Tuesday, December 29, 2015

Freedom Guarantees Inequality

Let’s start in grade school, the first time in life there is some correlation between performance and reward. Take any two random children. One of them will be smarter. One of them will work harder. The results of their efforts, in simplistic terms, are some combination of their native ability combined with the level of effort they apply to the task at hand. If one child produces measurable results that meet the criteria for a superior rating and the other child efforts are rated a failure, should both children receive a letter grade of C? Should all children receive a trophy even if they lose the little league game? Even children know what that trophy is worth?

Equal isn’t fair.

Let’s move on into adult life. Most people, by definition, are just average. Like most humans in matters of employment, I was not a risk taker. I didn’t want to start my own company. I didn’t want to work as a commission sales person. I don’t have a single salesman’s bone in my body. I wanted someone to give me a job. This is the approach that will be used by almost everyone in the world.

There are two inherent problems found in “working for the man.” First, you will need to cover your expenses plus contribute a reasonable profit to the enterprise or you will very quickly join the ranks of the unemployed.

Companies do not pay employees’ salaries. Customers pay employees’ salaries.

The second problem is time. It doesn’t matter if you are a world famous heart surgeon working for a great research hospital or a barista at Starbucks boiling coffee water and handing out a few pennies in change from a ten dollar bill to your customers. Your salary, whether minimum wage or something in the top 1% is limited by the number of hours you can work. In order to earn money, your presence at the job site is a necessary condition of your employment.

Assuming a free economy in which individuals are protected from immoral coercion by rule of law and property rights, your hourly pay is a direct measure of the value of your contribution to the welfare of your neighbor. If you want more money, find a way to become a greater blessing. There is a reason a man with a BS/RN earns more money than someone who pushes a lawnmower for a lawn service. I discovered that for some strange reason, the economy valued my degree in Mechanical Engineering at a higher level than my degree in English Literature and U.S. History.

Go figure.

I can’t see why any rational person wouldn’t expect to pay a heart surgeon more than someone who can spin a weed whacker. However, that is not where the one finds the greatest income inequalities in our economy. The really big numbers are generated when an individual finds a way to produce revenue without requiring their physical presence or by generating economies of scale.

In the 19th century the earnings of performing artists and athletes was limited by the size of the theaters and arenas of the day. An actor’s physical presence was required to give a performance. This limited his salary. With the introduction of new technologies such as radio, movies, and the Victrola wind up phonograph the salaries of performing artists and athletes began to rise to unheard of levels. Babe Ruth was asked why he deserved a higher salary than the President of the United States, his famous reply, “I had a better year.” while certainly true didn’t explain the fundamental change that had occurred in the economy of professional baseball. Now the amount of income the Babe could generate for the owner of the New York Yankees was no longer limited by the number of tickets he could sell to a game. The description of Babe Ruth’s exploits now could be broadcast on radio stations all over the country. Advertisers would pay top dollar to promote their products on this new medium. Today a major box office draw can earn $20 million or more working three months, the length of time required to film a movie. The producers consider it a bargain because that actor can appear simultaneously on thousands screens in movie theaters all over the world. Then the movie can appear on television, sold on DVDs, and downloaded from the Internet, generating more income for the owners of the film and for the actors even after their death.

Economies of scale can generate geometric increases in profits with mere arithmetic increases in efforts. Consider: One of my former neighbors started flipping houses on the side. He would buy a run down house from owners who need to make a quick sale for a bargain basement price. He would then spend six months or so rehabilitating the property for a quick sale at a reasonable profit. This worked quite well until 2006 when the bubble popped. He was funding this operation with borrowed money. When he could no longer make the payments, he lost everything including his own personal residence. The math worked something like this. He would buy a property for $150K, put about $85K of improvements into the house, and then sell it for $400K. Really, this is pretty much the same thing that made Donald Trump a billionaire. The Donald would buy a run down building in New York City for $100 million, spend two years rehabbing the place, and selling the finished product as a condominium development for $300 million. It maybe takes four times as long to generate 1,000 times the profit. The relationship between time spent and profitability is nonlinear. An interesting side note, early in his career Donald Trump came close to personal bankruptcy, as always debt was the culprit. However, there is an old saying, “If you owe the bank $1,000 and you can’t pay; you have a problem. If (as in the case of The Donald) you owe the bank $800 million; the bank has a problem.” Reasonable men allowed Trump the opportunity to work his way back to profitability thereby saving themselves from losses that would have cost their institutions hundreds of millions in an avoidable beat down.

This becomes even more dramatic in the stock market. It takes no more research or time to buy 400 shares of stock than it takes to buy 400,000 shares in the same company.

The same principal is at work in the development of passive income from sales of a digital product on a website. Once an independent musical artist has made a recording that can be sold from her website, it will generate income for as long as people want to hear her music. Her presence is not required once the product is in the can. I will be interested to see how this phenomenon might affect teachers’ salaries as Web based education begins to take hold. Today a teacher’s salary is limited by her presence in the classroom. Will superstar teachers command much higher salaries to develop and record course material in some brave new world of $2,000 college degrees?

So far so good; income inequality is not only fair, but it is a signal to those who have the ears to hear. Temporary shortages create opportunities for those who have the necessary skills and courage to make a quick profit. The demand for qualified experts in various computer languages and programming protocols come and go like changes in women’s fashions. Every few years we read stories about high school dropouts who are earning six figure incomes writing code for the latest and greatest operating system. Then articles are published lamenting that the market is now over saturated with unemployed programmers writing in the same language that is now considered obsolete.

The problems arise when the economy becomes distorted by direct Government coercion through punitive taxation, Government malinvestment, corruption, a politically well connected union such as the American Medical Association, or the power of a predatory monopoly such as Microsoft during the 1990s. In the past eight years we have witnessed one of the greatest transfers of wealth in history. The Federal Reserve Bank along with the Department of Treasury have mortgaged the future of our nation to benefit the major money center banks and similar “too big to fail” financial institutions. By allowing these corporations the opportunity to borrow nearly limitless amounts of money at close to zero percent interest, not only are the middle class investors and savers punished to benefit the well connected and powerful, but distortions in regulations and the tax code encourage these institutions to engage in financial engineering rather than investing in creating factories that would provide the economy with new jobs. This money, created at taxpayer expense, is also in use enslaving the naive (think student loans) or the impoverished (think payday loans). Government malinvestment seems to be the rule, rather than the exception. From bridges to nowhere to wars for no reason, hardly a day goes by without a report of Government waste, fraud, or abuse.

If there is any tectonic shift in the strata underlying the American republic that concerns me it would be the marriage between big Government and big business. We have had the military industrial complex since World War II. Today the profitability of the financial sector of our economy, automobile manufacturing, and a good portion of the health care industry is guaranteed by the American taxpayer. There is movement towards a national police force equipped with military style weapons. If this comes to pass we will have created the American equivalent of the First Triumvirate. I can assure you that Caesar’s children will not share the same opportunities given our children. Freedom guarantees inequality, but then so does tyranny.

Monday, December 21, 2015

How Do You Learn?

“Writing is like jazz, it can be learned, but it can’t be taught.
Paul Desmond

How do I learn? I have discovered that I have three different learning styles that seem to work for me when dealing with different kinds of material, hard classes, soft classes, and life classes.

Let’s start with hard classes. This is material that isn’t opinion on any level. From multiplication tables in grade school to a graduate level class in fluid dynamics, I have been confronted with subject matter that really doesn’t care what I think or how I feel about it. I have to learn how to do it or if I can’t understand it, I just have to memorize it. In the second semester of Calculus, I ran into peculiar, one of a kind, integration methods that I never understood. I memorized them for the exam. It was nothing but hand eye coordination. In real life it didn’t matter because I had access to a computer and the CRC Math Tables.

Soft classes would include the liberal arts, economics, political science, theology and the like. You are really just learning opinions. In the end, these are subjects where your beliefs are ultimately more important to your life than the opinion of your professors. I found it interesting that my fellow engineering students found the mandatory two semesters of economics incredibly difficult because there was no “right” answer. One week they learned what one economist stated on a particular subject. Then the following week they read about an economist who totally disagreed with the first author. I thought these courses were an automatic 4 credit hour A. If you just read the book or just attended the classes there was no excuse for not getting at least a B. All you needed to learn was one guy said this and the other guy said that.

Actually “learning,” really learning, one of these subjects is different. In such situations I learn best using some form of the Socratic Method. I am an auditory learner by natural preference. I have also developed the necessary visual skills to learn from a book. I am not a kinesthetic learner. When practicing the martial arts, I had to put the movement into words before I could practice it properly. I like to listen to someone put forth an opinion on something like the interpretation of a particular passage in Scripture. Then when I think I understand it, I like to repeat it in my words to see if I have a proper grasp of what the teacher is presenting. Then I like to attack the position to see it stands up under severe questioning. If it survives, I add it to my toolkit. If not, I discard it. Over the years, I have discovered my mind likes to make strange connections across disciplines and different kinds of life experiences. I guess I could describe it as my own personal version of Hegel’s triad, thesis, antithesis, and synthesis. This has helped me develop, not only my own philosophy of life, but also has helped me become a better person.

I always want to be learning, changing, and growing as long as there is breath in my body.

Then there are subjects like writing, living in the same house with another human being, or investing that can’t be taught. They have to be learned. In this blog, I am learning how to write about my experiences learning the ins and outs of Christian Personal Finance. Of course, I study the classics. I recommend that you read the writings of the great investors from King Solomon to Warren Buffet. They can save you from a lot of unnecessary pain. I am convinced that if you really understand Proverbs and Ecclesiastes, you have more than enough tools in you kit to find financial freedom. Next, learn from those around you, preferably people who know more than you know. Seek them out. But, you can even learn from the mistakes of those who know less than you know. It is better to learn from the mistakes of others than from your own mistakes. When you make a mistake or when a good plan goes awry, don’t beat yourself up. Just consider it feedback from the universe.

Pick yourself up. Dust yourself off. Start all over again.

“By three methods we may learn wisdom: First by reflection, which is the noblest; second by imitation, which is the easiest; and third by experience, which is the bitterest.”

Tuesday, December 15, 2015

I Don't Know Nothin'

I found Kinematics and Machine Dynamics to be the most difficult course I ever encountered while obtaining two undergraduate degrees and one graduate degree. It was not unusual to spend 3 hours working on a single homework problem. We were encouraged to work in teams, as the professor wasn’t confident we could complete all our assignments without group cooperation. Actually this wasn’t a bad idea. In real life almost all engineering problems are solved by project teams. One of our assignments called for the analysis of what the professor termed a “donkey engine,” an early type of steam engine used on paddle wheel river boats. It was called a donkey engine because it would “kick” in unpredictable ways. Later engines used governors to control this behavior. Recently I discovered that James Maxwell wrote the definitive paper on this subject back in the mid nineteenth century just before he published his famous equations that became the basis of the science of electrodynamics.

None of us were able to solve the donkey engine problem. The professor never provided us with the answer. Early in my career at the laboratory, I told this story to my coworkers. They didn’t believe me, so I gave them the opportunity to find the solution. They were experienced engineers. Most of them had their master’s degree. None of them could solve the problem. Finally my boss, a brilliant man with a PhD in mechanical engineering tried and failed to derive the equations of motion for the donkey engine. He concluded the system was too close to instability to be solved using normal, linear predictive methods.

From time to time, I am asked to predict the movement of stock market. If I could perform this miracle on even a semi-regular basis, you could try to visit me on my beachfront estate on the island of Maui, if you could get past my security force. People like the rube in the painting believe or at least entertain the idea that someone can predict the movement of the market with mathematical certainty, while the fortuneteller’s confederate is busy picking the victim’s pocket. Think about it. If I had the magic box that could predict the movement of the market, why would I share it with you?

I started studying investment as a discipline about 14 years ago. After much effort, I have come to the conclusion that, “I don’t know nothin,” at least not with anything that approaches mathematical rigor. What I have learned are some rules of thumb that have helped me save and successfully invest enough that I was able to retire comfortably at age 62.

Here are some of those rules of thumb, rules that work “thumb” of the time. Remember all these statements are based on past performance, which may or may not have anything to do with the future.

1) If you invest in American equities your money will grow at approximately 7% per year over any sufficiently long period of time. That sufficiently long period of time may not reach fruition until after you and your coffin have been carried home to victory on the Wabash Cannonball.

2) In any given year you can lose as much as half the money that you are holding in stocks. It happens. If you lose half your money, you will need to double your money to get back to even. That could take a long time. It is better to lose ½ of ½ of your money, especially if you are retired. If half of your money is in bonds and cash you will be able to pick up bargains after the market collapse, just like Joe Kennedy did back in 1933.

3) Bonds are not guaranteed. A wise man looking around for safe investments in 1910 might well select some German and Russian bonds for his portfolio. His great grandchildren may still have these souvenirs of a better time framed and hung on the wall of their study as a historical curiosity.

4) The world will end every eight to twelve years. About once a decade the market will suffer something that falls between a major correction and a crash. Count on it.

5) Indicators may or may not be of any use. For two or three years, all the fundamental indicators have been telling us the market is over valued. However, there is another rule of thumb at work here, “Never fight the Fed.” As long as the Federal Reserve Bank and the Department of the Treasury continue to pump astronomical sums of funny money into the economy, indicators are indicating something but not providing us with any useful information.

6) Debt is bad. Corporate debt is bad. Over the course of about two months, I discovered, KMI, one of my “safe” stocks that performed well for a long time had a debt problem. Now, I’m pretty much back where I started on that one. Large scale individual debt is bad for an economy. Excessive Sovereign debt is dangerous for a country. Debt has to be repaid. The principal and interest repaid to the creditor are funds that can’t be used to generate new sales and salaries in the private sector that can then be taxed by the public sector. During this “winter season” when debt is being squeezed out of the economy, the donkey engine can kick in unpredictable ways—like hyperinflation or bankruptcies for individuals or default for Governments. These events can cascade through society with truly disastrous results, like World War II.

So what can I say that is of any value to the beginner or even the experienced investor? If you spend less than you make over a working lifetime, you will have a surplus to invest in stocks, bonds, or real estate. If you don’t invest too much in any one thing or too much at any one time, it is likely that you are going to be all right.

I really can’t beat what Solomon wrote a long time ago. A broadly diversified portfolio containing different types of investments and wise trustworthy friends and counselors who have your back are your best protection against the uncertainties one finds under the sun.

Ecclesiastes 11:2
Invest in seven ventures, yes in eight, you do not know what disaster may come upon the land.

Ecclesiastes 11:6
Sow your seed in the morning, And at evening let your hands not be idle,

Proverbs 15:22
Plans fail for lack of counsel, but with many advisers they succeed.

Ecclesiastes 12:13
Now all has been heard, here is the conclusion of the matter. Fear God and keep his commandments, for this is the duty of all mankind.

Thursday, December 3, 2015

Pushing Water Up the Hill

First of all, I need to convince you that debt is generally a bad idea. Then I need to convince you that you can push water up hill.

The following is a highly embellished version of a thought experiment proposed in an interview by Nassim Taleb, an author who studies the impact of highly improbable events on economies and nations.

Consider twin brothers who have just graduated from school. One gets a job and begins to save 10% of his take home pay. He pays $1,000 cash for his uncle’s ten year old truck that was actually probably worth $3,000. He puts off buying a house until he can make that 20% down payment to avoid the dreaded PMI (Private Mortgage Insurance). The other brother gets the identical job. However, he buys a brand new pickup with a low down payment and a 72 month note that he can easily afford. He thinks he gets lucky when a local developer offers condos for sale with no money down to young folks with good credit ratings. After all, his mortgage payment will be less than the rent he is paying for a two bedroom apartment.

After three years their employer goes belly up. What happens next? One brother has $12,000 in the bank. He shrugs his shoulders, loads up the truck, and moves to Greenville, SC when he hears the words, “They’re hiring down here,” from one of his buddies, who made the move last year. The other brother can’t make the payments on his truck. It is repossessed. He can’t sell the condo because he is underwater. That is he owes more on the condo than it is worth.

Three months later the first brother found a job making widgets that are sold to the BMW factory in Greer, SC. He still has $6,000 in the bank and a beat up old truck on its last legs. The other brother is living in his parent’s basement with no job, no wheels, and a wrecked credit rating.

Savings are good because the impact of highly improbable events is often bad.

You can push water up hill. However, it requires wise decisions, energy, and discipline over long time periods. You will need some pipes, a pump, a source of electricity to run the pump, and some kind of reservoirs at different levels to store the water as it moves on its way up the hill.

For most of us, your job is the source of your money, the water you need to move up the hill of life. You start by moving a percentage of your income into a storage tank we will call an emergency fund. Once that tanks starts filling up, you can divert the flow of a portion of your savings to a 401(k) or some other tax favored retirement account. If your employer offers matching money, do this sooner rather than later. Later on, install a big tank for a down payment on a home. Once you have a mortgage, pay it down sooner rather than later, remembering how much sooner is a function of the interest rate you are paying. Finally, open a reservoir for your children’s education.

Here is how that worked during most of the years of my working life. First I had a checking account. I kept more than enough money in there to cover expenses for a couple of months. Later, I opened up a money market fund to cover emergencies and save for big ticket items like cars. My employer offered a 401(k) so I began by contributing some trifling percentage from day one. I don’t remember the actual number, but it was too low. When I had enough to make the then traditional 10% down payment, I became a home owner. Finally, I opened a taxable investment account at Schwab. Money went into that account but never came out of it for any reason until I retired.

Pushing water up the hill is a pretty simple task, but it isn’t easy. When dealing with money there is a bonus you don’t get with water. Once you have pushed enough money up the hill, you will find that the miracle of compound interest begins to fill your tanks without any further effort on your part. However, those tanks, your piping system, and valves still will need periodic inspection and repair.