But this apparently normal behavior somehow escapes the process of purchasing financial assets. And hence, an entire field of finance devoted to trying to understand why investors act the way they do while exhibiting perfectly rational behavior in other walks of life.

But I think investors behave the way they do because most fail to make a connection between buying say a box of Tide detergent versus buying shares in Procter & Gamble that makes that detergent.

And if we dig deep enough with anything we do or consume in our daily lives, there is always somewhere a connection between a product or a service and a business that delivers that product or a service. And that business, if publicly-traded, we can also own a piece of.

My younger daughter is all things LEGOs these days. I mean she spends hours building things like these…

And her gang is into it as well so we know she is not alone.

So then the discussion as usual leads to buying a piece of the LEGO making business. But she can’t because LEGO does not trade publicly.

But then that plastic that makes those LEGOs could be coming from a publicly-traded business. Or that oil that was dug up to make that plastic had to have a publicly-traded entity behind it. And so would the businesses that make those machines to injection mold these pieces or that steel that was used to make those machines or those semiconductor chips that control those machines and on and on.

So if she owned a diversified basket of global stocks, somewhere, somehow, she owns a piece of the supply chain that went into making those LEGO pieces. So she is all squared then.

Talk about supply chain, if you never came across this Milton Friedman video, well, you did now.

So the other day, I dug up some old notes and this one dates back to June 2nd of 2012. And that scribbling was all about yields – bond yields vs. earnings yield for a portfolio of global stocks. Earnings yield by the way is the inverse of price to earnings ratio.

So the 10-year Treasury bond yielded 1.5 percent at the time when global stocks were yielding 8.5 percent (price to earnings ratio of about 12). Global stocks here refers to the FTSE Global All Cap Index.

Stocks were a bargain then. How sweet of a bargain? The last time the spread was as wide was all the way back in 1962.

And yet investors were dumping stocks left and right, for some reason or the other and at the time, that reason appeared to be the Eurozone debt crisis. In just the April of that year (2012), U.S. investors sold a net total of 20 billion dollars worth of stocks. In May, they withdrew 26 billion dollars from the stock market.

All in all since 2007, investors withdrew some 530 billion dollars out of stocks and stock-type investments.

And where did most of that money go? Into the apparent safety of bank savings account and into bonds.

But that at the time could be considered as a reasonable behavior. Not right, not logical but reasonable. Investors were terrified of the slightest of turbulence. The trauma of the Great Recession was fresh in everyone’s mind.

And hence the equity risk premium. Stocks are risky because profits are not guaranteed. But if there was no risk, the earnings yield for stocks would collapse to meet that of bonds.

But earnings or profits for businesses can and do fall. And that causes the value of these businesses and hence the stock prices to fall. So the risk.

But in hindsight, that was THE time to plow everything you had into the markets.

And what was predicted at the time to be a great time to invest was indeed a great time to invest. I mean if you were anywhere close to the stock markets this past decade, you made money.

So where are we now? The bond yields are about the same but the earnings yield for stocks have basically cratered. That is, the equity risk premium got reduced.

And most of that reduction in the equity risk premium happened because of the expansion in multiples. I mean you were paying 12 times earnings for a portfolio of global stocks in 2012. Now you are paying 17 times that.

But then it sort of makes sense. Besides that small hiccup at the onset of COVID, we have basically forgotten what risk is. The Great Recession is a distant memory. The Dot-com crash of the early 2000s is like it never happened.

And hence the complacency.

What do I personally wish? I wish for a renormalization of interest rates. That’s assuming we know what “normal” is in the interest rate world. Maybe we are in a new era and maybe we never go back to the way things were but I think we must considering all the craziness that is out there in the markets these days.

I want things to reset a bit. I want the bond yields to grow and the equity risk premium to expand back up. So technically a double hit on the price of stocks.

Painful yes, in the short run but ideal for most of us in the long run. We rather take the medicine now than having to surgically remove a tumor later. Bubbles are painful when they deflate.

So if you are a millennial or a Gen Xer, you should get down on your knees and pray for a decade of flat returns. That’ll allow you to pump as much powder as possible into the markets while the bond yields normalize and the equity risk premium reflates.

None of it says that you sell your stocks. Because no one knows the future and you don’t want to get into the game of predicting the future. But if you’ve got a reasonable plan and a decent portfolio that fits that plan, you can tweak and make adjustments to that portfolio where and when necessary but you must stick to that plan.

That of course requires conviction and conviction only comes with knowing what you own is what you should own but once that’s done, all you can and all you should do is throw as much savings as possible into that plan and wait.

Thank you for reading.

Cover image credit – Tran Long, Pexels

Venture capital as a funding model didn’t exist back then. And back then is 1960s. You needed capital to start your business? You’d rely on the faith and generosity of friends and families or you’d go down to your local bank to pitch them on the promise that was your startup.

And banks were and still are in the business of lending. They lend instead of taking a stake in your business. So a completely different business model.

And conservativeness is the name of the game. Return of capital is more important to them than a return on capital. An excerpt from that book is indicative of those times.

“Here I’d built this dynamic company, from nothing, and by all measures it was a beast – sales doubling every year, like clockwork – and this was the thanks I got? Two bankers treating me like deadbeat?”

Phil Knight in Shoe Dog

So imagine where we would be if we had to rely on capital from banks to fund our bleeding edge businesses of today.

But then we also have the landscape of today. Apoorva Dutt wrote a piece that is based off of excerpts from Dan Lyons book titled Lab Rats which talks about how Silicon Valley’s business model of moving fast and breaking things is making life miserable for the rest of us. This was in 2018 and things have just gotten crazier since then. Some choicest excerpts from her piece about Dan Lyon’s book…

“Silicon Valley has no fountain of youth. Unicorns do not possess any secret management wisdom. Most startups are terribly managed, half-assed outfits run by buffoons and bozos and frat boys, and funded by amoral investors who are only hoping to flip the company into the public markets and make a quick buck. They have no operations expertise, no special insight into organizational behavior. All they have is a not-very-innovative business model: they sell dollar bills for 75 cents and take credit for how fast they’re growing.”

Apoorva Dutt, Tech in Asia

“The vast majority of these new companies are losing money. Traditionally, to get rich in business you had to build a company that turned a profit, and then the profits were shared with investors. The new VCs have invented a form of alchemy in which they make a fortune for themselves while skipping the step about building a profitable company. I call it, Grow fast, lose money, go public, cash out. You pump millions (or billions) into a startup, so that it grows rapidly. You generate hype, flog the shares to mom-and-pop investors in an IPO, and scoot away with the loot. In 2017, I made a list of 60 tech companies that had gone public since 2011. Fifty of them had never made a profit. Some new companies lose incredible amounts of money.”

Apoorva Dutt, Tech in Asia

That’s harsh but there is also truth in that. And we can see some of that play out lately with many of the newly listed companies with their values down 50 percent and more. And they are still nowhere from being reasonably priced.

Venture capital as an ecosystem is not designed to work with a lot of capital. In fact you make things worse for startups who are doing things right and playing by the books on their plans to grow a business with profits as the end goal. And that must be the end goal for the system to flourish.

Because you can always throw junk in the public markets and the public might lap it up. To a point. It’s that same fool me once, shame on you, fool me twice, shame on me endgame.

And we don’t want that endgame.

Of course, few businesses start out of the gate being profitable. But there must be a point beyond which profitability becomes imperative. We cannot have billion dollar businesses perpetually losing money.

Mihir Desai, professor of finance at Harvard Business School and an author of one of my favorite books, The Wisdom of Finance, wrote a piece in New York Times right before Uber was about to go public and why you should root for that IPO to fail. That’s cruel but hear him out.

“This cycle – in which unsustainable start-ups make ever-larger promises to bloated venture capitalists, who promise more than they can deliver to flush sovereign wealth funds, who are too eager to believe them – distorts the allocation of capital and talent. The rush to invest, no matter the underlying economics, diverts entrepreneurial energy toward unviable business models.”

Mihir Desai, New York Times

Of course that’s nothing to do with Uber but that’s what we get when so much capital is chasing returns wherever it can find in this ultra-low interest rate environment with pension funds, endowments and even John Q public piling in.

Now that I’d depressed you enough, there’s still a decent justification for you to still participate in this ecosystem because not many avenues exist that can add sparkle to your portfolio with returns beyond what you already have access to. Plus all that thing about backing entrepreneurs and helping turn their dreams into a viable product or a service.

So how do you decide how much can you afford to invest in this space?

I’d start with my 10 percent rule. That’s your play money and venturing into venture capital is equivalent to that. Very high risk with a potential to knock it out of the park.

For those that are into statistics, traditional stock and bond investing have returns that are more normally distributed. Venture capital returns follow a power-law distribution.

And data shows that you’ll need a minimum of 50 investments to even have a shot at this.

So assuming you deploy $10,000 in each one of them, that’s $500,000 right there.

But you can’t just invest once and be done with it. You need to invest at the minimum in a follow-on round to make sure you don’t get diluted out of your initial stake.

So that’s another $10,000 for each of those 50 bets.

So you need to carve out a million dollars from your portfolio to play this game. And since this can’t exceed 10 percent of all the money you have means you can only afford to play this game if your net worth is in the 10 million dollar range.

So that’s the hard math.

The way around it is to invest in a pool with other like-minded investors. That way, you can get exposure to this asset class even with a lot less.

To me, investing in this sphere if opportunity presents itself is to be an enabler of this ecosystem. Not that it needs any of mine or yours help in the current environment.

But if there is a chance to strike it big, there is also a chance it all flames out. That’s the nature of this game and you must play the game to find out.

Thank you for reading.

Cover image credit – Startup Stock Photos, Pexels

And as it is with anything exotic and of the swash-buckling kind, the media couldn’t get enough of him. The New Yorker pronounced him the stock market’s ‘certified golden boy’. Investors’ money of course followed. And by the boatload. Assets under management in his fund grew from a mere $12.3 million in 1959 to $340 million by the time he called it quits in 1965 to venture out on his own.

He then launched the Manhattan fund seeking to initially raise only $25 million. And we know investors chasing performance never gets old and hence they clamored to get into his fund. He ultimately wound up with 10x more money than initially planned.

And you probably know how that movie ends. The Manhattan fund had two middling years and then the roof caved in. By July 1968, it was the sixth worst performing fund in the country. And just a year later, it had lost 90 percent of its value never to recover again.

About a generation later, in March of 2000 just as the bubble created by the Dot-com boom reached its zenith, Merrill Lynch, the then world’s largest brokerage firm jumped on the bandwagon with not one but two new funds to sell. The first was a “Focus Twenty” fund. The other was an “Internet Strategies” fund.

The offering of course was an incredible success. It always is towards the tail end of a mania. The funds collectively pulled in $2 billion at the onset.

But then again, we know how that movie ends. It was a money-making bonanza for Merrill but a disaster for their clients. The Internet Strategies fund tanked almost immediately. By the end of 2001, less than two years after the launch, investors lost 86 percent of their money.

The Focus Twenty did the same with a cumulative lifetime return through 2006 of minus 79 percent.

I bet if I were to try harder, I could come up with countless such stories across the many booms and busts the world over. They might all start differently but they end the same.

Something similar appears to be transpiring with some hot funds and investments du jour of the day. And you don’t have to look hard to find bubble assets. In fact there are many. Maybe I am too old-fashioned but sometimes amazed at all these businesses selling at twenty, thirty, fifty times revenues with never a sight of profits. And profits are the only thing that matter eventually.

One or two of these bubbly assets could grow into their valuation if ever but these many, never.

So we know how this movie will eventually end and that end’s not going to be pleasant. But you have a choice to make. You can either be a willing participant in the making of that movie or you can watch it on Netflix whenever it comes out. I prefer the latter.

Thank you for reading.

Cover image credit – Jonathan Borba, Pexels

But whether it is different or not can only be known in hindsight. But when a majority of investors believe that this time is indeed different and are getting rich of it is when the chasm between asset prices and their underlying value grows. That’s happened in the past and will continue to happen in the future. That’s human nature.

So is this time different? Similarities are aplenty between the current stock market boom, especially in tech, with the Dot-com boom at the turn of the last century. New public listings were seeing euphoric rise in prices then as they are seeing now. Investors were willing to fund anything and everything that moved back then whether a viable business existed or not. Something similar appears to be the case now.

And a viable business of course means not just revenues but profits and cash flows. And sustainable at that.

So though there are a lot of similarities, there are BIG differences.

The price to earnings ratio of the stock market today stands at around 30, about the same as it was during the late 1990s. So the earnings yield of the stock market hence is 3.33% (earnings/price), about the same during both periods.

Now if you had money to invest, did you have viable alternatives to bypass the craziness with the stock market back then? You indeed did.

Back in the day, a 10-year Treasury bond yielded 6.5% so you could have locked in that yield every year for ten straight years. And mortgage rates are tied at the hip with Treasury bond rates so real estate had to yield the same or more. And it did.

No such luck now with yields on that same bond at less than 1%. There is no suitable alternative. Yields are low on pretty much everything and prices are hence, sky high.

One more thing that’s different between now and back then is the sheer size of the market debuts of many businesses going public today versus in the past.

Amazon went public in 1997 at a 438 million dollar valuation, literally a small-cap. Microsoft, a decade before that had its public market debut at $700 million valuation. Apple at a billion.

So public market investors at the time were literally getting in on the ground floor. They were the venture capitalists of the day.

And we know the venture capital business model. Most investments go nowhere with only a tiny fraction of them making up for all the losers. And that is what happened back then. You had to spray your money at many businesses going public at the time to get one Microsoft or Amazon or Netflix. That’s how it works. That’s how it was supposed to work. That was the 1980s and the 1990s.

And then the market crashed. Investors who were happy making money when all was great cried foul. So the politicians intervened to ‘protect’ the mom and pop investors from themselves but in that process, they killed that golden goose of letting investors participate in the growth phase of many of the businesses of today.

Now part of that intervention was justified because of the Enrons and the Worldcoms and the Tycos of the day but I believe that the pendulum swung too far in the other extreme.

But if investors were a little prudent back then and knew how to behave and participate right in the markets, the situation could have been different. And we sure hope the story ends for the better now but it looks less and less likely with each passing day.

And hence going public today means dealing with all the bureaucracy associated with quarterly filings and reporting to ‘protect’ investors. That takes time away from actually running and growing a business so a big hassle for newly formed companies. Plus the inability of investors to think beyond the next quarter doesn’t help either.

So businesses are making their public market debuts a lot later in the cycle than they did in the past. These are big businesses. Many are a decade old enterprises with established brands generating boatloads of revenues. The only thing that is amiss are profits.

So that’s a troubling sign. And valuations are outright outrageous but investors don’t care. No price is too high because this time is…

The only silver lining with owning these newly public businesses is that a lot of the losers that would have existed in their midst in times past have already been weeded out in the private sphere.

So private investors are absorbing a lot of the failures and only the ‘real’ ones are getting to you and me. But then we miss out on the growth phase of many of these businesses so both good and bad. I think it eventually cancels out but the process of going and remaining public needs an overhaul.

So my advice, if you care, to you is this:

• Limit this craziness to a portion of your portfolio that if it all goes to zero, will not disrupt your life. Start today and slice off say 10% of your chunk and go at it. That’s your Vegas money. Don’t add more. You don’t have to do any of it but if you must insist.
• Future returns are going to be low. There is no way that risk-free rates could be zero and yet you continue making double digit returns. That’s theoretically not possible. So don’t get used to this and plan to save more.
• The party will be over at some point. Low interest rates amplify asset volatility and the only side we are getting to see is the positive side of that volatility. The negative side is coming. That’s not to fear though. Just expect it and embrace it by sticking to your plan.
  

Rounding this off with this snapshot of a tweet from Chris Sacca, an early investor in some of the hottest brands around (Twitter, Uber, Instagram). I like him a lot. He means well. And there are many more in this business today who mean well. They are a different crop who care about all stakeholders and for them, making money is just one aspect. That should remain and that’s great.

So that’s that.

Thank you for reading.

Until later.

Cover image credit – Andrey Grushnikov, Pexels

But then you didn’t have much roads to build and maintain or government programs to run or the school system to educate or much of police, fire or military. They all came about and they cost money and hence the situation now.

The Federal income tax started out small with a base rate of just 1 percent on personal income but that came along with an exemption (no taxes) of $3,000. That virtually exempted the entire middle class from paying any taxes. On incomes above $20,000, there was an additional surtax of six percent.

And we are talking 1913 dollars here so a $20,000 income back then was huge. So only the super-rich had to worry about paying any taxes at all. 1913 by the way was also the birth year of the form 1040 that you still use to date to report and file your Federal income taxes.

So a simple little form that even a fifth grader could understand and file. But that was in 1913. That same form today goes on for pages and pages with all the modifications and additions to the tax code over the years. So not a simple process to file anymore.

But Federal income taxes are not the only taxes you owe each year. There are payroll taxes (Social security, Medicare) you pay that directly come out of your paycheck. Then there are state and local taxes, taxes on dividends, capital gains taxes etc. So taxes and more taxes. Approaching that 50% mark in terms of the total taxes you pay each year is completely plausible in some cases.

Now that you are happy, the system the way it’s designed is also fair. Or say fairer. That is, it’s progressive. As you make more money, you pay more in taxes. We’ll dig into that a bit more but before that, this is the general outline of our tax code.

Income is a combination of all things below.

Wages and salaries are typically what’s reported on Box 1 of your W-2 that you’ll need to file your taxes. Unless of course you are an independent consultant/contractor and receive a 1099-MISC with income reported on Box 7 of that form. That’s akin to running a business and hence is reported as business profits (or losses) in the income section above.

You could have both W-2 and 1099-MISC incomes in any given year if you have any sort of a side-hustle apart from your day job. And many do.

So what’s on a W-2? A detailed breakdown below…

The total Social Security taxes you paid for a year are reported on Box 4 of the W-2 and Medicare taxes on Box 6. Now it’s not completely fair to call them taxes as these are monies that you put in a system that pays for retirement and healthcare expenses for folks who are currently retired. But when you are done working and reach an eligible age, you’ll get some or most of it back from folks who are working and paying into the system then. So it’s a societal construct and a promise that’s made between generations and it’s an overall good thing. Not perfect but good.

But there are questions with respect to the sustainability of these constructs which we hope the leaders we elect will help resolve over time.

Apart from W-2 and 1099-MISC incomes, there is interest income that’s reported on something called 1099-INT that you’ll get from your bank that reports the interest income you earned on your savings for the year. You likely won’t have to worry much about earning anything on your savings these days though but you could if your stash has any heft.

Then there is dividend income that you’ll have to pay taxes on if you own stocks (publicly traded businesses) and when those stocks distribute profits back to you, the owner (stockholder).

Capital gains (or losses) are exactly that – gains or losses on an asset from the time it’s purchased to the time of its sale.

And business profits (or losses) we know. It could be anything that you make money off of and making money means paying taxes.

So that’s all the income but you don’t pay tax on all of that. You get to deduct a few things from that income to arrive at net taxable income.

What can you deduct? The most common ones below…

Your taxable income reduces by the amount of deductions allowed. So say your gross income is $50,000 for the year and you are filing as a single person and you rent instead of owning a home, your taxable income reduces by the standard deduction of $12,400 and you get taxed on the remainder of that.

Then comes the actual calculation of the tax due. We are part of a system that taxes income progressively. Almost all taxes are by the way. The more money you make, the more taxes you pay. It’s debatable whether it does an overall good or not and one can argue that at the margins, it does tend to discourage incentives to make more. I mean if you are in the highest tax bracket and the fact that the next set of dollars you earn, almost half of that is going to be taxed away anyway, that does create a little bit of discouragement to go out and make those dollars.

But then a healthy country needs a healthy middle class else we’ll all be living in armed and gated communities like many affluent folks do in other parts of the world where extreme gaps between the haves and the have nots persist.

But the system we are part of (capitalism), if not corrected from time to time, does tend to perpetuate accumulation of capital in the hands of the few. That’s the way it is designed so a bit of income and wealth distribution is for the overall good. Hence the tax structure the way it is.

And this is how taxes are calculated…

But then there are credits that directly reduce your tax bill. They are again designed to help folks on the lower income segment of the society to potentially help reduce or eliminate any tax liability thrusted upon them.

Tax credits fall into two camps; refundable and non-refundable. If a refundable tax credit exceeds the amount of taxes owed, the difference is paid as a refund. If a non-refundable credit exceeds the amount of taxes owed, the excess is lost.

Let me clarify that with an example. Say your tax due comes to a $1,000 and a refundable tax credit that you qualify for is in the amount of $1,250, you’ll get the difference in $250 back as a refund. But if that tax credit were non-refundable, your tax bill will drop to zero but you will not get any money back.

So not only do you pay no tax but you could get money back from your fellow taxpayers, if you qualify.

And after all that math, you get to your final Federal tax due bill. Then you’ve got state income taxes if they apply. Plus city taxes in some cases (New York City).

Now that we know a bit about how taxes work, let’s run through some scenarios to see what an individual’s total tax bill could amount to and what could be done to lower that.

This, for example, is a W-2 this single wage-earner residing in CA gets at the end of the year.

The taxes he or she ends up paying when filing a tax return that everyone MUST do come April 15^th of each year…

But that’s not all the taxes this individual pays for the year. A complete list…

Let’s take this same individual but this time around, he or she contributes to an IRA and to an HSA. The updated W-2…

The tax math when filing taxes…

His or hers total tax bill for the year…

So not only was this individual able to lower his or hers tax bill but now there is money that is invested on a tax-deferred (IRA) and tax-free (HSA) basis till retirement. So much better.

Let’s look at a few more scenarios. Here’s one where now we have two wage-earners with no kids (dual income, no kids, I mean DINKs) making great incomes and also CA residents. Both partners get a W-2 each at the end of the year and for simplicity’s sake, we’ll assume that to be the same for both.

So even with access to a retirement plan at work, both decide not to participate. The tax math hence…

The combined W-2 Box 1 income is 2x of what’s shown in the W-2 because dual income. The total of all taxes paid…

So not fun. But doing the same tax math assuming they had done what they should have done…

And the impact on total taxes paid…

So about $15k in total tax savings for the year by doing it right.

Of course, there are many permutations and combinations with the complex tax code we have but this hopefully gives a good overview of how our taxes work. And this applies to most of us.

Now only if we could figure out a way to make our government spend our tax dollars ‘right’.

That does it. Thank you for persevering through something as dull and dry as taxes. Not as fun to write about but necessary.

Until later.

Cover image credit – Oladimeji Ajegbile, Pexels

But why does this happen? To answer that, let’s think about what it would be like to have the opposite of that and that’s deflation. If the prices of goods and services were to fall every year instead of rise, you’d wait to buy whatever you were in the market to buy because it’s profitable (for you) to wait. You’ll be able to buy the same stuff cheaper tomorrow or next month or next year than today. So it’s great for you but if everyone started doing this, the overall demand for stuff in the economy will fall. If demand falls, businesses would have to cut expenses and with their biggest expense being people, many will lose their jobs. No job means no income and no income means no spending. So demand reduces even more and a vicious cycle sets in that can swallow an otherwise healthy economy. 

So an all-out deflation is bad but then is it always that bad? Let me explain with something that just transpired. My crazy dad was in the market for a standing desk to make working from home easier (and healthier) so he looked around to see what fits his budget. But just as he was about to buy a desk, he realized that he could improvise with the desk he already uses. A construction crew around our house left behind some dirty paint buckets that were supposed to be recycled. But we all should know by now that recycling is a myth, sold by the plastics industry. A very tiny fraction gets recycled if it does at all with the rest ending up in landfills.

So back to those buckets, oh they were real dirty and hence needed to be cleaned to make them be a part of his setup. But then he could have easily bought those buckets to be used as a foundation for his existing desk for say $3 a piece (he needed 4 of them). 

But instead, a minimalist that he is who hates waste, especially of the plastic kind, he cleaned those buckets and is using them as a pretty solid base for his standing desk.

But how does this one small decision trickle through our economy? In the process of DIYing his standing desk, he deprived the stores selling the desk and the buckets from making a profit. So both these businesses got impacted (though by a tiny amount) with this one decision. But multiply that by a thousand and now the stores are hurting. If stores are not doing well, they’ll have to cut expenses and maybe, they’ll resort to laying off employees. Once laid off, the employees then stop consuming and in turn, starting a chain reaction that impacts the entire supply chain.

So my dad’s decision to not consume is great for the environment but not so great for the economy.

Now let’s talk about Japan. Since the bursting of the twin real estate and stock market bubbles in 1989, the economy hasn’t been able to recover. The country since then has been mired in a deflationary spiral and with that comes fewer and fewer available jobs so it becomes harder to raise a family. So folks are delaying getting married and are having fewer children. Fewer people means less demand. So when goods are produced at the same rate and the demand declines, prices drop and deflation becomes ingrained in the system. That’s today’s Japan.

But increasing demand through population growth is not the right recipe, especially in light of the resulting environmental impact. What would be ideal is to grow demand with the global population we already have by uplifting the billions who are currently not enjoying anywhere close to the standard of living we in the West do. That’s fortunately changing for the better but we have a long way to go.

Deflation did once visit the United States post the stock market crash of 1929 when a lot of people lost a lot of money all at once. And since most of that money was borrowed money from the banks, a system wide banking collapse ensued. Thousands of businesses failed and unemployment skyrocketed to up to 25%. People who still had jobs just froze and stopped spending, setting off a deflationary spiral just like what Japan encountered many decades later. But fortunately or unfortunately, the economy was rescued out of that spiral through government spending on the Second World War effort.

So an increased savings rate in general is deemed good but when everyone starts to save all at once, things can get real bad, real fast. That’s what economist John Maynard Keynes once described as the Paradox of Thrift where it’s great in the long run if people save money but if they do it all at once, it can have disastrous consequences. 

So now we know why we don’t want deflation but what about inflation? Prices of goods and services rise over time but why? And is that good? 

Inflation in an economy is sort of intentional and is designed by the Central Bank of a country. Central Banks control the money supply in such a way that there is always a little more money in the system in any given year chasing the same quantity of goods and services in an economy. So what does that do? It causes prices to rise by just enough so that demand for stuff in an economy is always present. And because stuff gets more expensive over time due to inflation, people will not wait to buy what they need for better prices tomorrow or next month or next year. This keeps the businesses busy producing the stuff people need, employees employed and the economy stable.

So now that we know that inflation is going to be ever present, how do we make sure that it doesn’t hurt us in the long run? I mean how do we keep our purchasing power intact over time so we can buy the same amount or more stuff tomorrow, next month, next year and decades from now? 

Inflation rate in the United States historically has averaged at around 3% so if we want to make sure that we can buy the same amount or more stuff, we will have to beat that rate over time. Depositing our savings in a bank could be one option but banks don’t usually pay interest more than the rate of inflation so that’s not an option. So what do we do?

Let’s take that In-N-Out Burger’s situation for example. Say the cost of potatoes that’s used in making fries rise due to inflation. What would In-N-Out do? They can keep the price of the fries you buy the same but if they do, their profits decline. And if they keep doing that year after year, they can start to lose money. And no business exists to lose money. So they raise the price of those fries to compensate for the increase in the cost of potatoes to keep the profits the same. And sometimes they improve their process to make fries faster and better to meet demand or they offer different types of fries at a higher price. All these things increase profits which increase the value of that business. And if you own that business, not only do you match inflation but in the long run, you are likely to beat it.

So how do we own businesses? Through the stock market where pieces of thousands of businesses are on sale every day. All you have to have is some savings to go out and buy them. 

But a very high inflation rate (hyperinflation) is not good either. That causes the prices of goods and services to rise much faster than the supply. And why is that not good?

Say you are in the market to buy a laptop. If you believed the price of that laptop would be 20% higher next week, what would you do? You’d go out and buy that laptop right away. Not only that, sensing that the price will rise by that much in a week, you’d buy 10 laptops. Why? You’d keep one for you for sure but the remaining nine, you’d sell at a profit next week. And if everyone did that, the stores would run out of stuff with no one able to buy anything, especially if the supply can’t keep up. I think you get the point.

So both deflation and hyperinflation are not good though you could live with a bit of deflation here and there. What we ideally want instead is a Goldilocks type of economy where the price of all the stuff we consume does not drop like crazy and does not skyrocket like mad either. It just chugs along.

So that’s all for now. Thank you for reading.

Until later.

Cover image credit – Retha Ferguson, Pexels