Sorry for the delay in bringing you the much anticipated second installment of this blog post. You can catch up with where our hero left off here by clicking here.
I discovered the evils of peer pressure in fifth grade. It led good boys and girls to smoke cigarettes and drunk driving off of cliffs. Recently, I discovered that peer pressure never goes away. We've covered FOMO spending and investing. The root of which are both social but also economical. Today, we'll discover that this pressure to spend and invest is driven by inflation and deflation. Beyond conspicuous consumerism and peer pressure, there is a phantom menace at work: The Federal Reserve.
The 1% Live Upstream
When the Federal Reserve sees fit to introduce new money into the economy they do so for noble reasons. Typically, it's to speed up the flow of money that has gotten into a beaver dam of favorable high interest rates. Why spend your money when you are earning so much interest, risk free? So to create the velocity of money flowing through the economy, they add more to the marketplace.
Now, with more money to lend, interest rates go down. It’s simply supply and demand. But’s not the common, unwashed masses who have that money to lend. It’s banks. If they have lots of money to lend, the competition for loans causes interest rates to go down. So new money enters the economy as new debt, backed by new money at the banks.
Here's the problem for you and me, the hoi polloi: By the time it reaches our pockets too much time has passed. The cool kids, the 1%, who live upstream from us on this river of money got it first. They had to find a way to spend and invest it. What they chose to invest in was based on their business acumen. But when they chose to invest in it means that they took substantially less risk.
Let me illustrate. In 2001, after September 11, the Federal Reserve started to cut interest rates. Eleven times, in fact, from 6.5% to 1.75%. The place to safely invest that money if you were first was in real estate. By 2004, the rest of us caught on and home ownership peaked to 62% of the US population. By 2006, the Shiller Existing Housing Price Index had created a historical spike that you can see by clicking here.
Don't Fight the Fed
The point is that those that pull the money levers have much of the economic power. Those closest to them upstream in the money supply get the most profitable opportunities to spend and invest. You and I must make our decisions based on this information. It's not a morally perfect situation, but one that has existed for a while.
Irish economist made a boatload of money with this understanding. As a banker, he was morally opposed to the fiat money created by governments. But he was able to create a fortune in the Mississippi Bubble and the South Sea Bubble. The important to think to understand is that he saw an investment wave forming and rode the wave, getting off before it crashed. While he profited from it, he sought to expose it as well. He wanted to show he was not a criminal but that the system was to blame. So he wrote Essai sur la Nature du Commerce en General. He was mysteriously murdered shortly after finishing, which was a total coincidence I’m sure.
The same system operates in the cold light of day. No secrets being exposed by this blog. But we need to understand the potential impact it has on our spending and investing, from home buying to retirement planning. Keep in mind that the Federal Reserve lowered interest rates from 5.25% in September of 2007 to essentially 0.0% in December of 2008. Several months later the SP500 touched 666. Easy to remember. By January 2018, the SP500 touched over 2800. Should you be concerned?
How to Ride the Wave
So you live downstream from the cool kids. The 1% bankers who get the new money first. Given that, you are likely to be late to the party, spending and investing your money on things after their popularity has quadrupled their price. You must be ever vigilant that the wave you are riding could crash. We used housing in the illustration above, but it could apply to stocks, bonds, gold, antiques, collectibles or just about anything that can be bought and sold.
Here's a few concepts to help you ride the wave and help minimize riding the crash:
- Diversify your holdings. A notable example of this is gold and managed futures. Over different economic boom and bust cycles gold and managed futures zigs when others zag. We don't know where the cool kids are investing their money next, so owning multiple asset classes helps us find the next wave and offset the next crash.
- Make sure there's a liquid market for what you own. Hate to pick on real estate, but it's not easy to sell. Same with private placements and non-traded securities.
- Don't own with debt. Real estate with a mortgage becomes a terrible millstone when you owe more than the it is worth. Same goes for stocks on purchased with margin. If you own something with debt, factor that into the risk.
- Don't fall in love with an asset. Realize that there a no life-long monogamous investments. A stock, a bond, a rental property, a Picasso or a gold coin is just a tool to help you achieve your life's goals. Have a systematic, non-emotional exit plan.
The question then is, "How does this apply to my current portfolio." If you'd like to continue that conversation click here.