An American Future: Finding Real Return

Another guest post in the series of An American Future from Kevin:

An American Future: Finding Real Return

By Kevin of 20smoney.com

Through the first three parts of this series, we have been making the case that we’re in the beginning stages of a major shift in the American economy.  While this shift will change much of society as we know it today, we’re focusing on the financial aspects of this shift.  In the last post, we discussed finding opportunity, employment and income in this “new normal” economy.  Today, we’ll look at investing and finding return on our money today and tomorrow.

As we approach this subject, we must first differentiate between real return and nominal return.  Americans tend to not look past headlines when it comes to the news, and when it comes to investing, they also tend to not look past a nominal return.  In an era that might easily be defined by quantitative easing, nominal returns are deceiving and possibly worthless.

A nominal return is defined as the rate of return without adjusting for inflation.  For example, if your nominal return on your savings account is 1% but inflation is 5%, well your real rate of return is -4%.

A Quick Note On Retirement Funding

I find it very ironic that many Americans have a target “number” that is their goal for retirement savings.  This number is what they figure will sufficiently fund their retirement lifestyle for X amount of years.  What is ironic about this situation is that these folks factor in inflation into their stock returns, but don’t factor it in to the cost of their retirement lifestyle.  Everyone loves to preach about annual returns of 10% or so in the stock market over many years.  The reality is that a chunk of that 10% is due to inflation.  Therefore, to reach that magic “number” you are dependent on a decent level of inflation; yet, the cost of living increases that will come with this same level of inflation aren’t factored into the estimated amount of money we will need to fund such a lifestyle.  The result is an inaccurate calculation.

This is a major reason why the numbers simply do not work for the vast majority of Americans and their supposed future retirement.

How We Save and Invest

Americans chase large returns.  They do this mostly via the stock market – although real estate is the most recent example.  The core issue here is the lack of savings.  Because Americans want a high standard of living that requires spending a great deal of money, they don’t save much money.  To compensate for the low savings rate, they chase larger returns.

Further complicating the picture is that our policy makers have created a system that depends on inflation.  The sad reality is that to keep up with inflation, we often need to embrace higher levels of risk.  If inflation didn’t exist, we wouldn’t need to be max-invested into stocks chasing higher returns.

The Problem Today

There is a very grim reality facing Americans today.  Before our present circumstances, the investing strategy that most Americans are used to that I just described actually worked to some extent.  The inflationary policies and expansion of credit actually fueled some level of growth (as artificial as it was at times) and it resulted in a boost in asset prices, such as stocks or real estate.  Americans were becoming more wealthy via these assets or at least they thought.

This ended in 2008 and you could make an argument that it ended earlier in the decade, but for simplicity, let’s just say it ended in 2008.

With a shrinking real economy amidst a flood of liquidity into the financial system, retail investors are faced with limited options to grow their money.  Savings accounts offer nothing.  Stocks are risky – anyone remember the May 6^th flash crash?  Meanwhile, while CPI numbers might be benign, there is plenty of evidence out there showing cost of living increases proving inflation is a real risk.

So, how to invest?  How to protect our money from inflation?  Are real returns possible?

I believe there are two main principles we should always consider when making investment decisions in the current environment:

1. Capital preservation is first priority
2. We must be careful chasing nominal returns while accepting significant risk

Let’s look at each one briefly.

Capital Preservation

Unfortunately, the stock market rally that materialized from April 2009 to April 2010 has erased the memory of the sickening market crash in 2008 for many investors.  A one-way move higher for a year does a great amount of damage in creating complacent investors that think that making money in the markets is easy.

Complacency can often lead to significant loss.  Let this serve as a reminder to you that your number one priority should be to preserve your capital above all else.

Chasing Nominal Returns While Accepting Significant Risk

This is something most investors don’t understand.  To illustrate, I’d like to share an astonishing example.  If you read “The Black Swan” by Nassim Nicholas Taleb, he mentions an interesting example from the savings and loan crisis from the 80s and 90s.  In this crisis, the US financial institutions lost more money than US banks had ever earned collectively in the history of US banking.  How is that possible?  It’s possible because of the Federal Reserve and fractional banking, but that is a long explanation.  Taleb goes on to discuss how after getting bailed out and fixed by the Fed, the banking executives went on to brag on a quarterly basis about their earnings growth and their conservative strategies…. until of course the next black swan event hits and all those earnings are gone again.

What can we learn from this example?  We can learn that it doesn’t matter what return you make year after year if down the road a major economic event or Black Swan event wipes out all your gains and then some.

Investors learned this lesson to some extent in 2008 when the stock market dropped 50%.

Chasing nominal portfolio gains while leaving yourself completely exposed to a potential crash like we saw in 2008 is a terrible strategy in my opinion.

This brings us to a very tough task of earning real returns while protecting ourselves from major economic events that can severely impact our assets and our wealth.  First, I believe we must be willing to accept a lower rate of return (as long as it is a real rate of return and not a nominal rate of return).  Depending on how bad the economy gets, we should be willing to perhaps even be happy with simply growing our assets with the rate of inflation.

If you do want exposure to stocks, I’d recommend only the strongest companies with strong balance sheets and revenue that is generated internationally.  Look for companies with healthy dividend yields and a track record of increasing dividend payouts.

While I’m not going to recommend specific stocks, let me give a brief comparison to illustrate what I’m talking about.  Let’s compare Microsoft (MSFT) versus Apple (AAPL).  Apple is a stock that probably gets more attention than any other stock.  It’s a great company that is hitting on all cylinders.  Microsoft has the image of being a dinosaur and a company that has lost its edge.  I believe Microsoft is a better investment in today’s environment.  Microsoft has a ton of cash, is a AAA-rated company, and has businesses that are worldwide dominant cash cows.  Yes, Apple is sexier and has more growth, but it’s also much more expensive and much more prone to massive volatility.  Microsoft pays a dividend and Apple doesn’t.  Again, I’m not telling you to buy Microsoft, but the comparison sheds light on the investment strategy I think is best in the years ahead.

Again, if you want exposure to stocks, I would definitely not recommend having the bulk of your assets in stocks, because even the safest stocks will still get hurt in a broad market crash.

While fiat currencies are indeed in a race to the bottom, having a portion of your assets in cash is still a good strategy as the shrinking economy will present opportunities to buy assets at lower prices down the road.  What about inflation?  Won’t that kill your cash?  The risk of inflation is real but so is deflation in the short term.  While you should hedge your assets against inflation (more on that in a moment), you do not want to put all your eggs in one basket.  Cash provides a cushion in tough economic times and another form of diversification.

Precious metals absolutely must be a part of your asset allocation.  While I don’t believe gold is the solution to everything in the world, gold is much harder to manipulate than any other asset.  Paper assets can be manipulated via the central bankers, and while the official price of gold can be manipulated somewhat, the market price (the price by which two individuals agree to charge to buy and sell gold) cannot be manipulated.  Gold cannot be printed by central bankers.  In today’s economy that is propped up by quantitative easing, gold (and silver) must be a part of your allocation.  While there are different ways to invest in gold, nothing substitutes physical possession of precious metals.

To sum up, I believe having the bulk of your assets in cash and physical precious metals is a smart strategy.  A stock portfolio of quality companies that pay dividends can serve to provide some element of return and can also serve as a decent inflation hedge.  Be wary of the stock market, and if stocks ever feel like they are “easy money,” it is probably a good idea to scale back some of your positions.  Don’t be afraid to ring the register and take your gains if you have a good ride on some of your positions.  Paper profits are meaningless as many found out in 2008.  Use your cash reserves to buy quality stocks when major crises hit the news – the next phase of the European debt crisis should present an opportunity to buy shares of multinational companies that often trade down when the U.S. dollar trades up.

Don’t put your faith into the buy and hold forever strategy as the primary advocate of this philosophy is Wall Street itself.  Be nimble and stick to your strategy which should be to protect your assets against the shrinking economy and against inflationary policies.

Lastly, the most important advice I would have towards the younger readers today is that nothing will make up for a lack of savings.  If you spend all your money, you won’t increase your wealth regardless of what kind of return you think you will be able to make in risk assets.  Savings over speculation should be the cornerstone of your financial strategy.  Good luck!

Written by Kevin of 20smoney.com

For further reading, consider:

• Finding Returns In A Decade Long Depression

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