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Wednesday, October 6, 2010

Making Money With Money

TO earn money with money, you must place that money at risk. When I talk about earning money, I am talking about increasing your purchasing power. This is an important concept to understand.

For instance, a bank earns money by lending money, determining the likelihood of getting paid back by a borrower, and assigning a risk assessment - the interest rate - to that borrower. They can earn money on that borrower, or they can lose it all.

Where does the bank get its money to lend? There are a number of sources.

You are the number one source.  When you make a deposit at your bank, you're making a deal with them: In return for giving you my money, you will guarantee I get it all back. The bank buys an insurance policy for your money (FDIC insurance) then lends it out.

If you want to have 24/7 access to your money via a checking account (technically called a Demand Deposit Account), they won't pay you any interest. If you agree to some restrictions in a savings account - such as maintaining a minimum balance - they'll pay you a bit of interest. If you'll lock your money in with them via a CD for a considerable period of time - usually a year or more - they'll pay you a decent interest rate, historically much better than a regular savings account (although that's not the case right now). It's cheaper for them to give you some money rather than having to hunt around for other dollars to lend out.

A bank can also get money to lend by issuing stock. You give the bank money in exchange for an ownership interest in the bank. You can make money in two ways: The bank pays a quarterly dividend and the value of your stock can increase.

There's a catch, though: Your money is totally at risk. If the bank goes belly up, you can lose your entire investment.

Finally, a bank can issue bonds. In this case, the bank is the borrower, and agrees to pay the investors a set interest rate over a set period of time, usually 10 to 30 years. While your invested money is at risk, you are considered a secured investor, and get your money back first from the sales proceeds if the bank collapses.

There are a number of nuances and exceptions, but this is the general structure.

When you place your money in a savings account or even a CD, you are not earning money per se, even when you're getting paid interest on the account. You're being paid an inflation hedge.

What? Take a look at any extended period of time, and look at the inflation rate. Let's say it has been 4% over the period of time you review.

Now, look at the average savings rate. To just break even - to preserve your purchasing power - you need to make at least as much as inflation is taking, PLUS the amount you will pay in taxes on your interest income. If you're in a 20% federal and state tax bracket, you'd need to make at least 5% on your money.

If you have $1000 in a bank earning 5%, you will earn $50 in interest, and pay $10 (20%) in taxes, for a net of $40.

The inflation rate being 4%, has made your $1000 only able to buy $960 worth of goods. That net $40 you earned in interest preserved your purchasing power.

IN a post last week ("Ramblings On Finances") I wrote about putting money into precious metals as a way to preserve your purchasing power.

I don't look at PMs as an investment as much as I look at them as a hedge against inflation.

PMs are an odd bird. They can make you money by increasing in price, but there is a risk component that isn't there with savings or CDs. You're not guaranteed to get all of your money back. And like cash under the mattress, it can be stolen.

But unlike stocks, you will never be totally wiped out. There will always be an instrinsic value to PMs.

Right now, I am putting my long-term "savings" into PMs. Money I don't intend on spending or needing over the next 12 months. In my opinion, the convenience and interest rates being offered by savings/CDs is not enough. Both are paying rates that are lower than the rate of inflation.

Like a checking account, every dollar in a savings/CD account is reducing your purchasing power, so I want to limit the amount of money in those types of accounts.

Based upon the Federal Reserve's anticipated expansion of quantitative easing (printing up money to buy our own debt - "QE2") our government is telling us that their plan is to further devalue the dollar.

This MUST result in an even higher rate of inflation. The only thing that is keeping inflation in check right now is the deflation being caused by our depression/recession. So, ironically, if the economy strenthens, inflation will soar! 

Accept The Challenge

I AM NOT suggesting everyone go out and dump all of their CDs into PMs. I am suggesting that everyone do a little math and a little personal financial self-assessment.

Do you have money in a long-term bank account? How much of that do you expect to need to spend this coming year? Would there be any kind of incident that would require immediate access to your money? Or asked another way, do you have the time to convert your PMs into cash for this emergency?

A way that PMs are like stocks is that you have to pay attention to the economy. If you invested in BlockBuster Video stock, I hope you were paying attention, otherwise you are hurting right now.

Precious Metals could absolutely be in the middle of an "asset bubble" right now. The proverbial "irrational exuberance" might be pushing up prices.  The government could change policies to trash PMs.  There are a million things that could cause prices to crash.  Seriously.

I don't think so, but what I think isn't worth a damn for YOUR money. I'm just a guy that has done research and think I'm making the right decision. I think PM prices will continue to rise in price.

I could be very wrong. Take what I've presented and put it through your own filter. YOU are responsible for your money. You need to do the research and take a "gut check" to see what feels right.

As I noted in the comments of the cited post, my mom and one of my brothers will likely NEVER feel comfortable putting money in PMs. That doesn't make them wrong, or chickens or stupid. They've done their own look-see, and PMs aren't right for them.

That's OK. Do what's right for you.

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Copyright 2010 Bison Risk Management Associates. All rights reserved. Please note that in addition to owning Bison Risk Management, Chief Instructor is also a partner in a precious metals business. You are encouraged to repost this information so long as it is credited to Bison Risk Management Associates.


Russell said...

Just started dropping in to read your blog. Excellent post. Started buying a little silver, here and there, last year. One thing to remember: if there is an economic collapse in this country and the .gov starts closing banks - how are you going to withdraw your money? A little bit of silver may help if needed.

Joseph said...

Chief, good post.

Re: Inflation
The problem with this area is most average, middle-class people give it lip service but don't really understand the implications. A great example is where one spouse controls the money ($-SP) and the other spouse buys the food (Eat-SP). The $-SP gets on the Eat-SP for 'exceeding the food budget'. The Eat-SP can say things are getting more expensive and unless they want to cut out something it costs more, people do not take the time to analyze why they are in their predicament. Maybe it is the fact that it is a slow death so they don't see the slow erosion in their purchasing power. They don't take the time to critically analyze that the government is saying 3% inflation when their grocery bill jumped 10%, taxes went up 3%, there are now fuel 'surcharges' on things that weren't there before and the $.99 menu items are now 15% smaller. The answer seems easy at first but getting most people to 'get it' and then execute a plan to mitigate the problem is difficult.

Remember 'Where's the beef?' by Wendy's? Have you bought a Wendy's burger lately?

Re: PM Buying
You said some of what I'm about to say but I'd like to offer a different dimension to the conversation if you don't mind, any input is appreciated. After a handful of years of trying to get people to 'see' the benefit of PMs I've found it most productive to start off simply asking how they currently view PMs. Most people seem to see PM buying in one (sometimes more or sometimes none) of the following 3 types: Investors, People looking for an Inflation Hedge and Survivalists? If they don't know anything about PMs I ask how much planning they do for each of those 3 areas. This helps me to frame the rest of the conversation to their goals since the goals and expectations while holding PMs can be significantly different. For example investor types tend to be apprehensive about price changes where a survivalist could care less.

Chief Instructor said...

Russell, thanks for coming by. I hope you'll continue to make comments.

Your point on the Bank Holiday is well taken. It's one of the reasons I keep cash and PMs at my house. I want my money in my hands!

Joseph, very few people actually pay attention to the creeping of inflation. You're right: There's no beef left!

We had our first "survivalist" in the shop today. Most have been lookee-loo's or hard-core coin guys. This guy was a TEOTWAWKI guy. He was very interested in our scrap silver cabinet!

Anonymous said...


Quick question on junk silver. I've been buying for awhile but recently have been picking up more Franklin halves than anything else (also have a good amount of Morgan/Peace dollars).

The Franklins usually have very little wear and sell much closer to the spot price, while dollars with less wear seem to go for at least a couple bucks over.

Getting to the question; is it wise to go with a lot of Franklins for the closer-to-spot price, or do you think dollars are a better investment/hedge? Or neither?

Russell said...

I wouldn't call myself a survivalist. I am, however, a father and husband trying to do his best to provide for his family. I invest and trade stocks as a hobby. PM's are a logical choice for my portfolio. Silver has done very well for me this past couple of years.

I like to keep cash and a few hundred ounces of silver on hand just as a precaution. No tin foil hat stuff here. Just a fella who likes to be prepared.

Chief Instructor said...

Suburban, great question. For those that are unaware, for pre-1965 coins, 10 dimes, 4 quarters, two halves all weigh 25 grams and contain 90% silver, so their intrinsic "melt" value are all equal.

The Morgan and the Peace silver dollars weigh a bit more, and also contain 90% silver. At current silver spot prices, they have about a dollar of extra silver.

At full retail prices, a dollar face value of pre-1965 coins can be bought for about $16.50.

A Peace silver dollar will run you about $21 and a Morgan will run you about $21.75. Based on the silver content, they should be no more than $17.50 or so.

Now, to answer your question: Clearly, silver dollars carry a premium. Morgans, in particular, are highly sought after. If your Morgans are pre-1921 (the last year of the Morgans and the first year of the Peace dollars) you can expect to pay around $23 a coin.

Personally, I don't like paying a numismatic premium. It is based upon an opinion, not intrinsic value.

But, right now, you can sell your silver dollars at virtually every coin shop in America. You can ALMOST say that about halves, quarters and dimes. Not quite, though.

An American Silver Eagle retails for about $25 or 80 cents per gram of silver. A pre-1921 Morgan costs nearly 96 cents per gram of silver (spot silver at $22.50 per ounce equals 72 cents per gram)!

I have mostly 50 cent pieces and quarters. In pure silver, I'm at about 75% in silver rounds, and 25% in American Eagles. I don't have any Morgans or Peace dollars. Both of my partners, though, have TONS of Morgans.

Bottom line is, dollars sell more easily, "junk silver" not as quickly. Do you want a lower purchase premium, or greater ease of re-sale?

Chief Instructor said...

OOps, forgot something: Junk silver goes for about 73 cents per gram of silver.

Russell, I shy away from the "survivalist" moniker myself, as it tends to have a negative connotation with most people. I'm a prepper. I don't intend on just surviving what may come, but thriving.

What I do is the same as buying life or auto insurance. I'm preparing for bad things. I hope they don't happen, but I'm pretty well prepared if they do.

Anonymous said...

Thank you, much appreciated. I initially picked up Morgans and Peace dollars, but for about $16-17, and since then have focused mostly on Franklin halves, with a bit of quarters/dimes. I'll probably stick with the halves for now.