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How Much Control Does the Fed Actually Have?

AIER Trustee Walker Todd recently took note of this provocative piece from George Selgin, which argues that the Federal Reserve Bank’s actions since the Great Recession have done little good to boost the economy.

Todd and Selgin, director of the Center for Monetary and Financial Alternatives at the Cato Institute, recently sat on a panel at Cato’s Monetary Conference in Washington, D.C.

According to Selgin, the natural movements of the economy, not the Fed’s interventions, are responsible for the low interest rates we have seen in recent years. The Fed’s expected increase in the federal funds rate later this year follows actual increases in interest rates amid improving economic data.

The Fed isn’t entirely powerless: The Bank’s raising of rates in the months before the collapse of Lehman Brothers in 2008 contributed to economic conditions that were too tight, causing real interest rates – and consumer demand — to crash, he argues.

In the years since, the Fed kept reducing the federal funds rate, which is intended to stimulate the economy by encouraging banks to lend out more money. But at the same time, actual loan rates were already well below the Fed’s targets already in place, and “by the time the Fed got around to lowering it, the federal funds target had ceased to have any meaning, save as a symbol of Fed officials’ vain hopes.”

When the Fed used unconventional policies like quantitative easing to pump money into the economy, it would have been expected to boost spending, inflation, and nominal interest rates. But those variables were only affected modestly, if at all, and the Fed’s interventions have caused uncertainty about the course of future interest rates, which dampens the appetite for investment, he argues.

You can read Selgin’s piece here. A piece about Walker Todd’s participation in the recent Cato panel can be found here.

Do you agree? Send us your comments below. We’d love to hear from you.

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What Did Quantitative Easing Accomplish?


The Federal Reserve’s post-financial-crisis strategy of adding to the money supply hasn’t been successful at improving the economy, so it is curious that it continues to pursue that approach, an AIER trustee said at a recent conference in Washington.

Walker F. Todd sat on a panel discussion at the 34th Cato Monetary Conference. The focus of the conference was “Central Banks and Financial Turmoil.” It posed the question of what would be the long-run impact on financial markets of the Fed’s quantitative easing policies in the wake of the 2007-08 financial crisis.

The conference featured such speakers as Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation; former Sen. Phil Gramm, R-Texas; former BB&T CEO John Allison; former Fed Governor Robert Heller; and former Cleveland Fed President Jerry Jordan.

The conference also held a panel discussion questioning the effectiveness of the Fed’s monetary policy on improving economic conditions. Sitting on this panel was AIER Trustee Walker Todd, in addition to Jordan and Johns Hopkins economics professor Steve Hanke, as well as moderator George Selgin, director of the Center for Monetary and Financial Alternatives at Cato. Selgin is also a former summer visiting research fellow at AIER.

Todd said monetary policy failed to measurably improve the economy after the crisis, while government spending has done quite nicely. Since 2008, Todd said, two key financial indicators have shown weakness: the velocity of money, or the frequency of financial transactions; and the M1 money multiplier, or the expansion of a country’s money supply through banks being increasingly able to lend.

With this weakness, Todd questioned how the Fed has used its tools to help the real economy.

“For all the exotic measures attempted by the Fed after 2008, none have delivered,” Todd said. He said this failure includes no meaningful expansion of bank credit or expansion of the overall money supply, amid relatively modest growth in Gross Domestic Product.

So, Todd asked, “Why do they keep on doing it?” He also questioned why other countries are pursuing the same approach.

To watch the video of this panel discussion, click here. To view all of the day’s speeches and panel discussions, click here.

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My Mini Days


Editor’s note: The author wrote a companion piece about the MINI Cooper and globalization, which was published yesterday.

 In January of 1974, I drove the Morris back to my house. It was a cold day and the heater was intermittent at best. It still needed work, but the plan was that I would use the car and return to my uncle’s when time permitted to continue improvements.

I drove the car to school and back, learning its idiosyncrasies. It wouldn’t start in damp or wet weather, and was so low to the ground that if there was any snow beyond a dusting, you might find yourself hung up on a drift.

When spring finally appeared I spent much of my time addressing the obvious foibles and most immediate needs to keep the Mini on the road.

One bright August day that year, I went to a friend’s house to give him a lift to summer school. My friend John asked if he could drive the car the five miles to our destination. I agreed, and we went off with John behind the wheel.

We had just driven through town and down a hill on the other side. We pulled out to pass a car in our lane, and a second one came straight at us. John spun the wheel. We clipped a telephone pole, removing the passenger door in the process, and landed in a field.

We were both awake and jumped out of the car. He and I survived with some bruises; I had a minor concussion. The Mini was not so lucky. It was ready for a proper burial.

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The MINI Cooper: At Globalization’s Crossroads


Not too long after World War II, the United Kingdom was second only to the United States as the largest builder of cars, and the biggest exporter.

Think about the world order in those days: This was before the auto industries of Japan and Germany, or for that matter, China began exporting their products.  Auto factories throughout much of Europe were in their post-war ruins. England saved its steel for its own major exporting businesses – notably, cars.

And in postwar America, returning GI’s and their baby-booming families demanded more new vehicles than the American industry could supply.

The British cornered the market on the sports car. Iconic names like MG, Riley, Singer, Triumph, Sunbeam and Austin Healey had the ability to make Americans swoon with their top-down, low-cost, cheeky by-the-mile fun.

The future looked very bright indeed; yet less than three decades later, most of these brands were gone: either they were swallowed up in another merger, or were in receivership.  What might have looked like labor unrest or supply chain problems or even unimaginative design from the perspective of 1970s U.K., is today more clearly understood as the impact of globalization. Lower cost structures in developing economies put pressure on U.K. producers and resulted in labor disputes with management and the government, quality issues, supplier problems. Furthermore, investment in production facilities in developing countries increased competition and U.K. producers were sometimes slow to respond, which contributed to uninspired new products at higher price points.

In the years that followed, England lost ownership of many of its storied marques. Jaguar and Land Rover went to Tata Group of India, Rolls-Royce to BMW, and venerable Bentley to Volkswagen.

There is one car perhaps more than any other that embodies the many facets of globalization. Of all the vehicles the U.K. has produced through the years, none speaks more clearly to the British automotive story than the Mini (see sidebar). Designed by Sir Alec Issigonis and launched by BMC (British Motor Corp) in 1959, it captured a nation’s heart.

If any car can be said to have driven the “Swinging Sixties,” it was the Mini. Peter Sellers, The Beatles, Twiggy, James Garner, and Steve McQueen were all owners. It had a starring role in the 1969 film “The Italian Job” with Michael Caine. The Mini’s impact today is still both visceral and immediate.

The last “classic” Mini came off the line in October 2000. BMW of Germany had acquired Rover in 1994 from British Aerospace and in 2001 began building the new generation MINI at its Oxford, U.K. facility. The re-design, including larger wheels, was still based upon the revolutionary front-wheel-drive, transverse engine, combined sump and gearbox platform. These cars and the many variants now available have been highly successful in both the U.K. market and abroad.

It is not too far a leap to say that there has been something of a resurgence in U.K. car production within the past several years. A few of these marques are niche English brands, such as Morgan, TVR, AC and Bristol that were essentially too small to have been impacted by the larger forces of globalization.

A number of other companies build their cars in the U.K., including Honda and Nissan, much like those companies have opened factories in the United States. This is another aspect of globalization.

But in the wake of this summer’s vote for Britain to leave the European Union, the future of England’s motor industry is again somewhat clouded. Brexit could make it more challenging for the U.K. to get parts from other European countries, and to export finished cars to those countries. While BMW officials say they “will not speculate about the outcome of the Brexit negotiations,” observers have noted that the company, with factories throughout Germany and on four continents, will face pressure to keep production in place because of the MINI’s British heritage.

So globalization has been the archetypal blessing and curse to the Mini brand and others. Without the capital and reinvestment by foreign governments and entities, the country’s motor industry could look quite different.


Ask the average Briton and they will probably say they would much prefer to return to the England of the 1960s when 1,000,000 people made British-owned cars in the U.K.

A distant second, but certainly preferable to no industry at all, is the reality of the day. There are 800,000 people involved in designing, engineering, manufacturing and mending motor vehicles as well as making components for them.

With Brexit on everyone’s mind, the specter of a much smaller workforce than what is now required is ever-present. Some iconic brands are gone and others will never again be part of the empire. How the current workers fare will be the next chapter in the story of globalization.

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American Education’s Misunderstood “Dropout Crisis”

high school hallway 500 pix

Workers with a high school diploma have better success in the job market than those who have dropped out.  According to the Bureau of Labor Statistics, individuals with only a high school diploma earned $678 per week in 2015, while individuals without a diploma only earned $493. Similarly, high school graduates (without any college) have a 5.4 percent unemployment rate while non-graduates have eight percent unemployment.

President Obama claimed in 2010 that high school dropouts are “a problem we can’t afford to accept or ignore.”  In order to “end America’s dropout crisis,” he committed $3.5 billion to improve low performing schools. However, dropout rates in America have fallen steadily for over 40 years and continue to fall – hardly indicative of a national crisis. Today, less than one in 14 students drop out.  Lower-income students contribute the most to the high school drop-out rate, and these low-income dropouts are concentrated in a small number of schools dubbed “dropout factories.”  The true crisis that the president is referencing stems from these dropout factories and the disparity between dropout rates for low and high income students.

Nearly 11 percent of students from families in the lowest income quartile dropped out in 2013, compared to only three percent for students from the highest quartile, according to the Census Bureau.  But we have made progress in this area. The dropout rate continues to fall for all income levels, but it has fallen fastest for lower-income Americans, in both absolute and percentage terms.  The dropout rate for the highest-income Americans fell by 35 percent since the 1970’s. The middle quartiles have about half as many dropouts now as in the 1970s, and the lowest quartile has seen a 60 percent reduction in dropout rates. The chart below shows that the sharp reduction for lowest-income Americans has come mostly in the last ten years. Until 2003, the trends were similar across quartiles.

                                                         Income Level Dropout Rates (%)*
Year Total Lowest Quartile Middle Low Quartile Middle High Quartile Highest Quartile
1973 14.1 28 19.6 9.9 4.9
1983 13.7 26.5 17.8 10.5 4.1
1993 11.0 22.9 12.7 6.6 2.9
2003 9.9 19.5 10.8 7.3 3.4
2013 6.8   10.7 8.8 5.0 3.2

*dropout rate data from the U.S. Census Bureau, School Enrollment in the United States: October 2014

Recent gains may be due to an emphasis on reforming “dropout factories,” a term that describes high schools where fewer than 60 percent of freshmen graduate after four years.  Dropout factories account for more than 50 percent of the nation’s dropouts, even though they represent less than 10 percent of all high schools.  These schools are commonly characterized by poor leadership and poor administrative practices, such as high suspension rates, apathetic teachers, and disruptive environments.

When many students leave, a school can begin to develop a “dropout culture” where students begin to think that it is normal, or even cool, to drop out.  These schools also tend to have larger percentages of students from lower-income backgrounds.  For example, Theodore Roosevelt High School in New York City had a student body of more than 1500 students, and more than 80 percent of these students were eligible for free lunch because of low family income.  Theodore Roosevelt High School shut down in 2006 after only 3 percent of students graduated.  The graduation rate had been below 10 percent for many years before that.

Recent reforms actively target these dropout factories in the hopes of keeping more students in school.  The reforms seek to reduce dropout rates by targeting the lowest performing schools while also funding programs that engage disconnected youth.  For the lowest performing schools, school districts are given four options: replace the principal and a large number of staff, reopen the school under a new charter operator, transform the school’s teaching programs and teacher training, or close the school.   These programs have seen results, since between 2002 and 2013 the number of students attending a dropout factory has been halved.

The “American dropout crisis” is not the national dropout rate. The crisis is the existence of dropout factories: a minority of schools where the majority of students drop out. However, the detrimental impact of these schools is falling.  Dropout factories are being improved each year, and the dropout rate for the lowest income quartile has seen a sharp improvement.

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Can U.S. Automakers Crack the Cuban Market?

Chevys from the early 1950s, in Cuba.

This blog was written by our Robert Batesole.

Most of us have become familiar with the sun-drenched scenes of Cuba’s classic automotive transportation. The easing of relations with the United States could at long last herald changes in the fleet of cars on Cuban roads. Here is a little backstory on that history to propel us forward.

Fidel Castro and his revolution came to power on January 1, 1959. After several unsuccessful attempts, Castro ousted the dictator Fulgencio Batista and his supporters who fled Cuba to the Dominican Republic.

Shortly thereafter, as Castro began to ally with the Soviet Union, the United States imposed a trade embargo which is only now, 50-plus years on, under reconsideration. If Cuba is not the birthplace of the saying “Necessity is the mother of invention,” it has proven the adage daily since the embargo began.

Prior to September 2011, only automobiles that were in Cuba before the 1959 revolution could be freely bought and sold. For decades, the sale of a car by a State dealer to a Cuban citizen required approval by a governmental agency. Foreigners also needed authorization signed by “the agency that serves them” in Cuba.

The Cuban people have been living in a “Happy Days”-era auto time warp. In a land where planned obsolescence is an unknown commodity, almost every make and model of vintage American iron is on display. Far beyond basic transportation, these cars were, and are, an expression of creativity, individualism and dogged determination, a slap at the sterility and oppressiveness of the regime.

What about other cars, you ask? What alternatives to pre-1960 U.S. cars have been available?

The Communist system is known for their ability to produce “interesting” vehicles and Cuba certainly wouldn’t be complete without their poor to wincingly bad state-sanctioned cars. Mercifully it’s a short list of the Russian Moskvitch 2141, GAZ 2410 and VAZ 2105, along with several others including the Polksi Fiat 126p and the French Peugeot 405. The Peugeot is apparently quite common and very popular. I owned the 16-valve version of this car in the late 80’s, and can attest to its peppy performance and styling.

Russian Moskvitch 2141

Jay Ramey is an Associate Editor with Autoweek, and he suggests that “Cuba’s streets may be famous for American classics from the 1950’s, but there’s more to it once you dig a little deeper.

In January, the Cuban government began selling new and used vehicles to anyone with the money to buy one. But even under those recent reforms, a 2013 Peugeot sedan was priced at more than $250,000, and a 2010 Volkswagen Passat cost $70,000, according to a report earlier this year by National Public Radio.

Karl Brauer, senior analyst for Kelley Blue Book, noted that “the country is still ruled by a communist regime, and access doesn’t mean economic capability.”

Cuba’s citizens are eager to buy new or newer American products, as much as U.S. automakers would certainly like to satisfy their transportation needs. But the reality is there is still a significant transition from a state to a market economy that has to occur. In a country where automobile ownership for decades has been, and continues to be, a luxury afforded by a very few, it seems that time, patience and a little luck will play a significant role.

Source:, 2008.

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Measuring Your Economic Wellness

This piece was written by Max Gulker, senior research fellow, and Ryan Smith, summer fellow.

You may be familiar with the common business practice of using financial ratios to assess financial performance. You can use this trick with your personal finances too. With just a few numbers, you can get a basic sense of your own economic and financial wellness, relative to what the experts recommend.

Financially healthy people are prepared to pay their bills on time, finance short-term emergencies, and have a healthy balance between short-term and long-term savings. The concepts of liquidity ratio, leverage ratio, and investment-assets-to-net-worth address these important areas:

  • The leverage ratio (debt divided by total assets) shows an individual’s ability to pay their debts. A recommended maximum benchmark for this ratio is 36 percent, however, 50 percent is a more flexible benchmark for early-career individuals.
  • The recommended benchmark for the liquidity ratio (cash and liquid savings divided by monthly income) is 2.5 or above, which means having enough cash to cover 2.5 months of payments in the event of an emergency or a job loss.
  • The investment-assets-to-net-worth ratio shows how much people are saving and investing for the future. The established benchmark for the investment-assets-to-net worth ratio is at least 0.25. However, this ratio increases for most people as they get older, meaning a benchmark of 0.20 is more useful for early-career individuals.

Because numbers don’t always tell the whole story, economists like to include subjective measures of wellness along with hard data. We have identified a 10-item questionnaire released by the Consumer Financial Protection Bureau as a useful tool to capture peoples’ views about their finances. The questionnaire asks the degree to which you agree with statements like “I could handle a major unexpected expense” and “I can enjoy life because of the way I’m managing my money.”

As most of us know, information is only part of the recipe for change and must translate into changes in behavior. Not surprisingly, self-control problems are associated with higher borrowing, specifically on credit cards, and lower savings of income tax refunds. As we documented in a two-part blog post, human nature is such that it can be easy to under-save and overspend. But information like the ratios and questionnaire above can help us set goals and more easily put intentions into action.

Here at AIER, we’re developing tools and resources to help you evaluate and improve your economic wellness. With the right information and understanding, combined with a commitment to action, this initiative can help many people achieve greater financial and economic security.

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Pull Yourself Up By Your (Parents’) Bootstraps

By Tristan Coughlin, Visiting Research Fellow

We imagine a world where our lot in life is tied to our own talents and initiative, rather than our parentage.

We can measure our progress toward this goal: Intergenerational Income Mobility is the extent to which parental income levels are correlated to that of their children when the children are grown.

In the United States, the data shows we still have a ways to go to realize this dream.

Economists measure intergenerational mobility by estimating intergenerational income elasticity (IGE) between parents and grown children.

This is a number ranging from zero to one, where an estimate of one means that children’s income levels will be in exactly the same spot on the income distribution scale as were their parents (i.e. the child of a “one-percenter” will be a “one-percenter”; the child of impoverished parents will be impoverished). An IGE measure of zero means there is no parent-child income relationship.

This can move in either direction. It does not measure whether children are better off than their parents; it simply measures how close a grown child’s income correlates to that of their parents.

An IGE measure of, say, 0.5, means that the child of a parent whose income is $20,000 below the average would be expected (all else equal) to have an income level in adulthood that is $10,000 below the average. And a child of a parent whose income is $20,000 above the average would be expected to have an income of $10,000 above the average.

High intergenerational elasticity (low intergenerational mobility) is a concern for anyone worried about increasing levels of inequality.

It is perhaps not surprising that top economists have found the United States to have some of the highest  estimates in the developed world (0.4-0.6). Indeed, data suggest that an American’s lot in life is much less influenced her productivity, work ethic, determination, etc., and much more so by whom her parents are.

Compare this to the U.K. where estimates are closer to 0.3, and Nordic countries (Denmark, Norway, Finland, and Sweden) where IGE estimates are less than 0.3. This should be disconcerting for anyone who believes in the meritocratic aspects of American capitalism.

So why is intergenerational mobility relatively low in the United States? Some of the world’s most influential economists have turned their attention to this question, and although the answer is not completely clear, there is evidence of some very strong indicators. I focus my attention on one.

Perhaps the most intuitive mechanism through which income levels are transmitted across generations is education. Parents with relatively high levels of education also have relatively high levels of income. Therefore, these parents are more able to provide financial access to education to their child, which in turn, increases the child’s adulthood income level. This is called the “selection” effect of education on IGE.

It is also possible that parents with high levels of education pass on specific traits to their children that cause the children to pursue higher levels of education, independent of parental income. This is called the “causation” effect of education.

Deciphering the relative sizes of the “selection” and “causation” effect of education on IGE is of great importance as it pertains to economic policy. If, for example, the “selection” effect is very large, this suggests that increased public expenditure on education could reduce IGE and level the playing field.

This possibility is supported by recent research that finds that, over 10 developed economies, IGE estimates decrease as the percentage of GDP spent on public education increases (Ichino, et. al., 2009); and, in areas in the U.S. in which public expenditure on education is relatively low, IGE estimates are higher (Mayer & Lopoo, 2008).

On the other hand, if the “causation” effect is the driving mechanism, then there is less of a role for public policy and perhaps a larger role for parents to do things that support and strengthen their child’s education. Whatever the larger of the two effects, a cause of high intergenerational income transmission in the U.S. seems to be high intergenerational education transmission.  Policymakers, students, and parents take note.

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Can You Expect Your Money to Double in 10 Years?

by Luke F. Delorme, Director of Financial Planning, American Investment Services, Inc.

Sometimes when I do a back-of-the-napkin estimate about how much I’ll have saved in the future, I’ll use a handy formula known as the “rule of 72.” This rule says that if you divide 72 by your rate of return, the resulting number is roughly how many years it will take your money to double.

For example, if I expect returns of 7 percent a year, I would expect my money to double in about 10 years (72 / 7 = 10.3 years).

I was recently talking to an adviser who made a confident statement that he expected to double his clients’ money every 10 years. Based on the rule of 72, this suggests that he thinks he can return an average of 7.2 percent per year over the next 10 years. Historically, the S&P 500 has returned almost 10 percent per year, so this statement doesn’t seem outlandish. But let’s dive a little deeper and play this out in the real world.

Stock returns only

We have data since 1926 for the S&P 500. Using annual data, this means that we have 81 possible 10-year periods of overlapping historical data. If you were to invest 100 percent in the S&P 500, there would have been 59 of these 10-year periods during when you would have doubled your money. This is a pretty good success rate (about 73 percent), but nowhere near a guarantee.

Take, for instance, the period from January 2000 through December 2009. During this period, not only would you have failed to double your money, you actually would have lost money. On the other hand, the 10-year period ending in 1959 saw stock returns of over 600 percent. Suffice it to say, the range of possible outcomes is broad.

Of course responsible advisors realize that a 100 percent stock portfolio is rarely appropriate, even for the most risk tolerant investors. So what happens when we add a little diversification?

Diversified (60/40) portfolio

I looked back at returns for a portfolio comprised of 60 percent stocks (S&P 500) and 40 percent bonds (20 percent in long-term corporate bonds and 20 percent in five-year U.S. Treasuries). The good news is that this diversified portfolio would have mitigated the risk of that lousy 2000 through 2009 decade – you would have made about 36 percent instead of losing almost 8 percent.

But there is no free lunch. While diversification lowers your risk, now there are even fewer 10-year periods when you would have doubled your money with this 60/40 portfolio. Of the 81 possible periods, this portfolio would have doubled your money in only 52 of them (64 percent). Still not a bad rate of success, but this doesn’t yet account for any fees.

Diversified portfolio after fund fees

Mutual funds, index funds, and ETFs are subject to fees (often listed as “expense ratios”). The fees on ETFs using simple index funds can be low, ranging from 0.05 to about 0.30 percent. The fees on mutual funds tend to be higher, often ranging from 0.50 to above 1 percent. I have no idea what funds the adviser in question uses, but let’s assume he’s chosen a mix of mutual funds and ETFs with average fees of 0.50 percent.

After accounting for these fees, out of 81 possible historical 10-year periods, we’re down to 46 (57 percent) that would have doubled your money. Oh wait, doesn’t the adviser charge fees too?

Diversified portfolio after fund and adviser fees

I’m betting the adviser didn’t account for his own fees in his calculation of doubling up every 10 years. Let’s add in a lower-than-average adviser fee of 0.75 percent (many adviser fees start at 1 percent or above).

After accounting for fund fees and adviser fees, our historical 60/40 portfolio doubles every 10 years in only 41 of 81 cases (51 percent). Things are looking a little less certain. And we’ve yet to look at the taxes.

Diversified portfolio after fees and taxes

Capital gains taxes are 15 percent for most people. There may be other taxes paid during the course of the 10 years, but we’ll just assume this base 15 percent rate. The investor may not actually realize these taxes during the period, but if he wants to use the money for something in 10 years, he’ll need to sell his investments and realize the capital gains.

Accounting for these potential taxes, the number of periods where you could have doubled your money falls to 35 out of 81 (43 percent). This still fails to account for the purchasing power of the portfolio.

Diversified portfolio after fees, taxes, and inflation

If you doubled your money during the late 1970’s and early 1980’s, you barely kept up with inflation. In other words, prices of goods and services were skyrocketing as well, so doubling your money wouldn’t have got you anywhere in terms of what you could do with it.

For example, in the decade from 1974 through 1983, our diversified portfolio after fees and taxes would have more than doubled (2.07 times). But after accounting for price increases during this period, the value of the portfolio would have actually been about 5 percent less than at the beginning of the period. You’d be worse off financially.

If we account for inflation in our historical examples, we drop to just 10 of 81 periods (12 percent) during which you could have truly doubled your money. Suddenly, this adviser’s promise is looking doubtful, to say the least.


Anyone that promises to double your money in 10 years may be using a back-of-the-napkin estimate instead of a rigorous analysis that accounts for fees and inflation. Will your money double in 10 years? Maybe, but it’s far from a guarantee.

Instead of focusing on what you may or may not return over the next 10 years, it may be wise to focus on controlling what you can by minimizing costs, making efficient tax allocations, and diversifying your exposure. Save as much as you can and evaluate your situation only after the years have passed.

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American Investment Services, Inc. (AIS) is an S.E.C. Registered Investment Adviser founded in 1978. AIS is wholly-owned by the non-profit scientific and educational organization American Institute for Economic Research.

Investing: What You Know Might Hurt You


The author, Quinn Abrams, an intern at AIER, is a student at Bard College at Simon’s Rock.

Familiarity bias is the tendency for people to prefer a product that they know over one they don’t, even when the alternative may be better. Researchers have found that this bias can cause people to underestimate risk with the things they know well. Most of the time, this is a useful cognitive shortcut.But sometimes our familiarity causes us to gloss over important factors.

As a simple shortcut, gut decision making can help in everyday life. For example, when we find a brand of spaghetti we love, we can stop thinking actively about whether to buy it, because we trust that it will continue to be delicious. This saves us mental energy and ensures us an easier shopping trip.

With other goods, however, we may have to be more careful about making decisions from our gut. When we buy a painkiller for a headache, we have a choice between the name brand product (like Advil) and the store brand product with the same active ingredient (ibuprofen). Many people choose the name brand because they are familiar with the brand and feel that it will perhaps be more effective or cause fewer side effects. In fact, the FDA Read more