If you’re a long term reader of this blog, you may be aware that I’m anti-investment.  It’s not so much that I’m opposed to the concept, but I do not believe any of the typical investments in the first world (roughly: stocks, investment grade bonds and real estate) are likely to fare well over the next decade or three.  If you haven’t read the linked article above, I suggest you do so – the rest of what I’m going to say here won’t make much sense if you haven’t.  Similarly, you need to understand how I use the terms “investing” and “speculating”, since there is some diversity in how they’re used and we need to be on the same page.

Now, I’m well aware that the majority of people reading this blog do not share my negative opinion on investment or have never really considered the subject.  That’s OK.  I’m not necessarily trying to convince you.  I just want to expose you to a different way of thinking about your long term financial security – one that is not dependent on the end-game performance of any financial instrument or macroeconomic factor.  That’s my personal goal.  I don’t want my family’s prosperity to be tied to stock or bond prices, the value of my home, the employment situation, the performance of rental properties etc.  If the stock market crashes 50% in the year I intend to retire, I want to be a disinterested observer.  OK, really I want to be short.  But I don’t want any such event to have a negative impact on my family’s situation.

What I’m describing is not easy to achieve.  No matter how much you might wish otherwise, at some level you’re tied to the economic state of your surrounding city, country etc.  You can’t totally de-couple from the world.  But to the extent it’s possible, I’d argue it’s an attractive goal.  It’s also legitimate to ask, if I don’t want to be exposed to the macroeconomic situation, what exposure do I want?  What risk am I willing to take in order to earn my reward?  The answer is that the risk I’m willing to be exposed to is the accuracy of my own valuation of firms, commodities, and the broad market.  But I want those valuations to be systematic rather than personal judgement – I want to take my week to week mental state out of the equation.  This series is in essence about how I’m making those valuations and then speculating on them while avoiding other types of exposure.

In order to tackle a financial goal like this, you first need a substantially positive cash flow and to eliminate unsecured and/or unreasonable rate debt.  Without free cash flow, there’s really nothing you can do but live month to month until you die and your burial becomes a burden for relatives or the state.  Thankfully this is one place where I’ve never had a problem – I’ve never taken on any debt (not even for a house) and I’ve always managed a positive cash flow.  If you have problems in these areas the internet is drowning with advice on how to get positive cash flow and pay down debt, and I see no reason to repeat it here.  It all boils down to “get a better job, work more, spend less” anyways.

Now, for the portion of the population with positive cash flow and an appropriate debt situation, the question becomes what to do with that extra cash – how do you use it to permanently improve your financial security and lifestyle?  The historic answer, of course, was investment – buy assets that earn you a positive return.  That additional income can then be used either to improve your lifestyle, or folded back into the investment scheme.  Of course, this approach falls apart when the investments perform poorly.  It doesn’t make much difference if you’re receiving a 2% dividend when the underlying capital asset loses half it’s value in 3 months – which is exactly what happened to many perfectly legitimate dividend/growth stocks in late 2008.  If my thesis linked at the beginning of this article is correct, I expect such events will be more frequent for the next 20 or so years as a result of shifting demographics in the US.

So let’s assume for a second I’m right.  If investment is a bad idea in general for the next 20 years, what should a family do with spare money?  One option is to simply place it in a pile in the living room, or do the financial equivalent and put it in a checking or savings account.  None of those are particularly attractive, however.  Even the highest yield online savings accounts yield about 1% below inflation – rather that generating additional income, you’re just subjecting yourself to a slow bleed.

Let me suggest an alternative.  What I need to achieve my goal, and what I hope interests some readers of this blog, is an “investment replacement” speculation method.  Something that works as much as possible like an investment, and yields good income, but which is not fundamentally tied to economics or demographics or the performance of any given firm.  I’ve spent a lot of time over the past five years developing such a method, and I’ve decided I’m going to share it in its entirety with you.  No fees.  No scams.  No offers to manage your money.  And certainly no promises – I can’t guarantee anything you (or I) do will make money.  Just an explanation of what I do with the cash a normal person would invest, and why.  I’ve got a modest amount of money (about $30K) tied up in this, and I intend to increase that over the next year or so as some additional capital frees up and I demonstrate that what I’m doing is successful.  I’m going to share how I generate the trades (in sufficient detail you could follow along if you so desired) and share my results.  We’ll see where it goes from there.

Before starting something like this, it makes sense to lay out a set of goals describing what I’m trying to do.

I want to develop a method of speculation that:

• is more or less continuously active.  Capital should always be at work, although possibly not always 100% utilized
• returns substantially greater than inflation (I’m targeting about 15-20% simple annual return)
• is implemented on stock-like instruments – stocks and ETFs (ie. no derivatives)
• requires intervention on my part no more than once a week, and be robust if I miss a week for some reason.
• has limited exposure – no more than +-20% exposure to the broad stock market, any one firm’s alpha, any or all commodities, or US long term rates.
• uses only US instruments
• has a worst annual draw-down of no more than 5%, typically less than 3%
• can be implemented in a standard Reg-T margin account with as little as $10K of capital
• is robust to margin calls – it should be very unlikely that a margin call could occur, and if one does, the portfolio should be laid out so that the results are not particularly troublesome.
• has as little bias in terms of direction in any market as possible – ideally it would work just as well in a bear market as in a bull market.

The speculative method will however do some things that most people used to investing might not be comfortable with:

• trade in a margin account (a regular cash brokerage account won’t work for this)
• take both long and short positions
• hedge its broad market exposure (yup, that means math)

Now, this probably seems like a pretty tall order, and it is.  There are very few funds historically that have performed this well.  But I do believe I have a set of speculative methods that collectively will achieve these goals.  It will take me several articles to lay out the details and reasoning behind the whole system, so bear with me.

Part 2 will be a dive into the market theories of Robert Shiller and the importance of valuation.  Plus of course how to use that info to make a little money.

Continued: Part 2

This article was prominently featured in Control Your Cash’s Carnival of Wealth.  Thanks!