Money Cycle – are Banks that bad for us ?

I was reading some articles recently about how terrible banks are, how they screw Joe public and cripple economies with reckless lending. I started to muse on why their actions may not really be that bad for us overall. How do we actually make money by investing ? What is the cycle of money ? (and I don’t mean the economic one with countries printing it, we passing bits pf paper about etc, but rather when we invest and into what).

All looks terribly complication … or is it ?

I think fundamentally, we could consider when we make an investment what actually happens.

Really, there are four main ways we invest in terms of invest, get a direct return back. I am just ignoring bank interest (a subset anyway, and things like direct investment in property, commodities, land etc… all subsets in essence). There is after all no end we could buy in the hope we could sell later. But very little pays a direct return to us: in essence it is all fire, forget, sell => profit or loss.

We really invest either directly (purchase of Shares or Bonds) or indirectly (purchase of funds or Crowd Funding).


Just to reflect a little about economics

Our economies grow because we (either directly or indirectly through the funds we own) lend the money somewhere. This somewhere is often via a bank or a funding house and we leave it to them to lend it out, manage the risk, manage the profit and loss, take a cut in terms of cost and then give us a small slice before lending the money out again. When our salaries goes into our banks they have free reign of that cash and can (and do) lend it out to make a return. We get a pittance (current account rates are typically less than 0.1%pa) and the banks get what they can. In one way this looks like a bad deal for joe public, but what is often forgotten, is that money is like oil in an engine: it is the lubricant that makes everything flow and it is essential we should view this lending (and pittance of return) as the price for keeping our economies flowing.

When economics go negative what really happens is that business risk goes up (as business is finding it harder to sell and institutions lend less with higher terms). As a result there is less money flowing back to us in both capital and profit. Businesses go bust so we lose capital. (I have always found it interesting that the loss is invariably passed to the initial lender (us), but these financial houses still pursue the bad debt and if they get anything it becomes theirs … odd really). As a result, banks get more twitchy about lending out and restrict the money supply…. essentially, the engine runs low of oil and runs rough. A true economic crash is when it really stops: the engine seizes…. head off & major surgery !

Economics is so much more complicated economists will tell you and very true it is. But for we private investors, it is really about the viscosity of the oil (akka money) – we care (and should only care) about the cycle of money for us. (Remember that many asset classes work in cycles and if we track them we can go heavy or light, sell out or pile in). Ultimately it will govern whether we take cash positions, low risk options, buy gold or pile into high risk emerging market choices. Understanding the major asset cycles and the state they are in within our target markets is a key job of successful PI investing…. Unless you plan to pile into a few diversified funds and just accept the higher costs and lower overall returns.

The old adage of ‘follow the money’ is so very true.


So .. back to direct & indirect choices

There is a fundamental difference between direct and indirect investing for a PI. In the graphic below a PI indirectly investing places their money with some kind of fund house or manager (centre line). In essence when the decision is made to either let someone actively manage (fund house, bank or whatever), or we select a fund all actions beyond that are out of our sight and control. They lend this money out or make purchases of holdings, collate the returns, their fees and losses and pass us what is left over. or the most part we will get our money back and a return on it. When markets really ‘correct’ these funds can take a hammering and loosing 20, 30 40 50%+ of your money in a relatively short time.

We give them the money and say ‘go get me a return’. This is not the same as fire & forget. We look at the overall balance. We seek to make an investment and get a return made up of yield (akka interest) and capital (although in the case of bonds that is not always the case and yield may be the main driver).

Just remember, a loss is only a loss if you actually take the money back out – otherwise, it is just notional paper. The big bear corrections in the last 120 years have all been followed by very health recoveries. Simply leaving investments alone can often be the best solution. Just wait 2 or 3 for a healthy real profit, and one reason why bucket-strategies suggest keeping at least 2 years of your normal needed income in low risk or cash… just for this very reason.

For direct investing, we make a choice to buy a holding or bond directly. In the above graphic that is the top and bottom paths. We accept that it could tank, we look at its history and the management teams and make a personal estimation of the risk/return balance. Indirect investing is where we make the risk/return/history/management balance on a fund management team.

We do what the fund managers job is and the advantage for us is the fees will be lower so our prospective return higher. The downside is that we cannot have access to as much up to date information so just may not be able to make any transactions quick enough to maximise profit or minimise loss.

Just consider the effect of cost on your real terms fund available. If I assume a steady return of 5.5%pa, inflation of 2% and fees of 0.4% if I self manage or 1.4% for a fund manager (all including platform costs) and look at £100,000 invested over 25 years. I get a real terms growth of between 2.1% and 3.1%.

Does not sound a lot of difference … but compounded… look at the graph.

The real terms value of my fund is 28% higher.

Both approaches work well depending upon your appetite for risk, your personal financial skills and above all the amount of time you have….. this is FIRE after all and we should be enjoying life, not being a slave to corporate reports and daily worry about returns !


There is a further path I show, that of Crowd Funding. In essence, the crowd funding platforms could be considered in an identical way to a bank: we give them money to lend out and they manage risk, return and loss giving us what is left over.

Crowd funding has grown enormously in the past decade and I have invested in 3 platforms for several years getting a nice return. There are many types ranging from ones lending to individuals as personal loans, Funding company cash requests, Funding construction etc… In essence, the Crowd Funding house is taking the place of a bank and a useful way to think of them is just that. The major difference is that regulation is still evolving (so they carry a lot of risks for us), and there is no requirement for them to hold capital reserves. Again, that is evolving as two of the houses I use have reserve funds to smooth losses

I am not going to comment on individual schemes right now (but in the future I may do a look back on the three I use and muse on their relative returns and risks).

The risks in some of the Crowd Funding platforms has also reduced as although not regulated on the whole, some can now provide ISA level investment (i.e. no tax on the return) as they have passed the UK regulatory standards.


So what have we learned ?

However much we may bitch and moan about banks, financial houses, spivs in pin-striped suits quaffing Bollinger on excessing fees extracted from us, we do actually need them to keep pumping the oil round the economy. The choice we really face, is the balance of DIY vs fire and forget. When we do it ourselves, we are effectively taking on the role of a bank lending money out. It may not seem it when buying a share as we do not directly lend to a company (we do in bonds), but what we are doing is underpinning the working capital on the balance sheet. The stronger a balance sheet the more options a company has to borrow, to invest and to plan.

For a fun and interesting life, a few DIY investments is good (I think), but just remember that FIRE is about enjoying life and not spending all day playing banker, so some funds with lower returns (because of higher fees and rebalance criteria amongst several factors) is not a bad idea.