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Paradigm Shift III December 13, 2007

Posted by shaferfinancial in paradigm shift.
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How does a banker make money?  Well they borrow money from folks who put money into savings accounts and Certificates of Deposit or they borrow money from the government.  Then they loan that money out at a higher rate.  It is called arbitrage and is the basis for wealth creation for bankers over the last several thousand years.  Do banks incur risks?  Yes, their main risk is if people don’t pay them back what they owe.  Periodically, bankers forget about this risk and the result is disastrous.  Like in the 1980’s with the S & L’s lending money to real estate developers who just happen to be their buddies.  Or now, lending money to people who have a history of not paying their bills.  But the bankers do something else; they require collateral in most cases.  So, they reduce their risk this way.  They really don’t like to, but if forced they will foreclose and resell an asset to recoup as much of their money as possible.   But here is a key.  If bankers don’t think they can get their money from the asset, they will work with the borrower to avoid taking a loss.  Donald Trump tells the story of owing $100 million dollars and not being able to make his payments.  He told a room full of bankers he couldn’t pay them back.  What did they do?  They restructured his loan.  Did they take his yacht from him (yacht was his collateral)?  No.  Now here is the point.  It’s good to have a banker as a partner.  When they have a large amount of risk in the deal they will become very good partners, willing to work with you to insure that you become successful.

How do investors make money?  They buy assets.  These assets range from businesses to real estate to bonds.  Quite simply they put money to work for them.  Successful investors can create extreme wealth by infusing young businesses with capital (money).  For example Mitt Romney, Republican presidential candidate, and his company Bain Capital which turned 57 million dollars into 50 billion dollars.  The famous financier JP Morgan, along with being a banker also put together deals turning his bank into an equity investor creating tremendous wealth.

Now both of these ideas have been around for a long time.  Yet, they seemed to be reserved for only a special few.  But the new emerging paradigm is about extending these ideas to a larger percentage of the people.  Now on top of this is the fact the tax laws privilege business owners and investors.   

One of the biggest financial hoaxes is that you can achieve financial peace by being a consumer, either a spender or a saver (who saves so they can consume later in retirement).  Financial peace can only come from becoming an investor, using the arbitrage method of bankers, and using the power of leverage.  Now I know that most people view these ideas as extraordinarily risky.  But the financial truth is that they are far less risky than the risk most folks take every day with their finances. 

Now you might be thinking that you are an investor because you buy mutual funds inside your 401K.  Technically, you are and this is a good thing.  But I argue that becoming an investor is more about your state of mind, the way to see the world, than whether you own a microscopic piece of some corporations.  In short Wall Street has done a great job convincing us that investing in mutual funds is the way to riches (in order to retire), but behind this veil of propaganda is the reality that the only folks getting rich off of mutual funds is Wall Street.  I mean study after study has documented that 99% of mutual funds under perform the market over time (15 years or longer), that stock pickers are routinely beaten by darts thrown at a board (chance), and that you are best off finding a low expense index fund that will mimic the market.  In other words the best you can really hope for is average returns.  Yet, most people think that they can identify (buy) mutual funds that will turn them into automatic millionaires; or at least that is what the financial gurus are selling these days.  The facts tell a different story. Despite having been told to save and invest in mutual funds for a generation, despite having a good amount of folks retiring with a defined benefit retirement plan, despite living through the greatest economic expansion in the history of the world, less than 10% of folks retiring today are self sufficient.  Why?   Because they have the mindset of the consumer paradigm.  They shop.  They get caught up in the minutia of consuming, even to the point of consuming investments/retirement plans. 

These folks who consume investments are perhaps the saddest of the consumer paradigm, thinking they can save enough from their paychecks to retire wealthy by buying mutual funds.  Even the salesmen/financial planners are no longer arguing this is possible.  They now tell you that your goal should be to save enough to replace 60%-80% of your current income.  But of course they still tell you that you can beat the market with mutual funds, some arguing that you can get a return of 12% or more!  Here is another fact that should shock you.  Study after study has indicated that consumers of mutual funds’ total rate of return is approximately 10% below what the market returns! Why?  Because folks think like consumers, selling their mutual funds to change to the hottest funds of yesterday, cashing in their 401K’s to bid them over in times of trouble, and moving out of the market after a large drop in value.

Investors do not chase yesterday’s good investments.  They don’t panic when their investment dips.  Warren Buffet, perhaps the most successful investor ever, sums it up nicely: “You should invest like a Catholic marries-for life.”  The point that Warren Buffett has made succinctly is that you should do your homework on what you want to invest in, look for true value, and hold on to it for a long time until the fundamentals of the business don’t make sense anymore.  That is what being an investor is really about.

Bankers work a little differently, but ultimately it turns out to be the same viewpoint.  Their arbitrage strategy is based on taking money in at a fixed cost and putting it to work at a higher rate than their cost.  Now in all interest rate environments this works because interest rates move in tandem.  For example, in the early 1980’s bankers were issuing Certificate of Deposits that paid over 14% interest.  However, they were charging for their residential mortgages up to 18%.  Their commercial mortgages were over 25%.  Now you can get at Certificate of Deposit for 5% and a mortgage for 6% so the margin has gone down, but the strategy still applies.  The strategy works as long as no malfeasance occurs as when the Savings and Loans lent money to folks with no track record of commercial success or when some lenders lent money to individuals with bad credit.  But as long as you have accounted for the ability to be paid back on a loan the arbitrage strategy will create value and wealth.  If you don’t believe this, just take a look at any downtown center in the country and note the names on the large buildings.  Bet you they include bank names!

Now paradigm change is a very difficult thing to accomplish.  It takes much intellectual and emotional work.  You don’t accomplish this in a weekend seminar or by reading any single book.  For me, it took years of research, reading, thinking and yes mistakes to fully pull my financial viewpoint to the place it is now.

The question for your consideration is do you want to continue doing what hasn’t worked?  Or, are you ready to move forward in your understanding of financial principals?

Next blog on paradigm shift I will offer a suggestion on how to move forward.

  

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