The Results are in, the US Financial System is Stable

federal reserve

Intro

The Federal Reserve recently published its first financial stability report, which summarizes the Fed’s framework for assessing the state of the US financial system and presents the Fed’s current evaluation. This is important because the findings outlined in the Fed report are used in the design of future stress tests on the nation’s largest financial institutions and in setting the amount of liquid assets that banks and other financial institutions must have set aside in the event of an emergency. It is also highly informative about the current health of the US financial system and the vulnerable areas that may warrant future monitoring. The report is intended to increase public understanding of the Fed’s processes and transparency about its current view of the financial system, which informed stakeholders can use to predict and prepare for future actions taken by the Fed.

The Framework

The Fed’s framework for assessing the resilience of the financial system focuses on monitoring the vulnerabilities that can build up over time. Vulnerabilities are unstable aspects of the financial system that may lead to more widespread concerns in the event of a downturn or an adverse “shock”, such as a trade war or a debt crisis in the Eurozone. There are four broad categories of financial vulnerabilities that the Fed outlines in its report:

Elevated valuation pressures: High asset prices relative to fundamentals or historical norms, which is generally caused by high investor risk tolerance. When asset prices are elevated, there is a higher likelihood of large drops in asset prices.

Excessive borrowing by businesses and households: Too much borrowing can make businesses and households unstable. Falling incomes or asset values will then lead to deep spending cuts affecting overall economic activity and defaults on loan payments will impact financial institutions’ and investors’ performance.

Excessive leverage within the financial sector: In the event of an adverse shock, highly levered financial institutions are less capable of absorbing losses. This in turn reduces their ability to lend and may force them to sell off assets to offset losses.

Funding risks: The possibility that investors will run on the financial system by withdrawing funds. When a run occurs, financial institutions that do not hold enough liquid assets may have to sell assets quickly, forcing prices down and incurring losses.

The report notes that these vulnerabilities can interact with one another, having cascading effects across the financial system. For example, a severe drop in asset prices and income that impedes a business’ ability to pay back its debts could lead to high default rates, causing losses for investors and financial institutions that may be more difficult to absorb if the banks are highly levered. This could then lead to banks selling off assets, further exacerbating asset price declines.

The Fed’s Findings

Given the Fed’s framework and the broad categories of vulnerabilities, the high level view of the Fed’s findings are as follows:

  • Asset valuations are high relative to historical standards and investors exhibit high risk tolerance.
  • Household borrowing has grown in line with income, but corporate debt relative to GDP is high and there are signs that credit standards have been deteriorating.
  • Financial institutions are well capitalized, leverage is below pre-crisis levels.
  • Funding risks are low. Bank assets are liquid and banks rely more on higher quality capital (core deposits) to fund loans than before the crisis.

Overall, the report paints a positive picture of the US financial system’s health. While there are some vulnerabilities present, as there will be in any economy, the Fed does not deem them to pose a serious threat to the country’s financial stability. After providing a high level overview of the framework and the current assessment of the nation’s financial stability, the Fed report goes into detail on the various vulnerabilities outlined in its framework. Here, we examine some of the most interesting findings.

Asset Valuation Pressures
Not too much of what the Fed had to say about elevated valuations was very surprising or concerning. It does point out that current metrics show that corporate debt, leveraged loans (a riskier form of debt), equities, commercial real estate, farmland and residential real estate are all overvalued. However, while valuations are high relative to historical averages, they are still lower than before the crisis and seem to be somewhat in line with what can be expected during a normal business cycle. There will be a correction at some point, but this really only impacts investors in the short term. What’s more, the resilience of other aspects of the financial system reduces the likelihood that a drop in asset prices has a significant impact on the health of the financial system.

One piece of this section that was interesting, however, is the Fed’s conclusion that spreads on high yield corporate debt remain low despite signs that credit risks are increasing (though they have widened considerably in the weeks since the report’s publication). Spreads on high yield bonds reflect the compensation that investors require for the added default and liquidity risk of high yield debt versus investment grade debt. The fact that spreads remain low in the presence of rising credit risks and deteriorating lending standards may present a market inefficiency as investors are not being compensated for the excess risk they are taking.

Borrowing by Households and Investors
Household debt does not seem to pose much of a threat to US financial stability, with debt mostly growing in line with income. While the report notes that some households still struggle with debt and that student loan delinquencies are still above their long run trend (though decreasing lately), the findings seem mostly positive.

Among businesses, however, the Fed report highlights some troubling credit trends. Business sector debt as a percentage of GDP is high relative to historical trends. There are signs that credit standards are deteriorating for many business loans, with a high level of new loans issued to high leverage firms. In fact, the report notes that the leverage of some firms is near its highest level in 20 years and that firms with high leverage, low earnings and low cash holdings have increased their debt burden the most. However, this is contrasted by the fact that default rates remain at the low end of their historical range. In general, the deteriorating credit standards are a sign that the economy is strong and lenders believe low default rates will persist for the foreseeable future. Of course, lenders have been wrong before and in the event of a slowdown this could present more cause for concern.

Another interesting development highlighted by the Fed report is in the distribution of investment grade debt. The share of investment grade bonds near junk status (otherwise known as high yield) has reached near-record levels. This is important because in the event of a downturn, deteriorating business fundamentals could cause this outsized share of business debt to be downgraded to junk status. Many investment funds have mandates that prohibit them from holding junk bonds, so broad downgrades to junk status would force funds to sell off this risky debt, putting further downward pressure on bond prices.

Of all of the vulnerabilities highlighted in the Fed’s report, those affecting business credit seem to warrant the most continued monitoring.

Leverage in the Financial Sector
Financial institutions were largely vilified for their role in the 2008 financial crisis. They were highly levered and held insufficient assets, both in terms of amount and quality, to cover their liabilities when the downturn in the housing market first hit. Since then, reforms by US government agencies, including the Fed and the SEC, have significantly improved the health of the nation’s financial institutions. The report notes that leverage is generally low. The results of the Fed’s most recent stress tests show that banks would be able to continue their normal lending activity even in the most severe scenarios, which include a steep drop in asset prices, a deep recession and general deterioration of business credit quality.

However, there was one slightly concerning finding. Issuance of collateralized loan obligations(CLOs), a security comprised of a basket of loans, hit $71 billion in the first half of 2018. CLOs are largely backed by a form of risky debt known as a leveraged loan, the quality of which has been deteriorating according to the Fed. So, you have high levels of issuance at the same time that credit standards and credit quality are weakening. If economic conditions worsen, leading to increased default rates, the value of CLOs could fall dramatically. Likely for this reason, the Fed points out that CLOs are a vulnerability it will continue to monitor moving forward.

Funding Risks
There was really nothing to see here in the Fed’s report. Funding risks are low. Banks are relying less on capital that has proved susceptible to runs and more on stable sources of funding such as core deposits. Core deposits are those deposits held by the bank that typically come from local customers that are believed to have low risk of being withdrawn, making them a stable funding source.  Banks also hold a larger number of liquid assets to act as a buffer in accordance with regulatory reforms since the crisis.

Near Term Risks to the Financial Sector
After going in-depth on the various vulnerabilities to the financial system, the Fed report points out some of the notable international developments that could pose a threat in the form of adverse shocks. The main threats pointed out in the report are Brexit, a looming debt crisis in the EU (particularly Italy), problems in China and other emerging economies, trade tensions and geopolitical uncertainty. The importance of China in global economic activity warrants it some extra attention. Growth has been slowing and non financial private debt is now 200% of GDP. The Fed report points out that anything that may impede the ability of Chinese households and businesses to repay their debt could “trigger adverse dynamics.” A downturn that reduces income could increase default rates, further reducing growth and leading to economic and political turmoil in the region. The resulting spillover could reduce global growth and strain the US economy, though the impact would not be nearly as severe in the US as in other regions due to the overall resilience of our financial system as highlighted in the Fed report.

Conclusion

The Federal Reserve’s Financial Stability report shows vast improvements across the US financial system since the 2008 financial crisis. Yes, there are some vulnerabilities within the financial system that could undermine its resilience if left unchecked. Yes, there are some external threats that could affect the broader US economy, such as uncertainty around Brexit, currency crises in emerging markets and global trade tensions. However, the fact that the Federal Reserve is not only aware of these vulnerabilities and threats but has publicly released its findings is an extremely positive sign. The Fed will continue to monitor these vulnerabilities and threats, as will investors, financial institutions and other government agencies, and will be able to take mitigating actions before they can pose a serious risk to the economy. Subsequent financial stability reports, which are expected to be published twice a year, will further inform the status of these vulnerabilities and whether or not any future developments warrant monitoring.

Pat Daly is a regular contributor to no gradient, both as a guest on the podcast and now as a writer.

The Lowest Hanging Fruit: Getting Rich Slowly

The single greatest point of leverage for reaching your financial goals is simply understanding how to do it. I’m not asking you to learn new skills, build relationships, or start a business. Though all worthy endeavors, I’m asking you to do something much, much easier. I’m asking you to take advantage of one of the greatest tools accessible to everyone — investing in the stock market. Nothing takes less time and yields greater results. If this is true, why isn’t everyone doing it? Simple.

No one wants to get rich slowly. – Warren Buffett

However, getting rich slowly is the easiest way. The stock market is risky, you say? It’s only risky if you are trying to get rich quickly. Year to year it might lose value, but over a long enough time horizon it consistently marches upward. Below shows the performance of $10K invested in the S&P 500 (a basket of the 500 largest companies in the United States, indicative of the market as a whole) starting in 1926. By 2017 the value of that initial investment is $1.7M . And, with dividends reinvested that initial investment grows to $59.1M. The global financial crisis of 2008 is but a blip in the grand scheme of things. True investors, which is what you are, are not concerned with market downturns in the short term because they are long-term thinkers.

Screen Shot 2018-06-22 at 5.36.07 PM
From The Little Book of Common Sense Investing. Another helpful graph.

Dividends are payments you receive as the shareholder of a company. Remember, when you own stock in a company you are part owner of that company and are therefore entitled to reap its profits. Investing in broad market index funds means you are part owner of companies all over the world (“The Steps” I discuss below will outline how you utilize this investment philosophy). All those executives and employees are working FOR YOU, and you barely have to lift a finger. “Dividends reinvested” means more shares are purchased with the dividends you receive, which then receive dividends themselves. This is the power of compounding interest. It is why time is the single most important fuel that powers the money duplication machine that is the stock market. To illustrate this, if you save only $1K per month from age 25 to 35, assuming a 7% growth rate, you will have almost $1.5M by the time you are 65. However, if you wait until you are 35, and save $1K per month until you are 45, you will only have about $750K by the time you are 65. In each scenario you’ve made the decision to invest the same amount of money, but the time you decide to start doing this (age 25 vs. 35) yields dramatically different results. By starting at age 25, you can make double the money you would if you chose to begin investing at age 35. This is staggering. Time more than anything else is the key to unlocking your financial goals. Let’s get started.

The Steps

These should be treated as a solid starting point and will not apply to everyone perfectly. This is why I am such a proponent of becoming as financially literate as possible. How you save your money is an expression of how you wish to live your life, and no one can make that decision better than you.

The enemy of a good plan is the dream of a perfect plan. – Carl von Clausewitz

These steps are meant to be done sequentially. Complete each one before moving on to the next. I explain each step in more detail below.

  1. Save two months worth of expenses in your checking account.
  2. Pay off high interest debt.
  3. Save two months worth of expenses in a low-risk, interest bearing account.
  4. Save two months worth of expenses in an emergency fund.
  5. If your employer offers a 401k (or 403b) match, contribute enough to take full advantage of the match each paycheck.
  6. Max out your IRA contributions every year.
  7. Max out your 401k contributions every year.
  8. Contribute as much as you can to a regular taxable investment account.

The Steps Explained

  1. Save enough in your checking account so that if all of your sources of income stopped, you could sustain yourself without a change in lifestyle for two months. You never know what will happen, so it’s best to be prepared. This will also give you breathing room to make large purchases without having to dip into savings.
  2. Paying off high interest debt is a guaranteed return on investment. Paying off a $1K loan with a 20% interest rate is the same as making $200. Since not all debt is created equal (a credit card is going to have a higher interest rate than a mortgage), I recommend reviewing this guide to help you determine how you should pay off your debt.
  3. Saving two months worth of expenses in a low risk account will offer you greater  financial peace of mind and will partially protect you from the cost of inflation. The value of the dollar goes down over time, which is why keeping all of your net worth in cash is actually costing you money. I recommend opening an account with a 100% bond allocation on Betterment. A 100% bond allocation means your money is far less susceptible to market conditions, which for you means if the market is down you will be able to access your funds if needed with little to no losses on your initial investment.
  4. An emergency fund is just that — emergencies only. This is not for spending on vacation, a new car, etc. Ideally you will never need to dip into this account. Treat it as the backstop for your life. I recommend Betterment’s “Safety Net” account, which is made up of 60% bonds and 40% stocks. Bonds are safer and typically earn less than stocks;  stocks are riskier and typically earn more than bonds. A portfolio split 60/40 will ensure your money grows, but in a way that offers some protection against market conditions.

At this point you have high interest debt paid off and 6 months worth of expenses that are easily accessible. This is an amazing achievement and knowing you have funds to fall back on will give you peace of mind. Now, onto the fun part. Let’s really put your money to work!

5. A 401k is a retirement account that may be offered by your employer, allowing you to contribute up to $18.5K per year as of 2018. Not only are contributions to your 401k not taxed (except for Roth contributions, which you should consider making if you are young and your 401k plan allows it — more on that in the FAQ below), they also grow without being taxed. You will only pay taxes when you begin to withdraw from your 401k account in retirement (more on withdraw restrictions in the FAQ below). If your company will match a percent of your contributions, make sure you at least contribute the maximum percent your employer offers each paycheck. For example, if your employer matches up to 3%, contribute at least 3% of each paycheck to take full advantage of the match. This is free money! You will have multiple investment options in your 401k. Be sure to do your research on which fund you choose. This guide is a good place to start (refer to the FAQ below for additional resources).

  1. An IRA is an Individual Retirement Account which, like a 401k, encourages you to save for retirement by allowing you to deduct your contributions on your taxes (except for Roth contributions or if you make over $135K as of 2018– more in the FAQ below) and also allows your contributions to grow tax-free. An IRA, unlike a 401k, is not something provided by your employer. Anyone can contribute up to $5.5K per year as of 2018 (if you have earned less than $5.5K in a year, you can only contribute up to the amount you have earned). I recommend opening an IRA account on Betterment. Depending on your estimated retirement age, Betterment will recommend an appropriate mix of stocks and bonds. If you are young, it will likely be 90% stocks and 10% bonds, and as you get older Betterment will automatically transition more of your portfolio to bonds to avoid risk.
  2. Now that you have maxed out your IRA contributions it’s time to increase your 401k contributions beyond just what your employer matches. Contribute as much per paycheck as you can and if you are able to max out your contribution of $18.5K per year, do it! The reason I recommend only contributing enough to your 401k to get the match, and then maxing out your IRA, is because generally the fees you pay will be lower and the quality of investment options will be higher in an IRA. It is extremely important to be mindful of investment fees as these will eat away at your potential earnings over time.
  3. At this point you have taken advantage of the two main retirement accounts in the United States, a 401k and an IRA, which allow your investments to grow tax free. Your remaining option is a regular taxable investment account. This account is different from a 401k and an IRA in two important ways. Your contributions will not be tax deductible and the dividends you receive from the stocks and bonds in this account will be taxed. The good news is there are no restrictions on when you can withdraw this money from your account. However, stocks you sell before a year after purchase are taxed at a higher rate than stocks held for longer than year. This is the government encouraging you to invest for the long term. How you invest your money in terms of what percent of your portfolio is made up of stocks versus bonds depends wholly on what you plan to do with the money. Betterment makes it very easy to choose a portfolio that is appropriate. For example, if you are saving for retirement, just like an IRA account, Betterment will recommend a portfolio that is mostly stocks and transitions to a higher percentage of bonds the closer you get to retirement. However, if you are saving up for a major purchase that you plan to make in a year, Betterment would recommend a portfolio made up mostly of bonds because they are less risky over the short term. If you would like to save for a big purchase as well as save more for retirement, simply make two separate taxable accounts. Whatever you do, I highly recommend using Betterment’s Smart Deposit feature that allows you to automatically transfer funds to Betterment when your checking account reaches above a certain amount.

FAQ

What are the key takeaways?

  • Not investing your money is actually costing you money.
  • Low cost, broad market, index investing is the surest way to reach your financial goals.
  • The stock market fluctuates, but over time it marches ever upward.
  • Financial literacy gives you control of your life.
  • Time is your greatest ally for reaching your financial goals. Start as early as possible. Start right now.

Where can I learn more?

How much should I save?
This is a very personal question and really comes down to what your goals are, which is why I encourage you to become as financially literate as possible. Only YOU truly know what your goals are. Having said that, a good general rule is to save 20% of your pre-tax income every year. As for how much you should save based on your age, if you plan on retiring in your 60s a solid rule is your annual salary saved by age 30, twice your salary by 35, three times your salary by age 40, and so on. But don’t fall for the 40 years of work 9 to 5 trap. If you save diligently, and start when you are young, you can easily reach your financials goals while you still have some life in you.

I’m young. Why should I worry about saving now?
Because time is your greatest ally. To illustrate this, if you save only $1K per month from age 25 to 35, assuming a 7% growth rate, you will have almost $1.5M by the time you are 65. However, if you wait until you are 35, and save $1K per month until you are 45, you will only have about $750K by the time you are 65. In each scenario you’ve made the decision to invest the same amount of money, but the time you decide to start doing this (age 25 vs. 35) yields dramatically different results. By starting at age 25, you can make double the money you would if you chose to begin investing at age 35. This is staggering. Time more than anything else is your key to unlocking your financial goals.

How long before I can enjoy the benefits of investing?
On the order of a decade, not several decades. If you save diligently starting in your early 20s, by your mid 30s your investments can can be large enough such that the magic of compounding interest can do the rest of the work. This will allow you to save less and spend more even before you stop working.

Why Betterment and what are some alternatives?
I recommend Betterment because it has low fees, an investment strategy that exposes you to the entire market, is easy to use, and has advanced financial features like Tax Loss Harvesting. Betterment is what is known as a “robo-advisor,” which means a sophisticated computer algorithm, rather than a human, tailors your investment strategy based on your goals. I am a big fan of robo-advisors in general, and there are others like Wealthfront and Wealthsimple that are solid options as well.

If I don’t make a lot of money, can I really reach financial independence/retire early before my 60s?
YES. It all comes down to how much you save, that’s it. Cutting cable TV and your morning Starbucks run can help you retire 8 years earlier. Yes, I’m serious.

It’s not what you make it’s what you have left over. – Bob T., Legendary Family Friend

I’m having trouble cultivating a saving mindset, what do I do?
First, realize that $100 you spend today is thousands you could have spent in the future had you invested it. Second, understand the simple fact that humans get used to things very quickly. Purchasing a luxury car, designer clothing, and other unnecessary things give you a temporary happiness boost. However, soon that happiness boost becomes the new normal and you are right back where you started– except with less money in your pocket. I’m not telling you to save all your money. I’m telling you to truly think about how you spend it. I’m telling you to spend money on the right things when you are young and save the rest for when you are old.

What is the magical 4% rule?
This refers to the maximum amount you can withdraw from your investments while still sustaining you for your entire life. If you can survive off $25K per year, you only need to save $625K to reach your financial goals and retire. Estimate the amount you need per year to live a comfortable life, multiple this by 25, and that is your goal. This is backed by hard data and even takes into account having to withdraw when the market is down

The market crashed. What do I do!?
Stick to your investing strategy. Absolutely nothing changes. You are investing for the long term, so market downturns in the interim are pointless to worry about. Refer to the chart at the top of this post.

The market is hot right now. Why shouldn’t I wait for a crash to buy in cheap?
It’s always possible a crash is on the horizon, but it’s also possible the market goes up another 20% then crashes only 10%. The reality is no one can predict this consistently, not even professionals. Time in the market is always better than timing the market. Keeping your money in cash while waiting for a crash instead of invested in the market will make you lose out not only gains in the market, but also those precious dividends. Timing the market is extremely difficult to do. Even professionals can’t do it consistently and they do this for a living.

I just read an article about the hottest stocks/funds. Why shouldn’t I purchase them?
Because what is hot today will likely be cold tomorrow. As John Bogle says, “Don’t look for the needle in the haystack. Just buy the haystack!” Investing in low fee broad market index funds (which Betterment does) is the only way to ensure you earn your fair share of stock market returns. Buying and selling individual stocks will cost you trading fees, higher taxes, and more energy. Not even the best Wall Street traders can consistently beat the market over the long run. Warren Buffet, the most legendary investor alive, famously won a $1M bet that the S&P 500 index would beat a basket of hedge funds over a ten year period starting in 2007. Buffet has also gone on record saying that he wants 90% of his fortune to be invested in an S&P 500 index fund.

What other services do you reccomend?
I recommend Personal Capital for tracking all your accounts in one place and Credit Karma for building a solid credit score.

How often should I check my investments?
No more than once a month. True investors, which is what you are, are not concerned with market downturns in the short term because they are long-term thinkers.

What are Roth contributions and should I make them?
“Roth” means that your money is taxed before you put it into your 401k or IRA. That means when you withdraw the money in retirement you will not pay any taxes on it. As of 2018, if you make over $120K the amount you can contribute to a Roth IRA begins to diminish until $135K where you are restricted from contributing at all (no such restriction exists on a traditional IRA). The general rule is you should make Roth contributions while you are young because your salary is likely the lowest it will ever be. However,  the reality is no one has any idea what the tax code will be several decades from now when you withdraw from your retirement accounts, so I recommend a mix of both Roth and traditional contributions.

When can I withdraw from my 401k and IRA?
When you turn 59 ½, though a 401k and an IRA each allow you to withdraw before that under special circumstances. If you withdraw early without a special circumstance, you will pay a hefty fee. A Roth IRA offers more flexibility, and even allows you to withdraw contributions (not money earned on the contributions) without any penalty. Avoid withdrawing early at all costs because keeping your money working for you as long as possible is the surest way to reach your financial goals.

What happens to my 401k when I leave my employer?
You have several options, but likely you will want to (1) keep it where it is, (2) roll it into the 401k plan of your new employer, or (3) roll it into an IRA. Roll it into your new 401k plan if it offers lower fees and better investment options. If both your old 401k plan and new one have high fees, consider rolling it into an IRA. There are drawbacks to this, including funds in your IRA being less protected in the case of a lawsuit or bankruptcy.

Do I really need a six month buffer?
Everyone has different goals and risk tolerances, which is why I encourage everyone to become as financially literate as possible. Having less of a financial buffer will allow you to invest more of your money and earn more long term, but it offers less flexibility in the short term. The balance is up to you.

What about a dedicated financial advisor?
In a world where investing is a commodity and the internet provides information for free, most people don’t have a complex enough financial situation to justify an advisor. Don’t outsource your financial decision making. Take control of it yourself because it has never been easier. For those that insist, Betterment does offer dedicated financial advisors for a higher fee.

This all sounds great, but ultimately money doesn’t buy happiness so why bother focusing on it?
Don’t make the mistake of thinking money isn’t important. Money is power. It allows you to meet basic needs, support your family, donate to nonprofits, travel the world, fund your passion, and retire early. Money is what you make of it.

Money is a great servant but a poor master. – Francis Bacon

Project Treble, Coming into its Own

Project Treble is the biggest re-architecture of Android since it was born, and Google announcing that the Android P beta will be supported by nearly a dozen smartphones is the clearest indication yet that it is working.

The following shows the one year adoption rate of each version of Android:
50.6%, Gingerbread                 
23.7%, Ice Cream Sandwich 
25.0%, Jelly Bean                     
30.2%, Kitkat
25.6%, Lollipop
24.0%, Marshmallow
7.1%, Nougat
5.7%, Oreo (August 2018 will mark one year since its release.) 

Gingerbread was a fluke for many reasons, so it’s safe to say that 25% penetration after one year has historically been the norm. The drop off in Nougat and Oreo can be explained largely by the maturity of the smartphone market. The year over year improvement in devices isn’t as much as it used to be, inclining users to hold off on replacing their smartphone for a longer period of time. This downward trend is about to change dramatically.

The following are my predictions for the one year adoption rate of future Android versions (+/- 2.5%):
Android Oreo, 9%
Android P, 15%,
Android Q, 19%
Android R, 22%
Android S, 24%
Android T, 25%
Android U, 25%

There are two levers driving my predictions. The first is the fact that new Android devices will support Treble and thus contribute to an increased one year adoption rate. The second is the fact that the smartphone market is maturing and users are replacing their devices at an increasingly lower rate. And since even devices with Treble won’t receive updates for more than ~3 years, the one year adoption rate will taper off to ~25%.

Let’s see what happens.

 

Of Delusionists and Blochaters

For every popular phenomenon there is an equal and opposite group of detractors. This creates a positive feedback loop where the promoters become more fervent in their support as the detractors become more fervent in the opposite, and vice versa. This leaves us with two irrational groups.

Blockchain is no different. The delusionists on one side frothing at the mouth that blockchain will change everything, can be used for everything, and oh, many of them are financially invested so they are less concerned with the truth and more concerned with pumping their portfolio. On the other side are the blochaters, who have been pushed so far into the detractor camp by the delusionists that they dismiss the technology all together. Kai Stinchcombe is one of these blochaters, and he has written two excellent posts that many are rallying around because they are sick and tired of hearing the buzzword bullshit. I mostly agree with Kai but his second post makes two points that I’d like to respectfully attack. Kai writes:

“Blockchain systems are supposed to be more trustworthy, but in fact they are the least trustworthy systems in the world. Today, in less than a decade, three successive top bitcoin exchanges have been hacked, another is accused of insider trading, the demonstration-project DAO smart contract got drained.”

This isn’t fair. It’s not the blockchain systems that have been compromised, it’s the infrastructure built around them that have been compromised, i.e. the non blockchain parts. Bitcoin has existed for almost a decade and it has not been directly compromised once. That is a fantastic feat for a system that exists on the internet and is owned collectively by people all over the world. Yes, keys have been stolen, wallets have been drained, but the protection of private keys is outside the scope of the Bitcoin network. As for the DAO smart contract bug, that wasn’t an issue with Ethereum itself, that was an issue with the contract written on top of Ethereum. Companies worth billions of dollars are getting hacked on a regular basis, but that isn’t a problem with the internet, that’s a problem with the company’s security practices.

As for the second point I take issue with, Kai writes:

“A lawless and mistrustful world where self-interest is the only principle and paranoia is the only source of safety is not a paradise but a crypto-medieval hellhole.”

Brother, this is the world we already live in. Don’t let the shower twice a day and nifty technology fool you, humans are running on caveman software and we are all one week of no food away from destroying each other. 75 years of peace without a major war is not the result of a global morality boost, it is the result of mutually assured destruction. What has kept the peace is not that we trust each other more as a species, it’s that nations have guns pointed at each others collective heads. What an irony that the greatest weapon ever created has made war obsolete. Nations have a self interest to avoid war at all costs and miners have a self interest to follow the rules of the network or face financial loss. It is this very threat of loss that keeps both nations and blockchain networks well behaved.

The great innovation of blockchain technology is that consensus can be reached among parties that don’t trust each other individually, but are able to trust each other collectively- without an overseer. This is not only a huge technological feat, but a social one. The only previous technology that has come close to this is the BitTorrent protocol. Blockchain is in its infancy. It is a solution looking for a problem. I can’t tell you exactly what problems it will find, only that I’m optimistic it will find them. And no, IBM hasn’t found the problem either. Besides the fact that blockchain only complicates supply chain management, a company pushing its own blockchain system is backwards and removes its main selling point- decentralization. I’ll leave you with this from Benedict Evans (whose newsletter I recommend):

“You can believe both that crypto is full of delusional utopian lunatics saying stuff that’ll never happen and that it’s a profound technology that will change the world. That’s what talking about the internet was like in 1994.”

Reminiscing on the Release of Windows 7

Coming off the disaster that was the release of Windows Vista with its performance and compatibility issues, there was a palpable sense in the community that Windows 7 had to be our saving grace. Despite Windows having the vast majority of the market share, we fanboys felt under attack. Everyone thought Macs were cooler, easier to use, safer, and faster. And the worst part of all, you had to field the onslaught of “Macs are better” from your sister’s friends. “Security through obscurity,” we cried in defense. Harder to use wasn’t a bad thing, we took pride in it. We did our duty, we relished in defending our platform. The strongest among us believed Vista was only unsuccessful because the OEMs didn’t properly update their drivers. But in our heart of hearts, we knew the truth.

Much to our delight in 2007, a mere six months following the release of Vista, Microsoft announced the next version would be codenamed “Windows 7.” The salivating started, we saw a flicker of light that would be our salvation. Then, in 2008, Microsoft officially announced the name would be “Windows 7.” We cheered. The name was simple, obvious, to the point. It felt fast, easy to type, easy to translate, it oozed efficiency and we couldn’t wait to touch it. In late 2008 a beta version of Windows 7 was leaked and distributed on torrent sites. The bravest among us slapped it on our machines and sung its praises near and far, anything to wipe the memory of Vista from our minds as quickly as possible. “Using the beta on machines responsible for life support, at a hospital where I work, runs perfectly, absolutely zero problems,” sang the evangelists. In early 2009, Microsoft released the official Windows 7 beta. Microsoft wanted to hear from us and there was a real sense that they were listening. Our duty was to install the beta and give feedback, if only in the form of anonymous usage statistics. We were in this together.

I remember being stationed at my parents’ dining room table, installing it on my 10-pound machined plastic HP dv6000 with that AMD Turion engine.The feeling of risk and fear we all get when we do a fresh install, a part of us thinking, “this might not work.” Worked it did, and on boot I was awarded with that beautiful betta fish. I leaned back in my chair, looked up at the heavens to Steve Ballmer and Bill Gates, arms outstretched, palms up, head back, “We made it.”

The betta fish wallpaper, a nod from a large behemoth of a corporation that said, “Hey, thanks for testing our software, here’s an inside joke we know only the real hax0rs will get ;).” We ate it up. Windows Aero was fully realized, and for some reason we liked it a lot more in 7 than in Vista. The taskbar, unapologetically geometric, it all felt so right. And of course those insane wallpapers that were introduced in Windows 7 RC 1. I remember a digg.com post, God rest its soul, that topped the charts saying, “Microsoft is on some serious drugs,” linking to the wallpapers, we loved it. They showed us that Microsoft had changed. They showed us that Microsoft knew how to have fun, and have fun with us, the community, because no one else cares about these minor details. But we did, and we cared that Microsoft cared too. The wallpapers were a victory lap for a product that hadn’t even been released. At this point, we all knew the success of Windows 7 was a foregone conclusion.

The official release in October 2009 was glorious. Pre-order records were broken, adoption soared. The troves of Windows XP users who avoided Vista were beckoned, we took their hands and told them it was safe now, they could come out of their troll holes and upgrade. That default wallpapergreeting you on first boot, like the name, it was efficient, simple, it was a digital manifestation of the promises of Windows 7. Promises kept, thanks in part to us. We had arrived.

Only this time it’s Blockchain

In A Random Walk Down Wall Street, Burton G. Malkiel writes:

“It was called the tronics boom, because the stock offerings often included some garbled version of the word “electronics” in their title, even if the companies had nothing to do with the electronics industry. Buyers of these issues didn’t really care what the companies made- so long as it sounded electronic, with a suggestion of the esoteric. For example, American Music Guild, whose business consisted entirely of the door-to-door sale of phonograph records and players, changed its name to Space-Tone before “going public.” The shares were sold to the public at 2 and, within a few weeks, rose to 14.”

60 years later we are seeing companies add blockchain to their name with similar resultsCastle in the air theory is in full effect and I expect that most speculators are purchasing these shares simply because they think they will be able to sell it to someone else playing the same game for a higher price. Eventually the music stops, it always does. For better or worse I expect the havoc to the public stock exchanges will be mitigated by the fact that speculators can fill their insatiable appetite buy taking part in ICOs and purchasing cryptocurrencies directly. Do I think we are in a bubble? Absolutely. Do I think that blockchain and the potential of distributed consensus will ultimately prove to be useful? Yes. We are in the early days of blockchain and though not much has come of ityet, I think it’s only a matter of time. The bubble will burst, the hype will die, and the people in it for the right reasons will keep their noses to the grindstone and take this to the future where they’ll be waiting for us.

Hodlers, Consider This

Given the absolute stunning rise in the value of the cryptocurrency market, this is leaving many with the difficult decision of whether they should sell some of their position or not (remember, it doesn’t have to be all or nothing). So what should you do? There is no single answer as everyone has different financial goals and risk tolerance. But I ask you to consider two principles when determining when and how much you should sell, loss aversion and rebalancing.

Loss aversion “refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains: it’s better to not lose $5 than to find $5”. Given this, hedge your bets against your future self feeling devastated if the value of your position plummets. This will cause less pain than the pain of missing out on even greater potential gains.

Rebalancing “is the process of realigning the weightings of a portfolio of assets.” You never want your asset allocation to be heavily skewed toward one specific asset (e.g. Apple stock, Bitcoin, etc.) as this decreases the diversification of your portfolio and increases your level of risk. If you have $20k in traditional non cryptocurrency investments that include a range of different stocks, bonds, etc. and $20k in Bitcoin, half your portfolio is in one specific asset. This is an extremely risky position given all it takes is for Bitcoin to diminish in value, and that brings your entire portfolio down with it. You may even feel that given the performance of cryptocurrencies recently you should invest even more than you already have. This is dangerous. As the prices continue to climb, simply by not selling you are in effect increasing your investment already, because you have that much more to lose. Consider this, let’s say you purchased 1 Bitcoin in 2017 for $1k. At the time of this writing, your initial $1k investment is now worth ~$20k. You may be tempted to continue to hold, because you think to yourself, “this was only a $1k investment anyway, so what if I lose it.” This is an incorrect way of thinking and just because cryptocurrencies are new, doesn’t mean sound financial principles do not apply. The reality is, you now have $20k to lose, not $1k. And framing your position this way will allow you to make more sound decisions regarding when and how much to sell.

For those who have made significant gains, I would say there are two groups. The first group is loss averse, made up of those who are constantly worried about their crypto assets and constantly checking the prices throughout the day. To this group I would say, this is no way to live. If done in a healthy manner, making money should reduce the stress in your life, not increase it. If you fall into this group, I would sell enough so that even if all of your crypto assets go to zero, you will still be satisfied with the amount you made. The amount to sell to reach this point will be different for everyone but I would say a good starting point is to sell at least enough to get your initial investment back plus some on top of that. The second group is not phased by the extreme price changes and is not letting it affect their daily lives. To this group I say, seriously consider selling to rebalance your portfolio to a more appropriate asset allocation. Yes, crypto market capitalization has seen a fantastic increase, but that doesn’t mean it will continue forever, it almost certainly won’t.

Whatever you do, be sure you are aware of your country’s applicable tax laws (here is a great guide for US citizens). Even though it is in a gray area right now, I would err on the side of caution and report your gains to the government. You don’t want to get in a situation where you have made a bunch of money, didn’t report it, and then get in trouble for tax evasion down the road. That would cause stress and remember, making money should reduce stress. For those in the United States, the IRS has released guidelines which means your crypto gains are taxed as capital gains, just like a stock. If you have held for at least a year before you sell, it will be taxed as a long term capital gain, which means you will be taxed at a lower rate than if you held for less than a year. This should certainly factor into when you plan to sell, but don’t take this to mean you should wait a year no matter what. The extra tax associated with short term gains may pale in comparison to the loss of value of your crypto assets while you wait for the one year mark.

A lot of the narrative around cryptocurrencies is that they will replace our entire financial system and investing in tradition stocks and bonds no longer makes sense in this new world order. This is absolutely wrong. I think John Bogle’s thoughts on gold being a speculation instead of an investment apply to crypto as well. He argues “Bonds are supported by interest coupons, stocks are supported by dividend yield and earnings growth, and gold is supported by the ability that someone is going to take it off your hands for more than you paid for it.” Regardless of whether cryptocurrency proves to be a success and ultimately facilitates a large part of the world’s financial transactions, this doesn’t mean that investing in companies through stocks and bonds will be obsolete. No matter what happens in the crypto world, a steel company will still make and profit off of selling steel, and that profit will flow to its shareholders. The crypto world right now is where the web was in 1995. The pieces are there but no one quite knows for sure what’s going to be built. Bitcoin and all these other cryptocurrencies could very well be the Netscape of the crypto world.

Whatever happens with the price, the winners, the losers, don’t forget to appreciate how unbelievable all this is. A bunch of personal computers connected to each other in 2009 started something that the world’s largest banks and governments are needing to respond to. What a time to be alive.