 
THE Quick Guide to

## RISK-MANAGED INVESTING

### How to Invest in Today's Turbulent Markets

### By

### David Cretcher

Copyright 2012 by David Cretcher

Smashwords Edition V 1.2

Smashwords Edition, License Notes

This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you would like to share this book with another person, please purchase an additional copy for each recipient. If you're reading this book and did not purchase it, or it was not purchased for your use only, then please return to Smashwords.com and purchase your own copy. Thank you for respecting the hard work of this author.

  1. Table of Contents

Title Page

Chapter PREFACE

Chapter INTRODUCTION

Chapter One \- BUILDING PORTFOLIOS WITH RISK-BASED ASSET CLASSES

Chapter Two – FLOTATION

Chapter Three - POWER

Chapter Four – WIND

Chapter Five– WEIGHT

Chapter Six – COUNTERBALANCED PORTFOLIO DESIGN

Chapter Seven – Appendix: HOW MONEY MAKES THE WORLD GO ROUND

##

Chapter PREFACE

If you're having difficulty managing your assets in these turbulent times, you are not alone. Most investors are challenged and troubled these days. The advice they receive from advisers, friends, and the media often doesn't make sense, or worse yet, doesn't work.

This book seeks to solve these problems by getting past the investment industry hype and providing the average investor a simple method to construct risk-managed portfolios that work in these turbulent and difficult markets. It explains how to construct a portfolio using alternate methods from those commonly promoted by investment advisers and financial theorist.

This book shows you how to design portfolios based on counterbalancing asset classes and economic risk versus blindly allocating your wealth within a colorful pie chart of traditional asset classes like stocks, bonds, and commodities.

This book is valuable to investors looking for a better solution after having little success with common portfolio strategies like asset allocation strategies, age-based portfolios, efficient frontier or other theory-based strategies.

Chapter INTRODUCTION

At the least, a well designed portfolio must protect the investor from two major risks. First, the risk inflation devaluing the worth of the money the portfolio is denominated and second, the risk of deflation devaluing the worth of the investments in monetary terms. Inflation devalues the portfolio when the portfolio assets can be sold for the same amount of money or more but the money received is not worth as much as the initial investment. Deflation devalues the portfolio when the money is worth as much or more, but the investments themselves are worth less money. The effect is the same - the investor loses.

A well designed portfolio should also capture the economic growth generated from the expansion of the economy and the gains from asset price inflation or the relative increase in asset prices driven from increased enthusiasm for the asset by the investing public.

Most popular investment methods focus solely on capturing the last two forces, economic growth and asset price inflation, and ignore or under-estimate the risk of inflation and deflation. By doing this they leave the investor without any protection from inflation and deflation.

In the 1960s and 1970s, investors lost money when inflation devalued the stock market. The market was relatively flat at a time monetary inflation was moderately strong. In the 2000s investors lost money when deflation devalued the stock market the market was flat at a time that inflation was relatively weak. In the later part of the decade, financial asset prices declined rapidly as financial asset prices deflated from a lack of money pressure in the economy. Modern portfolio design under-estimates these forces.

The main failure of these orthodox portfolio strategies is an over reliance on financial theory that doesn't work in the real world. These theories rely on mathematics, and the use of statistical bell curves and volatility measures to manage portfolio risk. According to modern financial theory, the markets act like a gambler rolling dice. Risk is defined as the amount of fluctuation the investment normally experience or how far the dice roll lands from the average.

According to theory, stocks are riskier than bonds, not because bonds have a promise to return an investor's money and stocks don't, but because the historical prices of stocks fluctuate more than bonds. Within the theory, rolling one die with an outcome between one and seven is less risky than rolling a pair of dice with an outcome between two and 12, since the range of outcomes is smaller. Furthermore, risk is variable but not uncertain, all the players are rational and have all the available information all of the time.

When a gambler throws a pair of dice the result vary, but they aren't uncertain. The gambler knows the total will be between 2 and 12. The person rolling two dice knows with certainty he won't roll a 16 or a 1. In reality, markets don't work within a finite range and everyone participating in the market doesn't know everything or always act rationally.

Theory-based portfolios fail when the markets, unlike dice, don't react within a known range of certainty. This is what happened during the recent financial crisis. The market didn't act within the range predicted by the theory. It misbehaved. When the markets misbehave, the investments misbehave and when the investments misbehave the theory fails.

Investors need strategies based on practice, not on theories. In theory, if you drop a brick and a feather at the same time they will land at the same time, in practice they won't.

The second problem is investor rely too much on plans not strategies. Plans describes what you are going to do, a strategy describes what you are going to do if the plan doesn't work. Strategies provide reactions when the observations changed or the assumptions prove wrong. A typical asset-allocation sold by nearly everyone in the investment industry will work if the markets act like they predict. But, what if they don't?

Many investors lost money on conservative asset-allocations during the financial crisis, because the plan was rigid, the assumptions were wrong and there was no strategy to implement when assumptions failed. In the end, the plans weren't conservative at all. The most common strategy is to do nothing, wait it out, sit and take it.

Investors need a flexible portfolio strategy that is non-theoretical, non-mathematical and based on the real world. In the real world the assumptions change quickly and the markets act more like weather patterns than like dice rolls.

In practice, investors expose themselves to risk and lose money on investments for three common reasons:

1) Not knowing how the economy works and how it interacts with the financial markets.

2) Not understanding how economic events affect the behavior of investments.

3) Being caught off-guard by a future event they didn't plan for or expect.

Sometimes one or two of these pitfalls put investors into trouble, sometimes its all three.

In the first part of this book, I explain how the economy is misunderstood by the average investor and show how it works mechanically via money pressure and money flows and and how investors can develop a weather-eye for possible changes in the economy.

In the second part, I cover how to build a portfolio allocated by risk factors instead of simple asset classes. These are new easier to understand asset class definitions that will keep you from getting caught off-guard.

The selection of investments and their risks is based on the Money Pressure Model of the economy. This model is somewhat complicated so don't get hung up on it, just know that it exist and affects investment behavior. Readers looking for a more complete treatment can find it in Appendix One of the book. To build risk managed portfolio's investors should have a basic idea of how money pressure is created within the domestic economy and how it is absorbed.

HOW MONEY PRESSURE IS CREATED AND ABSORBED

In the US economy, the money pressure is created from five main sources:

1) New money spent into the economy by the federal government.

2) Money returned to our economy from foreign economies.

3) New bank loans created by commercial banks and spent into the economy.

4) Money spent from savings.

5) And last shrinking economic capacity in the US economy caused by labor or resource input constraints.

Increases in these six sources build money pressure within the economy causing activity to increase in the economy.

Conversely, money pressure is absorbed by five opposite actions:

1) The federal government can renmove the money by taxing it out of the economy.

2) Money can be spent outside the US economy on foreign goods including oil.

3) Bank loans can be repaid or defaulted on destroying the credit.

4) Money can be parked away from the economy by being saved into a bank account or government bond.

5) And last the domestic economy can expand to accommodate the pressure subject to resource constraints.

Increases in these five actions cause the money pressure in the economy to drop and reduce activity in one or more sector.

This money pressure drives the US economy by circulating through it like steam through a turbine, spinning the wheels of commerce, producing goods and services which create wages and profits that are re-spent, saved or invested. When there high pressure the economy is grows and the wheels spin faster and the money is re-spent to maintain the economic activity. When the money pressure drops the economy contracts and the wheels spin slower creating less wages and profit available to be re-spent lowering the activity level of the economy.

When there is too much Money Pressure withing the circuit to be absorbed by the domestic economy or vented out of it by savings, taxes, loan payoffs, or unrequited import spending, the excess pressure can inflate the domestic and create economic growth, inflate financial asset prices like houses and stocks, or inflate the price of goods and services. If there is enough pressure it can do all three, but this is rare.

Money pressure affects how to choose and think about your investments and gives you a way to analyze the mechanics of the economy without relying on the politics and bias of the news reporting and axe grinding commentators.

Chapter One - BUILDING PORTFOLIOS WITH RISK-BASED ASSET CLASSES

Traditional investment classes fail to effectively isolate the different movements of the economy making it difficult for the investor to understand the behavior of different assets and ultimately the risk inside of their portfolio.

Investors have two financial opportunities.

**Economic Dynamics and Growth.** First participating in the economic dynamics and growth of the economy. This is the motivation behind owning a business. This is the opportunity to capture money flowing through the domestic economic circuit of the economy. Typically the nominal GDP, the GDP not adjusted for inflation, grows around four to six percent per year and two to three percent per year after adjusting for inflation. Economic activity is the result of steady money pressure inside the domestic economy. Economic growth is the inflation of production capacity and requires increased money pressure.

**Financial Asset Inflation.** The second and more profitable opportunity is to capture financial asset inflation. This is the opportunity to sell your investment for more money than you paid not because the investment generates more money, but because the general public values the investment more now than it did in the past. It is a sign of high money pressure and is represented by an increase in the Price/Earnings ratio(P/E) of the investment. Because Asset prices do not always inflate in relationship to economic growth these two opportunities do not always coorelate.

These broad opportunities are balanced by two broad economic risks.

**Goods and Service Inflation:** First, goods and service inflation or a decrease in the relative value of money. Increasing goods and service inflation typically lowers the quantity of financial asset inflation and the P/E ratio of stocks. Inflation is a sign of high money pressure and in extreme doses, inflation can harm the economy. The inflation occurs when money pressure in the economy can't be vented off by other activities like, economic expansion, savings, taxes, increased imports or decreasing bank loans.

Contrary to common belief, inflation even high inflation doesn't always slow economic growth. The economies of Brazil and Israel and the US in the 1960's have grow with very inflationary economies. Understand that hyperinflation, like Wiemar Germany and modern Zimbabwe is a different animal and is a form of economic collapse. It is caused by many events that cause money pressure and velocity to hyperexpand usually driven from a common refusal to save the money in government backed savings, to tax it back, and the refusal of other economies to accept it in exchange for resources, foreign produced goods, or in exchange for other currencies. Inflation is common in world economies, hyperinflation is exceptional, rare and destructive. The risk of inflation is usually overblown in the media because it is a hot button for investors and an opportunity for gold salesman (which by the way is not a good inflation hedge).

**Economic Deflation:** The second risk is deflation. Deflation is caused by a rapid venting of money pressure, this lack of pressure reduces production utilization and economic growth and financial asset prices. It can in more extreme cases deflate goods and service prices. Investors must concern themselves most with the deflation of financial asset prices or the P/E ratio. Deflation in other areas of the economy may or may not affect asset prices.

TYPES OF RISK-BASED ASSETS

There are four broad types of classes based on the effects of these four money pressure mechanisms, goods and service inflation, financial asset inflation, steady economic growth and general deflation. These assets have two types of liquidation behaviors and two types of benefits to the investor.

The four risk-based classes are:

**Wind Assets** are speculative assets driven by money pressure blowing into the financial asset circuit and inflating price-earnings ratios in the stock market and prices in the financial markets. They perform best in when there is increasing money pressure accompanied with low or steady goods and service inflation. These assets can provide impressive capital gains.

**Power Assets** excel in an economy where the wheels of commerce are spinning steadily and there is low general inflation. Economies where businesses and people are earning money and can pay their bills on time. These assets provide reliable income to the investor.

**Weight Assets** are risk-free assets or hedging assets that perform best when the economy slows, people stop investing, and save money into government-guaranteed savings accounts and government bonds. These assets provide stability and protection to a portfolio.

**Flotation Assets** are inflation protected assets. These assets float the portfolio above the effects of goods and services inflation when the wheels of commerce can't turn fast enough to absorb the pressure and the money pressure can't be vented into savings, foreign goods purchases or stock market inflation.

In addition, there are three broad types of investment characteristics within these asset classes:

**Self-liquidating and non self-liquidating investment** \- Self-liquidating investments return money to investors automatically without the need to sell the asset to another buyer. A bond or bank CD returns money to the investor at maturity without the need to sell the asset. These assets self-liquidate. Investments that must be sold to convert to cash are non self-liquidating. To get money from a share of stock an investor must sell to another investor. Stocks, gold, commodities and real-estate are examples of investments that do not self-liquidate.

Investments that don't self-liquidate are more susceptible to phantom money valuations. For example, your brokerage statement says your stock is worth 10 dollars a share, but when you go to sell it you only get seven, where did the three dollars go nobody took it from you. The 10 dollars on the statement is phantom money, it is an estimate, not the actual value. Self-liquidating assets are easier to value because they return money automatically to investors, when a bond matures for 1000 dollars that's what you get, there isn't phantom value .

**Front-ended and back-ended investments** \- Front-ended investments provide the investor the financial benefit of the investment at the beginning of ownership. For example, a bond investor receives interest payment immediately at the front-end. Conversely, a stock investor doesn't realize the gain, or loss, until the share is sold at the back end of the transaction.

Back-ended investments are problematic for savers because they don't know how much cash they will receive until they are sold, and if it falls short it is often too late to recover. Retirement age savers that were hit hard in the global financial crisis experienced this problem.

**Risk Assets and Non-Risk Assets** \- Risk assets are speculative assets that can lose some or all of their value, like stocks, bonds, commodities, mutual funds and exchange-traded funds. Risk less assets are government-guaranteed assets like FDIC insured bank accounts, US Savings Bonds, and treasuries. These are assets that you can't lose money on if held to maturity, or at least nobody ever has.

CONSTRUCTING A RISK-MANAGED PORTFOLIO

A risk-managed portfolio is comprised of using all four of these asset classes to protect against the different consequences of money flow and pressure patterns in the economy. At its simplest, an investor would just allocate 25 percent to each asset class. But, since all not outcomes are equally likely to occur the investor may want to adjust the allocation to their match their assessment of the economy. By observing the economy's money pressure and its money flows the investor can adjust the allocation percentages to provide the protection they desire.

When additional money pressure is being generated by easy loans or increased government spending and the pressure isn't vented by savings, taxes or foreign spending - investors can increase the Wind Asset allocation in the hopes the pressure flows into the financial asset circuit and causes stock price and financial asset inflation.

Investors should allocate more toward Ballast Assets if loan defaults are lowering pressure or significant money pressure is being vented from increased taxes, increased gasoline prices, increased savings. During the recent financial crisis pressure was diverted toward savings in government-bonds and bank accounts.

When the money pressure is flowing through the domestic economic circuit you can move toward Power Assets and collect the steady income. Like when the economy is healthy and growing but not creating stock market inflation as in the 1960's.

More should be allocated to Floatation Assets when pressure is building and it appears it can't be vented to increased foreign goods purchases, higher gasoline prices, increased taxes or more savings. This occurred last in the 1970's when there was increasing un-vented money pressure.

By using this portfolio construction method you will understand why you are investing in an asset class and which economic outlook you are protecting yourself from and which outcome you are hoping to exploit.

ANALYZING YOUR CURRENT PORTFOLIO

To better understand this process you should take time to analysis your current portfolio, determine its advantages and disadvantages, and determine what behaviors it will express under different money flow scenarios. You can do this in four steps.

Step One - take inventory of your current positions. If you're starting with cash from your bank account it is easy. Cash is a Weight Asset. If you're all cash your 100 percent Weight Assets.

If you are not starting with cash then figure how much of your portfolio is currently in cash, money market mutual funds, short-term CDs and in US Treasury securities. Those Weight Assets are the ballast in your portfolio. Write down how much you have and label it Weight Assets.

Step Two - look and determine how much of your money is in Flotation Assets. Any TIPS or type I savings bonds are Flotation Assets. Commodities and Gold are not Flotation Assets. They are risk assets that rely on asset inflation and therefore are Wind Assets. Any mutual funds or exchange traded funds(ETF), or unit investment trust(UIT) invested in TIPS are also counted as Flotation Assets. Write them down.

Step Three - count up non-Treasury bonds, this includes corporate and municipal bonds, preferred stocks or mutual funds, UIT and ETFs that invest in them and count these as Power Assets. Government and non-government mortgage-backed securities if you own them are also Power Assets. Put these down on your list an label them.

Step Four - non-liquidating risk assets like common stocks, real-estate investment trusts(REITS), gold or commodities are Wind Assets. Again these can be in individual shares or mutual funds, ETF's, or UITs. Mark them down as Wind Assets.

Last, add each of these categories up Weight, Flotation, Power and Wind and visualize what your portfolio looks like. What percentage do you have in each of these categories? What economic circumstance does it look like your portfolio is most prepared for? If you're like many investors it will be mostly Wind Assets, a few Power Assets, a tiny amount of Weight Assets, and no Flotation Assets. A portfolio of this construction excels when there is a high pressure economy with the pressure driving stock inflation. It performs poorly in a low-pressure economy or a high-pressure economy that is generating significant goods and services inflation.

After reading this book, you should be able to look at your allocation, visualize it's personality, and understand how it will behave under different economic scenarios.

For instance, a portfolio with significant Weight Assets does well in a low pressure deflationary environment, but generates little in income and capital gains. An allocation heavy with Wind Assets excels in a price stable high pressure economy driving money pressure through the financial asset circuit and founders in a turbulent low-pressure market. It also does poorly when there is high inflation or any type of deflation.

A portfolio of Power Assets generates good income during steady periods of economic growth when money pressure is strongest in the domestic economic cycle, but misses the opportunity to participate in good stock markets. Take a closer look at you portfolio's Power Assets, and determine if the power is reliable or unreliable, is it invested in reliable high-quality bonds or is it in unreliable low-quality junk bonds?

Does your portfolio provide any protection from goods and service inflation ? A portfolio with few Flotation Assets performs poorly when there is general inflation as stocks and bonds do poorly during periods of high-inflation.

Visually does your portfolio protect you from the risks you worry about? How will it fare when the money pressure flows toward stocks, or bypasses stocks and expands the domestic economy, how will it respond to decreasing in money pressure? To get to those answers let's take a closer look at each of the new asset classes.

Chapter Two - FLOTATION ASSETS

Flotation Assets form the core asset of your portfolio. You want assurance that when you sell an asset the money received will buy the same quantity of goods and services as the money spent. Flotation Assets make that assurance.

Flotation assets gain when high money pressure can't create economic expansion or be absorbed into savings, taxes, or foreign goods purchases. When this happens it is instead converted into goods and services inflation. Flotation assets provide protection by floating the portfolio above the increase in goods and services inflation. Inflation can sink a portfolio in real terms, even a portfolio making steady gains, if those gains fail to keep up with the inflation rate.

For example, if your financial goal is to pay for a child's college and you saved a $2,000 bonus when they are a year old. If during this period the portfolio trails inflation by 2 percent per year earning 3 percent when the general inflation rate is 5 percent, then after 18 years you'll have have lost 20 percent of your buying power. The small yearly inflation rate compounds. Just like a good investment compounds positively, inflation compounds negatively.

The first goal of an investor is to not lose value and inflation is another way to lose value. Often, all an investor needs to be successful is to keep up with inflation.

CORE FLOTATION ASSETS

**Treasury Inflation Protected Securities (TIPS)** \- For U.S. investors the core of the portfolio is built using the safest inflation adjusted asset available - U. S. Treasury Inflation Protected Securities (TIPS) or alternatively an type I US Savings Bond(I-Bond). These securities are both government guaranteed and indexed to the official government CPI. TIPS are available to investors through the bond market, mutual funds and ETF's. I-Bonds can also be substituted. They are similar investments.

Before TIPS were first sold in 1997, if investors wanted inflation protection it was hit or miss. There was no pure inflation protection. The introduction gave investors a new government-guaranteed method to protect portfolios from goods and services inflation. Prior to this investors used assets like stocks, real estate or gold for inflation protection, but these investments are unreliable protection because they capture mostly financial asset inflation. Stocks have also historically performed poorly in times of very high-inflation.

How TIPS work - a bond is an investment where the investor gives some entity money, the issuer, usually a government, municipality or a corporation and the issuer in return promises two things, a coupon amount and a maturity amount. The coupon is an interest payment, i.e. 3 percent per year paid semi-annually in 1.5 percent coupon amounts and the maturity a fixed amount known as the face value paid at the maturity of the bond.

Long ago a bond was a big sheet of fancy paper with rows of coupons attached. These coupons were clipped and sent in to the issuing company for interest payments. The last coupon was sent in with the bond for a full payment of the face value. Now days the fancy paper is gone and it is all processed electronically.

For example, a 10 year $1000 par value bond with a 3 percent coupon pays an investor $30 per year in two $15 coupons and at the end of 10 years the issuer pays the investor the face value of 1000 dollars. As long as the issuer doesn't go broke, investors can expect to get their money back with interest. That's your upside with a bond you get your money back with interest The downside is the issuer defaults or partially defaults and misses payment.

TIPS and I-Bond provide additional upside. The bonds not only self-liquidate but they liquidate in an inflation-adjusted amount. The US Government adjusts the par value of the bond upward by the semi annual increase in the CPI. If there is deflation, the bond can be adjusted down from the inflated amount but never less than the original face amount.

For example, if the CPI increases 2 percent in the first six months, the new par value on a 1000 bond becomes 1000 dollars plus 2 percent or 1020 dollars. In the next period, if the inflation rate is negative, or deflationary by 3 percent, the bond goes back to its par value of 1000 and not below it. Because of the inflation protection the coupon rate is much lower.

Flotation Assets form the portfolio core because TIPS are the most stable assets. A $25,000 par value TIP has an asymmetric return because it never goes below $25,000, providing some deflation protection, but when the rate of inflation increases the bonds are indexed up. This provides both a deflation and an inflation hedge within the portfolio backed with a full faith and credit guarantee from the U.S. Government.

Because the face value of TIPS can be high many ordinary investors will need to invest in TIPS indirectly using a mutual fund or ETF. Be aware that a mutual fund unlike a straight bond or savings bond is a risk asset because it loses the self-liquidation feature. To liquidate the investment owners of mutual funds must redeem their shares with the fund company at the market rate. The market rate may or may not be more than the investor paid.

Another convenient way to buy TIPS is to use exchange-traded funds or ETF's which trade on an exchange like stocks. ETF allow investors to buy TIPS in a small amounts and to have the liquidity of a market. Like mutual funds, ETF's are risk assets because they do not self-liquidate and must be sold on an exchange at market price. The investor may or may not get their money back. Because these two products are risk assets they are a second-best option. ETF do have the advantage of daily trading and the option to use stop losses, which can be deployed in more complex risk-management strategies.

TIPS, are back-ended like stocks but self-liquidating like bonds. TIPS pay very little interest, with the gain coming in the inflation adjustment when the bonds mature. They are back-ended because an investors won't know the final index value until the bond matures.

I-Bonds are inflation adjusted U.S. Savings Bonds available directly from the U.S. Treasury in denominations from $50 to $5,000. There is currently a purchase limit of $5,000 per person per year, and a penalty if cashed out before 5 years. They work well but need to be held outside of your brokerage or investment accounts. You can learn more about I-Bonds at treasurydirect.gov.

Many investors shy away from TIPS because of low and occasionally negative interest payments often less than 1 percent. The low coupon makes TIPS unattractive to most investors, but their inclusion in the portfolio provides two important qualities, a benchmark against which to compare the yield of other assets and the needed protection against unexpected inflation.

In some circumstances TIPS many be the only investment needed. An investor can build a workable intelligent portfolio comprised only of TIPS or I-Bonds and own no other investments. If your only goal is to keep pace with inflation, Flotation Assets can do the job. This investment class guarantees your wealth and income until you need it. The other assets wind, power and weight are optional.

FLOTATION ASSET RISKS

Like any assets TIPS and I-Bonds are not risk free. Even with a government guarantee and inflation indexing there are four risks.

First is the market risk from selling early, if you need to sell before maturity you are at the mercy of the current market price. This isn't a concern if you hold to maturity. Investors that invest through ETF's and mutual funds are always at the risk of the market.

Second, the longest maturity is 30 years and if your time-frame is longer you will need to purchase new bonds and the interest rate may be different, or maybe the Treasury may stop issuing them if inflation is high.

Third, the government may do a poor job of measuring general inflation. The calculation may differ from the actual inflation amount. Also, not everyone consumes goods and services in the average way, if your consumption patterns are skewed toward consuming more inflationary items, you will fail to keep up with your own personal inflation rate.

Last, TIPS are back-ended investments and the inflation protection could go unused. When there is deflation instead of inflation, you suffer with a long-term low-yielding investment. That is why a well-constructed portfolio also has protection against deflation.

STOCKS, REAL ESTATE AND GOLD ARE NOT INFLATION PROTECTION

Stocks are provide poor inflation protection, although they are commonly sold for that purpose. Stocks capture money pressure that creates stock price inflation or P/E inflation, not goods and service inflation. Stocks only provide inflation protection when those two inflationary forces coincide and that isn't very often. For instance, in the late 1980's inflation was high, but the stock market declined.

Gold is also unreliable inflation protection. It captures money pressure causing commodity inflation and speculation driven gold inflation. There was steady inflation between 1980 and 2000, but the price of gold declined. TIPS on the other hand are guaranteed to index to goods and service inflation and insure specific protection.

Real-estate is also pitched as an inflation hedge because rents, particularly commercial rents are often index via inflation clauses. Contrary to this theory historically, REITs and real-estate index investments have been poor inflation hedges. The cash flow from rents is often stable and predictable, but valuation investors place on the cash flow is volition and difficult to predict. Therefore, real estate are speculative investments that are considered Wind Assets.

Chapter Three - POWER ASSETS

Power Assets are front-ended self-liquidating assets that produce reliable regular investment returns, like an engine that lumbers along producing power. They are not flight to safety assets like treasuries or cash. Examples are corporate bonds, preferred stocks, mortgaged backed securities, municipals bonds, and convertible bonds. Power Assets harness the money pressure flowing through the domestic economy and to a smaller degree foreign economies.

In a sail boat auxiliary power is important because it provides power regardless of the wind. Likewise, Power Assets provide reliable returns and steady cash flow to a portfolio without relying on the unreliability and risk of stock price inflation. Without a bull market pushing up P/E rations, stocks are not very good investments, but bonds can produce gains regardless of the performance of the stock market.

For example, a bond with a periodic interest payment provides a steady return from the time you buy it, it's money in your pocket, not the hope of money in your pocket, and the money comes regardless of what the other financial markets are doing.

Even in growing economies the stock market can go through long bear markets where prices are declining, or doldrums markets where the returns are flat. In both 1962 and 1982 the Dow Jones ended the year at 752 - twenty years of flat gains. Twenty years of market doldrums. You would have seen only dividend gains if you were saving for retirement during those 20 years and where solely invested in the the market. Worse yet, during that time general inflation increased prices almost three times. Because the effects of inflation compound, the real return on your money after inflation would have been over negative 60%. A portfolio of TIPS, if they existed, would have protected investors against this problem and significantly outperformed stocks.

During market doldrums, a combination of Power Assets and Flotation Assets are vital to keeping your portfolio growing and helping you make it to your financial destination. The maturity payments of bonds can also provide protection against goods and service deflation resulting from a decrease in money pressure. When deflation occurs the money returned is more valuable then it was when the bond was purchased.

POWER ASSET RISKS

These assets add reliability to a portfolio but are not fail-safe. Just as some mechanical engines are more reliable than others, power assets can also range from reliable to risky. A well-behaved portfolio of Power Assets pays out a steady stream of cash that can be used for building portfolio value, creating ballast, acquiring new assets, paying regular living or emergency expenses.

There is a trade-off with Power Assets. You can vary the amount of power in your portfolio by adding lower-quality higher-yielding corporate or municipal bonds, and preferred stocks. These lower-quality bonds provide more income from the same investment value, but like an engine that provides more power from the same displacement these high-yielding investments are less reliable and much more likely to default. Just like a temperamental racing engine, visualize your Power Assets with a failure risk that increases as the credit quality decreases. If the creditor can't pay - then you lose the yield and principal. In effect the engine breaks.

Similar to stocks, bonds create gains in the portfolio from two sources periodic payments - interest for bonds, dividends for stocks - and changes in market prices. When interest rates decrease bond market prices increase and vice versus. The important difference is that, unlike stocks, bonds self-liquidate and if the market price is unattractive investors can hold the bonds to maturity. Stocks never mature and stockholders must always find another buyer.

Bonds don't have a P/E ratio, like stocks, but they do have a price to interest ratio or a P/I ratio. A bond yielding 5 percent would have a 20 to one P/I ratio (100 divided by 5), at a ten percent yield it would be a P/I of 10. This isn't a common measure but, when valuing assets it is helpful to compare the P/I ratio of bonds to the P/E ratio of stocks. A stock market with a P/E ratio of 20 is similar to a 5 percent yield. When the ratios get too far apart it is time to reconsider the portfolio mix and move it toward the assets with the lowest ratios.

As you design a portfolio, visualize your portfolio and the interaction of the investments with the economy. See the trade-offs you must make to get different results. A portfolio without Flotation Assets is at risk from inflation, a portfolio without Power Assets suffers in a flat market.

Understand why you own the investment and what result you are trying to achieve? The many colors comprising asset-allocation pie charts from investment firms appear diversified, but it is hard to visualize what risk are being taken and what trade-offs are being made.

TYPES OF POWER ASSETS

**Municipal Bonds** \- Taxable and Tax-exempt Municipal bonds are used to finance local government projects, infrastructure, and schools. Municipal bonds have historically been reliable payers but unlike federal government bonds they are not immune to defaults and payment interruptions. Local governments can't print money like the federal government and have solvency risk. Many municipal bonds pay relatively low rates of interest because the interest is often exempt from Federal, State and local income taxes.

**Corporate Bonds** \- Corporate bonds are risky than government bonds and generally riskier than municipals. Like local governments corporations also can't print the money the need to pay back bond and have solvency risk. Corporate bonds have a place in a portfolio, but investors must understand the nature of the investment. Corporate bond suffer from a lopsided deal between stockholders and bondholders.

Most corporate executives are paid bonuses in stock and stock options not bonds. Because of this they have a bias to promoting stockholder interest over bondholder interest. If corporate presidents were paid in bonds or bond options they would behave in the interest of bondholders, structuring corporate balance sheets to be best suited to paying their bondholders. But, they are not.

Additional asymmetries include top-rated AAA corporate bonds can be downgraded but not upgraded creating a downside without an upside. And call provisions allowing corporations to issue new debt and pay off bondholders when interest rates decrease and bonds become more valuable. Heads they win, tails you lose.

**Preferred Stocks** \- Preferred stocks are hybrid investments that sometimes act like common stocks, sometimes act like bonds and sometimes are bonds. Preferred stocks are exchange-traded like common stocks unlike most bonds and stocks are used by Corporations generate cash without the burden of issuing bonds.

Preferred stocks are higher on the companies capital structure than common stocks, but lower on the capital structure than bonds. Their shareholders are paid dividends before common shareholders and in the case of a bankruptcy preferred shareholders get paid after the bondholders but before the common shareholders. Preferreds also have higher par values so there is more money to be paid back. Often preferred dividends must be paid back before the common dividend can be restored.

True preferred shares pay income taxes at the dividend rate - currently 15 percent. Sometimes preferreds are bonds held in trust. These trust preferreds are technically bonds with a maturity date and taxed as ordinary income. They are self-liquidating.

Preferred stocks are more complicated and should be by investors don't understand them. If you're an investor that doesn't understand or like bonds, preferred stocks can be a comfortable way to get Power Assets into your portfolio. It's not always the best way, but it's better than nothing.

FIXED INCOME MUTUAL FUNDS AND ETF'S ARE RISK ASSETS

Like stocks bonds and preferred stocks can be bought individually although unlike stocks most bonds are not traded through an exchange and require additional knowledge to purchase. Most investors simply buy bond mutual funds or fixed income ETFs instead of straight bonds. These products are easy to buy and sell, but don't ever mature and lack the advantages of self-liquidation. A buyer of straight bonds is guaranteed by the issuer to get their money back at maturity.

With bond funds the maturity value goes to the fund, not to the investors who must redeem their shares at the market price. Investors never their money returned directly. When this happens the market may be higher or lower than the initial investment. ETFs are indexes of bonds sold on stock exchanges that must be exchanged at market price to liquidate the investment. Bond funds are risk assets.

With a straight bond to receive the ownership benefit the investor only needs to buy the bond and never has to sell it, with a mutual fund or ETF the investor must both buy and sell. Mutual funds and ETF also have fees associated. The represent a second best option for the investor. Another pooled investment an UIT or unit investment trust also have fees but do self-liquidate returning the investor's principal when the bonds mature.

Unfortunately, many investors downplay or ignore Power Assets fearing the steady return is less than they can get from a stock. These assets are important because they provide an important measure of self-liquidation and reliability to a portfolio carrying it during flat markets and providing stability when markets are wild and tumultuous. Be aware of the cash flow reliability when choosing Power Assets and aim for a comfortable power to reliability ratio.

Chapter Four - WIND ASSETS

Wind Assets are volatile speculative assets with unreliable gains which gust some years and are in the doldrums others. They are back-ended assets, like stocks, that depend on financial asset inflation from bull markets to generate gains.

In nature wind power provides free energy, but a windmill only generates power when there is a strong wind. Likewise, Wind Assets generate their largest capital gains during favorable markets driven from money pressure flowing through the financial asset circuit. These gains are unreliable and come and go just like the wind. They rely on good luck.

Stock returns derive from two main sources, dividends generated from economic activity, and capital gains produced from inflation of the price earnings ratio. For stocks to provide their biggest gains, the P/E ratio must inflate.

The P/E ratio is the price an investor pays for one dollar of earnings. P/E expansion relies on money pressure flowing into the stock market, increasing bidding activity, and creating stock price inflation. Wind Assets typically have little or no yield - the way to make money is to buy when the pressure is low and sell when the pressure is high.

Wind Assets can be take many shapes but most often they are traded stocks, equity-based ETFs or stock mutual funds. They can also be real-estate, gold and commodities. All Wind Assets are unreliable and cannot be depended upon to increase in value. They are speculative. The intrinsic value of a stock is its future dividend stream but the biggest gains are generated from a bull market.

Bull markets occur when there is money pressure flowing toward stocks inflating the P/E ratio. Bull markets are simply a form of inflation - stock price inflation. Nobody brags about a bull market in groceries when food prices go up, but it's exciting when stock prices go up. It's the same process only in a different area of the economy.

STOCKS GROW WITH THE ECONOMY AND INFLATE FROM ENTHUSIASM

Historically, stocks offer investors the best chance for large gains, but with a catch. Wind Assets perform best when excess money pressure diverts from consumption and savings and instead flows toward stock purchases. Bull markets occur when stock P/E's inflate as more money chases fewer stocks.

Stocks do not self-liquidate. Dividends aside, to make money from a stock you have to buy it at a low price and sell it at a higher one. Without a relative price increase, all an investor captures is the the dividend yield plus baseline economic growth of the economy - about 3 to 6 percent including inflation. Corporate earning in aggregate just track the aggregate growth of the economy.

Under favorable conditions, stock returns come effortlessly like wind in the sails of a boat. In the markets of the 80's and 90's, all an investor needed to succeed was to own stocks and enjoy the ride - like riding the wind. That's why the buy and hold strategy was all the rage during that time - it worked. But, as we found out later in the 2000's, it doesn't always work.

In the 1960's, the situation was the opposite. In spite of strong economic growth between 1960 and 1982, the Dow Jones average remained flat. The market was in the doldrums, as money pressure flowed elsewhere in the economic circuits. An investor could buy a stock in 1960 but he couldn't find anyone to sell to at a profit in 1980. Good economies aside, the market only goes up when it goes up.

Just like the wind only blows when it blows. A sailor can't make wind and an investor can't generate a bull market. Inflation in the stock market is essentially the wind speed of the market. Stock prices go up when the pressure blows through the stock market and goes down when it the pressure deflates - just like high and low pressure in the earth's atmosphere creates wind.

Enthusiasm helps to drive the money flow. During the market doldrums of the 60's and 70's the market P/E bottomed in 1982 with a low pressure reading of around 8 times earnings. Newsweek infamously issued a cover proclaiming the death of equities. Then later during the high-pressure bull market of the 80's and 90's the market P/E inflated to near 40 to 1. A famous best selling book of the time proclaimed the Dow would hit 36,000, over three times its current level. It didn't. That's a five-fold change from 8 times earnings to 40 times earnings.

Why were earnings more valuable in 1999 than in 1982, dividends are dividends? Corporate earnings increased around three times during this period, obviously something else is at work - enthusiasm. If earnings went the opposite direction from 40 times earnings to eight times, the market would have been flat in spite of the tripling of earnings. But, they didn't.

In essence, the wind was blowing at 8 knots in 1982 and at 40 knots in 2000. Like a sailor, the question investors should ask is how much sail do they want to hang on the mast when the wind is at 40 knots versus how much they want at 8 knots. But, most investors do the opposite they want to own a lot of stock at 40 times earnings and less at 8 times earnings. It doesn't make sense and it's risky.

WIND ASSETS ARE VOLATILE AND RISKY

There is no right or wrong answer to how much to invest in Wind Assets. But, its important to realize Wind Assets are leveraged and volatile and therefore a small amount has a large effect on your portfolio's behavior - much more so then other asset classes. A 60 percent stock allocation acts almost like a 100 percent allocation and your portfolio will still crash when the stock market crashes.

Wind Assets are like putting pepper in a recipe, a little bit goes a long way and it doesn't take too much to make the whole dish taste like pepper. This is one reason investors were recently surprised when their conservative asset-allocation models tanked during the financial crisis, even an allocation with 40 percent stocks will behave poorly in a down stock market especially if it contains other asset correlated to stocks, like low quality bonds.

In general, stocks perform best in high pressure economies with stable prices and moderate inflation like the 1990's and perform poorly in high-pressure inflationary economies like the 1960s and 1970's, the late 1910's and early 1980's. Stocks also perform poorly during low-pressure deflationary economies like the early 30's and recently during the financial crisis.

Don't buy and hold Wind Assets without a plan to keep an eye on them. You don't want to be sailing on auto-pilot went a strong gust comes along. Think of all the investors during the crash of 2008 who wrecked their portfolio's by investing almost solely in stocks and not watching them. Stocks are back-ended, you don't know what you'll make until you sell them. Allocating money to growth investments doesn't guarantee growth and money allocated to poorly performing stocks is money that could have been allocated to a different asset class. The investor has lost time when the growth doesn't materialize.

To keep your portfolio stable keep a weather-eye and actively adjust your allocations. Active management doesn't necessarily get you a better return, but it gives you more control and less risk.

STOCKS ARE STOCKS

There are no stock strategies or stock portfolios that do well when the stock market does poorly. How you choose these assets is less important then understanding what you have chosen and why you have chosen it. There are thousands of books describing strategies for finding the best stocks, there are also hundreds of books telling you why it is a waste of time trying to pick stocks. You can pick your strategy or just go with an index. The result is the same - the investments will do well when the stock market does well and will do poorly when the market does poorly.

The important concept is the unreliable behavior of these investments. These assets can be profitable but they are not reliably profitable investments, they are speculative.

WHY STOCKS DOMINATE PORTFOLIOS

Stocks are the dominate investment in most investor's portfolios for three broad reasons.

First, historically stocks have done better than most investments with a long run average of 8 to ten percent. They did particularly well as inflation tempered and P/E ratios expanded in the 1980's and 1990's and that successful run hasn't been forgotten in investor's minds.

Second, stocks are aggressively sold by financial services industry and television stock promoters. It is simpler to promote a product with a potential big gain then a stable investment. Just as it is easier to promote the state lottery than a savings account, even though for the vast majority the saving account outperforms the lottery ticket.

And last, investors like stocks because they are familiar, easier to understand than bonds and other investments, and often have a positive story attached to them. Investors always like a good story.

CORE WIND INVESTMENTS

Since Wind Assets are not self-liquidating, ETFs and mutual funds can be successfully substituted. The following represent the most popular Wind Assets:

**Domestic Stocks** \- allow investors to participate in the profits and growth generated from the domestic economy and with some multinationals foreign economies. But like all equities their largest gains come from stock price inflation, not from economic activity.

**Foreign Stocks** \- are stocks of companies in developed foreign countries. They provide many of the advantages of domestic stocks but with the opportunity for the investor to participate in the money flows through foreign economies. Just like domestic stocks their biggest gains come from price-earnings inflation.

Foreign stock carry the additional risk of losing money from the changes in currency exchange rates, plus political risk. Political risk is the risk of nationalization or some political event that changes the ownership structure of the company. These risks make foreign stocks riskier than domestic stocks.

Foreign stocks can provide some diversification benefits in a portfolio since foreign markets may behave differently from domestic markets, but this is diversification is unreliable and much of the time foreign equity correlates with domestic stocks. Once again, stocks are stocks.

**Emerging Market Stocks** \- are equities from what were previously known as second and third-world countries. They also provide a way to participate in the growth of emerging foreign economies. But remember like all stocks, big gains come from P/E inflation not economic growth. These are high-risk investments that contains the same foreign exchange risk and have more political risk than developed foreign stocks.

Many of these countries have unstable and corrupt political structures. The governments come and go and sometimes nationalize industries with little warning. These additional risk can provide higher returns when the investment winds are favorable, and terrible returns or outright loses when the winds are not so favorable. Foreign investments may have foreign intrigue but they are not appropriate for unsophisticated investors. This is an asset class where professional managers may be an advantage.

**Real Estate** \- is another investment class benefiting from money pressure flowing to the asset and causing price inflation. Real estate combines elements of both stocks and bonds. They function in many aspects like a bond with the cash flow backed by a lease and generate rent as money flows through the domestic economy. The susceptibility to decreasing money pressure and economic downturns plus the risk of tenets leaving or unable to pay the rent give an equity component to real estate. Real-estate performs poorly during low-pressure deflationary times and good in high-pressure inflationary times.

Real-estate can be volatile. In good times, real estate is overbuilt and in bad times it is under built. During economic distress the cash flow slows or stops as tenants have trouble paying rent - especially commercial real estate. It benefits from rents generated in the domestic economy. But to make big gains it requires significant real-estate price inflation, the amount investors are willing to pay for one dollar of rent. In many ways real estate functions like a low-quality or junk bond - high cash flow combined with the speculative element of cash-flow risk.

Most average investors already have heavy allocations to real estate through home ownership and from a risk standpoint don't benefit from additional exposure in their investment portfolio. Amateur investors wanting additional exposure would typical obtain this through a Real-estate Investment Trust(REIT), a real-estate ETF, or mutual fund. Real estate is not a necessary investment in any portfolio, but the strong cash-flow from rents gives a degree of front-endedness.

MARKETS ARE BECOMING MORE TURBULENT

Stocks are not only unreliability, they are becoming riskier because of additional volatility. Market volatility in the last twenty years has been rising due to increasing computer power and lower transaction costs. Worse yet, the volatility is becoming more volatile, if you can imagine that. This rising volatility is making Wind Assets increasingly risky. The biggest problem from volatility for investors is risk drag.

Risk drag results from portfolio volatility. To understand this, imagine you have $100 in the market and the market then drops 50 percent and after which you are left with 50 dollars, the next year the market rebounds and gains 50 percent for an average return of zero When this happens your investment isn't flat, it goes from $50 to $75 for a 50 percent gain, not back to your original $100. That's risk drag.

The bigger the loss the larger the gain needed to recover. The recovery gain also grows exponentially with the loss so that an 11 percent gain is required to make up a ten percent loss, a 25 percent gain to make up a 20 percent loss, a fifty percent gain to make up a one-third loss, and a 400 percent gain to recover from an 80 percent loss.

WIND ASSETS ARE RISKIER THAN THEY LOOK

Stocks and real-estate investments are riskier than they look. Both investments are internally levered from bonds and bank loans and this leverage makes them riskier and more volatile then un-levered investments like bonds. If bonds were levered like stocks they would also have much bigger gains and losses. Stocks also go through very long periods of good and bad performance, bull and bear markets. It can take a long time for the market to return to average. Often, it's the wait that will destroy you.

WHAT DRIVES STOCK PRICES?

Stock prices are driven partially by economic dynamics and growth, but mainly by investor enthusiasm. The 1980-2000 bull market, as we discussed, experienced a tripling in earnings over 20 years. This increase was partly the result of general inflation and the typical three percent growth of the economy. But in addition to the economic and earnings growth, an increase in enthusiasm and money pressure into the financial asset circuit caused stock price inflation. During this period the amount investors were willing to pay for earnings, the price/earning ratio, also tripled.

Earnings can continue to multiply as the economy grows but how long can the willingness of investors to pay for the earnings also grow? If investors didn't increase the P/E multiple or the amount they were willing to pay for the earnings from eight times to almost 29 times the bull market wouldn't have been anywhere near as strong. In fact, there may not have been a bull market at all.

If the P/E ratio had remained constant as the earnings tripled, the S&P 500 would have increased from 110 to a much less impressive 418 and not from 110 to 1485, as was the actual case. The 1000 point different was driven by the favorable wind of investor optimism. This optimism was driven from a decreasing general inflation rate and other factors, not from earnings growth. In this case, decreasing goods and services inflation resulted in increasing financial asset inflation or a redirection of the money pressure from the goods circuit to the financial circuit.

Don't under-estimate the influence of investor psychology in driving a bull market. The P/E ratio was low when the 1982 bull market began. If P/E movement had been the opposite and the bull market began with an inflated P/E of 28 and ended with a deflated one of eight the S&P would have not gone from 110 to 1485 or even 110 to 418, but would have instead stayed flat at 110 as the 3.5 times increase in earnings is entirely offset by a similar 3.5 times decrease in the P/E ratio.

An investor who is willing to pay 28 times a company's earnings is more optimistic than an investor that is willing to pay eight times earnings. This underlying enthusiasm for stocks is what drives the strategy behind asset allocation, efficient frontier and age-based portfolio models. It banks on the hope that risk-taking always pays. It had in the past, therefore it will in the future. Of course, it will in the future only if the future repeats itself.

Investors are disappointed when future markets don't behave like good markets of the past. Asset allocation strategies built on modern financial theory were gaining traction in the early 2000's, and the models, relying on history, were optimistically allocated with risk assets. Optimism drove the models, and the volatility of risk assets drove the results.

This enthusiasm created allocation models loaded with risk in an increasingly risky environment. People forget about building hurricane resistance houses if there haven't been recent hurricanes. Likewise, why worry about stock market risk if there hasn't been any recently. It's human nature, out of sight, out of mind.

PREDICTING STOCK MARKET VALUES

It's easy to predict long-term stock market values - all you need is the S&P's future average earnings and the future P/E level. At it's simplest the stock market level is the average earnings times the average P/E ratio. It's simple multiplication.

Historically, the stock market is about 75 percent correlated with corporate earnings and about 70 percent correlated to P/E growth. If the future is like the past (and for the record, it isn't), these two numbers explain almost all stock market behavior. The problem is, of course, knowing the future numbers, and as we know the future is uncertain. The trick behind prediction is knowing the future P/E which follows the whims and enthusiasm of investors and is driven by the amount of money flow used for stock investments.

Historically, corporate earnings have loosely follow the nominal GDP rate or the GDP unadjusted for inflation. What the news reports is real GDP adjusted for goods and service inflation, nominal GDP is not adjusted for inflation. In many ways, nominal GDP is what you feel in the economy. When it seems more people are spending and working then the nominal GDP is most likely increasing. Nominal GDP as been very low recently and it feels like it.

Long-term nominal GDP in the United States has been more or less constant around four to six percent per year and the long-term real GDP has been between two and three percent with general inflation around two to four percent. Earnings are fairly easy to predict since they follow nominal GDP growth.

If the P/E remains constant, then investors can expect equities to return the historical GDP growth about five to six percent nominally plus the dividend yield of the stocks. The average rate of nominal GDP from 1948 until 2011 has been 6.68 percent, (about 3.25 percent was inflation), and the average dividend over the last 50 years has been 3.21 percent. Add them up and you get an average return of 9.89 percent, just about the 10 percent after inflation return many people believe they get from stocks when returns average what they have in the past. Investors can expect lower returns if the economy doesn't grow at it's nominal rate.

THE MARKET IS NEVER AVERAGE

The problem is stock market averages seldom return the expected average return. Stock market data from 1900 to 2009 shows investors can expect 10 year returns of eight to 12 percent from the stock market about 20 percent of the time, with returns below eight over 40 percent of the time and above 12 percent over 35 percent of the time.

It is much riskier to buy stocks when their P/E is far above average. Since nominal GDP growth, earnings growth, and dividend yields have been relatively predictable in the long run, the big mystery to stock pricing is always the course of future P/Es. The P/E ratio isn't easily predictable, historically it has fluctuated in a wide range between six to 26 with an average of 15.

It's not guaranteed, but historically investors face enormous headwinds over the following ten years when they buy stocks with a P/E of 26 like in 2000, and strong tailwinds when they buy stocks when the P/E is 8 as in 1981. The further the market trades above the historical P/E, the less likely the stock market P/E can continue to inflate over the next ten years.

STOCKS PRICES AREN'T STABLE, BUT STOCKS LIKE STABILITY

Earnings, more or less, follow the course of money pressure and nominal GDP, but the relative stability of goods prices is what drives the stock market to reach higher P/E levels. Price instability occurs when either excess money pressure converts to general inflation or conversely a lack of pressure creates deflation. When money pressure fuels goods and services inflation there is less pressure available in the system to push up wages, real estate and also stock prices. It takes a lot of pressure to push all four up simultaneously.

The biggest determinant of P/E level is the stability of prices. At the stock market bottom in 1981, inflation was extremely high and there were concerns it was out of control at over 10 percent, (although history and the experiences of foreign economies proved it wasn't), in the seven years previous to 1981 the minimum wage increased 210 percent, but in contrast in 2000 when the market peaked, inflation was near average at 3.38 percent with only a 20 percent increase in minimum wage over the preceding seven years.

Before 1980 the money pressure inflated wages and goods and service prices leaving little pressure to be diverted to stock price inflation, but after 1980 wages went relatively flat and the money pressure went to inflating stock price-earnings ratios and stock prices. The pressure remained but the path it took was different.

STOCKS ARE OVER PROMOTED TO AMATEUR INVESTORS

Wind assets and stocks in particular are consistently oversold to ordinary investors by the media and the financial industry. There are a few reasons for this.

First, many in the media and industry are simply true believers, they simply believe everything good about stocks and project these beliefs to their audience.

A second more cynical reason is volatility is a great way to camouflage fees. Many advisors are paid a percentage of the portfolio as a management fee. It is easier to extract an one percent fee from an investment averaging 8 percent with swings of 20 percent, then it is to take it from a treasury bond paying two percent per year. It's 50 percent of the treasuries yield but only five percent of a potential 20 percent gain. Paying out one percent when you are up and down 20 percent a year is less noticeable.

Last, because of the extraordinary performance of stocks from 1982-2000 many investors have also become true believers, it is always easier to sell people what they already want.

Under the right circumstances, stocks can be good investments for the average investor but the active promotion makes them look like better investments than they actually are. Most average investors need more reliability in their portfolio.

COMPOUNDING IS ELUSIVE

Another way wind assets are oversold is with unrealistic compound interest calculations. Stock strategies are commonly promoted with colorful historic graphs showing lump sum deposits generating impressive year over year gains. These graphs show impressive parabolic returns climbing to the sky and far out pacing alternative investments like bonds and government debt. These graphs are true in fact, but nonsense in practice. The problem is all compounding functions form graphs that eventually reach the sky. The graphs show that stocks historically have compound faster than bonds, but it doesn't follow you will have more success if you invest in stocks instead of bonds. The higher the compounding rate, the steeper it grows, but in reality it's more complicated than that.

There a calculation called the rule of 72. When you divide 72(actually 70, but 72 is easier) by the expected compounding rate, the solution tells you how long it takes to double your money. An investment growing at 9 percent doubles in eight years, 72 divided by nine. At 2 percent it takes 36 years - 72 divided by 2. At current bank savings rate, a tenth of a percent, it only takes 720 years. That's lousy and it's why promoters show linear graphs with high compounding rates.

Every time the compounding rate doubles the compounding time goes down by half - at 3 percent it takes 24 years to double your money, at 6 percent it's 12 years and at 12 percent it is only 6 years. Fast compounding makes the best-looking graphs, unfortunately it also makes the most unrealistic graphs. If you get shown one of these linear graphs, ask to see a logarithmic graph that tempers the effect of the compounding. You get a better picture of what is actually happening.

For the average investor compounding is harder than it looks. The exponential nature of compounding is the source of many exaggerations in the industry and causes a lot of false hope for the average investor. One of my sons, learning about compounding in school told me if someone saved a penny 2000 years ago at a 10 percent return they would now have a ball of gold the size of the earth. I don't know if that's true, but storage issues aside, it seemed like a good return.

Without checking the math we know from the rule of 70 that a 10 percent return would double every seven years and 2000 divided by 7 is 285 times. You get an enormous number if you double a penny 285 times, I don't know if it's the size of earth but it is big. The important thing is when you double it once more or 286 times, it is twice as big, and when you double it another time that's four times as big and that's the problem. Compounding the last few iterations causes a large result. It works when you can keep up the rate and keep up the time.

The obvious question is - people have been saving money since that time, so where's the ball of gold? Clearly, something is wrong with the theory. Archaeologist's find saved money all the time and it's not the size of a ball of gold. And if you save a penny by placing it under a rock in your backyard after ten years or ten thousand years you will still only have a penny. There is no ball of gold.

This is the problem investors face. To get the elusive ball of gold a saver can't actually save the penny, an saver must trade the penny for something with the potential to compound like a stock or an interest bearing bond. But the theory breaks down because stocks and bonds, in addition to compounding, can also become worthless or default. Also sooner or later the investor wants the money. That's the reason why no one has the ball of gold. It only works when the asset can continue to compound without default or conversion back to cash money. In reality, that doesn't happen very often.

At some point, most investors experience loses or they need to cash out the compounding asset to buy a house, or send a kid to college or finance a period of extended unemployment. Keep this in mind when you get all excited about compounded returns. You should still try, but remember compounded returns are easier to draw on paper then they are to achieve.

Another compounding hurdle is most investors don't save in lump-sums. Compounding a $7,200 lump-sum investment at 10 percent for 60 years is impressive - you'll have a 2,800,000 dollars. If you instead saved your 7,200 dollars by saving a $10 per month for 60 years your would have less than $500,000, still good but it's 82 percent less and that's assuming you didn't dip into it for college costs or a house or something. In reality, many average people simply don't have the opportunity to compound lump sums because they don't have a lump sum. They should focus on simple steady returns.

Chapter Five - WEIGHT ASSETS

Weight Assets are safety assets like treasuries or cash. When people are nervous about the economy they save more money into safe government-guaranteed bank accounts and bonds. This removes money from the economy and lowers the money pressure. Weight Assets allow a portfolio to benefit from this reaction.

In a ship, ballast is dead-weight carried in the bottom of the hull. Long ago ships would replace the weight of the cargo with rocks after the ship was unloaded. The rocks were not valuable like the cargo but they weren't valueless. The weight provided stability to the ship. Ballast lowers the ships center of gravity and increase the ship's ability to right itself. It helps to keep the hull from tipping and rolling.

A ship without ballast still floats, in fact it over-floats, causing the boat to ride poorly with quicker uncomfortable side-to-side movements. The drawback is ballast increases the weight of the ship, depth of the hull in the water, increasing drag and slowing boat's speed. Like a ships ballast, Weight Assets lower the center of gravity in a portfolio and lower the potential return, but increase the stability. Weight assets are almost non-investments, they can seem like deadweight. Because of this most investors carry little or no Weight Assets, but then suffer when the market gets turbulent.

Portfolio ballast is also the most difficult investing concept for the do-it-yourself investor to buy into. It seems counterproductive to have these investments in the portfolio. But, when you visualize the behavior of the portfolio you'll understand a portfolio like a boat needs some stability.

Modern ships use water instead of rocks carrying it in ballast tanks to trim the ships hull. Water being liquid is easy to move in and out of the hull. Your portfolio also needs liquidity that can be moved in and out of different asset classes as needed.

Most average investors get into trouble with a lot of Wind Assets and little ballast to offset them. If you don't like tipsy boats or tipsy portfolios then add more ballast by allocating more to Weight Assets.

CORE WEIGHT ASSETS

**Cash on Deposit** \- In an investment portfolio, the ballast water is cash money or money market funds or short-term treasury bills, or some investment that is near cash. Cash waters down a portfolio the same way water weakens a glass of whiskey. It doesn't change the flavor it just gives you less of it.

Cash softens the up and downs of a portfolio, a 25 percent cash position directly reduces the volatility of the portfolio by 25 percent. The portfolio will still move with the market but the most an investor who is 50 percent in cash can lose is fifty percent. Cash doesn't change the portfolio behavior , it reduces your exposure to the movements both positive and negative.

Cash performs well in deflationary times because it gains value, but poorly in inflationary times when it loses value. Cash is also liquid and easy to move into other investments when you sense a change in the money flows in the economy.

**Short-term US Treasury Securities** \- Government bonds have no solvency risk because the federal government controls the money supply. The government can pay whomever it wants, whenever it wants. Unlike the households, individual states and European governments, the United States government has a non-convertible sovereign currency. The US government controls its money and can print the money to pay its debts. Therefore, the US government can never be insolvent.

THE GOVERNMENT CAN'T GO BROKE

Ignore the rhetoric you hear from politicians about the government being broke, as long as the it maintains a sovereign currency it can never become insolvent. Bonds issued in US currency can always be paid. Government issued checks will always clear. To look at it another way, if you could legally manufacture money in your basement, would you ever be broke?

This ability makes US Government debt nearly risk-free. It is risk-free from a payment standpoint. The only risk is monetary inflation, there is no guaranteed the money you receive back for your 30 year government bond will be as valuable as the money paid for your bond thirty years earlier. Historically, it isn't but the interest rate is usually higher than the rate of inflation. This difference is called an inflation risk premium.

Potential inflation is why Flotation Assets are an important portfolio component. Flotation Assets provide inflation protection unlike Weight and Power Assets.

On the other hand, non-federal government debt like state government debt and corporate bonds do have solvency risk and there is a real risk is the issuer may not be able to pay off the bondholders. State and local governments do not control money like the federal government, they must tax or fee their citizens to obtain the money to pay back the bond holders. Corporate bondholders must earn their money or issue stock to payoff bondholders. This solvency risk makes municipal bonds less reliable and unsuitable for as Weight Assets.

The most powerful Weight Assets are investments that move in the opposite way of the stock market and actively counterbalance the portfolio's Wind Assets. When the market goes up they go down. Many investors dislike these investments because an investment that goes down for any reason makes no sense to own. But these investments can work especially if they pay a return in the form of a dividend or interest.

If an investor has a weight investment paying 4 percent interest than when the portfolio goes up they lose some of the gain but keep the 4 percent, when it goes down they prevent some loss but still keep the 4 percent gain. When it works it the investor gets an asymmetric return. Many hedge funds strive to achieve asymmetric return.

The strategies behind using active Weight Assets are beyond the scope of this book, and should be avoided by unsophisticated investors. The average investor should stick with the core ballast assets, cash and short-term federal government bonds.

One example of a counterbalancing Weight Assets are long-term zero coupon government bonds. , These bonds performed well when the market crashed in 2008 as scared investors flocked to safety investments. The money flows stopped running toward financial assets circuit and began to to be absorbed through savings into government bonds. Demand for government bonds increases bring higher bids when the investment climate is stormy than when it is smooth sailing.

There are also ETF and mutual funds, which in various ways, sell stocks short or use sophisticated option strategies to hedge their portfolio's. These can be used to provide both sail and ballast investments at the same time. Unsophisticated investors should avoid these investments. I

Keep it simple, most investors only need ballast water in the form of cash on deposit, CD's, Treasury Bills or money market funds. As tempting as it is to try an build a more sophisticated system active ballast should be avoided without professional help.

Chapter Six - COUNTERBALANCED PORTFOLIO DESIGN

This portfolio system has four counterbalancing asset classes. Flotation Assets protect against inflation. Weight Assets conserve capital and protect against deflation. Wind Assets capture inflating financial assets. Power Assets provide steady cash flow and self-liquidation.

These asset classes also correspond to different money flows. To review:

**Flotation Assets** are back-ended investments benefiting from unstable prices and high un-vented money pressure powering the domestic goods and service economy. They do poorly when money pressure is low or declining.

**Power Assets** are front-ended self-liquidating investments performing best with stable prices and steady to moderate money pressure. They produce steady cash flow but do poorly during both low pressure deflationary economies and high-pressure inflationary economies..

**Wind Assets** are back-ended investments benefiting from high pressure economies where the pressure inflates financial asset prices. They do poorly when prices are unstable from both highly inflationary or deflationary economies.

**Weight Assets** are front-ended investments and cash that do best with decreasing money pressure and deflation and perform poorly in highly inflationary economies.

Each of these asset classes creates tension against one another. Flotation and Weight Assets doing best when Power and Wind Assets do poorly. Wind assets performing when Weight and Flotation Assets perform poorly. Weight Assets performing when all other asset classes fail. This tensity between the different asset classes creates a more stable and resilient portfolio.

EVERY INVESTMENT IS A TRADE-OFF

Every time you add to one asset class you give up some benefit or protection in another asset class. Changing the allocation changes the behavior of the portfolio and the way it behaves under different economic conditions.

Reducing Weight Assets and adding Flotation Assets gives up stock market inflation gains and adds goods and service inflation protection.

Moving from Flotation Assets to Weight Assets decreases inflation protection but adds deflation protection.

Increasing Weight Assets and reducing Power Assets reduces income and self-liquidation but adds protection against deflation.

Reducing Wind Assets and increasing Power Assets reduces the dependence on stock market inflation and adds current income and self-liquidation.

Each asset class has a different behavior and brings advantages and disadvantages. The investor should tune the portfolio to add the behaviors they desire and remove the risk they want to avoid.

DON'T PREDICT THE ECONOMY, PREDICT ASSET BEHAVIOR

You can't predict the economy, but if you understand the behavior of the four asset classes, you can predict your portfolios behavior in different economic and money pressure circumstances.

An investor can create a portfolio that is evenly divided between the four asset classes and be assured they are both protected and susceptible to all economic events. Or the investor can seek to actively manage the allocations. The path to the highest returns requires the investor develop a weather-eye for changes in the direction of money pressure in the economy and apply those changes to the allocation.

Money pressure isn't measured by the government, so investors must rely on intuition and feel for changes in money pressure. You don't need a humidity gauge to smell humidity in the air. Likewise, even if you can't measure it you should be able to sense changes in the money pressure. A mail box full of credit card offers is evidence of increasing credit money and higher money pressure. People defaulting on their mortgages causes pressure to lower. If lots of people bragging about getting a raise or new job offers – pressure is increasing - or complaining they find a job no matter how hard they try – decreasing pressure. Is federal government talking about increasing spending - higher pressure - or decreasing spending and paying down debt - lower pressure. Are more goods being imported? - lower pressure- or fewer goods being made in foreign countries? - higher pressure.

Are gasoline prices increasing or prices other than gasoline increasing? Increasing fuel price lowers pressure by reducing spending on other goods in the domestic economy. Gasoline prices are a subset of dollar-denominated foreign imports and like all imports remove money from the system. When fuel prices increase money pressure decreases and vice versa.

USE HOPES AND FEARS TO BUILD YOUR PORTFOLIO

When you fear rising money pressure and inflation overweight Floatation Assets. If you fear decreasing money pressure increase Weight Assets. When you think the economy will just muddle along at medium pressure add Power Assets. If you believe there will be increasing money pressure and an expanding economy add Wind Assets. When you're not sure, keep a balanced portfolio. No matter what keep some money in each of the asset classes.

And last and most important, leave room for being wrong. Always ask yourself, what happens to my portfolio if I am wrong. If you're heavy Wind Assets and the market tanks so does your portfolio. If you fear inflation and buy more Flotation Assets and the economy goes deflationary, what happens? Think through the opposite of your ideal. This will protect you from surprises. It's OK to gamble but know you are gambling and what you are gambling on.

CHANGES IN PRESSURE CAUSE CHANGES IN THE ECONOMY

The earth's weather is driven by air pressure and the economy is driven by money pressure. Just as weathermen keep a weather eye on the barometric pressure and wind patterns, the investor must keep a weather-eye on the money pressure and money flow patterns.

Extreme pressure differences from one economic circuit to another will sooner or later cause a disruption as the system seeks pressure equilibrium. The economy is stable when the pressure between circuits is stable. There will be an economic disruption when the pressure moves from one circuit to an another. In the seventies, increase pressure in the domestic economy caused high goods and services inflation and low stock price inflation. It takes extreme pressure to drive both goods and financial asset inflation.

In the 1990s, high pressure in the financial asset circuit combined with strong pressure in the domestic economy to drive extreme stock price inflation. The market peaked with price-earnings ratios in the high thirties. These actions diverted pressure from bank savings and government bonds. The low demand for treasuries caused lower prices and higher interest rates.

Recent housing price inflation occurred from high pressure being diverted to housing creating housing and land price inflation. The increase in housing caused an related increase in the value of collateral, higher collateral values translated to higher bank loans and higher bank loans caused an increasing quantity of credit money in the system. The increase in credit money created higher money pressure.

When the economy releases pressure, the pressure must go somewhere. Recently, during the financial crisis, pressure was absorbed by savings into the government bond market and credit money was destroyed by loan defaults and shrinking of asset prices. These actions caused the money pressure to drop rapidly. The system no longer had enough internal money pressure to hold up stock prices.

The difference between the economy and the weather is the earth has a fixed level of air, but the economy has a variable level of money. Air pressure can't go up without it going down somewhere else. Money pressure, on the other hand, can go up without going down elsewhere. Unlike air, money in the economy is elastic, new government spending and new bank loans creation increase the money supply and potential money pressure.

PRESSURE CAN'T BE EVERYWHERE AT ONCE

At various times, the news reports the threat of higher inflation, a bubble in the Treasury Bond market, a recovery of housing, increasing stock prices and decreasing government spending. The prudent investor must ask how that would happen simultaneously? We know all of these actions - increasing inflation, increasing stock prices, and increasing housing prices require rising money pressure and decreased government spending lowers money pressure. Where will all this money pressure come from if the reduction in government spending is absorbing the pressure? Unless you have a good reason this would happen concurrently be careful of this analysis.

In this scenario, the money pressure must simultaneously go to housing inflation, stock inflation, and goods and service inflation at the same time treasury bond purchases are destroying money. Increased money pressure comes in mostly from government spending and private loan creation. Under this scenario, where will the pressure come from? It can only happen if private loan creation is greater than the government spending reduction. The private debt creation must outpace the government debt destruction.

Te term "dollar bill" is short for bill of credit. More loans more bills of credit, more bills of credit more dollar bills. If the government destroys credit the private sector must step up and create credit or else the money pressure decreases and the economy deflates. Clearly, some of this can happen but it is unlikely all of it can happen at once.

Just as the money can't be all places at all times the investor can't allocate investments to all places at the same time. To gain inflation protection with Flotation Assets, the portfolio must give up allocation to other Assets. And likewise the same with the other assets.

Your weather-eye must follow the flow of the money, it has to come from somewhere and flow to somewhere. But, it can only come from nowhere and flow to somewhere if people start spending their savings, and it can only come from somewhere and flow to nowhere if it is taxed or saved out of the economy.

AIM FOR BALANCE IN THE PORTFOLIO

Investors should use the counterbalanced nature of the four assets classes Flotation, Power, Wind and Weight to build a stable portfolio. Utilize the competing nature of the asset classes. Sailboats with large sails also have large keels, these heavy keels provide a counter force to pull the hull upright as the heavy wind on the sail tips the boat nearer to capsizing. Well design portfolios also have counterbalance.

If your portfolio is all Wind Assets and no Weight Assets it is like a boat that is all sail and no keel - fast but unstable. A portfolio that is all Weight and no Wind is slow but stable. A portfolio without Power Assets goes nowhere without Wind from inflating financial markets. A portfolio without Floatation Assets will sink from rising inflation.

Use your weather-eye to decide what money flows are most likely in the economy, tailor your portfolio investments in the four asset classes to best protect your assets from possible turbulence. Turbulence is caused by pressure imbalances in the economy. Look at the weigh the evidence. Determine if the money pressure is inflating or deflating. Use this information to choose investments appropriate for the climate. Be aware of the the behavior of these asset classes in deflationary and inflationary climates and growing and contracting economies. Understand the trade-offs.

PANIC EARLY, MOVE SLOWLY AND PLAN FOR BEING WRONG

Panic early and avoid violent changes to your portfolio. Make changes smooth and stable, panic in small increments. Aim for gradual 5 percent or 10 percent movements. It is better to make several five percent changes then to make one panicked 25 percent change. On the other hand, don't make changes of less than 5%, keep them meaningful.

Moving one percent of your assets won't make much difference. The goal of is to make adjustments that shift the odds in your favor. Don't try for a home run. This strategy won't always keep you from losing money in a stormy economy but it keeps you from losing as much and makes the recovery easier.

Always maintain stability in the portfolio. Regardless of the situation keep at least five or 10 percent in any asset class. Never give up all of your protection. There is always a chance you're wrong, but make sure you're never completely wrong. Don't plan on being wrong, but plan for being wrong. When you plan for being wrong, you'll be more likely to be right.

Chapter Seven - Appendix: HOW MONEY MAKES THE WORLD GO ROUND

The economy is complicated and often misunderstood. Not only does it drive the behavior of its participants it also drives the behavior of investments. A fundamental understanding is necessary to the selection of investments.

To understand how it affects the world of investments, you must divorce yourself from economics, as it is taught in schools and universities, and focus on economics as it really happens in the day-to-day economy. You need to understand the big picture of how the economy works in practice.

Forget what you've learned in elementary economics class about supply and demand, equilibrium, perfect competition, marginal cost and production. Those micro-economic concepts are hard to apply to investing. To make intelligent investments step back and look at the economy as a whole. When you look at the big picture, you'll find that the economy works on a simple model.

In practice, the economy functions like a steam engine, but instead of steam pressure it runs on money pressure. Money pressure is the force behind the money supply in an economy, just as steam pressure is the force behind the steam in an engine. The economy is a closed system that creates and destroys money and builds pressure from a variety of sources. The money pressure is pushed through three main economic paths or circuits just like steam is pushed through the turbines of a power plant. The Domestic Circuit, the Foreign Circuit, or the Financial Circuit

When there is too much pressure withing the circuit to be absorbed by the domestic circuit. This excess pressure can inflate the economy foreign or domestic and create economic growth, inflate financial asset prices like houses and stocks, or inflate the price of goods and services.

MONEY PRESSURE DRIVES THE ECONOMY

Everyone knows money makes the world go around. It flows through the economy from one hand to another without being destroyed. When you have money in your pocket you can only do three things with it - spend it, invest it, or save it. Specifically you can spend it on something within the domestic economy, something made by a foreign economy or it can be spent to pay taxes. You can also invest it in a financial asset, or you can save it in a government-guaranteed bank account, savings bond or treasury security. That's it, and that's what happens daily in the economy as people get money and spend, save, or invest it.

Within the economy businesses convert raw materials and people consume them, but not money, the money isn't consumed it just stays in the system going from one person to the next. Money can't even be wasted because one persons waste is another persons income. If you blow it in the casino, the casino still has the money they don't destroy it. In fact, it is against the law to destroy currency, only the government has the power to destroy currency in the economy.

In a well functioning economy the money pressure builds in the system like steam in a steam engine. The pressure is then forced through the three main circuits: the domestic economy, foreign economies, and the financial circuit where is continually recycled.

To understand the process, imagine a simple economy with 100 dollars of currency in circulation producing 100 mouse traps annually. Every year the population buys 100 mouse traps for a dollar each. This creates 100 dollars of gross domestic product(GDP) and 100 dollars in national income.

The 100 dollars flows through the system. It is spent for mouse traps generating profit for the trap company and wages for the workers. Afterward, these new profits and wages are again re-spent for a new batch of 100 mouse traps. The economy consumes the raw materials - the wood and springs - required to make the 100 mouse traps every year, but the money isn't destroyed - it is continuously recycled through the circuit from spender to producer back to spender.

CHANGES IN THE PRESSURE CAUSE CHANGES IN THE OUTPUT

Now, if for some reason the citizens decide not to spend all the circulating money and instead save 20 dollars and put it into a bank account. When this occurs, the money is parked unused outside the circuit like a car pulled from a race track and put into the garage, it is still at the track but no longer on the race circuit..

This savings causes the money pressure to drop, because there are now only 80 dollars left circulating in an economy that can build 100 mousetraps. The next time around only 80 dollars is spend and only 80 mouse traps are sold causing the GDP drop from 100 to 80 and creating 20 dollars less in national income. We have a recession when this happens. Until the 20 dollars in savings is re-spent back into the economy, or the 80 dollars is recycled at a 20 percent faster rate, the economy stays at a new 80 dollar level.

If we don't save the 20 dollars and instead magically increase the amount of money in the system by 20 dollars so there is now 120 dollars circulating in the economy. This increase in the supply of money is often assumed to cause inflation because too many dollars are now chase too few goods, and therefore a 20 percent increase in money leads to a 20 percent increase in prices. But, this answer is incomplete.

A number of other money flow scenarios can happen. First, when there are enough raw materials and available labor at the current price, the production capacity can expand by 20 percent allowing the economy to make 120 traps and generate a GDP and national income of 120, resetting the economy at the 120 mouse trap level.

Second, the savings level can increase. If no one wants more mouse traps the extra 20 dollars can be parked outside the system in government-insured bank account or treasury bond temporarily going unused in the economy.

Third, the money can be used to buy 20 imported mouse traps, in which case the 20 dollars leaves the domestic economy and may or may come back. (Or the foreigners may simply decide to save and park the money in a bank or US Treasuries).

Alternately, the money can be taxed back by the federal government destroying the excess money and leaving the economy with its original 100 dollars. Last, the extra money can be spent on financial assets like stocks. When this happens a third circuit is engaged.

ASSET PRICE INFLATION AND PHANTOM MONEY

When the money goes to buy financial assets a new phenomena starts. The movement of the money toward financial assets and stock purchases doesn't remove the money from the economy like saving it to a bank account does, it just transfers the money from a buyer to a seller. This movement can however cause the creation of new phantom money.

To understand this, imagine the extra twenty dollars goes to buy stock in 40 percent of the mouse trap company with 40 shares at one dollar each. The money is spent and goes back into the economy from the buyer to the seller, in this case, the mouse trap company.

Then lets imagine the person who bought the stock creates a credible story about the future of mouse traps and finds an more enthusiastic person willing to buy 20 percent of the mouse trap company at double the price or 20 dollars - two dollars per share. Again the money is not destroyed it is recycled from buyer to seller.

Now if we stop and ask these people how much money they have, they will tell you they have 100 shares of the company worth two dollars per share or $200 dollars total. That's 200 dollars in stock value, but remember there is still only 120 dollars in the entire economy. Should they try to sell these shares at the same time, the most they can possibly sell for is 120 dollars because that's the total money in the economy. So where did the extra 80 dollars come from?

It is phantom money. It is just an estimate, a book value, it isn't really there, but investors believe it is because that's what it says on their statement. The economy has 120 dollars and 100 shares of stock in total, not 320 dollars comprised of the 120 dollars in the economy plus another 200 dollars worth of stock. If the inhabitants of this imaginary economy believe they have 320 dollars to retire on, they will be disappointed in the end, because there is only 120 dollars of actual money in the economy.

A small amount of real money can create a large amount of phantom money in the economy. Take another example, if there are 10 ounces of gold in the the world and the last ounce of gold sells for 50 dollars, then there is a total of 500 dollars - fifty times ten- worth of gold in the economy.

Now if a speculative frenzy occurs and the next ounce of gold sells for 1000 dollars instead of 50, there are now 10,000 dollars worth of gold - ten times 1000 dollars. In this case, a small amount of money, the 1000 dollars used to make the last purchase, causes an increase of 9,500 dollars in the worth of the gold stock without changing the actual amount of gold or money in the economy. If the amount of gold didn't change and the amount of money didn't change where did the additional worth come from? It came from thin air. That's why it is phantom money.

Ultimately, investments are worth what they can be sold for and the investor won't know the amount until the asset is sold. When retirement savers watched the value of their 401(k)s tank during the financial crisis, they didn't lose real money they lost phantom money. Unfortunately, it feels the same.

A great way to get rich is to convert phantom money to real money at high prices, but not everyone in the economy can do that because there isn't enough money in the economy to make it happen. Unless there is a continually increasing money supply, it will only work for a minority, the majority will, as the saying goes, be stuck holding the bag.

The important point to keep in mind, is the dollar figure on your statement is not how much money you have. It is just an estimate of what you can sell your assets for on that day. Ultimately their worth won't be known until the end when they are sold. The result is back-ended.

The further the total amount of phantom money increases above the supporting money supply in the economy, the less likely the assets can be sold for their statement value. This is simply because there won't be enough money within the system to make all the sales at the price everyone believe the assets are worth.

The misconception that stock value is the same as cash money is one reason the ordinary investor finds making money in the stock market more difficult than it looks. Similarly, the housing market is also susceptible to phantom money, a small increase in the price of houses can create a huge amount of Phantom Money.

This Phantom Money causes an important economic effect - it increases the amount of collateral available for loans and results in increased credit. Prior to the financial crisis a lot of phantom money was converted to credit money through home equity loans. This increased credit creates new money injected in the economy.

Within the financial circuit circulating money is multiplied to create Phantom Money as described in our gold example,. Phantom money is than used to collateralize loans creating credit money. In an extreme cases, a spontaneous reaction occurs when the newly created credit money is used to convert additional non-circulating phantom money to circulating money which is used to buy goods and services in the economy. If it seems a little confusing, that's because it is.

Let's review, the economy has three main circuits - domestic, foreign and financial. And there are three types of money inside the system.

**Government-supplied real money-** the money created when the government spends to buy goods and services, pays for transfer payments, or pays interest on bonds. This money is permanent unless it is taxed back by the government. It represents a new financial asset.

**Privately-created credit money** \- the money created when you borrow on your credit card, margin account, or mortgage. This money is temporary and requires the payment of interest. Credit money is not a new financial asset, it an asset with a corresponding liability. It can however be used to purchase things.

**Phantom money** \- the pseudo-money in your brokerage account created when asset prices inflate. This is not actual money - it does not circulate and it cannot be spent, to be used it must first be used as loan collateral and converted to credit money or sold to a buyer for currency before it can be spent into the economy.

Money that is not required for spending or investment can be saved outside the economy in a bank account or a government bond or it can be destroyed by federal taxation. Extra money in the domestic economy can also be sent outside to buy foreign goods, and may or may not be returned.

HOW MONEY PRESSURE IS CREATED AND ABSORBED

In the US economy, the money pressure is created from five main sources:

1) New money spent into the economy by the federal government.

2) Money returned to our economy from foreign economies.

3) New bank loans created by commercial banks.

4) Money spent from savings.

5) And last shrinking economic capacity in the US economy caused by labor or resource imput constraints. Increases in these six sources build money pressure within the economy.

Conversely, money pressure is absorbed by five opposite actions:

1) The federal government can destroy the money by taxing it out of the economy.

2) Money can be spent outside the US economy on foreign goods or oil.

3) Bank loans can be repaid or defaulted on.

4) Money can be parked away from the economy by being saved into a bank account or government bond.

5) And last the domestic economy can expand to accommodate the pressure subject to resource constraints.

Increases in these five actions cause the money pressure in the economy to drop.

This money pressure drives the US economy by circulating through it like steam through a turbine, spinning the wheels of commerce, producing goods and services which create wages and profits that are re-spent, saved or invested. When there a lot of pressure and the economy is grows and the wheels spin faster and the money is re-spent. When the money pressure drops the economy contracts and the wheels spin slower creating less wages and profit available to be re-spent. This creates less production.

[In economic terms, the change in money pressure is the net change in bank loans and government spending minus the net change in government-guaranteed savings, net new federal taxes and net new dollar-denominated imports. But unless you want to be an economist you don't need to worry about that.

HOW MONEY IS CREATED AND DESTROYED

Understanding how the economy works in practice, involves two concepts investors should understand that are that are counter to what is commonly taught and believed. First, in the actual economy, there is no direct connection between the federal government taxing and spending. In practice, the US government doesn't collect tax money from citizens and then buy things with the tax money. The process is the opposite the government spends money and then collects it back as taxes (or bonds).

In the real world, the government collects tax money and destroys it. They virtually remove it from the system. Inside the banking system when the government spends money is credits the accounts of the supplier or receiver, and when they tax the money back they debit your checking account and credit their federal reserve account. When this happens the money essentially disappears from the system.

Another way t view this is by looking at the life of a a dollar bill. Our dollar is a Federal Reserve Note which is technically a non-interest paying bearer bond – a type of loan. When this bond is returned to the Federal Reserve the loan is extinguished and the bond is destroyed, just as a loan disappears when a consumer pays it off. The returning tax money is destroyed by the Fed and the notes are extinguished. Similarly, if you pay your taxes in paper currency the government will shred it. Crazy as it sounds, it's true, you can check their accounting.

To make a payment the government, or spend, the government just credits the account of the person or entity it is paying. When it does this it manufactures new money. There is an accounting relationship between taxing and spending but it is not a direct mechanical connection like in a household budget. A household takes in money and spends it, If you think the government runs like your household, it will cause you to make bad investment choices.

It's like a faucet, sink, and drain, the water coming from the faucet into the sink is new water, the water going out of the drain is not recycled back to the faucet. It goes to sewage. Federal government spending is the faucet, the drain is federal taxes and the water level is the currency supply in the economy. The two flows from the faucet and the drain may be equal but the drain is not connected to the faucet. The money must flow first out of the faucet then be removed by the drain.

That is the government must spend first and then tax back the money it spends. There are self-imposed political constraints and legal regulations on how the US government can manufacture money but they are a mechanical requirement. Be aware state and local governments don't create or destroy money, this ability only applies to the federal government.

Likewise, currency loaned to the federal government when a government bond is sold isn't used for government spending like commonly believed - it is also removed from the economy and destroyed, at least temporarily. The government manufactures new money to pay off the loan when it matures. This is not theory this is the actual mechanics of the operation. The bond money is removed. It doesn't recycle directly into the economy.

By definition, the government deficit is the sum total of the amount of money the government has manufactured during it's existence minus the amount it has destroyed by taxation. If we get rid of the deficit, we also get rid of the money. It's similar to a stock buyback.

Government spending creates money pressure by releasing new money into the system and taxes destroy money pressure by removing the money from the system. Short of self-regulation, governments with their own floating national currency are not required to borrow money to fund their operations, only governments without their own money, like cities and states and European countries, must borrow to fund operations. Governments borrow their own money voluntarily as a matter of public policy not necessity.

Unlike a household, the US government borrows its own money. In practice, US bonds function as a government-guaranteed savings mechanism as much as a funding mechanism. Under what circumstance would you borrow your own money to pay for your household expenses if you, like the government, had the enumerated power "[T]o coin Money" and "regulate the Value thereof"?

The second counter intuitive mechanism is there is in practice no direct connection between money deposited in a bank and money loaned to customers. It is commonly believed that money deposited in a bank account is loaned out to customers. This may have been true many years ago. But in the modern world banks just create the money they loan you. For the most part they aren't even required to keep reserves. In practice they just recycle the money lent to you for reserves.

Reserve requirements have effectively been eliminated and if the loans don't work their way back into the banking system as reserves the bank can always borrow the needed reserves from the Federal Reserve. This means when a bank makes a loan it creates the money electronically out of thin air, the loan is new privately minted credit money spent into the economy. Banks can make as many loans as they can find credible borrowers willing to take them.

When you charge a tank of gas of gas on your bank credit card the money comes from thin air not from someone's bank account. On the other side, money saved in a bank account is not directly loaned out it is money parked outside the economy unused.

The importance of this is that bank loans are another faucet pouring money into the economy, when loans are issued money pours into the system and conversely when the loans default or are paid off the credit money is drained out of the economy. Unlike government manufactured money, bank created money is temporary - it only last as long as the loan lasts. The draining of credit money from loan defaults and the resultant decrease in money pressure was a major cause of the recent financial crisis. The bank bailout, like it or not, was an effort to stop the draining.

Before the crisis, easy loans pumped new bank-created credit money and pressure into the economy spinning the wheels of commerce and creating additional phantom money by inflating the price of houses, stocks and other assets. When the economy became recessionary, marginal loans began to default draining credit money and pressure from the system, destroying phantom money and loan collateral as the markets collapsed. This slowed the wheels of commerce. This money destruction created a downward spiral of increasing defaults, more credit money destruction, and lower pressure, turning a recession into a crisis.

During the crisis, gas prices also increased sending more money outside the system to foreign oil suppliers. Instead of investing, people and business increased their savings putting money into the bank and purchasing government bonds. These actions further reduced money pressure and lowered national income.

Before the collapse, money pressure was increasing and creating a feedback loop where money was driven through the asset markets inflating the market price of assets. These inflated assets collateralize additional credit and the new credit money recycled through financial assets further biding up the asset prices increasing more phantom money. When pressure flow reverses, the collateral prices deflate, loans default and credit money is destroyed. This leaves a shortage of money in the economy.

These concepts are unorthodox, but the important point is to see tax payments as removal of money and pressure from the system, government bond purchases as a temporary removal from the system, and bank loans as newly manufactured credit money and pressure. Seen this way the mechanics of the economy and the behavior of your investments will become much easier to understand and visualize when. If you disagree with these ideas you don't need to argue, you can just make the opposite investment.

THE ECONOMIC EFFECTS OF MONEY PRESSURE

Increasing money pressure can inflate the size of the economy, inflate the price of financial assets, and increase the amount of savings in the economy. If increasing money pressure can't be vented by an expanding economy, increasing imports, increasing savings, or be taxed back by the government, then and only then, will the economy get higher domestic goods and service inflation. Un-vented pressure can drive up the price of goods, services, wages, houses, investments or inflation. But, typically there isn't enough pressure to do all of those actions at the same time.

To make money in the markets, investors want the money pressure to inflate the price of the financial assets they own. Stock prices benefit when the wheels of commerce are spinning and generating profits, but they benefit most from money pressure inflating the relative cost, or the price-earnings ratio of the stock. The biggest stock market gains are made when investors are willing to pay 30 times a companies yearly earnings instead of eight times the same earnings.

Keep in mind that goods inflation changes the dynamics and money distributions in the economy but doesn't always slow economic growth. Inflation is maligned in the press but there have been many economies e.g. Brazil and Israel and the US in the 1960's that have had strong growth with high inflation. One reason for the growth is inflation makes paying off debt easier and reduces the amount of debt relative to the money supply.

Inflation is good for borrowers and bad for creditors. Hope for high inflation if you owe people money, better to have your wages double with a fixed mortgage then have them halve. Also, don't confuse inflation with hyper-inflation - hyper-inflation is a form of economic collapse. Just because a steam engine holds a lot of pressure doesn't mean the boiler will explode.

SUMMARY

The economy is driven by money moving from one agent to another within the economy like steam driven through a turbine.

This economy has three main pressure circuits, the Domestic Circuit, the Foreign Circuit, and the Financial Circuit.

Within the Domestic Circuit money is spent creating profits and wages. Profits and wages are then respent, invested or saved.

Money in the Foreign Circuit is either respent back into the Domestic Circuit as exports, invested through the Financial Circuit, saved into government-backed savings or is circulated outside the US economy for oil or other goods.

Money in the Financial Circuit is transferred from the buyer to the seller of financial assets thus returning to the Domestic Circuit.

There are three broad types of money within the system - Government Money from government spending, bank-created Credit Money and last, Phantom Money created through financial asset inflation.

The money is driven through the economy from pressure that results from the amount of circulating money in the system, the willingness of the system agents to spend the money and the ability of the system to hold the pressure within the Domestic Circuit.

Money is introduced into the system from two primary sources – government spending and private bank loans.

Money is removed from the system from three actions \- government-backed savings consisting of insured bank accounts and treasury securities, payments for dollar-denominated imports and federal taxes.

Five forces build money pressure within the system – increased government spending, new bank loans, lower import spending including oil, lower federal taxes and decreased domestic economic capacity.

Five counterforces actions vent the pressure from the system – decreased government spending, loan payments and defaults, increased dollar-denominated import spending including oil, increased federal taxes and increased economic capacity.

Money driven through the Financial Circuit to purchase secondary financial assets like stocks and houses bids up the book value of those assets to create Phantom Money. This is money the asset owner expects to receive for the asset at sale if it is sold currently. It is perceived as money but is not money. Money circulating through the Financial Circuit flows directly from buyer to seller.

Phantom Money generated from asset sales can be used as collateral for bank loans and can be converted into additional Credit Money in the system.

Goods and service inflation occurs when the money pressure cannot be vented through economic expansion, increased dollar-denominated imports, government-backed savings or increased taxation. When this happens the money pressure cannot be vented and there is then too many dollars chasing too many goods.

Deflation occurs when there is decreased government spending or money pressure is quickly vented to government-backed savings, increased dollar-denominated imports, or increased taxes. In this case there is too much domestic economic capacity for the amount of money in circulation.

Financial asset inflation occurs when the pressure is diverted through the Financial Circuit to create Phantom Money. Every time an asset is sold for more money than previously then the book value of all similar assets increases.

Asset bubbles occur when this newly created Phantom Money is used as collateral to convert Phantom Money to Credit Money introducing new money into the system. As the value of financial assets increases so does the potential value of available collateral.

Economic growth occurs when the pressure is contained and is utilized to inflate the productive capacity or Gross Domestic Production of the Domestic Circuit.

MONEY PRESSURE FLOWS THROUGH THE DECADES

To get a better understanding of money pressure and how it affects the economy let's take a look at money pressure through the decades. This is what has happened in a nutshell.

The late 1910's were the last time we saw a pure form of money pressure induced inflation as credit money created by the first world war pushed beyond the constraints of the economic circuits without being vented into financial assets or increased imports. This inflation tamed during the early 1920's.

The later 1920's was a high-pressure economy driven by an increase in credit and phantom money. Consumer loans created lots of credit money with an extreme run up from 1927 to 1929.. This additional money drove strong economic growth. The excess pressure didn't cause inflation but was instead driven through the financial circuit causing severe stock price inflation and the creation of a large amount of loan collateral. Eventually the increasing difference between the phantom money and the actual supporting money supply and a few other triggers caused the price of stocks to collapse.

The 1930's are the best example of a low-pressure economy. The collapse of the stock market and the destruction of phantom money caused people to save and hoard real money in the economy. This generated deflation. The reaction of the Federal Reserve was to reduce the quantity of real money, opposite what should have happened. This shortage of money caused loan defaults and the destruction of credit money in the system. With phantom, real, and credit money contracting at once the economy collapsed driving unemployment to over 25% percent and you know the rest of the story.

The economy remained in a low-pressure state until World War Two. The war caused a massive increase in government spending which poured real money into the economy driving a massive amount of money pressure through the domestic economic circuit and inflated the production capacity of the the US economy. There was very little financial asset inflation or general price inflation as all of the pressure went to the inflation of production capacity and driving unemployment to less than 2%. After the war a deflation of production capacity required the money pressure to be vented elsewhere and created increasing goods and service inflation.

The 1950's were a period of moderate money pressure with steady growth of the domestic economy driven with help from spending on the Korean War and large infrastructure projects like the Interstate Highway project. Excess money pressure pushed stocks up moderately and increased goods and service inflation.

During the 50's. 60's, and 70's there was an effort by the government to tame the business cycles tby maintaining moderately high money pressure. There was more concern about employment and less concern about moderate inflation.

The 1960's saw moderately increasing money pressure first from the Kennedy tax cut and then government spending increases from social program expansion. This pressure was not directed toward the stock market which struggled the whole decade. The pressure fueled moderately high goods and services inflation.

The 1970's were a more complicated high-pressure economy. The money pressure continued to be directed toward goods and service inflation and not stock price inflation. This pressure was vented off with increasing pressure being vented toward imported fuel expenditures. Union contracts caused a shift in distribution from profits, which are more likely to be saved or driven through the financial circuit, to wages, which are more likely to be spent. This shift increased pressure. House price inflation contributed to an increase in phantom money and increasing bank loans created additional credit money.

Decreased fuel supply lowered pressure in the economy. Because oil is a raw material for so many other goods and services in our oil-price driven the oil shortage caused a shortage of other goods and a resulting shortages induced price increase. The increased cost of oil also caused an outflow of money from the economy. This caused a phenomena known as stagflation. Increasing prices with lower growth. This was not a pressure driven inflation, it was a supply constraint driven inflation. There was too little supply caused by an oil shortage. The pressure increased as the circuit shruck faster than the money pressure vented.

With phantom and credit money increasing and strong government spending to support the Vietnam War the pressure increased. The stock market languished as the pressure was vented with higher goods and service inflation instead of asset price inflation. Demonstrating that it is difficult to inflate both goods prices and stock market prices at the same time.

The 1980s saw more money pressure created with a decrease in federal taxes, a decrease in fuel prices, and an increase in government spending from naval rearmament. The excess pressure was not driven through the goods circuit and also into the financial circuit causing stock price inflation and increasing phantom money. High interest rates moderated the growth in credit money.

This pattern of pressure going through the financial circuit continued. This left little un-vented pressure remaining to create goods and service inflation. Increasing imports, particularly from China released the remaining money pressure. Stock price inflation created more phantom money and generated more collateral for the creation of credit money. This resulted in the biggest bull market in recent history and poured lots of money into the economy to fuel growth. The bull market continued until the amount of phantom money generated from the bull market far outgrew the supply of real money causing the eventual collapse of the stock market.

The balancing of the budget in the latter part of the 1990's meant less government spending and reduced the amount of real money in the economy. This combined with the reduction of phantom money from the stock market collapse and reduced real-estate prices lowering the amount of credit money caused a recession in the early part of the decade. This was countered with a tax decrease. The tax decrease was targeted to higher income citizens who spend less and invest more. This pushed the pressure through the stock market driving it higher. At the same time relaxed lending standards created more credit money.

The pressure from this additional credit money was used to drive house prices and stock prices higher. This increased the amount of collateral and further increased the issuance of credit money. This was a very high-pressure economy with the pressure going through the financial circuit. Excess pressure was vented off to increasing imports from Asia which was recycled back and parked outside the system as in treasury bonds - government-backed savings.

It all came to an end when the phantom money in the markets again outgrew the amount of real money in the economy. Credit money was extended to people that couldn't make the repayment causing loan defaults on marginal loans these caused a reduction of credit money. Leveraged bets by banks on these loans amplified the destruction of credit money. Additionally increased gasoline prices drained more pressure from the system. Like the 1930's the economy went in to a low-pressure state as phantom money disappeared, credit money was destroyed and money pressure was vented to higher fuel prices.

Unlike the 1930's government around the world increased the supply of real money. The amount of real money created was not enough to fully offset the amount of credit money destroyed. Much of the pressure from government spending has been driven through the financial circuit instead of the domestic economic circuit, leaving the economy with higher stock prices and lower employment. This is where we stand today.

This simple explanation of money flow and pressure just touches on the basic mechanisms. The important point is you don't need to analyse graphs and charts to understand what is happening in the economy. If employers are saying they have 10 applicants for every job, the money pressure going through the domestic economy must be low. There is no reason a healthy high-pressure economy would have that many applicants for a job. There should be only a few.

Likewise, when employers can't fill positions, that is evidence of a high-pressure economy. Recently, in early 2012, the percent of adults working is going down, but the stock market is going up. This means pressure is building in the economy but being diverted to stocks and not to domestic production.

USING MONEY PRESSURE TO MANAGE INVESTMENT RISK

Intelligent investment decisions require an understanding of the mechanics of money flow and how it effects the economy. There are four main consequences of rising money pressure \- increased production, increased savings, increased financial asset purchases and if none of those happen - increased goods and service inflation.

The best designed portfolios react and counter-react to these money movements.

Assets that perform well when the wheels of commerce spin normally generating steady economic growth.

Assets that excel when money pressure is diverted toward financial assets

Assets that protect against inflation from unreleased money pressure in the system.

And last, assets that hold their value during times of deflation and decreasing money pressure.

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About the Author

David Cretcher is an investment strategist for individuals and corporations. He is the director of Weather Eye Advisors,Inc. a non-profit Registered Investment Advisor. He has an A.B. in Economics from Miami University and an MBA from Ohio State University. He can be reached at david@weathereye.info.

