2009 02 01 Economics in a Nutshell

Economics in a nutshell
A five-minute guide to investments

When things go bad in the economy, many people try to explain why they do what they do and how they would do things differently if they were either in charge or if they had a chance to do it over again. It’s fun to try to know it all in this area, but my life experience tells me that even the most sophisticated and brilliant minds cannot predict with certainty what the future holds economically. There is a standing joke among economists that the only thing certain about their predictions is that they’ll be wrong. In spite of that, many people have made their fortunes by writing books on how to grow wealthy, advocating certain investment strategies on the radio or conducting seminars expounding wisdom culled from seemingly well-informed sources. Several methods for guaranteeing economic stability do seem to hold promise, but none of these are popular when things are booming.

Gold. While the world was on the gold standard, gold was a medium of exchange with limited supply. That meant that gold had to increase in value per gram if true expansion of the economy occurred. Increase in value really meant that inflation caused the currency tied to the gold to be worth less over time. If the currency was dollars that meant that one needed more dollars to buy the same amount of gold. The purchasing power of the gold remained constant in the goods and services it would buy. That seems to hold true today.

Banks. A loan to a bank is an asset, but only if it is repaid according to a pre-set schedule. Deposits or failing loans are a bank’s liabilities. Banks have the unique role of being able to stimulate the economy by simultaneously encouraging both savings and lending. Of course they charge borrowers more interest than what they pay to their depositors, which allows them to stay in business. Aggressive banks take more default risk to get more loan interest. All the while they pay as little as possible to their depositors and as much as possible to their stockholders. Because of their history and the insurance provided by Federal regulation, banks have been able to be very aggressive. As a result, when defaults rose to a critical level, banks risked failure and government provided the stability it promised. Some banks took a slower approach to risk, maintaining careful underwriting of loans. That is, they did not accept the premise that markets will always go up. Those banks are now in the catbird’s seat being able to cherry-pick the best loans at a bargain. The bank losers are standing in line for a hand out. That means those responsible for collapse are benefitting from their irresponsibility. I am of the opinion that failure is an important part of the business cycle. Those who take on too much risk lose—sometimes everything. Those who are responsible gain from the benefit of their patience. If it were certain that no bail out would occur, individuals would be more careful about choosing their banking partners.

Government. Local, state, federal and foreign governments position their citizens to depend on them for certain benefits. Those benefits can be minimal or they can be far-reaching. One example of a minimal governmental benefit is subsidized ferryboat service where roads for cars, buses and trains provide a more efficient means of transport. Another minimal government benefit is subsidy for farmers to not grow certain crops. I cannot see any viable reason for our taxes to support the purchase of nothing. An example of a far-reaching government program is the United States Federal Highway system. That system has enabled the transport of enormous volumes of merchandise in one of the most efficient manners possible. Another critical government program is air traffic control, which has kept our airspace safe for millions of passengers year after year. One final example of far-reaching government programs is Medicare and Social Security. By some estimates, those programs are destined for failure. Nevertheless many people still think government provided medical care is a good idea. Some government regulations actually hurt everyday citizens. Florida government, for example, has prevented responsible private enterprise from charging sustainable insurance rates in the face of hurricanes. When the government insurer of last resort is called on to provide benefits after one or two more “big ones”, they’ll go bankrupt trying and the regulators know that. Meanwhile, many of the productive workers employed in that private enterprise are going to seek unemployment benefits. Government almost always looks at only one aspect of its role at a time. Consequently, when the focus on a particular problem occurs, other problems previously “solved” by government continue to operate. The end result is that government inevitably gets bigger and more powerful. Only when a catastrophic collapse occurs will that change. Only then will people realize that government cannot solve as many problems as the people want them to solve. Sometimes government tries to solve a problem by borrowing. As the debt gets bigger and bigger through the sale of bonds, the financial markets at some point will not take the bait, since tax revenue will not support the repayment. Always sold as safe due to the taxing ability of government, bonds too will collapse when the tax burden gets too high.

Bonds. In normal times, the sale of bonds can finance projects with future revenues. Companies and the government borrow money to be paid back with interest in the future either from sale of product or taxes. The inherent risks of such a transaction are that the company or government will over-extend and not be able to pay back if projections don’t hold up on future revenues. The interest rate risk is that inflation will rise faster than the interest promised thereby decreasing the face value of the bond. That is what I predict will happen in our current economic situation. Inflation is inevitable as the government prints new money to pay back old money.

Stock. What a great idea! A company produces a product so enticing or necessary that people want or need to buy it. A company needs capital to produce, market, distribute and sell this product. Investors buy stock in exchange for (not a promise but) a hope that success will pay dividends. When a business is successful, the government will tax the profits, thereby increasing their influence in our lives for the sake of some cause. Obviously, a secondary market for stock exists because people change their minds or want to reap the rewards of success or cut their losses on failure.

Real Estate. Land will always be in limited supply. This is especially true as population grows placing more demand on finite space. The big question in real estate is whether the value of a specific location will rise over time and a corollary—what is the optimal use for the land. As is true with other elements of our economy, real estate can rise or fall in value. Over time, however, as long as population grows, real estate will be a hedge against lower values. By the same token, if the real estate lacks amenities necessary to sustain a comfortable life or extract mineral resources, value can plummet.

Insurance. Many people don’t look at insurance or annuities as investments. To some extent I do. My reason is that insurance takes the law of large numbers and applies them to individuals. By doing that, insurance mitigates against risks individuals face by spreading that risk among individuals not having losses. That makes insurance a very steady place to put money. Of course insurance companies invest in a variety of other investments, but balance those investments against the time when some of their insured individuals will need the money—which is fairly predictable. If the insurance company plans well, dividends are paid to either stockholders or customers (if it is a mutual company).

Derivatives. A very sophisticated and risky market is deriving value from another market. Not my cup of tea. Futures are exchange-traded derivatives. Betting against time is the futures game. Will the price rise or fall? What if I pay now for delivery of a commodity at a certain date in the future? If the price goes up, I can sell it at a higher price for a gain. However, if it goes down, I’ll take a loss. Many people enjoy the risk of this game. Then there are businesses delivering commodities that need to obtain the best price without knowing precisely what the future cost of delivery will be. Those businesses, by definition, engage in the futures market. Whether an individual or business, the futures market is fraught with pitfalls.

Diversity. Even in this economy, I prefer to take a well-balanced long-term approach to placing money in various markets. Thus, I own Gold, Stocks, Bonds, Real Estate and Insurance but avoid derivatives. There is an old adage, “Buy low and sell high”. I have noticed that people who have short vision tend to sell low and buy high. So courage is needed to counter the current trend, but that is one way to long-term success in the financial markets.

Mutual Funds. These provide a mechanism to pool many investors’ small purchases into consolidated account positions. Mutual funds are a good way to buy many positions for small amounts. By so doing, you diversify easily. It is a good way to get started in investing. You are also engaging a manager who watches over the positions on an ongoing basis, which most of us don’t have time for. Mutual fund managers make their money through fees, but to the small investor, it is worth a few dollars to have someone watch their investments.

Brokers. Because the stock and bond markets would be overwhelmed by the millions of investors trying to buy and sell, brokers provide access to those markets. Many brokers also have advisors who can help educate investors about risk tolerance and market timing. Brokers are paid on trades, so they have an incentive to churn investments. Nevertheless, they provide value to those wanting to hold Mutual Funds or individual stocks & bonds.

Time vs. Risk. The only way to I see to consistently beat the market is to have time. That way, when investments lose value on paper, you’ll have time to recover. That is one reason I like insurance products so much. If time is not on my side (as an individual) for reasons beyond my control, the insurance company makes up the difference. In comparison to the benefit derived from that peace of mind, the premium paid is small. That is a good thing. That is one reason why I like what I do!

©Frank Bliss 2009 All rights reserved
February, 2009