Financial Literacy

There have been hundreds of concepts of money over the last 5,000 years. Since the internet was popularized around 1993, there have been many failed digital currencies (look up Flooz that was promoted by Hollywood celebrities). New crypto currencies were supposed to be Gold 2.0 by solving all the problems related to failed digital currencies: limited supply (they must be mathematically mined), they are transparent (through the blockchain), and are peer-to-peer with no intermediary.

One cryto-currency shot up in value in 2013: Bitcoin. It rose from a value of $150 to $1,100 in a single month before it fell back in price. This popularity started an explosion in competing cryto-currencies, crypto-exchanges, and other digital products and services around them. Retailers jumped into accepting Bitcoins and everyday economists and financial advisers are asked, “What do you think of Bitcoin?”

Let’s review some key risks and benefits:

1. There is no intrinsic value underlying crypto-currencies – a specific mathematical number has no worth. So unlike gold or silver, cryptos require “faith and belief” in their value, just like the paper currencies of dollars, pesos, euros, and yen.

2. The blockchain of transparency has not prevented theft by hackers and there is no recourse to get your stolen “money” back (because there are Bitcoin money launderers just like cash launderers of illegal transactions).

3. There is personal benefit of temporarily using crypto-currencies to bypass currency controls and societal benefit to having a currency out of the hands of politicians that have a 100% track record of destroying it.

Right now, crypto-currencies are a new industry in flux. Many new cryptos are “pump & dump” currencies to defraud buyers while others are improvements upon deficiencies in older cryptos. Many cryptos are being hoarded because buyers are hoping that they will rise in value – they are being created and held for speculation, not for transactions. This indicates that cryptos are not yet money, but a gamble on a volatile price. Many cryptographers argue over which direction the industry should move to become more acceptable. Since this industry is quickly changing, it may be unrecognizable a year from now. If you want to get involved with these you’ll have to learn a new language around hash-rates, blockchains, mining methodologies, e-wallets, payment-gateways, the changing laws and regulations, along with possible user acceptance of cryptos.

However, it is my recommendation that current crypto-currencies are not yet a vehicle for money, a trusted store of value.

Most people have a natural inclination to “keep their options open.” However, in most areas of life the greatest rewards come from eventually making commitments that limit your options. A few common examples include: romantic relationships, academic study, learning a new skill, competing to win, and making a geographic move.

When people approach their own investing, it is no different. The common first impulse is to insist that your investment money is available at any time and comes with a guaranteed return. There are some investments that have these features but they also offer the tiniest returns. These investments may have a suitable place as part of a minor part of an investment portfolio. But, these types of investments will never make a notable amount of return to maintain purchasing power above inflation, grow into any meaningful amount, let alone generate wealth.

On the other side of the spectrum are investments that generate the highest returns. These investments require all kinds of commitments. The investment will likely have long lock-up period (3-5 years before you can get your money back), no guarantee of any return (you may possibly lose all of your investment), and you need to educate yourself in order to make a prudent investment of this type. A few examples of this type of investment would be: a start-up company, the construction of a new apartment building, a hedge fund, or partnering with a producer split the proceeds on a crop or inventory.

The easy investments require no knowledge but offer almost no return. The high-return investments require a lot of knowledge and due diligence effort but there can be substantial financial gains. Do you invest solely to keep your options open or do you have a couple investments requiring homework and a long-term commitment so you can earn an outsized return?

You have likely heard the adage that, “Compound interest is the greatest invention in human history.”

Earning interest upon interest is a powerful mechanism and is something you should be using to your advantage.

It is best to employ compounding in two ways: compound your debts down with extra principal payments while compounding your assets upward with additional savings. The result is an ever-accelerating increase in your net worth.

For example, $1,000 turns into $1,000,000 with only 27 compounding turns at 30%. If your return is lower than it takes more compounding turns. Active management is the best way that you can control and determine the return rate and how long it will take to earn it. Active management means spending time, money, education, and effort to learn how to get your money to earn more money for you.

For a real-life example, a teenager in California employed quick compounding and within 2 years turned a used cell-phone into a convertible Porsche for himself at age 17. Steven Ortiz began his bartering streak with only a used cellphone as his inventory. He continued trading up to better cellphones, then dirt bikes, laptops, and finally cars. After only 14 trades, in 2 years, he was driving his own Porsche convertible. Steven used two critical elements: speed of transactions and profitable transactions that he created by doing a lot of research. He simply located people who have a valuable item that they were no longer using and then he would then offer them something that they did want so they were happy to swap for it.

Whatever active investing you choose to employ, add compounding to accelerate your investment income and net worth.

The 2014 State of the Union Address by President Obama included a new retirement account called a MyRA account. This is a retirement account for employees who do not have access to 401(k) or other employer-sponsored retirement plans.

Unfortunately, this MyRA account only has one investment option, a fund of government bonds which earned only 1.89% last year. These bonds are earning low returns because the Federal Reserve has been keeping interest rates low for 5-years in trying to jump-start the economy. A tiny 1.9% return on your retirement funds is not high enough to keep up with inflation, let alone accumulate into a meaningful amount of money. In spite of the White House claim that there won’t be fees, the government bond G Fund, which is where your money will be placed, does have fees embedded within it.

The second problem with the low yield is that investors in these bonds are not being compensated for the risk that they are taking. According to the President, only your bond principal amount is “guaranteed” by the government. However, there are several fundamental reasons why U.S. federal government has already lost its top ranking of a AAA credit rating back in 2011. In addition, the last three countries that forced retirees to buy government bonds (Argentina, Hungary, and Poland), ended up taking some of the money or offering puny returns, or both.

In my opinion, the MyRA account is a very poor location for anyone’s money; basically, they are for the financially illiterate. Yes, it can take time for someone starting out, who is working part-time, to save up the $500 needed to open a regular brokerage account. However, many brokerages allow no-minimum Roth-IRA accounts if you commit to regular deposits. Retirement savings in a brokerage account of any type can vastly outgrow anyone’s MyRA account over any 5-10 year period.

Most people only have investments in a retirement account that consists of a few mutual funds. For these investors, the first rung of professional financial advice is the financial adviser. They will accept a client with any amount of money and place them in common mutual funds or index funds. The next rung on the financial advice ladder is the financial advisory firm that has a minimum requirement of investable assets like $250,000, or $500,000, or even $1 million. These firms will offer more active management but the investments will still primarily be in stocks, mutual funds, annuities, and index funds. A higher rung on the adviser ladder is called wealth management companies. Their minimum requirement may be $10 million or $25 million of investable assets.

The wealth management approach to investing only has a few extra components over more modest portfolios. At this level of wealth, annual distributions from a portfolio should never exceed 3% if the money is going to last for generations (or at most, only a portion of the portfolio earnings for a given year). Second, they will assess someone’s financial cash flow needs over the next 5 years and buy bonds maturing at intervals that will coincide and fund these needs.

The main portion of the portfolio will be a diversified portfolio that anyone may recognize:

• U.S. Equities: Small, Medium and Large capitalization
• Foreign equities: Europe, Far East, Emerging and Frontier markets

The components for these equity positions may be index funds or leading companies within these categories, and the specific allocation to these positions may go up or down with the current market outlook.

The final portion of the portfolio is devoted to investments only legally allowed for accredited investors (someone who has an income over $200,000 or a net worth over a million, excluding their home). These investments only permitted to accredited investors include hedge funds, private equity funds, private placements, venture capital, private lending (shadow banking), direct real estate and oil wells, and long/short strategies. Although these are the sexy investments that make the news, they represent the smallest portion of the overall portfolio where a little more risk is taken to reach for higher returns since the other two elements of the portfolio are relatively safe.

Corn prices are at a three-year low and wheat is falling on excess exports from Canada and Australia. One way to find investing opportunities from this is to consider, “Whose raw material prices will be dropping as a result of this?” Companies involved in the feeding of domesticated animals like chickens, pigs, and horses along with food companies using grain or even the sweetener, high-fructose corn syrup.

Thinking through scenarios like these is an important element of economic literacy. Understanding the macro-economic elements and how their movement ripples through the economy creating effects and side-effects. Perhaps the price of corn does not impact you in a notable way, however, learning how to think this way will put you ahead of your peers in the workplace, in your investing, and your planning in general.

In my opinion, the most important part of being an investor is to find new opportunities. This exposes you to new vehicles that can ratchet up your returns and broaden your investing knowledge. I always have a small budget to periodically try out new books, newsletters, courses, and seminar recordings. A few turn out to be junk, but I find a way to learn something from most of them; sometimes I come across something that dramatically increases my net worth and I have turned a few of them into a part-time profession.

Here are some examples: I’ve owned livestock for profit, a racehorse (that won its first race), peer-to-peer loans, several types of real estate, and all kinds of stock and derivative trading. There are two companies I am looking at now to open a small account: eToro.com and Currensee.com. Both of these websites allow you to copy the trades of successful currency traders in your own account for a fee. Also, I am trading a large percentage of a retirement account in something that I did not know existed a year ago. I discovered most of these examples from my small budget to learn about new ways to invest and I recommend you periodically do something to find new opportunities as well.

I recently reviewed an IRA account for someone who opened it with two $2,000 deposits that is now worth $100,000 today. The deposits were made 28 years ago into four large company stocks: Coca-Cola, American Express, Clorox, and Merck. A quick calculation reveals that this is just over a 12% annual return for that time period. This is an excellent return rate that any investor would be happy to earn. But I happen to know that the timing of this investment started right at a market bottom, 1984, just before both bull markets of the ‘80s and ‘90s.

I wanted to know what this portfolio would have done it had been opened at an inopportune time, such as the stock market peak of the year 2000 and been held until today. Excluding dividends, the portfolio would only be worth $5,800 for an average annual return of only 2.8%.

This example helps highlight that the difference between an opportune or inopportune time that you make a stock purchase can have a difference in your account balance by +1,000%. This is a very big deal; a return gap on your portfolio this big can create the difference between being able to retire early and never being able to retire at all. In my study of market cycles, I have determined that any lump-sum investment into stocks should be made over a 2 year period, made quarterly. For example, you just received a $5,000 bonus that you want to place into stocks. Divide the lump sum amount by 16, and these portions are used to make quarterly purchases into your stocks over the next two years. This way you are scaling in to minimize your exposure to buying everything at the peak without delaying too long to take advantage of future bull markets in stocks.

Unless your employer offers a 100-200% match to your 401(k) plan contributions, I highly recommend that you put your retirement money anywhere else but a 401(k), 403(b), or similar plans.

This is not standard financial planning advice, what are some of the problems?

1. Your money is locked in prison. Your 401(k) plan administrator normally offers 10-20 poorly performing mutual funds with very high fees. You can confirm this with websites like BriteScope.com or other companies that analyze retirement plans showing the +$150,000 you are losing to these plans over your career. Every plan portfolio I have reviewed is also highly correlated, meaning they all move up and down together, there is no opportunity to hedge or truly diversify your portfolio. Yes, a few 401(k) plan programs allow you to invest in anything (called a “brokerage option”), but they make it difficult to do this, charge you an extra annual fee, and the trend is moving away from permitting this type of investing.

2. Your 401(k) plan administrator is the metaphorical prison warden. Normally, it is someone in Human Resources with zero financial background. Unfortunately, they are frequently in meetings with attorneys to minimize their risk exposure to lawsuits from you – what is not on the agenda in these meetings is providing you the best financial options for a prosperous retirement. In the past, I have tried to assist many people trying to remove a minor shackle of their 401(k) plan. I have been about as successful as a convict complaining to the prison warden about something trivial.

3. What are your options when money is trapped in a 401(k) with poor performing funds? Try to time the ups and downs with newsletters or technical analysis. Not so fast Skippy – this activity is a slight extra expense for the mutual fund managers so they have several defenses to prevent this. First, they forbid frequent trading, impose extra fees for moderate traders, and impose trading bans for large groups of people making the same trade from a newsletter or advisory service.

4. I have gone through detailed retirement forecasting for many people and I have never found a 401(k) plan that is a successful location to put your retirement money. Even with a 50% employer match up to 6% of your contribution. This is because the extra fees and poor performance subsume the tax-deferral benefit. A Roth IRA or other retirement vehicles are far better at providing investments for a prosperous retirement.

5. Lastly, 401(k) plans are a political invention that is subject to the whims of both state and federal politicians. It seems that every year there is some politician trying to pass new 401(k) legislation at the expense of employees who invest in them. A few recent attempts include: forcing plans to buy U.S. government debt, making contributions mandatory for all employees, putting further caps on loans, adding more restrictions, and frequently, of course, adding more taxes on them.

Even if you are currently contributing the maximum to your 401(k) plan, you can stop contributing and divert your money toward far more friendlier locations for investors.

Interest rates have been falling for over 30 years. As interest rates fall, bond prices increase as previously issued rates become more valuable. There is an inverse relationship between interest rates and bond prices.

This 30-year up trend in bond prices has lulled some investors into thinking that bond prices are only stable or go up, not remembering that they can also drop a lot if interest rates rise.

In order to protect your portfolio from a sharp drop in bond prices, it is safer to own short-term bond funds, 5-years or less. Blackrock just issued a new fund last week where the bonds will mature in only a year or less, and 80% of them are investment grade. You may want to evaluate this fund for your portfolio; it is an ETF with the ticker symbol, “NEAR.”

Will interest rates rise? Someday, but before that time arrives you should have some kind of plan to protect yourself from rising interest rates on your longer-term bonds.