Fibonacci Financial

Asset Allocation

Asset Allocation is conceptually the effort of properly allocating your savings among broad categories of investment opportunities.  Why are these broad classifications important?  These broad classifications are extremely important because, 90% of investment portfolio gains or losses come from good or bad decisions about Asset Allocation. Therefore, the most important investment decision that you will make is how much of your savings should be allocated to each of these four categories.  It can either be static (the standard model is “Life Cycle Investing”) or dynamic (my model which changes based on broad persistent trend changes in the investment environment).  As far back as the writers of the Talmud, a rabbi provided the following financial wisdom “Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep by him in reserve” (B. M. 42^a)[1].  I have found it conceptually consistent to use four broad categories of investment opportunities.  They consist of:

Market Decision Dashboard⁴ Conceptual Layout

I designed the  MDD⁴ © to follow the standard accounting balance sheet model in existence since at least the fifteenth century.  Those crafty renaissance Italian businessmen invented modern double entry accounting and our current financial reporting model.  The investment and financial characteristics are very similar within each broad accounting category that those renaissance businessmen set up.  All investments will be classified as assets on your personal financial statements but for MDD⁴ © model purposes the categories are considered from the counter party side of the transaction.  For example when you lend money, it is an asset called “Loan Receivable” on you books but is classified in the debt section of the borrower’s books as “Loan Payable”.  Characteristic of “Lending” (Debt) investments is their sensitivity to interest rate fluctuations which leads to interest rate risk.  They are also subject to credit risk or risk of default.  They provide a steady and somewhat predictable income stream.  Below is the standard accounting model balance sheet:

Your investments generally fall into the following broad accounting  and conceptual categories:

1 Got Cash?

Quadrant 1

The Money/Cash Confusion

Or

Cash versus Lending

“Money in the bank” is really money that you have (under current law and custom) loaned to the bank.  This confusion over money that we lend to the bank originated back many centuries ago.  We commonly think of money taken and deposited in a bank as a bailment.  But it IS NOT a bailment.  A bailment occurs when the owner of personal property (e.g.: money or bullion) delivers his or her property to another person to be held, stored, or delivered.  In a bailment, the owner of the property is the bailor and the party to whom the property is delivered for safekeeping, storage, or delivery is the bailee. Possession of the property is transferred to the bailee but not title, ownership or the benefits of ownership.  If the bailee were to use the personal property entrusted to him for any self serving purpose during the period of bailment, that usage would constitute the criminal act of embezzlement (the unlawful usage of another person’s property).

Faith Based Banking System

Money we loan to the bank gets loaned back out to someone else.  It is not IN the bank!  Because of this arrangement I don’t classify money at the bank as Cash.  Whether it is a demand deposit or a certificate of deposit, it is still “loaned” money and carries with it credit risk.  All debt carries credit risk.  Therefore, for my model, I consider money left in the banking system as lending (debt).  On our own accounting records it would be called a loan receivable.  Currently, generally mandated accounting principles list all money in the banking system that matures in three months or less as “Cash”.  For investment categorization I DON’T.  Treating money in the bank as cash creates a dangerous illusion.  The FDIC was meant to protect you from isolated bank failures but cannot protect you from systemic credit risk inherent in every fractional reserve fiat money system.  If a substantial number of people lose all confidence in the fiat money system, printing more paper will only create more destruction.  This leads to what Ludwig von Mises called the “crack up boom”.

Also, money placed in a money market fund is lending and not cash.  During a credit crisis it carries substantial credit risk.  Money market funds lend your money out to other banks, corporations and governments.

So, what do I classify as Cash?

Silver, Gold, US Dollars (greenbacks), Euros (paper)

I consider gold and silver coin and bullion to be cash even though you can’t go buy a candy bar or pay the rent with them.  Their value in exchange is recognized across several millennia and across the globe (across both time and space).  They have been relegated by the central banking cartels of the world (at the point of a gun) to a position of secondary media of exchange but in the long run they are far superior to bank cartel (gangster) funny money.  Gold and silver don’t have a half life.  All fiat currencies have a half life.  Gold and silver coins will be around centuries after the US Federal Reserve Notes (dollars),  Euros (Euro Trash) and yes the Yuan (Yawn) have become historic relics.

I consider the physical possession of any legal currency as cash.  Yes, as much as I despise the con game of fractional reserve fiat money banking, those Federal Reserve notes (dollar bills), Euros and Yuans still buy candy and pay the mortgage.

2 Got Stuff ?

Quadrant 2

Tangible and Intangible Assets

Stuff

The next broad category includes what began as all those essential assets of life including a roof over our heads (Real Estate), our daily bread (Commodities/Futures), tools, transportation and art (Collectibles) and a grab bag of other intangible things such as royalties.  Each major sub category within this quadrant of stuff has its own very unique investment characteristics except that they each are subject to bull and bear markets.  There is a time and season for investing and disinvesting in each of the areas.

Real Estate

Real Estate is the aristocrat of investments – got land?  Owning real estate was one of the first acts of civilization as we moved from hunter gatherers societies to agrarian societies of land developers and owners.  Then as we progressed from agrarians to city dwellers real estate continued to be the Sine Qua Non of wealth.  Now it has evolved into a vast and complex market of residential, commercial and industrial real estate opportunities.

Commodities

Commodities and our daily bread come next.  The history of civilization has been driven by feast and famine events.  There are few people who go blank when you comment on Joseph and the 7 fat years and 7 lean years.  Many waves of barbarian invasion coming out of the steeps of Central Asia were driven by periods of crop failures and famine.  The evolution of modern commodity and futures markets has helped to almost eliminate periods of global famine.  Participation in these markets until recently was a very highly speculative adventure.  Recently, many new investment vehicles offer more conservative opportunities to diversify into this arena.

Collectibles

The collectibles sub-category is populated by such denizens as art, stamps, antiques, coins, rare books (the gentle insanity – a personal addiction) and of course cars. Is that 1966 candy apple red GT350H Shelby Mustang really a good investment at $120,000?  Collectibles represent an investment area rich in opportunity and aesthetic enjoyment but one that usually is best left to specialists and professionals.  Art for example as measured by the Mei Moses Art Index has a long term growth track record that competes easily with that of the Standard and Poors Stock Index of around 7% after inflation.  But few of us can put together a million dollar art portfolio or pick the next Picasso that do well over the long haul.

“Other”

The “Other” sub-category is a grab bag of exciting investment opportunities such as Hedge Funds, the Forex market and Texas Hold’em.  What? Yes, Texas Hold’em is not necessarily gambling.  Gambling is properly conceived of as a game of chance with a negative mathematical expectation (in the long run the house always wins and you always lose).  Whereas Texas Hold’em, with good technical and psychological training and money management, has a positive mathematical expectation and can be very profitable.

Hedge Funds provide an opportunity to place money under professional management in a fund that can invest in many different vehicles.  Typical hedge funds also use more leverage than is prudent for the average investor.  This has the potential to provide much higher returns from managed speculation.

The Forex (inter bank currency trading) markets are currently the largest financial markets in the world as measured by shear transaction and monetary volume.  This is the market where Euros, Japanese yen, Swiss francs, British pounds, and Australian, Canadian and American dollars are traded in currency pairs.  While it lasts, this massive game of currency musical chairs is rich with opportunity for those with that aren’t adverse to high risk.  As with its close cousin, the futures/commodity markets, the Forex market is populated by about 95% losers and only 5% winners.  “Do you feel lucky punk?”  For the most part, while the Forex has a place in the Market Decision Dashboard model at a theoretical level, it isn’t included as part of our actual asset allocation in our model portfolio.  The Forex consititutes not an investment vehicle subject to portfolio allocation as much as a business opportunity for some individuals (who enjoy street fighting).  While I must confess I find it incredibly exciting personally, it isn’t appropriate for most portfolios. There is an outside risk that this game of musical chairs may end with no chairs available to sit on when the music stops.

Last but not least in the “Other” sub-category is Texas Hold’em.  Yes, Texas Hold’em won’t be showing up as a percentage allocation in the MDD⁴©.  Learning to play Texas Hold’em, however, is an excellent process of education for serious do-it-yourself investors.  It brings you face to face with your worst enemy – YOU.  While after years of learning the art of investing (remember it takes about 10,000 hours and 10 years to become a competent expert), the most difficult skills to acquire are those of overcoming your own psychology.  Your emotions will derail the best laid investment plans in the long run.  Playing Texas Hold’em affords an excellent training ground for overcoming yourself.  It also teaches excellent money management skills.

3 Got Loans?

Quadrant 3

“Neither a Borrower nor a Lender Be”

There are always two parties to the lending process.  The first person or business has money, acquired either through self disciplined savings and thrift or inheritance, which they decide to put to work by lending it.  And there is the second person or business who borrows that money to acquire goods for either consumption or investment.  Without the first person there is no second person.  So who do you think is generally in the power position?  When you are in debt you are in Bondage.  “He who has the gold (money) makes the rules.”

Default – Dang I’m Sorry, But, I Can’t Repay You Dude!

ALL loans have one primary characteristic in common.  The primary reality or risk of lending money is that you may not get paid back.  This is known as credit risk.  Most of us are not competent at the business of managing the credit risk associated with our lending.  Lending requires skills such as consumer and business credit worthiness analysis.  Other skills such as the ability to craft competent contracts are also very important.  Then there is that mundane, monotonous and sometimes ugly skill called debt collection.  It can be a very, very messy business.

Therefore, we generally use an intermediary such as a bank or a brokerage firm when we lend money.  This is done through bank deposits and CDs or brokerage house money market funds.  Then the interest earned on the loan must be shared between you the primary lender and the bank or brokerage firm the secondary lender.  This of course leaves less money as a return to you the primary lender.  This leads to a lower rate of return experienced by most primary lenders who use secondary intermediaries to actively lend their money.

Yo Yo Interest Rates Causes Values to Yo Yo.

A common feature of lending is that most loan agreements state a fixed rate of interest.  Another feature of the lending landscape is that interest rates are constantly changing.  Interest rate changes usually persist in the direction of the last few rate changes.  If the loan is short term in nature, this has little impact on the value of the loan.  But the longer the term of the loan, the more sensitive the value of the loan is to interest rate changes.  The longer the term of the loan, the more likely one of the parties to the loan may need to liquidate it.  The borrower may want to pay the loan back early.  Or the lender may have immediate cash requirements and urgently need the money back and be forced to sell the loan.

As interest rates change, the liquidation value of existing loans with fixed rates changes.  For example, if a $10,000 loan has a fixed rate of 10% and interest rates rise to 15%, a purchaser of the $10,000 loan with a 10% per year will not pay full value of $10,000.  Why, because new loans are now generating $1,500 in cash flow per year.  Who wants to get 10% on their money when they can get 15%?  Therefore, the new purchaser of the loan will offer only $6,667 for the loan.  Then the $1,000 cash flow generated by the loan each year will constitute a 15% return on his money.  But this means a whopping $3,333 or 33.3% loss for the original lender!  This risk of loss due to rising interest rates is called appropriately interest rate risk.  Inversely, if interest rates drop the value of the fixed rate loan increases in value.

The Half Life of Money or Debasement Risk

Another dominant feature of the current (last hundred years) lending environment is that the value of money used to pay back a loan is constantly losing its purchasing power.  All fiat currencies such as the US Dollar are purposely (this is not an act of nature or god) debased by the government and the central bank.  This is a method of secret taxation (taxation without representation) or plunder of the citizens’ wealth.  If you are getting a 5% return on the money you lend but the inflation rate is 3%, your real return is closer to only 2% and the principal (the original money you lent) you receive back is worth less in purchasing power.  This is euphemistically (to hide the real nature of the theft) called inflation risk.  It should probably be called government embezzlement risk.  Periodically this reverses when boom turns to bust and the paper money pyramid collapses creating a deflationary environment.  In a deflationary environment money appreciates in value.  Cash is no longer “trash” but rather cash becomes king.  If you think the message here is that you have been conned and the value of your savings has been deliberately stolen, the answer is yes.

I’ve Got a Yen for the Euro

Since 1971 all governments and central banks of the world have moved to a fiat money system. Therefore all governments are engaged in a process of actively debasing their respective currencies.  The problem is that the process of managing money creation in this fiat ponzi currency system is a very inexact craft.  They like to pretend that it is a science. Compound that with political influence driven by special interest groups and you get an environment where the various world currencies are being debased at varying rates that are constantly changing.  This chaotic world is sorted out by having currencies trade against each other on the forex and futures markets of the world.  For individuals and businesses lending money across national boundaries, this volatility is called currency risk.

Comfort Zone & Known Rate of Return?

To sum up, when you lend money you have the comfort of an apparent mathematical certainty of a rate of return.  We humans love certainty.  Nevertheless, there are only two certain things in this world – death and taxes.  While most of the time we do earn a dependable measurable rate of return on our loans, we can’t ignore the following risks when constructing our investment portfolio:

1. Credit Risk
2. Interest Rate Risk
3. Inflation/Debasement Risk and
4. Currency Risk.

4 Got Stock?

Quadrant 4

What Does it Mean to “Invest”?

The etymology of the word “invest” goes back to the Latin investio (to clothe, to cover).  The applicable use of the commonly used term invest is found in Wiktionary definition number “3. to commit money or capital  in the hope  of financial”.  Now in common usage this commitment of money (”investing”) can be in any of the 3 MDD⁴ © non-cash quadrants.  However, for purposes of the  MDD⁴ © model this common usage will be confined to investing with a small ” i ” and “Investing” with a capital “ I ” will mean investing in your own business or in business ventures through publicly traded stock (Quadrant 4 activity).  This usage harks back to the Latin roots of the word Invest which was to clothe.  When you “Invest” in business through stock ownership, you like the ancient Romans wear the same clothing as your partners and share the same fate of profit or loss.  In modern terms being on the same team means wearing the same jersey or corporate colors.

Dynamic Growth

Investing represents the most powerful quadrant.  It is the area characterized by dynamic growth.  Businesses accumulate capital goods such as machinery and equipment & intellectual and human capital that increase productivity which leads to profits.  It is the quadrant where the explosive power of the entrepreneur and innovation is harnessed.  All the massive growth in resources in our world comes from business.  Investing in stocks (and our own businesses) enables us to participate in this marvelous engine of growth.  There is no prosperity (growth) without production and commerce.  The stock markets of the world provide us with investment opportunities in the dynamism of Capitalism.  To the extent that you invest in the stock market, you are a Capitalist.

How Much Will I Earn?

One of the unique investment characteristics of “Investing” in business is that there is no fixed rate of return in fact businesses loose money too.  And while there is uncertainty about rate of return when “Investing” in business, over the long haul (time frames in excess of 20 years) and on a non-leveraged basis (so we are comparing apples to apples) the growth generated by businesses far outdistances returns from the other quadrants.  The creative destruction that constantly goes on in a market economy leads to an environment with both abundant opportunity and considerable risk.  These risks are mitigated with tools such as proper diversification and money management.  Bottom line is that this is the GROWTH quadrant.  Even a conservative two to three percentage point advantage over 10 to 20 years will have a staggering impact on the size of one’s net worth.  Caveat emptor – this quadrant is deceptively easy to participate in; but it is possibly the most complex and dangerous.

So, How Much Do I Invest in Each Quadrant?

To everything there is a season,
a time for every purpose under the sun.
A time to be born and a time to die;
a time to plant and a time to pluck up that which is planted;
a time to kill and a time to heal …
a time to weep and a time to laugh;
a time to mourn and a time to dance …
a time to embrace and a time to refrain from embracing;
a time to lose and a time to seek;
a time to rend and a time to sew;
a time to keep silent and a time to speak;
a time to love and a time to hate;
a time for war and a time for peace.

Ecclesiastes 3:1-8

The answer to the question “how much and when do I invest in each quadrant?” is dynamic and is answered when you drill down on the underlined items in each quadrant.  The  MDD⁴ © is just a visual summary of the Fibonacci Financial portfolio guidance which will be backed up with a substantial amount of historical, conceptual, fundamental, technical, and tactical (what I call Praxis© or investment action called for - from the term “Praxeology”, the Science of Human Action) investment information for each quadrant (primary information) and sub-category (secondary and tertiary information).  Some of the information backing up the model will be static but much of it will be as dynamic and timely as the markets themselves.

To recapitulate, your first and most important portfolio decision, upon which 90% of your investment returns will depend on, is – which quadrants do I deploy money into and how much?

Caveat Emptor!

Investing successfully over the long haul is not a casual or part time endeavor, regardless of what the thousands of do-it-yourself investment books tell you.  Jesse Livermore when asked at cocktail parties what to invest in used to respond with the question “which surgery would questioner recommend for him to perform to make some quick cash”.  Here is one sphere of action where, over the long run, the judicious use of the Law of Comparative Advantage will deliver a genuine 10′fer.

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