People who are familiar with the popular board games of checkers and chess understand that there are vast differences between the two, even though they are played on the same board. Checkers involves a simple, linear game where the objective is to capture all of the opposing players through simple jumps and reach the other side of the board so that a player can be "Kinged" and move both forward and backward on the playing board. When the game shifts to chess, dynamics change drastically. The game of chess involves different movements for different pieces. There are also a handful of specialty moves. Furthermore, victory is not one of simply eliminating all of the opposing pieces. Winning a game of chess hinges exclusively on capturing the opponent's "King" and does not require that you capture more pieces than the other player.
The complexity of strategy increases by many orders of magnitude when moving from checkers to chess. Even though the playing board is the same, the games are completely and totally different. Checkers is simple, linear, and easy to understand... similar to the financial advice that most people receive. Frequently this advice is somewhere along the lines of go to college so that you can get a job, save 10% of your income in a stock account, and you will have a comfortable retirement with your stock account, pension, and social security.
On the other hand, we have the game of chess where strategies vary wildly based on individual game situations and super computers are placed into competition against master players to test the quality of their strategic thinking. This more closely resembles the current financial world. Real estate values have taken a beating, stocks have only experienced a partial recovery relative to pre-recession levels, the Government is running unheard of deficits, the Federal Reserve is printing new money out of thin air, pensions across the country are in danger of collapse and Social Security expenses are already exceeding FICA tax revenues. This situation is clearly not financial checkers, it's chess.
In order to prosper with the financial world becoming more complex and less predictable, it requires more sophisticated strategies. The promises of social security and pensions were made by past generations of politicians without the slightest thought or care how they were going to be financed in the long run. The long run has arrived, and the party is about to end. It is likely that the government will result to monetary expansion (known to regular people as "inflation") to satisfy their nominal obligations. This will carry the unfortunate result of de-valuing the social security and pension payments they are making, de-valuing the savings of people who acted responsibly, de-valuing the equity of people who paid off their homes, and de-valuing the income paid to people who purchased bonds because of their "safety" relative to other investments. In this situation, all of the people who have been trained to play financial checkers will be slaughtered by the financial buzz saw of runaway government and inflation.
What will happen to the equity in that home that everybody told you to pay off? What will happen to the value of your investment portfolio that everybody told you to judiciously save, and then invest in bonds to protect against market cycles? What will happen to the value of your employers pension payments? What will happen to the value of your Social Security payments, if you even receive them? The answer to each of these questions is that your hard work and sacrifice will be rewarded by inflation that decimates the purchasing power of all your assets.
So how do we play financial chess? How do we beat this game where responsible savers are punished so that politicians can spend money to purchase votes? The answer is to own assets that increase in value with inflation and owe liabilities that are destroyed by inflation.
Assets that Increase in Value with Inflation
The first thing that most people think of when talking about inflation-favored assets is gold. However, gold represents a fundamental enigma, since its value is purely speculative. The only thing that gives it value is a willingness by somebody else to pay you for it. It is not used for many industrious purposes outside of jewelry. Some people have certainly profited from increases in gold prices, but the fundamentals do not justify making gold the basis of your financial future.
Another thing that many people think of is stocks. It is certainly true that the stock market is a much greater hedge against inflation than bonds, but there is a deeper understanding that many stock market investors miss. Aggregate stock market values move up and down based on the total amount of capital in the market. Presumably, more money in circulation will result in more stock market investment. However, there is a danger that higher prices will mean less capital available to inflate market values. The flip-side of this danger is that many of the companies who will have their prices most impacted by inflation are the same ones who pay dividends. Thus, it is most likely that a higher percentage of stock market returns in an inflationary environment will come from dividends instead of capital gains.
Another very important asset that increases with inflation is rents. Not necessarily home prices, but rents. The important difference is that home prices are based on credit availability. During inflationary times, it is likely that high interest rates will decrease housing affordability. However, that same decrease in affordability will increase rents by pushing more people into the renter pool. Thus, people who invest in income properties are likely to have some very prosperous times ahead as their rents increase from the influx of people who need to find new housing.
Liabilities that Decrease in Value with Inflation
The key liability that decreases in value with inflation is fixed-rate debt. The reason for this is because inflation frequently rolls through to wage incomes, dividends, and rent incomes. Inflation also frequently pushes-up interest rates. However, if you own a long-term loan at a low rate of interest, it means that you can pay back that capital at a low rate. If your other forms of income flow from areas that increase with inflation, it will result in your loan becoming cheaper over time. In the Creating Wealth Show, Jason Hartman refers to this as "Inflation Induced Debt Destruction."
In this scenario, a paid-off loan can actually become problematic. If tight credit suppresses the value of your house, and inflation destroys the value of your equity, it can place you in a tight financial situation. People who use the power of the home mortgage to borrow at low rates of interest for a long time can frequently invest in assets such as income property that produce much higher rates of return than their interest payment and realize a significant profit.
The key to winning at financial chess and thriving in an inflationary environment is to create income streams that are pushed up by inflation, and finance those income streams with fixed-rate liabilities that are eroded by inflation. The incentives of the financial world have been rigged against people who took what was once good advice and turned them into people who are waiting to be fleeced by a government that is hungry for money to feed its unmet promises. It is a matter of mathematical certainty that the current trajectory of government entitlements and spending cannot continue. The result will be large budget cuts, large amounts of inflation, or some combination of the two. When these events finally unfold, it will be the people who have educated themselves and played financial chess that will come out ahead when the world of checkers finally implodes.
