Practical Economics: How to Retire Modestly Wealthy – Guaranteed!

The General Rule

Many people know the assertion that the best way to make a small fortune – is to start with a large one! But that is not the only way, or the best way.

Let’s review the three major categories of investment possibilities that Warren Buffett addresses in his recent Fortune magazine article, (2/27/2012 issue) then seriously discuss a strategy that absolutely works for amassing modest wealth. The entire exercise of investing, of course, is to delay the gratification of consuming purchasing power today, to obtain greater, after-tax purchasing power, in the future.

Three Categories of Assets

The three categories of investment possibility are –

1) Currency-denominated assets such as:

Bonds, Money-market Funds, Bank Deposits, etc.

2) Unproductive assets such as:

Gold, Silver, Diamonds or even Tulips.

3) Productive assets such as:

Businesses, Farms or Real Estate.

Buffett alleges that currency-denominated assets, though seen as least risky by many, in reality are the most risky, because of government politicians’ tendency to manipulate currency value (the inflation tax) for short-term political purposes.

Soon enough, the return on currency-denominated assets, after subtracting inflation and taxes, is zero, or close to zero. To quote Shelby Davis, “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

The most popular asset among non-productive assets is gold, seen as a safe haven by many today. But unproductive assets like gold never procreate. Please remember that one ounce of gold today is still one ounce of gold a thousand years from now, or even ten thousand years from now.

Both currency-denominated and non-productive assets are mostly popular because of fear, particularly assets like gold. Yes, the price of these types of assets may go up for a while, as the bandwagon for owning one or another particular non-productive or currency-denominated asset grows in popularity, but over time, bubbles always pop and price always fall back to earth.

Neither of these two asset categories ever meets the criteria of the real purpose of investment, which is to grow one’s future purchasing power, long-term. When bubbles burst as they inevitably do, Buffett observes, “investors who required a supportive crowd paid dearly for that comfort.”

The BEST Investing Strategy

May I point out, only investing in productive assets allows one to enjoy the possibility of increasing one’s future purchasing power for the long-term?

Specifically, the vast majority of one’s nest egg ought to be invested in productive assets, whether in owning real estate, and/or owning your own producing company, and/or owning equities (shares of productive companies), etc. Yet almost anyone would be lying if they said they knew exactly which productive assets to buy, when.

Because of this uncertainty, as well as short-term market and investment distortions, some portion of one’s investment pool should be cash, or S-T bonds, yet the vast majority of our investment pool needs to be invested in productive assets.

Lowering Risk

One important key to follow when investing is to diversify widely, thus lowering one’s total risk. Remember, the future is always uncertain and unknown, therefore risky.

May I explain what this might mean? When buying equities, spread investment risk around by investing in many companies and different industries. Whether your nest egg size is $20,000, $200,000 or $2,000,000, it is far less risky long-term to hold approximately the same dollar-size amounts of 40 or 50 companies in various industries, than investing your nest egg in only two or three firms. Yes, this approach puts an artificial ceiling on your short-term gains, but it also constructs a solid floor that keeps away irrecoverable losses.

The same logic applies to real estate. Owning several smaller rental units and/or apartment buildings and/or commercial buildings in different locations is far better than owning just one large piece of real estate in one location.

Though most of us cannot afford to buy entire productive enterprises, most of us can afford to own many smaller portions of productive companies. By diversifying our holdings, we lower our overall risk – portfolio theory and all that.

Lowering risk ought to be one of the biggest goals of prudent investing. Protecting one’s principal ought to be another. Read Benjamin Graham’s book The Intelligent Investor, (“if you read one book on investing, then read this one”, says the most successful investor who ever lived, Warren Buffett) before you really start investing. Then avoid as much as possible paying for other people to invest for you. Transaction costs often consume too much of the income generated by your wise investments – actually limiting the benefits of compounding interest.

The Nugget of Investing Wisdom

Due to compound interest (procreation working in your favor) following a prudent and diversified investment strategy will avoid catastrophic losses completely, protecting principle, lowering risk and growing your nest egg modestly throughout your life.

Let’s assume you are able to save 10% of your income, from age 25 to age 65. (There are many books written which discuss exactly how to save 10% of your income, which is not my topic today.) Say your annual income at this time is $48,000 a year. At a modest 7% annual return, your investment pool would grow to over $1 million. If you were able to average a 10% return, instead of 7%, that same $400 a month would then become $2.5 million! And an IRA can grow tax-free!

Over any 40-year period in the 20th century, the return on equities in America averages 10% plus. However much purchasing power a million dollars or 2.5 million dollars allows will undoubtedly grant you sufficient purchasing power from ages 65 to 95 to live comfortably, I suspect. Even major medical emergencies near the end of life most likely can be paid for out of your still mostly-compounding nest egg.

Conclusion

On the other hand, many people behave in ways that are risky indeed. Which leads me to one final piece of advice – never play the lottery. Winning the lottery requires overcoming odds of 5 million to 1 or worse. You have a much better chance of being struck fatally by lightning, which is a real, but unlikely risk that all of us bear.

Seize the day and choose to invest wisely and prudently in productive assets!

 

 

 

Practical Economics: How to make the economy go zoooom in the night.

Practical Economics:  How to make the economy go zoooom in the night.

Part 2 of 2 TAXES, REGULATION & ECONOMIC GROWTH

Animal Spirits

Former Federal Reserve Chairman Alan Greenspan regularly spoke of the need to unleash ‘animal spirits’ to attain and sustain robust economic growth. Greenspan identifies the uncommon motivation impelling certain entrepreneurs to spend 100 or more hours per week for years building their own new business as ‘animal spirits’. That type of entrepreneur is convinced the world needs the products and services to be produced by their new company, which production requires new jobs.

Most of us are not much like Bill Gates or Steve Jobs or Jeff Bezos (or Henry Ford a century ago) and the first difference most of us might notice is the inhuman hours these entrepreneurs put in for many years, until their company (Microsoft, Apple, Amazon and Ford, respectively) succeeds.

Today, each of these firms employ tens of thousands of highly-paid employees. Nearly all the many millions of people employed in the private sector fill jobs created by successful entrepreneurs. If we truly seek long-term economic growth, (assuming the education issues are properly addressed) perhaps the right question to ask is which tax and regulatory environment cause ‘animal spirits’ to flourish, allowing Herculean efforts (100-hour weeks for years) to be rewarded appropriately?

We are seeking to understand the underpinnings of economic prosperity. We know that when the overall capital stock (not ‘capital’ as a factor of production) is growing, then so too is the macro-economy. Therefore, we need to explore how we make the capital stock grow.

INVESTMENT ENVIRONMENT

Capital Stock Growth

Perhaps a closer look at Apple’s products will prove instructive. Mainly Apple sells a mix of notebook computers, smart phones, desktop computers, computer tablets, digital music players and access to digitized melodies. In the fiscal year 2011, Apple reported revenues of $108 billion.

The total cost to make or provide access to these products in 2011 was approximately $74 billion, leaving $34 billion before-tax profit, or $26 billion, after taxes, to add onto and grow the capital stock.

In other words, we consumers, in a mostly free global marketplace, willingly traded $108 billion of our own money for Apple items we valued at $108 billion – but that only cost Apple $74 billion to produce! Subtracting the $8 billion of taxes paid to government entities, the remaining $26 billion can be added to the capital stock.

Each time that profitable transactions like these take place in the global marketplace, the capital stock can grow. If a significant majority of the private companies around the world experience similar profitable bounty, even if not to the same degree as happened at Apple, then the total world capital stock can grow, which is desirable. Especially when this capital stock growth happens at a fast pace, like it did for most of the 17 years from 1983 to 2000, in America.

Uncertainty Due to Tax Rates

What has changed to cause the business activity among many global players and wannabe entrepreneurs to be subdued? What exactly unleashes ‘animal spirits’ over the long-term that allows for economic prosperity?

If we look at the financial statements of American financial institutions and large American public companies in 2012, we discover over $3 trillion of unused capital sitting on their balance sheets. Why? What might cause entrepreneurs to step forward and take calculated risks, using that $3 trillion to build the capital stock and create new jobs?

Here is one answer.

Making Money

First of all, entrepreneurs like to make and keep money. But making money is not really their primary goal, because after earning $10 million, or $100 million or perhaps their first billion dollars, these entrepreneurs do not stop, and additional money earned just becomes a way to keep score. Often entrepreneurs, rather than slow down, instead accelerate their immense efforts to make larger sums of their own money.

However, if government entities seem to be demanding an ever-growing percentage of what these entrepreneurs are creating, then a significant portion of the satisfaction quotient (Abraham Maslow’s hierarchy of needs term is ‘self-actualization’) is removed from the business environment and such achievement becomes much less interesting. If entrepreneurs feel unable to predict what the top marginal tax rate will be that affects them, then the consequence is restraining those invaluable ‘animal spirits’.

Specifically, if the effective tax rate to be paid by the entrepreneur is perceived by the entrepreneur to be relatively unpredictable during the five-year or ten-year or longer planning horizon, then entrepreneurs wonder why they ought to make Herculean efforts today. Why not just wait until the planning-horizon tax-rate facing the entrepreneur is more settled?

Laffer Curve

We might also profitably ask what tax rate is seen as too high by the entrepreneur? Though seldom by name, the Laffer Curve peak also enters the entrepreneur’s calculation. On 4/24/2012, an article in the WSJ opined that 50% or even 70% marginal tax rates would not lower tax revenues.

Peter Diamond and Emanuel Saez argue that the investment environment in America is to the left of the peak of the Laffer Curve, therefore an increase in US tax rates from where they are today will not decrease tax revenues. But at the URL http://www.bobkrumm.com/blog/?p=2354 Bob Krumm demolishes their argument.

More to the point, what the economist Art Laffer alleges is that there is some marginal tax rate, (probably between 28% [Reagan tax cuts] and 35% [Bush tax cuts]), that represents the real maximum marginal rate of tax revenues that government can hope to collect. This unknown, yet still reasonable top marginal tax rate likewise significantly affects entrepreneurial behavior.

Uncertainty Due to Regulation

Additionally, because entrepreneurs like Henry Ford, Jeff Bezos, Bill Gates and Steve Jobs are building global-size firms, the current and future regulatory environment also enters their decisions to go or not go with establishing and building new companies and new endeavors within established companies. This consideration makes sense because their new future entity will cross many political boundaries, bumping into all sorts of known and unknown government regulations.

It is not complying with the regulations, per se, that causes entrepreneurs hesitation, but the added costs to be borne because of these regulations and the follow-on lawsuits that potential “damage to the environment” manufacturing may generate. One way to check the accuracy of this assertion is to look around at the manufacturing landscape in America.

When Henry Ford established his automobile-making firm in America in the early 1900s, his factories were desirable to have nearby as factory jobs paid better wages than farming jobs.

Today, Apple avoids NIMBY (Not In My Back Yard) by doing most of its “messy” manufacturing in Asia, not America. Amazon does not really do manufacturing, nor does Microsoft. Likewise, the ‘dirty’ petroleum industry has seen no new oil refineries built in America for 33 years. The doubling of refined oil output occurring during this period has happened by building out the production facility already in place and adding more production shifts, as the NIMBY sentiment and potential lawsuits has prevented approval of new locations.

More Regulations Are Coming

In addition to these known concerns for manufacturing in America, the added burdens and potential increased costs of new regulations to come are magnifying the unknowns and adding greater uncertainty to the investment environment.

For example, consider the 2000-page Wall Street Reform and Consumer Protection Act (Dodd-Frank) which has not been fully fleshed out, or the 2500-page Patient Protection and Affordable Care Act (Obamacare) also not really fleshed out, and together these two new laws put thousands of new rules all entrepreneurs must follow on the books in America.

Is it really any wonder that the uncertainty in the investment environment caused by future likely higher marginal tax rates and likely large new regulatory costs, makes the entrepreneurial ‘animal spirits’ noises heard today akin to a whimper instead of a healthy roar?

CONCLUSION

It is reasonable to conclude that shoring up the investment environment certainty regarding future marginal tax rates and solidifying regulatory rules is akin to feeding the ‘animal spirits’ inside wannabe entrepreneurs red meat! In order to undertake the outsize risks which lead to outsize rewards, these risk-seekers still like the risk related to taxes and regulations to be as small as possible.

In this analysis, we have primarily looked at successful entrepreneurs who end up building large companies. But the same logic herein applies to successful entrepreneurs who end up building small to medium-size companies.

In fact, successful entrepreneurs create many more small companies, than large companies, and it is not the few large companies, but the many smaller success stories that contribute the most to economic prosperity. Yet the desirability of reasonable certainty regarding tax and regulation issues in the investment environment faced by wannabe entrepreneurs is exactly the same.

To summarize, if we want long-term economic prosperity, then we must  reduce the uncertainty surrounding the investment environment, after dealing well with the education issue explained in my 4/11/2012 blog, by 1) cementing for 10 years or more the marginal income tax rate at or below 35% (likewise, fixing the corporate tax rate at or around 20%)  and 2) solidifying the unknown regulatory environment faced by wannabe entrepreneurs.

To enjoy long-term economic prosperity, there is no other way!

Economic Indicators: Consumer Price Index or Inflation.

Economic Indicators: Consumer Price Index or Inflation.  

Should we be worried?   

The classic explanation for inflation is too much money chasing too few goods, which certainly describes well the current situation in America. Why then, aren’t we plagued by inflation today? Without getting too technical, may I offer some perspective?

In the two-year period from late 2009 to late 2011, according to Federal Reserve statistics, the US dollar monetary base grew around 28%. And M2, the broadest measure of the money supply, increased 12.9% for the similar two-year period between November 2009 and October 2011. During that time-frame, America’s GDP grew perhaps 5%, or approximately 40% slower than the growth of the money supply.

The Nobel-prize-winning economist, Milton Friedman, claimed that the primary function of the Federal Reserve ought to be basically matching the growth of the money supply with the growth of real GDP, keeping the inflation-dragon at bay. But that is not happening at the moment as the Fed is busy monetizing debt.

Currently, if product prices go up, then consumers quickly seek substitutes.

Most retailers today tend to lower prices to make sure that inventory turns over regularly, even at a lower margin, instead of simply raising prices to generate larger profit margins. Nor are there widespread strikes over wages being too low. Instead of wage demands to raise the cost of labor, causing ripples that beget rising inflation, most employed Americans are grateful to have a job.

Obviously, business activity of the entrepreneurial sort is strongly muted today, during what has been dubbed the ‘Great Recession’. As I noted in the last two AZ Fraud Fighter newsletters, though GDP is up a bit, at least nominal GDP is, the real Unemployment Rate, at 12.1% (if we count those people who used to be employed, yet at this time are too discouraged to even look for a job) is still significant enough to heavily constrain inflation pressures, at this time.

While we are not in a recession, technically, as GDP is growing, but because so many people are still unemployed, the effect is that the economy feels like it is still in a recession, to many people.

What about when a significant recovery finally comes – will we experience significant inflation then? Probably we will, because Ben Bernanke, the current Fed Chairman, has not shown the same aptitude for monetary manipulation that has been demonstrated by either previous chairmen like Paul Volcker or Alan Greenspan.

 

Economic Indicators: Unemployment Rate – January 2012

Economic Indicators:  Unemployment Rate –  A Look Behind the Numbers.   

From the Bureau of Labor statistics.

A                         B                           C                      D                   E

2007              231,867,000         153,124,000      7,078,000       4.6%
2008              233,788,000         154,287,000      8,924,000       5.8%
2009              235,801,000         154,412,000     14,265,000       9.2%
2010              237,830,000         153,889,000     14,825,000       9.6%
2011              239,618,000         153,617,000     13,747,000       8.9%
Dec-2011              240,584,000         153,887,000     13,097,000       8.5%
www.bls.gov/web/empsit/cpseea01.htm

Column A = Year or Period

Column B = Non-institutionalized Americans in Civilian Population ages 16 – 65

Column C = American Civilian Labor Force

Column D = Number of Americans Reporting They Are Unemployed

Column E = Calculated Unemployment Rate

Commentary:

Did the unemployment rate reported for December 2011 really decrease? Yes.

Better question – Why?

Answer – Because over 5 million otherwise eligible people, since 2009, are not included in the official unemployment rate calculation as they are likely too  discouraged to look for employment, and have withdrawn themselves from the Civilian Labor Force.

Proof:

During the ten-year period from 2000 – 2009 the Civilian Labor Force (column C) averaged a utilization rate of 66.3% (column C divided by column B) of the eligible Americans. Today, as of January 2012, only 64.0% of the eligible population are actually seeking employment, or 2.3% less. This difference of 2.3% means that 5,533,432 fewer Americans are seeking employment because they are too discouraged to look for a job. If they were included in the calculation, then the Unemployment Rate would skyrocket to 12.1%.