Saturday, December 28, 2013

“It's a Wonderful Life”: How to

It's That Time of Year

In “It’s a Wonderful Life,” George Bailey makes it a regular practice to wish he had $1 million.  Instead, he gets a wonderful life, a life not without trials, but a wonderful life.  In current dollar terms, he may be a millionaire, too, but the point of the movie is that a wonderful life is not a material thing. 
The picture below is the first hint at the secret to his success.  As he wishes for $1 million, he is not on the way to buying a lottery ticket.  He is going to work; not in a job that will pay him $1 million, but he is working toward his goal, not just wishing for it.

So, we have in the picture above one simple hint about the road to the wonderful life.   Wishing is not a waste of time if it is accompanied by working to realize the wish.  Therefore, it is a working toward the goal, not the wishing for it, that matters.

Although money is mentioned at a number of points in the movie, there is never a reference to how much money George is making working in the drugstore.  That is significant.  What is important is that he is working toward an objective.  What he is doing and what he is paid are quite irrelevant.  It could have been homework, extracurricular activities, volunteer work, or just about anything else.  What is important is that it was his objective that determined his activity.  He was not just killing time or following a trend.
As the movie unfolds, we learned that he does not take his earnings from his job lightly.  Rather than buying himself sundaes at the soda fountain where he works, he later tells his father that he has been saving whatever he can.  So, not spending every cent he has is another aspect of his approach.  It is amazing how many people nowadays do not comprehend that if one spends everything one can, the result is always being broke.
But it would be a mistake to assume that George just saves.  We know what he does beyond just saving. He is also investing in his business.  His investment timing is not bad either.  Keep in mind that when he is on his way to leave for his honeymoon he turns around.  He takes all the money he had saved for his honeymoon and invests it in saving Bailey Building and Loan.  What precipitates this change of heart?  A panic.  Buying when everyone else is selling is something he takes the time to explain to the customers of Bailey Building and Loan.

Although his timing of his investment in Bailey Building and Loan is excellent, it is clear from the balance of the movie that his investment is not a get-rich-quick, short-term scheme.  He is truly investing, not speculating.  The same can be said for his purchase of a home.  He purchases a true fixer-upper, not with the intent of flipping it, but with the intent of fixing it up and living in it.  Fixing it up is simply a way to build equity in his home. It is worth remembering that he is putting money into education.  We know that since he discusses putting his brother through college. 
So let's take inventory: hard work, saving, education, investing for the long run, and building home equity.  It is unfortunate that so many people today consider those values quaint while at the same time bemoaning the fact that they are not experiencing a wonderful life.  While the connection between those values and the good life should be obvious to people, that often is not the case.  What is even more tragic is that many people never realize what George finally comes to realize at the end of the movie.  A wonderful life is not a material phenomenon.  Those values in-and-of-themselves contribute to a wonderful life, whether or not it is one of material plenty.

The movie provides more subtle hints at other keys to a wonderful life.   Some, like the role of community and family, have social implications, but this posting will stick to those that have financial implications for individuals.  Nevertheless, it would be neglectful not to mention that George's service to his community and his commitment to his family play an important role in his achievement of the wonderful life.
For individuals, it is well worth noting that liquidity, the amount of money George can get his hands on at any point in time, is not what George seeks.  One of the major themes of the movie is the dire straits.  George finds himself in when he needs to get his hands on liquid assets.  When he needs money to address problems at Bailey Building and Loan, he finds that the cash value of his life insurance policy is his only source of liquidity, and it is far from adequate for his needs.

This predicament is telling.  His investments (his home, the building and loan, his life insurance policy) are all directed toward achieving objectives other than a large mark-to-market positive balance sheet.  The movie provides many hints at why that is the case.  George forgoes a number of trips or vacations (from his honeymoon to trips to New York to a trip to Florida with a friend); he drives an old car that at times frustrates him, and his “drafty old house” provides numerous ways he could consume (from the banister knob to the kitchen appliances).  George is just not motivated by current consumption ability.  He is not measuring his success by how much he can consume.  So, why would he need a large amount of liquidity? 
Not measuring oneself by what one can consume almost defines George Bailey's life.  One senses that George Bailey knows that happiness is not a function of how much one consumes.  George's prosperity has a lot to do with the fact that material consumption is not his primary objective. It does not take a rocket scientist or deep philosophical thinker to realize that confusing consumption and happiness keeps many people from achieving either. 

In the end, George's salvation, the liquidity he needs, is there.  It is easy to overlook the implications of that source of liquidity for financial planning.  From a macroeconomic perspective, it is the general public.  One often wonders why people are surprised that in our recent liquidity crisis it was the general public that had to "bailout” illiquid institutions.  It never dawns on people that there is no source of liquidity, other than the general public.  The general public can mobilize itself as occurs in “Its Wonderful Life,” or it can occur through an institution like the Federal Reserve.  It does not matter the form it takes, it is always going to be the general public.

From a personal perspective, it is the trust that George has built up among the residents of Bedford Falls that results in the availability of liquidity to George.  It is not surprising that when there is trust, the liquidity is provided without conditions.  One can imagine that if it were Potter who required the liquidity, it probably would have come in a form similar to the loans made to banks during the recent financial crisis. 
But here's the subtle point that is terribly relevant to personal finance.  It concerns how George has built that tremendous reservoir of trust among the people of Bedford Falls.  It is easy to overlook the fact that George has repeatedly borrowed from the residence of Bedford Falls.  It could be overlooked because it is done through the Bailey Building and Loan.  Each resident’s deposit at the Bailey Building and Loan is a loan to the Bailey Building and Loan.  The residents have all been paid back with interest when requested by the depositors.  Furthermore, the residents are aware that in some instances, like during the panic, they were paid back out of George Bailey's own money.  That sort of record of managing debts naturally leads to trust.  If one doubts it, simply look at how credit ratings are affected by a history of timely repayments of all debts.




Saturday, April 6, 2013

It's Hard To Believe.

Well, at least I'm not the only one to notice grandmother's portfolio.

The last posting (“In the Eye of the Beholder”) mentioned a widows’ and orphans’ portfolio.  When first I introduced the portfolio in “Investing PART 9: One versionof the ‘Unfinished symphony,” I described how my grandmother, who was a widow with children to support, first introduced me to some of the stocks.  So, when I saw an article on Yahoo finance entitled “Why Your Grandmother’s Portfolio Is Beating the Pros’,” naturally, I was curious.  Alas, it was not about my grandmother, but it certainly was about her investment style.
Sure enough, it made the same point as the last posting.  Some very conservative, high-quality stocks have been leading the market.  Or, to quote from the Yahoo article, “A scan of the stocks leading the rally to new index highs in 2013 reveals a pantry full of household-name, blue-chips of the sort that might have entered a conservative investment account 30 or more years ago.”

The interesting question at this point is what that leadership implies for future gains.  The WALL STREET JOURNAL article that mistakenly attributed leadership to low-quality stocks argued that it was time to rotate into the high-quality stocks.  However, as discussed in the last posting, much of the performance of the high-quality portfolio results from its lower volatility, especially in down markets. 
At some point the market will correct, which is market speak for go down.  At that point, it will be interesting to watch whether it is the market leaders (i.e., high-quality stocks) that decline the most.  That would be extremely atypical, but then the market likes to do things that are atypical.  More than likely, and therefore a good forecast, is that some of the stocks in the widows’ and orphans’ portfolio will go down more than the market and some of them will defy the market decline.  Overall, the portfolio will probably outperform the market during the next correction. 

An excellent illustration of the point of the posting right before the last.

The posting, “A KISS for Financial Education,”concluded with the statement:
“Financial management can be boiled down to a few simple principles. Interest rate compounding, inflation, and risk and diversification are important, but one suspects that often the failure of financial management education results from the fact that stating simple truths is sometimes painful. No one likes to accept the fact that there are limits. As a consequence, financial management education often focuses on how to try to avoid the limits rather than on what those limits are. The limits are unavoidable.”

As if on cue, the day following the posting, the WALL STREET JOURNAL ran an article entitled “12 Debt Myths That Trip Up Consumers.” The subtitle was “Borrowers too often fall prey to the conventional wisdom. And it can cost them.” The article was a perfect illustration of the concluding paragraph of the posting.
It started with the simple statement: “Avoid debt if you can. If you can't, borrow carefully and conservatively.” The article could have been very educational, if at that point it had explained why and pointed out the unavoidable limitations associated with consumer borrowing. Instead, the article provides an excellent example of using information to obfuscate. It goes on to state: “So the conventional wisdom goes. But if you follow it blindly, you may miss out on key nuances of dealing with debt.”
The information the article presents is interesting and accurate, but the deficiency is that the only potential use of the information is to try to avoid the limitations inherent in consumer debt. One can go through each of the 12 points and use it to illustrate the theme of the previous days posting. But in the interest of brevity, only the introductory examples are discussed in this posting.
The article starts with the statement: “For instance, consider store-brand credit cards. They often offer no-interest financing and rewards on store-bought products. Sounds great. But did you know those attractive financing terms can come back to bite if you carry a balance after a promotional period?” One has to wonder why the author thinks it “Sounds great.” It's equally reasonable to assume that having a bunch of merchandise in your possession that you don't own does NOT sound great.
This statement only makes sense if one assumes that it is legitimate to apply the logic of present value calculations to consumer goods. But, as has been argued on this blog in a previous posting entitled “Truth In Lending:”
“…present value relationships are appropriate for investing. They do not apply to consumption. A dollar today can be invested with the result that it’s worth more than a dollar paid a year from now. However, there is no guarantee that a dollar spent today will result in more satisfaction, happiness, benefit, or whatever you chose to call it, than the dollar spent a year from now. If a year from now it’s a medical treatment for a potentially life-threatening condition that is in question, the treatment has a pretty big benefit to most people. It would be rare to have whatever was bought be worth more than the treatment.”

Even the inducement of the rewards may not justify accumulating a bunch of junk that isn't yours. The statement is deficient in that it treats the absence of an interest charge during some specific period of time as the absence of a cost. Using any consumer credit involves giving up a very valuable asset: your control of your future income and the optionality implied by controlling your future income.
That critique should not be misinterpreted. In the body of the article, it does present the way in which using those interest free loans implies risk. It stresses the risk associated with not servicing the debt in a timely manner, but it overlooks the relationship between the surrender of optionality and that risk. Consequently, it misses an important concept. It completely ignores the fact that all leverage, even interest-free leverage, creates risk.

The second introductory example in the article is as follows: “Then there's mortgage debt. A big down payment may be a great way to steer clear of a huge home loan. But if you get the money for the down payment from relatives, lenders may scrutinize your financials closely.” It would seem to me as a casual observer that whether the debt is to a financial institution or a relative is quite irrelevant. If I isn’t a gift, it is still debt.
Perhaps if the article had gone into issues related to interest rate costs, or something else relevant, it would have made sense. But the whole focus of bringing up the point seems to be on preserving the ability to borrow more money by not affecting your credit rating and the mortgage review process.

Why should anyone in a position of taking on a major debt worry if an independent party wants to look closely at their financials? A more rational approach would be to welcome an independent party evaluating whether the loan makes sense. Further, the lending organization should have an incentive to want to be sure that the borrower is not taking on more debt than they should. One of the critiques of the behavior of financial institutions before the current financial crisis is that they weren't doing just that. So, the article seems to be trying to present ways one can develop the same sort of over-leveraged position that many people got into during the buildup to the financial crisis.
The posting included the comment: “We seem more intent upon making it possible for people to borrow rather than to educate them about the risks associated with borrowing.” That same focus seems to apply the WALL STREET JOURNAL article. As stated in the posting, “That is unfortunate because nothing is more destructive of prosperity, both for the individual and for society, than the US public's attitude toward borrowing. It is a system-wide problem.”

Monday, April 1, 2013

In the Eye of the Beholder

It's not beauty; it’s an interpretation.

The WALL STREET JOURNAL on March 22, 2013, had an interesting article entitled “Low-Quality Stocks Have Zoomed.  Time to Shift Gears?”  Some may legitimately object to my use of asset appreciation as analogous to beauty, but please, give me a pass.  Instead, focus on the theme of the article, which was that "junk" continues to beat "quality" on Wall Street because it’s a fiction.
To support that interpretation, one has to very carefully pick the time over which the analysis is applied.  If one uses the first quarter of 2013 during which time the market gained 11%, market leadership by sector has been healthcare, followed by consumer staples, followed by utilities.  Those sectors generally aren't associated with “junk.” One can undoubtedly pick junk from the sectors, but they hardly support the argument the author makes.

The author identifies his time frame with the statement: “Nearly four years after the end of the recession of 2007-09, it should be the other way around.”  As an economist, I don't object to the use of the business cycle, but as an investor, the business cycle is an inappropriate time horizon.  As an investor, the appropriate timeframe is ones holding period.  At a minimum the appropriate holding period would be through the entire cycle, not just since the low point of the recession.  
Further, as is appropriate for a journalist, the author focuses on what is changing the most, but that may not constitute the best investment.  To illustrate the point, the author uses two example stocks.  But as we all know, picking two examples may be an appropriate technique for illustration, but it hardly constitutes a reason to accept the hypothesis.  It would be equally possible pick two examples that support the opposite argument.

Better support for the author's hypothesis comes when one considers groups of stocks.  So, quote from “Low-Quality Stocks Have Zoomed. Time to Shift Gears?,” again:  “Consider two groups of stocks that were constructed according to financial-quality ratings from Ford Equity Research of San Diego. These ratings are based on factors such as debt, balance-sheet health, earnings consistency and industry stability. The first group contained the 20% of the firm's universe of more than 4,000 U.S. stocks with the firm's highest financial-quality ratings, while the other group contained those with the lowest ratings—junk, in other words.”
“Since March 2009, according to Ford, the average junk stock has gained 273%, versus 171% for the typical high-quality stock. And there is no recent evidence that this trend has reversed: Over the past three months, for example, junk has increased its lead, gaining 12.1% versus 9.6% for quality.”    

While the broader focus seems to present a more relevant data set, it suffers from the same flaw of only focusing on the recovery.  Further, and more seriously, it ignores dividends.  The same “quality” that the author points out as underperforming is strongly associated with superior dividend maintenance and growth.  Those dividends need to be added in, and compounded.
Some relevant information about dividends is pointed out a week later in BARONS in a column appropriately entitled “Speaking of Dividends,Payouts Outpace Price Gains in S&P” (March 30, 2013).  As it points out, “From 2007 through the end of 2012, dividends grew 14%, according to data from Howard Silverblatt, senior index analyst with S&P Dow Jones Indices. A dollar in 2007 is worth about $1.12 now, a jump of some 12% from 2007, according to data from the Bureau of Labor Statistics. So the rise in corporate cash distributions has outpaced inflation.”

“Dividend-paying stocks have seen healthy share-price gains, as well. A selection of S&P 500 stocks that have consistently increased their dividend payouts for at least 25 consecutive years -- the so-called Dividend Aristocrats -- actually exceeded their precrisis price highs two weeks before the broader index, marking a 144% recovery from the financial-crisis lows.”
But in terms of market commentary the BARONS column entitled “Don't Worry, Be Bullish” (March 30, 2013), probably presents the most accurate summary.  As it points out “WHATEVER ELSE IS SAID about the quarter, the winners have been a curious bunch…”
It notes that some of the leaders were “some companies all but left for dead last year” [the “junk”].  After providing some examples, it then goes on to note that “…exuberance of a most curious sort has put the staidest of sectors in the lead, consumer staples.”  It then notes some examples that are clearly from the “quality” group.

All this commentary is interesting, but only marginally relevant as investment advice.  It's news.  No doubt.  Ultimately, when viewed objectively, it does nothing more than highlight an old Wall Street saying: “it's not a stock market; it’s a market of stocks.”  It's individual stocks that matter.
In terms of direct investment advice the BARONS column, “The Striking Price,” on March 30, 2013, is probably most on target.  It's curious that the advice should appear in the “The Striking Price” column since that column usually addresses shorter-run option trades.  But the article entitled “Investing, the Rudyard Kipling Way,” advances almost the opposite approach from options trading.

Further, the column presents a good illustration of why the relevant holding period should be through the entire market cycle rather than just the recovery.  It points out that “one of the great riddles of our time is why so many people are such bad investors. After all, good investing isn't terribly difficult.”
“All you really need to do to be successful is pick a reasonably well-run company like IBM (ticker: IBM), or Johnson & Johnson (JNJ), or even a low-cost mutual fund or exchange-traded fund that tracks the Standard & Poor's 500, and forget about it. Dividends and inflation account for about half of investment returns, and the rest is largely attributed to time, perhaps a little luck, and an ability to remain graceful under pressure.”

“But few people, as demonstrated yet again by Dalbar's recently released annual ‘Qualitative Analysis of Investor Behavior,’ can do what Kipling extolled—keep their heads when all about them are losing theirs. Because of this, most investors fail to match the annual returns of the market. In short, they greed in to Wall Street's latest craze and panic out when the party suddenly ends.”
Clearly, for many people the advice to develop “an ability to remain graceful under pressure” and keep one’s head when many other people are losing theirs is a tall order.  But it need not be.  In a posting on January 9, 2011, this blog introduced what it referred to as “The widows’and orphans’ stock portfolio.”  The posting presented 10 stocks as a core portfolio as well as a number of alternatives that can be substituted.  It (“Investing PART 9: One version of the ‘Unfinished symphony”) referred to them as a widows’ and orphans’ stock portfolio because of the very low beta of the overall portfolio.  It's the type of portfolio a widow can hold through the entire business cycle.  It certainly isn’t unreasonable to assume that the average investor could do the same.

Of those 10 stocks, four recently made all-time highs, and three others have made 52 week highs.  Many of the potential substitute stocks have also made all-time and 52-week highs.  But the real secret of the widows’ and orphans’ portfolio isn't how it performs during upswings.  One of the quotes in the BARONS column entitled “Don't Worry, Be Bullish” (March 30, 2013), hints at the advantage of the widows’ and orphans’ portfolio.  Specifically, “Société Générale strategist Andrew Lapthorne attributes consumer-staples stocks' outperformance to their ability to cushion losses during times of market turmoil.” 
A major shortcoming of the average investor is a tendency to time the market wrong, buying when the market is in its peaks and selling when it's at its lowest.   “Qualitative Analysis of Investor Behavior” isn't the first study to uncover the phenomena.  The existence of the phenomena has implications.  A portfolio that reduces the impact of market swings on the individual mitigates one of the causes of the tendency that lead to investor underperformance.  Essentially by mitigating the impact of market swings on an individual's portfolio, the widows’ and orphans’ portfolio reduces the incentive to try to time the market.

If the market goes down 50%, as it did in the recent downturn, it's hard to see how the market upswing is going to provide 100% return required to get even.  By contrast, if one’s portfolio goes down 20%, it's a lot easier to believe that the portfolio will be able to gain the 25% needed to break even.  That's especially the case when each year the portfolio is generating two or 3% of that return in the form of dividends that can be reinvested.  Further, during the accumulation stage of one's life, it's fairly easy to set up a simple scheme to ensure that one’s purchases do benefit, at least a little, from market timing.  Automatic dividend reinvestment guarantees that one purchases more shares during down markets.
There's another saying on Wall Street about good investment.  It goes something like: Sucessful investors make their money during down markets not bull markets.  The Hedged Economist feels obligated to add something to Wall Street's inventory of sayings.  So, I would add that it isn't just at theme parks that “a roller coaster may be more fun but boring monorail ride is more likely to get you where you want to go.”  It works in the stock market, too.

Monday, February 25, 2013

A KISS for Financial Education

Common sense trumps mathematical sophistication

The WALL STREET JOURNAL had a piece entitled “Tackling Investor Ignorance” on November 3, 2012.  It was an interesting effort to try to point out a major financial problem.  They deserve to be congratulated for addressing the issue.  As they stated: “The financial crisis exposed greed, reckless decisions and regulatory failures. Now we can add another shortcoming to the list: the ignorance of too many small investors.”  It's about time someone pointed that out.  But it isn't just small investors: it's actually consumers in general. 

To me it seems obvious from the start.  You can’t have a financial crisis like we had if only one side participates.  It took all players, which seems fairly obvious given that the problems were system wide.

It is interesting that among the key things the article points out is a need for a broader understanding of budgeting.  Two years ago this blog pointed out the crucial role of budgeting.  Specifically, in a posting entitled “Investing Part 3: Setting thevolume,” it noted a scene in the movie “It's a Wonderful Life” where George avoids the clutches of the evil banker, Mr. Potter, due to the astute financial management of Miss Davis who only withdraws $17.50 rather than the $20 withdrawals of the customers before her. She knew she could get by for $2.50 less than the previous customers. That she leaves that $2.50 in the Bailey Building and Loan is crucial. George squeaks by with $2 left at the end of the day.  Ms. Davis’s ability to budget with such accuracy saves Bailey Building and Loan.
Budgeting is the starting point.  It is essential to financial management.  It is troubling that the origin of some of the research that “discovered” the deficiency in consumer’s financial management is a Securities and Exchange Commission multipart report, ordered up by the Dodd-Frank financial-overhaul law.  Why in the world did the Security and Exchange Commission need a study to figure out that people who took out loans they could not pay back did not understand financial management?  Talk about government waste! 

Far too many people believe that good financial management means simply figuring out how to spend more.  They do not have even the most rudimentary understanding of the role of budgeting in financial management.  Only the government would need a study to figure that out.  How could it be made more obvious?  All the government would have to do is examine their own behavior.

The article goes on to discuss some of the issues raised by the public's lack of understanding of basic financial management.  However, the article makes the issue sound far more complicated than it is.  That can be seen in the passage below:

“Still, people can't be experts about every financial product or investment. So what exactly do they need to know to make good decisions?”

“Plenty of experts have been wrestling with this. The nonprofit Council for Economic Education is working on standards for students in fourth, eighth and 12th grades in six main subject areas: earning income, buying goods and services, saving, using credit, investing and protecting and insuring assets.”

All of the items listed are important, and all, at one time or another, have been the topic of the discussion in this blog.  However, as has been pointed out on this blog, starting with the basics eliminates much of the complexity.  No one is an expert in every financial product or investment, but they do not need to be.  It is irrelevant to good financial management.

As the WALL STREET JOURNAL article goes on to note, “Mortgages and life insurance just aren't relevant to a 17-year-old.  Instead, both young and old need to understand broad concepts that can be applied to their current financial needs as well as those that might come along tomorrow.”  Much of the supposed complexity of raising the public's understanding of finance originates from overlooking the simple fact that there are not that many “broad concepts that can be applied to their current financial needs as well as those that might come along tomorrow.”

On July 10, 2011 a posting entitled “The Only Truth About Finance” discussed a fairly simple concept that trips up many people.  Many people who are broke are broke because they do not accept the inevitability of ending up broke if one always spends everything one can spend.  People spend inordinate amounts of time looking for other reasons why they are broke.  Their income is too low, they were cheated, something unexpected always comes up, or any number of alternatives excuses.  The idea that being broke is the result of a ratio between two variables (income and expenditures) never occurs to them.

As should be clear from the posting on investing that used “It's a Wonderful Life” as is point of departure (“Investing Part 3: Setting the volume”), the inability to budget is a recent phenomenon.  In “It's a Wonderful Life” the fact that all of George's customers can budget is an assumption made without fanfare.  It's just the way people lived.

The financial crisis that we just experienced revealed the problem is far more serious than people just spending everything they have.  The problem was that many people spent much more than they had and committed to continue the behavior by borrowing money they could not pay back.  The July 21, 2011 posting entitled “Truth In Lending” and July 25, 2011 posting entitled “Borrowing For Investment” contain some of the most important lessons on financial management. 

Those postings make quite clear is that there is only one way borrowing can be in the interest of the borrower.  If having whatever is bought for that period of time between when it is bought and when the individual could have saved the purchase price is greater than the additional cost that borrowing implies, then the cost of borrowing can be justified. But it is only justified if the borrower’s income does not go down during that period of time.  In the US borrowing seldom results in a person being better off.

It is no wonder that for many years the definition of a middle class lifestyle involved having no debt other than a mortgage.  A home is one of the few consumer items that meets the criteria that justify taking on debt.  The default assumption was that borrowing would only make it less likely for the person be able to achieve middle-class.  That's still the case, but now people don't seem to realize it or are unwilling to accept it.

Our current approach to truth in lending really should be referred to as truth in borrowing.  We seem more intent upon making it possible for people to borrow rather than to educate them about the risks associated with borrowing.  That is unfortunate because nothing is more destructive of prosperity, both for the individual and for society, than the US public's attitude toward borrowing.  It is a system-wide problem. 

Annamaria Lusardi, professor of economics and accountancy at George Washington University, has developed a number of ways to measure financial literacy.  Some of them have been referenced in previous postings.  She and numerous other people collecting data on the topic have focused on what they referred to as “The Big Three.”  They are:

·         Interest rates and compounding.
·         Inflation
·         Risk and diversification

In the WALL STREET JOURNAL article, Ms. Lusardi is quoted as saying “Individuals also need to be savvy about debt.” Another survey she worked on asked the following: “If you had a credit card that charged 20% annual interest, how long would it take for the amount owed to double if you didn't pay anything off or charge anymore?”
“Just 36% of adults recognized that 20% interest, compounded, would double in less than five years.”  In a more recent article (Feb 16th 2013), the ECONOMIST magazine quoted an even more startling example in an article entitled “Teacher, leave them kids alone: Financial education has haddisappointing results in the past.”

Both articles quote incredibly high portions of the population not understanding compounding, yet the questions in both articles are clear.  One has to wonder how many people would reduce their credit card balances if they understood.  It would seem to be a fairly safe to bet that it would be less than 64% (100%-36%). 

In fact, the ECONOMIST article cites a number of sources that would indicate that a lack of understanding of how compounding works is only part of the problem. First, the ECONOMIST cites a survey by the Federal Reserve Bank of Cleveland (“Do Financial Education Programs Work?” April 1, 2008, FRB of Cleveland Working Paper No. 08-0).  The report is summarized as finding that: “Unfortunately, we do not find conclusive evidence that, in general, financial education programmes do lead to greater financial knowledge and ultimately to better financial behaviour.”  Second, a survey of students from a Midwestern state found that those who had not taken a financial course were more likely to pay their credit card in full every month (avoiding fees and charges) than those who had actually studied the subject.

Part of the failure of financial education is that it only deals with the mathematics of how financial management works.  It would be far more effective if it were grounded in the simple day-to-day, “real life” implications.  For example, the simple statement that “if you spend whatever you have, you will always be broke” may be more effective than a lesson on budgeting.  Similarly, pointing out that “if you never spending everything you have you will never be broke and will probably end up fairly well off,” would be equally affective.  The simple statement that “borrowing money to buy something always makes it more expensive, and therefore involves giving up additional things you could have,” may be more effective than a lesson on compounding.   

Financial management can be boiled down to a few simple principles.  Interest rate compounding, inflation, and risk and diversification are important, but one suspects that often the failure of financial management education results from the fact that stating simple truths is sometimes painful.  No one likes to accept the fact that there are limits.  As a consequence, financial management education often focuses on how to try to avoid the limits rather than on what those limits are.  The limits are unavoidable. 

Thursday, January 31, 2013

Fiat Currency Scenarios

Change will occur.

What is clear from the current amount of questioning of fiat currency is that the current system will change.  How it will change is, to some extent, dependent upon developments that will occur as the pressure on fiat currencies increases.  So, it would be inaccurate to say that exactly what will occur can be outlined at this point.  Nevertheless, it is possible to determine some of the changes that will occur.  That is the subject of this posting.
Those changes can be broken down and looked at in a number of ways.  The overall analysis has to address the many roles of fiat money.  That includes international exchanges among sovereigns (i.e., the medium of exchange on transactions between governments).  It also includes how governments’ choose to hold their assets (i.e., the store-of-wealth role of money as it relates to sovereigns).  These are closely related to how international trade is carried out.  Within any individual sovereign, one needs to consider the role of fiat currency as a medium of exchange, store of wealth, measure of value, and method of paying taxes.  All the while, one should be aware that it is highly unlikely that changes will be the same in relationship to all the different roles fiat currency plays.
Some of those changes have already begun.  For example, the role of the US dollar as an international reserve currency is decreasing.  Governments around the world are already diversifying their reserves away from the US dollar.  That should not be too surprising.  The form in which countries choose to hold their reserves has changed periodically throughout the 20th century.  Some of those changes have involved violent dislocations of international trade, but others are best described as merely tinkering with the international exchange system.
The US dollar is losing its position as the central reserve currency among sovereigns.  The key issue for economic stability is how quickly that transition occurs.  It is easy to overlook how big a change it is when there is a transition in the major reserve currency.  Such transitions only occur every 30 or 40 years.  Often they are accompanied by major disruptions of international trade and widespread declines in prosperity.
There is, however, no reason why the transition cannot be orderly except that it involves numerous sovereigns with conflicting interests and an excess of confidence on the part of those sovereigns.  Each believes it can gain from the transition.  Unfortunately, they are not playing a zero-sum game where one sovereign’s gain is another's loss.  International trade facilitated by orderly exchanges of currencies is a win-win situation, unless non-market participants such as sovereigns decide that someone has to lose.  Then it becomes a lose-lose situation.
The risk that governments will turn it into a lose-lose situation is extremely high.  For individuals, especially those in the US, that poses a number of unusual risks.   There are limits to the extent to which the Federal Reserve System can suppress the interest rate pressure created by the shift.  As foreigners move out of the US Treasuries in order to diversify their reserves, the selling pressure could force up interest rates.  If the Federal Reserve continues to buy the Treasuries in order to suppress interest rates the eventual result will be inflation.
That, however, is only the impact of the shift in sovereigns’ choices of reserves.  At the same time there is a risk that large amounts of US currency held by individuals overseas will be repatriated.  Currently, the US dollar is a store of wealth for individuals in foreign countries who have lost faith in their own fiat currency.  If the dollar loses its status as a store of wealth relative to the local currency, those dollars could flow back to the US.  This action of individuals would tend to create the exact same pressures as a shift by sovereigns to an alternative reserve currency.
The pressure on the Fed created by these flows is manageable if the transition occurs slowly over time and sovereigns do not take their competitive devaluations to unreasonable levels.  Thus, those who see a marked period of chaotic activity may be wrong.  An equally likely alternative is a prolonged period of decline in the value of the dollar as a store of wealth.  An alternative way of saying the same thing is the US could experience a long period of inflation, a declining dollar, and eventually rising interest rates.
Since gold is often advanced as an alternative international reserve, the first step is to look at the role of gold as a reserve currency.  During the period when gold was a major reserve, countries left and entered the gold block.  Countries changed the rate at which they would exchange their currency for gold.  Some countries used other precious metals, most frequently silver, as an alternative.  Even among countries that claimed to be on the gold standard, the amount of gold held as reserves against their currency varied between countries.  Within individual countries, the amount of gold held as reserve against the currency was also changed over time.  In addition, it was not at all unusual for one country that did not have gold reserves to peg its currency to another country that did have gold reserves.  Governments knew how to offset the supposed automatic functioning of the gold standard.  The term of art was to “sterilize” gold flows.
The gold standard’s durability was the result of the flexibility in how was applied. Yet, for all the flexibility gold standard afforded, in the end it proved to be too rigid to survive.  That should not be surprising.  Both the supply and demand for gold fluctuate based on a multitude of factors other than just the amount of currency.  The interesting thing is that the demand is often driven by fictions surrounding gold.  Some of the factors that influence the price of gold were discussed in previous postings entitled “Gold, Be Sure You Know What You've Hedged,” and “Gold Again.” 
The period since gold prices have been allowed to float illustrates just how much the value gold fluctuates relative to other goods and services.  That is apparent even within the US, which experiences those fluctuations filtered through the lens of the practice of quoting the price of gold and many other assets in dollars.  In some countries where the price of gold and their currency’s exchange rate fluctuate in a synchronized fashion, the instability of the price of gold is even greater.
It does not take a rocket scientist to see that gold will never be central to international reserves.  The rate at which it is exchanged for other goods is not stable enough.  But most importantly, it will never be the central reserve because governments do not want it to be.  They may welcome the fiction that their currency is backed by something other than their promise and the coercive power implied by their ability to tax, but they do not want the limitations that strict backing by anything would imply.  Specifically, when it comes to sovereigns, no government is willing to accept the limitations their gold holdings would place on their freedom to set policies.  That was true during the period when the international system was supposedly on the gold standard.  It is even truer now.
At the same time, commodities have a certain appeal as reserve if the commodities are durable and their usefulness in the future is reasonably certain.  In the US and many other countries, a strategic petroleum reserve is a good example.  Recently, China's stockpiling of various raw materials has been in the news.  But even in biblical tales the Pharaoh stockpiled grain based on Joseph's economic forecast. 
Gold will probably play a high profile role among those commodity reserves.  But gold will not be alone as a reserve.  What is fairly certain is that the portion of international reserves held as gold will be small enough that it does not inhibit the flexibility of the government.  If gold constitutes 5% of a country’s international reserves, fluctuations in the amount of gold hardly justify changing government policies.  By contrast, if gold is 95% of international reserves, a change in the amount of gold may be considered indicative of a need to adjust policy. 
Once a country moves to holding only part of its reserves as gold, gold becomes a tool that it can use to manage its foreign exchange rate.  That adds exchange rate policies to the fiscal and monetary policy tools available to the government.  Ultimately, it is the ability to manage foreign exchange rates that governments seek.  The ability to manage foreign exchange rates is best served by holding not commodities, but foreign currencies or IOUs.  Thus, what is clear is that governments’ foreign currency reserves will include a variety of foreign currencies and foreign currency-denominated assets. 
The system will be a system of fiat currencies.  It will just be a system where the relative values of the currencies fluctuate substantially.  Such a system will retain the medium of exchange role of fiat currencies, but, clearly, an alternative store of value will be developed by sovereigns.  However, governments are more inclined to spend then to store wealth.  So, the store-of-wealth role of money among sovereigns is of minimal importance.
But, as noted in the introductory paragraph, there are alternative scenarios, but they almost all support the general observation that foreign currency reserves will be diversified.  The main difference in the scenarios results from the fact that it is not clear how governments will manage those reserves.  One alternate is the issue raised by those who talk about competitive devaluations (often referred to as “beggar thy neighbor” devaluations).  It is also quite possible that foreign currency reserves will be used as a method of intimidating foreign countries.  It is easy to overlook the fact that gold reserves, when the world was supposedly on the gold standard, were often used to damage or to intimidate other sovereigns.
As an international system, competitive devaluations will necessitate either a reduction in international trade because of the higher barter costs, or a method, probably privately developed, of laying off the risk associated with currency fluctuations.  Any privately-developed technique would probably first develop the capability to handle the risk for the private sector.  That would leave sovereigns to develop their own methods. 
At least initially, the asset category that will suffer most from this diversification is sovereign debt, especially the sovereign debt of the US.  What is not clear at this point is whether that transition will be accomplished in an orderly fashion.  The effect on the prices of stocks and physical assets will depend upon whether those moving out of US Treasuries use the proceeds to acquire assets in the US. 
As a shorthand conceptual explanation, envision the Chinese or Japanese governments choosing to liquidate their Treasuries in order to buy US companies.  Clearly, it will not be that simple, but conceptually the equivalent could easily be executed.  In many respects, it would be the most profitable approach for the Japanese and Chinese government.  They could avoid crushing the value of the dollar (a major asset in their current portfolio) and end up with a set of assets almost as liquid as, and certainly more productive than, their current inventory of Treasuries.  If it is accomplished in an orderly fashion, other dollar-denominated asset categories might not suffer along with US Treasuries. 
The macroeconomic risk is that there will be a spike in the cost of international trade associated with the increased risk inherent in fluctuating exchange rates.  That scenario would have a negative impact on almost every asset class in any country that is currently integrated into the international financial system.  Unfortunately, the possibility of this scenario is more likely than one would like.
To summarize, between sovereigns the likely scenario is that, at least initially, the substitute for the dollar as a reserve currency will be multiple foreign currencies. That process has already begun.  The issue actually is far less one of what will be the reserve than of how the transition will be executed.
Economics and economists have, to an unfortunate extent, become the handmaiden of sovereigns.  Thus, many economists see the issue of how sovereigns facilitate exchanges as the only real issue.  It is not.  It is curious that much of the public, especially among gold bugs, has been duped into thinking that how sovereigns facilitate exchange has to be linked to how the private sector facilitates exchange.  That also is not the case.  One would be inclined to think that eventually sovereigns would be forced to acknowledge how the private sector is facilitating exchange.  However, sovereigns have a phenomenal ability to live in a fantasy world of their own making.  So, it seems appropriate to look beyond just how sovereigns handle the issue.
Interestingly, among US corporations that process of diversifying reserves has already proceeded a long way.  The Obama administration chooses to call the process “tax avoidance by keeping the reserves overseas.”  Yet, it is a very logical step given the direction in which the global economy will evolve.   Further, it is very beneficial from a US perspective: US shareholders are acquiring foreign currency denominated assets through their ownership of corporations that trade on US markets.  Having those corporations own income-producing assets certainly implies a brighter future than liquidating the assets in order to pay taxes.
Similarly, there is also a raft of financial advisors who advocate a globally-diversified portfolio.  The issue of how one's assets should be distributed across fiat currency denominations is important.  However, first, we should address the alternative asset most frequently raised when fiat currencies are called into question.  That, of course, is gold again.
Each country’s transition from gold-convertible currencies proceeded at its own pace and within a timeframe unique to that country.  Nevertheless, the general model was fairly uniform.  Most countries first eliminated the need for gold convertibility internally (i.e., they eliminate the desire or even the ability of their citizens to cash in their banknotes for gold).  US citizens tend to associate that change with Roosevelt's banning of private gold holdings.  They overlook the less coercive approach used in many other countries.  Probably, the most common way of eliminating gold backing for banknotes is to simply continue to offer convertibility, but to set the price at levels that discourage conversion.  Combine that with taxation based on the paper currency, and the transition can occur quickly. 
The approach taken in many countries allows individuals to keep gold as a store of wealth.  It was the perceived superiority of the gold as a store of wealth that led to its abandonment as a medium of exchange.  It was a classic application of Gresham's law (i.e., bad currencies drive good out of circulation). There are people who view that transition as defining the beginning of fiat money.  Yet, often (e.g., in the US) that change was made in order to increase the reserves of gold available for backing of the fiat currency in international trade. 
Once the relationship between the currency and gold has been severed, the logical follow-on step is to allow the price of gold to fluctuate freely.  When that point is reached, citizens are free to convert their currency to gold.  The primary change from the gold standard is that an open, free market in gold does away with the fiction that the price of gold will not or should not fluctuate.  It is far more logical to assume that it will and that it should. 
Since governments use gold as a tool in the management of their foreign exchange rate, the price of gold will continue to be a function of government whims.  Because the price of gold is now so subject to unpredictable government whims, its role as a store of value is highly questionable.  Thus, gold will continue to be an interesting speculation.  It will continue to provide a hedge against distrust and chaos. 
However, the very instability in international relations that gold is often seen as hedging will produce increasingly large moves in the price of gold.  They will be the consequences of governments using gold to manipulate their exchange rate.  That will be especially true for those investing with US dollars.  As is currently the case, the magnitude of the price fluctuations in other currencies will depend upon the interaction of their exchange rate against the dollar and the dollar's exchange rate against gold.
There is a distinct possibility that gold will appear to be a store of value for US citizens.  As foreign sovereigns use their dollar holdings to diversify their reserve holdings to include a larger portion of gold, they will tend to raise the price of gold in dollars.  Keep in mind that at the same time, they will be using their dollars to purchase other fiat currencies to hold as reserves.  Thus, the price of gold will rise in dollar terms more than in other local currencies that are being purchased as a reserve.
However, as governments become more adept at managing reserve portfolios of multiple foreign fiat currencies, their need for gold will stop increasing.  Consequently, how smoothly we transition to a multiple currency reserve system will have an impact on gold prices in US dollars.  Nevertheless, in the long run there is no reason to assume that the rate at which gold can be exchanged for other assets and commodities should be stable.
As discussed in “Gold, Be Sure You Know What You'veHedged,” gold provides a valuable hedge.  But, there is no reason to believe that the price a rational individual will pay for that hedge should be stable over time.  The hedge is sometimes far more viable than at other times.  Consequently, as the title of that posting implies, it is very important to carefully analyze what gold can hedge and what it does not hedge. Since governments are using their gold reserves to manipulate their exchange rate, for individuals gold does not serve well as a method of hedging exchange rate fluctuations.
That failure to hedge exchange rate fluctuations is aggravated by the fact that most individuals are not in a position to trade with the sovereigns who are exchanging gold.  One should keep in mind that for long periods of time governments have agreed to exchange gold between sovereigns but excluded individuals from participating in that market.  At a minimum, for an individual, there is a three-step process: first, they have to convert the gold to their native currency.  Then, they can convert their native currency to the foreign currency.  It is only at that point that they are in a position to acquire whatever it was they wanted the foreign currency for in the first place.
Just as the most efficient way for the sovereign to manage foreign currency exchange rates is by holding reserves of foreign currencies and assets, individuals who want to hedge foreign currency risk are best served by having reserves of foreign currency-denominated assets.  Viewing foreign currency assets as a hedge against foreign currency risk implies a portfolio allocation that is very different from the standard financial advice of holding foreign currency assets on a cap-weighted basis. 
Thus, to summarize, when individuals view gold, they have to view it from the perspective of its relationship to their native currency.  Further, it is important to keep in mind that one of the reasons that gold is not a good store of wealth is that the price of gold is being made unstable by its use as a reserve currency by sovereigns.
For individuals, foreign currency-denominated assets are the best hedge against instability in the value of their native fiat currency.  Investors can determine the desired allocation across currency exposures by their personal exposure to that currency.  Each individual has to determine how he or she wants to measure that exposure. 
For investors whose sole focus is the return on their investments, the allocation is best if it is based on their best guess at relative returns when converted back to their native currency.  Capitalization-weighted asset allocations are a variation on this general approach recommended by those who choose not to try to guess which currencies and financial markets will appreciate the most. 
An alternative is for individuals to base it on their country’s exposure to foreign economies through trade.  This has the advantage of providing a hedge against the economic impact of currency fluctuations on the local economy.  The logical allocation under this approach would be the trade weighting appropriate to one’s native currency. 
Yet another alternative is to base it on one’s personal exposure through one’s need to acquire goods that are denominated in various foreign currencies.  This is in many respects the hardest approach to apply.  Since individuals are investors as well as consumers, it retains an element of the first approach listed above.  Further, since every individual is exposed to the economy, it retains an element of the second alternative listed above.  However, since every individual has a different personal exposure to foreign currencies, it is the most logical. 
Applying that logic is less than straightforward.  But one can get a general feel by considering such factors as one’s relative need for, say, pharmaceuticals produced in Europe versus, say, toys or electronics produced in China.  Thus, while the third approach does not provide the nice, simple rules that the first two approaches imply, it should yield superior results for individuals.  There is no denying that there is an element of judgment, perhaps subjectivity, required to apply this third approach; it is a fiction to pretend that the same is not true of the alternatives.
The questioning of fiat currencies discussed in the previous posting should not be dismissed without addressing an underlying cause.  To a large extent, that cause is a questioning of the ability to maintain a system of fiat currencies without producing destructive inflation. 
It is highly likely that the most pronounced transition associated with the questioning of fiat currencies will be the development of separate ways to address the store-of-wealth and medium-of-exchange roles currently played by the single item, fiat currency.  Whether economists will ever be able to recognize the separation of the two roles is an interesting question.  The separation that has already occurred in many peoples’ minds does not seem to have affected “economist’s think.”
There is, however, another alternative.  It is the development of ways to address the medium-of-exchange role of money and the store-of-wealth role of money that are unrelated to how taxes are paid.  This is far more likely than most people believe.
One of the impacts of the debasement of fiat currency that is often overlooked is its impact on the sovereign.  As mentioned in the discussion above, one of the consequences of the shift currently taking place will be an increase in sovereigns’ cost of borrowing.  That will be a global phenomenon that will be particularly acute in the US.  Since governments are not particularly good at reducing their expenditures, they will have no alternative but to raise taxes in order to compensate for the increased cost they would incur if they just borrowed the money.  The fiction that their central bank can offset that eventual consequence by printing money only aggravates the phenomena because it encourages further abandonment of the fiat currency.
Many countries that have ruined their fiat currency experienced a rapid escalation in the amount of barter taking place.  That barter reflects two phenomena.  One is that it avoids the taxation that usually accompanies a government failure to manage its fiat currency.  The second, and, in many respects, the more important, is that barter eliminates the need to receive a depreciating fiat currency in exchange for goods.
Sometimes such failures result in the use of a foreign currency as a substitute for the failed fiat currency.  That substitute foreign currency may substitute for either the store-of-wealth or the medium-of-exchange role of the failed fiat currency.  Many of the US dollars currently circulating in the world are being used in this way.  Unfortunately, the abandonment of currency as a store of wealth is often accompanied by a shift of assets into unproductive forms.  There are numerous examples of the phenomena historically.  Land has often been one of those assets that benefited from the phenomena, but livestock, metals, and just about any other commodity has at one time or another benefited from the phenomena.
What is particularly interesting about the current mismanagement of fiat currencies is that it is not restricted to just a few countries.  Consequently, it is quite likely that the debasement of many fiat currencies will stimulate the development of multiple currency blocs.  The interesting question is whether the currency blocs recognized or encouraged by the sovereigns are the same as the currency blocs that developed informally between trading partners and individuals.  A country may peg its currency to the US dollar, the Euro, or the Yuan.  Individuals in those same countries may choose to trade in, or hold, a third currency.
Many people assume that if one has a forecast, it automatically implies a course of action that is appropriate.  That is not the case.  Every forecast involves uncertainty.  The appropriate action is as dependent upon the uncertainty as the forecast.  Some of the changes in fiat currency are apparent:
1) The diversification of reserves to include more of currencies other than the US dollar
2) The abandonment of fiat currencies as a store of wealth
3) Eventual increased cost of borrowing for the US government and probably in many developed economies
4) A shift to higher taxes as a way to fund government in the US, and the increased use of alternatives to fiat currency as a way to facilitate exchange of goods
5) Most importantly, nothing is more apparent than that there is a new scope to the uncertainty surrounding future developments.
One implication is that the risk associated with sovereign debt is greater than it has ever been in the past.  That is true of many sovereigns, and particularly true of the US sovereign debt.  The irony of that development is that sovereign debt is often used as a proxy for the risk-free rate of return.  In many countries right now that supposedly risk-free rate of return is in fact a risk-free rate of loss. 
Most people do not realize that the instability of the risk-free rate of return has implications for almost all bond trading strategies.  Basically, it means that there is a new dimension of risk in any bond portfolio.  That is particularly true of managed bond funds that depend upon a trading strategy that uses any analysis of spreads.  In simple language, bonds are the high risk investment.  Since they do not offer high returns, holding bonds in the current environment makes little sense unless each bond is specifically intended to meet a liquidity needs upon maturity.
No implication is as clear as the overwhelming evidence that tax management of assets is going to increase in importance.  One unfortunate consequence is that the most tax efficient investments are not always the most productive.  That loss of productivity is the hidden consequence of the failure of many sovereigns to manage their fiat currency. 
Generally, investing in things that will produce in the future is the best way to provide for the future.  The more a portfolio is designed to avoid taxes, which is becoming of increasing importance in the current environment, the more it will have to sacrifice productivity in the future in order to avoid tax consequences.  That can be seen in some of the additional implications discussed below.
In a serious twist of the historical experience of most people, the US currency probably embodies the greatest risk.  For non-US-based individuals, that represents less of a problem since it implies that a very common alternative to their own currency can be removed from consideration.  For US-based individuals, it introduces some serious complexities.  One implication is clear.  US-based individuals should have some non-US-currency-denominated assets. 
Those assets should be productive resources whose earnings are not dependent upon exports to the US.  The major focus is not on the currency in which the asset’s price is quoted, rather the important thing is to have assets that produce returns in a foreign currency.  Mutual funds that invest outside the US and ADR’s are good examples, but actually holding the assets in the non-US-currency has benefits that may be more appealing to some individuals.
Another implication of the increased uncertainty and a broader range of potential outcomes is that the value of the hedge provided by gold has increased.  Consequently, regardless of the future price of gold, its value to individual investors right now is greater than it has been in the past.  Thus, one implication is that the portion of an individual's portfolio allocated to gold should be allowed to increase.  If that portion has declined, additional purchases may be required.  As discussed in previous postings, the gold exposure is a hedge similar to insurance.  It lays off certain risks that one hopes will never surface.  In that respect, the increased gold exposure is not the end in-and-of itself.
An investor is presented with numerous options for how to hold that gold exposure.  Some, such as ETFs, make it quite simple for investors to switch between exposure to the metal and exposure to the miners.  In the long run, exposure to the miners stocks should provide a better return than exposure to the metal itself.  Miners are, after all, producing future consumable output while the metal itself produces nothing.
Ownership interest in real estate, and especially real estate that produces income, is a highly effective hedge against a failing fiat currency.  For individual investors, the easiest way to acquire income-producing real estate is through REITs (unless the investor is in a position to acquire the real estate out right).  REITs, however, have experienced considerable price appreciation over the last few years.  Nevertheless, they should be included in an investor’s portfolio.  However, because of the run the REITs have had, careful selection is extremely important.  Another form of owned real estate is one's own residence.  Despite low interest rates, increasing one's equity in one's own home makes sense.
The inverse of the desirability of income producing real estate is the undesirability of mortgages on such assets.  Commercial mortgages are risky in the current environment, but residential mortgages and residential mortgage bonds are downright foolhardy investments.  Without the Federal Reserve Bank’s monthly purchases the price of mortgage backed securities would fall substantially.
An indirect implication of the concentration of risk in mortgage debt is implied by our regulatory environment.  Under current bank regulations, banks are encouraged to hold mortgages and mortgage-backed securities by lower capital requirements.  Thus, investing in banks should be done with considerable care.  Very few have appealing risk reward profiles.  Bank stocks appreciated significantly last year and may do the same this year, but once the Federal Reserve abandons monetary easing, bank earnings will be dependent upon interest rate spreads.  Once they make the transition, they will be good investments.  However, the transition will be very difficult for some of them.
It should be obvious that every investor should be carefully watching the development of alternatives to fiat currencies.  For him or her it is not yet time to abandon currency as one's method of holding a reserve for a rainy day.  But that day is closer than it has ever been and vigilance is warranted.  Even now it is possible that some investors will prefer to diversify that rainy day fund into multiple currencies or combination of currencies and commodities.  After all, that is what foreign governments are doing.
One final point that needs to be noted is the fallacy in the notion that all asset prices will collapse if a fiat currency fails.  Income-producing assets, assets that actually produce, will retain their value.  However, that value in the original fiat currency becomes irrelevant.  They will continue to have value, but that value will be measured in a totally different way. 
Bonds by contract are denominated in fiat currency terms.  Equities on the other hand, are quoted in fiat currency terms, but actually represent percentage ownership of the underlying asset.  If nothing else during a period of uncertainty regarding the currency, that consideration alone would argue in favor of equity over debt, or, put differently, stocks over bonds.