The Art of Not Destroying Wealth
The Lull, Part 3
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Then I went broke, said the investor, now very wealthy. He was recalling a time when he lost it all.
At least he made the money back. I know a number of people who did not, typically when circumstances shifted in ways that were hard to foresee and impossible to recover from. A sudden lurch from a crazy political leader, plague, or the economy.
Wealth is unstable. It’s hard to earn and easy to lose. Many of the people, companies and countries that have money now won’t in the future. If you sit on cash, inflation eats away your stash. Right now, US inflation is around 4%, the yield on cash is zero, meaning cash is guaranteed to lose 4% a year! If you take market risk, you take risk. We must live with this uncertainty, even smile at it.
The chart below created by Rose Technology illustrates this. It shows the top countries in terms of GDP per capita going back … 1000 years. The country with the highest GDP per capita in 1150 was Iraq, as of 2016 the order was Qatar, Norway, USE, Luxembourg, etc.
Today’s post is the third in a series answering the subscriber question: what is the big picture and what should I do about it? I first shared my investment framework, then my outlook, today is about what to do. Post-pandemic, the most likely outcome is low growth and low inflation BUT the political risks are so high now growth and inflation almost don’t matter.
In particular, the US and China, the two largest economies in the world, are both threatened by a cult of personality. This undermines the rule of law (stronger in the US to begin with) and threatens wealth. The recent article by Robert Kagan about Trump and George Soros about Xi are both important.
Asset Allocation
Asset allocation is both boring and important. An abbreviated version.
When you invest your savings, you are participating in what’s called a capital market.
A market for capital is different than, say, a farmer’s market. Unlike buying an apple, when you invest, there are two steps. First spend money, then get the money back. Call it renting out your capital.
There are three primary risks when you rent out your cash: you don’t get repaid, you get repaid in money that isn’t worth what it once was or your payment gets delayed, sometimes for years. Visualize a tenant not paying, or paying in money that is losing value very quickly or paying after a protracted legal fight. In Wall Street lingo, these risks are called default, inflation or illiquidity.
Rent can be structured in different ways. The structure is important to understand because it relates to how to protect yourself from wealth shifts. There are three primary structures:
a. A loan, also called a bond. If the risk is low, the interest rate is low. If the risk is higher the interest rate is higher. Either way, a bond is a contract. If the government borrows, your risk of default is low. If a new tech start-up borrows, the risk is higher.
b. A share of the business. This is also called a stock or an equity. It means you own a slice of the business. The owner is under no obligation to pay you back. If the business does well the return can be much, much higher than a bond. If it is bad, you get nothing.
c. Switching your currency. This means you get paid your rent not in dollars (or whatever your home country is) but in gold, bitcoin or some other material that can be exchanged for currency.
The art of not destroying wealth is to hold a bit of everything. My starting point is 1/3 bonds, 1/3 stocks and 1/3 some form of “switch your currency.” Government bonds are good when things are bad, like 2008. Stocks are good when things are good, like this year. Switching the currency provides protection when your home country goes bad, either due to inflation or a demagogue.
So for instance, if I bought a house in Canada and rented it out, this would be like a bond (the rent) but also switching my currency, I’m paid in Canadian dollars. Or buying the stock of a foreign company that produces commodities. This is a share of a business but also switching my currency (the commodity they produce).
At the same time, and this is why investing is tricky, I don’t follow this rubric rigidly. Also, THIS IS NOT INVESTMENT ADVICE, YOU CAN AND WILL LOSE MONEY, I HAVE MANY TIMES. I deviate from the above, particularly around what I’d refer to as the gas and the brake.
The Gas and Brake
Only the government can create money. Printing money is stepping on the gas. Reducing money is stepping on the brake. If the government, reduces the supply of money, assets fall. Most of what you earn on an asset allocation comes from when the government is stepping on the gas. So be mindful when they step on the brake. Right now, the US is planning to step on the gas a bit less hard. That’s one reason why the stock market stopped going up.
Next week, for subscribers. I’ll share my current asset allocation in more detail. If you are enjoying these, become a paid subscriber.