The Falling Capital by ~Latuff2

My friend sent me a funny link about CNBC that brought forward a few thoughts about assets. What I am about to write you can and should safely ignore as it is likely to have little to no impact on your life. If you know me, you already know I don’t know anything and carry my cross like everyone else in the world. If you don’t even know me, how can you take what I say as anything of value, anything to use as basis for even a simple decision. Please apply this test to all the noise that comes at you at hundred miles per hour from all the sources of your information. It is actually fun to find the hidden assumptions, the flaws in arguments, the hard-to-notice issues with the opinions given out so freely by everyone. Find issues with what I say, and I’ll thank you.

I only watch CNBC, keep an eye on the papers, and the Internet to gather clues about public feelings. Don Chu’s eloquent points about the fractal nature of humanity come to mind here because just as we have good days and bad days, so does the society. Our aggregate public feelings appear in media. As an example, jokes are only funny because we can relate to them. These feelings in today’s complex and constantly changing world cannot be internalized without one keeping both eyes and ears open and watching and listening on all frequencies. Often the clues are subtle, insignificant and sometimes I cannot even verbalize what I’m “hearing” but I don’t stop listening. My only limitation is time. CNBC plays its vital role in filling in the picture of public sentiment. All of the networks cater to their audiences so well, that we can easily approximate the mood of the audience by simply keeping an eye on the media catering to that audience.

Why did I think about assets? Actually, I don’t like that word at all. The reason is debt. Assets can be acquired with debt. It is not difficult to have significant assets balanced by significant debt. I like the word capital much better. Much of the media, your neighbors, everything you see screams “assets.” Assets are visible and quantifiable. Debt is a hidden, private matter. Of the various definitions of capital, I like this one “any form of wealth employed or capable of being employed in the production of more wealth.” This concept is too basic, I agree. However, often the very basic and simple ones contain more energy than complexities (who would have thought tiny atoms could produce so much energy).

The first challenge is the preservation of capital which encompasses everything we do to make sure that whatever capital we have does not turn into nothing as a result of everything that happens around us. Public sentiment is critical for this because after all the vehicles for storage of capital only work if someone out there is willing to accept them in exchange for something we need. I lived through a period when currency turned into nothing after the collapse of the Soviet Union. Every day I would take the money I earned with my friend and buy something, anything I could buy (cheese, butter, dollars, etc.) because the next day that money would buy less. To contrast that, I was speechless when I visited the Vatican and realized how the Roman Catholic Church had preserved its wealth throughout centuries, changing regimes, wars, and changes in public sentiment. It is a superb lesson in wealth preservation which even includes sovereignty. Contrast that with someone trying to hold on to their property during the gold rush. Keeping in touch with the world and public sentiments is critical for taking the necessary measures ahead of time to protect one’s capital.

The second challenge is employing the capital to produce more wealth. I actually consider this an easier challenge than the preservation of capital but there is nothing easy about this. CNBC and millions of “advisers” are ready to give us that one perfect method that will surely increase our capital. They (referring to the money machine) even convinced a lot of people to borrow someone else’s capital (mortgage or margin put into stock market). They “help us” with enormous amounts of data (real-time quotes, hundreds of statistics, derived metrics, research reports, derivative instruments, etc.), with “education” contrasting investors with speculators (no real difference here), with language (buy and hold, dead cat bounce, MBS, ABS, CDS, etc.), and everything else one would ever “need” to turn capital. The US government wants constant turnover of capital because at every turn increases can be taxed. If capital is not turned (artwork passed from one generation to another), no worries as there are laws to tax the transfer. I still cannot understand how the capital gains are taxed fully but capital losses are only used to offset gains (+$3,000 break). People unfortunately do not often understand what capital is because we sometimes start out with negative capital (student loans, mortgages, etc.). By the time we create enough value to pay off these loans by helping someone else turn their capital, time (our most valuable resource) becomes depleted. CNBC, the mutual fund companies, the government, our friends, this blog, and nothing else in the world can tell you how to preserve and increase your capital. Once this became clear to me, CNBC and all forms of media and information took their proper place in my mind.

Mona Lisa by Leonardo da Vinci

Heavily used machines are considered great when the quality of their output is constant with no statistically significant variances over time. In other words, they consistently produce according to their exact specifications especially long after the end of expected useful life. We, on the other hand, cannot simply maintain good quality in what we produce. We must continuously show improvement in our results (such as progressively advancing resumes, higher levels of education and achievement, etc.)… and many of us do.

Few artists are able to produce top music hits decade after decade. Few authors’ every work is considered a timeless classic. Few portfolio managers can beat their benchmarks through every market while improving against negative factors such as portfolio growth and constantly changing socioeconomic and geopolitical landscapes. Few Olympians maintain record scores for decades. These people represent the tail of a bell curve that’s infinitely approaching zero.

Unfortunately this also applies to companies (and teams, governments, organizations). Few of them have been or will be around for decades and even fewer for centuries. Why should companies be any different, especially given that even with 85% employment, they in aggregate are employing the very large majority of the human bell curve? Why should we expect more from them?

One reason is that they have the advantage of diversification. If each member in a team of five members has only one great product idea, one great initiative, one great article, then the team has potential for five great achievements. Therefore, a company with five such teams has enough potential for twenty five great achievements, products, or services at a minimum. Some companies also have the advantage of hiring top talent in the first place who have the potential to produce far more than one great work over their lifetime. Great companies, with thousands of employees should have thousands of great new accomplishments that should last them for centuries. Especially since their workforces change over time with each change bringing fresh new perspectives and strengths into the mix, they simply have no excuses to arrive at a place where, for example, the US automakers and the financial services companies before them found themselves these days. Maybe it’s a sideeffect of satisfaction with performance that meets or exceeds expectations. Instead, perhaps we should see ourselves and everyone around us as people who are two, or five steps away from the great breakthrough, the achievement of a lifetime, our one (or more) contribution to human progress. I’m sure once we achieve that, we will invariably want to keep going for more…

NYSE by ~liquidsunshine1024

While reading a post from Daily Speculations, I thought of many reasons why the markets are so fascinating. I think it important to be fascinated for the right reasons. Here’s the partial list for me:

1. Markets offer a unique perspective on life and events. This perspective cannot be appreciated by those who do not follow the markets. Here I mean the stock, bond, commodity, currency, real estate and other financial and investment markets. At a basic level, these provide the vital signs (blood pressure, temperature, weight, etc.) for the state of affairs in the world. I believe everyone follows a few markets whether they know it or not. For example, people may follow the clothing or shoe markets, the grocery market, the cell phone market, the job market for a particular profession, etc. I find that these folks miss out on the unique perspective gained from seeing the interrelated cycles in the various financial markets across the globe.
2. One cannot know everything about every market which makes it very exciting to never run out of new knowledge to discover and learn. Time is the only limiting factor. I believe that “What has been will be again, what has been done will be done again; there is nothing new under the sun. (Ecclesiastes 1:9)” but it is our own discovery that makes the journey so exciting. Newton did not create the forces in mechanics, he simply explained them. Copernicus did not move the earth from the center of the universe, he discovered that was not the case. Similarly, in the markets there is always something new to discover, something that is obvious to another person or something that has been explained incorrectly in the past. The one difference is that the new discoveries, large or small, allow us all to affect the functioning of the markets. Imagine a long book where the sentences you have not read change as you read each new sentence.
3. Markets force the issues that people are otherwise unable to force through political, commercial, or not-for-profit means. I believe this is one of the reasons Soviet Union did not have such markets. They provide the environment for natural selection of the healthy from the unhealthy.
4. Markets provide the means for a very large and powerful industry capable of shifting massive amounts of wealth around the ecosystem. The mechanisms are so large and so complex that I think of these as not too dissimilar to the building of the pyramids. Millions of people go to work each day making infinite improvements to these modern day pyramids.
5. Markets provide the means to diversify and preserve purchasing power in the absence of an alternate method or mechanism to store and transfer purchasing power. Soviet Union could not afford to store purchasing power because of the overall inefficiency of the machine. What is amazing is that even those of us with little wealth, no stocks or bonds, participate in the markets in one way or another.
6. Markets provide the means to examine, learn and better understand ourselves. Some of us learn who we are. Some of us learn who we want to be. Some want to get ahead at all cost, others simply want want to preserve capital. I continue to learn a great deal about myself by examining my thoughts, actions, and results in the context of the never ending stimuli from the markets.

If your reasons for being fascinated with the markets are not listed above, feel free to mention them. I would encourage everyone at any age to pick up this subject. You never know… it might help you make or save a dollar or two in the process.

Assorted United States coins

Many families in the US are going through difficult times lately mainly because of the effects of the revaluation of real estate. Every day I hear about people being negatively impacted by the current downturn. I feel that with additional preparation, the struggling families would weather this storm better. I have already said that teaching finance, discipline and especially financial discipline should be a priority for our school system but that’s not going to happen overnight. In the meantime, here are my tips on preparing for a financial storm. You should get ready for a financial storm now even if it may seem like you’re barely coping with the current one.

Savings. In addition to your retirement savings and all other savings, make sure you set aside serious funds into a rainy day savings account. This account must increase with EVERY dollar you receive. This is a tax that you must pay to yourself and your family. If you have a family, the account balance should be enough to sustain your family for at least one year without earnings. If you do not have such an account, next time and every time you get ready to pay for anything, consider instead depositing the funds into the savings account. Never purchase new cars, houses, or anything else if you have not saved into this account the required sum. If you do not pay your family into a rainy day account, you’re likely to run into financial troubles some day. Never fund purchases out of this account unless your family is in a serious hardship and you see no other alternative. Replenish immediately after the situation improves.

Insurance. Never consider debt as your “insurance” for the difficult days. Just because you have equity in your home, it does not mean you’ll have access to these funds when you need them most. Just because you have a credit card with a high credit limit, it does not mean that you should use it or rely on it during financial hardships. Do not borrow against your retirement account just because that option may be available to you. Even bank accounts are not good enough in some cases (bank runs, lack of confidence in banking system). Cash on hand isn’t even good enough in some situations (hyper-inflation). Do you think your lines of credit will protect your family? Get enough insurance for your house, car, and other valuables to protect your family against disasters. Do not buy into income protection and other similar schemes because they are simply ways for others to build their savings accounts.

Debt. Get rid of your short-term debt. People who care about you do not care what car you drive or where your house is if your credit cards are choking your family every month. If you owe large sums on your credit cards or in other short-term loans but drive a new car, get rid of your new car, you cannot afford it. You have student loans, pay them off. I have heard most arguments in favor of one type of short-term debt vs. another. They are all bad! Pay them all off just as soon as possible.

Credit. Treat your credit score and credit rating very seriously as that not only matters when you ask for a loan but also in many other situations such as getting a job and renting a home. Low credit score means lack of discipline. Cancel your TV service, get rid of your cell phone, take public transportation, buy only basic ingredients for your meals, do not eat out until you pay off your creditors and improve your credit score. There are all kinds of complex ideas on how to increase your credit score. If you care about them, you are wasting your time. Live your life responsibly and you will not have to worry about this. That’s the fundamental fix.

People. If you care about your extended family, friends, your community and your country, start yourself a program of financial discipline if you don’t already have one. Get books from a library, take classes on this subject and discipline yourself and your family into financial stability. When you get into financial trouble, people around you are also affected very much. Your family, the state or the country may need to help you. If the whole country had acted in a responsible manner in the recent history, we would probably have avoided the current difficulties.

A lot of strong statements have been made above. Obviously, I fully understand the unique situations that people have. You know your situation best. I hope you realize that you have the ability to change that situation when it comes to your finances. It just requires your focus and attention.

You will invariably hear rules #1-#3 in real estate as location, location, location… This is not entirely true. Be careful since deception is not uncommon as we have seen in recent past!

Your home is not an investment; it is an expense. Investments have returns, your home only has expenses such as taxes, heating/cooling expenses, water bills, etc. As long as you live in your home, it has zero return. The money you invest in your home is frozen and earns nothing. If you consider the appreciation of your home as your main investment strategy, then you ought to instead focus on two other topics — how to increase the income from your job or business and how to decrease your living expenses so you can save more and invest in other assets.

I am not trying to discourage home ownership. There are numerous advantages to home ownership such as better communities, schools, etc. You should own your home if you wish as long as you can afford it — just do not consider it an investment. Quite a number of people bought houses in the past five years without having the means to weather a real estate storm such as the current one.

Various factors contribute to the misunderstanding that our homes are investments. First, home ownership generally requires a mortgage with a set monthly payment consisting of interest and principal. This principal would have been spent in most cases if the bank was not there to collect it. The mortgage enforces a form of savings discipline which is further encouraged by government tax deductions and other minor benefits. Even if the real estate and currency markets remain flat over time, these principal payments add up to result in sizable savings — especially if the home is held long enough. Again, this factor might make your home a sound purchase (certainly better than your car) with low risk and possible long-term benefits. I am certain you can do better than rely on a mortgage to save. Second, home ownership is perceived as an investment because of constant inflation. You can borrow $100 today and by the time you pay it back (even including all of the interest payments), it might be worth $10 if government acts with sufficient recklessness. Third, home ownership brings leverage and any appreciation seems like an incredible percentage of return but remember so does depreciation during falling house prices.

You should only invest in real estate in one case — to diversify. I am probably being a bit too strict for a number of reasons:

• Diversification implies you have lots of cash already invested in other assets (CDs, stocks, bonds, gold, etc.) and need to invest in yet another asset class, real estate, for higher long-term return.
• By its nature, diversification requires that you not invest all of your cash in real estate, which is a much safer mode of operation.
• When you borrow (get a mortgage), you will consider the earnings potential of the real estate alone, rather than all your other sources of income as in the case of buying your home.
• You will not get emotionally attached to the property as people get attached to their homes because it will simply represent another investment.
• You will be free to sell without worrying about uprooting your family, driven strictly by investment strategy and without any emotional family bias.

There is one danger here: do not under any circumstances speculate in real estate. I would go as far as saying do not ever speculate in any asset. Your chances in speculation are not that different from gambling at the casino.

When used appropriately real estate can be a good source of return with lower risk but the opposite is also very true, you can lose thousands of dollars in a short time.

The Harvard Management Company is one of the best money managers in the world. It invests Harvard’s endowment in almost a dozen asset classes. If real estate was the ultimate money maker, why own the other assets at all? Their asset mix changes annually but gradually. I hope you will be careful with real estate and will avoid the misfortune in the form of foreclosures that many around the United States are experiencing today.

What does this have anything to do with “buy low, buy slow?” As you build your wealth, it is important to consider all the factors affecting the storage mechanism. For most people wealth is stored in terms of currency (such as bank account with dollars) or a house. Unfortunately, for some people wealth is negative because of debts. I hope you do not find yourself in this situation.

For the elite fortunate enough to have abundant current purchasing power, wealth is stored in a diversified form of different assets such as gold, money, stocks, bonds, land, commodities, contracts, obligations, new ventures, patents and so on. The smart ones know that they must diversify but they don’t just diversify overnight. Instead they accumulate assets slowly. They know when is a good time to begin accumulating an asset but they are not arrogant. They do not just go out and buy gold because gold has lost 20% of its value, for example. When you see a good deal such as an asset that you have been trying to diversify into which has lost a lot of its value, consider buying some carefully — for example 5% of your intended holding. Then wait and see what happens. Do not be arrogant to buy 100% of your intention because the asset could lose its value further. The key is to buy a bit more as it loses its value. If it appreciates instead, then you’re in good shape.

I believe you will improve your returns much more with this strategy than trying to guess and gamble where the next dip or downturn might be. Your wealth preservation machine will operate better with this small yet powerful adjustment.