Investing 101

In response to the recent post “We’re All Greeks Now“ a reader wrote,

Hi Freeman,
Based on your concerns about the state of the economy what would you be investing in currently for investments with a:
* – 5 year time horizon
* – 10 year time horizon and longer?
Thanks for the interesting posts.

Ah, the age old question, where should I invest? We get this question a lot, and it’s a very important one, so I thought I would take some time to spell out some investment basics and help readers develop a sound investment framework.

Let me preface this discussion by saying that Human Action does not dispense with specific investment advice to specific readers investing specific amounts of money.  Apart from the potential legal problems that type of advice can create in our over-regulated no-one-wants-to-take-responsibility-for-their-own-actions financial/legal system, there are other more fundamental reasons which will become clear in this post and relate to one of the most fundamental aspects of successful investing – don’t listen to anyone else but yourself when allocating your capital.

Right here goes…

Investing 101.

When considering investing one has to follow these 4 golden rules step by step:

1. Check your motives (Why do I want to invest or buy this or that asset?)

2. Check your understanding (Do I truly understand the mechanics and essence of the asset?)

3. The touch and feel test (How tangible is this investment or asset?)

4. Check you partnerships (Who am I trusting for this investment to work?)

1. Motive

Without question, most people invest for the wrong reasons and with the wrong motives.  Most people just give their money to some suit with a degree and expect it to magically grow.  This mostly amounts to nothing more than outsourcing your financial decisions and wealth future to the whims of speculators, and is usually underpinned by simple greed for “more money”.  The outsourcing culture in personal money and capital management is an indictment on a society of supposedly free and responsible adults and only perpetuates the dependency culture and permanent infantisation of adult men and women.  

But it’s not all our fault.  Most employers for example will pay your medical aid, pay over your tax for you, decide for you how much you’re going to save for your pension and where it’ll be ‘invested’, and decide how much life insurance cover you need.  Governments also have a strong affinity for forcing citizens into personal financial choices the examples of which are too mind-numbingly numerous to mention.

The entire financial and economic system is corruptly designed so that the only way most people know how to protect their earnings for old age is to take excessive risk through ‘financial intermediaries’ investing speculatively in financial assets.  Joe Average of 12 Dull Street, Plainsville, through lack of better understanding but also severely limited better options, is forced to take excessive risk and trust people he’s never met just to protect his earnings from the corrosive poison that is inflation.

The reality of the current monetary system is that the purchasing power of currency, even currency stored in a money market or savings account, is lost over the long-term.  This has not always been so.  If you saved £1.00 in a hole at the bottom of your English country garden in the year 1800, it actually bought your grandchildren more goods when they dug it up 100 years later in 1900.  Persistent monetary inflation by central banks throughout the world from the early 20^th Century onwards means that paper money is no longer a store of value.

A world of naive investors forced to join the herd chasing after inflation while being tossed to and fro amid the erratic waves of ‘expert’ opinion is a sad world indeed.  Thankfully, with a clear and calm mind, thinking for oneself, and understanding the essence of a distorted monetary system, any investor can develop the right motive for investing.

The first question you should ask yourself as a potential investor is, “why am I investing?” If your answer to that question is, “to make money”, it’s wise to step away and reconsider.  Chances are you’ve missed something crucial.  Is making money really the fundamental aim of investing? After all, isn’t money just a medium of exchange?

No, the aim of investing must be far deeper than just producing more ‘medium of exchange’ (a.k.a money) in your bank account.  Let’s call this medium of exchange ‘Medex’.  The only way to produce Medex in your bank account is to produce value first that will be exchanged for Medex thereafter.

Ah ha, so the aim of investing must be to produce value.  But what is value?  To make a deep topic very simple, true value is created when people’s needs and wants are met.  In other words, the essence of creating true value is serving people.  The better people’s needs are served, the more value is created in the economic system.

Ok, so the fundamental aim of any investment must be to serve people by meeting their needs.  In other words, true investment creates real value by ultimately serving people’s needs.  The value the investor creates and owns can then be exchanged for Medex.

Making more Medex in your bank account therefore is the ‘fruit’ (the end result) of a good investment, and a desirable and noble fruit it is, but it must not be your ‘motive’ for making that investment.  While this might be hard to stomach for most investors, remember, the more people’s needs you serve, and the better you serve them, the more Medex you’ll get in your bank account.  Areas and markets with unmet or poorly met needs are an investor’s greatest opportunity, not areas or markets where speculative profits happen to be soaring.

Remember also that you’re not investing money or Medex, but real value (money only facilitated the transactions), so it makes sense that you should be looking for real value in return, not a medium of exchange.

Here are the wrong reasons to buy any asset or make an investment:

• To make money when I sell
• Because others are doing it and making money
• Because if I don’t buy/invest now I’ll miss out

These are common reasons for investing and usually end in disaster.

Again, here is the right reason to buy an asset or make an investment:

• To produce more real value by better serving my needs, my family’s needs, or the needs of other people and businesses

The right motive can lead to the right investment, but not before applying step two.

2. Understanding

Successful investors do not blindly take tips from other people, they think for themselves, are inherently skeptical of consensus views, and always ask, “why?”.  They don’t take other people’s word for it and they personally check the facts… which, by the way, is exactly how you should be reading this article.

Successful investors understand what they’re buying.

In terms of understanding the asset class you’re buying, we’re not talking about the mechanics of the asset/instrument. Any investor can do a bit of research and discover what a government bond is or what he’s buying when he buys a stock or enters into a debenture deal or bridging finance agreement or buys a house, a company, or a gold coin.

We’re talking here about understanding the essence of what you’re buying. 

Let me explain.  Understanding the mechanics of a government bond is quite simple.  The government borrows money from you and pays you interest for the life of the loan until the set maturity date upon which it pays you back the principal.  But understanding the essence of government bonds goes far deeper than that.  On one level you’re buying a simple government debt security, but on another level you’re lending the government money it’s likely to never repay.  You’re lending the government money to spend on wasteful projects and salaries for public servants.  You’re lending the government money for which the ultimate recourse to avoid default is taxing you and your fellow citizens more or printing more currency and destroying your wealth.  You’re allowing government to live beyond its means and saddle the bill with your kids.

How does government pay you the interest on the bond?  Well it makes interest payments from tax revenues which citizens pay, including you.  Sound weird?  That’s because it is.  Sound like a fraud?  That’s because it is.  Sound like a bad investment?  That’s because it is!  Government bonds are a ponzy operation.  Most governments don’t pay off their debt – ever – they just roll it over to the next sucker who just has to make sure he sells to the next plonker before government goes belly up.

Another example: The mechanics of gold are that it is a precious metal, a liquid (in the financial sense), highly traded commodity whose price trades up and down, used as a hedge against inflation and currency risk, offering little else but the chance of capital gain and almost zero yield.  But the essence of gold is that it is money, it is the most successful marketable good in history, and it has held its purchasing power for over 5000 years.  More than being a hedge against monetary inflation, it is the very antithesis of monetary inflation.  Gold is free market money while currencies are regulated monopoly money.  Gold savings are true monetary savings.

That’s what I mean by truly understanding the asset you’re thinking of buying.  The mechanics are the easy part.  The lazy investor always knows the mechanics but seldom understands the essence.  So-called financial advisors will always tell you about the mechanics, but never the essence.  To understand essence, you personally need to do the digging and ask the right questions.

It is necessary to understand the mechanics of the asset you want to buy, but not nearly sufficient to make a truly informed investment decision.  Most investors don’t understand the essential characteristics of the assets they own and so most investments are either a failure or at best just strike it lucky.

Here are some basic but key questions to ask for gaining essential understanding of assets or investments:

• What is the ultimate purpose of this asset’s existence?
• Who’s ultimately benefiting from this asset or investment and how?
• Does the asset/investment ultimately serve people’s needs better than any other asset/investment?
• What is the essential risk of owning/making the asset/investment (ie. what would cause this asset/investment to be unable to meet people’s needs and create real value)?
• Is that risk covered, and, if so, who ultimately covers it?
• Is this a Ponzi, fraudulent asset or a sound one?
• Apart from earning a yield or capital gain, is there anything else inherently attractive about owning/making this asset/investment?

Understanding the asset requires a lot of critical thinking and skeptical questioning, and, more importantly, sound economic thinking (Hopefully Human Action can help you out with these aspects along the way).

Once you’ve done this and are comfortable you understand the essence of the asset or investment, it’s time to move to the next step.

3. Touch and Feel

This step is really an extension of step 2, but has been isolated as a unique step because of how important it really is.  Once you have the right motive for investing and you understand essentially the assets under consideration, you’re ready to apply the tangibility test.

How real is the asset?  How tangible is it?  Can you personally touch it, feel it, see it, grasp it, or does it sit in cyberspace somewhere, or on a piece of paper in a bank’s filing cabinet?

Tangibility is crucial because it speaks of obligation, liability, and liquidity.  A tangible real asset which you would take physical possession of does not require someone else’s signature or does not hinge upon someone else’s solvency or trustworthiness.  A tangible asset is not someone else’s liability.

Paper assets (like share certificates, bond certificates, currencies and derivative instruments) by contrast are easily defaulted upon in weak economic and/or legal systems.  Even if you can legally enforce payment, your debtor may not actually have the means to repay you, and you may have to line up behind numerous other creditors to extract value from a seized and liquidated asset that might only be worth 25c to the rand.

Tangible assets are easier to truly understand while intangible assets are often far more difficult to truly understand.  More tangible assets hold less counterparty risk, are not someone else’s liability, and generally confer greater real and measurable value.

This is not to say that intangible paper assets are all inherently poor assets, but simply that an intangible asset is often a speculative purchase (motive), is difficult to truly understand (mechanics AND essence), and often comes with tremendous counterparty risk which can make it a poor asset in times of crisis.

Having said that, tangible assets are often less liquid while intangible assets tend to be far more liquid.  Liquidity offers an investor greater flexibility and mobility and therefore is a vital component of any investment, especially in the times of financial and economic crisis which are likely to come upon us in the years ahead.

After you’ve established the correct motive, a sound understanding, and a sensible appraisal of tangibility, counterparty risk, and liquidity, the next and final big piece of the puzzle is people – who do you need to partner with, trade with, and trust, in the buying, ownership and administration of the asset?

4. Partnerships

Almost every investment relies on other people, whether it be in the execution of sale, the drawing up of contracts, facilitation of the deal, investing in someone else’s expertise or business, relying on them to administer the asset and its profits, or relying on their stewardship of the asset itself.

Partnering will make or break your investment.  No matter how sound and thorough you have been with all three steps above, a rotten apple can ruin it all.  Having said that, the three golden rules above are designed to minimise partnership risk significantly and if followed correctly will DEFINITELY shield you greatly.

Here are some basic DON’Ts of partnering and people-picking

• Don’t expect others to manage your interests as if they were their own
• Don’t partner with someone with no track record (no matter how clever, confident, trustworthy and sincere they sound)
• Don’t partner with a friend just because they’re a friend
• Don’t expect a lawyer representing a counterparty to kindly also factor in your best interests
• Don’t expect brokers or facilitators to shoulder risk or responsibility adequately

Here are the DO’S of partnering and people-picking:

• Partner with others only to the extent that it is absolutely necessary (unnecessary partners create unnecessary risk)
• Partner with people you know and trust, or someone with a well documented, trusted, successful, and provable track record
• Partner with a tried, tested and trusted lawyer as far as contracts are concerned.  Make sure the lawyer has zero conflict of interest in dealing with your affairs.
• Minimise the use of brokers and middle-men, thereby minimising partnering risk outright but also bringing yourself closer to the actual asset deal, ie. close to the actual value being created.

If you feel removed, at arms-length, and uneasy about the people you need to partner with, trade with, and trust, in the buying, ownership and administration of the asset, it should be the biggest red flag of all.  Even if the steps above are followed diligently and you have set your sites upon the perfect asset with the right motive, if the people you need to trust are the wrong people, walk away.

Conclusion

You will notice that the phrase ‘risk and return’ were hardly mentioned above.  That was for a reason.  Following the golden rules properly will by definition optimise your risk/return profile, and in any case, when your motives are right, you truly understand the asset, you are comfortable with its tangibility, minimised the counterparty risk, and you have partnered correctly, risk ceases to be of concern because it has been managed before the asset has even been purchased.

Return meanwhile is subjective because it depends on how you measure it and how you measure it depends on the type of asset and on your motive for investing in the asset in the first place.  Yes, pure money or Medex return can be a very useful measure, but measures of true value are diverse.

With these golden rules in mind let’s get a little more specific and ask ourselves what assets we should be buying as we look ahead 5, 10, 15, 20+ years?

Let’s start with the motive.  What can I own (whole or in part) that will produce more real tangible value to serve my needs, my family’s needs, or the needs of other people and businesses?

Assets one might consider buying after following golden rules 1 and 2 are:

• My business/company – easy to understand, productive, serves people, directly helps provide for me and my family
• Other businesses/companies (that I fully understand) – productive, serves people, directly provides for business owners and their families
• Industrial property (factories and warehousing) – easy to understand, productive capacity, serves companies’ needs who in turn are serving people
• Gold and Silver coins – easy to understand, real money, functional, serves my family’s need for a sound stable medium of exchange and savings, serves other people’s need for capital in future when paper monetary systems collapse
• Gold and Silver ETFs – a paper claim to real money, functional, serves my/my familiy’s need for sound stable money, can serve other people’s need for capital in future
• Corporate convertible bonds – company loan with equity collateral guarantee, enabling productive investment, serves companies’ needs for capital who in turn are serving people
• Farm land – easy to understand, basic human necessity, productive, serves peoples’ need to live
• Minerals or Mineral rights – easy to understand, primary productive resources, serves companies’ and peoples’ needs throughout the value-chain

Assets one might consider discarding/not buying under golden rules 1 and 2 are:

• Other businesses/companies I don’t understand – hard to understand, speculative, who are they serving?
• Equity, Bond, and Commodity market index trackers – speculative, who are they serving?
• Financially engineered derivatives (CDOs, SIVs, CDSs, credit derivatives) – hard to understand, speculative, essentially unsound, who are they serving?
• Government bonds or government-backed bonds – hard to understand, value destroying, disserving the public
• Speculative currency holdings – speculative, not serving monetary or liquidity needs, who are they serving?

Under golden rule 3 we need to assess our chosen assets for tangibility to gauge counterparty risk and liquidity:

Here are the chosen assets in order of counterparty/legislative risk and liquidity…

1. Gold and Silver coins (zero counterparty risk/moderate legislative risk, high liquidity)
2. My own business/company (zero counterparty risk, low liquidity)
3. Publicly traded businesses/companies (low counterparty risk, moderate to high liquidity)
4. Industrial property (zero counterparty risk, low liquidity)
5. Private businesses/companies (low counterparty risk, low liquidity)
6. Farm land (zero counterparty risk/moderate legislative risk, low liquidity)
7. Gold and Silver ETFs (high counterparty risk, high liquidity)
8. Corporate convertible bonds – equity  collateral guarantees (moderate counterparty risk, moderate liquidity)
9. Mineral rights (low counterparty risk/high legislative risk, low liquidity)

This is where one needs to apply golden rule number 4 to determine specific investments.  In general terms, one might prefer only keeping those assets with low counterparty and legislative risk, and the prospect for good or reasonably good liquidity in times of crisis, as that combination would tend to minimise the risks of partnering.

This leaves…

• Gold and Silver coins (store of value, medium of exchange, liquid)
• My own business/company (personal and public value generative)
• Publicly traded businesses/companies (public value generative, liquid)
• Private businesses/companies (public value generative)
• Farm land (public value generative, high necessity)
• Convertible corporate bonds (public value generative)

Probably the most important thing is to be liquid when a crisis hits.  This is why, in addition to all this, you need to keep a good stock of currency for trading purposes (note: not for speculative purposes).  Yes, inflation will eat away at it, but view currency as interchangeable with gold.  To buy most stuff you will need to change your gold into currency until such time as gold becomes an accepted medium of exchange.

So, here is something like the kind of allocation of funds one might consider as they position for the coming decade.

Cash (liquid on-hand currency): 20%
Gold and Silver Coins and Bars: 40%
Companies: 20%
Farms: 10%
Convertible Corporate Bonds: 10%

60% of this portfolio is very liquid, while another 10-20% is liquid.  About 20-30% is not very liquid, but sacrificing that liquidity comes with very good value creation prospects, especially in a time of financial and economic crisis.

Alternatively a business-owner may prefer something like this…

Cash (liquid on-hand currency): 20%
Gold and Silver Coins and Bars: 30%
Companies: 50%
Farms: 0% (none)
Convertible Corporate Bonds: 0% (none)

40% of this portfolio is very liquid, while another 10-20% is liquid.  About 40-50% is not very liquid but is strongly value generative. 

So there you have it, Investing 101.  Invest wisely and patiently.  Look for value, not just whether an asset is ‘cheap’ or ‘expensive’, but whether the investment has the potential to increase value by better meeting the needs of more people.

Maximising new value created per existing value invested… now that’s the heart of good investing.