing here.

It reminds me of back in the day when I used to do some tax and bookeeping services. Of course, I choose the name AAA Business Services.

From now on, call me Arvin Arpad Aardvark.

HT: Smart Graduate School Applications.

It's a Monday

I couldn't get to sleep last night, so I tossed and turned until 2. Then I woke at 7:30 for a routine checkup with my new physician (at 8:30). When I got there, I discovered it was actually a 3:30 appointment. Ah well, I chalk it up to it being a Monday and to my not having had enough coffee.

I'm only linking to a few things today - mostly M&A related stuff, with the obligatory reference to options backdating. It's interesting to see the NYT pieces, since we discussed similar things in my doctoral program.

So, here are today's links:

According to BusinessWeek, hostile takeover bids are on the rise. That's probably a good thing - things were getting a bit too comfy for the last few years. They give some reasons.

The NY Times has a couple of good pieces: one reports on a new study by Bebchuck, Grinstein, and Peyer that finds that options backdating wasn't limited to top executives - directors appeared to have gotten into he game too.

And a second NYT piece by Mark Hulbert discusses whether the current merger wave means that markets are overpriced. He does a good job of explaining the theories behind an overvaluation/acquisition link.

Jeff Cornwall is hosting the Christmas edition of the Carnival of The Capitalists.

And finally, for all you doctoral students on the job market, Craig Newmark links to "the ultimate rejection letter".

Enough blogging - I have exams and projects to grade, and some writing to do (and let's not forget the doctor's appointment at 3:30).

Electronic Trading And The Need For Speed

This piece from the Wall Street Journal shows how electronic trading has changed the face of securities markets:

About four years ago, Dave Cummings moved his trading firm's computers from a storefront in this Kansas City suburb to buildings in New York and New Jersey that house central computers for two big electronic stock exchanges.

The move shaved a precious fraction of a second from the time it takes Mr. Cummings's firm, Tradebot Systems Inc., to buy or sell a stock on computer-based exchanges like Archipelago. It now takes Tradebot about 1/1000 of a second to trade a stock, compared with 20/1000 before the move -- a difference of about the time it takes a computer signal to zip at nearly the speed of light from Kansas City to New York and back.

Read the whole thing here

It's pretty amazing when you think about it - the company moved its computers from the Midwest to the same zip code as the exchange to save the time it takes an electronic message to travel from the Midwest to New York.

It turns out that electronic trading systems allow Cummings to effectively act as an exchange specialist - he's constantly trading in and out of stocks, and is fast enough to cut in front of exchange specialists - to the tune of over $100 million a year in profits (a penny a share at a time). And better yet, he makes markets more efficient, since he only gets to trade when someone needs fast execution. According to the article, on some days, his company accounts for 5% of all Nasdaq trading volume, and 5% of the trading in Microsoft.

The only ones unhappy are the specialists.

Tis The Holiday Season

Sorry for the lack of blogging lately, but it's the end of the semester, and that always means crunch time. I gave my last final Friday night (from 7-10, which means someone's very, very mad at me). Now all I have to do is grade them (but there's hope - see below).

The School of Business had it's holiday party from 5-7, just before the exam. I've discovered that exams go much better when I've had a couple of glasses of wine beforehand. Luckily, the students didn't have too many questions (gee, our professor must really like giving exams - he seems pretty happy).

Anyway, here are some of the tidbits that have been accumulating while I've been a slacker in the blogging world:

Michael Lewis at Bloomberg.com has a good piece contrasting the private and public equity worlds. Here's the money quote: "In effect, the smartest, best-connected money has separated itself from the rest of the stock market, and has gone into the business of trading against that market. It seeks to buy from the stock market cheap, and sell to the stock market dear, and if you need evidence that this is possible you need only look to the returns on private equity, which have been running three times the returns of the public stock market."

In a related vein, the Wall Street Journal reports on "loan to own" PE investors. Larry Ribstein has further comments here.

CXO Advisory group reviews a paper on a potential way to exploit the "small firm effect"(for the unitiated, small cap firms tend to outperform on a CAPM risk-adjusted basis). Given that my student managed fund may be moving to a small-cap value style (with a few tweaks), this could be one for them to read.

The almost-always-on-target Flexo at Consumerism Commentary says that Freecreditreport.com is a scam.

Concurring Opinions has no trouble grading exams. Maybe I can adapt it to my student's investment analysis projects.

Rob Sama is hosting this week's Carnival of the Capitalists. Unfortunately, I don't have time to highlight my picks of the week this time around. Maybe later.

Finally, how many of you know the differences between Shiite and Sunni Muslims? Joe Carter at Evangelical Outpost does, and he has this great primer on the topic.

That';s enough for now. Blogging will pick up next week - I have about a day's worth of grading, and then I'm done with my first semester at the new school.

And then I'll have time to placate all my coauthors who've been hounding me...

What's Your Legacy?

It's been an interesting couple of days. Late last week, I was informed that one of my mentors had passed away at the relatively young age of 50. He wasn't my dissertation chair, but did teach one of the seminars I took, and was an integral part of my thesis committee. So, I flew out Tuesday afternoon and went to his memorial service yesterday.

He'd had an enormous amount of success as an academic - got his Ph.D. at age 24, published a phenomenal volume of research in top journals such as the American Economic Review and the Journal of Finance (multiple times). He'd been a visiting scholar at top universities and was a scholar in residence at the Federal Reserve Bank for years.

But publications fade over time. What was even more impressive (and will endure) was the impact he'd had on so many doctoral students. Many of them are now faculty around the country, and they dropped everything to fly across the country (and in the final week of the semester, yet) to honor the guy.

After getting my degree, I subsequently had the opportunity to visit at my alma mater for a while, and got to know him as a colleague and friend as well as a mentor. He was truly a class act, and whenever I needed advice on how to handle something, he was one of the first I'd go to.
I hope I can have even a small fraction of his impact.

Godspeed, Steve -- you'll be sorely missed.

Weekend Link Dump

Looks like the end of the semester is just around the corner. My investment fund students did their presentation to the advisory board this week and acquitted themselves pretty well. My investments class has one final meeting, and then the exam. I'll have to grade about 20 investment analysis projects, but that comes with the turf.

I figured out a number of things I need to change in both classes next semester, which always happens the first time I teach a class. So all in all, it seems like I'll survive my first semester without serious damage to either me, my colleagues, or my students.

I've got some writing to do (as always). But in the meantime, here are some links to keep y'all busy.

John Carney at Dealbreaker has a piece on how PE firms are starting to get loans with fewer (or even no) covenants. It's a good example of how PE firms get to interact with credit markets on different terms than do traditional companies.

In a second related PE piece, the Boston Globe seems surprised that bondholders often lose in PE deals. Maybe they should have thought of that when they put the covenants together.

Mike Moffatt at About Economics has a nice explanation on how markets use information to set prices.

Joe Carter at Evangelical Outpost has put up another installment of his Yak Shaving Razor series. This one's the "How To" edition.

And last but not least, the Phantom Professor has a link to a very cool video on Post-Its - it reminds me of old-style ClayMation.

That's all for now, folks. Enjoy.

Tonight we take the clan walking down the main street of our town - they've done up the store fronts with lights and decorations, and there are cheese, cider, and carriage rides to be had.

Wednesday Link Dump

The semester continues to wind down. Students in my Student Managed Investment Fund make their presentation to the alumni advisory board tomorrow night. So, they've been hard at work grinding away on their presentation. They're panicking, but they should do all right.

And my investments class has only a little more material to cover. So, I'm almost done except for exams.

While I work on my class material, here are a few things to keep you busy:

James Hamilton at Econbrowser explains why the inverted yeild curve might not signal a recession. His answer - foreign purchases of treasuries.

Private Equity (over at Going Private, one of my favorite blogs) takes a few well aimed shots at the recent Market Watch piece I recently highlighted on dual-class shares.

Information Arbitrage discussses a New York Times article on how to interpret stock buybacks.

Steven Dubner at the Freakonomics Blog points to a really creative use of the Web - a YouTube For Data.

According to Calculated Risk, implied probabilities from options on Fed fund futures indicate a 75% chance of a Fed rate cut at the March meeting.

And finally, Sound Money Tips has a great list of resources for using the web in finding people at no (or low) cost.

Enough blogging - back to work.

Monday Link Dump

I had a tough night last night -- I woke at 3 a.m. and tossed and turned until 7. And of course, today's my long day (I teach until 8:30 tonight). So, I'm a bit of a wreck, and I'm sure I'll be worse as the day goes on.

Having said that, here are today's links. Some are from the weekend, but at least I've now cleared out my feed reader. Enjoy:

Want to make a humorous poster easily? Go to hetemeel.com (HT: Market Power)

Marketwatch.com has a piece on companies with dual-class shares that concentrate voting power in management's hands. These are interesting from a governance standpoint - the usual justification for the dual class structure is to insulate management from the supposed short-term focus of the market.

Dealbook tells us how investment banker compensation incentives result in so many deals being announced near the end of the year.

The WSJ seems to be doing a lot of pieces lately with an international investing flair. In this piece they talk about investors turning to currency funds to hedge risks. The investment results to this strategy haven't been all that great lately.

Finally, this Week's Carnival of The Capitalists is hosted at Show Me The Money. There wasn't that much in the finance realm, so I won't give a pick of the week this time around.

That should keep y'all busy. If I take a nap, I might blog more later. If I don't, I might just end up falling asleep in the middle of my own lecture.

Winter Wonderland (but not enough for my son)

We woke this morning to a snow covered yard - we got about an inch or two overnight.

My two children had very different reactions: Unknown Daughter was all excited and started making plans make a snowman after school.

Unknown Son, however, was pounding the pillow becasue there wasn't enough snow to cancel school.

Don't worry, U.S. -- where we are there'll be plenty of opportunities to skip school because of snow.

Exotic Markets Survival Guide (from the WSJ)

Just yesterday, I blogged about an article in the weekend Wall Street Journal on the "Three Fund Investment Strategy" (i.e. construct a portfolio consisting of three assets: a domestic stock index fund, a domestic bond fund, and an international stock fund).

So, to follow that up, I thought I'd highlight a second piece from the Journal, on investing in emerging markets. It's titled "Exotic Markets Survival Guide", and is also from the Saturday Journal. Here's a snippet:

As more Americans invest abroad, the past year has served as a cautionary tale about the promise -- and risk -- of such a strategy. In May and June, emerging markets plunged amid worries over rising U.S. and Japanese interest rates and a possible global slowdown.

But within months, the markets rebounded. The MSCI Emerging Markets Index is up 23.7% in dollar terms this year -- just 1% away from its all-time high. The Dow Jones Industrial Average is up 14%.

Emerging markets have benefited from accelerated economic growth, large and youthful populations, and little-known but profitable companies. The category includes much of the world outside the U.S., western Europe, and Japan, encompassing countries as big as China and as small as the Czech Republic.

In the past, investors were wary of political upheaval, poor infrastructure, and shaky economic fundamentals that sometimes erupted into a full-blown financial crisis in such markets. Geopolitical risk still disquiets investors, who worry Middle East turmoil could spill over into Turkey, for example.

It's definitely worth reading the whole thing. Here are a few thoughts (in no particular order, like most of my thoughts:

• There's a huge variation in performance for the various individual emerging markets. Rather than try to pick winners, it's best to invest in a broad cross-section of markets-- ideally in an index fund or ETF.
• A good part of the performance in the last year is due to exchange-rate fluctuations. Whenever the dollar weakens, it increases the "US Dollar" returns relative to the returns in the emerging market's own currency. For example, MSCI index is up 20.9% in local currency terms, but has returned 23.7% in dollar terms.
• There are risks to investing in emerging markets (political risk, the risk that the emerging market's home economy will collapse, and so on. So, it's best to DIVERSIFY.

All in all, the piece is worth reading. I think most portfolios should have some exposure to international equities. Not surprisingly, stocks in emerging markets are less correlated with the U.S. index than are the typical U.S. stocks. So, adding them to a portfolio reduces portfolio risk. And they might even outperform the U.S. markets over time.

The Three Fund Portfolio (Stocks, Bonds, and International)

Today's edition of the Wall Street Journal has a piece on creating a simple portfolio using three funds - a broad domestic equity fund, a broad domestic bond fund, and an international fund. It's worth a read, and could easily form the basis for the bilk of your portfolio:

Though the idea may not be for everyone, the formula is easy enough: One index fund to cover U.S. stocks, another for the international markets and a third for the U.S. bond market. Together, this trio has rivaled U.S. stock returns over one-, three- and five-year spans, and with more stable returns year-to-year than the broad market.

With thousands of fund options, it may seem hard to believe that a portfolio that doesn't even try to beat the market can do a better job than most professional money managers. But in this case, less is more.

The three-fund strategy "makes sense," says Meir Statman, a Santa Clara (California) University finance professor who studies investor behavior. "What makes it hard is that it seems too simple to actually be a winner."

Make no mistake: A blend of bland index funds isn't going to provide you with scintillating cocktail-party conversation to dazzle your friends who own hedge funds or hot sector offerings.

"It's a 'cold shower' portfolio," Mr. Statman says. "You'll do fine, but you'll not have the biggest house in the fanciest neighborhood."

Read the whole thing here (subscription required).

The idea has a lot going for it.

First, by diversifying across domestic stocks and bonds, you lose some potential for lagrge returns, but end up with much lower volatility. That's more improtant than you might think, because the amount you have in the future is based on geometric, not arithmetic returns.

To see the difference, consider a simple case where you invest $100 and gain 30% one year, then lose 10% the next. Your arithmetic return is simply (0.30 + (-0.10))/2, or 10%. However, your "true" return is the geometric return - you end up turning $100 into $117 over two years (the $100 grows to $130 in the first year, then drops to $117 in the second. So, your geometric average annual return is actually 8.17%. In case you're wondering how I got that figure, to calculate the geometric average return, first take the annual return for each year and add 1. Then multiply the "1+return" for each year, and then take the "nth" root. Then subtract 1.

So, for two years, in an Excel spreadsheet the return would be:

[(1.+0.30)(1 + (-0.10))]^(0.5) - 1

= [(1.30)(0.90)]^(0.5) - 1 = 0.0817, or 8.17%

The higher the volatility of returns (i.e. the more returns fluctuate from year to year), the lower the geometric average return will be relative to the arithmetic average. So, reducing volatility could have a big impact on your future account value.

Adding some international exposure could also further decrease the riskiness of your portfolio, since international equity markets have a fairly low correlation with domestic markets. In addition, there's a good chance that they'll add some return "spice" to your portfolio, since many international markets have higher growth potential due to the higher growth rates of their countries' economies.

Like the article says, it's not a "sexy" portfolio, and it won't give you bragging rights around the water cooler. But it will probably outperform a great many of the alternatives.

TGIF Link Dump

It's Friday, and there are only 5 more classes to the semester. So, we're pumping away here at Unknown University, trying to get all the material on our syllabus covered before the clock runs out.

Today, I have class to teach, students to work with, a paper to edit (and no, it's not done yet), and a research presentation to go to. Luckily, whenever we have a presentation, we take the speaker out to the local watering hole afterwards for what we call "Faculty Professional Development" .

So, here are a few things to keep y'all busy while I try to get through the day:

Robin Hanson is discussing why men and women complain in different amounts. He blogs at Overcoming Bias, which is well worth a look - they've got some extremely smart on their roster. In fact, I think it should be added to the blogroll. And a Hat tip to Bryan Caplan at Econlog for the link.

In another "men and women are different" piece, Dr. Paul Irwing's research indicates that men generally score about 5 points higher on IQ tests. Let the comments begin!

Joe Carter at Evangelical Outpost has posted the latest installment of his Yak Shaving Razor Series. They're full of useful tips and tools. In fact, I just downloaded the undelete tool he mentioned.

Private Equity (at Going Private) is beating the whole "MBOs are unfair" idea like a pinata.

And finally, Richard Kang is commenting on options for replicating hedge fund performance without all the high fees.

That's enough blogging for now -- back to work!