Some consider making gold a waste of time and effort. "It doesn't do anything but sit there and look at you," according to Warren Buffett. “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” When Aztec culture noticed the Spanish conquistadors’ obsession with this shiny metal, they genuinely couldn't understand it. For them, it could be neither eaten nor drunk. It was useless for weapons or fabric of clothing. When the natives approached Hernan Cortes, (who invaded Mexico in 1519), on why the Spaniards had such an obsessive interest in gold, the conquistador answered: “Because I and my companions suffer from a disease of the heart which can be cured only with gold.”59 Apparently, that disease still exists today and is stronger than ever before. Investors around the globe still buy and love gold for two reasons: wealth protection and pure speculations.
Gold Speculators and Traders
Since the early dawn of civilization, humans and societies have somehow agreed that gold is money. The choice makes sense and is not a fluke. Gold does not tarnish, can travel, is visibly valuable, and is malleable. The idea spread with its expansion over the centuries. Money can be exchanged for goods and services. It is the starting and ending point of our capitalistic system. Because there is such a widely held understanding regarding the role of gold, the market for gold is huge and relatively liquid. Countless speculators and traders are overly reliant on sophisticated trading strategies and gambling systems; have been regularly crushed by substantial market price manipulation; and, are losing substantial amounts of money in the process.
Wealth protection
For most gold lovers, it is simply an asset protection and a hedge against government induced inflation or other financial and economic uncertainties.
A person with extensive financial resources should look into purchasing physical gold at reasonable prices. Two questions come to mind:
What are reasonable prices for gold?
When is a reasonable time to buy gold?
First, if you have financial resources that exceed 5 to 10 times your net annual spending, there is certainly no harm in purchasing gold for the specific purpose of protecting parts of your wealth. Traditional allocations go from 5 to 10%. Anything more, and you could be considered a hoarder and rob yourself of deploying your wealth for economically sensible projects that contribute to society, such as philanthropic projects.
On the matter of price, giving a satisfactory answer is more difficult. As we have previously determined, gold cannot be valued on classic cash flow scenario nor simple demand and supply. It has its own valuation character that is often determined by psychological factors. A rule of thumb is to purchase gold whenever so-called experts predict further declines. These moments exist but are rare. In hindsight, the most obvious opportunity was in 2000 when gold traded below $300 an ounce. Another chance existed in late 2008 when it experienced a temporary decline due to supply demand imbalances. Recently, gold dropped to $1100, which in my point of view, is another reasonable entry point to build a position such as a simple portfolio hedge.
Like any asset class, there is a time when purchasing gold makes sense. In a typical periodic market crash, gold drops with any other asset class in price. There is just no liquidity in the system to make purchases possible. Wealthy independent investors with excess cash reserves and continuous cash inflows will be able to pick up gold at some great bargain prices. In the face of recent macroeconomic and geopolitical uncertainties, wealthy individuals who don't already possess gold will find that prices around even $1,300 an ounce still make sense for long-term wealth protection.
REAL ESTATE: THE ANALOG ASSET
Investing in real estate will never lose its charm as the basis of wealth creation for generations to come. However, it does come with its own set of issues and challenges that can only be managed with proper financial education, experience, and simple math.
When I was a young banking apprentice in the state bank of North Rhine-Westphalia of Western Germany, I worked for several months at the largest Builders Society in the state (Westdeutsche Landesbausparkasse). Its mission was to help millions of Germans realize their dreams as homeowners, by helping them save through a monthly savings plan at favorable savings rates. The Builders Society have been able to help customers build up the necessary home equity to apply for a traditional home mortgage with appropriate conditions. “No money down” and "teaser rates” conditions do not exist in Germany.
The savings and finance plans we sold came with all sorts of tax and government incentives. After all, Germans consider their homes their castles. Whenever money flowed from A to B, we took our cut. On top of that, with the monthly cash inflow from reliable and eager Germans, my bank was able to do more with the money that accumulated in our accounts—cash that was entrusted to us.
In the end, we fulfilled an important function within the economy and helped realize dreams of homeownership for the vast majority of our clients (mainly working and middle-class families). Even though we took our cuts whenever we could, it was still a true win-win situation for everybody involved. But not everyone will treat you with as much respect because pitfalls can range from overpaying to outright fraud.
House Flipping
In the U.S, the whole process of financing and encouraging people to buy their own homes, even when they can’t afford it, has become a nightmare. During the years leading up to the subprime crisis of 2007 and even after that, the term “house flipping” or “real estate flipping” became popular among the masses of amateur investors and professionals alike, all the way up to Wall Street itself. It is a type of real estate investment, in which “an investor purchases properties with the goal of reselling them for a profit. Profit is generated either through the price appreciation that occurs as a result of a hot housing market and/or from renovations and capital improvements.” As is usually the case with such booms, the smell of easy and quick money led to a gold rush of unseen proportions. Very soon, house maids and delivery boys owned 4 to 5 properties, “flipping” themselves to new riches of wealth, only to end up with less than they had started. House flipping in general, like speculation, is nothing illegal, or even immoral in the strictest sense. However, if an entire population or group of amateur investors join the fun, and the financial incentives to cheat, fraud, and abuse the uneducated public are high and barely kept in check, the entire economy and society have a problem. Even today, eight years after the crisis, the world is still digesting its effects.
Real Estate for Investment Purposes
Real estate with a conservative down payment and proper finance plan, purchased at moderate prices, makes economic sense. It is a fantastic asset on anybody’s balance sheet. But, it's an asset that costs money. Don’t make the mistake of thinking of your home as an investment. According to Robert Kiyosaki, author of the Rich Dad book series, buying the first house you live in is not an investment in the strictest sense of the definition. It’s either shelter or liquidity, not both.
Real estate, as an investment, is probably one of the easiest assets to value, but it has its own circumstantial challenges. Consider the traditional Japanese middle class during the asset bubble years between 1986 to 1990. During the period when Japan experienced its own epic stock market and real estate bubble in the late 80s. The Japanese Imperial Palace and its adjacent land (3.41 km2 or 1.32 m2) were considered more valuable than the value of all of the real estate in the state of California.56 A generation of middle-class families saw themselves in a severe economic dilemma. On one hand, middle-class families had well-paying jobs where the unemployment rate was extremely low, and the economy was booming with experts projecting an ever more prosperous future for Japan. On the other hand, real estate for ordinary folks was simply too expensive relative to their already generous salaries.
As in any industrial society, property ownership is a
strong symbol of wealth and social standing. An entire generation felt that it had no choice other than to buy properties for their families, regardless of the cost. Those who couldn’t afford to live in the center of Tokyo were ready to endure 2 hour daily commutes just to secure their dreams of having their own homes.
Their decision to buy homes at any cost had some very eye-opening, long-term consequences. More than 20 years since the bubble popped in Japan, I interviewed some of the families who had decided to buy homes at the peak of the bubble. The picture they described was, depressing yet revealing.
Those who could afford houses and apartments in central Tokyo were all sitting on huge book losses if they ever decided to sell. Those who were able to buy somewhat cheaper properties outside of Tokyo, with an average commuting time of one hour, were in an even more dire situation. Land prices have gradually declined, and the value of their homes has steadily written down. Houses in Japan are only built to last 30 years, and the Japanese population growth has been declining since the early 2000s. As a result, general demand will only decline.
Many owners, bound to their properties, feel as if they have no choice but to finish their mortgage and continue living where they are. Most of them learned bitter lessons, but still prefer to keep their hard earned cash in hand or in zero interest-paying bank accounts.
Lessons Learnt
Leaving some of these extreme cases aside, property ownership teaches aspiring investors all of the essential elements of prudent investing: the time involved, the detailed work necessary, and the fees paid to third parties. Investors learn about real estate taxes and the regional economic development, by managing appropriate return expectations and assessing financial risk prudently. Most importantly, it will keep the majority of middle-class families out of casinos.
People who have developed a bigger risk and entrepreneurial appetite could buy their first real estate for investment purposes. The most important financial guideline would be to purchase at a price that makes sense relative to the “expected cash flow,” all relative and built on conservative assumptions. Don’t forget any repairs or additional investments that you would need to do to enhance the value of the property, as determined by increased cash flow potential. There is a lot more to managing a real estate investment well than just the location.
BONDS: WHEN TRUST IS TRADED
The international bonds market is huge. In 2015, it was estimated that the global bond market was about $100 trillion large, with the United States having the largest market, followed by Japan.57 These markets are played foremost by professional players, such as pension funds, insurance companies, large bond funds, and financial institutions. Bonds are less important to individuals unless they are incredibly rich and can stand the boring nature of bonds.
Bonds are also called fixed-income securities, because their contractual obligation is to pay out fixed interest, a coupon at a predetermined time, to the holder of these securities, usually semi-annually. They are also obliged to return the nominal amount in full at the end of the contract—usually between 3 to 5 years for corporate bonds and much longer periods (e.g. 10 to 30 years) for government bonds. The primary function of bonds is to raise funds to be used for business projects like establishing factories, developing new products, or even financing M&A activities. For governments, a bond’s main functions are to fund government projects (including wars) and to finance their budget deficits. Bond issuance can influence world economies and financial markets. They represent the building blocks for many other financial products, including currency trading, interest rates swap trading, and other complicated derivatives structures called structured notes, that will be discussed under derivatives.
Trading Bonds
The important point readers should understand and remember about bonds and bond markets is the importance of bond price fluctuations. A solid economic idea that attempts to raise funds from the public to finance significant economic and social projects, bond price volatility have become a breeding ground for all sorts of gambling, side bets, and fee income sources for the facilitators.
Let me explain; if a bank loans you money to buy a house, that's it. Both parties know what to expect and what to do. The contract can be securely saved in respective vaults and not be touched again until the contracts expire.
Somehow, people decided to trade using these papers and with each other even though the contractual obligations between the person who issued these securities and the current holder of these papers didn’t change at all. Just imagine your mortgage bank provided you the original mortgage and decided to sell your mortgage contract to another buyer. It might have decided it didn’t want to be your mortgage bank anymore, or just wanted to make a quick profit due to the price fluctuations of your original mortgage contract. Maybe, it just wanted to do more business and generate more fee income by issuing new mortgages with the money it received from the sale. All is well, but then the next buyer decides to sell again or create new financial products on the back of the original mortgage (which is entirely possible with modern financial alchemy). You can see how the long chain of people owing each other can lead to confusion and errors.
Bonds are like classic bank loans contracts: just for large corporations, institutions, and governments, but standardized so that the owner of these securities in question can change with a push of a button. Their active trading creates liquidity for markets and the ability to raise more capital. There are many kinds of variations of bonds that investors can buy and trade today, such as high yield bonds (junk bonds), TIPS, zero coupon, and convertible bonds. Because bonds are influenced by daily interest rate fluctuations that move with any economic news, there is a lot of trading action going on in the bond market on any given day or time. The most popular and most liquid bonds are sovereign bonds of leading economies such as the U.S., Germany, or Japan.
EQUITIES: GAMBLING WITH OWNERSHIPS
Everybody knows, of the stock market its dramatic crashes, vast fortunes, and suicides. Wall Street-—market ticker tapes flickering along big screens and Bulls and Bears- – is the graphic image that comes to mind when we talk about stocks and equity markets.
The theoretical concept behind stocks is that each represents a contract that entitles the buyer to buy equity in a public company. It is simply entering into part ownership of a company that is listed on a public stock exchange. It’s like a bar of chocolate where one piece of it is broken off and handed to you as your share of the bar. The rest of the chocolate bar is divided up among the remaining chocolate lovers.
With your share of the company, you are entitled to dividends payments, if any (i.e. a proportion of any profits, in the form of annual or semiannual payments). Shareholders usually have voting rights at annual shareholder meetings where they can vote on matters of significant corporate policy. Another wonderful advantage of owning shares is that you could never be sued personally for what is going on within the company, as your losses are limited to the value of the piece of contract you own. Unfortunately, when a company does go belly up, shareholders are the last to see anything from a liquidation auction. Banks and bondholders have the preferential right to be served first. Like any investment category, there are different forms and types of shares, but the above description sums up the largest portion of the market. Other than that, there is not much else to know about simple stock contracts.
The Mechanics
To buy a share of a publicly listed company, you need to open a brokerage account to access the stock exchange. An individual can't just go to a stock exchange directly and say, “I want to buy ten shares of IBM.” You need a proxy for that. That would be your stockbroker. In other words, your stockbroker is your facilitator to trading financial products on regulated exchanges. Today, all of them have online trading capabilities that reduced the cost of trading enormously. Nevertheless, making use of proxies is not free. Brokers, through their expensive licenses to access stock exchanges, execute client’s orders, and place their new
ly acquired shares into a separate account at a depot bank (a particular bank that specializes just as trust bank for safekeeping) under your name. Make sure they do that and don't lend your shares to anybody else—contact your broker for that.
The days of easy profits for brokers, of making money through trading commissions, and of market makers are long over. When I traded my first stocks, I paid 1% commission of my invested money on both sides. Today, through an online broker, you might pay less than $20 per trade.
Nevertheless, the industry has found other ways to earn money. What they lost on percentage commission, they made up for in the sheer trading volumes of today's markets. Active Fund managers, including hedge funds and the ever-increasing group of day traders, secure a constant flow of profitable business for brokers. It’s only logical that brokers have a very real pecuniary interest to keep up this flow, and even increase it over time—at all costs.
Not so long ago, you were able to get these beautiful stock certificates that looked like oversized bills. A good friend of mine who worked in the industry got me an old stock certificate from a now defunct Japanese Brokerage House called Yamaichi Securities, which was one of the largest securities firms in Japan. Today, this worthless piece of paper is framed and still hangs in my room where I grew up. In the age of electronic trading systems and the internet, most financial transactions have become paperless. Why should traders get a stock certificate when most buyers sell their shares in seconds or minutes later in a frantic day of trading activities? It looks great, with all the Japanese characters, important looking seals, and long numbers at the bottom and back of the certificate. That gift is also a reminder that, especially in stock markets, nothing is forever.
DERIVATIVES: HYDRA WITH MANY HEADS
Modern Investing Page 14