Pragmatic Capitalism

Sample Contents

What is Money?

From an economic and financial perspective understanding precisely what money is and how it influences the economy is crucial. Why? Because money is the most important tool we use in modern life. Money is at the heart of every financial transaction, including our calculations of output, profits, and every measurement of our financial health. Understanding how this tool works is central not only to understanding how the monetary system and the economy works but to understanding modern human life.

Why Do We Use Money?

Before we can say what money is, it’s helpful to understand first why money even exists. To answer that question, and really begin to understand money and the history of money, it might help to understand the most basic purpose that money serves. As highly socialized and intelligent animals, we humans have created various tools that improve our ability to trade and interact. A barter system is relatively primitive and insufficient because it forces you to be able to obtain something that someone else will want in exchange for the things you might need. Creating a universal medium of exchange is the bind that ties all goods and services together by making all goods and services exchangeable. At its core money is simply a social construct that allows for the exchange of
goods and services.

Money, within a modern human society, is highly evolved, formal, and even institutionalized. The true history of money is lost in time, but it’s likely that money started in the form of unspoken promises, evolved through a barter system of some type, and has expanded over time into formal promises and legal contracts. Today most money is defined and protected by laws. Modern money has evolved primarily into the electronic records of account.

We live in a highly advanced and sophisticated economic system that is predicated on the social interaction of trading goods and services for money. Said differently, money is the medium by which we gain access to the things we desire. You can’t always trade a back scratch for a back scratch, but humans have resolved that issue by creating something that facilitates the exchange of most goods and services. For instance, if I want a back scratch, but I don’t want to scratch your back, it’s not a problem. Instead you scratch my back in exchange for $10, thereby voiding my need to provide you with an equivalent back scratch, and you can go buy whatever you want.

At its most basic level money is just a tool that is created to facilitate exchanges among highly socialized animals—a social tool that acts as an intermediary in transactions. So now we can arrive at our first understanding of money:

1. Money is a social construct.

But this still doesn’t tell us why money exists. Why do you work such long hours to acquire pieces of paper or electronic credits in a bank account? Why do we stress and worry about money? It might help a bit to think of money as a theater ticket.1 If the economy (and our access to goods and services) is the theater, then we can think of money as the ticket that gains us entry to the show. In a modern monetary system a specifically designated form of money is little more than something that gains you entry to be able to transact within that economy. And we work because of and stress about our ability to obtain money because our access to the goods and services that we need ultimately relies on obtaining this tool. At times in human history money has been many things, including unspoken bonds, sticks, rocks, precious metals, pieces of paper, or records on the Internet. Technically, many things can and do meet the various properties of money. These things generally represent something of a certain value that can be easily measured. In other words we have developed a system of using items of particular value that represent the right to claim a certain amount of goods and services. It is, in essence, a way of recording a deferred promise. But we should be careful not to always think of money as a physical thing or something that has intrinsic value. Money represents a certain value, but the money thing itself (like a cash note) does not necessarily have intrinsic value.

Money in a modern society is largely made up of electronic records and numbers in computer systems. Your bank account exists primarily in a computer system as a record of account and not as a bar of gold in a vault. The electronic money system has come to dominate the way we transact and use this social tool. This brings us to our second crucial understanding about money:

2. Modern money is not necessarily a physical item or something with intrinsic value but is merely a medium of exchange and a record of account.

But what is the primary purpose of money? As I mentioned briefly earlier, the primary purpose of money is to provide us with a convenient medium of exchange for access to goods and services. That is, instead of toting around bars of gold to buy groceries at Walmart or relying on a barter system, we have created convenient ways to record our payments in order to obtain goods and services that we might desire. This gives us access to the ability to feed our families, send our children to school, maintain our health, enjoy ourselves, and so on.

Money, while important, should never be confused with true wealth. Remember, money is merely the medium of exchange. It is a tool like many other tools humans create, and it provides us with a means to an end. While the ticket gets you into the theater, what you want is not the ticket. The ticket simply gives you access to the show, which is the true end. Money is merely the means to that end. Although money is a necessary component of modern life, it is not a necessary component of acquiring true wealth.

Now, true wealth has different meanings to different people, but in most cases it involves the addition of companionship, good friends, good family, good health, access to food, access to water, security, et cetera. More money might make it more convenient to achieve certain things,  but money and true wealth should not always be thought of as the same thing. Confusing money with true wealth is like confusing the theater ticket with the performance. Although we need some amount of tickets to enter the theater, the quality of that show is not necessarily dependent on the number of tickets we obtain throughout our lives. While money can certainly make it easier to obtain material goods, and perhaps even some level of happiness, it is always a means to some other end and
should not be confused with the end.

The end of sample contents

Reviews:

Pragmatic Capitalism progresses towards a thorough discussion of economics, by building his case piecemeal.

Roche starts by laying out some basic building blocks, including an overview of the concept of money, and remarks on money as a social construct, and a medium of exchange, as well as the notion of fiat money; he also alludes to how most modern money is credit (which sets the stage for a discussion of the monetary system later in the book).

Next, shifting to economics, he discusses how in an increasingly integrated global economy, it is important to maintain a “big picture” perspective, versus a more “local” perspective that prevailed in the time of Ben Graham, when investors focused on bottoms up analysis of individual companies. The modern world is obviously very different from the days when the Intelligent Investor was published, as today S&P companies generate an ever growing portion of their earnings abroad, and market correlations increase. Between 1990 and 1995, US markets had a 29% correlation with global markets, whereas between 2005 and 2010 the correlation was 73%. That’s a big change. Although many of us are conditioned to think locally, the spread of technology, rapid growth of an emerging global middle class, and the integration of markets demand that we think globally.

Moving to a personal perspective, Roche counsels us to make a distinction between investing and saving. The semantics here are subtle. Roche defines “investing” as it relates to capital investments that are then used generate production or productivity in the future. Investing might include financing your own entrepreneurial business that will use the money to finance future growth, or an investment in your own education, or job training, which might enhance your career prospects. Investing can be for “hitting a home run.” Saving, by contrast, is allocating capital that is neither consumed nor invested, but that you might consume (or invest) in the future. We should be more careful with this capital, since we may have a real need for it at some point, as with a specific event like college tuition, or an emergency. With savings, we are focused on preserving purchasing power and protecting ourselves from a permanent loss of capital. Roche returns to this concept later.

Next, Roche discusses a number of market myths which, though untrue, we persist in believing, and which cause us to do things we shouldn’t do. Many of these are solid contributions. You’re not going to be Warren Buffett, and trying to beat the market causes problems. The stock market won’t make you rich, and neither will anticipating the “next big thing.” High fees don’t always equate with good value. Modern portfolio theory does a poor job explaining how to construct the portfolio. There are other good observations that can help investors avoid common pitfalls in managing their finances.

The next section was my favorite part of the book, and covers how the new macroeconomy is changing portfolio construction. This relates to the “savings” portfolio, as defined earlier, which allocates capital that you may need to access at some point in the future.

Roche divides global assets into 7 classes on a spectrum, with protection against loss of purchasing power at the top and protection against permanent loss at the bottom:

1. Emerging market equities and developed market small cap equities
2. Developed market large cap equities
3. High yield corporate bonds, preferred stock and REITs
4. Foreign emerging market corporate bonds, foreign emerging market government debt
5. Investment grade corporate bonds, municipal bonds
6. TIPs, long-term developed market government bonds, intermediate term developed market government bonds
7. Money market funds, treasury bills, bank deposits, cash

Roche views risk as the “potential you will not meet your financial goals.” This spectrum is useful for thinking about allocating across these asset classes, based on whether you are generally accumulating or protecting assets.

When you’re younger, gathering assets, and with a longer investing horizon, you might emphasize protecting against the loss of purchasing power, while when you’re older you might focus more on capital preservation. There’s no radical new thinking here, but by thinking broadly in terms of matching assets (savings) and liabilities (future needs) instead of using some whiz-bang mean-variance approach, you can position yourself with a more individualized and practical approach that will maximize your chances for meeting your financial goals. Roche also advises us to establish a methodology, automate it, and stick to it. This is good common sense advice that can be easy to forget in a rapidly changing world.

Next Roche tackles the importance of an appreciation of behavioral finance, and how our behavioral instincts affect financial markets and can lead us astray. This section includes a nice overview of a number of well-known behavioral biases, and how they make us behave irrationally. But there’s good news: if we can accept and acknowledge our biases and weaknesses, we can learn to identify and avoid them.

Roche then takes us through the workings of the modern monetary system. This section was dense, but enjoyable. Roche builds on his earlier discussion of money, by discussing private sector banking, the public sector and central banks, and currencies. - www.alphaarchitect.com

***** 

Being successful in the modern world of finance requires a more in-depth understanding of our global economies on a macro level. What does a shifting demographic cycle mean? How does the explosive growth of emerging markets matter? Why does the world’s population affect my portfolio? Does the global monetary system impact my results this year? How does government intervention in markets impact my strategy? In Pragmatic Capitalism, Cullen Roche explores how our global economy works and why it is more important now than ever for investors to understand macroeconomics. Cullen Roche combines his expertise in global macro portfolio management, quantitative risk management, behavioral finance, and monetary theory to explain to readers how macroeconomics works, and provides insights and suggestions for getting the most out of their investment strategies. This book will uncover market myths and explain the rise of macroeconomics and why it impacts the readers’ portfolio construction. Pragmatic Capitalism is a must for any sophisticated investor who wants to make the most of their portfolio. - www.Amazon.com

*****

One of the many reasons investors have been so whipsawed by the markets since 2007 is a lack of understanding about the dynamics at work between the financial markets and the economy.

In general, most of the experts in the field of economics haven’t done investors any favors in this regard. There have been hysterics by many over Fed policies and what they would mean for the financial markets yet not enough voices that offer objective or helpful views on the matter.

My problem with most economists is that (a) they spend way too much time trying to prove their intelligence, (b) their opinions are biased by their political beliefs and (c) they fail to connect the dots to show how or why the economic data they use does or does not matter to investors or relate it to average people in a tangible way.

This causes a ton of confusion for people without an economics background that don’t know what to pay attention to and what to ignore.

One of the few level-headed economic commentators I’ve been following on the subject is Cullen Roche over at the blog Pragmatic Capitalism.

Cullen’s new book, Pragmatic Capitaliam: What Every Investor Needs to Know About Money and Finance, is a collection of everything he’s learned about the relationship between portfolio management, the financial markets and the economy. It covers a wide range of topics to give readers a better sense of the interplay between the many different factors that affect people’s finances.

Roche cuts through the noise to provide a guide that people can actually understand. There’s no agenda or hidden motives behind his opinions. He doesn’t spend time covering political narratives or arguing about topics that have have no relevance to your financial decisions. He sets out to help provide perspective, something that’s generally lacking in the finance industry.

Although the subject matter can be complex depending on how it’s presented, Roche uses common sense language and useful analogies throughout to make his point.  I always appreciate when intelligent people are able to make complex topics understandable to a wider audience.  This is not as easy as it sounds.

While understanding the past helps you become a better investor, you also have to pay attention to the future.  Roche describes in great detail the impact that globalized markets and economies will have on the future portfolio decisions.  This is an area that I think is extremely important for investors to understand as globalization continues to re-shape the financial world.

But my favorite message from the book is one that I don’t thing gets enough attention in the financial blogosphere — the importance of investing in yourself. Here are a couple of quotes from the book ion the subject:

The best investment you’ll ever make is in trying to understand and maximize the value you can contribute to other people.

This means that most of us will make our true investments in things like our education, skills, training, and so on so we can provide something even more valuable for others.

Most people spend their time trying to increase their investment returns or save more money but end up ignoring their asset with the biggest potential — human capital.

I really enjoyed this book. It was unique, covered a wide variety of interesting material and I gained a new perspective on a number of important financial issues. - www.awealthofcommonsense.com