More Than One Way to Skin a Cat

 In the world of buying and selling stocks, the terms "trading" and "investing" are often used on an interchangeable basis. But they have key differences and thus should not be lumped in the same basket. Trading could be considered a type of investing - much like a square could be categorized as a rectangle. Appearing below are some of the primary differences in Trading vs. Investing:

                                                                TRADING   

1.) Time horizon: short-term (minutes to weeks).                                                                                             

2.) Risk tolerance: higher risk, including potential for significant losses.

3.) Strategies & goals: active, frequent buying and selling focused on short-term profits by taking advantage of price fluctuations.

4.) Costs & tax implications: typically higher due to frequent buying and selling.

                                                                INVESTING  

1.) Time horizon: long-term (years).

2.) Risk tolerance: lower risk, relies on potential long-term upward trends.

3.) Strategies & goals: "buy and hold" with a focus on potential long-term wealth accumulation through compounding and dividends.

4.) Costs & tax implications: typically lower due to fewer trades over a long period.

At their most basic level, trading and investing are identical. Both involve buying and selling securities. As noted previously, that is where the similarities end. Trading by nature is short-term. Trading decisions rely heavily on technical analysis, such as identifying price patterns and gauging market sentiment. Buying and selling investments becomes riskier the shorter your time line is and the more you concentrate your money into just a handful of holdings - two challenges traders often face. Additionally, due to the amount of analysis and research it takes, successful trading can be - and often is - a full-tme job. Investing is considered a long-term endeavor. Investment decisions are typically based on an analysis of fundamentals, including company earnings, growth potential, and industry trends. Long-term investing most often takes a set-it-and-forget-it mentality. Compared to trading, it is definitely a hands-off approach. 

Neither trading or investing would be considered easy. Of the two, however, trading stands out as the more arduous and risky of the two. It is not for the faint of heart, intellectually challenged, or those unable to subordinate their emotions. The 90% rule in trading - often called the 90-90-90 rule - is a well-known industry saying that 90% of new traders lose 90% of their money within the first 90 days. The numbers are even more abysmal for those who trade on a daily basis. Academic studies on active day traders indicate that only about 1% to 3% generate net profits after accounting for transaction fees, commissions, and inflation. Many day traders treat trading like a get-rich-quick scheme rather than a disciplined business.

A short list of the world's greatest traders ever would include:

1.) Jesse Livermore: Early 20th-century speculator who famously made $100 million shorting the 1929 market crash.

2.) Paul Tudor Jones: Renowned for predicting and profiting heavily from the Black Monday stock market crash of 1987.

3.) George Soros: Famous for "breaking the Bank of England" in 1992 by shorting the British pound, clearing a $1 billion profit in a single day.

4.) Stanley Druckenmiller: Managed money for Soros's Quantum Fund and built a stellar multi-decade track record without having a single down year.

5.) Jim Paulson: Made history with the "Greatest Trade Ever" by shorting subprime mortgages ahead of the 2007-2008 financial crisis.

None of the famous traders listed above can hold a candle to the money-making accomplishments of Warren Buffett, the Oracle of Omaha. Buffett is usually considered the greatest investor of all time. He has been uniquely successful for a very long time - approximately 80 years. The longevity has contributed to Buffett's legacy and fame. His baby, Berkshire Hathaway, has compounded money at a 22% annualized rate since 1965. This has pushed Mr. Buffett's net worth above $100 billion and made millionaires of numerous Berkshire Hathaway shareholders. Warren Buffett focuses on the intrinsic, long-term value of a business. He buys shares in companies with strong brand advantages and management, often holding them for decades. He is very gregarious, transparent, and educational - giving frequent interviews, spends hours answering questions at annual meetings, and writes much anticipated shareholder letters.

There is another gentleman, who died in 2024 at the age of 86, who arguably achieved superior investment performance than the legendary Warren Buffett. This fellow's name was Jim Simons. Mr. Simons's modus operandi was to design and utilize mathematical models and algorithms to make investment gains from market inefficiencies. Simons's background was in the fields of mathematics and physics, primarily operating in academia. In 1964, Simons worked with the National Security Agency to break codes. Eventually, at the age of 50, Simons decided to get filthy rich. In 1988, he established the Medallion Fund. How did it do, you ask? Well, between 1988 and 2021 (33 years), it had an average annual return of 66%. Note that this is three times the level of Buffett's average annual return. The Medallion Fund was capped at $15 billion and thus compounding was not an option. Profits were returned to Simons and his co-investors on an annual basis. At the time of his death, Simons's net worth was estimated to be $31.4 billion. In comparison to Buffett, Simons was highly secretive and proprietary. He shunned the limelight and rarely gave interviews. Simons did not wear socks. He was also known for smoking up to two packs a day of Merit cigarettes.

It is possible, maybe even desirable, to trade and invest at the same time. Many people hold long-term investments while doing short-term trades. It is important, though, to establish clear rules and distinct goals if this approach is elected. Separate brokerage accounts should be opened to segregate short-term trading money from long-term money. Another suggestion would be to set money limits for each account. For example, one may set a 90%-95% allocation for safe, long-term growth, while allocating 5% - 10% for riskier, short-term trades. I see the trading account serving dual purposes. It focuses the investor/trader on different facets and movements of the market. Additionally, it satisfies a primal desire to speculate without losing a significant portion of one's net worth. Lastly, if a person is consistently losing money on his or her short-term trades, it might be a good idea to put the trading hat in the closet.

 

Trump is Not a Conservative (at least economically)

 While President Trump would be considered a conservative in areas such as national defense, Supreme Court nominations, and various social issues, he most definitely would not be considered an economic conservative in the traditional sense as embraced by the Republican Party for the past 170 years. Trump's economic policies, in particular those espoused in his second term, fundamentally reject core free-market principles. Instead of championing free-trade, fiscal restraint, and limited government, his platform relies heavily on protectionist tariffs, massive deficit spending, and government intervention in private enterprise.

By weaponizing across-the-board tariffs, Trump effectively betrayed one of the basic tenants of the conservative philosophy that Republicans have long claimed was a pillar of their party - free trade. For a mature economy like the United States, protectionism makes no sense whatsoever. Economists generally view tariffs as a tax on domestic consumers that distorts the free market rather than allowing it to operate efficiently. Tariffs are a sales tax that inflates prices for consumers. We know from decades of experience that tariffs reduce employment, productivity, and output. Trump loves tariffs partly because companies come begging him for relief, and he can extract more tribute from them. Both the tariffs and the jockeying for special favors ought to be abhorrent to the party that holds itself as the defender of the free market. Trump has consistently made claims that tariffs can build a trade wall around America while also raising trillions of dollars in revenues to replace the income tax. This is a seriously flawed claim. A tariff cannot raise revenues from imports if those goods are no longer being imported. Tariffs can either lock out imports or collect revenues from them, but they cannot do both.

Fiscal conservatism traditionally prioritizes balancing the federal budget, reducing the national debt, and limiting government spending. Under Trump's administration, the U.S. national debt has grown significantly due to a combination of tax cuts and increased spending. Should we be surprised that the self-proscribed "King of Debt" doesn't give a rat's ass about the level of our national debt ($40 trillion), and more importantly, the fact that the government's debt is growing faster than its economy. Interest payments now consume 20% of federal revenues and have surpassed defense spending. The vast majority of politicians promise things during a campaign, and then fail to deliver when elected. It seems that Trump takes that approach to a whole different level. During his 2016 presidential campaign, Trump promised not only to balance the federal budget, but even to pay off the entire national debt. Then, during this first term, he signed legislation and executive orders adding $7.8 trillion more in red ink. Through his first 18 months in office the second time around, he is well on pace to surpass the cumulative deficit levels for his first term. His questionable fiscal policies cannot escape the mathematical reality that deep tax cuts and spending expansions cannot reduce surging budget deficits. Trump has continued his predecessor's economic errors. Either on Trump's watch, or that of his successor, there is an above-average chance of a severe shock to the economic system. Problems will first surface in the sovereign bond market with contagion subsequently spreading to the equities market. As they always do in a crisis, The Fed wll open the spigots and flood the financial system with liquidity. The proverbial can will be kicked down the road. The inevitable reset of the monetary system will be deferred again, buying time, but increasing the severity of the eventual demise of the fiat world.

Trump has steered the Republican Party away from long-standing support of free-market capitalism to a bastardized form of state corporatism that features crony capitalism. Rather than letting the free market dictate business success, Trump has advocated for heavy government involvement. He has repeatedly squeezed or lured corporations into doing his bidding. Eleven companies have given the federal government a stake in their ownership, making the government in some cases their largest shareholder and giving the president leverage over them. Imagine the outrage among Republicans if a Democrat had done that. In the past year, in exchange for an export license needed to sell advanced AI chips to China - a license previously denied on national security grounds - Nvidia secured Trump's approval by agreeing to pay the government 25% of the proceeds. Trump has taken "pay to play" arrangements to a level rarely seen in the executive branch of government.

The majority of business leaders are frustrated by Trump's apparent desire to micromanage the U.S. economy. Trump has called for CEOs who do not support him to be fired. He will stop at nothing to ensure those who cross him are punished, whether it is by their businesses failing or the CEOs being sacked. Trump does not want companies that oppose his rule to succeed. Trump's ever-changing trade policies, whether it be across-the-board tariffs, or the U.S.-Mexico-Canada Agreement (USMCA), is creating a climate of economic uncertainty that will disincentivize business investment. The main value of a trade agreement is that the rules and provisions stay stable long enough for companies to make plans and act on them. Per former Undersecretary of Commerce, Dr. Robert Shapiro - "Every investment is based on an assessment of the likely future demand for whatever you're investing in, and how much it's going to cost to produce it. So there are assumptions about labor costs, material costs and other input costs - and again about demand."

In conclusion, for the most part, Republicans have gone along with the betrayal of conservatism because they relish the power and care more about results than long time, fundamental standards. The jury is still out insofar as determining the efficacy of Trump's economic policies. My concern is that this departure from free-market principles will accelerate an eventual economic crisis. As mentioned previously, problems will start in the sovereign bond market and then contaminate the equities market. Like the 2007-2009 Great Financial Crisis, it will be a global phenomenon. And a nasty one. Unlike the 2007-2009 GFC, I see the current fiat system being replaced by a new monetary system that will take away the printing presses from spendthrift governments.

Don't Let the Tax Tail Wag the Dog

 The headline for this blog is one of the golden rules of personal finance. It means you should never make an investment or financial decision based solely on minimizing taxes. While tax-efficient investing is smart, making decisions purely to dodge the tax man (IRS) often leads to taking on needless risk, holding onto losing assets, or missing out on better returns. All too often, a smart, successful person holds on to a stock for far too long because selling would trigger a capital gains tax. Say a stock holding was up 400% at its peak. Then it falls in a precipitous manner, and now it's up 30%. They still won't sell because they are hopeful of a reversal back to their previous high level. Eventually, there is a realization that the reversal is not forthcoming. The stock is back to its cost basis. Our investor has lost years of potential returns, all to avoid a tax bill that would have been a fraction of the ultimate damage. This is the tax tail wagging the dog.

Before proceeding further, it probably makes sense to introduce the applicable income tax rates to the discussion. Capital appreciation (when investments go up in value and the gains are realized) is taxed at your capital gains tax rate. There are short-term gains and long-term gains. If an asset is bought and sold within one year, it will be subject to short-term capital gains. Generally speaking, this will be the investor's marginal income tax bracket. Investments that are sold after being held for more than one year will be subject to long-term capital gains. There is preferential tax treatment as it will be lower than your marginal income tax bracket. The applicable capital gains tax rates are itemized below. Please note the taxable income parameters are for single filers.

LT Capital Gain                                                                                                                                                  Tax Rate                                  Taxable Income    

-0-                                            $0 - $49,450                

15%                                         $49,451 - $545,500

20%                                          over $545,500

Besides the obvious example as detailed previously in the first paragraph, there are other common mistakes associated with holding on to securities at all costs. One risk is that it can get in the way of your overall investment strategy. Rebalancing a portfolio is a critical part of any investment strategy. Rebalancing goes hand in hand with asset allocation and diversification. Over time, certain asset classes will increase in value compared to others. This can disrupt the original asset allocation that was chosen when your strategy was determined. While this is a good thing, normally the advice is to return the portfolio to its original strategic asset allocation. This involves selling appreciated assets - which means paying some capital gains taxes. Paying taxes is the price you pay to participate in the equities market and, even more specifically, the price you pay to keep a strategic asset allocation over time. It is never enjoyable to write a check to the Internal Revenue Service. However, you're paying taxes because you made money (which is the goal) based on either a smart or lucky investment decision, and that sure beats being on the losing side of a trade.

Several years ago when I was a young banker and novice investor, my late father was always pestering me to purchase municipal bonds. Many investors buy munis because the interest income from these bonds is generally exempt from federal income taxes. My reluctance to buy municipal bonds at a fairly young age was supported by multiple considerations. First of all, I wanted the risk/reward associated with the stock market. Second, the commissions charged when buying munis can be fairly stiff. Lastly, I simply was not in a high enough federal tax bracket to justify an allocation to municipal bonds. Munis are inherently more valuable the higher your marginal tax rate is. Another consideration would be that changes to the federal tax code can draw investment monies into bad deals that would never attract attention except for the favorable tax treatment. Always run the investment through a non-tax filter first. Ask: Would I own this if there were no tax benefits? Still another example of chasing "tax-free' growth would be over-funding whole life insurance policies. The returns need to be evaluated honestly against alternatives. The question is always, "Is this a good use of my capital?"

Investors would be wise to consider future tax risk. There is a strong possibility that in the not-too-distant future, income derived from long-term capital gains will be taxed at a much higher rate than is currently the case. In the 1970s, long-term capital gains tax rates were over 30% - peaking at 39.875% in 1976. It would not surprise me in the least if we see a return to those much higher rates. With a national debt of $40 trillion and annual budget deficits consistently around $2 trillion (6.5% of GDP), there will be increasing pressure to increase taxes. The growing wealth inequality will reach the point where Congress will modify the tax code to address this issue before social unrest leads to violence on our urban streets. I expect the top 10% of income earners, especially the top 1%, will be paying significantly more in income taxes in the next few years. It might even be worse than I am predicting. Can you imagine the tax rates for wealthy Americans if President Mamdani has a Democratic House of Representatives and more than 60 Democratic Senators in the United States Senate?

I'll end this blog with a comment I came across when reading an article for research I was conducting on this subject matter. " The best tax shelter of all time is a great investment. Don't contort your portfolio into unrecognizable shapes trying to avoid taxes. A well-diversified, well-managed portfolio that grows steadily will always outperform a tax-optimized portfolio of mediocre investments."

Beware of IPOs

 IPO is an acronym for Initial Public Offering. An Initial Public Offering is when the stock of a private company is sold to the public. In other words, the company becomes available for the public to invest in via the stock market. As if the equities market isn't animated enough sitting at all-time highs, currently there is a tremendous amount of buzz surrounding three companies going public in 2026. Those companies are Space X, Anthropic, and Open AI. Space X launched June 12, 2026 and already has a market capitalization of $2.65 trillion. Space X's value currently makes it the world's fifth-largest publicly traded company, leapfrogging Amazon and within spitting distance of Microsoft. Last year, Space X took in $18.7 billion in revenue and lost $4.9 billion, while Amazon took in $717 billion and earned $77.7 billion. Anthropic and Open AI both formally filed their form S-1s with the SEC in early June. They are projected to go public in the last quarter of 2026 and first quarter of 2027, respectively. Both of these companies are expected to top the $1 trillion market cap level right out of the gate. Needless to say, this 2026 mega-IPO bonanza is unprecedented and crazy.

If you would have invested $10,000 in Amazon at its IPO price of $18 per share in May 1997, you would have approximately $28,500,000 today. If you had invested $10,000 in Netflix at its IPO price of $15 per share in May 2002, you would have approximately $7,200,000 today. If you had invested $10,000 in Apple at its IPO price of $22 per share in December 1980, you would have approximately $26,400,000 today. It's easy to see with these three examples why people get so excited about IPOs. So, why am I extremely cautious with IPOs and why do so many well-known investors just say no and refuse to touch an IPO, any IPO, with a 10-foot pole.

There are multiple reasons why IPOs should be avoided. They often feature inflated opening valuations driven by media hype and usually arrive on the scene when market excitement is at its peak (sound familiar?), selling incentives are high, and valuation discipline is low. Traditionally, by the time a company goes public, the easiest money has already been made by the founders, insiders, venture capitalists, and the investment banks who underwrite the stock issue. IPO shares are generally only available to high net worth investors before they become available to the general public via the stock market. Furthermore, the underwriters often price the stock aggressively, leaving little room for immediate growth and making the stock vulnerable to steep sell-offs once the initial excitement wears off. In other words, average retail investors frequently get hung out to dry.

Newly public companies lack a proven track record as a publicly traded entity. Without extensive historical price data, their stock prices can swing wildly on IPO day and during the weeks that follow, making them a risky proposition for long-term or conservative portfolios. Early insiders, executives, and major investors are often subject to "lock-up periods" (typically 90 to 180 days) during which they cannot sell their shares. When these restrictions expire, a flood of new shares can hit the market, causing the stock price to plummet.

In general, IPOs disappoint investors with poor returns. According to Verdad Capital, the median IPO (out of 3,700 IPOs reviewed since the late 1980s) lost 31% of its value three years after its IPO. After five years, the loss was even greater at 41%. In a Dimensional Fund Advisors' (DFA) article titled, "IPOs: Profiles are High. What About Returns?", DFA reviewed approximately 6,400 IPOs from 1991 through 2018. Their research concluded that the collective group of IPOs underperformed the broad stock market (Russell 3000) by 2.20% per year. To put that into context, an investment of $100,000 into IPOs would have been worth $653,000, while the same investment in the broad stock market would have been worth $1,155,000. If you are going to take on the additional risk associated with IPOs, you better make sure you will be compensated for it.

If my powers of persuasion have not convinced you to avoid buying an IPO, then I offer the following bits of advice:

1.) Wait. Let the market determine the stock's true price as opposed to the price the investment bank initially sets. Wait until after the lock-up period ends. Sit back and evaluate a minimum of two or three quarters of earnings before serious consideration is given to the purchase of shares. 

2.) Only invest in an IPO with money you can afford to lose. Don't use your "serious money" such as a retirement nest egg.

3.) Keep your fingers crossed.

Batting Average vs. Slugging Average

 One of the biggest misperceptions in the field of investing and trading securities is the viewpoint that investors have to be right nearly all of the time to be deemed successful. In other words, they have to accrue a batting average that reflects vastly more winners than losers. The batting average for an investor is derived by computing the number of investments that make money as a percentage of total investments made. In baseball, a 0.400 batting average would be considered the holy grail. This was last accomplished by Ted Williams in 1941. The argument can be made that Ted Williams was the greatest hitter of all time. In the world of investing, a 0.600 to 0.650 batting average is considered top-tier, while professional investors often look for at least 0.500. This tells me that picking winners in the stock market is considerably easier than hitting a major league curveball.

In both baseball and investing, the slugging percentage supersedes the batting average in terms of importance and relevance. On a baseball diamond, the slugging percentage measures a hitter's batting productivity, and it differs from batting average because it values hits differently by weighing them differently. A single is worth one base, a double is worth two bases, three bases for a triple, and accordingly a home run is worth four bases. The total bases are the sum of singles + (2 x doubles) + (3 x triples) + (4 x home runs). Slugging percentage is the total bases divided by the number of at-bats for a player, ranging from 0.00 to 4.00. A player near the -0- level will soon be looking for a new day job. While a player at or near the 4.00 level will most assuredly be a deity. In general, a high slugging percentage tends to lead to more runs being scored and to winning more games.

Concerning investments, the slugging average is the average absolute gains for successful investments divided by the average losses for unsuccessful ones. This would apply to both realized and unrealized gains and losses. The key to investment success is ensuring when you have winning ideas, they are big positions generating outsized returns (e.g. doubles, triples, or home runs), and when you have losing positions, the positions become smaller (singles). Your losses are minimized and do not significantly matter. Thus, the best investors focus more on "slugging average" - the magnitude of gains - rather than just the frequency of winning trades.

What you're looking for are multi-bagger winners that go 3x, 4x, 10x, and more. Multi-bagger winners drive the majority of returns for exceptionally robust investment portfolios. Although multi-baggers don't grow on trees, they are out there just waiting to be discovered. My Achilles Heal is that I tend to prematurely realize relatively decent gains by selling early, and then rebalancing and reallocating to other positions. This approach does not allow gains to run, and sometimes they run wild. A case in point - I bought Meta (formerly FaceBook) in 2013 for $28 per share and then promptly sold it for a modest profit a few months later. A second case in point - I bought Micron in 2018 for $52 per share and then sold it a year later at a 20% loss. It is too painful for me to write down the current share price for those respective companies.

One of the key insights thus is that an investor can be correct much less than half of the time, with say a 0.400 batting average, and still generate high returns if the winning trades are significantly larger than the losing ones. Listed below are a dozen quotes from legendary investors that pertain to the subject matter of this blog:

1.) "Even the best investment analyst is going to be right just two out of three times." - Sir John Templeton

2.) "Most traders make money only in the 50 to 55 percentage range. That means you're going to be wrong a lot. If that's the case, you better make sure your losses are as small as they can be, and that your winners are bigger." - Steve Cohen

3.) "No investor can be right all the time. If an investor is correct half of the time he is hitting a good average. Even being right three or four times out of ten should yield a personal fortune if he has the sense to cut his losses quickly on the venture where he has been wrong." - Bernard Baruch

4.) "I am a professional mistake maker. One third of my trades are probably wrong." - Ray Dalio

5.) "I always say to people who come in to see me that you have to realize in our business a really, really good person is wrong 30% of the time. That's a world-class investor. Are you comfortable being wrong 30% of the time? By the way, you can't be wrong in a massive way." - John Phelan

6.) "It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong." - George Soros

7.) "If you're terrific in this business, you're right six out of ten." - Peter Lynch

8.) "During 68 years on Wall Street, I have been wrong about 30 percent of the time. That means a lot of losses. But it's the 70 percent right that matters. If any investor had been right all the time, he or she would have accumulated a considerable portion of the world's wealth. But as you might suspect, always-right investors don't exist, except among liars." - Roy Neuberger

9.) "Our portfolio managers have a tough job as you are wrong half the time. They get a report card every day that is an F. It happens to be that 53%/47% still is very profitable in finance, but it's still a tough report card. We hire the best and brightest and they go from having 90's as their average test score to 53%." - Ken Griffin

10.) "John Templeton said something to me a couple of years ago - he said if you are right 60% of the time and wrong 40% you will be a hero, and if you are right 40% and wrong 60%, you will be a bum. But I am sure he used more gracious language than that." - Peter Cundill

11.) "Five to one means I'm risking one dollar to make five. What five to one does is allow you to have a hit ratio of 20%. I can actually be a complete imbecile. I can be wrong 80% of the time, and I'm still not going to lose." - Paul Tudor Jones

12.)"So you have flops. Maybe you're right 5 or 6 times out of 10. But if your winners go up 4-or10-or 20-fold, it makes up for the ones where you lost 50%, 75%, or 100%." - Peter Lynch

Financial and Economic Illiteracy

 Based on policies and decisions emanating from the federal government during the first quarter of the 21st century, it is obvious to many that our leaders at the national level, for the most part, are intellectual lightweights and believe the citizens they represent are primarily disengaged idiots. I wouldn't go quite that far, but there is sufficient evidence to support the contention that roughly half of Americans are financially illiterate and lack even an elementary understanding of economics.

 American exceptionalism does not extend to dominance in the rankings of financially literate adults by country. The Scandanavian countries, followed closely by Canada and Israel, are the "cream of the crop" when it comes to financial knowledge. The United States languishes in 14th place, stuck between the Czech Republic and Belgium. In general, men are considered more financially literate than women, White and Asian Americans are considered more financially literate than Black and Hispanic Americans. Before stringing me up for being a sexist racist, I will go on record for saying these differences are not due to genetic reasons, but rather due to systemic and socioeconomic factors. Since I've opened the generalization box, I'll also mention that members of Gen Z have the lowest level of financial literacy, while Baby Boomers exhibit the highest level. This is not surprising, considering the priorities of our educational systems and the fact that wisdom is accrued over time. Among U.S. adults, risk comprehension is the weakest point of their financial literacy. Only 36% of U.S. adults answered related questions correctly.

The impact of financial illiteracy on financial outcomes is both obvious and impactful. According to the National Financial Educators Council (NEFC), a lack of financial knowledge costs adults $948 annually on average. Limited or no financial knowledge often leads to costly choices for individuals and the country as a whole. Too many Americans have excessive debt levels, and the majority feel anxious about their finances. Over 42 million Americans are carrying student loan debt, with the average student loan borrower owing $39,075. Over 14 million Americans have more than $10,000 in credit card debt. Wages not keeping up with inflation is obviously a major factor, but lack of financial knowledge contributes as well.

Even many Americans who have jobs that pay way above-average compensation struggle with establishing a savings program for present-day expenses and for retirement down the road. A surprising number of households with significant income generation live paycheck to paycheck. Part of the reason for this phenomenon is attributable to something known as "lifestyle creep." As income rises, so do expenses, with high earners spending on luxury items, upscale housing, extensive travel, and other pricey lifestyle choices. High debt levels are often incurred to fund expensive primary and secondary residences, six-figure vehicles, and tuition payments for children attending prestigious universities. Money management skills are often lacking among the high income earners that find themselves living paycheck to paycheck.

There are steps that can be taken that will hopefully improve our abysmal financial literacy rates. According to NEFC, nearly half (44%) of 18-34- year- olds said their high school didn't offer a personal finance course. Many who had the option to take a course but decided not to wish they had. Early education is key to success. In 2024, 35 states required K-12 students to take at least one personal finance course to graduate. That's up from 23 states in 2022, a step in the right direction. The internet is also a great source for advancing one's financial knowledge. Although that comes with the caveat that there is also a surplus of junk and voodoo economics in this area of the internet. That said, there are also a number of reputable financial podcasts that can be extremely educational and helpful. My favorite is "Thoughtful Money" featuring Adam Taggart. Still another source for improving financial acumen would be the vast number of published books that deal with personal finance and economics. Lastly, among U.S. adults who are knowledgeable about personal finances, 49% say they learned a great deal or a fair amount about personal finance from family and friends. My advice to a young person would be to ask a ton of questions and entertain a wide variety of opinions from family and friends who at least understand the basics of economics.

I hesitate to include professional financial advisors on the list of potential sources in which to enhance one's investment acumen. There has been a proliferation of salespeople masquerading as financial  advisors. Salespeople are not inherently bad, evil, or ne'er-do-wells. They simply have a job that creates conflicts of interest that are detrimental to the financial planning process. All too often, they fail to take a wider view to improve their clients' chances of accomplishing their objectives by offering solutions that are often outside the range available to sales-oriented representatives. I've also thought that too many financial advisors, at least when it comes to investments, prefer to keep their clients in the dark and incapable of truly understanding the nature of their various investments. I would be remiss if I didn't acknowledge that there is a modest percentage of financial representatives that are talented and always act in a fiduciary capacity for their clients. They are the exception, and not the rule.

Besides financial loss at the individual level touched on earlier in this blog, widespread financial illiteracy also poses a risk to our economic and social systems. Congress may be a check and balance on the executive and judicial branches of the government, but the people are the check and balance on Congress. The short-sighted and unwise policies that economists deplore often turn out to be immensely popular with voters. Why should we think that politicians fail to listen to the voice of the people when heeding the voice of the people is the usual path to political power in a democracy? Politicians listen all too well, and as a result, they heed to a host of economically illiterate demands.

   

   

How Money Is Created

 Money is ubiquitous and fungible. It also plays an important, if not dominant, role in practically everybody's life. A minuscule number of individuals (economic nerds), however, truly understand how money is created in our financial system. The process by which the money supply of a country is increased or decreased is important in understanding how an economy functions. Before proceeding with the details, I should mention I am specifically addressing money creation in the United States. Most other countries with a central bank operate in a similar fashion, but this blog will only pertain to the United States.

The majority of the money supply that the public uses for conducting transactions is created by the commercial banking system. This is done by commercial banks exercising their lending function. Bank loans expand the quantity of bank deposits. Our system of banking is called fractional reserve banking because banks only keep a fraction of deposits as reserves, and they loan out the rest. A bank creates new money merely by issuing a loan. The amount it creates is limited by the reserve ratio or "fraction" it is required to maintain to cover its cash-flow needs and comply with standards mandated by its regulators. With a general industry reserve ratio of 10%, then each $100 it lends includes $90 that never existed before. A commercial bank, therefore, can create a sizable amount of money merely by making loans. Conversely, money is destroyed when bank loans are paid off by borrowers or charged off by the lender.

In the world of dollar creation and destruction, the "Wizard behind the curtain" is America's central bank, the Federal Reserve Bank. There are multiple levers the Federal Reserve can pull to influence the nation's money supply. One way a commercial bank can expand reserves and make even more loans is to borrow funds from the Fed. This process is called going to the "discount window." When a bank goes to the discount window, the bank is expected to pledge collateral. The collateral can be government bonds, but it commonly consists of commercial loans. The Fed then grants credit to the bank in an amount equal to the debt instruments. This allows the bank to convert its old loans into new reserves. Every dollar of those new reserves then can be used as the basis for lending nine more dollars in new money.

The Federal Reserve Bank is the banks' bank. That is, banks hold deposits at the Fed much like you or I might hold deposits in a checking account at our local bank. From its inception in 1913 until October 2008, the Federal Reserve never paid a penny of interest to its various depositors (commercial banks). That all changed a month after the collapse of Lehman Brothers during the throes of the Great Financial Crisis. On October 6, 2008, the Federal Reserve began paying interest on depository institutions reserve balances (both required and excess). The program is known as the Interest on Reserve Balances (IORB). This tool allows the Fed to implement monetary policy by influencing short-term interest rates. The higher the interest rate the Federal Reserve offers to pay its member banks on their reserve balances, the less likely it is for the banks to lend money to private borrowers. Banks are generally unwilling to lend to private parties at a rate lower than what they can earn risk-free on reserves at the Fed. If the Federal Reserve wants banks to lend more of their deposits, thereby creating more money, all they need to do is lower the IORB. And that's exactly what they did during COVID. In January 2020, the interest rate on reserves was 1.55%. By mid-March 2020, the Federal Reserve had dropped the rate to 0.1%.  

The Fed can also manipulate the amount of reserve deposits in the financial system by purchasing or selling bonds (primarily Treasury securities) in the market. This is referred to as open market operations. When the Federal Reserve buys bonds from banks they digitally create new money out of thin air and exchange this new money for the bonds that are then included on the Fed's balance sheet. An increase in bank reserves theoretically increases bank lending and in turn increases liquidity and the money supply. This open market purchase strategy is known as Quantitative Easing (QE) when it is pursued on an aggressive basis for an extended period. QE during the financial crisis (2008-2009) added about $3 trillion to the Fed's balance sheet. The COVID crisis triggered the addition of another $5 trillion to the Fed's balance sheet. From January 2020 to January 2022, the M2 money supply increased from $15.4 trillion to $21.6 trillion. That's a 40% increase in the money supply - unprecedented in recent U.S. history.

There are risks associated with an insufficient money supply, but it happens so rarely in history it is not worthy of discussion. The historical problem, however, which we happen to be currently experiencing, is excessive money supply with more most assuredly coming down the pike. Excessive money supply growth, when outpacing economic output, triggers inflation, erodes purchasing power, and causes currency devaluation. To quote Milton Friedman: "Inflation is always and everywhere a monetary phenomenon." When too much money chases too few goods, prices invariably rise. High money growth often precedes inflation by roughly a year. This was seen in the 1970s when inflation hit double digits and hung around for a few years at dangerous levels. It was also evidenced in 2021-2022 when inflation went from 2% to 9%. This was triggered by the massive (40%) increase in the money supply in response to the COVID pandemic. Consumers painfully discover their cash buys fewer goods and services. Excess money and liquidity can also flow into stocks, real estate, and other assets, creating asset price bubbles. Sound familiar? 

Although it will never be acknowledged by the leaders of either of our major political parties, it is my opinion that the government will continue to run the economy hot and intentionally target an inflation rate of 3% - 5%. Inflation works as a "soft default" on current debt since the real value of the debt is repriced. The total real liability of the current federal debt decreases by 19% with an inflation rate of 5%. Inflation acts as a mechanism that reduces the consequential debt-to-GDP ratio. It also effectively transfers wealth from holders of government debt (creditors) to the U.S. government (debtor). Inflation is an insidious, hidden tax that decreases the purchasing power of the populace. Using inflation to reduce debt is a blunt, dangerous tool that ultimately can serve as a catalyst for a fiscal crisis and significant social upheaval.