I’m very pleased with my new book, What’s Wrong With Money? The Biggest Bubble of All, which was published this month by John Wiley & Sons. I am also pleased that TalkMarkets has asked to publish this small snippet, from the start of Part III of the book. What’s Wrong With Money? is about, at its root, the structure of money itself and why our money - backed by nothing but trust that someone else will accept it at a reasonably-predictably level in exchange for something we need - is at risk if lazy or incompetent central bankers and other policymakers play fast and loose with that trust. As I say in the Preface: “Never before has so much ridden on trust. And never before has that trust been so abused, and so stretched. What’s wrong with money? Nothing, and everything.”

In the book, Part I is concerned with what money is, how it is distinct from the concepts of currency and wealth, and why we need money in the first place. In Part II, I write about how the actions of fiscal and monetary agents in response to the global credit crisis have impacted us today, and how those actions narrow the set of potential future outcomes. In Part III, which this excerpt introduces, I tell you how this should affect the way you arrange your investments, today. I hope you like this look inside the beginning of Part III.

Book Excerpt:

In Part III, we take the important step of implementation. How might you actually arrange your investments to prepare for the various possible scenarios (many of which are quite ugly)?

Higher inflation rates will tend to be accompanied by higher interest rates. Higher interest rates, of course, imply lower bond prices; as bond prices fall, then the equilibrium prices of other asset classes which compete with bonds (such as, but not limited to, equities) will also be likely to fall.

You may put different weights on the probabilities of those potential outcomes than I do. But regardless of what your probability matrix looks like, there is no denying that inflation is a risk factor. It is a risk factor that is critically important in finance theory, which tends to speak of the investment problem as “maximizing the inflation-adjusted after-tax return over time.” Investors can improve on that definition, as I will show later.

Building an inflation-aware portfolio isn’t difficult, and doesn’t have to mean a wildly exotic approach. But most investors—and many investment advisers—treat inflation as such a low-probability event that there is no reason to consider it in portfolio construction. Approaches I have seen, from major brokerage houses in fact, will nod to inflation by incorporating an “inflation assumption” that is used to adjust Social Security cash flows, for example—but that is fixed at, say, 2 percent. That’s not inflation-aware; it is inflation-obtuse. Unfortunately, the answer for how you should build an inflation-aware portfolio isn’t as simple as “buy fewer bonds and more commodities,” or Part III could be much shorter than it is!

Most investors focus on the investment portfolio as a stand-alone entity. This is natural since theorists have until relatively recently focused on the trade-off between a portfolio’s risk and return. It was assumed that there was a single “optimal” portfolio that best balanced risk and return or, at best, a single curve of optimal portfolios the choice among which depended on the investor’s risk/return trade-off preference. This is why many brokers have a “model portfolio” that tracks the analysts’ recommendations, along with the recommendations of the asset allocation committee.

But the model portfolio doesn’t make any sense for many investors. Nor can most “rules of thumb,” such as the old saw that an investor should have an equity allocation equal to 120 minus his age, be universal. Aside from the obvious absurdity that it implies a 16-year-old should have a leveraged equity portfolio, with a higher-than-100 percent allocation, it would be weird indeed if by some bizarre coincidence of modern finance it just happened that the optimal allocation turned out to be linear in time. It would be like discovering that the number of people in any given room of a particular age was always 70 minus the age. Why would we expect such symmetry between unrelated quantities? Moreover, it is curious that not all authorities agree what number we should subtract our age from. It seems that more equity-minded shops recommend a higher number. I am not sure why that should be. Finally, I don’t know how that rule changes when I add asset classes. If I am considering only stocks and bonds, and the formula is 120 minus my age, then is that still the right allocation to equities if I can invest in stocks, bonds, real estate, hedge funds, commodities, and inflation-linked bonds? I am pretty sure the answer is no.

Figuring out the “right” portfolio for you is not simple, and if you are looking for simple answers you have come to the wrong place. On the other hand, if you keep reading from here, it implies you are willing to put some work into the question. The good news is that the fundamental truths about organizing your financial life are, at the end of the day, fairly simple. It is the application of those truths to your own personal situation that calls for deep introspection. Occasionally, I will be asked for some investment advice in a taxi, or in an elevator, or in some other place where a lengthy exposition is not possible. In these circumstances I have distilled everything down to “the three miracles of finance”:

1. Thrift
2. Compound interest
3. Rebalancing

Some people think that all you have to do in order to make money in the long run is to own equities, because “stocks always rise in the long run.” This is wrong, or at least is right only in the most useless of ways: If you own stocks for 40 or 50 years, then you’re reasonably likely to outperform inflation by a little bit—as long as you don’t panic when the market plunges, you reinvest your dividends, and you are not so unlucky as to invest when valuations are high and sell when valuations are low. But that isn’t a fundamental truth. There is no mathematical reason that stocks must always rise in the long run, and there are many cases that can be pointed to as examples of periods where stocks lost ground to inflation over a very long period of time. However, each of the three “miracles” I’ve listed above are mathematical certainties,1 and we will begin by talking about them in more detail.