The Investment Scientist

4c458964d197788163d689ce046fbe26.jpgThis happened over the past weekend. A reader of my newsletter signed up for my free 2nd opinion financial review.

As I went over his 401k investments, I saw that he had invested the entire balance in a target-date fund which normally is a good choice. Upon closer examination, I realized that the target-date fund has an expense ratio of 0.8%. That’s high. I went through the list of available investment options since most 401k plans limit them. I found an S&P 500 index fund, an international stock index fund, and a bond index fund, all with an expense ratio of only 0.05%. I constructed a portfolio made up of these three funds, saving him 0.75% a year. The entire exercise took me around 15 minutes.

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How would you feel if you were told by your broker that your IRA had to pay $60k in taxes to the IRS? This is not just some grim fairytale, this is actually happening to a new client of mine. I share this horror story so all of you can learn something.

The IRA account was transferred under my management last year. The entire amount was invested in a private partnership, something I have never thought highly of. They are an investment vehicle that is unregulated and not registered with the SEC and thus is not supposed to be sold to the public. They nevertheless find their way into wealthy investors’ portfolios since brokers love to peddle them due to their exorbitant fees. My client invested in 2006, long before he became my client. After 13 years, it has a grand total return of only 40%. A 50/50 portfolio of stock and bond index fund would have more than doubled his money over the same period of time.

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How a financial crisis comes about?  I am gonna use a simple styled example to illustrate the key elements that lead to a financial crisis: easy creditleveragecontagionshock amplification.

ABC Shipping has 100 vessels. The market value of a vessel is normalized to 1. (You can imagine that as 1 million dollars.)  Because of easy credit (low-interest rates,) the company uses debt financing to the fullest extent. Banks demand a loan-to-value ratio of no more than 60%, so ABC Shipping borrows 60, and has its own capital of 40.

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Now imagine, ABC Shipping is doing well operationally speaking, but the industry is Read the rest of this entry »

Why was the Great Depression so bad? Are we likely to experience something like that in our lifetimes?

This month and next, I plan to write a series of articles about financial crisis. The ideas for this series will come from my Oxford University economics class. The class was taught by Professor Oren Sussman, a prominent scholar on the subject of financial crises. My aim is to explain concurrent economic policies, as well as to answer important questions like those posted above.

Irving Fisher (1867 – 1947) was an American economist who had a very simple theory about the great depression, and who inspired many post-Keynesian economists in later years. He observed that the prices of all things tumbled during the great depression, 43% to be exact, and that had a devastating impact on firms. See a stylized example of a surviving firm below.

Irving Fisher’s debt-deflation theory of the great depression

The firm had $100 in assets on its balance sheet. On the liability side, it had $50 in debt so its capital or owners’ equity was $50. Once the gross price level P fell by 43%, the firm’s assets were reduced to 57, its debt remained at $50, thus its capital or the owners’ equity dwindled to only $7. That’s a devastating 86% loss. The simple example isn’t just an unrealistic example. During the Great Depression, the S&P 500 actually did fall by 87%!

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For the final article of this macroeconomics series, I want to write about something that is much more relevant to your financial wellbeing, whether you are a wage earner or business owner. That is, what would happen if the dollar loses its status as the predominant reserve currency?

The Quantity Theory of Money states:

M/P = kY where

M is the total money supply, P is the gross price level, and kY can be interpreted as the demand for money.

If the dollar loses its “gold” status, central banks around the world will need much fewer dollars and the demand kY for the dollar will drop. To balance this out, either the gross price level P will increase, or the total money supply M will have to be reduced. To put it in layman’s terms, we will get hyper inflation and hyper interest rates, the latter to reduce the money supply.

Let’s look at a historical precedence. See the chart below

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“Why are so many countries lending to the US for negative real interest?” Professor Sussman opened the floor for debate at our Oxford macroeconomics class. In totality, foreign countries own $6.2T of US debt. The chart below shows the countries that lend to the US.

In the previous three articles, I wrote about The Gold StandardThe Fiat Money andThe National Saving Shortage respectively. I hope I explained that the trade deficit is recycling of foreign savings for US private investments. And as long as we are paying negative real interest on our national debt, It’s not a problem, but a win to be able to keep borrowing. What I did not explain is why foreign countries would lend to us at negative real interest, and this is exactly what the professor asked in class and what I hope to explain with this article.

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In macroeconomics, there is the balance of payments (BOP) identity …

Imports – Exports = Investments – Savings

This formula is called an identity, not a theory, because it is as true as 1+1=2. The identity basically says if a country imports more than it exports, that is, having a trade deficit, it is because the country does not have enough savings for its investments. (The chart below shows the saving rate of the US in the last few years.) The intuition is this. Foreign countries only have two ways to spend the money they earned from exporting to us, they can either buy our products, or they can lend the money to us. If we have a national saving shortage, we need them to lend us the money, not buy our products. This creates a trade deficit.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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