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An Idea for Cash: Get Outta Town?

No matter how well you have most of your money working for you, you should always have some money sitting around for day-to-day expenses.  Not only that, but you really should have an emergency fund that holds at least three months (preferably six) of living expenses in case of, well, and emergency,   Job security isn’t what it used to be.  In fact, for many of us, job security isn’t.

 

But the question is, what do we do with that cash?  Should we just leave it sitting in a chequing account in a currency run by a government severely below the curve in budget and trade deficits collecting next to no or no interest?

Well, we could, and since we’re not talking about our entire nest egg, (hopefully) it’s not that big of a deal if we do.  However, I have a low-risk, low-reward idea that will add a few percentage points of return onto the money you have just sitting around.

Remember that the main factor in inflation by the creation of money.  If country A produces money faster than country B, then one unit of currency A will generally go down in value relative to currency B.  There are other factors of course, but this is the biggest.

Why don’t we want to be in USD?  Because while almost every country in the world runs a budget deficit, the US runs the largest deficit in the world on an absolute (number of dollars) basis, and is always right near the top when it comes to deficit per capita.  Which means they’re printing up money (causing inflation to shrink the value of their debt) at a faster rate than pretty much anyone else to make up for the shortfall.  Which also means that there are very few currencies that don’t increase against the dollar.

Let’s take the value of the USD vs another troubled currency, the Euro.  It’s no secret that the Euro has seen it’s share of difficulty lately.  Greece has defaulted, Ireland is on the verge of doing so, Spain and Italy are having to make drastic cuts in their standards of living.  But from 9/11 when America single-handedly financed two wars simultaneously, to 2008, when the “Euro Crisis” first came into the public eye, it was a march straight up for the Euro.  And even since then the Euro, one of the worlds most troubled currencies, is managing to keep it’s ground against the dollar.

Now what happens if we look at a currency that’s very stable?  Like the Swiss Franc? Observe.  Planes hit buildings, America goes to war again.  (and again, and again, it seems), and the CHF (franc) takes off.  In fact, the value of the franc has very nearly doubled since that fateful day.

Canada’s has done almost as well.  Australia has more than doubled.  Starting to see a pattern here?  It’s not everyone else that’s going up.  These countries all run deficits as well.  It’s America’s currency that’s going down.

In fact, the problem covers a lot more than the cash sitting in your bank account.  But that’s a start for now.

 

But if you go to the bank and open a foreign currency account, you may not be able to open an account in the currency you want, and you’ll definitely take a big hit (often more than 2%) on exchanging your money from one currency to another.

One solution you can use is to invest your money into a foreign currency ETF or open a forex trading account.  I’m not suggesting you get into active forex trading, as 90% of the people that get into that game come out losers.  But you can get an account, shift your savings over to it, and put it into a different currency far cheaper than you could at your local bank.   Using an ETF exposes you to a management fee (or MER), but you can  move your money there much more easily than opening a forex account.

Also, you can expose yourself to short-term bonds from other governments.  While the Canadian and Australian economies are on pretty much the same track (straight up, because they rely on natural resources that have to be harvested locally rather than industries whose labor can be outsourced), the US and Canadian gov’t short term bonds pay less than a percent, while Australia’s pays upwards of 4%.  Try getting that in a Citibank savings account.

Income: The Final Nail in the Coffin For Inflation

Last week we covered how we can use debt to fight inflation, not only by requiring less money to secure possession of an appreciating (at least in the eyes of inflation) asset, but by shrinking the debt that we take out to secure it.  While that shrinkage usually does not make up entirely for the interest payment, it usually will take a rather large chunk out of it, resulting in a real interest rate (interest rate minus inflation rate) of 1-3%.    That combined with the “appreciation” of the asset (the nominal value increasing not because the asset is becoming more valuable, but because the dollar is weakening), leads to a small gain in real terms (after inflation is factored in).

But there is one last thing that you can do that will take your returns from gaining slightly against inflation to shooting it through the roof.

Income.   Income doesn’t just kinda-sorta keep up with inflation like most asset’s value does.  It keeps up with it absolutely.   Have your electricity and water bills stayed constant over say, the last 5 years?  Hell no!  Have restaurant prices?  Get outta town!  Has the price you’ve paid at the gas pump stayed constant?  Girlfriend, please! (OK, I’ll stop now.)

If you find yourself an asset that produces income that keeps pace with inflation, while simultaneously “appreciating” (see above) over time, you’ve got yourself a winner!   You couple that with the power of inflation to shrink debt, and your investment is flying!

For example, say you take a loan at 4% interest.   You put down 25% of the value as a down payment, using the loan for the other 75%.

While your last payment will be the same number as the payment is worth today, but that number of dollars will be worth much, much less by then. If the average rate of inflation over the life of the loan works out to be 3%, you’re going to have paid roughly 1% more than you took out in terms of today’s 2018 dollars.  At 4%, you break even, at 5% you’ll have paid less than the value of the loan and so on.      Ditto for how much your investment has appreciated.  If the value of your asset has gone up 5% in one year, but inflation was 4%, you made real value, if it only went up 3%, you lost it.   Depending on what kind of assets you choose, we’re hovering around breakeven territory.

But now… let’s add income from say, a rental property.  Let’s be conservative and say that it generates 2% of the value of the building after expenses and the mortgage service.   Since you’ve only put 25% down, that’s actually an 8% return cash-on-cash.    And here’s the real beauty…. the value of your rents go up every year with inflation, but the debt payment doesn’t.   That 8%?  That’s year one.  By the end of a 20-30 year loan, your debt payment will be half to one third the size relative to the rents.  Your yearly return on that down payment will be much, much higher.  

You’ve borrowed money from the bank which you’ve paid back at a tiny real interest rate to make a great return on investment.  And if inflation spikes at some point in that 20-30 years because, say, our government has debt payments that are way too large to service any other way, you may even be paying a negative real interest rate.  To make money!

Everybody dance now!

Using Debt to Fight Inflation: If You Can’t Beat Them…

So last week we covered TIPS, a way to protect yourself against inflation in a no-risk, no-reward, but-at-least-not-sinking fashion, which is perfect for those who are getting close to retirement.

This week, we cover a totally different approach.  The way to not just keep up with inflation, but to turn it into something that works for you, not against you.

First, let’s ask ourselves again, why does inflation occur in the first place?

Governments spending more than they take in, creating debts which require the additional printing of money to pay back.  When they print more USD without adding value to the assets that USD holds, it reduces the value of USD that was already in existence.  They are intentionally using inflation to “pay” (shrink) their debts by removing value from the assets you and I own. 

So what does this mean for the gov’t?  They borrow $1000 in 2018 with a promise to pay $1,020 in 2019, but pay it back with currency that is only worth $980 by 2018 standards.  And they’re doing it in a way that the average joe does not understand, and thus, won’t get any negative feedback in the way that raising taxes would.    Why would they ever stop?

So not only do we know how inflation works, we also know that people in power have a very vested interest in keeping the little shell game up.  It’s not going to be changing anytime soon.  Unless gov’ts all of a sudden decide that they’d rather run balanced budgets.  I’m not holding my breath on that one, are you?

But wait… if it shrinks their debt… doesn’t that work for us, too?

You bet your ass it does.

That is the one single reason most baby boomers will manage to have a healthy retirement.  Not because of the value of their retirement savings, but because of the value of their debts like their house loans literally melted away in the early 80′s.   Say you bought a house in 1977, with an 8% interest rate.  But in 1980, inflation hit 16%!  That means that as the value of the money someone was making their mortgage payment with shrunk by 16% in one year.  In fact, within a six year stretch, the real-world value of their debt had shrunk by half before we even took the payments themselves into account!  

A $300 mortgage payment was a hell of a lot bigger in ’77 than it was in ’83.    And during that period, the value of the house itself increased along with inflation as well.  Not as high as the rate of inflation… real estate prices didn’t increase by 16% in 1980, but it was 8-10%.  Add that on to the debt shrinkage, and you have some serious damn value creation!  So much so that many smaller savings and loans either required bailouts in the early 80′s or went under entirely.  That money went somewhere alright… right into baby boomer mortgageholder’s pockets!

But there’s still one problem.  We have to pay more interest to borrow money than a government does.  While real interest rates (interest minus inflation) is negative for governments, it’s still positive for us, which means we’re losing value on the debt.   ex.   3% inflation a year isn’t going to do much against a 23% credit card interest rate. 

But, if we buy something that appreciates faster than inflation, we can add that onto the total, giving us a net profit!    Think of it like this.  Let’s (in our dreams), buy a Picasso.  Say we get a loan for $1,000,000 and put down $250,000 to do it.   (Cheap Picasso… was it a sketch on a bar napkin or something?)   And unlike the gov’t, which is getting it’s loans for 2% (or less!) We have to pay 3% or more based on the length of the loan.  Let’s say we’re paying 4%.

But, the value of the painting is going up an average of 4% in nominal dollar terms every year as well.  So we’re breaking even.

But if, for some, strange reason, inflation spikes because, say some gov’t debt goes through the roof and goes above 4%, we actually start making money because the value of the dollars the debt is in is shrinking!  And our 4% apprecation?  Well, the reason that painting’s dollar value is going up is not just because fine art becomes rarer over time… it’s also going up because the value of the dollar is shrinking.  And if that value starts to shrink faster, the “appreciation” goes right along with it!   

Let’s say that the time of inflation reckoning is year one (it won’t be, but for the sake of easy math) of 10% inflation.  You paid 4% interest, but the value of your debt shrunk 10%, and the value of the painting went up 8%!  We mostly kept up with inflation in our re-sale value, but we actually lost 2% of it’s value.  But our debt lost 10% of it’s value!  In inflation-adjusted terms, we made (-4% of $1m, -2% of $1.25m, +10% of $1m) $35,000 of post inflation value ($60,000 pre-inflation) on an investment of $250,000!  That’s 24% pre or 14% post inflation cash on cash!

Of course, don’t run out and buy a painting.  There’s all sorts of transaction and maintenence costs we’ve neglected, and how do you sell a painting, anyways?   And the value of art will go up and down independant of inflation due to other market pressures, the same as any other asset does.  (ask American homeowners about their houses)

But the principle remains.   Find something that you are very sure will appreciate at least as fast as your interest rate.     Get a rate of interest if not below inflation (damn near impossible),  as close to it as possible.   As long as the appreciation plus debt shrinkage is high enough above the interest rate to offset the risks and expenses of being in that asset, you are making value!

 

Inflation… Someone’s Got Their Hands on my Money!

As we’ve talked about before, one of the biggest, if not the biggest downward drag on your savings and/or portfolio is inflation.  Sure, you’ll be sitting on a big pile of dollar bills, but they’ll be worth about half as much as they are now 15 years from now.

Before we can talk about inflation-beating, it’s important to have at least a basic understanding of what inflation is, and why it exists.

Imagine you and three and your friends at work have chipped in and bought a pie.  You each plan on having an equal sized slice… one third of the pie.  Then your boss comes along and decides that he’s going to take a share, too.  Now, even though only three of you paid for the pie, you still have to cut it in four pieces.

Well, that’s what inflation is.   A dollar represents one share in everything that comes under the influence of that currency.   Everything that is owned by US dollars (land, possessions, services in places that use the currency) is the pie.    When more dollars come into existence, but the pie stays the same size, the amount of pie each previously existing dollar is able to buy is reduced accordingly.

And guess who the boss is.

For every dollar that the government spends that it does not have revenue to pay for (which is close to one trillion in the US this year), it has to issue a dollar of debt.  Debt that is bought up by anyone that wants the interest rate that is paid out.  Banks, individuals, corporations… and more increasingly, the Federal Reserve, the institution that controls the money supply. 

Basically, the Fed has the power to create money, or shares of US influence, out of thin air, without adding anything to the pie to make up for it.   And at the moment, the Federal Reserve is buying up about half of the debt that USgov prints up.  (For the sake of comparison, Chinese interests hold about 7%.)

But doesn’t that basically leave the government at the mercy of their debt?  Not really.  Here’s the clever bit.

Let’s say that you buy $1000 of US debt with a 1% interest rate for a period of 1 year.   If the rate of inflation (the rate at which the Fed has increased the amount of money over and above the growth of the US pie) is above 1%, THE GOVERNMENT MADE MONEY.

Well, not exactly money, but they made value.   They paid you $10 a year later.  But a year later at 3% inflation, that $1,010 of 2019 dollars is now only worth $979.70 of 2018 dollars.   The value of the debt has been shrunk.   Anyone

So does that mean the Federal Reserve is being ripped off?  No… they just made the money to buy the debt out of thin air in the first place.  But it DOES mean that everyone that bought US debt with real money IS losing value every year that inflation outpaces their interest rates.    So who sets the interest rates?   Again, the Federal Reserve. 

Which basically amounts to a tax on every dollar you save every year.   

And people simply holding dollars in savings accounts don’t even get the courtesy of an interest rate, so the value of their money declines even faster.  If the rate of inflation is 3%, then the value of a dollar in a chequing account goes from $1 to .97.  The next year, it goes down to .941.   And on, and on.  Pull up a calculator and type 1 x .97.  then hit the equal sign.  Hit the equal again, 19 more times.  That’s what your money is worth after 20 years.

And THAT is probably the single biggest reason why saving doesn’t work worth a damn.  Because the Federal Reserve is going to sneaky-tax the holy hell out of it.  Every.  Single.  Year.  Aaaaaaaah!

So what can we do?   For now, two things…  a)  Don’t go spending everything you’ve saved because it’s all hopeless.  It isn’t.     b)  Stay tuned.  It’s about to get good.

How Counting Chickens Before They Hatch Can Kill You

I recently found out that a house that I had bought in a small town for my mother to run a small business in has since tripled in value since I bought it 12 years ago. (It’s not in America.)

Does that mean I’ve made three times my money? Not even close.

There seems to be a prevailing myth out there that a home is a terrific investment. While it can be ok, it’s certainly not a no brainer. In fact, it is not unusual to only break even on a house EV-wise (expected value… in this case, inflation adjusted profit) even when you haven’t lived through a massive housing correction like America just has.

There are all sorts of expenses that go into the care and maintenence of a house that eat into your “profits”.

For example’s sake, let’s say I purchased the house at 33k, and is now “valued” at 100k. “Gross profit”: 67k.

First, before you even walk in the door, there’s taxes. Depending on what state or province you live in, you are probably going to have to pay 5-15% sales tax to get ahold of a piece of property. Selling with a real estate agent? Tack on an extra 4-7% in commission. Then there’s property taxes and homeowner’s insurance. Typically around 1-2% of the home’s value combined. Paid every year. 12 years. Ouch. Home maintenence. Say another 1% per year to keep everything in shape and keep up curb appeal. Most years will be less, but some will be a lot more.

Finally, you didn’t buy that house cash, did you? Uh oh. Then you’re paying interest, and a lot of it. With a 20 year loan at 4% interest, expect to pay more than 40% than the value of your loan over the period of the loan. Want 30 years? Better bump that up to 75%. And if you need 30 years to pay off a mortgage, believe me, you can’t afford whatever home you’re looking at. You’ll be paying so much interest that even a small increase in interest rate is going to have your mortgage underwater. That’s how the American housing crisis got started in the first place.

Now the wild card in all of this is inflation. It works on several variables of the equation. Let us assume that we will see an average of 3% inflation per year, which over 12 years means that the value of a dollar declines by one third. Your yearly expenses keep up with inflation, which means that every 12 years, you’re going to be paying 50% more for them. So does the value of the house. In fact, it’s a major driver of the appreciation of real estate. If a $33k house is worth $50k 12 years later, it may have “made money”, but it hasn’t appreciated a single iota in real value. So in EV terms, my gross profit is only twice what I paid for the house (before expenses), not triple.

So take a 100% gross profit, and take off say 10% for commission and taxes. Then 3% (proerty taxes, insurance, maintenence) times 12 years, reduced to 1/2 to account for appreciation/inflation (because 3% when it was worth 33k is not as much as now that it’s worth 100k). No, that’s not the exact math. It’s just ballparking, but it’s close enough. That’s another 18%.

Then there’s the interest on your loan. Your payment does not go up over time unless interest rates do. But inflation marches on regardless. A $200 payment per $30k of loan may suck now, (it will really suck), but 12 years from now, it’s going to feel like a $100 payment. Of course, you’re paying an inflated price for your home because of the interest you pay. But when your interest rate and inflation are equal, (which is pretty close to the case these days) they effectively cancel each other out.

But when the interest rate you pay is higher than inflation (most of the time), then you’re losing value by paying more interest than inflation shrinks the value of your payments. Which means you’re losing EV via interest.

So I haven’t really tripled my money. I’ve made anywhere from 20-70% in EV based on how big my loan was.
Wow, what a letdown. I could have made more money just buying 25k worth of gold and hiding it under my bed.
And I GOT LUCKY. If the house was in America, I would have lost a boatload of EV.

So what’s the good news? Well, it’s twofold.

How many assets do you know that would have even kept up with inflation over the last 12 years (50%)? Stocks? Nope. Bonds? Sorry. And did you have 25k just laying around 12 years ago to buy gold with?

Here’s the beauty of home-ownership. It doesn’t have to keep up with inflation. It has function above and beyond that of an investment, unlike gold.

We all need a roof over our heads. Our physical bodies, at least in a financial sense, are liabilities. We have to pay money each month to keep them going. If you didn’t own a house, you’d have to pay rent. That money is going out the door regardless. And let’s say you bought a house 12 years ago, saw it appreciate 3% a year (which works out to a 50% increase… a 50k house would be worth 75k twelve years later), but then lost it all in the housing correction in 2008. Sure, you lost value, because your house is worth the same money as 12 years ago, and a dollar is worth only 2/3 as much as 12 years ago, but you would have had to pay that much EV in rent anyways. It was actually a breakeven situation, not a loss!

But if you were counting on a gain to balance out bad spending habits…. you are effectively floating up Shit Creek.  Paddle sold seperately.  Basically, buying a house is not really an investment. It is ideally a way to turn a liability (needing a place to live) into less of a liability, or hopefully breakeven or even make a little bit of EV over time if you’re lucky.  But if you’re buying a house assuming it’s going to make you money down the road, make no mistake… you are not investing, you are gambling.

Not only that, but if you’re counting on making money on your house, you are almost certainly going to buy more house than you need, (or can afford) and thus unwittingly be taking risk on par with that of derivative traders.

And you ain’t getting no bailout.