Generally, a mutual fund is a diversified assortment of stocks, bonds, or other so-called assets. When a person buys a diversified portfolio of mutual funds, in many cases, they are buying the same stocks in different mutual funds. This is not diversification. This is concentration.
When someone says, "I am debt-free. My house and car are paid for, and we pay off our credit cards the moment we use them." Rather than disturb their dream, an expert says, "Congratulations," and move on. Let such people live in their oxymoron. The fact is that, "Have you seen the size of the national debt? How can one be debt-free when everyone is paying the principal and interest on national debt? How can one be so naive?"
The subprime crash of 2007 was caused by excessive debt owed by subprime borrowers. The next crash will be caused by excessive debt owed by subprime nations. So far, the world has supported the crash of smaller countries, such as the PUGS (Portugal, Ireland, Italy, Greece, and Spain).
If Germany had not bailed out Greece, the crash would have spread. The first major country to go will probably be Japan. Why is Japan in trouble? Debt. Japan has the largest percentage of debt-to-GDP ratio of the major world powers. The irony is that Japan is a highly educated, hardworking, homogenous population, with one of the highest savings rates in the world. In spite of these solid personal work and savings ethics, their government continues to mismanage their economy.
The illusion, the American leaders promote, is that Americans can work hard and produce a way out of these rising mountains of debt, that Americans need to work harder and save more money. This is why President Obama says: "American workers are the most productive workers in the world." It seems that he wants American workers to save the US economy when it is the ongoing incompetence of political and financial segment that is the true cause of the problem. The people that need financial education the most, are our leaders.
Japan is doing the same thing the United States is doing, using debt in an attempt to stimulate their economy. This is no different than a worker using credit cards to pay the interest on their credit cards. During the real estate boom, millions of people refinanced their houses to pay off their credit cards and kept using their credit cards. When the entire system crashed, people started losing their homes.
For example, in Japan's case, its GDP is approximately $5 trillion, the fourth largest economy in the world, and its reported debt is approximately $10 trillion. This is approximately $75,000 per person. Japan's debt-to-GDP ratio is similar to a worker earning $50,000 a year with $100,000 in credit card debt. To make matters worse, the worker is using credit card to pay the interest on its $100,000 debt, an action that only increases the debt. In very simple terms, debt-to-GDP ratio is a country's credit score.
Why is debt rising? Countries are like many people: They spend more than they produce and make promises they cannot afford. The richest people in the world are entrepreneurs such as Bill Gates of Microsoft, Steve Jobs of Apple, Richard Branson of Virgin, and Sergey Brin of Google.
The ability to sell is essential for entrepreneurs. The reason most businesses fail is because the entrepreneur lacks adequate sales skills. In 1974, IBM and Xerox had the best sales training. I was hired by Xerox and was sent to Leesburg, Virginia, for intensive sales training. It took me four years of training to go from last place to first in sales. Real estate is the asset that requires the ability to control debt and manage property and tenants. Real estate is great because debt and taxes make the investor rich.
Buying gold and silver coins takes the least financial education, yet you still need to know something about the asset class. Gold and silver do go up and down in price. Also, there are many con artists in the gold and silver business, especially today with prices climbing.
Which asset class is best for me? The one's looking interesting to one. Remember that a business creates most of the truly wealthy people, but a business takes the most financial education. Real estate requires the second-highest financial education. Paper assets are easy to get into, but are the riskiest. Commodities like gold and silver take the least financial education but are not risk-free.
Which asset class do most people invest in? Paper assets. Paper assets are the most liquid, which means they are easy to get into and get out of. Getting into paper assets requires the least financial education, zero sales skills, and zero management skills. All you have-to do is go online or call a broker and say, "I want to buy 100 shares of this or sell 100 shares of that." You can train a monkey to buy and sell paper assets.
Why don't one invests more in paper assets? Not enough control. As an entrepreneur, one controls the income, expense, asset, and liability columns of the financial statement. If one invests in, let's say, Microsoft, Bill Gates will not take a call. He does not care if one thinks his expenses are too high or too low. One has to care. When one invests in oil, he can call the president and he will take his call. When one invests in real estate, he can call anyone. When you run your business, one can call anyone in the offices around the world and may discuss the business. That is what is known as control.
This does not mean paper assets are a bad investment. Paper assets make a few people very rich. Paper assets have also lost trillions for unsophisticated investors forced into the stock market by government laws, laws that created pension plans such as the 401 (k) in America.
Good financial education is essential for knowing good financial advice. How does a person make money and reduce risk in paper assets? Start at the shallow end of the pool. Take classes and practice, aka paper trading. Commercial message: Rich Dad suggests playing the CASHFLOW 202 game, a fun and fantastic way to learn to reduce risks and increase returns with paper assets. One needs to understand CASHFLOW 101 before going on to 202.
In the world of investing, there are always professionals and amateurs. The stock market is a great place for professionals because there are so many amateurs who are forced to be in the deep end of the pool where the sharks wait.
When it comes to paper assets, the biggest differences between amateur investors and professional investors are:
a) How they seek to generate income, and b) how they manage risk. The easier of the two discussions is their approach to managing risk.
In real estate, the battle cry is usually "location, location, location." It seems that in paper assets, the battle cry is "diversification, diversification, diversification." In both real estate and paper, the battle cry should be "cash flow, cash flow, cash flow."
Less-sophisticated investors seem more likely to turn to managing risk by what they have been sold as diversification. This brand of diversification is a hope that the winners will outnumber losers at a pace that will achieve financial objectives, outpace inflation, and not be hurt by possible changes in the tax law. But professionals will often seek to manage risk by purchasing contracts. While these contracts cost money, they give the investor the chance to regain some control.
For example, one investor will simply spread money around lots of different stocks and hope winners outnumber losers in the long run. Another investor will purchase a contract that gives them the right to sell their stock at a set price, no matter how bad the stock price falls. A put option contract is one simple type of contract that does this.
In a nutshell, amateurs often seek to earn their money in paper from capital gains and to manage risk by diversification. The professionals often seek to control their money with cash-flow strategies and to manage risk by using contracts.
Insurance for paper assets One of the things one may purchase on a regular basis is rental insurance. One does this in case his tenants damage his property by accidentally starting a fire, for example. Imagine trying to manage that risk with diversification. It wouldn't make much sense to buy a whole bunch of houses and just hope that while some might burn down, most will not.
One likes the idea of having a contract that one pays a relatively small amount of money for to protect an asset that is worth a much larger amount of money. Most of the people call these types of contracts "insurance." When a person gets in an automobile accident, the first question that is often asked is, "Are you covered?" or "Do you have insurance coverage?"
In the stock market, we don't usually use the word insurance. Instead, we use the word "hedge." Like insurance, we can protect a relatively large amount of money against loss by spending a relatively small amount of money on a contract, such as a simple put option, as I mentioned above. Many professional investors will spend money on put options during times of uncertainty and when they're faced with events that are beyond their control, such as an earnings report or an announcement by the central bank. The more risky the situation, the more expensive the contract. In fact, these kinds of contracts can give an investor insight as to how risky the situation is.
An example of this is the credit-default swaps for countries like Greece, Portugal, Ireland, and Spain. Lenders don't want to lend money to all these countries and hope that some pay them back and some won't. They want contracts that protect them against default. Lately, the price of these contracts has been soaring, which tells me things are getting more unstable.
(Concluded)
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)