Premie Retirees

"I'm gone. Don't try to find me. You won't. I'm on strike."
--Ellis Wyatt (Atlas Shrugged: Part 1)

This article suggests that the pandemic taught many people, especially young ones, that work doesn't pay. It is better to stay home and goof off rather than to toil one's life away.

Makes sense when the government was sending stimulus checks that paid people to stay home--given axiomatic aversion to labor that steers human behavior. However, it doesn't explain how those young non-workers will continue to not work once the stimmy checks dry up.

That said, it is entirely possible that an older, yet still capable cohort has indeed left the workforce for good as part of the Great Resignation. Many people approaching retirement age became disgusted with restrictive pandemic work policies, such as masking and mandatory vaccinations and hit the silk rather than deal with unpleasantries that conflicted with their principles.

Unlike younger workers, this cohort has a substantial nest egg that can be used to fund unexpected early retirement. Because they are still productive, premature retirees could always step back into the workforce if they change their minds, or if their budgetary situation changes.

Given the still-oppressive regulatory overhang governing many workplaces, however, many of these premies may be gone for good a la John Galt.

Futility of Saving

Who's gonna tell you when

It's too late?

Who's gonna tell you things

Aren't so great?
--The Cars

Nice graph (taken from this article) showing the futility of saving cash as a means to beat inflation. The inference is that cash hasn't covered cost of living increases in years.

This graph is conservative, given that inflation numbers under-report price increases. Stated differently, the actual ability of saving to cope with price inflation is significantly worse than suggested here.

What corresponds to the step changes down in earnings on savings? Easy Fed monetary policy that went into overdrive with the onset of the quantitative easing regime in 2009.

Saving Rain

Here comes the rain again
Raining on my head like a tragedy
Tearing me apart like a new emotion
--Eurythmics

Nice graphic that shows that not only do Americans have no net savings, but that savings is negative after inflation.

As the Fed has suppressed interest rates over the past 30-40 yrs, people have had less incentive to save. Why put money into a savings account when there is little or no compensation to do so?

Now add inflation. As prices go higher, why put money away today when those dollars are expected to be worth less tomorrow?

Remember the saying 'Save it for a rainy day'?

No savings means no buffer against uncertainty (i.e., you'll get rained on). And, perhaps more importantly, no capital to fund productivity improvement.

Positioning for Retirement

Doing the garden
Digging the weeds
Who could ask for more?
--The Beatles

With retirement coming up fast I've been doing a few things w.r.t. personal finance. I've been saving more and spending less in order to build cash. Have also been selling some stuff on ebay and elsewhere to collect extra 'juice.' Also helps thin things out at the house--much needed.

Preparations are being made to rollover my 401(k) from work. I'm looking forward to allocating this capital among far more choices than those available thru the current fund administrator.

In both my brokerage and IRA accounts, I've been buying dividend paying stocks. Dividends are real cash that can provide a significant, and perhaps under-appreciated, income replacement in retirement.

Inflation is particularly bad for retirees as it erodes purchasing power of savings. To hedge against the prospects of Big Inflation, I've been building stock positions in the oil complex (e.g., ENB, XOM) and miners (e.g., AEM, AGI, PAAS). 

The miners appear particularly attractive. The financial strength of many in this group has perhaps never been better. Solid balance sheets and cash flows. Many are paying significant, and increasing, dividends (which helps me kill two birds with one stone). The sector has been pounded down to attractive valuation levels--particularly given the growing inflationary environment.

I've been swapping funds out of precious metal ETFs such as PHYS and into the miners to more fully express my perception of this situation--albeit at a slightly higher risk profile. 

positions in AEM, AGI, ENB, PAAS, XOM

Dividend Geese

Billy Chapel: Are you saying I should retire?
Gary Wheeler: Why not? It wouldn't hurt the negotiations. And it would serve those sons of bitches right.
Billy Chapel: I, uh. I don't know. I don't know what to say.
Gary Wheeler: Well, you can't tell me that you haven't thought about it. And you've been smart with money, right?
--For Love of the Game

Until recently, dividends didn't matter much to me. Like most investors, I focused on price appreciation potential. 

A few years back my brother reacquainted me with the value of cash dividend payouts. Managing my mom's portfolio, he invested primarily in stalwart dividend paying stocks. Over time, he built an income-producing machine capable of covering a large share of monthly living expenses. Yes, the portfolio gradually increased in value as well. But so did the dividend payouts.

The capacity of a well-designed stock portfolio to generate income--particularly 'replacement' income for retirees--impressed me, perhaps in part because I'm approaching retirement myself.

In the olden days, common wisdom was that aging people in need of income replacements should invest in bonds and other fixed income instruments. Being traditionally less volatile, fixed income was seen as less prone to big capital loss. Moreover, many fixed income instruments tended to offer yields superior to stocks.

In the late 1970s/early 1980s, for example, 10 yr Treasury yields traded north of 10%. Those cash payouts were far higher than dividend yields on stocks. Of course, inflation was also flying which negated much of those cash gains.

Since then, of course, T-note yields have been in secular decline--due largely to interventionary policies of the Federal Reserve. Dividend yields on stocks have also declined as shown by the yield in the S&P 500 since 1900.

Overlaying the two trends reveals a couple of things. One is that stock dividend yields have not always been lower than bond yields. In early decades of the 1900s, stocks generally yielded more than bonds by a couple of percent. The other note is that, more recently, the offset between stock and bond yields has narrowed to the point where cash returns on stocks once again looks attractive.

Index-to-index comparisons tend to understate the superior cash-yielding capacity of stocks. For example, the yield on the S&P 500 Index currently stands at about 1.3%. However, many stocks in the SPX pay tiny or no dividends. Investors can readily assemble a portfolio of reliable dividend payers from the SPX with an overall yield north of 3%. This handily beats the current 10 yr Treasury yield of about 1.5% (and nearly all other fixed income alternatives for that matter).

If Treasury yields should rise relative to stocks then the calculus changes, of course. That said, because central banks worldwide are determined to suppress sovereign yields, large increases in bond yields seem unlikely unless policy makers lose control of the interest rate markets. While this could certainly happen, it is likely to occur in the context of Big Inflation. Big inflation jeopardizes the attractiveness of bonds. Moreover, companies may be able to navigate inflationary environments in a manner that preserves value. Dividend payouts might even increase.

Preparing for retirement, then, I view the cash-generating capacity of dividend paying stocks as central to creating 'replacement income' when the paychecks no longer roll in. Essentially, the dividend payers write the checks instead of an employer. The more I can draw on steady-to-rising dividend payments, the less I will have to cut in on the principal that generates the cash.

Stated differently, I don't want to kill the dividend-paying geese that lay the golden eggs.

Extraordinary Idiocy

"We must just pray that when your head is finished turning that your face is to the front again."
--Sir Thomas More (A Man for All Seasons)

So much foolhardy commentary is posted on social media that it is easy to build an immunity to it after a while. Every now and then, though, one stumbles across posts of such extraordinary idiocy that they are difficult to ignore.

"There is, in fact, in the writings and teaching of those who nowadays call themselves “economists,” no longer any comprehension of the operation of the economic system as such." - Ludwig von Mises https://t.co/F1GH9dRFwv

— Mises Institute (@mises) January 31, 2020

The post above comes from a professor of economics at the University of Utah. He did his undergrad at Oxford and his doctoral works at the University of Chicago.

How someone like this gets past his comprehensive exams much less defends his dissertation and gets hired by an R1 university is beyond my comprehension.

Fallacy of We

Leo Getz: You hungry? I'll call for anything you want. See this silk robe? Free.
Sgt Roger Murtaugh: It's not free. 
Leo Getz: Yes it is.
Sgt Roger Murtaugh: It's taxpayer's money.
Leo Getz: Same thing.
--Lethal Weapon 2

Article discusses the absurd claim that federal debt is not a problem because it is money that we owe to ourselves. The 'we owe it to ourselves' crowd argues that because government debt can be passed on to future generations, the debt can persist into perpetuity so long as people are willing to lend and government is able to service the debt. Moreover, because federal debt is owned by domestic citizens, the money used to repay debt doesn't leave the economy.

But, as the article points out, about 1/3 of federal debt is in fact owned by outsiders. In other words, we don't owe a substantial portion of federal debt to ourselves. We owe it to others.

A larger problem can be called 'the fallacy of us, we, and our.'  Individuals lend and borrow, not collectives. Individuals who incur federal debt are different from individuals who bear the burden of repaying the debt. The beneficiaries are people today who enjoy the borrowed funds and what they can purchase. However, future taxpayers are hurt, as they must repay the debt borrowed by previous generations.

However, the most fundamental problem is one not directly addressed in the article. Government debt constitutes borrowing by force. Sovereign debt is a contract between governments and private lenders with the promise that bond principal and interest will be repaid by citizens under threat of force. Confiscating economic resources by force distorts how those resources would have been allocated by individuals engaging freely in production and trade.

Moreover, when government knows that it can take resources at gunpoint, it will surely 'borrow' more, which leads to lower saving and, ultimately, to capital consumption over time.

The result is fewer resources available for investment and productivity improvement down the road. Prosperity, consequently, is restrained.

Decline in Job Quality

Hey, I'm not complaining
'Cause I really need the work
Hitting up my buddy's 
Got me feeling like a jerk
--Huey Lewis & The News

Article indicates that, while unemployment is near record lows, quality of work has been declining. The Job Quality Index, a product of Cornell Law School, factors in hourly wage growth, hours worked (higher deemed better), labor force participation rate, and rates of core economic growth to reflect to find a ratio of 'high quality' to 'low quality' jobs. A number less than 100 indicates more low quality jobs.

Notice that the index has been trending down since its inception in 1991. Why might this be? The best jobs come from capital investment. But real capital investment has been dwindling as savings have declined. We are now engaging in capital consumption. High quality jobs are unlikely when there is little real capital to create them.

Until we borrow less and save more, job quality should continue to deteriorate.

Negative Productivity Trends

Gonna pack my lunch in the morning
And go to work each day
And when the evening rolls around
I'll go home and lay my body down
And when the morning light comes streaming in
I'll get up and do it again
--Jackson Browne

These pages have observed downtrends in productivity growth--particularly over the past ten years. After the Q3 number printed at -0.3% earlier this week, people are once again wondering what is going on.

Let's look at the productivity series. Below we see the annual percentage change in productivity (i.e., output per hour worked) in 'non-farm business' (i.e., manufacturing and service sectors excluding agriculture).

Ignoring measurement challenges (e.g., how to accurately capture all hours worked?), it is clear that productivity has been declining over time--with perhaps some pushback inspired by the productivity-boosting info tech movement in the late 20th century. Although I don't have statistical capability right this moment, I would bet that a linear regression model fitted to these data would find a negative and significant slope.

What is grabbing people's attention is that the variation that accompanies the data points in this downtrend is beginning to touch, or cross zero with increasing regularity.

What is driving the decline? While many theories are being advanced, it seems to me that the central cause is this: dwindling savings.

To improve productivity, humans need tools that they can combine with labor to produce more output per hour. In order for some people to produce those tools, however, they must forego producing food, clothing, and other vital resources necessary for their own survival. The toolmakers live off of resources that others have set aside (i.e., savings).

Savings that fund tool production are often referred to as capital. When people save less and consume more, there is less capital. Less capital means less tool production. Less tool production means lower propensity for productivity improvement.

When people consume everything they make and dip into past savings to fund their immediate lifestyles, then they are engaging in capital consumption. When government debt is factored into the mix, savings rates in the US have been increasingly negative for some time.

Negative savings rates are driving productivity decline--a decline which will surely compromise standard of living if it continues to persist.

Underfunded Pensions and Systemic Risk

Here comes the rain again
Raining on my head like a tragedy
Tearing me apart like a new emotion
--Eurythmics

Managing a pension fund is similar to saving for retirement. Just like each of us needs to determine how much money to set aside for when we're no longer working, pension fund managers must determine how much to set aside for all of those payments to retirees down the road.

Naturally, when you put money into a retirement account, you're unlikely to let it sit there idle. You'll try to grow those funds through investment vehicles like stocks, bonds, etc. It follows, then, that determining how much to contribute to your retirement account is influenced by the return that you expect on your investments in the account.

The basic rule is this: The higher the expected return on investment, the less you have to set aside in order to achieve your retirement goals. A simple example helps demonstrate. Suppose that you'd like to have a million dollars available to fund your retirement beginning 40 years from now. If you expected no return on your savings, then you would need to set aside $25,000 for each of the next forty years to obtain $1 million. However, if you're able to realize annual growth of 7% on retirement fund investments, then you would only need to contribute about $5,000 annually to meet the $1 million goal in forty years.

Pension managers go through a similar process. When many pension funds were created in the 20th century, returns on investment portfolios consistently averaged 8-12% annually. Pension managers began to bake those return assumptions into their decision-making processes for determining how much new money to put into the pot. Because they assumed 8-12% returns in the future, pension managers contributed less new funds than they would have added in anticipation of lower return scenarios.

Then the unexpected happened. Realized returns on pension fund investments began dropping. Interest rates on long term government bonds fell into a secular decline. Because pension funds traditionally over-weighted their asset allocations toward fixed income instruments, as bond yields fell, so did portfolio yields and annual returns.

In an effort to win back some of the returns lost in fixed income, pension fund managers shifted asset allocations toward more stock exposure. Stocks, of course, are generally riskier, and, under normal conditions, throw off less income, than bonds. Moreover, because every time stock markets take a dive, funds with large equity exposure lose a big chunk of value, funds carrying significant stock exposure are more subject to capital loss.

The last 30 years have seen a steady decline in pension fund investment returns. Today's returns are far lower than the assumptions used by pension managers years ago when they were determining how much new cash to sink into theirs funds to cover future payouts to pensioners.

What that means is that many pension funds today are chronically underfunded. Investment returns are lower than expected, and not enough new cash has been injected into pension funds to make up for the shortfall. This is similar to individuals who did not contribute enough to their retirement nest eggs over the years because they assumed that the returns on their investment positions would be higher than they turned out to be.

How to deal with underfunded pension situations? Ideally, pension fund sponsors would simply raise a bunch of cash and dump it into the fund the plan adequately. But think about it. If you as an individual have not saved enough for retirement over the course of many years, then how realistic is it for you to make up the difference when you are older? Many organizations with pension obligations face a similar problem. They simply don't have the resources to allow them to make up ground lost from years of chronic underfunding.

To reduce some future liabilities, some pension plans are offering lump sum buyouts to prospective pensioners. By dangling one time cash payments in front of some participants in exchange for them agreeing to exit the plan, pension managers hope that many of these people, using 'a bird in the hand is worth two in the bush' line of thinking, take the money and run. The managers' hope is that, by buying some participants out of the plan, the monetary resources remaining will be more capable of fulfilling monthly payment obligations to pensioners still in the plan. At best, however, buyouts more likely offer a way to reduce the degree of underfunding rather than to eliminate it.

Another option is for pension plans to default on their future obligations. Cease payments to pensioners. Or pay only a fraction of what was initially promised. Some of this is already occurring in chronically underfunded pension plans in the public sector involving teachers and government workers.

In the private sector, most corporate pensions are insured by the Pension Benefit Guaranty Company. The PBGC is a federally chartered corporation designed to take over private sector pension plans that go bust and cover monthly payouts to pensioners up to a certain amount. Unfortunately, the PBGC itself is thinly capitalized, meaning that it would not take many pensions defaulting at the same time to bankrupt the insurer.

It is here, I think, where serious risk lurks. A pension insurer that is essentially an agency of the federal government carries an implicit promise that the government will make pensioners whole--even in the event of a systemic crack-up that drains the PBGC's capital reserves. With so many pensions so chronically underfunded, the chances of such a systemic event cannot be ignored.

Where would the federal government get the resources to make pensioners whole? Taxing and/or borrowing are possibilities but politically unpopular. Federal tax rates are near the upper bound of political expedience, and federal debt levels are at $23 trillion and growing by the minute.

More likely is that the federal government would opt to monetize (i.e., print money) to pay pensioners. Send pensioners monthly checks for monetary sums created at the click of a mouse. Such a policy would create a form of 'helicopter money' infamously suggested by former Fed chair Ben Bernanke.

The inflationary implications of such a bail out policy are obvious. Specifically for pensioners, these people would be getting the nominal monthly paychecks originally promised them, but each dollar paid would be worth less due to the increasing supply of dollars in the system. The effect, from a purchasing power standpoint, would be as if the original pension plan defaulted on a fraction of the original promised payments. The systemic consequences could be far worse. As history indicates, once inflation toothpaste is out of the tube, it is difficult to put back in.

The bottom line is this. If you believe that pensions are chronically underfunded, then there is a significant likelihood that pensioners will not receive anything close to their promised monthly payments in real purchasing power terms. Inflationary bailouts designed to make pensioners whole are likely to do anything but.

Emergency Fund

"I'm tapped out, Marv. American Express has got a hit man looking for me."
--Bud Fox (Wall Street)

An early step toward financial independence involves establishing an emergency fund. An emergency fund is cash savings that can be used to pay expenses in the event that either a) you have no income (e.g., temporarily unemployed) and must pay routine expenses such as mortgage, rent, utilities, insurance, entertainment, etc, or b) you are subject to a large, unusual expense that your regular income can not easily fund (e.g., big car repair, medical expense).

It is commonly proposed rule that an emergency fund should be large enough to cover six months of living expenses. Personally, I would recommend more than that--a year's worth of expenses is a better target.

To determine how large your emergency fund needs to be, you first need to estimate your expenses. I recommend estimating expenses on a monthly basis for an entire year. An easy way to do this is to make a spreadsheet. Put months JAN thru DEC in the rows. In the columns, put various categories of expenses (school payments, clothes, entertainment, transportation, insurance, etc). When you are young, you won't have many expense categories but it is a good habit to begin tracking them.

Once your spreadsheet is set up, forecast your expenditures for each month throughout the year. If you think you'll spend $100 for clothes this month, then put that estimate in the appropriate cell. Sum up your expenses each month, and then sum the months to get an annual estimate of expenses. That number serves as the initial target for your emergency fund.

As the year unfolds and you pay actual bills, replace the estimates on your spreadsheet with the actual amount you spent. If you actually spent $121 on clothes this month, then revise accordlingly. On my spreadsheet, I boldface actual expenses to distinguish them from my forecasts. Over the course of the year, you'll get a better idea of what you actually spend, and that bottom line number for annual expenses will become a more accurate target for your emergency fund.

The other thing you have to do, of course, is save money to build your emergency fund. Put your savings in accounts where you can easily access cash to pay bills if you have to. Although it would be nice to earn as much interest on these savings as possible, the priorities here are safety and ease of access. If you have to sacrifice some returns in order to ensure liquidity, then do so.

Be patient. Emergency funds are not completed overnight, especially when you're just starting out. Over time, though, tracking your expenses and building savings to fund life's expenses will put you in better control of your financial future.

Taxable or Tax-Deferred?

Let me tell you how it will be
There's one for you
Nineteen for me
--The Beatles

Since the advent of individual retirement accounts (IRA) and 401(k) employer-sponsored retirement plans over 30 years ago, financial planners have been promoting these 'tax-deferred' investment accounts as the primary vehicles for accumulating retirement resources.

Tax-deferred accounts do have benefits. Each year, individuals can contribute funds, up to a limit, to an IRA or 401(k) 'before tax,' meaning that contributions are subtracted from your paycheck before income taxes are calculated. Moreover, gains from capital appreciation and dividends that accumulate in these accounts are tax-deferred, meaning that account holders do not pay taxes on these gains until withdrawals are made--presumably far down the road during retirement. An additional benefit of 401(k)s is that employers often match a percentage of employee contributions up to a particular limit, offering what essentially amounts to a salary bump for participating employees.

Tax-deferred accounts do carry disadvantages, however. Tax-deferred does not mean tax-free. When individuals do withdraw from IRAs and 401(k)s--and they are legally required to begin doing so by age 70 1/2 if they have not done so sooner. Those distributions are then subject to ordinary income tax. While it is often assumed that individuals will be in lower income tax brackets by the time they retire, the reality is that future tax rates are uncertain, and an argument can be made that future tax rates could be considerably higher depending on the political climate. For instance, higher tax rates might be deemed necessary down the road to fund our burgeoning and ever-increasing federal debt.

One way to reduce this risk is to open what is known as a Roth IRA. Contributions to Roth IRAs are done 'after-tax.' meaning that you pay income taxes upfront on your contributions. Because you've paid taxes on the front end, withdrawals subsequently made during retirement are not subject to further taxes. For many people already involved in saving for retirement using the above-mentioned tax-deferred vehicles, however, Roth IRAs tend to be viewed as more of a supplemental vehicle for wealth-building. Roth IRAs are also subject to future political risk that could reduce or even eliminate the tax benefit.

Perhaps the largest disadvantage associated with tax-deferred accounts is loss of financial flexibility. Once you contribute to an IRA or 401(k), you lose access to those funds for a long period of time. If you want to withdraw from a tax-deferred account before you are legally permitted to do so, then you must pay a substantial penalty. Early withdrawals from a 401(k), for instance, are commonly subject to a 10% penalty in addition to the income tax burden.

The commitment that accompanies tax-deferred investing creates a strange (and risky) situation. Conceivably, you could be socking away lots of excess income in IRAs and 401(k)s yet have insufficient savings available to fund life in the present. By tying up economic resources in tax-deferred vehicles, you can compromise capacity for living in the here-and-now. Your financial flexibility declines.

Can you see that one explanation for rising household debt loads over the past few decades is the diversion of too much income toward IRAs and 401(k)s--which has left these people with insufficient  savings for funding everyday expenses? Borrowing has been necessary to make ends meet.

So how did people save for retirement prior to IRAs and 401(k)s? Some employers offered 'pension' plans that promised employees a pre-determined monthly retirement income based on years of service. Most of these 'defined-benefit' plans are being phased out in favor of the 401(k) 'defined-contribution' design. Of course, not everyone worked for employers with rich pension plans. How did they save?

They simply used taxable vehicles. For everyday savings they kept money in checking and savings accounts. Lots of money. High balances in these accounts allowed funding everyday expenses while still saving for the future. For people seeking more potential return on their capital, then they could open taxable brokerage accounts to enable purchase of stocks, bonds, and other risky assets.

Use of taxable saving and investment vehicles permitted previous generations to remain financially flexible. They could comfortably provide for the present while saving for the future in a direct, uncomplicated manner.

Today's focus on IRAs and 401(k)s has reduced awareness of the benefits from taxable saving and investing. In a future post, we'll discuss advantages of taxable brokerage accounts in more detail.

Negative Rates Impair Prosperity

"Negative, negative!"
--Lt Chris Burnett (Behind Enemy Lines)

Daniel Lacalle is correct. Negative interest rates are not a gift that enables prosperity. They amount to enormous wealth transfers from savers and the efficient to debtors and the inefficient.

Financial repression is not a gift. It is a huge transfer of wealth from savers and the efficient to the indebted and inefficient. You' may think it's great that countries are financed at negative rates... Until you see your deposits and pension fund disappear. pic.twitter.com/8KaQLb0eZE

— Daniel Lacalle (@dlacalle_IA) June 22, 2019

In prolonged negative rate environments, productivity and prosperity are destined to fall.

Sovereign Debt Distortions

Watt: How's it feel to be carrying all that cash in your pocket?
Keith Nelson: Well, a little uncomfortable.
Watts: Want me to tell you one more time that I think you're crazy?
Keith Nelson: Nope.
Watts: Been hording that cash for years?
Keith Nelson: Yep.
Watts: How bad's your dad gonna ream you?
Keith: You won't be able to measure it with existing technology.
--Some Kind of Wonderful

On the back of yesterday's post about the inverting UST yield curve, some eyebrow-raising anomalies among sovereign debt yields worldwide help explain what we're seeing in Treasuries. Here are some rates on various 10 yr country bonds per WSJ as of this pm:

US   2.243%
UK  0.900
Sweden   0.005
Spain   0.765
Portugal  0.863
Netherlands   0.021
Japan   -0.081
Italy   2.651
Germany   -0.171
France   0.242
Belgium   0.320
Australia   1.543

Only two countries besides the US sport rates above 1% (!). Many are close to zero. In fact, yields on 10 yr German and Japanese bonds are negative, meaning that creditors are effectively paying debtors for the privilege of owning the paper.

What is going on? It's the global version of 'quantitative easing.' Central banks, namely the BOJ and ECB are buying sovereign debt in an effort to keep rates low. Interest rates on bonds go down when prices go up. As central bank buying programs bid up the prices of sovereign debt, yields shrink globally.

Although they may be difficult to measure with existing technology, the market distortions wrought by this activity help explain what is going on here in the US. If you are on the market for 10 yr sovereign bonds, which country offers the best risk:reward prospects?

As investors vote with their wallets, they are buying US tens in size, which is pushing their rates lower than would be the case in unhampered markets.

Net Worth

Don't you try to pretend
It's my feeling we'll win in the end
--Simple Minds

"Where do I stand financially?" One way to answer that question is to periodically estimate your net worth. Simply defined, net worth is the difference between what you own and what you owe. The more you own and the less you owe, the greater your net worth.

In financial accounting, the instrument for measuring net worth is called a balance sheet. When companies report their financial results, they include a balance sheet so that shareholders can understand the capital structure of the business and their underlying net worth (a.k.a. shareholder equity). Individuals can similarly employ the balance sheet approach to get an idea of their net worth.

Assets

First comes what you own, a.k.a. 'assets.' Record them, then add them up. Here's a list of typical assets, beginning with the most liquid:

Cash and cash equivalents. Value of checking accounts, savings accounts, CDs held in banks. Don't worry about physical cash on hand unless it's substantial.

Investments. Value of brokerage accounts, mutual funds, IRAs, 401(k)'s.

Alternative assets held in physical form. Precious metals, collectibles, other real estate besides personal dwelling. Value of alternative assets can be harder to estimate because they are less liquid. Be conservative with your estimates.

Home. If you own a house, include the property's estimated value. A conservative reference is often the county assessment done every few years for property tax purposes.

Car. Estimated selling price of a car if you have one. Remember that car values depreciate quickly, so be conservative.

Other personal property. For the most part, ignore possessions like clothes, electronics, etc. They usually have little 'salvage value' if you have to sell them.

Liabilities

Next comes what you owe, a.k.a. 'liabilities.' For the most part liabilities are various forms of debt. Record them, then add them up. Here's a list of typical liabilities.

Credit card debt if balance not paid off monthly.

Student loan debt--remaining balance that you owe.

Car loan debt--remaining balance.

Home mortgage debt--remaining balance.

Other debt. Rare but could include personal loans (money you've borrowed from another person) and other unusual obligations.

Don't include monthly bills like phone, cable, gas and electric as long as they are paid when due.

Net Worth

Once you've summed up your assets and liabilities, find the difference:

Net Worth = Assets - Liabilities

You want the number to be positive and growing over time. When you are just starting out, you net worth will be small. It may even be negative. The way to stay out of negative territory is to avoid debt. Stated differently, owning tons of assets matters little from a net worth standpoint if those assets have been funded by a mountain of debt.

The smaller your debt load, the quicker that you can build your financial net worth.

Personally, I estimate my net worth quarterly using a spreadsheet. Nothing to obsess over. Just a way to track progress along the way.

Investing Reference Page

"The most valuable commodity I know of is information. Wouldn't you agree?"
--Gordon Gekko (Wall Street)

Reference page to catalog posts on investing. Will be updated as new missives appear.

Personal Finance
Income, Saving, and Investing
Debt Reduces Freedom
Net Worth
Determining Portfolio Yield
Taxable or Tax-Deferred?
Emergency Fund
Situational Awareness of Markets
Pensions
Inflation and Purchasing Power
Taking the Buyout
New Year's AA 

Investment Strategy
Primary Asset Classes
Asset Allocation
Capital Gains vs Dividends
Dividend Stocks I
Dividend Stocks II
Starting With Diversification
Anchor Positions
Beginner's Portfolio Template
Buying Small, Scaling In
Raising Cash
Working Orders

Valuing Securities
Valuation
Market Cap
Moats
Income Statements
Fortune 500
Cash Flow Statements
Balance Sheets
Price-to-Earnings Ratios
Discount Rates

Market Structure
Prices
Interest Rates
Ten Year Yields
Money
Central Banks
Underfunded Pensions and Systemic Risk

Technical Analysis
Uptrends and Downtrends
Support and Resistance

Behavioral Finance
Sentiment and Investing
Bulls and Bears
Loss Aversion

Interest Rates

Peter Venkman: You won't regret this, Ray.
Ray Stantz: My parents left me that house. I was born there.
Peter Venkman: You won't lose the house. Everybody has three mortgages nowadays.
Ray Stantz: But at 19 percent? You didn't even bargain with the guy.
Egon Spengler: Ray, for your information, the interest alone for the first five years comes to $95,000 dollars.
--Ghostbusters

Last time we discussed the centrality of prices to market functioning. Of the myriad prices powering market behavior, none is more important than those conveyed by interest rates. Interest rates indicate the price of money or, more precisely, the price of borrowed money.

As discussed in a previous post, borrowing requires that you pay back the original amount of a loan (i.e., 'principal') from the creditor along with a charge for borrowing those funds (i.e., 'interest'). The charge, or 'interest rate,' is usually expressed as the percentage of the principal that you pay in interest to the creditor on an annual basis.

For example, if you borrow $10,000 from a bank and you pay $500 annually for use of the money, then the interest rate is $500/$10,000 or 5%.

Previously we observed that prosperity increases when savings are invested in capital improvement projects that improve productivity. Since the cost of productivity improvement projects often exceeds what they can fund out-of-pocket, entrepreneurs commonly tap credit markets for the resources that they need.

Interest rates are vital to markets because they permit calculation of the cost of acquiring capital for investment and productivity improvement. Without the prices conveyed by interest rates, markets could not function.

While interest rates come in many shapes and sizes, there is one interest rate in particular that projects outsized influence on markets. We'll discuss this next time.

Scarcity and its Alleviation

Thurston Howell III: What is this slop?
Skipper: It's Gilligan's own creation, Mr Howell. It's coconut pot pie.
--Gilligan's Island

Although it abounds with life and 'natural resources,' the earth in its natural state does little to advance human life. Human advancement requires people to transform earth's unconsumable resources into those that are. Man must work to alleviate a natural state of scarcity.

Imagine dropping a group of men and women into the middle of the wilderness with no supplies--including clothing. It will be difficult for them to survive. Extreme poverty is their default condition. There is only one way that they will survive and, over time, improve their standard of living: production, trade, and saving.

Production is work that alleviates scarcity. In the beginning, production for our struggling group will involve purely manual labor aimed at scavenging to convert readily available resources that are not consumable in their natural state into resources that are. Even edible berries growing on bushes are not consumable until they are picked.

Our group will naturally divide work, because it is intuitive that division of labor improves productivity. Some might pick those berries for food. Others might gather wood for shelter and heat, or hunt animals for food and clothing.

The workers will then naturally engage in trade--because productivity gains from specialization can not be realized unless specialists trade with each other to acquire from others what they did not produce themselves.

Because humans are blessed with reason and ingenuity, it will not take long for people in our group to realize that productivity can be further improved with tools such as shovels, axes, bows and arrows, etc. that can increase output per hour for each specialist. But tools require production just as consumable resources do. As such, some of those consumable resources must be saved to fund the production of tools.

Stated differently, food, clothes, shelter, etc need to be set aside for those who forego scavenging in order to make tools, lest they will be unable to survive on tool-making alone. It should be clear that, absent such saving, advances in standard of living will be limited.

Production, trade, and saving are natural responses to alleviate scarcity in the world.

Unequal Incomes by Force

And I get so tired when I have to explain
When you're so far away from me
See you've been in the sun and I've been in the rain
And you're so far away from me
--Dire Straits

As these pages have observed, income inequality is not a bad thing when it occurs naturally. In fact, it is an essential feature of a thriving market economy. The specter of higher incomes motivates producers to become more productive. When producers are compensated (by consumers) for being more productive (either thru innovation or efficiency gains), then standard of living improves for all.

Problems arise, however, when income inequality is increased by force. "Huh?," you ask, "I thought income equality is what bureaucrats seek to achieve by force--using, for example, socialist tactics of re-distribution."

Yes, but while income equality can be forced, so can income inequality. The primary platform for increased income (and wealth) inequality is central bank policy. Whenever the Fed and other central banks ease monetary policy, which requires force to do so, then incomes become more unequal.

When rates are forced lower, financial assets like stocks and bonds are bid higher. Wealthy individuals, who tend to own more financial assets, benefit in an out-sized way compared to people of lesser means. Moreover, people of lesser means, who commonly climb the first few rungs of the economic prosperity ladder by saving more of their incomes in interest-bearing accounts, get paid less for doing so. With less incentive to save, many lower income people save far less than they otherwise would--and may even take on more debt since the cost of borrowing has been forced lower. Yet, more debt and less saving is precisely the opposite of what poorer people need to do to boost income and wealth over time.

Another group that benefits from easy monetary policy is the financial sector. Because banks, brokers, et al. get first dibs on newly created cash and credit money by central banks, they can buy things (financial securities in particular) while prices are still low and then profit handsomely as prices rise when those lower in the food chain subsequently get their hands on the money and bid things higher in an inflationary cycle.

With central bankers engaged in the most radical monetary policies that the world has ever seen, we can be confident that these policies have forced income distribution markedly wider in their wake.

Why the Fed Caves

"Well, we're now so levered up that once it gets outside these limits, it gets ugly in a hurry."
--Will Emerson (Margin Call)

Chart below shows the Fed Funds target since 1992. The low periods correspond to recessions (~1992, 2002, 2008). Note the lower lows and lower highs--the technical definition of a downtrend.

This helps portray the Fed's predicament. Each time we have a recession, the Fed lowers rates below market, prompting more borrowing than would otherwise occur. In natural market cycles not subject to central bank intervention, just the opposite should occur. Debt should fall during a recession as bad loans get extinguished, interest rates rise, and saving commences.

In unnatural market cycles, with Fed policies that force rates lower, we get more debt and leverage. And, by definition, less savings.

This leaves the system weaker coming out of downturns rather than stronger. Thanks to central bank policies, the system always exits a recession more levered up than before.

Thus, attempts by central banks to 'normalize' rates back to levels of previous expansions are destined to fail. Why? Because the greater the leverage in the system, the less tolerant the system is to rising interest rates and falling asset prices used as collateral against the debt.

Stated differently, the collective balance sheet, being more leveraged, is more susceptible to insolvency should rates rise and asset prices fall.

This is why the Fed always caves and turns dovish earlier in the present cycle compared to the previous cycle. With each passing cycle, the Fed paints itself (and the economy) farther into a corner that it cannot escape.